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What If Valeant's Big Pharma Blasphemy -- "R&D Doesn't Work" -- Is Right?

Valeant (VRX) CEO J. Michael Pearson didn't quite describe himself as the heresy-spouting Antichrist of Big Pharma in his recent interview with Bloomberg, but he might as well have. In the chat, he basically said that drug research and development was a waste of time and money. In previous interviews he has hinted that he believes the R&D assets of Cephalon (CEPH) -- which he's trying to buy via a hostile takeover -- should be sold off.

This is blasphemy in the pharmaceutical business. For decades, drug companies have burnished their reputations as R&D centers. Their scientists toil for years to bring a single drug to market. When that happens, big profits often follow. R&D is Big Pharma's sacred cow.

But what if Pearson is right? Once you've finished your spit-take, the prospect starts to make a whole lot of sense.

Pearson appears to hold R&D in disdain. He's a McKinsey & Co. alum, not a former scientist, and therefore a perfect hate-figure for keepers of the R&D flame in the drug biz. His company spends only 6 percent of its revenues on research; the average drug company spends about 14 percent. Here's what Pearson was quoted as saying by Bloomberg:

R&D is a very risky investment ... The odds of you succeeding in that are kind of against you.

We're not into high science R&D; we're into making money.

We do not bet on science, but on management.

In a previous acquisition, he cut 25 percent of staff and pared R&D staff, telling them:
I recognize that many of you did not sign up for either this strategy or operating philosophy ... Many of you may choose not to continue to work for the new Valeant.
So if Valeant isn't going to develop new drugs, where are its new drugs going to come from? Acquisitions, basically, which is why Pearson wants to take over Cephalon and its quirky portfolio of products (it sells the narcolepsy pill Provigil and the painkiller lollipop Actiq, among others).

Why do two things at once?
This strategy embodies a central insight about the business: That developing drugs and marketing drugs are two completely different, unrelated skills. Yet companies traditionally attempt to do both at once, sometimes with disastrous results (Pfizer, for instance, has conspicuously failed to come up with enough new medicines to plug the hole that will appear when it loses patent protection on the cholesterol drug Lipitor).

Let's apply this insight to a real life example. Recently, Bristol-Myers Squibb (BMS) launched a cancer drug, Yervoy, which is expected to earn up to $1.7 billion in annual revenues. CEO Lamberto Andreotti suggested this was a product of BMS's awesome R&D efforts but in fact the company acquired the drug from a small research company for $2.1 billion in 2009. The drug cost less than $400 million to develop in cash expenses.

On the face of it, this seems like an inefficient use of capital. The small company, Medarex, could have earned those revenues itself and become wonderfully profitable (assuming the drug fulfills its promise). Surely, BMS overpaid?

Perhaps not. BMS picked up the drug at a late stage in its development when it knew the product had a high chance of success. It may have been expensive, but its capital at risk -- the money it would have "wasted" on dozens of other failed cancer drug candidates before hitting on Yervoy -- was close to zero. What BMS lost in cash it gained in certainty and speed -- it was less than two years from the deal to approval; normally, drug development can take a decade.

Pfizer v. Merck
If you agree that there ought to be a division of labor in the pharma business -- that some companies should develop drugs and then sell those products to the companies that have the salesforces to market them -- then this says some interesting things about recent corporate strategy moves among the largest companies. Pfizer (PFE) is downsizing its R&D operations and Johnson & Johnson (JNJ) is said to be on the prowl for a ~$10 billion acquisition.

Merck, on the other hand, is doubling down on its own research and stopped giving Wall Street guidance in hopes of lessening the scrutiny paid to its R&D expense base.

Viewed through the Valeant prism, Pfizer, BMS and J&J would be on the right track and Merck is only storing up future problems for itself. Maybe, in about 10 years' time, Valeant will launch a hostile bid for it...


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