Investing in R&D – two tacks

It would be easy to take a superficial read of this recent Wall Street Journal story about Pfizer versus Merck. Pfizer’s new CEO announces he will cut R&D spending and the stock goes up. Merck’s new CEO announces no cuts in R&D and the stock drops. The easy read: “Wall Street doesn’t get it.”
But the reality is much more complicated and sophisticated. It is really about who should pay for and take the risks of research. As the story points out:

Underlying the divergence is a deep-seated philosophical dispute over the merits of the heavy investment that companies must make to discover new drugs. By most estimates, bringing a new molecule to market costs drug makers more than $1 billion. Industry officials have been engaged in a vigorous debate over whether the investment is worth it, or whether they should leave it to others whose work they can acquire or license after a demonstration of strong potential.

In other words, big pharma is trying out different strategies: path-breaking innovator, fast-follower or (as the generics play the game) efficient mass producer.
On top of the strategic shift, the process of R&D has changed. Following on a trend that has been going on for decades, companies are shifting more and more to outside research. In the era of the Bell Labs, companies did their own research — both basic and applied. But the industrial giants long ago closed down their big basic research labs. Now more companies are moving to an open innovation model where innovations come from outside.
With these changes, the issue shifts to where will the research funding come from. At one point, it looked like there was a pharma-biotech division of labor. Start-up bio-tech firms with VC and other high-risk capital would fund the research and sell the results to the pharma companies who would use their larger capital base to implement the results. But even that implementation is risky and requires a great deal of R&D funding (heavy on the D-side). It looks like some companies are no longer willing to bear that risk.
So the question remains, where will the funding for the research come from? Some new models may be emerging — mostly to tackle the “orphan drug” problem (those drugs for specialized diseases where the total market does not appear to be able to cover the costs of drug’s development). As big pharma sorts through its R&D strategies, look for new models to emerge.

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