Financial Challenges For Pharmaceutical Companies

Editor's note: This excerpt, from Boston Consulting Group's recent report, The Pharmaceutical Industry into its Second Century: From Serendipity to Strategy, discusses emerging financial challenges facing pharmaceutical companies during the next few decades.

The 100-year-old pharmaceutical industry is at an important crossroads and is facing a period of radical change stemming from advances in technology, stiff competition and a savvier consumer. Short-term financial pressure on pharmaceutical companies, together with profound long-term systemic change in the industry, will demand a new philosophical and strategic approach to science and the marketplace. The opportunity inherent in the new era of pharmaceuticals will be available to only the most flexible and visionary players.

An unprecedented number of patent expirations currently threaten earnings, while payer pressures limit the raising of prices. This near-term financial pressure will reduce sales and overall growth and force the hand of managers who have been contemplating mergers or leveraged buyouts. Pharmaceutical companies that survive this short-term crisis will face a new set of challenges as technological breakthroughs, activist consumers and new organizational models change the competitive landscape in a definitive way. Companies will have to be willing to alter their strategic visions, and accept radical operational and cultural adaptations to compete. Successful adaptation during this long-term shift will not only ensure survival, but also secure strategic positioning in a new growth period.

The Short-Term Financial Challenge

Pharmaceutical companies have a history of strong profits, leading to high expectations from Wall Street: Between 1992 and1997 the earnings of pharmaceutical companies increased by 11% per year on average—outperforming the S&P 500 index by 90%.

Traditional success in the industry driven by: Ability to increase prices above inflation and expand market for existing drugs and a consistent stream of new product introductions. Between 1992 and1997 pharmaceutical companies increased earnings by 11% per year, outperforming the S&P index by 90%.

Between 1980 and 1993, drug unit prices increased by 7.4% a year, outpacing inflation by 2.7 points per year. Wall Street expects pharmaceuticals to continue this trend with 13% annual earnings growth for the industry. However, the Boston Consulting Group (BCG) projects that pharmaceutical companies will disappoint experts, analysts and investors in the near term: Top pharmaceutical companies will lose as much as 35% of 1995 sales to generic drug competition over the next five years. Even top performers in the industry will likely generate only about 7.7% earning growth per year.

Traditional growth and earnings will be threatened by patent expirations and payer price pressure: Between 2000 and 2003, patents on drugs representing a significant percentage of current U.S. sales will expire. This unprecedented number of patent expirations will reduce sales, as generic drugs cannibalize volume and force branded manufacturers to cut prices. The typical top pharmaceutical company should expect to lose as much as 35% of 1995 sales to generics. The late-stage development pipeline will not make this up sufficiently to deliver expected growth.

Payer pressures will limit the ability to raise prices. Traditional growth in the industry has been driven by the ability to increase prices above inflation, but it is likely that prices will increase no more than 3% per year in the short term. Prices from 1993 to1996 rose only 2.8%, equal to inflation.

Solutions for the Short Term

To survive the near-term earnings gap, management must relentlessly push to operational limits and look to strategic alliances. In addition, companies must strive to speed up and streamline product launches.

By making product launches more efficient and faster, a company can gain a competitive foothold. Based on an analysis of 103 drug launches by 15 companies between 1990-1996, pharmaceutical companies required 23 months to gain FDA approval; the best performers, however, averaged only 11 months. Ultimately, reducing product development time by 16 months could increase earnings by 0.7%.

Companies should aggressively seek to "in-license" drugs from external sources. Today, drugs licensed from biotech companies and other external sources represent 35% of the existing pipeline in the typical pharmaceutical company. However, there are approximately 150 more compounds in biotech company pipelines that could generate 8 to 12 new launches per year. Assuming that these drugs can achieve peak sales of $200 million, this portfolio would generate $14 billion in revenues by 2003. Another way of looking at this: A top company that in-licensed a fair share of available compounds from biotech companies could generate approximately 0.8 points a year in incremental growth.

Enhanced international market penetration is another area where pharmaceutical companies can improve. Traditionally, most drug firms approach global marketing only after they've made commitments to their domestic markets. This "sequential" approach puts fewer resources at risk but wastes precious patent life and gives competitors time to react. By accelerating global launches so that drugs reach peak global sales in five years rather than seven, companies can generate 11% more in annual sales for the first five years of an average launch, improving earnings by approximately 0.5% per year.

Many companies today, however, are not efficient at achieving ideal market penetration in global markets. Companies need to achieve local market "scale" through investment, synergistic local partnering or selective acquisitions. Returns from these efforts could increase market penetration in the top seven markets by nearly 10%, contributing one point of earnings growth per year over the next five years.

In addition, drug firms can reduce costs immediately through inventory and capital asset management. From 1986 through 1997, pharmaceutical companies reduced costs, increasing operating margins by roughly 4%. To be successful over the next five years in an increasingly competitive environment, companies will need to do an even better job of cost reduction.

As a corollary, today's inventory levels are generally inefficient. Most drug companies have substantially overestimated their inventories. By reducing inventory to best-in-class levels, the typical company could realize $1.2 billion in savings. Even if improvements are made slowly, the net result could improve earnings by two points more per year. On average, pharmaceutical companies maintain 208 days of inventory internally. Best-in-class performers succeed with only 89 days of inventory.

Management should focus on "asset productivity" by consolidating manufacturing facilities, addressing manufacturing complexity, streamlining supply chains and "staging" investments over longer time periods. This effort could deliver a one-point increase in earnings growth per year over the next five years. Improving asset productivity to best-in-class levels would allow the typical company to reduce its asset base by $3.25 billion, or $320 million in carrying costs.

Emergence of a New Era in Pharmaceutical Competition

Over the past two decades, companies have focused on "blockbuster" drugs and the mass market. The industry has been characterized by: Serendipitous discovery of blockbuster drugs supported by vertically-integrated operations designed to speed the drug from development to market. Only about 450 new drugs have been approved during the industry's hundred-year-old history—largely through labor, capital and luck.

There are inherent problems with the current paradigm: Mass-market pharmaceutical products are not effective for entire patient populations. 20% to 50% of prescriptions today are either marginally effective or wholly ineffective for certain patient groups. Effective or not, these products inevitably produce "me too" imitators from the competition. By blocking a single "me-too" product, a company could increase its market share by as much as 50%.

The scientific revolution—new breakthroughs in science have the potential to expand drug production exponentially:

• Genomics, the science of mapping genes, will be able to generate between 3,000 and 10,000 gene-targeted drugs in the next decade.
• Combinatorial chemistry, a form of automated chemical synthesis, now allows scientist to systematically create new drugs at 10,000 times the recent rate at one-tenth the cost.
• High-throughput screening uses automation, robotics, and miniaturization to allow scientists to screen new drugs 100 times more rapidly than a few years ago.

The breakdown of vertical integration means the emergence of viable and highly capable specialist providers who will render obsolete the vertical orientation of current pharmaceutical corporate structures. For example, the outpouring of medical compounds and new drugs, and the infrastructure required to support them, will be a challenge to house within a vertical corporate structure.

Pharmaceutical companies will be forced to rely on outside partners for their knowledge and facilities. These outsourcing partnerships will allow pharmaceutical companies to take advantage of lower cost structures.

Companies will have to focus on developing new IT technology, such as communications, networking and database management, which will allow them to manage complex and sensitive data across corporate borders.

Passive patients will become active consumers—the advent of prolific discovery coincides with a new, more demanding pharmaceutical consumer: Patients will become more active in their treatment as they take advantage of tools such as the Internet and other counseling groups to become more active in care decisions. Better-educated consumers will drive demand.

The new era in pharmaceuticals has significant implications for how the industry interacts with payers, providers, regulators and patients: Payers—Pharmaceutical companies must assuage the concerns of payers who are currently debating issues such as who should pay for lifestyle-enhancing drugs like Viagra, downward pressure on prices, and the proliferation of new drugs. Pharmaceutical companies can do this by identifying cost containment opportunities and leading the debate on spending and protocols for care.

Three considerations:

• Providers. The pharmaceutical industry must rethink its approach to educating providers in a way that matches the increasing sophistication of both consumers and tailored drug treatments.
• Patients. The industry must shape the debate on genotyping to focus on the positive impact of improved diagnosis and care (as in the case of breast cancer) and actively engage patients as a way to make them more receptive to new treatments.
• Regulators. The pharmaceutical industry must try to shape policy debate on the national and international level. The next 10 years will be critical in addressing intellectual property questions as companies lay claim to individual genes, techniques, compounds and tools.

Strategies for Long-Term Success

Integrated, strategic management of drug portfolios. Companies will need to learn to effectively select and capitalize on a portfolio of drug opportunities, as opposed to nurturing rare, individual compounds. Portfolio management must thus assume a broader definition and a new strategic significance as pharmaceutical discovery becomes more prolific, consumers become more activist and external alliances emerge as a way to scale capacity.

Partnering and relationship management skills. This will be key in obtaining access to external technology and execution capabilities across all functions.

Strategic human resources management. Human resources capabilities will need to be honed to attract talents that are new to the pharmaceutical industry. These include scientific specialization; creative definition and protection of intellectual property; consumer franchise definition and development; assessment of economic and financial risk profiles; and active networking and deal-making.

Development must be expanded and streamlined, both to manage the increased volume of leads emerging from discovery as well as to set priorities among projects. This includes sophisticated portfolio management techniques and the possibility for targeted and even simulated trials. Further, companies must establish a link between compound development and development of diagnostics.

Marketing must become consumer-driven, capable, sophisticated and amply supported. The pharmaceutical industry should take the lead of consumer goods companies in developing better consumer understanding, insight development, targeted communication and relationship management.

Discovery must be expanded to identify attractive external technologies and partners. This means that sales must address the changing needs of both payers and providers. Managing pricing and coverage will become increasingly difficult as the number of diagnostic tools and lifestyle drugs increases. In addition, patenting must shift from a "downstream" support function to an early and integral strategic capability, tightly integrated with the discovery process. Defining and protecting intellectual property must become the dual strategic focus for the patenting function.

Leadership agenda

Short-term: To overcome the earnings gap, integrate organic growth opportunities with the potential benefits of external mergers and acquisitions.

Mid- to long-term: Address the question of how the company should position itself as a competitor: with a technology focus, as patient or disease franchise leader and/or as a broad-based "orchestrator."

Rethink the organizational structure, emphasizing new functions such as patenting, IT and renewed marketing efforts. Clear communication of priorities across functions and target audiences will be key.

For previous installments in this series, see:

The Pharmaceutical Industry Into Its Second Century: From Serendipity To Strategy

For more information: Gayatri Sondhi, vice president, Boston Consulting Group, 135 E. 57th St., New York, NY 10022. Tel: 212-446-2800. Fax: 212-754-4424.