Pharma's Next Top Model: Slimmer Business Models

After almost two decades of blockbuster-driven prosperity, the model for success in pharmaceuticals has broken down. Growth and profitability have declined across the board. In fact, the sector as a whole has created no value in the past five years. The sources of this stagnation are many: higher development costs, declining R&D productivity, increased competition for in-licensing, higher marketing costs, generics, pricing pressure, and increased political and regulatory scrutiny. The path forward, once clear, is no longer obvious.

Stagnant Value Since 2000

In the face of such challenges, pharma is not yet experimenting with new business models. For the most part, top companies are clinging to their traditional strategies. Fifteen years ago, pharma tried to play everywhere possible. Industry pipelines were full. Industry leaders maintained vast discovery, development, and marketing organizations. They pursued medicines in a similarly broad footprint in all of the major disease areas. No longer: Integrated pharmaceutical companies are likely to migrate to areas of strength, be it a particular disease area, customer group, or value-chain position.

Segmenting Disease Areas

But deciding where to focus today is complicated by the fact that the pharmaceutical world could evolve in very different ways. The most optimistic view sees a new wave of innovation solving a myriad of medical problems for an aging global population that is eager to pay for a new era of medicine (or to secure public funding for it). At the other extreme, pessimists see a descent into commoditization: a world in which innovation stalls, pricing challenges persist, and competitive pressure mounts from consumer products, generics, and India and China.

Playing to Win Everywhere

"In selecting where to play it is important to ask how the industry is evolving," says Reinhard Ambros, managing director, Novartis BioVenture Fund. "What disruptive events could reshape the industry? How can you ensure that your company will survive?"

Growth Rate Increases as R&D Focus Narrows

What's right for a business pursuing life-saving cancer medicines will likely not work for a company in mature segments like allergy, ulcer control, or fertility control. But the choice of model is not obvious for either company. Because the business models of the largest pharma companies have been virtually indistinguishable, there is far more to be learned from a different cohort of companies—mid-cap pharmas and biotechs with sales between $1 billion and $5 billion.

We segmented the mid-cap companies along three dimensions of business-model choice: disease-area footprint, the breadth of focus, and customer and channel mix. We found that the choice of "where to play" drives differences in the financial performance and value-creation profile of these companies.

Disease is the Differentiator

Twenty-five years ago, most medicines we use today weren't discovered yet. But today, whole categories of medicine are well served by safe, effective drugs, many of which are available over the counter or as low-cost generics. Different disease areas—some more mature, others less—generate different business-model requirements. Two dimensions effectively segment disease states—the criticality of need (life saving vs. lifestyle enhancing) is one axis, and the maturity of therapy in specific segments is the other.

• Criticality of the need for treatment Diseases range from those that aren't gravely serious, like signs of aging or allergies, to those that are fatal.

• Maturity of treatment Therapies range from incremental improvements in treatment for already well-served markets, to highly innovative, unprecedented therapies for intractable diseases.

Using those two dimensions, we broke up our sample set of 20 mid-tier companies into four cohorts based on the disease profile that most reflects their discovery, development, and marketed product portfolios. We dub these cohorts "Incrementalists," "Integrators," "LifeStylists," and the "LifeSavers."

• Incrementalists play in the lower left quadrant of the matrix, and pursue well-served, less serious conditions. Here the formula for success appears to be speed and efficiency in developing incremental improvement over existing therapies, managing competition from over-the-counter and generic drugs, and maintaining relatively high cost-consciousness and low-cost and low-risk R&D. Tennessee-based King Pharmaceuticals typifies this group.

• LifeStylists (upper left quadrant) engage in medicalization, targeting conditions not previously treated with drug therapy—addiction (smoking and alcohol), sexual dysfunction, signs of aging, and weigh control. R&D costs are high for the novel targets. Once approved, these products require significant investment in patient and physician promotion to develop markets that haven't existed previously. While this high risk/high reward space belongs almost exclusively to the major pharmas, a few small players have distinguished themselves as successful LifeStylists. Notable among them is Allergan.

• Integrators (lower right quadrant) focus on well-served but serious diseases. In this space, the challenge is to manage complexity, often combining multiple therapies, pursuing clinic and caregiver channels, multiple R&D technologies, or significant manufacturing scale. Typical of this cohort is MedImmune, whose products—Ethyol, for chemo toxicity; Cytogam, an antiviral used in transplantation—are used typically in conjunction with other highly complex therapies or procedures.

• LifeSavers focus on high unmet need. They have both the most difficult and the easiest task. The difficulty lies in their focus on the most intractable diseases—cancer, Parkinson's, stroke—that remain without effective treatment despite decades of intense research. On the flip side, when successful, they don't face the kind of business-model pressures that exist for other cohorts. Companies like Genzyme, Genentech, and Gilead operate in relatively immature, uncrowded markets.

We compared the financial performance of the 20 mid-cap companies and their respective cohort on a variety of dimensions: growth, profitability, risk intensity, and efficiency. First, while most companies want both high growth and low risk, our analysis shows a clear trade-off. LifeSavers are expected to grow at a compound rate of 26 percent through 2009—much faster than other cohorts. But this is difficult terrain, as just 10 to 20 percent of drug candidates entering clinical development in this space reach market. In contrast, the Incrementalists face much lower risk, with 20 to 30 percent of their candidates reaching market. But growth is elusive: Incrementalists are expected to see an average decline of two percent in overall revenues through 2009.

The high-risk innovation for unmet needs targeted by the LifeSavers requires more costly R&D (up to 25 percent of sales) than for Incrementalists (10 percent), Integrators (15 percent), and LifeStylists (20 percent). But life-saving innovations are more likely to sell themselves once they are on the market, requiring only about 25 percent of revenues to be spent on sales, general, and accounting (SG&A). LifeSavers garner additional advantages, including more receptive regulators and less reluctant payers. Incrementalists face hurdles on every front: They pay up to 35 percent of revenues for SG&A, owing to the high-persistency marketing needed to justify their positioning versus OTC and generic products. LifeStylists, who spend up to 40 percent of revenues on SG&A, require an even greater investment in consumer awareness and physician education.

Bet Broad or Bet Narrow?

Second behind disease-area category is the question of focus: how a company deploys its capabilities. Even among our mid-cap cohort, there are relatively divergent attitudes toward focus. Some companies have chosen a relatively tight focus on one or two diseases or therapeutic areas, namely Biogen Idec, with more than 60 percent of its sales in immunology, and Novo Nordisk, with nearly 70 percent of sales in central nervous system drugs. Others have spread their bets, maintaining a significant presence in as many as four or more separate therapeutic areas.

"One of the challenges of focus is that, at some point, you need to broaden horizons again," says Howie Rosen, vice president of commercial strategy for Gilead. "When you get there, how do you maintain discipline, and at the same time get comfortable outside of the existing zone of expertise? Specifically for Gilead, we're good at drugs that are active against the virus, not the host. As we move out from this core, there is fundamentally different biology, and a different risk profile."

Companies often cite as a motivation for breadth the desire to hold diverse options for future growth. But, a narrow focus does not necessarily mean lower growth. In this mid-cap cohort, companies with fewer marketed franchises (one or two) have grown faster over the past five years (26 vs. eight percent average), sustained higher profitability (17 vs. 10 percent net margins), and launched twice as many products than companies with three or more franchises. Similarly, companies with fewer research areas, like Genentech in oncology and immunology, are expected to grow faster (17 percent compound annual growth rate through 2009) and launch more products than less-focused R&D companies, such as Taisho and Solvay (eight percent CAGR on average).

Focus provides value in several ways. In the commercial realm, continuity in a franchise area drives faster uptake of new products, creates barriers to entry for competitors, and improves appeal as a licensor. Valuable promotional assets are rarely stranded. In R&D, focus provides for products with a richer understanding of the biology of disease areas and of unmet medical needs. In clinical development, focus bolsters probabilities of success through increased knowledge of key pitfalls and disease dynamics, and strong relationships with opinion leaders and regulators to assure rapid enrollment and agency review. Other benefits include: cost synergies through common platforms, better leverage of historic brand positioning, and increased ability to attract the top scientific and commercial talent in a particular disease area. "Establishing focus is one of the most important things I do," says Joe McCracken, vice president of business development, Genentech. "Otherwise, you can spin your wheels and waste a lot of time in competing for business development opportunities."

With all those benefits, why do some spread their bets? The truth is: Drugs are rare, and focus only increases their scarcity.

Customer and Channel Focus

The final element we examined involved the channel focus and choices about the relative emphasis in marketing to patients, primary care physicians, or specialists. For some companies, disease-area and breadth-of-focus choices mean that only a narrow set of doctors must be targeted, as with Genentech in oncology or Gilead in anti-virals. For other companies, the customer and channel mix is much broader, as with Akzo Nobel (Organon), which targets a mix of patients, PCPs, and specialists.

Choices of channels are often, but not always, driven by the disease areas a company focuses on. Most primary care physicians treat a range of chronic, non-life threatening conditions, including hypertension, diabetes, bacterial infections, and ulcers. Presence in any of these segments necessitates a large and expensive sales force. Patient or consumer-driven marketing is most likely to occur in lifestyle conditions, like sexual health and skin care, but also in diseases like anemia, allergic conditions, or diabetes, which require high patient involvement. Consumer-directed marketing almost always means expensive print or television disease awareness or drug-specific advertising, often with spending exceeding $200 million in a single year for the most heavily promoted drugs. Finally, specialists tend to work in high criticality conditions, such as cancer and HIV, but they also serve less threatening diseases, like dermatology and ophthalmology. Marketing to the specialist channel is perhaps the most efficient, due to the smaller number of doctors and more focused medical community that should be targeted

We examined how channel focus correlates with several performance metrics, including growth, profitability, and stock-price performance. Once again, the analysis shows that focus confers significant benefit. Companies such as Ono, Solvay, and Akzo Nobel play to multiple channels and may be paying multiple entry fees. As a group, they showed the slowest growth and lowest profitability across the mid-cap cohort. In contrast, companies that have the greatest channel focus—Gilead, for example, with virology specialists—show the most robust growth, as well as the highest overall margins. "What Gilead did well was focus when we found something that worked," says Gilead's Rosen. "There had been much broader exploration into therapeutic areas, such as oncology, cardiovascular disease, and anti-infectives. But when we got a hit—in anti-virals—we had the discipline to focus, selling off oncology and other assets to provide the resources needed to bring our antiviral products to market. Even Tamiflu, which fell within the antiviral focus, required commercial capabilities we didn't have at the time, so we out-licensed it."

While specialist focus correlated with the strongest performance, companies focused on consumers and PCPs also performed better on average than those with mixed commitments. Channel focus increases promotional effectiveness. At launch, better relationships with opinion leaders and doctors drive faster uptake. Further on, they increase the number and quality of sales calls. Channel relationships can be leveraged both to understand marketplace needs and compete for partnering opportunities. Companies that fail to develop this advantage are likely to lose ground over time to more focused competitors.

Looking Forward

So how will industry have to change? The capabilities that develop, like their expectations for size, growth, and investment, must reflect the disease areas they choose to work in. Parts of what was recently an emergent medicines industry are maturing and the requirements for success are diversifying. New capabilities—technology integration, consumer marketing, and cost rationalization—play growing roles in the capability mix. The integrated, doctor-focused, high-growth and high-profit model is still appropriate for some companies, but only those that are diligently and successfully pursuing the areas of highest, most critical need.

The lessons for smaller companies seem obvious—choose a disease-area footprint carefully, make sure it aligns with financial market expectations, and don't wander too broadly into adjacent or distant therapy areas or channels: Focus the business. But for the largest players in our industry, focus won't be achieved so easily. Most companies of scale continue to pursue medications across disparate disease areas—from the highly innovative to the highly mature. Few have the luxury of shedding older segments of medicine, as the pressures for top-line growth remain intense.

For these larger companies, the lessons are more subtle: Different segments of their business may require fundamentally different scientific capabilities, risk and investment intensity, and commercial orientations. One size no longer fits all, and a single company might have to develop different models—in R&D, commercial structures, and governance processes—to succeed.

Focusing on marginal areas just to preserve growth options is bad medicine for large players, and for small. The number of focus areas a company pursues should not be determined by what it needs to meet growth objectives, but by where the company maintains leading capabilities to develop and market new medicines.

If excessive legacy scale is a barrier to focus, re-basing remains an option—shedding non-core assets and aligning investment and capabilities around a related set of opportunities.

In the future, there will be no common model, no shared success template. As industry leaders learn to play by new rules, they will need to experiment more radically—not just with choices about channel, breadth, and disease focus, but also with choices involving geographic scope, product and service integration, and where to play in the value chain.

Jerry Cacciotti is managing director and Bill Shew is a principal of SDG's Life Science practice. he can be contacted at jcacciotti@sdg.com and bshew@sdg.com