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Today's research and development [R&D] is tomorrow's new product or process. The other day we (or more specifically, Phil Fisher) asked, "Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?"

The goal of R&D is to produce new products, services, or processes that will "still further increase total sales potentials" for the company. Not an easy question to answer, Fisher asks:

How effective are the company's research and development efforts in relation to its size?

This is very much an industry-specific question with a near-unanswerable solution — one of the reasons there is so much art (versus pure science) in investing. Since both annual sales (revenue) and research and development expenses are published on financial statements, it's fairly easy to come up with a mathematical answer by dividing R&D by total sales to see how much the company and its competitors spend each year.

Remember: The value of a company lies entirely in the future. The past does little more than offer insight into how the business has performed under various conditions. Still, we can look to the past to help us see into the future. So, let's look at the above formula applied to a few companies. First, however, we qualify this discussion with Fisher:

Figures of this sort can prove a crude yardstick that may give a worthwhile hint that one company is doing an abnormal amount of research or another not nearly enough. But unless a great deal of further knowledge is obtained, such figures can be misleading.

Pfizer vs. Glaxo vs. Lilly

Ignoring dollar amounts for now, let's compare the percentage of R&D spending at three of the industry's major players. From 2000 to 2007, sales at Pfizer (NYSE:PFE) grew some 62% compared to 51% for Eli Lilly and 17% for Glaxo (NYSE:GSK). Pfizer had the best gross margin — 83% — versus about 79% for the other two. In essence, Pfizer had a lower cost of goods sold which helped convert more sales into cash.

Of that after-sales cash, Pfizer spent about 19% on R&D versus 18% for Glaxo. Lilly (NYSE:LLY) was the clear winner on a percentage basis, spending about 24% of its gross profit margin on research and development.

As a percentage of sales, Lilly is spending the most on R&D — about 19% of gross sales and 24% of gross profits versus 15% of gross sales and about 18%-19% of gross profits for Pfizer and Glaxo.

R&D Growth

But who has been spending more and more in an effort to increase product lines? Over the past eight years, Pfizer's R&D spending has increased about 72% — ten points more than sales. Lilly has increased R&D about 60%, or nine points more than its sales growth. Glaxo comes in with a 28% increase, a full eleven points above its sales increases.

On a percentage basis, Glaxo has been ramping up R&D the fastest (in relation to sales), Lilly spends the largest portion of its gross margin on R&D, and Pfizer has been ramping up R&D the fastest on an overall, absolute basis.

So, Let's Try to Answer the Question

How effective are the company's research and development efforts in relation to its size?

For the four full years from the beginning of 2000 through the end of 2003, Glaxo spent £10.9 billion (US $21.5 billion) in R&D, which translated into £6.7 billion (US $13.3 billion) in additional sales from 2004 through 2007.

During that time, Lilly spent $8.8 billion on R&D which resulted in $16.8 billion in additional sales from 2004 through 2007. Pfizer spent $22 billion in R&D and generated an additional $58 billion in sales.

You can't look at these as a dollar-for-dollar translation; rather, focus on the results. They all have brilliant teams working long hours trying to develop the next blockbuster drug. Pfizer spent the most on an absolute dollar basis and enjoyed the greatest sales growth. Based on sales, Glaxo and Pfizer are roughly the same size. But Pfizer spends 17% (or $1.2 billion) more on R&D. Assuming researchers at both Glaxo and Pfizer are equally as smart, Pfizer is giving itself a better chance at developing a new wonderdrug and giving investors a better chance of benefiting from a new revenue stream.

But let's not ignore Eli Lilly. With R&D spending of $3.2 billion a year — less than the other two, but still a full 20% of sales — Lilly is spending as much as it can to compete with its larger rivals.

Which Looks Best?

Out of the three choices, it's a toss up between Pfizer and Lilly. In relation to its size, Lilly is spending the most on R&D. On the flip size, Pfizer is spending a comparable amount, but much more on an absolute dollar basis.

Then again, it's research and development. With a much smaller budget, a tiny competitor can develop (or even stumble across) a wonderdrug and beat Glaxo, Pfizer, and Lilly to market. In that case, the money spent by the big boys on that particular drug is largely wasted. This is why the breadth and depth of the pipeline is so critical.

(For that and other reasons, a company like Amylin — with just $270 million in R&D and four drugs in the pipeline — are so speculative. If any or all of them fail or are beat to market, Amylin has to start from scratch.)

Think Outside The Pillbox

Looking at pharmaceuticals right now? Why not include TEVA in your research? While all the big boys are spending crazy money on R&D, hoping to develop the next wonderdrug and beat everyone else to market, TEVA sits back and scans the patent database to see when blockbuster patents are expiring. Then, it simply cranks out a generic and starts raking in the dough.

While Pfizer frets over its Lipitor patent, TEVA is licking its chops. Reverse engineering a drug to make a generic is nowhere near as expensive as the R&D required to create a new drug, as can be seen by TEVA's relatively small R&D expenses. And since the Lipitor brand and results will be well known and documented, TEVA will have little to do but slap a label on a bottle and blow some money on marketing — and probably less than Pfizer will have to spend to try and keep its Lipitor market share.

How effective are the company's research and development efforts in relation to its size?

When a major patent expires, you are rolling the dice, betting on which big pharma will have the next blockbuster. All the while, companies like TEVA are piggybacking big pharma's R&D spending, without all the failures. To answer Fisher's question above, I'd have to rank TEVA first, followed by a Pfizer and Lilly tie for second, with Glaxo coming in fourth.

Source: What's Happening in Research and Development?