AstraZeneca's Risky Bet on Drug Discovery

During a meal of beef and potatoes at AstraZeneca's (AZN) drug research center near Stockholm in October, Chief Executive Officer David Brennan grilled six drug development managers over a concern raised by a laboratory scientist. During a town hall meeting that morning, the newly recruited researcher had told Brennan he didn't have the freedom to pursue unusual ideas that he would have in academia, and Brennan wanted to know why, according to one research manager who was questioned by the boss. Brennan has more reason than most drug company CEOs to want his scientists to be happy and productive. While competitors such as GlaxoSmithKline (GSK) and Sanofi-Aventis (SNY) expand into flea sprays and energy drinks to offset slowing drug revenue, AstraZeneca is sticking to one business: developing pharmaceuticals innovative enough to command premium prices.

Betting on drug discovery is risky. The industry has gone through a dry spell: All of the current 15 best-selling drugs won approval at least six years ago, according to data compiled by IMS Health and Bloomberg. More than half of London-based AstraZeneca's $32.8 billion in sales came from drugs that may face generic competition by 2014. The company has been one of the worst performers among big drugmakers in winning approval of medicines in the U.S. or the European Union in the past three years, according to statistics compiled by rival Novartis (NVS). "We're going to figure out how to get through this," says Brennan, a former college linebacker. "People are living longer and getting older, and they are consuming more health care. They want advances."

Investors are skeptical. AstraZeneca's shares trade at about 7.1 times estimated earnings, the cheapest of the world's big drug companies. Switzerland's Roche Holding, which gets about 20 percent of sales from disease-detecting tests, and Johnson & Johnson (JNJ), which derives almost two-thirds of revenue from medical devices and consumer products, are more highly valued in part because of their diversification beyond the feast-or-famine drug business. "The market seems to be saying essentially that R&D productivity [at AstraZeneca] is dead, that they're destroying value by investing in research and development," says Gareth Powell, who helps run $200 million in health-care funds at Polar Capital Partners in London.

Brennan's commitment to research stems from his time at Merck (MRK), when the U.S. drugmaker dominated global drug discovery and blockbusters were easier to find. He joined Merck as a 21-year-old salesman in 1975 and was there when the company's labs pioneered new ways to treat hypertension and cholesterol. "This is what David saw happening," says P. Roy Vagelos, who ran Merck's R&D and later, when he became CEO, promoted Brennan to run its new collaboration with Swedish drugmaker Astra. "That apparently has influenced his view of running a pharma company, which I think is a correct view," says Vagelos, 81. "The world has changed, but the impact of important new drugs that fulfill unmet medical needs is no different now than it was then."

While researchers today understand diseases better because of breakthroughs in genetics, drugmakers are having limited success translating those advances into major new medicines for heart disease, pain, or cancer. Regulators also are requiring more safety measures after several big-selling drugs proved more dangerous than anticipated, and governments, especially in Europe, and insurers in the U.S. are pushing back on price hikes.

Despite these headwinds, Brennan's commitment to R&D as the road to growth is making AstraZeneca a magnet in the research community. Looking for someone to invigorate his labs, Brennan in May recruited Menelas Pangalos as head of early-stage drug research. Pangalos previously helped build the industry-leading portfolio of experimental drugs at Wyeth, which Pfizer (PFE) bought in 2009 for $68 billion, largely because of those drugs. "As the head of research, you want to be hearing your CEO say that the way we are going to grow the business is by driving successful research and development," says Pangalos. "It's an incredible challenge." Brennan also poached Pfizer's global research chief, Martin Mackay, for AstraZeneca's most senior R&D role, president of research and development.

Brennan has reviewed every step in the development process, has narrowed the scope of research to focus on more promising areas such as diabetes and cancer, and has shut some sites to save $1 billion annually by 2014.

To succeed, Brennan will have to fix an R&D operation stung by failures. In December, the company dropped development of motavizumab for infant respiratory disease, taking a $445 million charge, after a U.S. advisory panel recommended against approval because studies linked it to allergic reactions and didn't prove it worked better than older medicines. Trial results released by AstraZeneca in May showed the experimental drug Recentin didn't improve prospects for colon cancer patients. And in June the U.S. Food and Drug Administration failed to approve Axanum for ulcers. These follow four potential blockbuster cardiovascular or diabetes drugs that failed in late-stage trials from 2006 to 2008.

AstraZeneca did win permission in December to sell Brilinta, the company's most important experimental product, in the EU. The clot-preventing drug proved more effective in studies than Sanofi-Aventis' and Bristol-Myers Squibb's (BMY) Plavix, which had $9.8 billion in sales in 2009. Still, the FDA declined to approve the drug on Dec. 17, saying it wanted additional analysis of a study that compared the two drugs.

Like its competitors, AstraZeneca is experimenting with new ways to organize research to improve productivity. Scientists now are responsible for candidate drugs until they begin the final human trials, ending a culture of handing off early-stage products to other researchers as if on an assembly line, Brennan says. He's also willing to license experimental compounds from other companies. "We need to change the way we're doing it because we haven't been successful," Brennan says.

AstraZeneca's focus on pharmaceuticals puts additional pressure on the company, according to Andrew Baum, a Morgan Stanley analyst in London. "When you have an enormous patent cliff, poor record of returns in R&D, no diversification, what do you do?" asks Baum. "It's not a strategy of choice. It's a strategy that was thrust upon them."

Brennan wants investors to focus on dividends and buybacks while revenue "fluctuates" until 2014. The company expects revenue of $28 billion to $34 billion annually through 2014 as it loses patent protection on its two biggest-selling drugs, heartburn treatment Nexium and anti-psychotic Seroquel. Brennan has gotten additional time to make his plan work. On June 29 a U.S. judge ruled that the patent on AstraZeneca's Crestor cholesterol drug is valid until 2016. The decision safeguarded $2 billion in U.S. sales. The company plans to submit the diabetes drug dapagliflozin for approval in the U.S. and Europe by early 2011. AstraZeneca may get a decision from the FDA by Jan. 7 on vandetanib, a treatment for advanced cases of a rare thyroid cancer.

Brennan has convinced AstraZeneca's board that the company should stick to the business of developing pharmaceuticals, says Jane E. Henney, one of the directors who chose him as Tom McKillop's successor in 2005. "I don't sense there's any feeling among the board that we should move in another direction," says Henney, a former FDA commissioner. "It's the path that we've chosen. Only history is going to be able to judge if we were correct."

The bottom line: While other big drugmakers are diversifying beyond pharmaceuticals, AstraZeneca is sticking with risky in-house drug development.

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