With the major pharmaceuticals companies facing up to a bloated cost structure and the legacy of two decades of underinvestment, the biotechnology industry is more or less guaranteed to outgrow the big drugs firms because of it structure.
Last year was awful for big pharma, with big US companies lagging the S&P500 by 28%. This has left the sector trading at the cheapest it has been relative to the market as a whole in 10 years. This is not a temporary affair. It is the result of big pharma focusing on marketing at the expense of developing new drugs. The number of new drugs approved in 2004 is about the same as in 1985. Yet the cost base has grown sharply over this time. The average big pharma company now spends about 32% of its budget on sales and marketing, roughly the same as companies selling soda or candy.
Luckily for biotech companies, the pressures on big pharma either have little effect or may even be beneficial for them. And the market’s differing reactions to the two sectors last year reflects this. Big drugs stocks ended 2004 down 7%; biotech stocks rose by 12%.
More, better executed R&D
There are several reasons for this. First, not only do biotech companies spend proportionally far more on R&D; in addition their money appears to be better spent. Pfizer’s $7 billion R&D budget is 10 times the size of Genentech’s but the smaller company has had more success in introducing profitable drugs over the past few years. And this isn’t exceptional. Of the drugs approved in 2004, more originated in biotech labs than in the labs of big pharma.
What’s more, the benefits of being small actually seem to be rising as medicine moves towards tailoring drugs for individual patients. This means lots of small but high-margin markets. This is the opposite of the big pharma model of large sales forces pushing a few drugs at a lot of people. And niche drugs have other benefits besides.
In 2003 biotech Genzyme received US approval for its niche drug Fabrazyme for patients with a rare genetic condition called Fabry’s disease after testing it on 29 patients. In contrast, big pharma trials now routinely use 40,000 or more patients. Big trials are both more expensive to run and take longer to finish. This means a shorter time on the market with patent protection. Granted, the markets for niche drugs are smaller – Fabrazyme will probably peak at about $500 million in annual sales, while many cardiovascular drugs sell over $3 billion a year – but the relative cost seems to favour smaller trials.
Furthermore, niche drugs tend to be resistant to increasing price pressures. Huge markets attract multiple entrants, niche markets don’t. And niche drugs often make a larger difference in both quality and length of life, making it harder for payers to quibble over price. Fabrazyme, for example, costs about $275,000 per patient, per year.
And focusing on life-threatening conditions means that even serious side effects are tolerable. For example, the finding that Genentech’s new cancer drug Avastin increases the risk of heart attack has barely dented sales. A similar increase in risk killed big pharma Merck’s painkiller Vioxx.
Big pharma’s drought of drugs has raised the value of biotech pipelines. In addition to substantial royalty payments, it now costs on average $30 million in hard cash and research funding and $140 million in conditional progress payments to buy the rights to a drug close to market according to boutique investment bank Recombinant Capital. The cash component has more than doubled over the past five years, while the milestone payments have increased more than seven-fold.
Royalty payments also appear to be climbing. Given the decade-long lead time typical of drug development and pharma’s dry pipelines, this may continue for years.
And growth for the industry backs up this point. Sales and profitability are expected to increase by 20% this year. And no longer are all biotech companies tiny tiddlers. Amgen is now the sixth-biggest drug company by market capitalization in the world. One can expect a few of its brethren to join it over the next few years.
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