The Pharmaceutical Industry

Historically the pharmaceutical industry has been a profitable one. Between 2002 and 2006, the average rate of return on invested capital (ROIC) for firms in the industry was 16.45%. Put differently, for every dollar of capital invested in the industry, the average pharmaceutical firm generated 16.45 cents of profit. This compares with an average return on invested capital of 12.76% for firms in the computer hardware industry 8.54% for grocers, and 3.88% for firms in the electronics industry. However, the average level of profitability in the pharmaceutical industry has been declining of late. In 2002, the average ROIC in the industry was 21.6%; by 2006, it had fallen to 14.5%.

The profitability of the pharmaceutical industry can be best understood by looking at several aspects of its underlying economic structure. First, demand for pharmaceuticals has been strong and has grown for decades. Between 1990 and 2003, there was a 12.5% annual increase in spending on prescription drugs in the United States. This growth was driven by favorable demographics. As people grow older, they tend to need and consume more prescription medicines, and the population in most advanced nations has been growing older as the post-World War II baby boom generation ages. Looking forward, projections suggest that spending on prescription drugs will increase between l0 and ll% annually through 2013.

Second, successful new prescription drugs can be extraordinarily profitable. Lipitor, the cholesterol-lowering drug sold by Pfizer, was introduced in 1997, and by 2006 this drug had generated a staggering $12.5 billion in annual sales for Pfizer. The costs of manufacturing, packing, and distributing Lipitor amounted to only about 10% of revenues. Pfizer spent close to $500 million on promoting Lipitor and perhaps as much again on maintaining a sales force to sell the product. That still left Pfizer with a gross profit of perhaps $10 billion. Since the drug is protected from direct competition by a twenty-year patent, Pfizer has a temporary monopoly and can charge a high price. Once the patent expires, which is scheduled to occur in 2010, other firms will be able to produce “generic” versio ns of Lipitor and the price will fall-typically by 80% within a year.

Competing firms can produce drugs that are similar (but not identical) to a patent-protected drug. Drug firms patent a specific molecule, and competing firms can patent similar, but not identical, molecules that have a similar pharmacological effect. Thus, Lipitor does have competitors in the market for cholesterol-lowering drugs, such as Zocor, sold by Merck and Crestor, sold by AstraZeneca. But these competing drugs are also patent protected. Moreover, the high costs and risk associated with developing a new drug and bringing it to market limit new competition. Out of every 5,000 compounds tested in the laboratory by a drug company, only five enter clinical trials, and only one of these will ultimately make it to the market. On average, estimates suggest that it costs some $800 million and takes anywhere from ten to fifteen years to bring a new drug to market. Once on the market, only three out of ten drugs ever recoup their R&D and marketing costs and turn a profit. Thus, the high profitability of the pharmaceutical industry rests on a handful of blockbuster drugs. At Pfizer, the world’s largest pharmaceutical company, 55% of revenues were generated from just eight drugs.

To produce a blockbuster, a drug company must spend large amounts of money on research, most of which fails to produce a product. Only very large companies can shoulder the costs and risks of doing this, making it difficult for new companies to enter the industry. Pfizer, for example, spent some $7.44 billion on R&D in 2005 alone, equivalent to 14.5% of its total revenues. In a testament to just how difficult it is to get into the industry, although a large number of companies have been started in the last twenty years in the hope that they might develop new pharmaceuticals, only two of these companies Amgen and Genentech were ranked among the top twenty in the industry in terms of sales in 2005. Most have failed to bring a product to market.

In addition to spending on R&D, the incumbent firms in the pharmaceutical industry spend large amounts of money on advertising and sales promotion. While the $500 million a year that Pfizer spends promoting Lipitor is small relative to the drug’s revenues, it is a large amount of a new competitor to match, making market entry difficult unless the competitor has a significantly better Product.

There are also some big opportunities on the horizon for firms in the industry. New scientific breakthroughs in genomics are holding out the promise that within the next decade pharmaceutical firms might be able to bring to market new drugs that treat some of the most intractable medical conditions, including Alzheimer’s, Parkinson’s disease, cancer, heart disease, stroke, and AIDS.

However, there are some threats to the long-term dominance and profitability of industry giants like Pfizer. First, as spending on health care rises, politicians are looking for ways to limit health care costs, and one possibility is some form of price control on prescription drugs. Price controls are already In effect in most developed nations, and although they have not yet introduced in the United States, they could be.

Second, twelve of the thirty-five top-selling drugs in the industry were to lose their patent protection between 2006 and 2009. by one estimate some 28% of the global drug industry’s sales of $307 billion would be exposed to generic challenge in the United States alone, due to drugs going off patent between 2006and 2012. it is not clear to many industry observers whether the established drug companies have enough new drug prospects in their pipelines to replace revenues from drugs going off patent. Moreover, generic drug companies have in challenging the patents of proprietary drug and in pricing their generic offerings. As a result, their sales of industry sales has been growing. In 2005, they accounted for more than half by volume of all drugs prescribed in the United States, up from one-third in 1990.

Third, the industry has come under renewed scrutiny following studies showing that some FDA-approved prescription drugs known as COX-2 inhibitors, were associated with a greater risk of heart attacks Two of these drugs, Vioxx and Bextra, were pulled from the market in 2004.

Case Discussion Questions:

1. Drawing on the five forces model (Porter), explain why the pharmaceutical industry has historically been a very profitable industry? 2. After 2002, the profitability of the industry measured by ROIC, started to decline. Why do you think this occurred? 3. What are the prospects for the industry going forward? What are the opportunities, and what are the threats? 4. What must pharmaceutical firms do to exploit the opportunities and counter the threats?

Wide Market

Narrow Market
(1) cost-leadership, (2) differentiation,

(3) cost-focus, and
(4) focused-differentiation.

Harvard Business School professor Michael Porter is a leading authority on competitive strategy.

• Porter’s work during the 1980s suggested that five forces affect industry competition: |– |(1) |Rivalry among industry firms | |– |(2) |Threats of new entrants | |– |(3) |Threats of substitute products or services | |– |(4) |Bargaining power of suppliers | |– |(5) |Bargaining power of buyers |

1. Rivalry among existing firms

It is strong or weak by:
1. Concentration (number of firms)
2. Size of distribution Network of each firm
3. Diversity of competitors (differences in goals, strategies, cost, structure, etc.) if diversity is low we can predict their next move, if high that would be more difficult. 4. Product differentiation (by using the quality, reliability, and specifications or differentiation in the value chain by Targeting different segments) 5. Excess capacity and exit barriers. High excess capacity means that competitors are unable to produce with their full quantity, thus they are not able to achieve economies of scale. 6. Cost conditions (if high that lead to stronger rivalry)

2. New Entrants & Entry Barriers:
1. Capital requirements (strong distribution and strong promotion requiere high investment) 2. Economies of scale: Mass production reduce unit cost. 3. Lack of absolute cost advantage (Experience reduce cost by time for existing firms-not available for new entrants)

4. Product differentiation
5. Access to channels of distribution
6. Legal and regulatory barriers.
7. Retaliation by existing firms (sudden price cut-increase of distributors commission )

3. SUBSTITUTES: this force depends on two factors:
1. Buyers’ willingness to substitute
2. The price-performance characteristics of substitutes

4. Bargaining Power of SUPPLIERS
5. Bargaining Power of Buyers

1. Buyer’s price sensitivity:
– Cost of purchases as % of buyer’s total costs.
– How differentiated is the purchased item?
– How intense is competition between buyers?
– How important is the item to quality of the buyers’ own output?)

2. Relative bargaining power
• Size and concentration of buyers relative to sellers.
• Buyer’s information.
• Ability to backward integrate

Conclusion:
•If you are testing the market from inside you will see how the market environment variables is changing, and see what threats or offensive situations are present or not, and according to the case you can react.

• If you are outside the market and preparing to enter to the industry, you have to measure the cost of jumping the barriers, and if it is too high, it would nonsense to employ huge investments to overcome the barriers, capitalize all the results expected, just for this cost of entering. • Defending your business? you should try to make it very difficult to others to enter your market.

Generic Strategies:
1. Cost-leadership strategy: keeping costs and prices low for a wide market. •a. The cost-leadership strategy is to keep the costs, and hence prices, of a product or service below those of competitors and to target a wide market. • b. This puts pressure on R&D managers to develop products that can be created cheaply. • c. Example: computer maker Dell

2. Differentiation strategy: offering unique and superior value for a wide market. •a. The differentiation strategy is to offer products or services that are of unique and superior value compared to those of competitors and to target a wide market. • b. Managers may have to spend more on R&D, marketing, and customer service. • c. An example of this strategy is the maker of Lexus automobiles. •d. Companies use the strategy of differentiation to create a brand—a distinctive image—that they hope will differentiate them from their competitors. • e. Example: the brand Pepsi Cola

3. Cost-focused strategy: keeping costs and prices low for a narrow market. • a. The cost-focus strategy is to keep the costs, and hence, prices, of a product or service below those of competitors and to target a narrow market. • b. This is the strategy executed with low-end products sold in discount stores, such as low-cost cigarettes.

4. Focused differentiation strategy: offering unique and superior value for a narrow market. • a. The focused-differentiation strategy is to offer products or services that are of unique and superior value compared to those of competitors and to target a narrow market. • b. Examples: makers of expensive luxury cars.