Is outsourcing the prescription for Pfizer?

The battered pharma giant wants to buy up new ideas from smaller, more nimble firms. But that strategy carries its own risks, argues Fortune's John Simons.

By John Simons, Fortune writer

SILVER SPRING (Fortune) -- With the failure of torcetripib behind it, Pfizer is now likely to play to its strengths to add more medicines to its pipeline.

No, that strength isn't research, even though Pfizer (Charts) spends some $7.5 billion a year developing new drugs. It's using the company's enormous cash pile to acquire promising medicines from smaller, more innovative drugmakers. The question is: Is relying on outside innovation a viable long-term strategy?

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In the last half decade, as Big Pharma labs have discovered fewer and fewer new medicines in their own labs, large companies have been buying a growing proportion of their new drugs from smaller, more innovative drug firms and biotechs. As they do, there's a quiet debate in Big Pharma about whether large drug companies can - or should - permanently morph into more "virtual" operations, primarily by moving out of basic, early-stage research and focusing mainly on things they are clearly better at: later-stage development, regulatory maneuvering, manufacturing, sales, marketing and distribution.

Outsourcing brainpower

The core argument for this strategy? Big Pharma can jettison the incredibly high risk of early clinical research out of their operations. Pfizer has been effectively doing this for a number of years. Smaller companies are discovering more and more of Pfizer's new medicines. Of the six medicines Pfizer submitted for FDA approval in the last year, three were the products of non-Pfizer brainpower.

All the industry's top companies are doing the same. Of the nine drugs Eli Lilly has launched since 2000, for instance, five were discovered in-house, one was discovered jointly with a collaborator, and three are discoveries from outside. According to market research firm, Datamonitor, in-licensed products represent nearly 20 percent of Big Pharma sales today, and will grow to 26 percent over the next four years.

Pfizer, Merck (Charts), Eli Lilly (Charts) and others have already developed adept in-house portfolio management teams to identify opportunities in smaller companies' pipelines. "True strategic outsourcing of early research has to be the model for the future," says Kenneth Kaitin, director of the Tufts Center for the Study of Drug Development. "The output of the industry just isn't keeping up with the demands of investors."

Indeed, large investors have come to expect that companies spend to get what they can't create. In early November, a group of major AstraZeneca (Charts) shareholders publicly demanded that the company use its $4 billion cash pile to make acquisitions that will fill gaps in the company's weak pipeline.

Some experts argue that companies would be wise to cut most early-stage research projects and transfer that money to outside deal-making. "Today, drug companies are double-spending in R&D. They're spending internally, but because of their productivity problems - caused by their size - they need to purchase outside projects. Why pay for both?" asks Roger Longman, a partner with Windhover Information Inc., a Connecticut-based healthcare market research firm.

Drug company or portfolio manager?

Of course there are downsides. Some experts argue that while small acquisitions and in-licensing deals might temporarily fill gaps in Pfizer's planned medicinal offerings, as a long-term strategy, it would be more costly - both financially and politically - than fixing its own research operations.

One reason is that competition for small company discoveries is becoming brisk, and prices are rising. According to market research firm Wood Mackenzie, the cost of royalties and related payments for an average in-licensed drug five years ago was $44 million. Today, it is $373 million. Also, notes Derek Lowe, a research scientist at Bayer Labs who has helped his company screen deals, "there's not enough out there to in-license to keep a reasonable pipeline going."

Besides, says Patricia Danzon, professor at Healthcare Management at the Wharton School, "When I invest in a drug company, I'm investing in research, not portfolio management. Being a strong discovery company is a much better route to offering competitive returns."

And that kind of perception could have broader repercussions. Big Pharma companies have long been able to hold off political cries for cheap drugs in part because of their claim to be medical research businesses, ultimately toiling for the public good. But, if at some point it becomes clear that they are nothing more than portfolio management companies, merely in the business of buying and selling research operations, they may have to kiss their high margins - and laissez faire treatment from Washington - goodbye.

So how do drug companies regain their growth? Certainly, before Big Pharma can be a viable investment again, it needs to borrow not just medicines from small companies but the spirit of innovation.

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