A Prescription for Saving Big Drugmakers

Shares in traditional "Big Pharma" drug companies have fallen on hard times. After outperforming other stocks for decades, they have lagged the market in recent years. The pharmaceutical business is still one of the most profitable industries in the U.S. But concerns over patent expirations of blockbuster drugs, generic drug competition, regulatory problems, and a lack of promising new products are giving investors caution. Significant drug price increases did not help the drugmakers' public perception, and President Obama's health-care reform plans might limit future prospects.

For the past 15 years, the dominant pharmaceutical company strategy has been to shed noncore, nonpatented drug assets, focus on the high-price U.S. market, build mammoth primary care sales forces, and expand direct-to-consumer advertising budgets. If they continue to follow this road map, drugmakers run the risk of being caught in a high-cost, high-price trap by relegating themselves to an ever smaller part of the global drug market that can deliver their traditional 80% gross margins. These margins do not represent the norm, but a pocket that is bound to shrink over time.

There are, however, signs of change. Pharmaceutical companies have shown renewed interest in other health-care segments, such as generic drugs, consumer health-care products, and vaccines. These segments generally do not enjoy the same barriers to entry through patent protection. Intense competition drives constant efficiency improvements. And with a smaller pricing gap between the U.S. and international markets, there is a stronger incentive to pursue global growth. Competitors in these nontraditional segments—with their sense of urgency, decisiveness, and relentless focus on operational excellence—can thus serve as role models for Big Pharma.

reduce sales and marketing costs

Taking a lesson from these health-care segments, the action plan to fix the pharmaceutical business focuses on three key themes. First, the aggressive pursuit of global opportunities will add to total revenue and profit growth. Second, selling, general, and administrative expenses (SGA) need to come down significantly. Third, drugmakers need to continue to invest in their product pipelines while dramatically improving research and development efficiency.

Big Pharma's global opportunities have traditionally taken a backseat to the lucrative U.S. market. Many key drugs have only spotty patent protection overseas. Avoiding international price concessions seems to take preference over capturing growth opportunities. Elaborate country-by-country price differentiation strategies create customer mistrust and limit access to potentially life-saving products—a far cry from George W. Merck's credo that drugs are for people, not for profits.

True, U.S. drug prices are about double those of many other industrialized countries. But there are more than 1.3 billion people living today in countries with per capita gross domestic products of $10,000 or more, where there is a reasonable market for advanced drugs. For drugmakers already enjoying 80% gross margins, slashing prices in half still leaves them with 60% margins—outstanding by any standard if costs are under control.

One way to ensure that is to tackle sales and marketing costs. Today's pharmaceutical SGA expenses are frequently more than 30% of revenue—almost twice the level of R&D spending. That puts pharmaceuticals in the same league as branded luxury goods (which they are more often than not perceived to be these days). Bringing SGA expenses down by one-third, to a level more in line with overhead in other health-care industry segments, will require significant changes. A fat-free corporate structure is a no-brainer. More importantly, oversized sales forces will need to slim down by focusing on fewer and related therapeutic areas. And reining in consumer advertising will free up funds for "push" marketing through price concessions to health plans—a critical step in light of the increasing backlash from employers about rising health-care costs.

focus on fewer therapeutics

R&D spending in the pharmaceutical industry is significant, frequently reaching 15% to 20% of revenue. It should stay there, and with reduced SGA spending, that level of R&D spending should continue to be affordable. The key is to get more results out of the money spent. It is ironic that for all their R&D spending, none of the leading pharmaceutical firms ranks anywhere near the top of the world's most innovative companies listings.

Tighter focus is also essential. Targeting fewer and related therapeutic areas will avoid sprawling and unmanageable lab operations. To instill competition, drugmakers will need to open up the front end of their R&D pipelines to outside developments. External scouting for early-stage licensing should compete with in-house substance discovery. To give a fair chance to outside developments and rein in the not-invented-here syndrome, both pathways will need their own reporting lines to the CEO.

These steps add up to a comprehensive strategy shift for Big Pharma. The result will be new global growth at lower average drug prices, a focus on fewer therapeutic areas, a leaner cost structure, and a high-performance product development engine. These changes can reignite growth without exploding the U.S. health-care budget, while at the same time bringing much-needed drugs within reach of patients around the globe. And not to be overlooked, sustainable growth—instead of hanging on to outsize margins in the U.S.—will reawaken investor confidence and drug company valuations.

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