Outsourcing - The Drug Research War

Last year, pharmaceutical companies worldwide spent nearly $2 billion doling out parts of the drug research process, mainly to U.S. specialists. By 2007, spending should reach $6 billion, according to a report by research firm Kalorama Information. The largest outsourcers, which account for 25% of the outsourced drug-discovery spending, are big pharma companies like Pfizer (nyse: PFE - news - people ), Merck (nyse: MRK - news - people ), Novartis (nyse: NVS - news - people ), Bristol-Myers Squibb (nyse: BMY - news - people ) and Eli Lilly (nyse: LLY - news - people ), with Pfizer being the largest single customer.

The U.S. pharmaceutical industry already spends an estimated $14.5 billion annually on outsourcing the manufacturing, formulation and packaging of drugs, according to Desmond Mascarenhas, chief executive of consultant Bioexpertise. Big companies have contracted out management of clinical trials for years, to companies like Covance (nyse: CVD - news - people ) and Pharmaceutical Product Development (nasdaq: PPDI - news - people ).

With pressures on pharmaceutical companies to reduce the time and money it takes to develop a drug--typically seven to ten years at a price of $800 million or more--lower-cost locales like India and China look likely to take a bigger piece of the action.

India already has done some contract manufacturing of generic drugs. Next year, under World Trade Organization guidelines, India will have to adhere to worldwide intellectual-property protection of drugs patented after 1995. (Thus far, India's patent law has recognized processes but not products, so many drug firms have come up with new ways to make drugs that are patented in the U.S.)

Tighter intellectual-property protections are opening the way for a growing number of Indian firms to take on pieces of U.S. companies' drug discovery work. The hotbed for most of the Indian activity is Hyderabad, nicknamed Genome Valley. A smaller Indian firm like Shantha Biotechnics, which has done some of its own drug development, now produces enzymes for U.S. clients like Calbiochem, an affiliate of Merck KGaA of Germany. Ociumum Biosolutions, also based in Hyderabad, develops bioinformatics software in India. It has sold some of its software to Dow AgroSciences, and set up a contract research arm in Indianapolis.

China lags behind India in servicing the U.S. life sciences markets, but it's striving to catch up. Kenneth Epstein, a principal at Los Angeles-based boutique investment banking firm NewCap Partners, has been working to set up contract research deals between U.S. companies and Shanghai Genomics, a 70-person firm in Shanghai, China, led by two Western-trained Chinese Ph.D.s.

Epstein says a U.S.-trained Ph.D. in life sciences in China would make about $8,000 to $10,000 per year; it would cost at least four times that much for similar talent in the U.S., he adds.

"You can get a lot of analyzing done for $10,000," Epstein says. Though intellectual-property protection is improving in China, it is more of a concern there than in India. So Epstein advises clients to outsource to China the detailed, nitty-gritty work: assembling microarrays (a selection of DNA samples on which experiments can be performed) or tinkering with the formulation of existing drugs to possibly extend the patents or come up with less expensive production methods for use after a drug's patent expires. Shanghai Genomics has landed customers in Japan and the U.S., neither of which want their names disclosed.

Big pharmaceutical companies also have caught on to the availability of highly trained, low-cost Chinese scientists. Roche (otc: RHHBY - news - people ) and Eli Lilly have operations in the same science park where Shanghai Genomics is located.

The growth in outsourcing parts of the drug discovery process is being fueled primarily by two factors, according to the Kalorama report. First, most drugs marketed so ferociously today were not actually discovered by the company doing the marketing. Second, the relatively new fields of genomics and proteomics have produced a host of new drug targets--too many to work on all of them in-house at even the largest drug companies. It can also be faster and cheaper to have discovery work done outside of the company.

For now, much of drug discovery outsourcing work will likely go to specialty drug discovery companies or biotech firms in the U.S. The top three providers, per the Kalorama report, are Millennium Pharmaceuticals (nasdaq: MLNM - news - people ), Pharmacopeia Drug Discovery (nasdaq: PCOP - news - people ) and Albany Molecular Research (nasdaq: AMRI - news - people )--the first two of which also develop their own drugs. Each of these three pulled in at least $120 million in 2002 revenue from their outsourced drug discovery activities. With Chinese and Indian firms revving up their operations, the U.S. firms could see their business shanghaied.