Thinking Beyond the Next Blockbuster

Success in the pharmaceutical industry has long depended on finding the precise blend of molecules and atoms to create the next blockbuster drug. The combination of cutting-edge science, dogged persistence and a bit of luck artfully mixed to create magic. But as the era of powerhouse treatments transitions into its next season, the magic is more elusive and costly.

The coming years won’t be as easy for the once-favored U.S. pharmaceutical industry. Long the envy of other industries, it now faces mounting and unprecedented challenges. Smaller drug pipelines are drying up profits. Revenues are being hunted down by aggressive regulations and oversight—and patent expirations threaten to finish off what remains. Big Pharma’s place in the sun appears to be ending.

Pharmaceutical companies are vigorously combating these challenges—adopting both growth and cost-cutting strategies to address the earnings gaps and boost top-line performance.

These include mergers and acquisitions, outsourcing nonessential activities, offshoring or bestshoring, and developing more nimble business processes. Such efforts will defer the erosion of shareholder value but they will not alter a broader, more structural shift that is underway.

As significant as these challenges are, they are merely symptoms of a much stronger, more fundamental power shift from the pharmaceutical companies to the broader industry stakeholders—consumers, doctors, payors, litigators and regulators. The shift is the result of a number of factors, including an increasingly aggressive regulatory environment, better access to information, rising research and development costs, and ongoing globalization.

While executives are responding tactically to the immediate high-profile issues, the overall industry has not adopted a more strategic perspective to manage the impact of this shift. Yet, in our view, now is precisely the time for executives to think beyond the next blockbuster and begin to envision an industry structure very different from today’s.

The Future of Pharma
If a “bigger-faster” version of the current industry model is not in the cards, what might the industry look like in 10 or more years? We believe that the forces confronting companies today will drive a transformational change—either initiated by the industry under its own terms or by market forces operating under theirs.

There is much to learn from observing other industry transformations: the collapse of the studio model for entertainment companies, the regulatory-spawned transformation of the utility and telecom industries, and the effect of REITs (real estate investment trusts) on the real estate industry. Even the auto industry’s move away from vertical integration offers lessons to be learned.

With these precedents in mind, we can begin to envision the road ahead for the pharmaceutical industry. We anticipate a future in which the principal value chain activities—all part of today’s Big Pharma companies—will break out into independent entities. The new companies will be built around core competencies and clumped around a few key sectors— drug research and development, manufacturing and logistics, and commercialization (sales and marketing). This disaggregation, in turn, will drive the need for innovative financial tools and structures to support the new relationships. We also see a fundamental rewrite of the industry’s contract with society, one built on the tenets of partnership and that includes shared responsibility and transparency.

Let’s take a closer look at this vision.

An Industry Reconfigured
It is likely that today’s large, integrated pharmaceutical companies will eventually break into distinct components based on core competencies (see figure 1). Each sector will have its own business and operating model as well as different risks and rewards for investors.

There are a number of analogies for this competency-based structure. For example, the utility industry includes generators and transmission segments. The energy industry features exploration and production, refining, and retailing sectors. And the entertainment industry is divided into artists, producers and distributors. Each group implies a different economy, a different operating model and different levels of investor participation.

For today’s large pharmaceutical players, there are three competencies that could form the nexus for a more “distributed” operating model: research and development, manufacturing, and commercialization.

R&D companies. These will become centers of innovation that run on complex knowledge-based processes and have experience managing highly creative and expertly trained professionals. They might focus on specific therapeutic areas or diseases (such as cancer or AIDS), new technologies, or innovative ways to apply existing technologies. They will continue to collaborate closely with academic and governmental institutions.

Manufacturing companies. Manufacturers will focus on efficiency and low-cost sources of production. Likely participants in this sector are companies with access to inexpensive manufacturing (for example, Teva, Ranbaxy and Dr. Reddy). The different manufacturers will compete on their ability to provide low-cost, high-quality solutions similar to today’s outsourcing models or licensing agreements.

Commercialization companies. These companies will form the link between consumer needs and the products and solutions available and under development. They are both knowledge brokers and relationship-based organizations, which means today’s established pharmaceutical companies are the obvious contenders in this area. These sales and marketing firms will work closely with distributors to promote and sell products. They will also collaborate with discovery and development firms to ensure that market needs drive new products.

From an investor’s perspective, the drug developers will have the potential for larger, although much less certain, financial returns compared to the manufacturers — whose revenues and profits would be more stable and predictable. Companies specializing in commercialization will face risk-reward profiles somewhere in the middle. Also, to the extent that these companies are publicly traded, an investor’s participation in the pharmaceutical sector could be managed using a portfolio theory to replace the structured conglomerates of today.

New Tools for Financial and Capital Markets
As the industry reconfigures, new financial instruments and tools are needed to facilitate efficient capital allocation. The current sources of capital in the pharmaceutical industry — operational cash flow, debt instruments, privately negotiated licensing arrangements, and joint venture agreements — are not sufficiently transparent, liquid or numerous enough to create an efficient market. They limit the ability for significant economic improvement because there is neither an active market nor an efficient vehicle to set prices and valuations.

The pharmaceutical industry should be considering financial tools from other industries. Tools such as commodity contracts, collateralized mortgages and bond mutual funds all helped to transform the financial structure of various industries. They improved market efficiency and allowed risk to be tailored and managed. Indeed, two existing financial constructs might provide some interesting models:

Real estate investment trusts. REITs allow investors to pool their investment capital into a vehicle for commercial real estate projects. By facilitating investment in a wide range of projects, they help to diversify and manage risks and create a more liquid and disciplined real estate market. As an equivalent for the pharmaceutical industry, companies could pool their investment resources to fund drug development or clinical trials in return for a percentage of any resulting revenue.

Financial options. Financial options allow for participation without full ownership and permit investors to amplify or minimize their risk-reward equation. For the pharmaceutical industry, these could be “drug development participation rights” modeled after traditional financial options. Companies could buy, sell or trade drug development options in a public market for a class of therapies or individual drugs. The construct could also take the form of warrants, where the value of an option or warrant would fluctuate according to a drug’s prospects, timing and anticipated sales potential.

Ultimately, the financial discipline available from the capital markets could lower the cost of capital and wring operating and transaction inefficiencies out of the system. Companies will share financial risks with broader investor groups that have different levels of risk tolerance and are able to access other sources of capital that are traded in more liquid and efficient markets.

Contract with Society: Increase Transparency Consumer trust and confidence in the pharmaceutical industry have fallen dramatically in recent years. The spate of drug withdrawals, combined with accusations of faulty or misleading research and the taint of pharmaceutical consulting dollars, is compromising the objectivity of medical research and has impugned the fundamental values of the industry. A Wall Street Journal survey found that only 3 percent of Americans believe drug companies are working for the public good. Many people no longer trust the industry and actively express their desire for access to objective information, creating the age of the "activist health-care consumer."

As if the loss of trust and consumers' hunger for new information were not enough, the specter of huge litigation costs raises the stakes even higher. We need only look at the asbestos and tobacco industries to appreciate litigation's impact. Overall, the current tension in the industry's relationship with the consumer is unsustainable.

Although legislative relief might ease the pressures of litigation, there has to be an equivalent contribution from the pharmaceutical industry. One possible answer is to find a compromise: Companies could offer increased transparency in return for protection from litigation— thus transforming today’s adversarial contract with society into a partnership.

To build this partnership, the pharmaceutical industry must aggressively respond to growing calls for transparency, ending its practice of compartmentalizing data and releasing only limited information. Indeed, the Internet and increased globalization are already driving out price inequalities, and the power of the subpoena is forcing more transparency.

To achieve full transparency, the FDA or another publicly funded and managed institution could serve as a clearinghouse of information (see figure 2). This would provide a central repository of information on drug development, clinical trials, submissions, approvals and post-marketing surveys. All industry players could add and access information with some level of protection for intellectual property, health information and other confidential data. Given its importance to public-health issues, we envision federal legislation requiring companies to participate fully with this system.

For R&D companies, this will mean registering all clinical and human trials in a central location, as well as voluntarily disclosing all relevant information. This could possibly include compulsory reporting—directly by researchers—of all data to a third party. On the commercialization side, direct marketing would be redefi ned as comparative data became common and readily available. Indeed, the FDA has already created a center for post-market drug evaluation and research and is considering requesting a voluntary two-year waiting period before companies advertise new drugs to consumers.

Should executives fight growing pressure for increased transparency? Before answering, consider the fate of the asbestos and tobacco industries. By taking action now, companies will have a greater say in how the industry achieves full transparency. Better to defi ne your own future than have someone else do it for you. Companies that embrace information transparency will benefi t from renewed public trust, fewer and smaller settlement payouts, improved P/E ratios, and lower costs of capital. Transparency also means that society will begin to share the risks inherent in the pharmaceutical business. Ultimately, as pharmaceutical companies give to society, society will balance its need for innovation against the risks involved in new drug therapies.

Take Control of the Future We are not so bold as to believe that this vision of the future is either completely accurate or will be passionately embraced by the industry. Debate and spirited discussion should occur. The important point is that companies, and the industry as a whole, begin to design and prepare for a new environment. Companies must prepare for these changes today to ensure that they can use the upcoming shifts to their advantage. The following steps are offered as a guide:

Review competitive positioning. Is your company stronger in research and development or manufacturing and marketing? Rethink your strategic goals and choose a business model that best supports them.

Adopt new financial tools. Assess the feasibility, costs and benefi ts associated with various fi nancial tools and then understand the implications that each alternative brings.

Plan for information transparency. At the most basic level, companies must identify and mitigate the risks inherent in sharing information. Recent examples of personal data threats in consumer finance and retail banking offer good lessons about the difficulty of maintaining data integrity. By working with public advocacy and legal groups you can help shape data transparency.

Encourage patients to become active partners in their health care. Patients are becoming increasingly active partners in their health care decisions. Companies can facilitate this trend through better consumer education and by stressing the importance of two-way communication. Also, all marketing strategies should reinforce this partnership message.

Ultimately, it is up to all pharmaceutical companies to begin managing their challenges to emerge as part of a better, more productive and stronger industry. The future will depend on confronting each challenge and on a new mindset—it’s time to think beyond the next blockbuster.

Consulting Authors
BOB O’MEARA is a partner based in the Chicago office. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .
SEAN RYAN is a principal based in the Chicago office. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .