Transforming Pharma

After a significant slowdown in 2008, drug companies posted more robust year-end results as the effects of two years of cost-cutting measures kicked in. But despite improvements to their bottom lines, big pharma firms such as GlaxoSmithKline and AstraZeneca paired their earnings announcements with another round of belt tightening, including lowering R&D budgets and shedding more jobs.

Much of the fat is already trimmed from the administrative and sales sides of their businesses, which means research organizations are now feeling the squeeze. Drug companies claim a leaner R&D structure can still be efficient and productive, but some analysts fear the move could hamper the industry’s innovation engine.

Major drug firms are scrambling to find new ways to grow as productivity stalls and the first wave in a set of patent expirations hits this year. Among the most sizable patent losses are Pfizer’s Alzheimer’s drug Aricept, Sanofi-Aventis’ breast cancer drug Taxotere, and Merck & Co.’s blood pressure treatment Cozaar.

Companies have been preparing for the onslaught of this generic-drug tsunami for what seems like years by cutting costs, in-licensing late-stage products, and, more recently, diversifying portfolios into areas such as biopharmaceuticals, generic biologics, and emerging markets. The megamergers of 2009—Pfizer and Wyeth, Merck and Schering-Plough, Roche and Genentech—were largely designed to help buttress businesses that would be impacted by patent losses.

This year, “the famous cliff is now on the spreadsheets,” Sanofi Chief Executive Officer Christopher A. Viehbacher told analysts during the company’s earnings presentation.

In coming years, even bigger-selling products will see their revenues quickly eroded by generics, including the schizophrenia drug Zyprexa from Eli Lilly & Co., the blood thinner Plavix from Bristol-Myers Squibb and Sanofi, and, most critically, the cholesterol-lowering drug Lipitor from Pfizer.

The reality of flagging productivity seems to be causing companies to make more fundamental changes to their operations. Both GlaxoSmithKline and AstraZeneca announced job cuts along with their annual results, and several other big companies are significantly curtailing internal R&D.

GSK posted robust growth, with fourth-quarter sales up 17.1% to $12.9 billion and earnings rising 31.8% to $2.9 billion. For the full year, earnings rose 13.2% to $10.0 billion, based on a 16.5% increase in sales to $45.2 billion.

Despite the healthy results, the British drug firm said it needed to once again evaluate its research structure. To carve an additional $800 million out of its costs by 2012, the company is making significant cuts to internal R&D.

GSK is exiting some types of neuroscience research and, in tandem, cutting back or closing R&D operations at several sites. The sites affected include those located in Tonbridge, England; Verona, Italy; Zagreb, Croatia; and Pozna´n , Poland. Furthermore, the company has proposed ending preclinical development at its Mississauga, Ontario, site and ending neuroscience drug activity in Harlow, England. Although the company has not said how many jobs will be lost, early reports from labor unions suggest thousands of researchers will be laid off.

As it scales back internal R&D, GSK is also looking to acquire more products. Currently, 30% of the projects in development come from outside the firm’s labs, and that portion will increase going forward, GSK CEO Andrew Witty told investors.

AstraZeneca is also shaking up its R&D, despite a robust year. Fourth-quarter earnings were up 13.4% to $3.0 billion, based on a 9.2% rise in sales to $8.9 billion. Full-year sales for the firm came to $32.8 billion, a 3.8% increase, and earnings improved 24.3% to $13.6 billion.

Although fourth-quarter sales of its cholesterol-lowering drug Crestor leapt 28% to $1.3 billion and increased 25% to $4.5 billion for the full year, AstraZeneca is expected to feel the impact of generic versions of Lipitor coming on to the market. In addition, AstraZeneca is battling patent challenges to the schizophrenia drug Seroquel and the heartburn pill Nexium, which brought in $4.9 billion and $5.0 billion in 2009, respectively.

To mitigate these losses, AstraZeneca, already in the process of shedding 15,000 employees from an earlier restructuring, will cut another 8,000 jobs as it looks to save an additional $1 billion by 2014. Although the first round of staff cuts affected some 1,600 research jobs, about 3,500 of the new cuts are likely to be on the research side. Some R&D sites could face closure.

Meanwhile, the company has made some changes to its pipeline and how it funds research. Twenty compounds, including five in Phase II or III trials, have been pulled from development, and funding for future products will be decided by a portfolio investment board.

Overall, the company spent about 15% less on R&D in 2009 than in the previous year. Financial services firm Credit Suisse forecasts that AstraZeneca’s overall R&D spending between 2009 and 2015 will shrink on average by 1.5% per year.

With the June 2011 patent expiry date on Lipitor looming, Pfizer is also looking to cut research costs. The company reported a 12.9% decline in fourth-quarter earnings to $3.8 billion; earnings for the year were down 13.2% to $14.2 billion. Fourth-quarter sales surged 33.9% to $16.5 billion because of the inclusion of Wyeth’s product portfolio. For the full year, sales were up a more modest 3.5% to $50.0 billion.

Sales of Lipitor were up 1% in the fourth quarter but were down 8%, to $11.4 billion, for the full year. Pfizer’s main goal has been to find ways to offset the sales erosion that will begin when the Lipitor patent expires.

One strategy has been to trim projects and diversify the portfolio away from small molecules. Since its merger with Wyeth, Pfizer has abandoned 100 of the 600 drug candidate programs that were ongoing when the companies combined, and the composition of projects is now heavily weighted toward biologics. Pfizer CEO Jeffrey B. Kindler says that the ratio of small molecules to biologics was 3:1 before Wyeth was incorporated. Because of the merger and pipeline review, it is now 1.3:1.

Pfizer also plans to spend less on R&D in the coming years. The firm invested $10.8 billion in R&D in 2008, a slightly lower $10.6 billion in 2009, and this year will further decrease its budget to between $9.1 billion and $9.6 billion. By 2012, spending will be cut to somewhere between $8 billion and $8.5 billion.

Sanofi-Aventis is also paring back its internal R&D operations and leaning more on biologics—namely, vaccines—for growth. The cutbacks are being made in anticipation of patent expiration on the firm’s breast cancer drug Taxotere and the blood thinner Plavix. Sanofi posted healthy results in the fourth quarter, with earnings up 10.4% to $2.6 billion and a 3.8% rise in sales to $10.6 billion. The company’s full-year sales were up 6.3% to $42.0 billion, and earnings increased 21.6% to $12.5 billion. But sales of its “flagship products,” which are primarily small-molecule drugs, fell nearly 9% in the quarter, whereas vaccine sales grew by more than 50%.

Like its competitors, Sanofi is also looking externally for new drugs and vaccines. The company said in its earnings report that 55% of the products in its development pipeline came from partners. In a portfolio review conducted last year, 30 internal projects were cut from development.

The firm’s R&D investment was down about 7% in the fourth quarter, but Sanofi was quick to note that it boosted spending on vaccine research and external projects. Traditional small-molecule research, on the other hand, took a hit. “This trend will clearly continue as part of transforming in 2010,” Sanofi Chief Financial Officer Jérôme Contamine said during the company’s earnings presentation. “You will see a real shift in the way we spend on R&D, the way we use our fixed costs, and the way we put more contribution into external research and also external products.”

Not everyone is embracing the cuts pharma firms are making to their R&D budgets. Bernstein Research analyst Tim Anderson notes that in past years, the bulk of big pharma’s cost cutting has largely been from the sales, marketing, and administration segments of its business. Now, after several rounds of megamergers, there’s little left for trimming on those fronts, leaving research as the only place to look for savings.

But the analyst questions whether such cuts will only slow down innovation. “Some companies have recently been claiming that R&D spending is not correlated to output, to which we ask, ‘Where is the data supporting this claim?’ ” Anderson said in a note to investors.

Companies argue that they can make better funding decisions by implementing the kind of project investment boards seen at GSK and AstraZeneca or by licensing compounds from biotechs that have taken some of the risk out of the equation.

“We’re all really looking more seriously at research and development,” Sanofi’s Viehbacher told analysts when its earnings data were released. “Big companies, not just in our industry but in other industries, are not very good at innovation, partly because we avoid doing anything disruptive.”

Anderson is skeptical. “Pfizer and other companies that are also cutting R&D, like Sanofi-Aventis, are implying that they will spend R&D dollars in a smarter fashion going forward,” he says. “Perhaps, but in an industry where innovation lies at the core, cutting R&D should raise at least some red flags.”

Another sign of a shift in resources away from innovation is companies’ increased focus on emerging markets. In the past two years, big drug firms have significantly expanded their presence in regions such as China, Eastern Europe, and Latin America, where improving economies are enabling more people to pay for medicines. However, those medicines are largely generic or branded versions of products that are off patent in the U.S.

GSK opened its earnings statement by touting 20% growth in 2009 in emerging markets, which now represent 10% of the company’s overall sales. Going forward, AstraZeneca will also look for double-digit growth in emerging markets, which brought in 13% of overall sales in 2009. To continue achieving that growth, the company will, in addition to selling its own portfolio, look to acquire branded generics. As a result, the emerging markets segment is forecast to represent more than 25% of AstraZeneca’s overall sales by 2014, the company’s chief financial officer, Simon Lowth, said in a discussion of the firm’s earnings.

Sanofi already derives just over a quarter of its sales from emerging markets, with the segment growing 19% to $10.1 billion in 2009.

Pfizer enjoyed a 25% surge in emerging markets, thanks in part to the addition of Wyeth’s businesses abroad. In the fourth quarter, sales of Lipitor in those developing regions increased 9% to $237 million, and the company saw double-digit growth on several other drugs, including the pain pill Lyrica and the erectile dysfunction pill Viagra.

Pfizer expects to aggressively increase its presence in China, where it sees massive opportunity, and is in the early stages of penetrating the Indian market, said Ian C. Read, president of Pfizer’s Worldwide BioPharmaceutical Businesses, on a call with analysts. “We are really at the very beginning of our investments in India,” he said. “It is a difficult market to develop, but we are focused on it.”

But the emerging markets strategy is no longer limited to the big firms. Many biotechs are struggling to grow beyond their first crop of products, and investors say the sector will encounter its own patent cliff starting in 2017.

As a result, one company is also jumping into the emerging markets field. Cephalon is paying $590 million for Mepha, a Swiss firm that sells generics and branded generics in 50 countries. The deal will immediately transform the company’s business into a global operation spanning several segments of the pharmaceutical market.

Cephalon’s fourth-quarter sales increased a modest 5.2% to $563 million, and earnings rose 14.8% to $131 million. Full-year earnings for the firm increased 27.9% to $469 million, based on a 10.8% improvement in sales to $2.2 billion.

As 2010 progresses, industry observers will be keeping a close eye on how these new diversification strategies at big pharma and biotech firms play out. Pfizer’s Kindler told investors he is confident the company is “striking the right balance” in its R&D strategy. Investors will anxiously await next year’s earnings release to see if he is right.