Sector: Pharmaceuticals & Biotechnology

Not only are pharmaceutical sector valuations ‘still too low’, but the shifting spending patterns of the industry look set to benefit its smaller drug developers.

With many lucrative drugs coming to the end of their patent protection timeframes, and increasingly losing out to generic competitors, and management changes in research and development departments, investment bank Morgan Stanley now expects ‘material cuts to internal small research spend in 2010/11, after a decade of dismal internal R&D returns’.

As a result, the US finance house believes that pharma companies are going to ‘withdraw from most internal small molecule research and reallocate to in-licensing and other non-pharma assets’ to ‘yield three times the likely return’.

What’s more, Morgan Stanley’s analysts ‘expect industry fundamentals to improve’ and say that they see ‘material upside to return on invested capital, earnings and multiples’ in the sector. In particular, Roche and AstraZeneca are ‘favoured names’, with the former one of the expected leaders in outsourcing research as it reallocates at least $1 billion a year to in-licensed assets.

For smaller pharmaceuticals companies and biotechs, and, of course, their investors, this bodes extremely well, as many rely on ‘big pharma’ companies to in-license their drugs and generally receive hefty milestone payments, help with development costs and shares of any revenues that emerge if and when the products reach market.