Drugbaron Blog

May 15, 2015 no comments

What the travails of the UK’s largest grocer can teach the pharmaceutical industry

In the five years since DrugBaron posted his first article, entitled “Hard Times, Harder Times”, it seems that in the business of drug discovery and development everything has changed – and at the same time nothing.


On the one hand, the ubiquitous gloom that surrounded the industry has lifted, to be replaced with a febrile enthusiasm that has seen more than a hundred biotech IPOs in the last two years; something no-one (least of all DrugBaron) was willing to predict in 2010.


And the root cause of the enthusiasm is pretty easy to diagnose: earnings. Expenditure on prescription medicines has continued its double-digit compound annual growth, driven primarily by a relatively small number of premium franchises, both old (such as Abbvie’s Humira™) and newly approved (led by Gilead’s Sovaldi™ and now Harvoni™).


Add to that a healthy dose of optimism about the next wave of sure-fire winners, with the immune-oncology drugs Keytruda™ from Merck and Opdivo™ from BMS in the vanguard, and the anti-PCSK9s from Amgen and Sanofi/Regeneron not far behind, and the palpable excitement seems entirely justified.


Make no mistake, if your capital was invested in these winners, it would yield eye-watering returns unavailable in any other sector. Products such as these can yield billion-dollar annual revenues almost overnight, with gross margins that leave profits outstripping costs by a ratio of ten to one. Not since the gilded age at the end of the 19th Century have we seen industrial machines capable of generating such returns.


But scratch the surface, and arguably nothing has changed at all.


R&D strategy, at least in the larger companies, remains entirely driven by “gold rush economics”. The potential returns from these mega-blockbusters is so great, it justifies any cost for finding them. Capital efficiency remains a foreign concept for drug companies, where R&D budgets are set “top down” as a fraction of sales, rather than “bottom up” on the basis of need. And when budgets get trimmed, the process resembles a hair cut (where whole projects or even therapeutic areas are abandoned) rather than a search for more capital-efficient behaviours across the whole organization.


As long as the world (well, the US government and its citizens, at least) remain willing to pay an ever-greater fraction of national production on healthcare, the pressure to change is unlikely to build.


However, the problem with gold rush economics for investors is the heterogeneity of returns. Back a winner, and riches beyond your wildest dreams shall be yours. But of course, the vast majority of prospectors find nothing at all.   And so it is with the pharmaceutical industry. There are so many expensive misses, that the hits only just cover the total costs (witnessed by the average return on capital across the industry which is, over the longer term, no greater than for most other industries).


This fine balance between huge costs and slightly larger earnings leaves the industry vulnerable to any changes in the external environment. Such a situation resembles a futile cycle in human metabolism (where the body deliberately converts fructose-6-phopshate to fructose-1,6-bisphosphate and back again very rapidly, so that the flux through glycolysis is exquisitely sensitive to regulation of the key enzyme phosphofructokinase). It also resembles any heavily leveraged financial transaction, where the leverage can cause a large profit to swing to a large loss with only very small changes in the deal fundamentals.


In this respect, the travails of Tesco, a UK-centric grocery business, provide a surprisingly relevant lesson for the global pharma companies. In the good years of the last decade, Tesco was a money-printing machine generating substantial profits off the base of massive revenues and a very narrow margin. Like Walmart before it, by optimizing its logistics and exploiting its size to squeeze suppliers it created a seemingly robust business model despite wafer-thin profit margins on each transaction. But even a small change in customer behaviours, triggered by the global financial crisis in 2008, is in danger of bringing down the whole house of cards. When equilibrium is maintain by two vast, opposing forces (revenue and costs) being equal, a very small external push can lead to swings that even the largest balance sheet can no longer tolerate.


As long as pharma companies continue to generate only modest return on capital by relying on vast returns to (slightly) outstrip massive costs, then they will remain on this knife-edge. If external factors do eventually reduce the ability to earn these massive returns on blockbuster franchises, then the impact on the viability of the organizations that develop them will be (as it has been for Tesco) swift and severe.


DrugBaron has argued from that very first article that these external changes are inevitable and that they are already visible on the horizon. Five years later, they are surely closer, but still (it seems) far enough away for investors to ignore their darkening shadow.


Pricing pressure still seems to be more of a talking point than a pinch point.   The internet is alive with discussions about over-priced drugs, and payers are beginning to act to control prices. But the impact of these changes (so far at least) is negligible. Even where prices have been “eroded” by payer activism, volume increases have outstripped any price reductions. And in any case the majority of the drugs budget is spent on high-volume prescriptions far from the headlines.   Until payers (whether US pharmacy-benefit management companies or governments) address the problem of the “unearned premium” we are unlikely to see a material fall in drug revenues. Attacking the pricing of a few high-profile examples (which also happen to be highly effective in the clinic) will not deliver the step change in overall prices or revenues that risk seriously undermining the current “gold rush economics” business model of the major pharma companies.


Pressure from biosimilars probably falls into the same category. Although we are seeing one or two examples of biosimilar products reaching the marketplace, it is likely to be a decade before the trickle turns into a flood.   Pharma have been particularly effective, certainly in the key US market, in bolstering the regulatory hurdles that slow biosimilar approvals. It has taken the best part of a decade for a regulatory framework for biosimilars to emerge, very much to the detriment of the taxpayer and patient, in part because of the difficulty in defining just how similar should be considered interchangeable. True biogenerics are not yet even on the agenda.


For public markets pricing stocks on the basis of visible revenues, then, there is little wonder that healthcare remains hot property. With a horizon of a couple of years, even a pessimist like DrugBaron sees little prospect of fundamental change in the healthcare marketplace. Revenues, and hence profits, seem sustainable – for now.


But is that an argument for status quo?


Sustaining the “gold rush economics” business model (‘find me a blockbuster at any price’) only makes sense if that lack of attention to capital efficiency really does increase the likelihood of finding the next blockbuster.


And because it comes at such a high price – like any leverage model, it leaves the business highly vulnerable to the changes in landscape when, indeed, they eventually come (as Tesco is now discovering) – you would need to be pretty confident that your current returns were large enough to compensate for the risk of complete catastrophe down the line.


But arguably (for pharma, unlike Tesco where the precarious position was a direct consequence of the competitive advantage that established them in the first place) the reverse is true. Focus on capital efficiency may not only improve returns by reducing the denominator (the amount of capital employed), but also by increasing the numerator (revenues and profits). DrugBaron has spent the last five years (for example, here, here and here) arguing that reducing the costs of early stage discovery and development programs simply allows more shots on goal with the same capital without decreasing the likelihood that any of those shots actually hits the target. And that’s not just an assertion: mathematical models support the notion that, in a low validity environment, such as drug discovery, paying extra to improve your decision-making capabilities is a poor investment.


In the end, there is no wonder that we have not seen a shift towards “lean development” among the large pharma companies. If the gloom of the first decade of this millennium was insufficient to shake the foundation of the “gold rush economics” model, its hard to see it happening in the current euphoria. The conservative mindset says “if it aint broke, don’t fix it”.


Yet among smaller companies, the trend to capital-efficient, often virtual or semi-virtual, business models, pioneered by the ‘asset-centric’ approach of my partners at Index Ventures a decade ago, is well-established.   Capital efficiency is coming to drug R&D from the ground up.


Global pharma companies beware. When the barbarians reach the gate it may be too late to change the habits of a generation (as Tesco now seem to be discovering – although for the grocer, its less clear what changes are possible to insulate them from seismic changes in the landscape). And as the dinosaurs found out when the mammals arrived, your nemesis may be very much smaller than you.

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