Big pharma is getting bigger.
A wave of consolidation throughout the sector is likely to create a new breed of behemoths, supposedly better equipped to face the future challenges of an industry whose business model is widely regarded as unsustainable.
Pharmaceutical companies have historically relied upon breakthrough blockbuster prescription drugs to drive their growth and generate profit. But the industry is being hit by a number of colliding factors: low R&D productivity, a patent ‘shelf’ in 2012 when a number of best-selling drugs will come off patent, and an increasingly risk averse international regulatory regime which requires more lengthy and costly clinical trials. Other challenges include aggressive competition from generic drug companies and healthcare systems becoming better at negotiating pricing of new drugs: all of these factors are stacked against the backdrop of a global economic slowdown – and big pharma’s response is to diversify.
This strategy of diversification has spurred the consolidation craze as companies make acquisitions outside the traditional confines of drug development to add life sciences and biotechnology businesses to their portfolio. For example, in January, Pfizer’s $68bn takeover of Wyeth added biotechnology drugs, vaccines and consumer health products to its product offering. Eli Lilly’s acquisition of Imclone in October last year paved the way for the company’s expansion into cancer therapies. And Swiss firm Roche’s successful $47bn bid for Genentech in March followed an eight-month battle to buy the remaining share of its California-based partner and adds a promising portfolio of experimental cancer, arthritis and diabetes medicines to Roche’s product offering.
Despite big pharma’s strong cash flows and a relatively small decline in product sales, the industry is nevertheless responding to the economic downturn by cost cutting and seeking out greater efficiencies. Big pharmaceutical companies are taking the long-term view because despite no immediate fall in drugs sales, industry estimates predict a decrease in sales of more than $100bn over the next five years as patents expire and drug research pipelines become threatened by generic rivals.
The big buyouts are designed to create more lean and efficient organisations through integration. As well as diversification of product offerings and business activities, consolidation demonstrates a push for greater geographical reach that will mean big pharma becomes increasingly globalised.
PricewaterhouseCoopers (PwC) predicts that by 2020 the €7 countries of Brazil, China, India, Indonesia, Mexico, Russia and Turkey may account for one-fifth of global pharmaceutical sales, representing a 60% leap from 2004.
In March, Merck announced an agreed $41bn takeover of its New Jersey rival, Schering-Plough. The deal created one of the world’s biggest drugmakers with combined sales of nearly $50bn, and not only expanded Merck’s business activities to include biotechnology, consumer and animal health businesses but also gave the company a broader geographical presence in Brazil, China and other emerging markets as well as enabling planned annual savings of $3.5bn by 2012.
This push for reaching growth markets is likely to continue as emerging economies remain the great white hope for big pharma’s future prosperity. As the innovation pipeline shrinks and developing new drugs becomes increasingly costly, most leading pharmaceutical businesses are seeking to establish an R&D presence in Asia. US company Wyeth has jointly opened an early development centre with Peking Union Medical College Hospital in Beijing; Roche has set up a research base at Zhangiang Hi-Tech Park in Shanghai, as has Astra Zeneca; and Novartis is building an $83m R&D centre in the same business park with a view to employing about 400 scientists on the 38,000-square-metre site. Sanofi Aventis has also invested in China and GlaxoSmithKline is investing in both China and India. In India it has set up a Mumbai-based global drug development support centre with Indian software firm Tata Consultancy Services.
Eli Lilly, Novartis and GlaxoSmithKline have all set up research centres in Singapore. Novartis has established a clinical research venture in Indonesia and AstraZeneca has opened a process R&D laboratory in Bangalore. PwC predicts that by 2020 China will be the second largest pharmaceutical market in the world after the US, which means there are advantages in having operations closer to such a big market.
However, despite this shift to the East it is important to remember the investments that big pharma make in emerging economies remain dwarfed by investments in the more traditional locations in mature markets. In this respect, the US is likely to remain the centre of gravity for pharmaceutical R&D. According to PwC, North American spending on biopharmaceutical R&D in 2006 reached $55.2bn and the US accounts for about three-quarters of global expenditure in this area.
Distinct business models
KPMG’s head of chemicals and pharmaceuticals in Europe, Chris Stirling, believes that two business models will emerge; one will be the highly specialist pharmaceutical companies specialising in complex therapeutic areas focused on innovation, and the other will be large pharmaceutical companies which will continue to diversify and have a much broader range of activity. The leader in the latter group, according to Mr Stirling, is Swiss firm Novartis.
“Within the diversification model there is a real push to get positioned into emerging markets, particularly those areas with large populations where large pharma companies are desperate to improve their market positioning,” says Mr Stirling. Novartis has, in recent years, expanded its geographical reach to include China, India, Singapore and Brazil. “These companies are tying up with local companies and putting investment into R&D and to some extent manufacturing,” he says.
Jo Pisani, a partner at PwC’s pharmaceutical practice, sees a hybrid model emerging, comprising of a European or US front office while leveraging the cost savings of an Indian or other emerging economy back office. In terms of R&D, locations are always driven by the availability of scientific talent but also by the availability of patients for clinical trials, says Ms Pisani. “There are still discovery centres in areas of heavy scientific resource but parts of that process are being offshored to low-cost locations such as India,” she says. Late-stage clinical trials that require anything upwards of 500 people are about one-third of the cost in India or China compared with the West. And trials in less mature economies are said to be more effective because patients are ‘naive’ with little or no exposure to other drugs which could distort results.
However, although multinationals are keen to expand in Asia, according to PwC, only 8% of companies are interested in doing more research in the continent whereas 50% wanted to increase sales and marketing activities and 25% wanted to ramp up manufacturing activities in the region.
Pharmaceutical products are small volume and easy to ship around the world, which is why companies have globalised their supply chain in recent years to take advantage of
low-cost manufacturing destinations. However, all big pharma companies have an inflated manufacturing asset base, a throwback from the 1970s and 1980s, says Ms Pisani. “Portfolios have shifted from high-volume production and some big pharmas have been trying to offload their manufacturing assets from as far back as 1995,” she says, adding that the effects of consolidation on the process may be demonstrated by the fact that Pfizer and Wyeth were both in the process of offloading excess manufacturing assets and their union will accelerate the divestment.
On the other hand, Ms Pisani says that flexibility in manufacturing is a key focus so the ability to bring products to market quickly may mean manufacturing will remain in dependable, safe locations that can be trusted, such as the US, western Europe and Scandinavia.
“People are nervous about locating in India and China because of either security of supply or intellectual property protection. I know one big pharma company which relocated operations from China to Canada because of its proximity to the US,” says Ms Pisani. “Having said that, once you are in the high-volume game, it probably would make sense to have some facilities there from a low-cost perspective,” she adds. Eastern Europe has also become increasingly popular for its low cost base and EU harmonisation of regulatory and cultural factors. And big pharma will continue to look at untapped areas, such as Taiwan, Russia and South Korea, to find cheap and motivated scientists and interesting pockets of innovation isolated from the rest of the world.
Big pharma is also increasingly relying on contract manufacturing in order to become more flexible in its supply chain and more specialist in certain technologies. This business model can be beneficial depending on which markets are served and the volumes involved, says Ms Pisani, especially as big pharma is notoriously bad at predicting volumes.
A possible scenario for big pharma’s future location choices is that the West will remain the location of choice for the initial stages of a product launch and development, during which time there is a requirement for technical development expertise as well as the flexibility and reliability to build a market in the early lifecycle of a product. As a product develops and volumes become more predictable then a shift to lower-cost destinations in emerging economies or tax-competitive locations is likely. “As well as low-cost destinations, companies also tend to locate facilities in favourable tax regimes – in Ireland, Singapore and Switzerland where locating your intellectual property along with your manufacturing can give you very good tax incentives,” says Ms Pisani.
Investing in innovation
Ms Pisani believes big pharma will continue to invest in R&D despite the poor productivity of the innovation pipeline, while streamlining and becoming more efficient organisations. “High margins mean no one has scrutinised the cost base so far so there is room for more efficiency,” she says.
Consolidation will create bigger, more diversified and flexible organisations but whether or not it will improve the underlying businesses and performance of the sector is a big question. Concerns as to whether mergers are likely to stifle innovation have long been mooted. The entrepreneurial and innovative culture of smaller companies, while making them attractive at the time of acquisition, may be the thing to suffer within the confines of a more rigid corporate environment.