Is Big Pharma’s business model broken?
“Complex and Convoluted”
Pharma’s business model needs “productive innovation to create value by delivering greater customer benefits” and “steady R&D productivity with a positive ROI in order to drive future revenues that can be reinvested back into R&D,” according to an article by Kelvin Stott in Endpoints. Numerous analysts have lamented Big Pharma’s problem with declining R&D productivity while attempting to measure it in terms of the internal rate of return (IRR) on investment, using a “complex and convoluted” analysis that “depends on many detailed assumptions and forward-looking forecasts at the individual product level.”
Instead, Stott proposes a “simple new method” to measure R&D productivity/internal rate of return (IRR) on investment “by considering only the average return on investment across the industry as a whole.” According to Stott’s method, one assumes that all profits in a year are derived 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.”
Stott asserts that such a 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.” Further, he explains that “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.”
He adds one more detail: net return on R&D investment includes resulting profits (EBIT) as well as future R&D costs, because future R&D spending is an optional use of profits resulting from prior investments. He suggests calculating 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.”
Using this formula, Stott projects a “robust, consistent and rapid downward trend in return on investment over a period of over 20 years” for Big Pharma. He also says 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.” He then provides suggestions on the reasons for the trend and the problems with changing it.
Some of the well-known causes include escalating clinical trial costs and timelines, diminishing success rates in development, a more difficult regulatory environment, greater pressure from payers and providers and growing generic competition. In addition, when new drugs raise the current standard of care, it makes new drugs “more expensive, difficult and unlikely to achieve any incremental improvement, while also reducing the potential scope for improvement.”
Stott posits that return on investment in pharmaceutical R&D is declining because of the way investment opportunities are prioritized over time. He says that “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.”
Pharma as we know it will have to make adaptations and eventually become a newly evolved industry. As Stott says, “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.” He believes that Darwin’s theory of evolution is applicable to pharma: “It is not the strongest of the species that survives, nor the most intelligent, but the one most adaptable to change.”