Will Eroom's law damage CSL Limited?

The cost of taking a new drug to market is ever-increasing: should you sell CSL Limited? Biotech investors need to understand Eroom's law.

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Warren Buffett's company Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) has recently finished selling its shareholding in pharmaceutical giant GlaxoSmithKline (LYSE: GSK) (LSE: GSK), and started selling down its interest in Sanofi last year. Clearly Mr Buffett is not avoiding healthcare altogether, as he has increased his holding in DaVita Healthcare Partners Inc (NYSE: DVA). Shareholders in CSL Limited (ASX: CSL) should nonetheless be wondering if the next 10 years will be as positive for the company as the last 10 years were, because the company is priced for extremely strong growth over the long term.

Since the new CEO of CSL, Mr Paul Perreault, took the reins one of the noticeable changes has been an increase in R&D spending. However, as Malcolm Maiden pointed out in The Sydney Morning Herald, the R&D budget has in the past been "smaller than the ones the global pharma giants run." At the end of FY 2013, the company announced the intention to increase R&D to about $480 million, being about 9% of revenue for FY 2014. It will be interesting to see how accurate that forecast turns out. In any event, it's worth thinking about the return CSL is likely to achieve on this research.

As I have preciously pointed out, CSL has managed to improve as a business the larger it has become. That is, in part, because of the efficiency of scale, but also because the company has a ready-made distribution network for new products. Generally speaking, however, the cost of bringing a new drug to market is increasing. In fact, a recent article in Forbes claimed that:

In 1975, the pharmaceuticals industry spent the equivalent of $100 million in today's dollars for research and development of the average drug approved by the U.S. Food and Drug Administration, according to the Tufts Center for the Study of Drug Development. By 1987, that figure had tripled, to $300 million. By 2005, this figure had more than quadrupled, to $1.3 billion.

The ramifications of this trend for CSL are not entirely clear, as these figures apply to averages rather than an individual company. However, the average cost of a new product is higher for a large company, because large companies tend not to fail and distort the statistics. Indeed, the R&D spent per new drug for some big pharmaceutical companies is now over $5 billion. The ever increasing cost of R&D is dubbed Eroom's law (the reverse of Moore's law), because the impact is the reverse of Moore's law. That is, the same amount spent on research makes forever smaller incremental benefits. The graph below demonstrates Eroom's law:

Source: Derek Lowe https://pipeline.corante.com/archives/2012/03/08/erooms_law.php
Source: Derek Lowe https://pipeline.corante.com/archives/2012/03/08/erooms_law.php

Foolish takeaway

Don't be in a hurry to sell your CSL shares as a result of Eroom's law. The increasing expense of taking new medical products to market widens the company's business moat, so the news is not all bad. Furthermore, CSL is a company that takes a product from donors (in Australia) or pays a small amount of money for it (in the USA) then separates it into its constituents, and sells it for a massive profit. While new drugs resulting from R&D are essential to CSL's growth, the core business is heavily regulated, essential to society and extremely profitable. I still think the company is a little too expensive to buy (though I'm tempted), but I don't think long-term shareholders need to sell in a hurry.

Motley Fool contributor Claude Walker does not own shares in any of the companies mentioned in this article. You can find him on Twitter @claudedwalker.

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