The drug industry is comprised of companies that produce and sell chemically and/or biologically derived remedies used to cure disease or improve a patient's health. It is considered a defensive industry, because consumers typically continue to purchase the drugs even in times of economic distress. The industry is highly competitive, being dominated by a handful of large, multi-product, international, name-brand pharmaceutical companies. That said, the group also contains many small biotech companies, mostly unprofitable, that are attempting to develop a novel drug or two. The task of a drug company is to create a drug, obtain approval to sell it, and then sell it to make a profit.

Research and Development

The development process is multi-year in duration, with overall R&D expenditures ranging from $500 million to many billions for a drug to receive the approval of the Food and Drug Administration (FDA). Too, there is no guarantee that the work will produce a commercially successful product. Larger companies have many candidates in various stages of development, in the hope that one or more of them will obtain approval from the FDA. Smaller companies may have only one drug in development, making the venture especially risky.

Drug Pipeline

The drug pipeline refers to the portfolio of drugs that a company is developing. It is commonly described according to the approval stage that each of the prospective drugs has reached. Investors place more value on drugs that are likely to be approved by the FDA in the near future than they do for drugs that are in an exploratory stage.

In addition, a pipeline that contains multiple drug candidates, that are in differing stages of development and targeted at a range of illnesses, tends to be viewed more favorably, since the structure works to increase the odds of regulatory approval and, hence, profitability.

Drug Approval Process

This multi-year process is highly regulated. It begins with pre-clinical animal trials, which determine if the drug is safe enough to be given to humans. An IND (Investigational New Drug) application is then filed with the FDA to obtain permission to begin testing the drug on humans. Once the application is approved, clinical trials begin.

In Phase I trials, the drug is taken by healthy volunteers for a short period, to ensure that it is safe for human ingestion, to learn more about how the drug is broken down in the body (metabolized), and to determine how long the drug stays in the blood stream (half-life).

Phase II requires that the drug be tested in sick patients, to determine if it is effective (efficacy), to obtain more information about the drug's side effects (safety), and to determine the correct dosage and dosing schedule (e.g., 10 mg once per day or 20 mg once per day).

In Phase III, the drug is tested in a large number of sick patients, with some trials using up to 5,000 patients. This phase usually contains a control group that receives a placebo, and can take several years to finish. The objective in Phase III is to prove that the drug is effective (it works) and safe (limited side effects).

Assuming a successful completion at clinical trial, a NDA (New Drug Application) or BLA (Biologics License Application) is submitted to the FDA. The application contains data from preclinical and clinical trials, how and where the drug will be manufactured, and a proposed label indicating how the drug is to be used. At this point, the FDA can approve the drug, reject it, or request more information.

Branded Drugs

Once approved, a drug is given a "street name" and commercialization begins. Large companies (Big Pharma) spend considerable amounts on advertising and distribution, and often have large sales forces that promote their drugs to physicians to convince them to prescribe the drug. Brand name drugs are protected by patents, which sustain profit margins that offset the expenditures required during the expensive R&D and drug approval process. The number of years that a brand name drug is patented for is extremely important to a drug company, which will fight tooth and nail to prevent its expiration. In order to extend patent times, drug companies will endeavor to get the exact same drug FDA-approved for a slightly different dosage level, or for a different patient demographic, such as the pediatric or geriatric markets.

Generic Drugs

These copy-cat versions of branded drugs appear when a branded drug's patent protection expires or when the patent is legally invalidated by a competitor. Generic drugs offer equivalent efficacy, but are much less expensive largely because the generic drug company has little R&D expense. Generic drugs present savings to consumers, and are being encouraged by pharmacy benefit management companies as a primary means to reduce healthcare costs.

Investment Considerations

Investors must examine a number of factors. The revenue potential of each drug or drug candidate is impacted by the size of the target market (the extent of a disease), competition (alternative remedies already on the market, or others about to obtain approval), and a drug's patent expiration (at which time profitability typically drops sharply).

The drug development pipeline also must be examined, because it represents potential future revenue and earnings streams. Contract Research Organizations (CROs), like Covance (CVD) are contracted out by large drug companies to efficiently and comprehensively perform research on their products and help them bring the drug to market. Investors are encouraged to review a drug pipeline for its breadth, as well as for the timing of possible new drug approvals. Because of the difficulty in judging whether a new drug will meet the rigorous approval requirements, particular attention should be paid to whether there are drug candidates in each of the various approval phases, or if commercial success is solely dependent on approval of a single drug.