A Wake-up Call for Big Pharma
Lower profit margins suggest a need for new business models.
October 2015 | by David Delaney
The good old days of the pharmaceutical industry are gone forever. Even an improved global economic climate is unlikely to halt efforts by the developed world’s governments to contain spending on drugs. Emerging markets will follow their lead and pursue further spending control measures. Regulatory requirements—particularly the linkage among the benefits, risks, and cost of products—will increase, while the industry pipeline shows little sign of delivering sufficient innovation to compensate for such pressures.
These factors suggest that the industry is heading toward a world where its profit margins will be substantially lower than they are today. This dramatic situation requires Big Pharma executives to envision responses that go well beyond simply tinkering with the cost base or falling back on mergers and acquisitions. A bolder, more radical approach to Big Pharma’s operating model must become a realistic planning scenario. While an immediate corrective response in the coming weeks and months may not be the answer, a purposeful strategy that provides for this change in the medium and longer term is necessary.
Years of expansion and profitability were in part enabled by regulatory regimes permitting new products to be introduced, benefiting patients and pharma companies alike. More recently, and to varying degrees, regulators are introducing new measures raising the bar for entry, particularly in parts of the developed world. They show little inclination to permit market access, price increases, and follow-on products without proof of substantial incremental clinical benefits. As health care spending relative to GDP continues to rise in many countries, pharma costs will come under increasing scrutiny from governments under pressure to balance their budgets.
The era now drawing to a close may have brought outstanding innovations to patients and profitability to Big Pharma, but the industry’s composition evolved considerably during this period, and not necessarily in favor of large companies. Conventional wisdom, perhaps fed by high-profile mergers, holds that the industry has consolidated. But on the contrary, our analysis shows that it has become more fragmented: the number of companies competing for the profit pool has more than doubled. As a result of that fragmentation, Big Pharma must compete for parts of the value chain with focused players—for example, generics companies that excel at manufacturing; life-science service providers that offer flexible, specialized services (such as managing clinical trials) at scale; and biotechnology companies that generate innovative ideas and products.
Fragmentation is especially troubling for Big Pharma because it would be natural to expect that economic rents will accrue to an industry’s most innovative companies. Since some Big Pharma players can’t deliver innovations as quickly as biotech players can, only brand strength and a global commercial footprint would allow it to go on charging premium prices. A parallel might be drawn with the consumer goods industry, where companies operate on margins about half of those that big drugmakers enjoy. Continuing with this scenario, we would expect Big Pharma’s current level of R&D spending to become a luxury that investors no longer tolerate. We already see these signs today, as some investors and analysts believe that many of Big Pharma’s R&D investments destroy value.
A look at the evolution of the automotive industry may offer some lessons. For many years, it was vertically integrated and dominated by large, primarily Western corporations. But the value chain has been disaggregated into companies specializing in narrow parts of the process. Today, component manufacturers, design houses, and basic-materials companies share much of the industry’s revenues: the automakers are responsible primarily for the design of major components (such as engines), assembly, sales, and marketing.
Similar trends are already apparent in the pharmaceutical industry: Big Pharma increasingly focuses on sales and marketing, relies on in-licensing for innovative products, and outsources portions of activities such as research and manufacturing. This approach has helped pharma and medical-product service providers to grow at a disproportionate pace. Of course, the analogy can be taken only so far—the functions that big companies retain in the two industries will differ. The key message, though, is that the value chain has been disaggregated and that the role of incumbent, soup-to-nuts players is much diminished.