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!

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