A research article issued in January from Morgan Stanley (MS) titled "Pharmaceuticals: Exit Research and Create Value" created a stir when it called for Big Pharma to toss out all small molecule research. A group of MDs, PhDs, MBAs, and CFAs calculated that reinvesting internal research to in-licensing would result in a three-fold increase in returns. This process, they said, would even triple the number of new drugs reaching the market each year. Research and Development, Morgan Stanley said, should be replaced by Search and Development. The core competency of Big Phama should shift from in-house research to late stage development and commercialization.
Aside from the first extreme suggestion of divesting all research, there isn't much new in this prescription. Big Pharma has already shifted a large percentage of their early stage research spend outside the company. Pharma is in the midst of transferring ever more research to both CROs and biotechs alike. Where at one time only relatively simple functions were outsourced, nearly all research and development functions are now carried out by third parties to some extent.
The fastest growing trend today is outsourcing biology research and transferring development work to lower cost markets, especially Asia. It has been estimated over $300 million can be saved by performing drug development in India(1). In-licensing has increased to the point where approximately 30% of current Pharma revenue now comes from in-licensed compounds(2).
Forest Labs (FRX) is an example of a fully in-licensed pharmaceutical company. It did well for some time, but has recently suffered from the same problem as the rest of Pharma with its own pipeline gaps. Two drugs, Lexapro and Namenda, approved in 2002 and 2003, accounted for 87% of 2009 sales. Revenue growth is in the mid single digits, and its operating margin, at 18% is far below that of the average Pharma company- peculiar considering Forest has only 5000 employees and has no need to conduct discovery research. The stock has dropped by half since its 2007 high.
In any case, in-licensing is unlikely to be Big Pharma's savior. As this trend has intensified, the cost of quality compounds has gone up. Pharma historically favored in-licensing compounds post Phase II to reduce risk, but with increased costs, they have turned to earlier stage compounds. Today, even these have become pricier. Many companies backed by VCs have begun pushing for buyouts for their portfolio companies due to the inability to access the IPO market, further increasing the cost of acquiring compounds.
In-licensing allows Pharma to access novel technologies and may have some cost efficiencies for now, but it will only buy time for Big Pharma as costs spiral upwards. While ROI for Pharma compounds is a lowly 5%, the increasing costs combined with increasing failure rates of in-licensed compounds has reduced the ROI of compounds licensed at the Phase III stage from 12% in the 1995-2000 period to just 6% from 2000-2002(3).
Even as Pharma pays higher prices for biotech compounds, they will need to increase their diligence in selecting them. As Harvard Business School Professor Gary Pisano noted, biotech is even less efficient than Pharma in developing drugs(4). Pharma will certainly need to retain a highly innovative research group, and I imagine that is the case, if not for the sake of drug discovery, then at least to maintain the know-how to thoroughly vet compounds from biotech companies.
Another suggestion has been for Pharma to focus on limited therapeutic areas, citing biotech as examples of companies with core focuses that lead to greater levels of success in drug discovery. It appears this is not the case; a look at maturing companies such as Amgen (AMGN), Gilead (GILD), Genzyme (GENZ), and Biogen Idec (BIIB) shows they are all dependent on drugs discovered years ago. Indeed, they have all broadened their disease focus in recent years in an attempt to boost sagging growth. Of the largest biotechs only Celgene (CELG) has maintained its focus on its core disease area. However, when it comes to successful drug discovery, Celgene is no different from the others, with only a single drug developed in-house driving most of its growth.
Genentech (DNA), often highlighted as the epitome of innovative biotechs, has some of the world's best researchers, but even they have not developed a new drug since Avastin was approved in 2004. Their most recent attempt for accelerated approval with the antibody-drug conjugate T-DM1 has just been denied by the FDA- the new anticipated filing date is now 2012. Two other late stage molecules target HER2 and CD20, the same targets as Herceptin and Rituxan, two approved Genentech drugs. Contrast this with BMS, market cap $45 billion; since the start of 2005, it has received approval for five NMEs. It may receive approval for the novel cancer vaccine Ipilimumab as early as the end of this year. Pharma does not lack for innovation. The difference between Genentech and BMS? Genentech has yet to be hit by generic competition.
An interesting report from Accenture draws a line between two Pharma business models: Innovative Medicines and Integrated Therapeutics. Innovative Therapeutics companies focus on discovering novel medicines for high unment needs using world-class drug discovery capabilities. Integrated Therapeutics companies on the other hand provide a suite of medical solutions that include risk-sharing pricing contracts, drug delivery devices, companion diagnostics, or care management services. In this report, the authors suggest that companies must choose between these or models such as generics and OTC medicines(5).
I believe the pure Innovative Medicines model can no longer survive in the long run in the current regulatory and business environment. In the current environment, there will continue to be pipeline gaps due to shortened patent exclusivity, generic competition, and difficulty in developing new drugs. Depending on discovery alone will lead to highly cyclical earnings. In a model by researchers from Kellogg School of Management, a company aiming to maintain 18% earnings growth over a period of 15 years would need to increase its number of drug launches five fold, with each launch reaching double the average peak sales of the original drugs. This is not sustainable. In the period from 1992 to 2002, only "a handful of companies" were able to bring on average one or more NMEs to market per year(6). Even if one is lucky or resourceful enough to develop a drug, the regulatory environment is difficult, competition is fierce, and switching costs are low.
By deploying a model focused around Integrated Therapeutics, meaningful value is added to the product. The molecule alone is no longer the only differentiator. Done correctly, this creates a higher barrier to entry for competitors from both makers of novel drugs and generics. At the same time, it generates greater benefits for the many parties involved, including patients, payers, and drug makers.
- Pharmalicensing: The Productivity Tiger - Time and Cost Benefits of Clinical Drug Development in India
- McKinsey & Co: The New Math for Drug Licensing
- In Vivo: Rebuilding Big Pharma's Business Model November 2003
- Gary Pisano: Science Business: The Promise, the Reality, and the Future of Biotech
- Accenture: The Era of Outcomes- Emerging Pharmaceutical Business Models for High Performance
- Kellogg School of Management: Strategic Alternatives in the Pharmaceutical Industry