Phar­ma's bro­ken busi­ness mod­el: An in­dus­try on the brink of ter­mi­nal de­cline

Biotech Voic­es is a con­tributed ar­ti­cle from se­lect End­points News read­ers. Com­men­ta­tor Kelvin Stott reg­u­lar­ly blogs about the ROI in phar­ma. You can read more from him here.


Like many in­dus­tries, phar­ma’s busi­ness mod­el fun­da­men­tal­ly de­pends on pro­duc­tive in­no­va­tion to cre­ate val­ue by de­liv­er­ing greater cus­tomer ben­e­fits. Fur­ther, sus­tain­able growth and val­ue cre­ation de­pend on steady R&D pro­duc­tiv­i­ty with a pos­i­tive ROI in or­der to dri­ve fu­ture rev­enues that can be rein­vest­ed back in­to R&D. In re­cent years, how­ev­er, it has be­come clear that phar­ma has a se­ri­ous prob­lem with de­clin­ing R&D pro­duc­tiv­i­ty.

Var­i­ous an­a­lysts (no­tably De­loitte and BCG) have tried to mea­sure Big Phar­ma’s R&D pro­duc­tiv­i­ty in terms of the in­ter­nal rate of re­turn (IRR) on in­vest­ment, but in each case the analy­sis is high­ly com­plex and con­vo­lut­ed (and thus sub­ject to doubt), as it de­pends on many de­tailed as­sump­tions and for­ward-look­ing fore­casts at the in­di­vid­ual prod­uct lev­el. Here for the first time, I in­tro­duce a far sim­pler, much more ro­bust method­ol­o­gy to cal­cu­late phar­ma’s re­turn on in­vest­ment in R&D, which is based on­ly on re­li­able and wide­ly avail­able high-lev­el da­ta on the in­dus­try’s ac­tu­al his­toric P&L per­for­mance. This new analy­sis con­firms the steady de­cline re­port­ed by oth­ers, but here I al­so ex­plore the un­der­ly­ing dri­vers and make con­crete pro­jec­tions, which sug­gest that the en­tire in­dus­try is on the brink of ter­mi­nal de­cline.


A sim­ple new method to mea­sure R&D pro­duc­tiv­i­ty / IRR

Phar­ma’s busi­ness mod­el es­sen­tial­ly in­volves mak­ing a se­ries of in­vest­ments in­to R&D and then col­lect­ing the re­turn on these in­vest­ments as prof­its some years lat­er, once the re­sult­ing prod­ucts have reached the mar­ket. How­ev­er, the sit­u­a­tion is com­pli­cat­ed by the fact that both in­vest­ments and re­turns are phased over many years for each prod­uct, and not all prod­ucts make it to mar­ket; in fact, most prod­ucts fail to reach mar­ket at all and they fail at dif­fer­ent times and costs dur­ing their de­vel­op­ment.

Now we can great­ly sim­pli­fy this pic­ture by con­sid­er­ing on­ly the av­er­age re­turn on in­vest­ment across the in­dus­try as a whole, which is what in­ter­ests us in any case. We sim­ply as­sume that all prof­its in any giv­en year come from in­vest­ments made with­in a sin­gle pre­vi­ous year, where the gap be­tween these two years rep­re­sents the av­er­age in­vest­ment pe­ri­od, from the mid­point of R&D in­vest­ment to the mid­point of re­turns at peak sales. As it hap­pens, this av­er­age in­vest­ment pe­ri­od is rel­a­tive­ly sta­ble and well-de­fined, as it is large­ly dri­ven by a fixed stan­dard patent term of 20 years, as well as a his­tor­i­cal­ly sta­ble R&D phase last­ing rough­ly 14 years from start to fin­ish. Thus, the av­er­age in­vest­ment pe­ri­od is about 13 years, from the mid­point of the R&D phase af­ter 7 years, plus an­oth­er 6 years to reach peak sales be­fore loss of ex­clu­siv­i­ty.

There is one po­ten­tial ar­gu­ment against this method, which is that the lat­er phas­es of R&D tend to cost many times more than the ear­li­er phas­es. How­ev­er, we must al­so re­mem­ber that we need to in­vest in many more projects at the ear­li­er phas­es than we in­vest in at the lat­er phas­es, due to nat­ur­al at­tri­tion with­in the R&D pipeline. Thus, the to­tal R&D in­vest­ment is ac­tu­al­ly dis­trib­uted quite even­ly through­out the de­vel­op­ment time­line. And, as I show be­low, the cal­cu­lat­ed re­turn is not very sen­si­tive to this sin­gle as­sump­tion in any case.

Be­fore we use this sim­ple method to cal­cu­late the re­turn on in­vest­ment, there is one more small but im­por­tant de­tail to re­mem­ber: The net re­turn on R&D in­vest­ment in­cludes not on­ly the re­sult­ing prof­its (EBIT), but al­so the fu­ture R&D costs. This is be­cause fu­ture R&D spend­ing is an op­tion­al use of prof­its that re­sult from pre­vi­ous in­vest­ments.

So now we can cal­cu­late the av­er­age re­turn on in­vest­ment (IRR) as the com­pound an­nu­al growth in the val­ue of past R&D in­vest­ments to the val­ue of re­sult­ing prof­its (EBIT) plus fu­ture R&D costs, as il­lus­trat­ed here with in­dus­try P&L da­ta from Eval­u­atePhar­ma:

Now we get the fol­low­ing sim­ple for­mu­la to cal­cu­late the In­ter­nal Rate of Re­turn (IRR) on phar­ma R&D in any giv­en year x:

IRR(x) = [ (EBIT(x+c) + R&D(x+c)) / R&D(x) ]^(1/c) - 1

Where c is the av­er­age in­vest­ment pe­ri­od of 13 years.


Re­turn on in­vest­ment in phar­ma R&D is rapid­ly de­clin­ing

Ap­ply­ing this sim­ple for­mu­la across mul­ti­ple years of P&L da­ta from Eval­u­atePhar­ma, we see the fol­low­ing down­ward trend, which is ful­ly con­sis­tent with re­ports pub­lished by both De­loitte and BCG:

Now the scari­est thing about this analy­sis, is just how ro­bust, con­sis­tent and rapid is the down­ward trend in re­turn on in­vest­ment over a pe­ri­od of over 20 years. But more­over, these re­sults con­firm that re­turn on in­vest­ment in phar­ma R&D is al­ready be­low the cost of cap­i­tal, and pro­ject­ed to hit ze­ro with­in just 2 or 3 years. And this de­spite all ef­forts by the in­dus­try to fix R&D and re­verse the trend.

I men­tioned ear­li­er that this analy­sis is based on one as­sump­tion, the av­er­age in­vest­ment pe­ri­od which is quite sta­ble and well-de­fined, but here be­low we see that the re­sults are not sen­si­tive to this sin­gle as­sump­tion in any case. The down­ward trend is just as clear, as is the pro­ject­ed IRR of 0% by 2020:

So what is dri­ving this trend, and why haven’t we been able to do any­thing about it?


Law of Di­min­ish­ing Re­turns

Many dif­fer­ent caus­es and dri­vers have been sug­gest­ed to ex­plain the steady de­cline in phar­ma R&D pro­duc­tiv­i­ty, in­clud­ing ris­ing clin­i­cal tri­al costs and time­lines, de­creas­ing suc­cess rates in de­vel­op­ment, a tougher reg­u­la­to­ry en­vi­ron­ment, as well as in­creas­ing pres­sure from pay­ers, providers, and in­creas­ing gener­ic com­pe­ti­tion, how­ev­er there is one fun­da­men­tal is­sue at play that dri­ves all these fac­tors to­geth­er: The Law of Di­min­ish­ing Re­turns.

As each new drug im­proves the cur­rent stan­dard of care, this on­ly rais­es the bar for the next drug, mak­ing it more ex­pen­sive, dif­fi­cult and un­like­ly to achieve any in­cre­men­tal im­prove­ment, while al­so re­duc­ing the po­ten­tial scope for im­prove­ment. Thus, the more we im­prove the stan­dard of care, the more dif­fi­cult and cost­ly it be­comes to im­prove fur­ther, so we spend more and more to get di­min­ish­ing in­cre­men­tal ben­e­fits and added val­ue for pa­tients which re­sults in di­min­ish­ing re­turn on in­vest­ment, as il­lus­trat­ed here:

But why does the analy­sis above sug­gest a lin­ear de­cline that will hit 0% IRR by 2020? Shouldn’t the de­cline slow down and curve away so that it nev­er reach­es 0% IRR?

No. 0% IRR cor­re­sponds to break­ing even and get­ting ex­act­ly your orig­i­nal in­vest­ment back, but as any­one who has worked in phar­ma will know all too well, you can eas­i­ly lose all your orig­i­nal R&D in­vest­ment as most drugs fail with­out mak­ing any re­turn at all, so the min­i­mum the­o­ret­i­cal IRR is in fact neg­a­tive 100%. There is no rea­son why the IRR should stop de­clin­ing be­fore it reach­es 0%, or even -100%, be­sides the lim­it­ed pa­tience of in­vestors.

To fur­ther il­lus­trate how the Law of Di­min­ish­ing Re­turns ap­plies to phar­ma R&D, let us con­sid­er a lim­it­ed set of 200 po­ten­tial drug de­vel­op­ment op­por­tu­ni­ties de­fined by a ran­dom ex­po­nen­tial dis­tri­b­u­tion of ex­pect­ed costs (in­vest­ments) yield­ing an in­de­pen­dent ran­dom ex­po­nen­tial dis­tri­b­u­tion of ex­pect­ed val­ues (re­turns) af­ter an av­er­age in­vest­ment pe­ri­od of 13 years. The ex­pect­ed IRR of each op­por­tu­ni­ty is giv­en by the for­mu­la:

IRR = [ eRe­turn / eCost ] ^(1/13) - 1

Now we rank and pri­or­i­tize all these po­ten­tial op­por­tu­ni­ties by their ex­pect­ed IRR over time, just as we se­lect and pri­or­i­tize drug de­vel­op­ment projects by their ex­pect­ed re­turn on in­vest­ment in the phar­ma in­dus­try, and this is what we get:

No­tice how the mid­sec­tion of the IRR plot of pri­or­i­tized op­por­tu­ni­ties fol­lows a per­fect­ly lin­ear down­ward trend that pass­es right through 0% IRR, which is ex­act­lywhat we have seen with our analy­sis of phar­ma R&D pro­duc­tiv­i­ty above! The im­pli­ca­tions of this are rather strik­ing:

Re­turn on in­vest­ment in Phar­ma R&D is de­clin­ing be­cause that is pre­cise­ly how we pri­or­i­tize in­vest­ment op­por­tu­ni­ties over time.

In essence, drug dis­cov­ery is rather like drilling for oil, where we pro­gres­sive­ly pri­or­i­tize and ex­ploit the biggest, best, cheap­est and eas­i­est op­por­tu­ni­ties with the high­est ex­pect­ed re­turns first, leav­ing less at­trac­tive op­por­tu­ni­ties with low­er re­turns for lat­er. Even­tu­al­ly, we are left spend­ing more val­ue than we are pos­si­bly able to ex­tract:


Im­pli­ca­tions and pro­jec­tions for the phar­ma in­dus­try

Now giv­en that the steady de­cline in re­turn on in­vest­ment in phar­ma R&D fol­lows the Law of Di­min­ish­ing Re­turns as the nat­ur­al and un­avoid­able con­se­quence of how we pri­or­i­tize R&D in­vest­ment op­por­tu­ni­ties, where does that leave the in­dus­try?

We can sim­ply ex­trap­o­late the ro­bust lin­ear down­ward trend in IRR, and then ap­ply the same for­mu­la we used above to cal­cu­late IRR based on past per­for­mance in re­verse, to pre­dict how the in­dus­try will evolve in the fu­ture. This is what we get:

Wow! What we see is that the en­tire phar­ma in­dus­try is on the brink of ter­mi­nal de­cline, and will al­ready start to con­tract with­in the next 2 or 3 years!

This seems in­cred­i­ble, but re­mem­ber that this is not some ar­bi­trary bleak fore­cast. It is the di­rect math­e­mat­i­cal re­sult of the Law of Di­min­ish­ing Re­turns which we have al­ready seen in our analy­sis above, and which we have been able to ex­act­ly repli­cate by pri­or­i­tiz­ing a lim­it­ed set of ran­dom in­vest­ment op­por­tu­ni­ties.

So what is go­ing on here? Can this re­al­ly hap­pen?


Phar­ma’s bro­ken busi­ness mod­el

The sit­u­a­tion is il­lus­trat­ed nice­ly by this schemat­ic here be­low:

What we have here is an in­dus­try that is en­ter­ing a vi­cious cy­cle of neg­a­tive growth and ter­mi­nal de­cline as its fun­da­men­tal busi­ness mod­el has run out of steam by the Law of Di­min­ish­ing Re­turns: Di­min­ish­ing R&D pro­duc­tiv­i­ty and re­turn on in­vest­ment leads to di­min­ish­ing growth in sales. Even­tu­al­ly, growth turns neg­a­tive and sales start to con­tract. Re­duced sales then re­duces the amount of mon­ey avail­able to in­vest back in­to R&D, which caus­es sales growth to de­cline even fur­ther. And so on, un­til the in­dus­try is gone al­to­geth­er.

This prin­ci­ple is fur­ther il­lus­trat­ed here, show­ing how val­ue cre­ation is turn­ing neg­a­tive:


In­dus­try life cy­cles and re­gen­er­a­tion

So can this hap­pen? Will phar­ma re­al­ly shrink out of ex­is­tence, and is there any­thing we can do to stop it?

In short, yes, it can and will hap­pen. Phar­ma as we know it will shrink out of ex­is­tence, and no, there is noth­ing we can do to stop it. We know this be­cause the steady de­cline in IRR is an un­avoid­able con­se­quence of pri­or­i­ti­za­tion, and has con­tin­ued de­spite all our ef­forts to slow, stop and re­verse the de­cline to date.

We should not be sur­prised by this. All in­dus­tries and busi­ness mod­els fol­low the Law of Di­min­ish­ing Re­turns, and many in­dus­tries have come and gone through his­to­ry. In fact, the Phar­ma in­dus­try it­self sprout­ed out from the ter­mi­nal de­cline of the chem­i­cals and dye in­dus­try as it was slow­ly com­modi­tized. Out of the ash­es grows the new.

And there­in lies the on­ly re­al hope for the phar­ma in­dus­try — or at least the com­pa­nies and hun­dreds of thou­sands of peo­ple work­ing with­in it.

Just as the phar­ma in­dus­try evolved from the chem­i­cals in­dus­try, and the bio­phar­ma in­dus­try has evolved from the phar­ma in­dus­try, the phar­ma and bio­phar­ma in­dus­tries to­geth­er will evolve in­to some­thing quite dif­fer­ent, most like­ly con­tin­u­ing the his­toric trend of in­creas­ing com­plex­i­ty to­wards more com­plex bi­o­log­i­cal so­lu­tions to press­ing health­care prob­lems, such as cell & gene ther­a­py, tis­sue en­gi­neer­ing and re­gen­er­a­tive med­i­cine:

But who re­al­ly knows?

What is clear is that phar­ma (and bio­phar­ma) will not be around for­ev­er, and Dar­win’s the­o­ry of evo­lu­tion ap­plies to com­pa­nies and in­dus­tries just as much as it ap­plies to the species of life:

It is not the strongest of the species that sur­vives, nor the most in­tel­li­gent, but the one most adapt­able to change.

In­deed. Adapt or die!

Cell and Gene Con­tract Man­u­fac­tur­ers Must Em­brace Dig­i­ti­za­tion

The Cell and Gene Industry is growing at a staggering 30% CAGR and is estimated to reach $14B by 20251. A number of cell, gene and stem cell therapy sponsors currently have novel drug substances and products and many rely on Contract Development Manufacturing Organizations (CDMO) to produce them with adherence to stringent regulatory cGMP conditions. Cell and gene manufacturing for both autologous (one to one) and allogenic (one to many) treatments face difficult issues such as: a complex supply chain, variability on patient and cellular level, cell expansion count and a tight scheduling of lot disposition process. This complexity affects quality, compliance and accountability in the entire vein-to-vein process for critically ill patients.

A lab technician works during research on coronavirus at Johnson & Johnson subsidiary Janssen Pharmaceutical in Beerse, Belgium, Wednesday, June 17, 2020. (Virginia Mayo/AP Images)

UP­DAT­ED: End­points News ranks all 28 play­ers in the Covid-19 vac­cine race. Here's how it stacks up to­day

(This piece was last updated on August 13. Endpoints News will continue to track the latest developments through the FDA’s marketing decisions.)

The 28 players now in or close to the clinical race to get a Covid-19 vaccine over the finish line are angling for a piece of a multibillion-dollar market. And being first — or among the leaders — will play a big role in determining just how big a piece.

Endpoints News

Keep reading Endpoints with a free subscription

Unlock this story instantly and join 87,700+ biopharma pros reading Endpoints daily — and it's free.

Cal­lid­i­tas bets up to $102M on a biotech buy­out, snag­ging a once-failed PBC drug

After spending years developing its oral formulation of the corticosteroid budesonide, Sweden’s Calliditas now has its sights set on the primary biliary cholangitis field.

The company will buy out France-based Genkyotex, and it’s willing to bet up to €87 million ($102 million) that Genkyotex’s failed Phase II drug, GKT831, will do better in late-stage trials.

Under the current agreement, Calliditas $CALT will initially pay €20.3 million in cash for 62.7% of Genkyotex (or €2.80 a piece for 7,236,515 shares) in early October, then circle back for the rest of Genkyotex’s shares under the same terms. If nothing changes, the whole buyout will cost Calliditas €32.3 million, plus up to  €55 million in contingent rights.

James Wilson, WuXi Global Forum at JPM20

FDA puts up a red light for Pas­sage Bio’s first gene ther­a­py pro­gram, de­lay­ing a pro­gram from James Wilson's group at Penn

Gene therapy pioneer James Wilson spearheaded animal studies demonstrating the potential of new treatments injected directly into the brain, looking to jumpstart a once-and-done fix for an extraordinarily rare disease called GM1 gangliosidosis in infants. His team at the University of Pennsylvania published their work on monkeys and handed it over to Passage Bio, a Wilson-inspired startup building a pipeline of gene therapies — with an IND for PBGM01 to lead the way.

Endpoints News

Keep reading Endpoints with a free subscription

Unlock this story instantly and join 87,700+ biopharma pros reading Endpoints daily — and it's free.

Inside FDA HQ (File photo)

The FDA just ap­proved the third Duchenne MD drug. And reg­u­la­tors still don’t know if any of them work

Last year Sarepta hit center stage with the FDA’s controversial reversal of its CRL for the company’s second Duchenne muscular dystrophy drug — after the biotech was ambushed by agency insiders ready to reject a second pitch based on the same disease biomarker used for the first approval for eteplirsen, without actual data on the efficacy of the drug.

On Wednesday the FDA approved the third Duchenne MD drug, based on the same biomarker. And regulators were ready to act yet again despite the lack of efficacy data.

Endpoints News

Keep reading Endpoints with a free subscription

Unlock this story instantly and join 87,700+ biopharma pros reading Endpoints daily — and it's free.

Stéphane Bancel speaks to President Donald Trump at the White House meeting on March 2 (AP Images)

UP­DAT­ED: Mod­er­na of­fers steep dis­count in US sup­ply deal — but still takes the crown with close to $2.5B in vac­cine con­tracts

The US pre-order for Moderna’s Covid-19 vaccine is in.

Operation Warp Speed is reserving $1.525 billion for 100 million doses of Moderna’s Phase III mRNA candidate, rounding out to about $15 per dose — including $300 million in incentive payments for timely delivery. Given that Moderna has a two-dose regimen, it’s good for vaccinating 50 million people. The US government also has the option to purchase another 400 million doses for a total of $6.6 billion, or $16.5 per dose.

Endpoints News

Keep reading Endpoints with a free subscription

Unlock this story instantly and join 87,700+ biopharma pros reading Endpoints daily — and it's free.

Phase III read­outs spell dis­as­ter for Genen­tech’s lead IBD drug

Roche had big plans for etrolizumab. Eyeing a hyper-competitive IBD and Crohn’s market where they have not historically been a player, the company rolled out 8 different Phase III trials, testing the antibody for two different uses across a range of different patient groups.

On Monday, Roche released results for 4 of those studies, and they mark a decided setback for both the Swiss pharma and their biotech sub Genentech, potentially spelling an end to a drug they put over half-a-decade and millions of dollars behind.

Qi­a­gen in­vestors spurn Ther­mo Fish­er’s takeover of­fer, de­rail­ing a $12B+ deal

Thermo Fisher Scientific had announced an $11.5 billion takeover of Dutch diagnostics company Qiagen back in March, but the deal apparently did not sit well with Qiagen investors.

After getting hammered by critics who contended that Qiagen $QGEN was worth a lot more than what Thermo Fisher wanted to spend, investors turned thumbs down on the offer — derailing the buyout even after Thermo Fisher increased its offer to $12.6 billion in July. Qiagen’s share price has been boosted considerably by Covid-19 as demand for its testing kits surged.

Endpoints News

Keep reading Endpoints with a free subscription

Unlock this story instantly and join 87,700+ biopharma pros reading Endpoints daily — and it's free.

Xuefeng Yu in Hong Kong, 2019 (Imaginechina via AP Images)

CanSi­no reaps $748M wind­fall from Shang­hai IPO — as it warns Covid-19 vac­cine won't be a huge mon­ey mak­er

CanSino began the year with a clear goal to secure a secondary listing on Shanghai’s STAR market. Then something more urgent came along: As a rising vaccine developer on a mission to bring global standard immunizations to China, it heeded the call to make a vaccine to protect against a virus that would paralyze the whole world.

Xuefeng Yu and his team managed to keep doing both.

More than a month after CanSino’s Covid-19 vaccine candidate is authorized for military use in China, the Hong Kong-listed company has made a roaring debut in Shanghai. It fetched $748 million (RMB$5.2 billion) by floating 24.8 million shares, and soared 88% on its first trading day.