The pharmaceutical forecast

A new environment for pharmaceutical companies is on the horizon and it will be the fittest who survive, predicts Ian Nisbet.

We are currently witnessing the equivalent of global climate change in the pharmaceutical industry. Like many 'macro' phenomena, the change has been emerging over a period of years but the ramifications are just starting to appear. And, just as the outcome of the last global climate change led to the extinction of some life forms and the emergence of others, the changing pharmaceutical climate is likely to cause some major shifts in the pharmaceutical landscape.

The first portent of major change came with the advent of the biotechnology industry, a mere 25 years ago. While its initial impact was not immense, early successes led pharmaceutical companies (which had initially shown modest or no interest in biotechnology) to see the industry as a useful source of targets or pre-clinical work; a sort of 'useful, specialised vendor'. However, in a very rapid timeframe, biotechnology has gone from 'small supplier' status to 'critical industry player', based on its discovery and development of breakthrough therapeutics and diagnostics that are making a difference in patients' lives. Today, the presence of an innovative and entrepreneurial biotechnology industry has become an (maybe 'the') essential success factor for the pharmaceutical industry.

Concurrent with the emergence of the biotechnology sector (and, in some cases, driven by it) some industry-defining trends and events have appeared, including:

* The productivity dilemma.

* Price pressure/control on pharmaceutical products.

* The genomics revolution.

* Personalised medicine and the potential demise of the 'blockbuster'.

The productivity dilemma

The cost of developing a new molecular entity (NME) is estimated to be greater than US$800M (and rising). Disconcertingly, despite the increasing cost, the number of new drugs being approved each year is declining. The heavy investment in R&D made by pharmaceutical companies is not delivering corresponding products or results. Driven significantly by the challenges of declining productivity, product licensing and company acquisition have taken on increasing importance to the industry. The aggressiveness of in-licensing activities is reflected by deals of breathtaking proportions (such as the BMS-ImClone deal for Erbitux, valued at US$2 billion; the Aventis-Genta deal for Genasense, valued at US$480 million; or the Pfizer-Eyetech deal for Macugen, valued at US$770 million) -- the importance of acquisitions is demonstrated by sheer weight of numbers. According to Bloomberg, in the first five months of 2004, drug companies were involved in 224 mergers worth US$96 billion, making the global drug industry the most active acquisition market after banking. It is clear that pharmaceutical pipelines are getting hungrier and hungrier. It is also clear that, increasingly, individual companies are not able to feed their own pipelines.

Price pressure/control

At the same time that productivity is decreasing, the profit margins on marketed drugs are being called into question by both the general public and governments. The industry's argument that it needs to extract a reward from the few drugs that make it through the high cost/high risk drug development process is increasingly falling on deaf ears. Declining productivity in drug development would, logically, drive an argument for even higher costs for marketed drugs. In the current climate this is a tough argument to sell. With limits on patent coverage, increasing generic competition and the emergence of cross-border trading in pharmaceuticals, the push towards lower rather than higher prices is gaining momentum. The golden era of unfettered growth in the revenues and earnings of pharmaceutical companies appears to be over.

Genomics

Prior to the sequencing of the human genome, the entire pharmaceutical industry was built on several hundred known drug targets. Most of these targets had been studied for many years (and often decades), so that drug developers often had a large resource pool upon which to base their development activities. Model systems, multiple experts and large reservoirs of fundamental biological information were generally available, supporting the drug development process. And then, in the space of just a few years, along came thousands and thousands of new targets, most of which were unvalidated and were supported by a meager ration of background knowledge. Implicitly, developing drugs against these targets means additional cost, time and risk. The upside? Drug companies now have a wider choice of drug targets, opening up the possibility of new breakthrough treatments. The downside is the potential for even lower productivity.

Personalised medicine

In addition to its potential for identifying drug substrates (ie. targets), genomics provided a new way of identifying drug subjects (ie. patients). Molecular markers for disease susceptibility, drug responsiveness, or adverse events may (ultimately) be used to select sub-populations of patients for either inclusion into, or exclusion from, a particular therapeutic regimen. Gone would be the 'one size fits all' model for drug treatment, replaced with 'the right therapy at the right time for the right patient' -- the personalised medicine vision. It remains unclear exactly how this vision will impact the financial underpinning of the pharmaceutical business, should it be achieved. However, as a starting proposition, it's hard to see that less patients for a given drug is likely to drive increased drug revenues. Of course, there's always the argument that better patient selection will reduce clinical trial costs and increase probability of success, thereby reducing some of the up-front costs. Even so, with the advent of personalised medicine we are likely to see a change in both the number and the market value of blockbuster drugs. Increasingly, drug companies will need to occupy 'high value niches' rather than rely on blockbusters to drive growth.

The pharmaceutical industry is in a squeeze

The bottom line with all these trends is that the pharmaceutical industry is faced with ever-increasing costs, and there's a lid on prices. The pharmaceutical industry is in a squeeze.

In response to this squeeze, the model for pharmaceutical development (and by extension the pharmaceutical industry) is undergoing a dramatic change. Gone is the model of large, stand-alone, companies able to develop products in relative isolation. Now we have a model of complex interdependencies, where large companies increasingly look to multiple relationships with fast-moving, innovative companies to keep their pipelines relatively full and to drive medium and longer-term growth. Indeed, the catchphrase in the pharmaceutical industry at this time is 'alliance management' in recognition that managing relationships is a skill that will be essential for future success. While alliance management may currently be perceived as a differentiator, in the near future it will be a just another development competence required to be in the game. In the near future, companies that cannot successfully manage a portfolio of multiple product and technology relationships will go the way of the dinosaur.

This environment of growing competition for a shrinking number of opportunities and increasingly complex relationships between small and large companies raises some fundamental questions about the future of the industry. Will the existing pharmaceutical companies, with their tremendous cash and size advantage, continue to dominate the industry by being able to 'buy up' whatever innovations they need? At the same time that the established, companies are trying to entrench their position in the new environment, the upstart biotechnology companies are trying to become the pharmaceutical companies of the future. What are their prospects for long-term growth and survival?

It's tough to build a company

In the modern era, is it really possible to build an independent, sustainable, pharmaceutical company? And, in the light of the changing environment, what does a sustainable pharmaceutical company look like? These are fundamental questions facing the biotechnology industry. Despite the scientific successes of the past 25 years, no one has succeeded in building a pharmaceutical company completely organically, without in-licensing or acquistions. Amgen, arguably the most successful biotechnology company to date, created tremendous value and built a substantial company out of the fruits of its own pipeline. However, despite the phenomenal success of Neupogen and Epogen (and their successor compounds), Amgen had to implement licensing and acquisition strategies to grow beyond a large molecule company with a narrow portfolio. An early acquisition was Synergen (which ultimately provided Kineret); more recently Immunex provided another blockbuster product with additional growth potential (Enbrel) and Tularik provided small molecule development capabilities and an oncology pipeline. Along the way there have been licensing deals, such as with NPS (for osteoporosis products) and the terminated deals with Praecis and Immunomedics (both for oncology products).

Genentech, of course, is the other biotech giant, and the company that is generally recognised as having the best pipeline in the biotechnology business. And while much of the pipeline has been internally derived (and Genentech has steered away from acquisitions) it is sometimes overlooked that many of Genentech's products have come through licensing deals and other types of partnerships. Rituxan, Genentech's huge oncology success story, originally came from Idec. Xolair came out of a complex relationship between Genentech, Tanox and Novartis. Raptiva was co-developed with Xoma. Tarceva, Genentech's first successful foray into small molecules, came from OSI.

And, of course, there's Roche. While Roche did not provide products to Genentech, it did provide many of the dollars that enabled Genentech to build the company through to self-sustainability. And although Genentech has been able to stay largely autonomous, it is effectively limited to being a US operation because of Roche's access to Genentech's pipeline outside the US. Genentech has been able to build a fantastic business based on the US alone; up until now this has been enough this enough to drive growth and value creation.

Bigger is not necessarily better

And what of the other big biotechnology companies? Biogen and Idec merged to try and create a sustainable company. Genzyme acquired several companies, including Geltex (primarily for Renagel, Peptimmune (which was later spun back out), Sangstat (for its transplant business) and, most recently Ilex Oncology (for its oncology pipeline). Genzyme has also done licensing and other partnering deals with biotechnology companies such as Cambridge Antibody Technology and TKT Therapeutics. MedImmune built its pipeline through licensing deals with BioTransplant (Vitaxin) and US Biosciences (Ethyol), along with the acquisition of Aviron (for Flumist). Likewise, the newer generation of significant biotechnology companies, such as Millennium, Gilead, Cephalon, Human Genome Sciences and Vertex, have all built themselves through both acquisition and licensing.

The bottom line is that building a company in this industry is tough; building a company organically is effectively impossible. Moving forward, with increasing pressure on near-term earnings and revenue growth, the situation is only going to get more challenging. In the emerging environment, should biotechnology aspire to become pharmaceutical companies? Maybe not - maybe enough value and growth can generated through high value niches. Maybe the Genentech-Roche model represents the path for biotechnology companies to follow.

So, what about the pharmaceutical companies? What role will external relationships play in their future? Here, the answer is relatively straightforward, and it has already been recognised by the industry: licensing and acquisition will be absolutely critical to the ongoing viability of pharmaceutical companies. Recently we've seen a wave of mega-mergers (Pfizer-Pharmacia, GlaxoWellcome-SKB, Astra-Zeneca, Aventis-Sanofi Synthelabo, etc). However, these mergers are primarily financially driven (the so-called 'synergy' factor) and really do not address longer-term systemic and sustainability problems. At some point (arguably already reached in a number of cases) size becomes a weakness rather than a strength. Recently, AstraZeneca, Roche and Lilly have all stated that M&A is not part of their forward strategy, supporting the notion that bigger is not necessarily better.

Aside from the mega-mergers, pharmaceutical companies have shown an increasing passion for smaller licensing or acquisition initiatives. Importantly, many of these have taken the pharmaceutical company into non-traditional areas. For example, both Lilly and Aventis entered the antisense field (through licenses with Isis and Genta, respectively); Merck made an entry point into cancer through its acquisition of Aton; AstraZeneca moved into antibodies through a strategic partnering arrangement with Abgenix; Pfizer made a similar move through Medarex, as did Novartis more recently through a deal with MorphoSys. Similarly, the entry point into genomics for many pharmaceutical companies was through strategic relationships with companies such as Millennium, HGS, Curagen, and the like.

Blurring the lines

It is a natural trend that, as companies become larger and more complex, and are fundamentally judged according to short-term financial metrics, it becomes increasingly difficult for innovation to come from within. Thus, the prospect that growth for the big biotechnology companies and the pharmaceutical companies will come from outside should not come as a surprise. Indeed, given the productivity equation for the industry ($800M or more for each NME), it could be argued that it makes more sense for all innovation to come from outside. Of course, this approach does not work if everyone comes to the same conclusion.

So, if the big biotechnology companies need licensing and acquisition to grow, and the smaller companies will need licensing and acquisition to move into the ranks of the big companies, and the pharmaceutical companies are dependent upon licensing and acquisition for ongoing viability, how is it going to play out? Who will get whatever opportunities are out there? Where will the opportunities come from? The equation doesn't add up.

If the pharmaceutical productivity challenge is going to be addressed, short of some quantum leap in technology, one obvious answer is for companies to leverage off their strengths. Maybe the fully-integrated pharmaceutical company (FIPCO) model is not the right one for the industry. Would productivity be enhanced by specialist discovery, development and commercialisation companies working as a network or a loose set of affiliations, rather than as part of a single company? Is that where the industry is evolving in any case? Certainly, in a number of the more recent deals pharmaceutical companies have been prepared to view the relationships as strategic partnerships rather than as traditional licensing deals. The smaller partner often has co-development rights, as well as co-promotion rights in their home territory -- or, if not co-promotion, a profit share or a very large royalty. Sometimes the relationships are formalised into true partnerships, as in the case of the Lilly-Icos joint venture for Cialis. The lines are becoming blurred between large and small companies, between technology suppliers and technology users. The new pharmaceutical world of relationships is much more 'fuzzy' than the old one.

What can be learned from higher level trends?

Established players trying to hold on to gains of the past, upstarts pushing for a new balance of power, increasing competition for fewer resources -- do these features of the pharmaceutical industry seem familiar? It is interesting to think of the recent history of the pharmaceutical industry in the context of the global political and economic environment. At the same time as we've seen an inflection point in the pharmaceutical industry, we've also seen some major political upheavals and economic changes throughout the world. Consider these changes over the past 25 years: the breakdown of the Soviet Union, the emergence of economic blocs (European Union, NAFTA) and major new markets (China), the emergence of the concept of an eco-economy in place of the traditional 'grow at any cost' model, the emergence of global terrorism.

Of course it's not possible to bundle these (and other) changes together into one geopolitical model but some basic themes are apparent:

* Central command and control governments have largely disappeared, being fundamentally unable to either command or control in a period of rapid change.

* 'Think globally, act locally' has become the catch-cry of organisations as diverse as conservationist groups and global terrorist organisations.

* 'Friend or foe' (competitor or collaborator) is a temporal and situational concept, rather than an absolute.

Are these macro trends relevant to the pharmaceutical industry? Over and above the fact that the pharmaceutical industry is inexorably tied into the global political and economic environment, there are direct parallels to be drawn. In the brave new pharmaceutical world large, centralised, decision-making structures will not work. Rigid structures will be replaced with flexible ones. Affiliations will be made, and un-made, and made again. Independence will be replaced with interdependence. The question of 'building an independent, sustainable pharmaceutical company' will be irrelevant, since 'independent' and 'sustainable' may well be mutually exclusive!

Survival of the fittest

So, in this brave new world of a networked, interdependent pharmaceutical industry, who's going the way of the dinosaur and who's going to survive and drive value-creation? I think it will be the bold, rather than the meek, who inherit the pharmaceutical earth. The companies that will survive in this new environment are the ones that are able to move quickly, and operate in a decentralised environment; that are willing and able to devolve decisions to local operations; that are confident in their own strengths and willing to acknowledge their weaknesses; that are able to access rather than own the strengths of others; that have the confidence and creativity to work with and through a competitor; and that are comfortable with (or thrive upon) uncertainty, change and complexity.

Does this mean that the existing large companies cannot survive? No, but size will be something to overcome rather than being the basis for competitive advantage.

Of course, size is contextual. A small individual can be part of a larger whole (think of individual coral versus coral reef), just as a large entity (such as an ecosystem) can be made up of a network of interdependent entities. In the new pharmaceutical world, the large companies will more closely resemble an ecosystem rather than an individual.

An existing example of this type of company is Johnson & Johnson. As a corporate entity, J&J is one of the largest pharmaceutical companies. However, as an operational entity it is more like a network of affiliated companies. This mode of operation is reflected in J&J's approach to M&A. Rather than integrate acquired companies into a single, centralised entity, they are kept intact as semi- or largely-autonomous entities with their own management and decision-making structures. This model has been used with companies such as Centocor, Scios and Alza, each of which remains as a defined entity with its own management. Similarly, J&J's operating companies are a network of semi-autonomous, affiliated organisations, rather than a neat, centrally-controlled organisation. Holding this network of companies together is not an all-powerful, corporate structure, but rather a clear company vision and a strong set of core principles. J&J's success in managing this complex, interdependent internal network (not to mention its external network of collaborators) should put it in a strong position to be a survivor and key player in the new environment.

Another existing pharmaceutical company that has shown flexibility, adaptability and foresight in the past is Roche. It had the foresight to take an equity position in Genentech at an early stage in that company's evolution. It had the insight to keep Genentech as an almost independent entity. It has had the confidence to resist the mega-merger trend and again shown foresight in recognising relationship management as a strategic value driver. With regard to this latter point, Roche recognises the value of long-term relationships and supports its partner companies' development as independent entities, rather than feeling compelled to acquire them. These attributes should help Roche establish a viable place in the new pharmaceutical world.

The point in mentioning these two companies is not to say that they will be successful and others will not, but rather to highlight existing philosophies and modes of operation that should offer a competitive advantage moving forward. Natural selection works by pre-existing traits providing the basis for an advantage in a new environment. Some companies, even if they recognise the changing environment and want to adapt to it, will be inherently unable to do so because they don't have any (or enough of) the requisite traits. They are the ones that will go the way of the dinosaur.

Does this mean that M&A will not be a part of the new pharmaceutical world? No, it will continue -- but it is more likely to involve the smaller companies, not the larger ones. As already discussed, smaller companies cannot become sustainable through organic growth alone so they have no option but to (actively or reactively) include M&A as part of their growth strategy. Therefore, consolidation will continue at the 'low end' of the scale.

A fuzzy future

However, for the larger companies, M&A will increasingly become a distraction that they cannot afford. For these companies, spin-outs or other forms of de-merger will become more common as they begin to realise that the central 'control and command' organisation cannot cope with the new environment. The first signs of this trend are already appearing, with Schering recently deciding to spin out its dermatology group, thereby creating one of the largest biotechnology companies in Europe. This move followed similar actions by Aventis (spinning out Proskelia) and Pharmacia (spinning out Biovitrum). While this has been a European phenomenon so far, the same trend is likely to occur in the US as companies choose 'divide and conquer' over consolidation as a key strategy.

The so-called golden age of the pharmaceutical industry has passed. The brave new pharmaceutical world will not be one of neat corporate structures and ever growing corporate entities. There will be consolidation at the bottom end and fragmentation at the top. Critical mass will have upper, as well as lower, bounds. Complexity, ambiguity and uncertainty will be hallmarks of the new environment. Companies that are flexible and adaptable in their structures and are built upon principles and practices that embrace complexity, ambiguity and uncertainty will be well positioned to lead the industry in this 'fuzzy future'. For the rest, the survivors will pick over their bones.

Ian Nisbet is CEO of Meditech Research in Melbourne. Prior to joining Meditech, he worked at Millennium Pharmaceuticals in the US.