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DBL%20Hendrix%20small.png College chemistry, 1983

Derek Lowe The 2002 Model

Dbl%20new%20portrait%20B%26W.png After 10 years of blogging. . .

Derek Lowe, an Arkansan by birth, got his BA from Hendrix College and his PhD in organic chemistry from Duke before spending time in Germany on a Humboldt Fellowship on his post-doc. He's worked for several major pharmaceutical companies since 1989 on drug discovery projects against schizophrenia, Alzheimer's, diabetes, osteoporosis and other diseases. To contact Derek email him directly: derekb.lowe@gmail.com Twitter: Dereklowe

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February 5, 2010

Sheer Economics: How We Got in This Fix

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Posted by Derek

I hate to do another post on this subject, after a good part of the week has been devoted to layoff news and the like, but this one is too much to ignore. A reader sent along this link, which quotes a Morgan Stanley appraisal of the pharma industry as an investment. Here's what they're telling their clients:

". . .Still significant value in Pharma - we see material upside to ROIC [return on invested capital], earnings and multiples as Pharma withdraws from most internal small-molecule research and reallocates capital to in-licensing and other non-pharma assets. Worsening generic pressure and R&D management changes lead us to expect material cuts to internal small research spend (~40% total R&D) in 2010/11, after a decade of dismal internal R&D returns. We expect AstraZeneca and Sanofi-Aventis to be among the leaders in externalizing research, and this is a key driver of our upgrade of AstraZeneca today to Overweight.

Reinvestment of internal research savings into in-licensing will yield three times the likely return, we calculate. Under in-licensing deals, downside risk for pharma companies is currently materially lower than for internally developed drugs. Although upside is also capped by pay-aways and milestone obligations, the net present value of these payments is more than offset by the lower risk-adjusted invested capital. Over one-third of pharma R&D spend is in pre-phase II, where the probability of reaching the market is <10%. our proprietary analysis indicates that, unless the probability of an in-house molecule reaching the market is 30% or more, the risk-adjusted economic value added, or eva, is three times higher under the external research model, with a greater predictability."

It could be said in fewer words, but it's all there. If you're looking for the reason the big companies are doing what they're doing, look no further. Agree with it or not, there's a case to be made - and there's Morgan Stanley, making it - that the cost of running new drug projects in big pharma is just too high relative to the risks of failure. Those returns, in fact, are calculated to be off by a factor of three.

You may not believe that factor, and I have to say, I found it hard to believe myself. But let's say the Morgan Stanley folks have their numbers off. Perhaps it's only twice as profitable to bring in outside drugs as it is to develop them internally. Don't believe that one, either? Maybe it's only 25% more profitable - can you imagine making a move that would increase your company's return on investment by 25%? Industries get remade by such changes at the margin, and this one is remaking ours. Why do we have any internal R&D left at all, if those figures are anywhere near right?

Well, no one's tried to run a large company entirely by in-licensing, and I think that there are a lot of reasons why that wouldn't work. (For one thing, I don't think that there are enough things to in-license, and if one or more large companies announced that they were doing that exclusively, the price of each deal would go right up). And there needs to be some internal expertise left, if only to evaluate those external drug candidates to make sure you're not being taken. But still. All this means is that internal R&D will stay around, but it has to get cheaper and will very likely get smaller.

We can argue about the assumptions behind all this, but there's no doubt that a compelling business case can be made for this world view. Anyone who wants to argue differently - and a lot of us do - will have to come up with solid numbers and reasoning for why it just ain't so. I'm not sure such numbers exist.

There are many corollaries to this line of thought. One of them - and I hate to bring this up, considering all the horrible layoff news recently - is that one of the most psychologically comforting theories that we in R&D have for our present fix is likely wrong. I refer to the "Evil Clueless MBA CEO" theory, which has its satisfactions, but is a hazardous way to think. It is always dangerous to assume that people who do things you disagree with are doing them because they're just idiots or because they're innately malicious. In general, I'd say that the first explanation to jettison is malice, followed by stupidity (Hanlon's Razor). What that leaves you with is that these actions, stupid and malicious though they may appear, are probably being done for reasons that appear valid to the people doing them. I know, I know - some of these reasons are things like "So I can keep my high-paying CEO job", and we can't ignore that one. But a good way to lose a high-paying CEO job is to try to tell your board of directors (and your shareholders) why you're going to pass up an opportunity to get three times your ROIC.

Another thing to think about is, if these cost estimates are right, how did we get here? The best reason I can think of for such a disparity is that small companies (the source of these in-licensed drugs and projects) are often betting their entire existence on these ideas. They are very strongly motivated to do whatever they can do to get them to work (sometimes a bit too motivated, but that risk is already factored in), and if things don't pan out, they usually disappear. Basically, the in-licensing world unloads the risk from the large pharma company (and its shareholders) onto the investors in the smaller ones. The cost disparity will exist for as long as people are willing to back smaller companies. Now, this isn't to say that the big companies are always going to do a great job picking what to bring in. We've been talking a lot, for example, about the GSK-Sirtris deal, and that one may or may not work out. But the idea of doing big in-licensing deals in general - that's a different story, no matter how any individual company manages to execute it.

What that also means is that more of us are going to end up working for those smaller companies (which is something that I, and several commenters around here, have been saying for a while). If the large pharma outfits are going to devote more money to in-licensing, there will then be more opportunities for people developing things for them to in-license. The rough part is that all these structural changes in the drug industry are taking place (largely by coincidence, I think) during economic conditions which make funding such companies difficult.

And then there's the internal cost-cutting, for the R&D that's actually staying at the big companies. That, of course, generally means sending a lot of it to China, or wherever else it can be done more cheaply. And that's going to continue as long as it can indeed be done more cheaply, which means "not forever". Costs are already rising in China and India, although they have a good ways to go before they catch up to the US and Europe. I know that we can argue about how well that whole idea is going to work - there are clearly inefficiencies to doing a lot of your work through outsourcing, but as long as those don't eat up all the cost savings, it's still going to keep happening.

This, as a side note, is why I think that one of the suggestions that gets floated here in the comments from time to time, the idea of forming a "medicinal chemist's union", is completely useless. Unions form when workers have the leverage to preserve a higher-cost business model. In the end, the big industrial concerns of the early 20th century had to have workers, and they had to have them in certain locations, so the unions always had the threat of going on strike. At attempt to lower the boom under these conditions would result in everything going to China, and damned quickly.

So. . .what's happening to us, and to our industry, is not really mysterious. Our cost structure does not look to be supportable, and since there are cheaper alternatives that appear to be feasible, those will get tried. The disruption and destruction that all this is causing is real, of course. But the best I can offer is to try to understand what's driving all this upheaval, because that might help people to figure out how to protect their own jobs or where to jump next. Everyone has to give this some serious thought, because I don't see any reason why all this won't keep going on for some time to come.

Comments (109) + TrackBacks (0) | Category: Business and Markets | Drug Industry History


COMMENTS

1. David P on February 5, 2010 11:08 AM writes...

Excellent analysis, Derek.

A colleague of mine recently speculated that Big Pharma would coalesce into about 4 companies and that they would pick and choose over the individual projects that small companies develop. This Morgan Stanley piece makes it look like it is moving that way even quicker than he thought.

On the plus side, I tend to prefer working in a smaller company (better work environment, despite lower salary/benefits), which will be handy if I want to continue in drug discovery.

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2. J-bone on February 5, 2010 11:09 AM writes...

I don't imagine you will make too many friends with this entry.

As a new postdoc I'm left wondering what scraps will be available for me when I finish. I hadn't planned on even doing a postdoc when I entered grad school, it just ended up being a necessity when the economy bottomed out. Now it looks as if I may end up having to do ANOTHER postdoc while job opportunities slowly emerge from the ashes.

Although I have experience in pharma and fond memories of it, I am open to suggestions about alternative fields where I might apply my trade.

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3. John FitzGibbon on February 5, 2010 11:09 AM writes...

So
This is an issue I've been thinking about for a while. Is a career in this model more or less attractive for scientists? While big pharma has it's drawbacks it has (at least in the past and I mean no disrespect to the people who are feeling the cuts right now) been fairly stable as a career. Whereas if one were to work in small companies with finite lifespans you have what I would perceive to be less stability, searching for a new job every five years or so. It's not something that really appeals to me.

All I'm saying is that there are already a lot of obstacles to becoming a research scientist, grad school is long and while many of your friends are buying houses and starting families you're sitting in lab on labor day running the longest column of your life. Then there's post docs, and I've seen 5 year post docs easy. Then you step out of that into a situation where you're not really stable? Is this going to push people away from science? I mean I already feel academia is doing that with the way it is. If the best and brightest are to choose this as a career there in some ways have to be other possible motivations than just love of science. Economic and family stability are things that a lot of people are looking for in life and I just can't see the pharma industry providing it now or in the future.

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4. Dave on February 5, 2010 11:13 AM writes...

Derek,

Been a follower of yours both online and in Chemistry World for several years and I have to thank you once again.

As a still wet behind the ears chemist, I had dreams of finishing my PhD and heading into big pharma to make a real difference. As I "ride out the recession" (or so I tell myself) in a postdoc position (med chem) I have appreciated yours, and regular posters to this blog, insights into what's REALLY going on in big pharma. I don't want to join a company that does clinical trials and paperwork, I want to take the incredibly small chance that someday I'll make the drug that cures cancer/HIV/TB (take your pick).

Is it wrong though to expect to achieve this with some modicum of job security? You expect me to believe that in China they have life-long contracts in their biotech companies? Do these economists put a price on such a simple commodity as loyalty? Or should I accept that mine will be the life of a wild rover until, footsore and weary, I finally tire of the travellers life and settle down to any old job. No matter what the number crunchers say, that model of life just can't be right and surely there are arguments that settled workers are more productive? I would hope so.

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5. darwin on February 5, 2010 11:13 AM writes...

I am going out to open a Chrysler dealership

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6. Nick on February 5, 2010 11:17 AM writes...

So if the risks of internal R&D are so high relative to in-licensing, then how did we get to the current (now deteriorating) model of big pharma companies with internal R&D pipelines? Must one assume that the success ratio of R&D used to be higher? Is this current collapse entirely mediated by the exhaustion of low-hanging fruit and the shabby state of ladders to get us up to the higher branches? If so, then who, in this brave new world, is the giraffe?

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7. anonymous on February 5, 2010 11:23 AM writes...

The Morgan Stanley appraisal is essentially the rationale GSK Sr. management have given for the lastest round of layoffs and divestiture from the NS therapeutic area- that the risk/ROIC does not justify the significant level of financial investment, particulary compared to a better ROIC/ risk profile with consumer healthcare products. Although the margins are lower, ROIC looks better for toothpaste, nutritional products, etc that depression compounds.

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8. paul on February 5, 2010 11:23 AM writes...

There already is a med chemist union... it's those with a PhD. rather hard for anyone without one to move up in pharma research; it creates a barrier to entry that artificially increases cost of labor.

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9. cookingwithsolvents on February 5, 2010 11:28 AM writes...

Would someone with experience in the big pharma / start up be able to comment on the possibility of "loosing" more potential drug candidates to poorly run small companies just not getting the science done (well)? Is this a real possibility/fear? Certainly size buffers on against a bad decision which could easily sink a small company and a big R&D department allows more chances that the "right" person thinks hard about a crucial part of developing the drug.

This certainly falls into the realm of "there is no data for that". Anecdotes? Thoughts? I'm curious. . .

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10. J-bone on February 5, 2010 11:28 AM writes...

Paul, you'll be happy to know that many big companies have dropped the axe on Ph.D's (usually first to go due to salary) and dissolved the barrier that once existed between BS and Ph.D.

Back when I worked in pharma if I was looking for a job I skipped over everything titled "Scientist" because I knew it was for someone with a Ph.D. Now most of those same entries are looking for someone with a BS and 5 years of experience. Makes me wonder what I could be doing if I had continued with my previous company rather than go to grad school.

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11. PharmaHeretic on February 5, 2010 11:29 AM writes...

But how sound is the business model of financial institutions for them to preach fiscal sanity to others?

They are just publicly funded ponzi schemes, and therefore have no right to preach fiscal responsibilty.

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12. Hap on February 5, 2010 11:32 AM writes...

Outsourcing, though, works (among other things) by lowering the labor costs - and while that can happen for a while, at some point (unless there is some sort of intervention) labor costs will balance - wages in China for drug dev people are supposed to be increasing, for example, and if the jobs in pharma end up mostly being lower-paying and riskier small company jobs, the assumption would be that people will migrate to fields where they can get paid more (or more certainly), which will eventually force either labor costs higher (because there are fewer people) or force further outsourcing (which would increase labor costs elsewhere). There's also the issue of relative productivity, which this doesn't address (but, I think, whose resolution is not clear).

If outsourcing is mitigating early risks to smaller external companies, then won't companies simply demand more for their candidates, knowing that their potential purchasers have none of their own to support their business? Outsourcing also can't mitigate the expensive late-stage risks which seem to be the source of the cost issues (and which are, presumably, squarely in the niche that larger pharmas hope to secure for themselves), and outsourcing earlier risks will likely mean that risks will be pushed later (because, small companies have a large incentive to sell candidates, whether or not they may succeed in the long run, and unless diligence is good, larger companies will buy them and advance them to failure).

None of the benefits of outsourcing seem to be long-term ones (except, perhaps, the development of expanding markets, but that doesn't depend on outsourcing drug research, but on their general economic development). The method of outsourcing only mitigates those risks in the short-term (which, granted, is a requirement to reach the long-term) but does not solve them. It also creates problems for the long-term - for example, pushing people away from fields which require lots of learning to enter such as the sciences, for fields which either pay more or offer more situational flexibility (if my ability to get another job is my only security, then mastering a narrow field doesn't help me). If the ability to produce useful things and ideas is important, then basing an economy on the ability to manipulate things and money while devaluing the ability to generate the ideas and things to be manipulated seems to be damaging to our country's or society's long-term survival.

The incentives to outsource seems to be short-term cost cutting and not long-term company viability. The structure of executive pay (which seems to be fueled by low-cost stock options and direct pay, neither of which depend much on a company's short- or long-term successes) lead to the "MBAs are killing us" theory of pharmaceutical failure - people behave according to their incentives, and if their incentives make short-term benefits trump all else, well, then management will behave accordingly. I think, though, that pretending that outsourcing solves pharma's money problems is a management person's (or financier's) fantasy.

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13. g on February 5, 2010 11:35 AM writes...

It seems fairly obvious that this is not some cyclical downturn, but rather a fundamental restructuring. Morgan Stanley is saying that big pharma will become conglomerates, where they buy up mid-sized and startup companies.

The business model for these small companies is quickly becoming one where they madly rush to develop a drug, layoff everyone so they can pay for clinical trials, and then hope they can hold on long enough to show good Phase I and early Phase II data to get bought up.

Big pharma will hold the purse strings and will be the feudal lords and everyone else will be the lowly serfs doing the work for their daily bread. With the consolidation of big pharma, prices for buying drugs/companies will go up in the short term. But long term, I am betting on implicit collusion between the 3-5 remaining companies to push prices down. End result for scientists doesn't seem good-no job stability, downward pressures on compensation, and little likelihood for being around for the big payouts. eeep!

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14. LargerVier on February 5, 2010 11:42 AM writes...

Well said Derek. Also, the portrayal of the industry as “villainous capitalist” by governments and their doting media lapdogs have helped catalyze this industry’s reorganization with increased pressure on pricing. Although in the short term, capital will be hard to find to support new drug company startups, over the long term, more VCs will be lured in by the potential of huge returns.

It seems this will have a negative impact on the pipeline over the short term, but level out over the long term. Unfortunately, small market diseases may not see the opportunity for therapy they once had, and scientists may have to get used to bouncing from one venture to another with more compensation in the form of equity (risk spread even further). It would me nice to have a few “Pharmacon Valleys” spring up to avoid too much relocation during a career.

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15. Karel Krakatit on February 5, 2010 11:43 AM writes...

So does this new landscape for drug discovery alter the mission for those of us running academic research labs? As a PhD student in Medicinal Chemistry, I was taught by my professors that our goal was absolutely NOT to discover new drugs. That was the job of the pharma industry, and it was foolish to think we could, or should, compete. Our mission in academia was to innovate new insights and new tools valuable for the drug discovery process.

Now that big pharma is abdicating its role in drug discovery, should we step in to this vacuum?

This would be consistent with some of the grant proposal reviews I have been getting lately, in which I have been dinged for not presenting ADME profiles of proposed new compound families.

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16. Ty on February 5, 2010 11:47 AM writes...

I understand where Morgan Stanley is coming from. What it is is what it is. I believe it shows how this money-driven (ROIC, my ash) short-term 'visions' can take the entire industry down the drain. They did it for American electronics industry. They did it for American auto industry. Now, it's pharma's turn. They can save all the cost they want for now by externalising and in-licensing. But there are thing that you simply cannot translate into money.

I don't think anyone can change the tide. Don't look now, but there will be Samsungs and Hyundais of pharma in 10, 20 years while the current big pharmas will still be struggling to survive, if not taken down by then (bail out anyone?). And it's Western pharma company's own doing.

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17. anchor on February 5, 2010 11:47 AM writes...

Derek

Fantastic analysis and your take also informed us as to where this monster is headed. This Morgan Stanley analysis will put a serious dent on all those aspiring professors and students, if they really want to pursue carrier in organic chemistry/chemistry. What type of future awaits them, when they graduate? Opinion on this issue from your blog followers are much appreciated. Certainly, this sober article left me with a belief that our best days are behind us.

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18. Vader on February 5, 2010 11:50 AM writes...

All this is moot. With the omnibus health care "reform" bill on life support, Obama, Reid, and Pelosi are going to look for easier targets, and de facto nationalization of pharma is likely to take place. Fair nor not (I don't think it is) Big Pharma is not popular with many voters, and demagogues will take note and take advantage.

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19. BioBrit on February 5, 2010 11:55 AM writes...

Interesting post, thanks Derek.

So, I'm intrigued. Is the ROIC in a small company significantly different. Is it that much better because everyone cares more as they have 'bet the farm'? If not, why would anyone put money into a small company rather than a big pharma? And, given the push over the last year or so, for small companies to cut their discovery, or to just inlicence themselves, who exactly is going to discover the new stuff in the future? We can't all in-licence, surely those opportunities are going to dry up soon.

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20. Dster35 on February 5, 2010 12:02 PM writes...

Derek,
Great points.
I'm relatively new to this industry and as such hear pinings for the "golden days" but didn't experience them.
I like the current environment as I'm resourseful and knowledgable and, due to the small cap science company I work for, am able to make an impact as my value is based on my aptitude and work ethic, not based on the number of years I've served or letters behind my name.
For any new graduate looking for "stability" - the only real stability you will find is in a solid network, good attitude, willingness to be resourseful and productively add to the value of an organization. I think the average, even just graduated, PhD has the opportunity to make impacts on many more smaller organizations than they did in the big pharma's that are just now adapting to the financial atmosphere of 10 years ago.

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21. David P on February 5, 2010 12:03 PM writes...

Karen (17):

There is a movement towards academic drug development. I believe the center at Vanderbilt University was the first (run by Jeff Conn), UNC has set one up more recently (staffed by several ex-GSK folks, naturally). I can see a place for them, especially now, where the drive is for publication and research rather than short term profit.

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22. processchemist on February 5, 2010 12:08 PM writes...

From my european point of view things are quite simple. The interests of the top management of the big global players (pharma, banks etc) is totally conflicting with the interest of the workers in the scientific field. Workers of different nations have different rights/levels of protection, but no one, IMHO, in Europe or US can swallow the pill of his layoff thinking that is for "a greater good". The real problem is that our contractual strenght, as singles or as category, has fallen to very low levels.
About analyses coming from Morgan Stanley, or GS, O JPM, well, these dudes did an heck of a brilliant job in the last three years, or I'm I wrong?
Sure, if they say so, in this direction things will go for some time (outsourcing to asia was heavily advertised from top world banks in the last three years).
How we and consequently a reasearch oriented western pharma environment will survive, this is the problem. And I think it's a collective problem, in the wider sense.

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23. Jack on February 5, 2010 12:10 PM writes...

Derek,
Thought provoking piece, as usual. A minor quibble. Your comment about no big pharmas being successful by simply in-licensing stuff. You're probably too young to remember Marion Merrell Dow-they were hugely successful doing this, at least until they merged with Hoechst (remember them?). And today, Forest is a great example of a successful in-licensing only model. Sure, they don't just rely on small biotechs as providers, but they have successfully gone to Europe for regional deals, too (eg, Lundbeck). Shire is another successful in-licensing only company. And there are a number of others in the specialty space. So it can be done.

I agree with you that big P needs some discovery infrastructure to properly evaluate opportunities. And since a number of licensing deals are collaborations, there obviously has to be a coterie of qualified scientists within big P to enable that. In fact, when I was a big P licensing exec, I would "sell" our internal capabilities to drive the deal.

One point you bring up is particularly depressing-given that big P needs small B, where's the money going to come from to support the latter? Many VCs, thankfully not quite all, have become very gun shy of early stage discovery companies (they have good reasons to be this way due to the lousy financial climate); and big P is equally risk averse in this space-the heck of it is, that's where all the innovations will occur. Or not.

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24. Lu on February 5, 2010 12:15 PM writes...

Morgan Stanley seem to be interested in existence of small start-ups (borrowing money from banks) rather than large diversified companies financing research with their own profits.

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25. YoAdrian on February 5, 2010 12:15 PM writes...

One thing not really mentioned is the NIH's recent strong emphasis on funding "translational research" and away from basic science. This is basically subsidizing academic drug discovery efforts, which is where the IP originates for most small biotech start-ups.

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26. ManageThis on February 5, 2010 12:42 PM writes...

Derek-

You said it brother. With way more eloquence and perspective than I ever could. Keep on speaking the truth.

I've been in both models, and the risky venture is the much more stimulating environment. Data go from your notebook to a presentation to investors in a matter of hours. Every success is an epochal victory and every failure is the brink of disaster. It's a rush. I'm looking forward to getting back to it.

And it's not all about outsourcing to Chindia. Read Derek's post carefully, the outsourcing bit only nibbles at the margins. In my experience, smaller firms actually outsource a lower proportion of their work, because they have to be nimble and they need to trust their data without double checking everything. So if one were really a sunny optimist one would say that the new model may actually result in more jobs for US/UK chemists. But nothing will happen until the VC money flows again. The financial crisis and the Madoffs of the world killed the VC spigot for a few years. As Derek alluded to, this is most unfortunate timing.

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27. hibob on February 5, 2010 12:50 PM writes...

Derek: I'm guessing the reason for the difference in ROIC is so high is because the numbers Morgan Stanley calculated are dominated by changes in the stock prices of the large company after each milestone during R&D rather than the differences in actual expense of taking drug candidates to failure/market in a small or large company. At each milestone, the big company is free to say "OUR drug is succeeding" or "THEIR drug failed".
The "dumb management" theory has a refuge there too:
"They are very strongly motivated to do whatever they can do to get them to work (sometimes a bit too motivated, but that risk is already factored in)"
Compared to an in-house project, the management in charge of licensed projects have had less incentive to keep questionable projects going, and probably face more pressure to terminate them. Management in charge of questionable in-house projects have had more "valid" (to their own careers) reasons to keep them alive until they die on someone else's watch.

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28. FMC on February 5, 2010 12:58 PM writes...

So guys,

before we all get way too excited, including Dr. Lowe I must add, I recommend to check what the Great Bankers of Wall Street are writing: "....our proprietory analysis......., with a greater predictability."
Well I have a couple of comments. When there is talk of a proprietory analysis, which I cannot check and people come up with a factor of 3 somewhere, favouring a new model then I must say that I do get a little suspicious, to say the least. Now when we are turning to more humble numbers, say like the ones quoted by Derek, then again I find that hard to believe (at this point of time). The additional issue I have with the analysis provided by Morgan Stanley, is that devilish half sentence: with a greater predictability !!!! Greater predictability of what? R & D spend? Reaching market? Not entirely clear to me. In this context, as we are talking outsourcing, in licensing and all that we should not forget, that the shift change in the business of big P that we are witnessing might finally bear a much larger cost on society than we can fathom at this point in time. Derek has touched that subject already marginally. If the workforce (highly qualified and driven) that was formerly needed in the US and Europe is obsolete (due to outsourcing into countries with a wage structure that is below ours) than one must think about the ramifications of this change also to academia. Furthermore, how in say 20 years time will it be possible to assess a good outsourcing/licensing deal, when the caliber of scientists that is available (well was available) to companies is just not there anymore ????
Over and out. All the best to you folks that are in trouble at GSK ....

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