Morgan Stanley Recommends Pharma Cut Research March 12, 2010
After a decade of “dismal internal R&D returns,” Morgan Stanley says it expects “material cuts to internal small molecule research spend in2010/11” and a reallocation of capital to in-licensing and other non-pharma assets. The investment group says it expects AstraZeneca and sanofi to be among the leaders in externalizing research.
Why should pharma exit internal research?
In a late January report by its European research group, Morgan Stanley cites several reasons for sharp reductions in return on invested capital (ROIC) for internal R&D:
• Cost per successful drug has risen ten-fold in real terms since 1980 from $150 million to approximately $2 billion in 2009.
• New drug approvals have not kept pace with rising R&D spend.
• Regulatory hurdles for new drugs are higher and periods of economic return are shorter.
• Increasing time (on average 10-15 years) and cost of drug development has driven invested capital higher.
• About 40% of R&D spend is pre-phase II, where attrition rates are very high (probability of reaching the market is less than 10%).
Morgan Stanley calculates that reinvestment of internal research savings into in-licensing will yield three times the likely return. The downside risk for pharmas in in-licensing deals is currently materially lower, the group explains, than for internally developed drugs.
Research by Morgan Stanley indicates that unless the probability of an in-house molecule reaching the market is 25% or more, the risk adjusted Economic Value Added is three times higher under the external research model, with a greater predictability. Considering current market economics, the group recommends that the industry should reallocate the bulk of small molecule research invested capital to in-license external assets post phase IIa, especially in therapeutic areas with high attrition rates (i.e. gastrointestinal, CNS, cardiovascular and respiratory).
And it reports that` the current quality and variety of third-party discovery and research assets and services makes externalization of small molecule R&D “a real option with highly attractive economics.” Morgan Stanley’s research team predicts that pharma companies under greater earnings and valuation pressure and with changes in R&D leadership are likely to be the first to shrink internal research.
“The ongoing restructuring of R&D teams along therapeutic areas together with the departure of a generation of senior R&D managers, in our view, facilitates accelerated moves to reduce internal discovery and research and reallocate capital towards external opportunities with higher ROIC,” the authors note. “Reallocating small molecule research spend to licensing could triple the number of new drugs reaching the market every year, and would increase net present value by an average of c.19% for large cap pharma, on our estimates.”
And the group says its estimate of the uptick in new drugs reaching the market could be too conservative, since it assumes the attrition rate for in-licensed compounds is comparable with in-house agents. But Morgan Stanley believes analysis from the period 1981-2003 suggests that in-licensed agents have a two to three times higher probability of commercialization than internally developed molecules.
Why has internal research failed to deliver?
Morgan Stanley suggests that the adoption of discovery tools such as high throughput screening and combinatorial chemistry clearly have not industrialized the R&D process as it was once thought they would. “We agree with Sir James Black that drug discovery depends far more on scientists with great noses rather than the ability to screen many more drugs more quickly,” the authors say.
And the group believes the centralization of research by the industry into centers of excellence has stymied diversity and original thought, rather than enhanced it. In addition, they say “the easy commercialization wins of line extensions have diverted intellectual and financial support away from truly innovative value-added research.”
Why hasn’t the shift happened sooner?
The authors say with R&D viewed as a core pharma competency, inertia and historical legacy have played a part. Concerns have included: losing optionality, the need to invest in new platforms, potential negative implications for reimbursement and taxation ,and a feared scarcity of attractive, fairly priced external candidates.
But Morgan Stanley’s research team believes pharmas should replace “research and development” with “search and development.” The transition will mean significant but manageable change, including meaningful downsizing of current research infrastructure, demand for new skill sets and careful negotiations with governments over tax subsidies and intellectual property.
“The shift away from in-house research investment simply redefines the core competence of major pharma as late-stage development and commercialization, where the industry has, until late, had an impressive record,” the authors say.
Pharma will need more skilled translational medicine scientists within its business development and licensing divisions, the group says. They anticipate that companies will increasingly seek to build BD&L competence by transitioning research scientists to commercial externalization functions.
“BD&L teams are typically less than 100 compared to more than 700 for internal research teams,” the researchers note. “We think this ratio could easily reverse in a scenario in which the BD&L team not only sources products, but also champions their progress once in-licensed.”
Source: Lisa Roner, founder and editor, Pharma Philos
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