Analysts at Morgan Stanley have issued a major report on the state of the pharmaceutical industry, saying the sector still provides significant value for investors as drugmakers are getting to grips with the challenges they face.

Specifically, the broker says that “we see material upside to return on invested capital, earnings and multiples” as the pharmaceutical sector “withdraws from most internal small molecule research and reallocates capital to in-licensing and other non-pharma assets”. It adds that “worsening generic pressure and R&D management changes lead us to expect material cuts to internal small research spend in 2010/11, after a decade of dismal internal R&D returns”.

Morgan Stanley expects AstraZeneca and Sanofi-Aventis to be among the leaders in externalising research. Indeed, it has upgraded its recommendation to 'overweight' from 'equal-weight' on AstraZeneca because it is reallocating up to $1 billion a year to in-licensed assets, and the broker expects US prescriptions for the Anglo-Swedish drugmaker’s Crestor (rosuvastatin) to pick up sharply following likely Food and Drug Administration approval for an expanded label in the next couple of months..

The analysts go on to say that this reinvestment of internal research savings into in-licensing “will yield three times the likely return, we calculate”. These types of pact represent “downside risk for pharma companies” despite milestone obligations, they say, noting that “over one-third of pharma R&D spend is in pre-Phase II, where the probability of reaching the market is less than 10%”.

Morgan Stanley concludes by saying that “sector valuations are still too low” because companies are more focused on “core commercial competences, and we expect industry fundamentals to improve”. It adds that Roche and AstraZeneca “remain our favoured names in the group”.