By Paul Thomas, Senior Editor

As crazy as it sounds, we have reached a point where major pharmaceutical manufacturers (especially those focused on small molecules) are being driven out of discovering and developing their own drugs. A new advisory report from Morgan Stanley, titled “Exit Research and Create Value,” suggests that there is little financial gain from internal small-molecule research, and “externalizing” it and most early-stage development will provide much higher returns.

Biotech companies have more ways of “de-risking” their development efforts, and thus there is more justification for large-molecule manufacturers to continue to develop drugs in-house. Still, biotechs can also greatly benefit from what Morgan Stanley terms its Search and Development (S&D) model.

The Morgan Stanley report cites direct data from Roche, AstraZeneca, Novartis, GSK, sanofi-aventis, and others to support its conclusions. The report is available to Morgan Stanley clients, though media copies were made available. Allow me to summarize some of the more intriguing findings and recommendations:

• More than one-third of pharma R&D spending is pre-phase II, where the probability of a drug making it to market is under 10%. It’s easy to see why externalizing makes sense, the report says.
• Attrition rate is a critical factor in making in-house development unsustainable. “Unless probability of commercialization for the in-house molecule reaches at least 25%, the risk-adjusted Economic Value Added created is at least 3-fold higher under the externalization pathway than the internal pathway, with a greater predictability.”
• The “diminished reliance” on companies’ internal R&D is part of what Morgan Stanley calls its Pharma 2.0 model. AstraZeneca and sanofi-aventis are the most proactive externalizing companies.
• Most companies have been slow to outsource R&D, for various reasons: “With R&D viewed as the core of pharmaceutical companies, inertia and historical legacy have played a part. Concerns about losing optionality and the need to invest in new platforms (iRNA, biologics, sirtuins) also argued in favour of retaining internal Research. Potential negative implications for reimbursement and taxation, as well as a feared scarcity of attractive or fairly priced external candidates were put forward as reasons not to pursue externalization.” All of these concerns are no longer valid, the report explains.
• “Biotech companies are over-optimistic in assessment of commercialization” and can benefit from a sourcing model as well.
• Diagnostics is the “last hope for in-house small molecule research,” the only way to lessen attrition rates and thus increase the economics of developing drugs in-house.

If drug companies go looking elsewhere for promising targets, are there enough to go around? Yes, the report says, “there is a plethora of novel targets in academia and third parties.”