Warning: What you're about to read will ruffle some feathers. That's not the intent - just the likely effect. And yes, there are always exceptions. The problem is, there aren't enough exceptions.
Though it started to happen in 2011, this year is the one that starts the really nasty part of a wave of patent expirations for the major pharmaceutical companies. Pfizer (NYSE:PFE), for instance, lost patent protection on Lipitor last year, while AstraZeneca plc (NYSE:AZN) is losing Seroquel in 2012. Merck's (NYSE:MRK) Singulair is on the chopping block for this year too.
The 'big deal' is the contribution these drugs make to their respective companies' top lines. As an example, around $11 billion worth of Lipitor was sold in 2010, versus Pfizer's typical annual revenue of $68 billion. Merck managed to sell $3.2 billion worth of Singulair in 2010... about 7% of its annual revenue.
You get the idea - it's going to get real tough for some of these companies real soon as generic competition starts to pop up. And, investors have correspondingly punished these companies by refusing to buy their stocks (at least not in a meaningful way).
Of course, none of this is really news; this horse has been more than adequately beaten by the media and analysts since 2010.
There's a bit of a flaw in the "pharmaceutical companies are up the creek without a pipeline" mentality though. Some of them are up the creek more so than others, while some aren't up the creek at all.
Problem? What Problem?
The criticisms of major pharmaceutical companies' R&D pipelines are often well-deserved. Big pharma rarely seems interested in - or capable of - getting most of its development efforts approved by the FDA or equivalent regulator overseas.
Take AstraZeneca's trials for ovarian cancer drug candidate olaparib as an example. Testing was halted in latter stages of its development because of a lack of a clear survival benefit. Work on its depression drug TC-5215 has also been halted due to weak results.
It's not just AstraZeneca though. Merck's MS drug was shot down by the FDA in early 2011. Bristol-Myers Squibb (NYSE:BMY) and AstraZeneca were working on a diabetes drug called dapagliflozin that was rejected last year. Breast cancer treatment Avastin, made by Genentech, was also denied in 2011.
None of it exactly screams that big pharma is getting much done on the R&D front. Yet, in many ways, it doesn't matter.
See - and this is where the premise turns into a debate - why should large pharmaceutical companies bother with the time and expense of developing their own drugs when they can buy a partially-developed drug for less than the cost (and much less risk) than developing one themselves?
Case in point: The mid-December acquisition of Adolor Corporation (ADLR) by Cubist Pharmaceuticals (NASDAQ:CBST). For $221 million, Cubist got a pretty nice pain-management portfolio, and prior ADLR shareholders saw a nice 143% jump in the share price after the acquisition was announced.
You know what Cubist bought for $221 million though? About $530 million worth of drug development ... the amount of accumulated deficit Adolor had built up as it was laying out money to complete research on ENTEREG. Adolor had swung to an $8.9 million profit (its first) in the quarter before the buyout, which was more than enough to convince a suitor that the drug had potential.
In other words, the reason Cubist was interested is clear, but the actual buyout value compared to the drug's development-cost didn't quite add up. Nice deal - Cubist actually saved about $300 million by not doing any work themselves.
Another example of "buying-is-cheaper-than-developing" comes from Merck, which opted to acquire Inspire Pharmaceuticals in the middle of last year for $430 million. At the time of the acquisition, Inspire had already poured $453 million worth of shareholders' money into the development its ophthalmic products. Not only did Inspire not actually earn anything for the success of its R&D efforts, but it didn't even get fully reimbursed for the work it had done. Merck not only got a bargain, but it abated a great deal of the risk of designing a drug from scratch.
Again, nice deal for the buyer.
Not Black & White
Before scoffing at the idea that large pharma companies are incapable of developing a drug or unwilling to), or that biotech acquisitions are ultimately unfair deals, a handful of acknowledgements ...
1. Yes, the two examples above (Merck's acquisition of Inspire, and Cubist's acquisition of Adolor) were cherry-picked extreme cases intended to make a point. Some pharmaceutical buyouts are reasonably fair, and more than profitable enough for the acquired company's owners.
Take the recent buyout of Inhibitex (NASDAQ:INHX) by Bristol-Myers Squibb for example. Though Inhibitex was mostly a development-stage company with its hepatitis C drug - the reason Bristol-Myers Squibb bought the company - it had also generated some revenue during its lifespan to keep the net accumulated deficit down to a palatable $267 million. It was still a $771 million company before BMY opted to pay $1.9 billion for it. That one clearly favored INHX owners and rewarded drug-development success. But, deals of this scope and payoff are a rarity ... not the norm
2. Yes, there's more to the story that just an accumulated deficit. This commentary isn't designed to be a complete statistician's report. It's just designed to get investors thinking about the pros and cons and potential math of buying a drug/technology versus developing one. A quick look at net deficits succinctly makes that point. .
And that point is? That buyouts are generally only 'great' for the shareholders that get in during the latest stages of development of only a handful of small biotech companies. The early funders/shareholders often see more money put into a drug than ever gotten back out of it.
So, it's not a sin for large cap pharmaceutical makers to refill pipelines with acquisitions rather than in-house R&D. Big pharma companies have big checkbooks, and it's often in the best interest of shareholders to not incur the expense and risk of developing a drug; the best fiscal decision is often simply buying companies that are in late-stage development of a key drug instead. [FYI - This has actually been going on for years. It's just more pronounced now.]
Numbers Don't Lie
If big pharmaceutical stock shareholders really knew time and expense and risk of drug development though, they may better understand why big pharma is hesitant to innovate
According to the FDA, only 70% of new drugs make it past phase I testing. Only about a third of all drugs that enter clinical trials make it past Phase II and go into phase III trials. Drugs that manage to get into phase III testing are still only about 50% proposition in terms of winning final approval. All told, roughly 20% of all NDAs ultimately are allowed to be put on the market by the FDA.
Now, those odds alone seem semi-encouraging considering what's at stake; drugs should be a little tough to bring to the market. And they are. They're not great odds, but palatable, all things considered.
What they don't tell us, however, is that only about one in fifty drugs that are tested in a pre-clinical environment ever make it into Phase I stages. Yet, this pre-clinical phase can still take years to complete, depending on the drug. And, this work can still collectively cost billions. Couple that with a one in five chance of getting a drug from phase I and successfully past phase III, and a lack of interest in self-developed pipelines is understandable.
Numbers Still Don't Lie
With all that being said, pharmaceutical investors need to keep a couple of ideas in the back of their heads, whether they're mulling large caps, or considering the small caps that seem to be developing most of the new drugs.
1. A great "non-innovating" large pharma company should have deep pockets and a history of buying smaller pharma companies and turning their preliminary work into a marketable drug. AstraZeneca is an example of one of those.
While it's headed off the same patent-expiration cliff that Merck, Pfizer, and several other Pharmaceutical companies are, there's a reason AstraZeneca plc has managed to increase earnings over the past several years while Merck and Pfizer haven't ... AZN has been making good acquisitions. It's made seventeen full and partial acquisitions since 2000, to be precise. Merck has made five in the same timeframe. Pfizer has made 49 acquisitions since 2000, which is a ton and forces one to wonder why income has been flat for so long. The answer to that question is, Pfizer has also sold 71 divisions or businesses during that timeframe.
To be fair, AstraZeneca has sold 24 units in the same period, but clearly it's holding on to more of the good ones than it's giving away ... a skill its competitors don't seem to have nailed down yet.
The proof of the pudding is in the numbers. AstraZeneca earned $1.03 per share in 2000, and has grown that figure pretty steadily every year since. For the past twelve months, the company has earned $7.28 per share. That's in sharp contrast with Merck, which earned $2.81 per share in 200, but has only earned $1.36 per share in the past four quarters. Pfizer has tepidly grown earning from $0.59 per share in 2000 to $1.27 over the past twelve months, but that income growth has been stagnant since 2004.
It would be wrong to say the reason for the disparity is 100% attributable to better pipeline and acquisition management, but it's got a lot to do with it.
2. Second, most drugs being developed by small cap companies will never see the light of day; their publicly-traded companies won't fare much better, especially if they're one-trick ponies
So why all the chatter about breakthrough drugs? Why does the media love to tout success stories? Because nothing draws a crowd like a dream come true; failure is boring.
Think about it like this - when someone wins a multi-million jackpot in a lottery, the media swarms the winner, yet doesn't even acknowledge that millions of people didn't win that same jackpot. Losing is a non-event, since it doesn't change the status quo.
In the same vein, even a drug that has the potential to be a biotech jackpot winner (a breakthrough blockbuster drug) gets investors and the media into a frenzy. Shutting down the development of a drug for weak results doesn't have the opposite effect, however, even though that's the ultimate outcome for most new drug candidates.
3. Third, while biotech M&A gets more than its fair share of attention, many of the game-changing acquisitions aren't buyouts of U.S. publicly traded companies - they're buyouts of privately-held organizations, small, and foreign companies most American investors have rarely if ever heard of. It's one more reason why gambling on a small publicly-traded biotech name isn't statistically a high-payoff decision.
There are an alarming number of examples of this too. A year ago, Amgen (NASDAQ:AMGN) had its pick of several publicly-traded companies working on a head and neck cancer treatment. It chose to acquire privately-held BioVex Group, paying $1 billion for (primarily) a drug called OncoVEX ... a phase III therapy for advanced melanoma and head/neck cancer. Most investors have never heard of the drug or the company, though a closer look at it reveals it's a frontrunner in the race. Stock traders never even had a chance to play it, though it could be a very big deal for its new owner.
And it's not just BioVex. Stryker Corporation (NYSE:SYK) bought privately-held Concentric Medical in August of last year, looking to nab its technology for the treatment of acute ischemic stroke (AIS). Alexion Pharmaceuticals (NASDAQ:ALXN) is paying $1 billion for privately-held Enobia Pharma in order to get its hands on its fast-tracked phase II candidate ENB-0040 (asfotase alfa), for the treatment of hypophosphatasia (HPP). The list of privately-held buyouts goes on and on.
To be clear again, there are always exceptions to the norm, and the '1 in 100' scenario does occasionally make millionaires out of a few lucky investors. For the rest of us though, we shouldn't necessarily complain that large cap pharmaceutical makers have weak pipelines. We should thank them for having the cash to buy good pipelines and the brains to turn a compelling drug into a franchise.
Let 'er rip.