(FORTUNE Magazine) – In a queasy, headachy economy like this one, it's easy to understand why investors would reach for the medicine chest. Pharmaceuticals stocks have shone for decades as growth stalwarts relatively unaffected by economic turbulence--they've been beacons of dependability, like antacids or aspirin. Today the argument for loading up on such stocks seems stronger than ever. Baby-boomers are aging, for one thing, and older people buy more pills. Virtually every week newspapers carry headlines about breakthroughs in understanding and treating disease, and the exploding promise of biotech. The top companies have enormous reservoirs of scientific know-how and armies of effective salesmen. Medicines are playing an ever larger role in health care, which in turn accounts for an ever-growing part of GDP.

Yet so far this year, Big Pharma has done nothing but aggravate investors. The companies have been battered from all sides. With Congress debating whether to cover prescription drugs under Medicare, and Africa becoming increasingly paralyzed with AIDS, critics have railed against drug companies as greedy and callous. Individual giants face glaring problems: Bristol-Myers Squibb has had to pull promising new drugs from the market for years' more testing, while Eli Lilly is bracing for the day--Aug 2, to be exact--when Prozac will lose patent protection. Last month even bellwether Merck (see box) let investors down, jolting Wall Street with the disclosure that sales of Vioxx, its blockbuster analgesic, have fallen seriously short of projections. All told, pharmaceuticals stocks are down this year by a sickening 15%, vs. 6% for the FORTUNE 500 index.

Don't call Dr. Kevorkian just yet, though. No one thinks drugmakers will go the way of dot-coms; in fact, never has an industry had brighter long-term prospects. But like a bottle of pills reaching its expiration date, Big Pharma faces a big problem: The business formula on which it built its recent success--inventing and selling so-called blockbuster drugs--is getting old. Though blockbusters aren't going away, they've become unnervingly costly and hard to find; new ones will be too scarce to keep Big Pharma growing at the double-digit clip investors have become accustomed to. So companies across the industry are scrambling to find new ways to hatch and sell prescription drugs that will let them cash in on the rich promise of 21st-century medicine. Just consider:

--Novartis has divided its massive R&D operation into semiautonomous units, aimed at central nervous system, cancer, cardiovascular, and other drug specialities. In May, its CEO declared blockbusters dead.

--Bayer, Germany's $28-billion-a-year giant, joined forces with a $20-million-a-year U.S. genomics pip-squeak called CuraGen to hunt for obesity and diabetes drugs. The size of the deal--$1.34 billion--rocked the industry. What rocked it even more: The unequal partners will split profits from any products they develop roughly fifty-fifty.

--Allergan, a rising FORTUNE 1,000 company that makes drugs to treat eye ailments, is showing how a tight focus on a niche can enable a "mid-pharma" to thrive where Big Pharma can't. Allergan's stock has risen 150% since early 1999.

While it is too early to tell which innovations will prevail, there are plenty of interesting ways for investors to bet (see following story). And two things are already clear: First, drugmaking will change as dramatically in the next ten years as it has in any decade before; and second, in that period pharma is highly likely to match or exceed the past decade's performance, in which it generated average annual returns of 25%. In a queasy economy, that's powerful medicine indeed.

THE BLOCKBUSTER BUST

Big Pharma seemed on top of the world until this year. Blockbuster drugs like Warner's Lipitor, Pfizer's Viagra, and Pharmacia's Celebrex propelled the U.S. industry's phenomenal sales growth, from $22 billion worldwide in 1980 to $149 billion last year. The industry's earnings rose 15% a year for much of the '90s, and growing shareholder expectations sent the market caps of the top ten pharma companies soaring too--up by $1 trillion in the decade. Muscular companies like Pfizer and Glaxo crafted takeovers and mergers to extend their research and sales power even further. Companies also bulked up on consumer marketing, after Schering-Plough made allergy reliever Claritin a multibillion-dollar seller by unleashing a barrage of direct-to-consumer TV ads.

Yet no truly dazzling medicine was rolled out last year, and nothing terribly impressive is in the wings for this year or next. Some giants have already concluded that the blockbuster era is ending. Dr. Daniel Vasella, head of Novartis, the $22-billion-a-year Swiss drugmaker, calls blockbusters a "losing proposition."

"The major companies don't have enough...in their pipelines to keep the engines going at the rate they have been," writes Merrill Lynch securities analyst Jami Rubin. Adds Art Pappas, a former board member at Glaxo and now head of a biotech investment advisory firm in Research Triangle Park, N.C.: "In the last five years, every major drug company CEO said that to grow 15% a year his company would need to launch two genuinely original drugs a year. They said at least one would have to be a breakthrough, with sales above $750 million a year. It hasn't panned out. They aren't coming up with enough unique molecules."

Some companies, like Pfizer and Pharmacia, are better positioned than others to keep blockbusters coming--at least for a while. But all drugmakers share the problem to some degree, and pursuing such drugs is an increasingly high-risk undertaking. On top of the hundreds of millions of dollars that must be spent on a drug's development and clinical trials, the cost of all the pre-launch drum beating required to lure customers and impress doctors quintupled in the past decade, to around $400 million per drug. "It's like the movie business," says Michael Pearson, director of pharmaceuticals consulting at McKinsey. "The bulk of the companies' spending is done before they get a nickel back in revenue." And since blockbusters are almost always designed to treat a chronic ailment like high blood pressure or depression, and the number of such ailments is finite, developers tend to converge on similar problems with similar solutions at the same time. A company nowadays may have less than a year before a rival comes along with a nearly identical pill, "clinically proven" to be superior, if only by a decimal point. Celebrex from Pharmacia, Vioxx from Merck: Can your arthritis tell the difference?

CREATE IT, AND THEY WILL PAY

Rather than overdose on gloom, though, consider the drug industry's inherent vitality. There's no need to worry about the world's appetite for useful pharmaceuticals. Even if growth slows for Big Pharma companies as they retool development and marketing to make up for the blockbuster bust, they will enjoy a demographic tailwind in the U.S. and most other developed countries for decades. Baby-boomers are turning into wrinkly, postmenopausal ladies and balding, paunchy geezers with growing aches and ailments--and will stay that way a long time. Says Kenneth Kaitin, head of the Center for the Study of Drug Development at Tufts University: "Extended life span doesn't mean people stay young longer. It means people stay old longer. They suffer from high blood pressure, depression, arthritis, and so on for longer periods." Boomers, of course, are not known for suffering stoically. They will demand any pill that lets them exercise their God-given right to a pain-free, fun-filled, long life.

The opportunity lurking in all that extended morbidity has not gone unnoticed by the drug industry. "The fundamentals are massively positive," says Tom McKillop, head of AstraZeneca, maker of the world's best-selling drug, Prilosec, which is popular among seniors with heartburn. "We've got huge increases in the number of elderly. And we're at a new phase of pharmaceuticals. Discoveries now involve the chronic degenerative diseases, like Alzheimer's, cancer, and atherosclerosis. We understand them now. The science has never been more exciting." McKillop adds with a laugh, "I say everyone should die healthy!"

Did he say "healthy" or "wealthy"? The rising cost of new drugs sometimes seems destined to bankrupt all but the well-to-do. Will drugmakers have any customers able to pay for all these fabulous advances in medicine?

In a word, yes. For one thing, to label drug costs as soaring is an exaggeration. It's true that drugs are the fastest-growing part of health-care spending--in 1998 they accounted for 7.9% of America's medical bills, up from 4.9% in 1985. Yet increased usage of new drugs, not price hikes, caused much of that increase. In 1999, for example, U.S. prescription spending rose 19%, but just four percentage points of the increase were traceable to price increases. What's more, drugs can be highly cost-effective: It's well established that medicines like warfarin, which helps prevent strokes in people with heartbeat irregularities, save money by lowering other medical costs. Finally, the typical drug bill isn't so bad: In 1997 American consumers on average spent 64 cents a day on prescriptions--compared with 91 cents on alcohol, 92 cents on electricity, and $1.05 on car repairs.

Prices remain a political issue, though. Newscasts show busloads of seniors traveling to Mexico and Canada to save money on prescriptions. Says Tufts' Kaitin: "There is a strong public sentiment that the industry has been arrogant in pushing drugs out so fast and doesn't care if 50% of the population can't pay for them, because they just charge a lot to the other half." Too many people now, especially the uninsured elderly and the working poor, complain of having to choose between drugs and food. Annual spending per senior for prescriptions is up 116% since 1992, to $1,205 last year--and a third of seniors pay for all their drugs themselves. Absurdly, regular Medicare will cover hospital and doctor bills but not prescriptions. (That's because there were fewer drugs back in 1965 when Medicare was established, and they made up such a small percentage of total medical costs that Congress didn't bother to cover them.)

But drug companies appear to be betting that if they make a useful drug, someone will pay for it. And they're probably correct. For one thing, it seems inevitable that Congress will include a drug benefit in Medicare in the next few years. The managed-care industry will come around too. Indeed, it isn't a huge threat to the drug business. HMOs did try to limit drug costs, but a funny thing happened in the past decade: The number of people whose prescriptions were covered by managed care or some other private third party grew from 26% of the population in 1990 to 69% in 1999, according to a report by PhRMA, the drug industry's lobbying group.

That still leaves huge numbers of people without coverage, of course, who are squeezed ever harder by the cost of drugs. But it also means that there are more Americans whose growing appetite for medicine is barely dented by the rising price tag. Besides, managed care has discovered how difficult restricting drugs can be. Doctors hate being told by insurers which medicines they can prescribe. Even if docs were willing, keeping track of different prescribing rules from dozens of insurance companies would be a hopeless task.

Most important, it is employers, not managed care companies, that ultimately make the rules about medical benefits. Says Pearson at McKinsey: "During good times, when they are eager to attract people, corporations are willing to pay for good medical care. A generous prescription-drug benefit is often used as a recruiting tool." Big managed-care companies also think twice about limiting what drugs they will pay for. "The great irony," says Carl Seiden, a drug industry analyst at J.P. Morgan Chase, "is that managed-care companies often have to compete for patients. Companies let their employees choose among several HMOs, and the one with the most generous benefits generally wins."

That fact helps explain why the drug industry has shifted from vigorously opposing the idea of adding prescription benefits to Medicare, to supporting it--as long as the drugs are provided through competing managed-care companies. For eons, the industry feared that the federal government would become the biggest--perhaps the only--buyer of prescription drugs, and thus be in a powerful position to demand lower prices. That's the way it is in most countries, so brand-name drugs are almost always cheaper overseas than in the U.S. The prospect of a few dozen managed-care companies recruiting seniors in the U.S. by dangling the newest drugs has allayed the pharma industry's concerns. And even if the feds are able to squeeze some discounts from manufacturers, that would be offset by much greater consumption: Seniors with drug benefits typically use five more medications per year than those without. Drug execs aren't worried that Medicare would withhold expensive medicines, either. Says Fred Hassan, CEO of Pharmacia and incoming chairman of PhRMA: "I don't see the government intervention being too strong. No politician will say we have to ration drugs. Americans just won't accept it."

PILLS TO FIT YOUR GENES

The cure for Big Pharma's blockbuster blues lies almost certainly in drugs tied to the deciphering of the human genome. The genomics opportunity is enormous, verging on overwhelming. In the history of the pharmaceuticals industry, only about 500 basic "targets" have been identified--disease-causing functions in cells or viruses that can potentially be fixed with the right new chemical compound. But with growing understanding of how DNA makes or mismakes proteins, the basic functional molecules of the body, it is expected that the number of potential new targets could soar to 10,000. Finding the right chemical, though--here's the overwhelming part--will mean testing hundreds of thousands, even millions, of compounds against each target. Costly new "high-throughput screening" equipment that every major drug company is installing will help, but testing all those compounds will be a monumental task. No wonder researchers skilled in genomics account for 40% of new R&D hires, according to an Accenture study.

Lab challenges are only the beginning. The economics and marketing of gene-based drugs will be fundamentally different from those of blockbusters too. Not that genomics won't generate blockbusters--imagine the money that would flow to a company that unearths a compound to thwart Alzheimer's. But the typical gene-based medicine is likely to benefit a far smaller number of patients. A new medicine might not be for all 50 million people with high cholesterol, for example; it might be just for the 50,000 or 500,000 people whose cholesterol is high because they have an aberrant gene producing a faulty liver enzyme, which is different from the enzyme afflicting some other group that also has bad cholesterol. This pattern of specialization is evident already. Genentech, the $1.7-billion-a-year biotech subsidiary of Roche Group, has found that breast cancer patients with large numbers of a certain kind of cellular receptors identified in their biopsies respond particularly well to its cancer drug, Herceptin.

The scramble to find the medical needles in the genomic haystack is prompting deals and alliances between drug companies that are utterly different from those that dominated the blockbuster era. Back then mergers were the thing: A weak company with a meager pipeline would marry another in the same predicament and cut overhead, hoping to buy more time for the researchers' luck to change. "In-licensing" was important too: A weak company would license a drug developed in, say, Japan to keep its otherwise empty-handed sales force busy. But lately the deals to watch are those between big and bio: symbiotic relationships that link Big Pharma with genomics companies. Says James Palmer, head of R&D at Glaxo: "Increasingly, no discovery organization believes they have all the answers. So all companies are looking for collaboration."

For years biotech has been a disappointment. Many startups were founded by brilliant researchers who broke away from a government or university lab to exploit some insight into the inner workings of a disease. But their ideas fizzled, or they couldn't devise and run the right clinical trials, or they couldn't sell what they found. Investors and venture capitalists who had hoped to get in early with a nascent Pfizer wearied of their losses. In the '90s, when VC money started drying up, the big companies began to step in, offering the biotechs rewards for sharing their discoveries.

The harbinger was a deal in 1993, when SmithKline Beecham agreed to fork over a whopping $125 million for access to Human Genome Sciences' genomics data. In 1997 the trend began in earnest: Millennium Pharmaceuticals signed a record-setting $343 million agricultural-genomics alliance in 1997 with Monsanto. Ever bigger deals followed: a $465 million deal between Millennium and Bayer in 1998; an $815 million deal between Vertex Pharmaceuticals and Novartis last year. This year CuraGen's billion-dollar alliance with Bayer took the big/bio tango to a new level. Announced in January, the agreement shows more clearly than any deal to date how well-capitalized biotech companies, turbocharged by genomics, can now negotiate with big drug companies as equals, rather than as poor small cousins coming begging. Bayer and CuraGen will share up to $1.34 billion in drug development costs over 15 years, with Bayer bearing 56% and CuraGen 44%. Unlike in Bayer's earlier deal with Millennium, Bayer and CuraGen will act as join development partners--they'll share profits from the drugs they develop at the 56% to 44% ratio.

Big Pharma is partnering with biotech startups too. That's meant a sea change for little companies, says Max Wallace, CEO of Cogent Neuroscience, a biotech in Research Triangle Park looking for ways to stop brain cells from dying after a stroke. "The biotechs are almost becoming a farm system for the big pharmaceuticals companies." Big-company interest helps the startups survive, he says. "Our technology is so intricate that few financial investors will bet on us. But a deal with a big drug company is a stamp of approval."

To work more smoothly with small partners, Glaxo and Novartis both recently broke their R&D departments into several semiautonomous organizations centered on basic therapeutic areas like central nervous system, cancer, and cardiovascular. When Glaxo made early progress on a new form of anti-infective, it offered its discovery to a small biotech that could make use of it in exchange for an equity position in the firm. Novartis has numerous deals with biotech too. Vasella says that many of them are much better managed than they used to be: "The better biotech firms figured it out. They brought in talent from big outfits like Genentech who could manage research and development. The balance between bio and Big Pharma has stabilized."

Will biotechs be any better at drug discovery than Big Pharma? In the aggregate, says David Barry, they will be. Barry was head of R&D at Burroughs Wellcome when it discovered AZT, the first medicine to work against AIDS. But when Glaxo acquired Burroughs in 1995, he left and formed his own company, Triangle Pharmaceuticals, to find more AIDS drugs. "Biotech is critical for the large companies. That may be counterintuitive, because each large company spends billions on basic research, and there is nothing the small companies are doing that the large cannot. But the pipelines at most large companies are just not impressive." Why? Research programs at big companies can meander for years, he says, and top managers may lack the scientific background to ask penetrating questions. "It's much more Darwinian in biotech. Investors tend to be much more demanding in their expectations than any internal review organizations in large companies." A small biotech's pipeline has to look good, or the company will starve for money.

Don't expect these new drug-development partners to grow into full-service big pharmas anytime soon, though. They are science-heavy and lack the experience that big companies have in devising clinical trials designed to point up a new drug's superiority over a rival's. They also lack the armies of sales reps needed to get doctors enamored of a new cure. Says Vicky Sato, president of Vertex: "We are a company that focuses on providing high-resolution atomic structure. To discover a cure, it's important to understand the hole in a molecule you want to fill. We understand that, and how to fill it with a molecule that can be effective inside the human body. But we look to Novartis for expertise in development."

NEW FORMULAS FOR MAKING MONEY

Like any revolution, this one will be untidy. Mastering the genome and developing drugs to cure its flaws will be an expensive, time-consuming undertaking that will force companies to abandon strategies that have worked wondrously for decades. The shift from a relative handful of blockbusters to a medical armamentarium consisting of thousands of sharpshooter drugs aimed at small disease populations will have a dramatic impact on marketers as well. How will companies sell these hyperspecific drugs to patients, or explain them to doctors already beleaguered by sales reps? Meanwhile alliances between companies will form, break, and re-form; some companies will fail, while others will seem to spring from nowhere.

Big Pharma, however, won't go the way of the passenger train. There are barely a score of companies in the world that have mastered drug making and selling, and while strong companies will likely continue to acquire weaker ones, the roster of top players is unlikely to change fast.

Despite their growing reliance on biotech partners, none of the big drugmakers is abandoning in-house research. For some, making and selling blockbusters is still the best game around. Pfizer, which vaulted to No. 1 among U.S. drugmakers last year, now has seven drugs with sales above $1 billion each, a massive research arm, a vast army of salespeople, and a full pipeline. It would be foolish to abandon that.

Pharmacia, the No. 9 drug company worldwide, with $10.2 billion in prescription-drug sales last year, is still squarely on the blockbuster trail. American Home Products, No. 10, also is thriving by beefing up internal R&D. Once known as an excellent marketer of prescription drugs (Premarin, a hormone for women) and consumer goods (Advil) but as an R&D mediocrity, AHP has pared back its consumer products and introduced an impressive nine new drugs in recent years. CEO Robert Essner says the company has three potential blockbusters, including Enbrel, a major drug to treat rheumatoid arthritis, a nasal flu vaccine, and a meningitis vaccine.

Novartis, which is disdaining blockbusters, is marching down the path of specialty drugs with some success. It recently won approval for Gleevec, the first real wonder drug for cancer. Unlike many cancer drugs designed to kill any rapidly dividing cell, Gleevec works by blocking a signaling mechanism that cancer cells use to reproduce. In early tests it caused remission in virtually all the patients with a rare form of blood cancer, with almost no side effects. "It's a new paradigm--drugs targeting signaling in cells," says CEO Vasella. At around $2,500 a month, Gleevec is expensive, Vasella admits. But he argues it's "about as much as existing treatments, which aren't very successful." What's more, Novartis' pricing scheme is almost as innovative as the drug itself: The company will supply Gleevec free to uninsured people making less than $43,000 a year, with a rising co-pay tied to income for those earning under $110,000. For most people, though, Novartis expects managed care--or, overseas, the government--to pick up the tab. Gleevec may never be a blockbuster, Vasella says, because the cancer it is approved to treat is rare, "but I think we can make some money on it."

Allergan, meanwhile, has built a $1.6-billion-a-year business without a blockbuster to its name, yet with margins and a growth rate that rivals the big guys'. By a combination of design and luck, the company has specialized in eye and skin drugs. CEO David Pyott says Allergan owes its success in part to the fact that the ophthalmic and dermatological prescription markets are too small for the majors to play in profitably, so Allergan can be the biggest player in a small pond.

"I often describe the world of Allergan as Lilliput--everything's the same but smaller," says Pyott. The company has the biggest ophthalmic sales force on every continent, he notes. With only 1,600 salespeople, that's a fraction of the 36,000 at Glaxo, say. But Pyott notes that out of 750,000 doctors in the U.S., there are only 14,000 ophthalmologists and 7,000 dermatologists. Allergan's eye research is narrowly focused, on glaucoma and macular degeneration, two leading causes of blindness.

When Allergan needs a drug that it can't develop in-house, it often becomes a beneficiary of its relatively small size. Johnson & Johnson was selling a drug well suited to prevent infections but had no plans to adapt it for use on eyes, so was willing to let Allergan license it. Allergan got a glaucoma drug from Pfizer that the big company decided would be too small to sell efficiently. Allergan's deals with Big Pharma work the other way too. When it developed Ocuflox, an eye antibiotic that could be prescribed by pediatricians, it partnered with Johnson & Johnson, which had the sales force to handle the job. (Botox, its $240-million-a-year anti-wrinkle drug, Pyott admits, was a lot of dumb luck. The main ingredient, botulinum, is a poison that kills by paralyzing muscles; tiny doses have long been used to relax eye muscles in people with severely crossed eyes. A Canadian dermatologist, married to an eye doctor, noticed that the Botox used on a cross-eyed patient also relaxed facial muscles that cause frown lines. Botox now accounts for 15% of Allergan's revenues.)

Allergan's success suggests that the drug industry may in ten years look very different than it does now, with much more horse-trading between companies. A McKinsey study on the industry foresees the entire industry moving to a "free market" in products, "where the companies best equipped to market do so, regardless of who holds the patent." A small company lucky enough to discover a blockbuster may ship it off to Pfizer, Glaxo, or Merck, while promising drugs below the "dignity level" of the big guys may be sold or licensed to smaller fry. Mid-pharmas like Allergan may flourish too--doing business not only with big companies but also with startups. "Midsized companies will probably be more attractive partners to biotech companies than the big ones," assert the McKinsey authors. "Midsize can pay more to in-license, and will work harder to sell them."

Those graying boomers can rest easy. There will be plenty of drugs coming at them to cushion the ravages of old age, and plenty of investment opportunities to sweeten their retirement years (and help them pay for pills). The pharmaceuticals industry isn't going away. Just changing.

RESEARCH ASSOCIATE: Julie Schlosser

FEEDBACK: boreilly@fortunemail.com