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

Biotech Voices is a collection of exclusive opinion editorials from some of the leading voices in biopharma on the biggest industry questions today. Think you have a voice that should be heard? Reach out to senior editors Kyle Blankenship and Amber Tong.

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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Welcome back to Endpoints Weekly, your review of the week’s top biopharma headlines. Want this in your inbox every Saturday morning? Current Endpoints readers can visit their reader profile to add Endpoints Weekly. New to Endpoints? Sign up here.

Next week is shaping up to be a busy one, as our editor-in-chief John Carroll and managing editor Kyle Blankenship lead back-to-back discussions with a great group of experts to discuss the weekend news and trends. John will be spending 30 minutes with Jake Van Naarden, the CEO of Lilly Oncology, and Kyle has a brilliant panel lined up: Harvard’s Cigall Kadoch, Susan Galbraith, the new head of cancer R&D at AstraZeneca, Roy Baynes at Merck, and James Christensen at Mirati. Don’t miss out on the action — sign up here.

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