The Need for New Business Models: Big Pharma¹

By Jim Austin, MPA/MURP
Director, Life Sciences and Executive Education

Future developments in U.S. healthcare technology will affect our lives in ways neither science fiction writers nor prescient futurists could possibly imagine. To get a glimpse of the future, we need to understand both the current state of U.S. healthcare and the driving forces that could lead to major disruptive change in tomorrow’s healthcare delivery. The following is a brief look at one important segment: the pharmaceutical industry.

The Struggles of Big Pharma

The pharmaceutical industry is clearly under stress. R&D pipelines are running dry. Industry giants face increasing pressure to consolidate. New technologies, such as genetic mapping and individualized medicine, may be incompatible with the traditional, chemical-based and large population model of drug development. Aging populations in developed societies are concerned about healthcare cost and quality, while the developing world populations feel ignored. New industry players, from biotech start-ups and information industry leaders like Google to generic drug manufacturers in developing nations, are eyeing business opportunities in the world once owned by branded, large pharmaceutical companies such as Pfizer, Merck, Novartis, Bayer, GlaxoSmithKline and broader healthcare players like Abbott and Johnson & Johnson.

About 13% of annual U.S. healthcare spending, or approximately $259 billion, is budgeted for “drugs/supplies.”² The proportion of total healthcare spending that the United States allocates to drugs and supplies, in both relative and absolute terms, is higher than almost every other country in the world.³ Increased revenues would normally mean greater prosperity for an industry, but all is not well within Big Pharma. While 73% of the public believes that drugs have improved people’s lives, only 56% view the industry favorably (see Figure 1).⁴ This represents a dramatic change in perceptions given that a decade ago 79% of respondents indicated “the drug industry is doing a good job.”⁵

Figure 1. Public's Perceptions
[click for larger image]

Drug discovery has always been a high-risk endeavor, involving long time horizons and complex processes (see Figure 2). Drug development typically takes over 12 years from concept to launch at an estimated cost of over $1 billion, up from $54 million in the late 1970s. As shown in Figure 2, the success rate is not very high. Only one in every 5,000 potential compounds eventually survives to enter the market. Patent protections typically provide only eight to ten years for companies to recoup their drug development costs, after which the arrival of generic competition erodes prices by 70-80%.

Figure 2. Drug Development Phases (U.S.)
[click for larger image]

The problem for pharmaceutical companies is that as drug pipelines dry up, revenues decrease for many years to come. With the rigidity of current drug development processes, especially the relatively long period from initial compound identification to eventual launch, drug companies must retain full pipelines to sustain sales. The outputs from R&D not only must offset the high risks of drug discovery, but also fund the other critical activities of a traditional pharmaceutical company: highly capital-intensive, regulated manufacturing facilities; extensive regulatory filing capabilities; well-trained sales forces; broad patient information/support channels; and vast global distribution networks. As payers increasingly support generic substitution for branded products, pharmaceutical companies are forced to re-examine traditional cost structures to maintain profit margins in the face of declining revenue. For example, large sales forces have been a mainstay of pharmaceutical marketing strategy, with coverage ratios in 2002 of nearly one pharmaceutical sales person for every ten physicians.⁶ This massive sales force is gradually declining as more “conflict of interest” restrictions are placed on pharmaceutical marketing.

In addition to reconsidering previously accepted marketing costs, pharmaceutical companies have attempted to protect profitability by “extending” the patent protection or life of a product by introducing minor variations to the original, such as stronger doses or combination products, that require minimal regulatory approval yet capture new and extended patent protection. Abbott’s Depakote, a treatment for bipolar disease and epilepsy, was reformulated to Depakote ER (extended release), gaining incremental patent coverage and further differentiating the product from generic alternatives. These efforts are increasingly being scrutinized by reimbursement agencies and insurers, who often penalize such “line extensions” by requiring patients to pay higher co-payments for the reformulated drug than for the generic substitute.⁷

Jean-Pierre Garnier, the recently retired CEO of GlaxoSmithKline argues that R & D organizations in Big Pharma may be literally “too big” and need to be revamped into smaller, more entrepreneurial groups which focus on treating very specific diseases.⁸

Between increasing government scrutiny, declining favorability ratings among the public, diminishing pipelines of true “breakthrough” products and rising tides of generic substitutes (often manufactured in countries with relatively lax intellectual property and regulatory safety frameworks), the pharmaceutical industry is facing an unsettling future. One forward-looking indicator is stock market valuations. From late 2000 to early 2008, the top 15 pharmaceutical companies lost a combined $850 billion in shareholder value as the “price-earnings” ratio of their shares fell by two-thirds.

Another possible opportunity is the developing world, with its enormous, unmet demand, but typically fewer resources to spend. For example, the new CEO of GlaxoSmithKline, Andrew Witty, recently announced a major push into developing markets and closed a deal with South Africa’s Aspen to market branded generic products. However, this strategy remains the exception among Big Pharma. The exciting vaccine advances for preventing cervical cancer illustrate the issues at play.

Globally, cervical cancer is a major killer. It is the second-leading cause of cancer deaths in women, with approximately 500,000 new cases arising each year. According to the World Health Organization (WHO), 274,000 women died of cervical cancer in 2006, 95% in developing countries. In the United States, 12,000 new cases of cervical cancer are diagnosed annually, and the disease causes 4,000 fatalities each year. Thanks to near universal acceptance of Pap smear programs in developed countries, early detection of cervical cancer and its treatments have greatly reduced the disease’s impact. The National Cancer Society does not even list cervical cancer among the society’s top 10 deadliest cancers.

In 2007, Merck launched Gardasil in the United States, the first vaccine against the major virus strains responsible for over 70% of cervical cancers. Today, 24 states are reviewing proposals to mandate the vaccine for junior high school girls; Virginia will require the vaccine this fall. A competitive product, Cervarix, by GlaxoSmithKline, will be given to all 12 year-old girls in Great Britain starting in the fall of 2008. Canada expects to spend over $300 million on cervical cancer vaccines this year. At a cost of nearly $360 per vaccine (three shots), Gardasil is a blockbuster. Merck estimates 2008 sales of Gardasil at between U.S. $1.4 and $1.6 billion.⁹ Since the vaccine only protects against the majority of viruses believed to cause cervical cancer, most women are still advised to receive regular Pap smears. In addition, while the vaccine has been studied in human populations for nearly a decade, no one is certain about the lifetime efficacy (will re-vaccination be required?) or safety issues. Public policy critics raise troubling cost-benefit issues. Unlike traditional vaccines (such as for polio or measles) that reduce healthcare expenditures by preventing illness, cervical cancer vaccines are “among the first vaccines approved for universal use in any age group that clearly cost the health system money”¹⁰ with their high price tags and continued monitoring requirements. Today, that high cost can only be borne by developed markets and not by the developing world, where the majority of cervical cancer cases occur. Widespread availability of Pap smears, much less Gardasil, in many developing countries remains a challenge due to economic constraints and a lack of public health networks.¹¹

In summary, large pharmaceutical companies are employing a number of inter-related strategies to address the various issues facing their industry:

• Greater focus on global market opportunities to lift sales;
  
• Ever more creative alliances with smaller biotechnology companies to fill the diminishing drug development pipeline of larger entities;
  
• Mergers and acquisitions to consolidate the strong firms and garner scale advantages;
  
• Increased spending on research and development, while decreasing investment in marketing and sales;
  
• Smaller, more entrepreneurial R&D groups with tighter efficiency controls, especially outsourcing high-cost efforts (such as Phase II and III trials requiring often thousands of patients) overseas, and;
  
• A new pharmaceutical model is evolving away from mass-oriented blockbuster drugs toward a broader portfolio of new drugs, possibly focused on “personalized medicine” and disease “niches” as identified by new discovery techniques.

How well these strategies are realized will determine whether or not the large pharmaceutical companies can regain the power and promise that they once had.

Notes

 ¹Adapted from Jim Austin's chapter “The Business of Biosciences” in Paul J. H. and Joyce A. Schoemaker, Chips, Clones and Living Beyond Hundred, Pearson Publishing, 2009 (forthcoming).

 ²Catlin, A., et al, “National Health Spending in 2005: The Slowdown Continues” (Health Affairs,26,1; 2007) pgs. 142-53.

 ³In most countries, there are national formularies where federal or regional governments control the price and availability of drugs in order to manage healthcare expenditures. Japan, which spends proportionally more on drugs than we do, in large part reflects our different cultural norms. In Japan, for example, patients expect to receive a drug when they visit their physician, even if not necessarily required. And a significant portion of MD revenues in Japan are derived from in-office drug dispensing.

 ⁴USA Today/Kaiser Family Foundation and Harvard School of Public Health, 2008.

 ⁵David Dranove, Code Red (Princeton University Press, 2008), pg. 102.

 ⁶L.R. Burns, ed., The Business of Healthcare Innovation (Cambridge University Press, 2005), pg. 85.

 ⁷Thus patients either pay more for the convenience of newer formulations, or less for generics of the older formulation that may require more frequent dosing.

 ⁸J.P. Garnier, “Rebuilding the R&D Engine in Big Pharma,” (Harvard Business Review, May 2008), reprint #R0805D.

 ⁹Not including European sales where Merck has a co-marketing alliance with Sanofi Aventis.

 ¹⁰Elisabeth Rosenthal, “Drug Makers’ Push Leads to Cancer Vaccines’ Rise”, New York Times, 8/19/08.

 ¹¹Interestingly, Merck does have a history of helping developed countries, even at a cost to the company: in the 1970’s and 1980’s, Merck continued its research and essentially donated the drugs developed to cure river blindness, a disease only afflicting developing countries.

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