Research and development (R&D) plays an integral role in the success of pharmaceutical firms. According to a study conducted by Booz & Co, the healthcare industry had R&D expenditures of over $111 billion in 2009. Based on evidence provided in the report, of the 10 most research-intensive firms in the world, six are in the healthcare industry.

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The Tech Factor
Not surprisingly, tech-based firms such as Nokia (NYSE:NOK) and IBM (NYSE:IBM) cumulatively devoted the most resources to research and development, while the auto industry, which is pushing to rebrand its image to one of a more environmentally friendly business, came in third. Computing/electronics and autos had 2009 R&D expenditures of $146.7 and $85.2 billion respectively.

R&D in Healthcare
After analyzing R&D spending of the world's 1,000 top innovation-driven companies, Booz & Co. revealed that 2009 spending decreased by an average 3.5%. Although most of the declines were attributed to the auto industry, many American healthcare firms saw cutbacks as well.

Pfizer (NYSE:PFE) and Johnson & Johnson (NYSE:JNJ), which ranked in the five and seven spots on the list, saw year-over-year outlays decrease by 2.6% and 7.8% respectively.

Expiring Patents
However, with improving economic conditions, major pharmaceuticals are forced to renew their focus on R&D spending. As numerous major drugs such as Pfizer's Lipitor and GlaxoSmithKline's (NYSE:GSK) Advair lose their patents, generic drug makers will enter the market and begin to mass produce these medications. The best-selling cholesterol drug, Lipitor, contributed $8.1 billion to Pfizer's top line as of the first nine months of 2010. In fact, Lipitor sales contribute approximate 16.1% to Pfizer's total year to date revenue. Xalatan, another drug with an expiring patent in 2011 produced third-quarter sales of $416 million.

Competition
Israel's generic pharmaceutical giant, Teva (Nasdaq:TEVA), is set to capitalize on the growing list of patents set to expire in upcoming years. A major advantage for generic drug manufacturers is that they can allocate fewer resources to R&D. For example, Teva's nine-month R&D-to-sales ratio sits at 5.7%, compared to Pfizer's 13.1%.

In its latest quarter, Teva's North American sales increased by 22%, largely driven by a generic version of Pfizer's antidepressant, Effexor.

The major drug companies have two primary alternatives to maintain revenue growth: boost R&D spending and/or acquire competitors with drugs in the pipeline, which can replace the sales lost to generic brands. The major drug companies have been utilizing both approaches.

Merck (NYSE:MRK) increased its third-quarter research and development expense by 77%, spending $2.3 billion compared to $1.3 billion in 2009. Likewise, Pfizer's R&D spending surged from $1.63 billion to $2.19 billion. Furthermore, both of these corporations have been involved in large acquisitions with Merck purchasing Millipore for $7 billion. Pfizer is acquiring Wyeth for $68 billion.

The Bottom Line
Research and development spending is a crucial component of the pharmaceutical industry, as drug companies cannot rely on previously-developed technology to drive profits indefinitely. With many major patents expiring in 2011, companies will be forced to find alternative revenue streams. (Investors take note: companies that cut research and development are in danger of saving today but losing big tomorrow. Check out Buying Into Corporate Research & Development.)

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