Aspects of the Pharmaceutical Business Model: Implications for Australia

Aspects of the Pharmaceutical Business Model:
Implications for Australia


Draft Working Paper No. 15
Final Draft


Bruce Rasmussen






Pharmaceutical Industry Project
Working Paper Series



August 2003






Centre for Strategic Economic Studies
Victoria University of Technology
PO Box 14428 Melbourne City MC VIC 8001 Australia
Telephone +613 9248 1340
Fax +613 9248 1350

Email: csesinfo@vu.edu.au
Website: http://www.cfses.com

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Aspects of the Pharmaceutical Business Model: Implications for
Australia
Bruce Rasmussen
Sources of stress in the pharmaceutical business model
The business model of the large pharmaceutical companies is complex and has
become increasingly so with the technological developments in the industry
particularly in relation to the innovations introduced by biotechnology. A business
model is not a well defined concept but may be paraphrased as a description of ‘how a
business makes its money’.

It answers a series of questions essential to any business – who are the customers,
what do they value, what is the underlying economic logic that explains how that
value can be delivered to the customer at an appropriate cost and finally how the
business makes its money. It consists of both a narrative of how the business works
and the numbers – how it makes a profit (Margretta 2002). Underlying any business
model is the structure of its value chain.

The business models of large pharmaceutical companies have certain unique aspects.
One is the drawn out, highly structured value chain determined in large part by the
regulatory process itself. Another is the high cost of product development, with
associated high risks of failure. Offsetting these high costs and risks are the high
returns for successful product development. A further defining characteristic is the
focus on innovation. The pace of innovation both in terms of product innovation and
in the process of drug discovery and development has intensified over at least the last
decade.

These three characteristics while not exhaustive go quite some distance towards
identifying the pressure points currently being experienced on the business model of
the fully integrated pharmaceutical company and in explaining the changes in strategy
necessary to meet these challenges.
High risk, cost and return aspects of ethical pharmaceuticals
This may be demonstrated in a number of ways. One is to calculate the probability of
successfully taking a drug candidate through the tortuous regulatory process from
preclinical to final phase clinical trial and regulatory, generally FDA, approval. Table
1 below provides one estimate of these probabilities, illustrating the low probability of
reaching market with an identified drug candidate.

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Table 1. Industry average success rates: Probability of reaching market from start of
each phase*

Clinical Phase
Reg. App.
Pre I II III

10% 18%
28% 66% 91%
* The Pharmaceutical R&D Compendium, CMR International and Scrip’s Complete Guide to Trends in
R&D 2000, cited in PAREXEL (2001, p. 195).


Another is focus on the profitability of drugs reaching the market. This too is
instructive in that it illustrates the small number of drugs that make a profit.
Grabowski and Vernon (1994, 2001) calculated that the NPV of drugs on the market
in the period 1980-84 by sales decile. They compared the NPV of drugs in each decile
with the estimated average R&D cost of a drug, which they put at just over $200m.
The NPV of only the top 20% of drugs exceeded this amount with the NPV of the top
10 % averaging $1000m. In other words 1 out of 10 drugs making it to market
returned their owners 5 times their cost. However 3 out of 5 drugs making it to market
failed to return to their owners the risk adjusted cost of capital.

Perhaps an even more revealing analysis of the dependency of the industry on a small
number of drugs for its profitability is provided by Table 2.


Table 2. ‘Blockbuster’ sales by major pharmaceutical companies, 2002
Number of
Pharma sales
Blockbuster sales
Blockbuster
blockbuster
Company
$m
(>$US $1b) $m
ratio
drugs





GlaxoSmithKline $28,970 $14,259
49.2%
8
Pfizer $27,815
$22,307
80.2%
8
Merck $21,627
$14,055
65.0%
5
Aventis $18,446
$5,090
27.6%
3
BristolMyer Squibb
$18,119
$6,056
33.4%
3
AstraZeneca $17,841
$7,746
43.4% 3
Johnson & Johnson
$17,151
$5,900
34.4%
3
Novartis $15,181
$3,026
19.9%
2
Pharmacia $12,037
$3,050
25.3%
1
Wyeth-Ayerst $11,733
$3,143 26.8% 2
Eli Lilly
$11,078
$4,693
42.4%
2





Total Top 11
$199,998
$89,325
40.7%
40
Source: Annual reports and Credit Suisse First Boston.


The table above lists the 11 largest global pharmaceutical companies by sales of
pharmaceuticals for 2001 together with total sales of those drugs with global sales
exceeding $US1 billion (‘blockbuster’).

According to the measure used in Table 2, there are only 40 blockbusters representing
on average 41% of pharmaceutical sales of these companies. The blockbuster ratio
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however varies widely between companies from a high of 80% for Pfizer to a low of
20% for Novartis. Ownership of the blockbusters is highly concentrated with the three
largest companies by sales owning 21 of the 40.

The life of a blockbuster drug may not be particularly long. Loss of patent protection
is one issue. Another is the entry of follower drugs reducing the market exclusivity
period. According to the industry constantly emerging competition from follower
drugs has cut market exclusivity from about 4 years in the 1980s to less than 1 year in
the 1990s (PhRMA 2001).

A number of companies have found themselves caught short, without new
blockbusters to keep sales growing. In some cases this arises from a failure to invest
adequately in the pipeline. Gambardella (1995) outlines the case of SmithKline which
failed to reinvest the proceeds of its Tagamet success in upstream research and it was
forced to merge with Beecham in 1989. More often than not mergers occur to cover
weaknesses in the R&D pipeline.

The need for large pharmaceutical companies to constantly replenish the supply of
potential blockbusters requires a consistent and dedicated approach to drug R&D.
However no longer is in-house research expertise sufficient and as will be discussed
further below pharmaceutical companies have taken the opportunity to utilise various
alliance strategies and licensing arrangements to bring prospective drugs into the later
stage development processes in which they excel.
Improving the productivity of the pharmaceutical company value chain
One of the responses to the need to bring increasing numbers of drugs to market is to
improve the productivity of the product pipeline. At one level this has simply
involved an increasingly disciplined approach to drug candidate selection and R&D
investment.

A series of Harvard Business School cases outlines the efforts that Ely Lilly made
through the 1990s to improve the focus and efficiency of its drug development
pipeline for its blockbuster drugs. The efforts concentrated on improving speed to
market, leveraging existing products and establishing a global and focused therapeutic
presence. The company narrowed its R&D focus from eight to five therapeutic areas.
It organised its staff into product or ‘heavy weight’ teams. These were to break down
the functional silos – development, marketing, sales etc into multi functional teams
that were designed to take a single drug through the testing process, launch and
subsequent marketing.

The first such teams were established in 1995 – one for the osteoporosis drug, Evista
and the other for Zyprexa, the antipsychotic drug. These teams had an almost free call
on resources from the functional groups (Burgleman et al. 2001). Their role evolved
over time so that as well as focusing on the sales, marketing and distribution of their
blockbuster drugs, they also came to exert more discipline on the drug discovery and
development process.

Another response has been to in-licence drug candidates from biotech companies. In
the pre biotech days, big pharmaceutical companies supplemented their own research
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with that drawn from university research institutes and hospitals. The new biotech
companies offered not only a range of large molecule biologics as drug candidates for
range of therapeutic areas, but also an array of new platform technologies that hasten
the drug discovery and development process, ranging from high throughput screening
based on combitorial chemistry to genomics and proteomics (Granberg and
Stankiewicz 2002). This range of specialisations has vastly complicated the lives of
pharmaceutical companies.

Pharmaceutical companies have actively pursued biotech companies to form alliances
for the development of new drugs. Biotech companies have benefited from the
funding available from the pharmaceutical companies. It is rare for biotechs to be able
to afford to complete the clinical trial process without significant external assistance.
Often the pharmaceutical company in return for a revenue stream to be paid to the
biotech acquires the development and marketing rights. The structure of these
alliances depends on the relative positions of the two companies.

Lerner and Merges (1997) have undertaken a detailed analysis of a small number of
biotech alliances to determine the balance of control between the biotech and
established pharmaceutical company. Their main finding is that, perhaps not
surprisingly, the biotechs ceded the greatest control when their financial position is
weakest. The study also examined which party was likely to control particular aspects
of the alliances. This indicated that the pharmaceutical company was most likely to
control the marketing and manufacturing aspects as well as the power to terminate the
alliance. The biotech was more likely to retain control over the patents and related
litigation.

Alliances can take many organisational forms and involve many different payment
structures – milestone payments, equity injections, royalty payments etc. Reflecting
this the OECD has defined alliances in the following terms:

Strategic alliances take a variety of forms, ranging from arm’s-length contract to joint
venture. The core of a strategic alliance is an inter-firm co-operative relationship that
enhances the effectiveness of the competitive strategies of the participating firms
through the trading of mutually beneficial resources such as technologies, skills, etc.

Strategic alliances encompass a wide range of inter-firm linkages, including joint
ventures, minority equity investments, equity swaps, joint R&D, joint manufacturing,
joint marketing, long-term sourcing agreements, shared distribution/services and
standards setting. (OECD 2001)

Alliances have not only been formed in pursuit of new drug candidates but have also
been with platform companies, which provide the specialist technologies to improve
both the drug search process as well as speed up development. Early in the 1990s the
sought after technologies related to combinatorial chemistry, high throughput
screening, and microarrays while towards the end of the decade the focus moved to
technologies relating to genomics.

The rapid growth in pharmaceutical related alliances is illustrated in Figure 1.

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Figure 1. Number of global pharmaceutical and biotech alliances by party, 1990-2002
2000
1800
1600
1400
1200
Uni/ drug
r
e
Uni/ biotech
mb 1000
Bio/biotech
Nu
Drug/biotech
800
Drug/drug
600
400
200
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Note: 2002 may be incomplete.
Source: Recap May 2003.1


There are a number of remarkable aspects to this figure. The first is the growth in total
alliances which totalled 314 in 1990 and reached 1776 by 2002. This growth has two
phases. The first is the growth between 1990 and 1996 in alliances between
pharmaceutical companies (drug) and biotech companies from 180 to 491. The second
is the period from 1997 to 2001 when alliances between biotechs grew from 364 to
937 but alliances between pharmaceutical and biotech companies remained virtually
unchanged at about 615.

The first phase is a product of the pressures being felt by the pharmaceutical
companies to maximise the productivity of their pipelines and the complementary
need for funding by the emerging biotech companies. In the second the driver seems
to be the sharing of technology between the biotechs as will be discussed more fully
below.

Given that the pressure for pharmaceutical companies to bring drug candidates to
market was undiminished, the absence of growth in pharma/biotech alliances perhaps
suggests that pharmaceutical companies looked to alternative strategies to obtain drug
candidates eg mergers and acquisitions or focused on say a higher proportion of later
stage alliances. Certainly the period to 2000 coincided with greater availability of
equity capital for biotechs, providing them with increased capacity to internally fund
drug development and consequently, with a lower reliance on early stage alliances.

Another feature of the chart is the relatively modest growth in alliances with
universities or research institutes. This probably reflects the university
commercialisation process that begins with the formation of a company, which is
often the alliance vehicle rather than the university itself. Most of the university

1 For detailed discussion of the Recap database refer Rasmussen (2002).
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alliances are with biotechs. The number of direct links with large pharmaceutical
companies is very small, an average of about 10 per annum over the period.

To illustrate some of the ‘technology’ factors behind the two growth phases identified
above, Figure 2 shows alliances classified by Recap by type of alliance technologies.


Figure 2. Alliance technologies: Genomics and other drug discovery technologies
700
600
500
400
Total other drug disc.
Total Genomics
300
200
100
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Source: Recap May 2003.2


The so-called ‘genomics’ technologies are those involving gene therapy and
expression, proteomics and bioinformatics. These grew very rapidly to prominence in
the later part of the 1990s and early 2000s from 240 in 1998 to 615 in 2001. Doubtless
their growth is a factor behind the second phase of growth in alliances between
biotechs. The group of alliance technologies described as ’other drug discovery’ relate
to an earlier group of new technologies, combinatorial chemistry, screening, micro
arrays etc. Alliance formation based on these technologies began to plateau out in
around 1997 at about 250 although they have since risen further to 321 in 2002. The
growth in these alliances in the mid 1990s may help explain some of the growth in
alliances in the first phase.

Although more work on the Recap database would be necessary to dissect alliance
technologies by type of alliance partner, this data suggests that the first growth phase
in alliances between biotechs and pharmaceutical companies was focused on the
acquisition of drug candidates while the next phase had a greater technology focus
with alliance between biotechs a dominant feature.



2 For detailed discussion of the Recap database refer to Rasmussen (2002).
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Implications for Australia
The Australian pharmaceutical and biotechnology industry is small – perhaps 1% of
the global industry. It has a number of components, including some of the R&D and
other activities of the major foreign owned pharmaceutical companies and some of the
activities of Australian owned pharmaceutical companies. However, in terms of the
number of companies, the largest component consists of substantially Australian
owned companies undertaking drug discovery and development for human purposes
and a further group of companies developing supporting technologies and other
associated products and services.

With one or two exceptions the companies comprising the Australian industry are at
an early stage of development. The development prospects of the total industry reduce
to the choices made by these young companies on how they obtain the necessary
resources and how successfully these resources are applied to transform their early
stage product pipelines into marketable drugs and other products. A study of the total
drug development pipeline for the larger Australian listed biotechs indicated that it
had collectively about 130 drugs under development. More than half of these were at
a periclinal stage, only 4 were in phase 3 clinical trail. This compares with over
10,000 under development worldwide (Rasmussen and Sweeny 2002).

As with the global industry, the largest 10-20 global pharmaceutical companies have a
pivotal role in determining the future direction of the Australian industry. The
relationship between these large companies and small biotechs is a vital part of
industry development.

Many of the same trends for the global, largely US based industry, are observable in
Australia. Alliances have been formed by Australian biotechs with the larger
pharmaceutical companies and overseas biotechs.

Table 3 sets out alliances formed by Australian companies and listed on the ReCap
database and supplemented by searches of company web sites, for which detailed
information eg via press release provided detail to classify and analyse the purposes of
the alliance.


Table 3. Australian alliance payouts and trends in the number of alliances, 1996-2002








Total 1996-2002
Partners
1996 1997 1998 1999 2000 2001 2002 Alliances Payouts($m)*









Bio/Biotech
5
2
6
4
10
25
11
63
126
Pharma/Biotech
4
3
7
4
9
6
5
38
222
Biotech/Uni
0
4
2
3
2
3

14
9
Uni/Biotech



2


4
6

Other
1
0
2
2
1
5
3
14
0
Total
10 9 17 10 22 39 23 130
357
* Excludes payments made for acquisitions.
Source: Recap Aug 2002, updated Aug 2003.


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About half of the alliances were between biotechs (63 of 130); about thirty per cent
(38) were between biotechs and pharmaceutical companies and 15% involved
universities mostly with biotechs. Almost all alliances between biotechs and
pharmaceutical companies involved the biotech providing the R&D, with the
pharmaceutical companies acting as the funding source.

The number of alliances reporting payouts was small – only 17, so drawing firm
conclusions are difficult, even though the results are interesting.3 Of the total of
$357m reported, almost two thirds ($222m) was for payments made to biotechs by
pharmaceutical companies. However almost all of the remainder was for alliances
between biotechs ($126m), with payouts to universities from biotechs totalling $9m.
While the prominent role played by the pharmaceutical companies is as expected, the
magnitude of the biotech payouts to other biotechs is perhaps surprising. This must be
qualified to the extent that one of the largest biotech alliance payouts ($43m) involved
a biotech company, which was in the process of becoming a subsidiary of a
pharmaceutical company.

The small number of transactions reported means that the results tend to strongly
reflect the activities of a small number of companies. Of the total payout value of
$357m, $187m relates to alliances involving AMRAD. Whether this properly reflects
AMRAD’s relative position or an under reporting by other companies, is a little
difficult to judge. Undoubtedly there are some alliances in which the payments are
confidential.

The purpose of most of the alliances reviewed in detail fell into one of three
categories:
• drug discovery or development;
• development of platform or other supporting technologies; and
• product distribution.

A significant proportion (23%) was concerned with drug development although only 4
alliances of this kind were with pharmaceutical companies. Most of the ‘development’
alliances have a biotech as the client and either another biotech or university as the
research house. These results provide further evidence of the more influential role
being adopted by biotechs in alliance structures.
Table 4. The number of alliances by main purpose, 1996-2001
Main purpose*
Bio/biotech Pharma/biotech Biotech/Uni Other Total
Development
9
4
7
1
21
Distribution
4
9
0
1
14
Technology
24
12
4
2
42
Other
7
5
0
1
13
Total 44
30
11
5
90
* Includes only alliances announced by press release.


3 The data for payouts is derived from the value disclosed in press release or other documentation
announcing the alliance. It is generally a lump sum incorporating an upfront payment (e.g. licence fee)
together with expected near term milestone or other payments.
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By far the largest category (42) was where the main purpose of the alliance was the
exchange, or a collaboration with a company to further develop, platform or other
supporting technologies (see Table 4). Some of these alliances involve the acquisition
or development of Australian technology for use by or incorporation in an overseas
company’s product line. In other cases the alliances appear to contemplate a genuine
partnership in which different specialisations are to be combined to produce a new
prototype product that is to be marketed by both alliance partners. Alliances between
biotechs are the largest sub category within the ‘technology’ category, 24 out of 42,
although the number with pharmaceutical companies (12) is also significant.

With respect to the types of Australian alliance technologies, alliances involving
genomics are prominent in recent years, but other features such as the early growth in
‘other drug discovery’ technologies noted earlier for the rest of the world (see Figure
2) seem absent from the Australian data.

Overall however similar trends are observable in Australia as for the global industry.
Alliances between biotechs are of increasing numerical significance. Typically this
involves technology transfers although in a number of cases overseas biotechs are
helping fund drug development by Australian biotechs. Nonetheless the
pharmaceutical companies continue to be important in underpinning both drug
development and technology transfers by Australian firms. Their funding role is
especially crucial.

Implications for Australian Policy Developments: Some Observations
This paper focuses on the importance of linkages to the large pharmaceutical
companies and increasingly overseas biotechs as sources of funding support and
opportunities for technology transfers.

This analysis suggests that both pharmaceutical companies and larger biotechs have
an important role in funding drug development. They have a desperate need for drug
candidates to top up their product pipelines and so there is a significant opportunity
for Australian companies to form valuable relationships with these companies. The
Victorian and Queensland Governments have led the way in supporting international
showcasing of Australian talent at the various international fora. However while these
events can provide valuable contacts and individual successes, a program of support
for tours by in licensing teams of large pharmaceuticals and selected biotechs would
seem to allow less pressured consideration of Australian opportunities.

The role of the large pharmaceutical companies remains central to alliance funding of
drug development. The biotechs seem more important for technology transfer. It
seems to be essential that Australian companies form part of the ‘inner circle’ of
consideration of alliances by the major overseas pharmaceutical companies.

A further aspect is to increase the flow of drug candidates and other biomedical
technologies. Despite the heavy investment in medical and biotech related R&D,
Australia has little to show by way of commercial outcomes. While having some
success in medical equipment, the biomedical industry has produced only one
commercial drug, Relenza, in alliance with Glaxo – itself only modest success due to
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