CFA - The Pharmaceutical Industry

CFA INSTITUTE

INDUSTRY GUIDES

THE

PHARMACEUTICAL

INDUSTRY

CFA INSTITUTE

INDUSTRY

GUIDES

THE

PHARMACEUTICAL

INDUSTRY

This publication is designed to provide accurate and authoritative informa-tion with regard to the subject matter covered as of the date of publicainforma-tion. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

978-0-938367-81-9 October 2013

ABOUT THE AUTHOR

Marietta Miemietz, CFA, is a cofounder of and director of pharmaceutical advisory services at Primavenue. Previously, she spent 13 years as a sell-side analyst of the European pharmaceutical and health care industries and was consistently rated among the top 10 pharmaceutical analysts from 2006. Ms. Miemietz holds an MBA with a concentration in finance from WHU–Otto Beisheim School of Management and the Belgian Diplôme d’Etudes Spécialisées in biotechnology from Université Libre de Bruxelles.

CONTENTS

Introduction 1

Industry Overview 2

The Drug Discovery, Development, and Approval Process 9

Intellectual Property: Patents, Regulatory Exclusivities, and Other Forms of

Protection 18

Business Models 22

Industry Consolidation 23

Notable Trends 25

Financial Statement Analysis 27

Forecasting Drug Sales and Company Profits 31

Valuation of Pharmaceutical Firms 39

Portfolio Considerations 42

Industry Resources 46

Regulatory Agencies 46

Other Resources 46

INTRODUCTION

Among the most distinctive features of the pharmaceutical industry are the com-plexity and length of the product development cycle and the independence of phar-maceutical companies’ operating performance from industry trends. The earnings outlook of individual companies is determined, first and foremost, by the products they develop and market. Consequently, the industry is characterized by excep-tional heterogeneity that notably complicates peer group analyses and often entails divergent share price performance. These unusual characteristics are attributable to the fact that the prospects of each player are linked to the prospects of the drugs to which it has full or partial commercialization rights. Drugs are approved by regula-tory agencies for specific indications, and their peak sales potential depends on the prevalence of the conditions they are intended to treat, their efficacy and safety, and the competitive landscape. In this context, it is worth noting that the conditions a medicine is intended to treat are often narrowly defined; for example, a drug that is licensed for the treatment of colorectal cancer is unlikely to compete with a blood cancer drug, and even two different blood cancer drugs might be targeted at sepa-rate patient populations.

These dynamics have profound implications for pharmaceutical industry analysis and investing. Top-down analytical approaches based on overall market growth rates and market share development, often a good starting point in other industries, add limited value at best and may often be misleading. The quality of bottom-up analyses that take into account the clinical utility, cost-effectiveness, competitive landscape, intellectual property, and economics of individual drugs is typically the main success factor in selecting pharmaceutical and biotechnology stocks.

Following a brief overview of the industry, this primer delineates the determinants of success in drug development and marketing and then reviews the implications for financial statement analysis and forecasting, as well as valuation and portfolio con-siderations. Unless noted otherwise, analysis is confined to branded drugs for human use, and conclusions may not apply to other areas of health care, such as consumer and animal health care products or generics. The aim of this report is to provide a general understanding of the complexity of pharmaceutical industry analysis and the main issues involved. It is designed to enable the reader to critically appraise research, corporate presentations, and other communications with respect to drugs, companies, and the industry. It is by no means exhaustive. Myriad issues may arise— issues that are deeply ingrained in the scientific aspects of a molecule, the clinical considerations pertaining to a particular disease, regional clinical practice and regula-tory legislation, or specific patents—that must be reviewed on a case-by-case basis.

INDUSTRY OVERVIEW

Given that introduction, it should come as no surprise that the pharmaceutical mar-ket is large and highly fragmented. In 2012, the global marmar-ket for human prescrip-tion pharmaceuticals was valued at more than $850 billion. The four largest mar-ket categories—the central nervous system, cancer, metabolic and gastrointestinal diseases, and cardiovascular disorders—accounted for slightly more than half the market in terms of value; each of these categories can be subdivided into numerous conditions that require separate treatment approaches. As depicted in Figure 1, the largest players hold mere single-digit market shares, and many of them are active in other segments of the health care market (note that revenues from activities other than health care are not shown). Successful drug development today requires a unique skill set that cannot be transferred to other industrial activities. Nonethe-less, many of the leading pharmaceutical players are exposed to other areas of health care for historical reasons and with a view to smoothing out the growth pro-file and cash generation on the group level as well as exploiting the modest syner-gies with regard to, for example, target markets, research and development (R&D),

Figure 1. Branded Human Prescription Drugs: Key Players

0 10 Pfize r Roch e Novar s Merck & C o GlaxoSmithKlin e Sanofi AstraZenec a Johnson & Johnson

Lilly Bristol-Myers Squibb AbbVi e Amge n Baye r Novo Nordisk Takeda 20 30 40 50 60 70 80 2012 sales in $b n 0% 1% 2% 3% 4% 5% 6% 7%

Pharmaceucal market share (RHS) Other healthcare

Industry Overview

or production. These ancillary health care activities primarily include consumer health, animal health, generics, diagnostics, and medical technology.

As noted previously, the dynamics of the market for patented prescription drugs for human use are such that drug-specific attributes are a far more important deter-minant of success for individual companies than are general industry trends. In most of the key pharmaceutical markets of the developed world, the majority of patients are able to obtain the drugs they need; for the most part, their treatment is paid directly or reimbursed by third parties, although restrictions often apply (e.g., mandatory generic substitution or requirements to initiate therapy with the lowest-cost medicines). Consequently, the pharmaceutical industry is among the least cyclical of industries, but recessions may entail such austerity measures as drug price cuts, and dwindling consumer confidence may, to some extent, result in fewer physician office visits by patients or “drug holidays” (discussed later). Most innovative drugs enjoy a period of market exclusivity—because of either patents or regulatory exclusivities—that may span many years, implying that a new molecular entity will have monopoly status for a certain period. Thus, a pharmaceutical com-pany that is commercializing a highly effective, patent-protected drug in a thera-peutic area of high unmet need may be able to generate strong sales growth in the same year that a competitor faces a rapidly declining top line—for example, owing to patent loss and ensuing generic competition or as a result of emerging branded competition or safety concerns about its main products.

Under the pharmaceutical industry’s cost structure, positive revenue develop-ments translate into significant operating leverage. Companies incur substantial R&D and marketing expenses that are largely fixed in the short term; the variable cost of producing and distributing higher volumes of any given drug is compara-tively low. Consequently, the accuracy of forecasts of a pharmaceutical company’s profits hinges on the analyst’s ability to predict the future sales of each drug in the company’s portfolio and pipeline. Substantial errors in forecasting a company’s top line will almost invariably lead to even greater errors in forecasting the bottom line and, thus, a “bad call.” Therefore, a thorough analysis of a company’s drug portfo-lio, which frequently requires expert knowledge in various therapeutic areas, is of paramount importance.

In addition, various megatrends and industry-specific themes affect the dynam-ics of the industry to a meaningful extent. In light of the pronounced changes in pharmaceutical business models that have been implemented over the last five years, a brief history of the pharmaceutical industry is in order before reviewing its dynamics. Although the discovery of the first drugs was largely the result of serendipity, increasing levels of insight into disease biology and the mechanism of the action of drugs on the molecular level resulted in ever more targeted drug discovery efforts, which bore fruit initially. The latter part of the 20th century saw

step changes in medical innovation; given the dearth of effective drugs available at the time to treat such widespread conditions as diabetes and hypertension, many newly launched drugs became blockbusters, attaining peak sales of $1 billion or more. The pharmaceutical industry enjoyed high earnings growth, and the invest-ment community’s expectation that the industry would continue to innovate at the same pace was reflected in the industry’s valuation: P/E multiples often reached the high teens or greater.

Many companies put in place significant production, marketing, and administra-tive infrastructure in an effort to maximize the top line; as recently as 10 years ago, some of the most successful primary care drugs were each promoted by thousands of sales representatives in the United States alone. Most major pharmaceutical firms dedicated substantial resources to such life-cycle management (LCM) activities as the development of new formulations of existing drugs or clinical trials in addi-tional indications or patient subgroups, all with a view to extending the lives of the drugs’ patents. Although pharmaceutical companies generally do not disclose the proportion of their R&D expenses attributable to LCM as opposed to the discovery and development of new molecular entities, evidence suggests that LCM activities proved to be highly lucrative.

The decline in new-drug approvals observed through much of the last decade, despite rising absolute R&D spending, may be attributable in large part to the focus on product LCM. Other possible contributory factors include rising hurdles for some of the largest indications, such as diabetes and hypertension, in which improving on existing drugs has become increasingly challenging, as well as a delay in the adapta-tion of R&D and business models to a changing regulatory and payer environment. At the beginning of the new millennium, the industry placed much emphasis on the development of primary care drugs with billion-dollar sales potential in order to leverage their existing infrastructure and replace older drugs that were approach-ing patent expiration. To minimize the perceived risks of the costly clinical devel-opment phase of new drugs—whereby pharmaceutical firms test the efficacy and safety of new-drug candidates in hundreds, if not thousands, of patients over many years—many firms developed new molecular entities that displayed only modest structural variation and only minor therapeutic advantages over existing drugs. In referring to these products, critics used the derogatory term “me-too” drugs.

Shifts in the regulatory and payer environment eventually derailed the industry. In particular, the US Food and Drug Administration (FDA) displayed heightened risk aversion in the wake of the withdrawal of Merck’s painkiller Vioxx from the market in 2004 owing to side effects, thus raising the bar for the approval of new-drug candidates targeted at non-life-threatening conditions. Payers grew increas-ingly reluctant to reimburse for expensive new drugs that offered only a modest perceived benefit over older drugs, which were losing their patent protection and

Industry Overview

becoming available generically at much lower cost, a trend that was exacerbated in the financial crisis of 2008. Collectively, all these trends resulted in high attrition rates for new-drug candidates as well as some commercial failures.

Toward the end of the last decade, many large pharmaceutical stocks were trad-ing on strad-ingle-digit forward P/E multiples as “patent cliffs” loomed and investors’ confidence that the industry’s R&D engines would yield novel agents to offset the imminent revenue loss plummeted. The realization that the past strategy might no longer be viable, coupled with the market’s disenchantment, triggered the industry’s quest for a new commercial model. Large pharmaceutical corporations recruited managers who were industry novices but possessed extensive experience in such fields as marketing and operational excellence. The major players embarked on large-scale cost-reducing initiatives to ensure acceptable levels of profitability beyond the patent expirations of key blockbusters; many companies reduced their cost base by billions of dollars in a matter of years. Although some of these cost reductions were attributable to synergies in the context of “megamergers,” various companies achieved multi-billion-dollar savings in the absence of material M&A activity. This outcome was achieved in part by scaling back primary care field forces in Western markets, a step that was accompanied by changes in the commercial model: Firms relied increasingly on key account management to drive the top line and shifted their R&D efforts toward specialty care. The relative attractiveness of specialty care over primary care lies in the fact that it can be served by a smaller sales force and thus at a smaller fixed cost; at the same time, clinical and regulatory success rates tend to be higher for drug candidates that target underserved niches of debilitating and potentially life-threatening indications, such as cancer.

Previously neglected aspects of cost control were also addressed, including excessive procurement bills that resulted largely from a lack of coordination of group-wide purchasing activities. Furthermore, the industry reduced fixed costs, especially those related to R&D, by outsourcing various activities. It proactively identified incremental business opportunities; many companies rediscovered ancillary activities (consumer and animal health) that are less prone to patent loss and notably increased their presence in emerging markets. Although the drug industry is global in nature—regulatory approvals all over the world can usually be obtained for drugs that have proved safe and effective in the treatment of the targeted conditions—many pharmaceutical firms have focused primarily on West-ern markets in the past. And although WestWest-ern markets continue to dominate in absolute terms—with the United States estimated to account for approximately 40% of the global pharmaceutical market in 2012—much of the majors’ growth is now coming from the emerging markets.

Many pharmaceutical companies have made steady progress toward replenish-ing their pipelines, partly by tappreplenish-ing into external innovation provided, to a large

extent, by midsize and biotechnology companies. In the aggregate, pipelines com-prise numerous molecules with novel modes of action that target medical areas of high unmet need and are tailored to well-defined patient populations, thus imply-ing that a genuine market opportunity is likely to materialize for compounds that prove safe and effective.

In fact, many recently launched drugs and compounds in development are so highly targeted that a debate has ensued whether “personalized medicine,” one of the most extensively discussed megatrends of the health care sector, represents an opportunity or a risk for the pharmaceutical industry. Proponents argue that the more clearly a drug’s target population is defined and the more easily it is identified—for example, by the use of biomarkers that confirm the presence or absence of a mutation—the higher the chance that such a drug can be developed. This approach may, in turn, increase the chance of successful clinical trials and save the firm the considerable expense of conducting negative trials. Although skeptics are concerned that personalized medicine might shrink a drug’s target market to relatively small patient subgroups, proponents contend that highly targeted drugs may gain traction rapidly in the treatment of conditions characterized by a significant genetic component, such as tumors that bear certain mutations, whereas patients suffering from such multifactorial illnesses as diabetes may be more difficult to stratify.

Thus, personalized medicine should not be regarded as a threat per se to prof-itability; drugs that are more narrowly targeted and thus more effective have a higher chance of obtaining regulatory approval as well as reimbursement at attrac-tive price points, which may compensate for the potential volume tradeoff. Further-more, payers are increasingly embracing value- and outcome-based pricing models. For instance, health technology assessment bodies assign grades to a drug’s benefit in certain indications and patient subgroups, and some pharmaceutical companies have agreed in some regions to refund the cost of drug treatment if the patient does not benefit meaningfully, suggesting that they have nothing to gain from the admin-istration of medicines to patients who are unlikely to respond.

In this context, it is worth noting that disease prevalence is only one of the fac-tors that determine a drug’s peak sales. A drug’s efficacy, both in absolute terms and relative to competing drugs, and the severity of the condition it is used to treat have a significant impact on its price point as well as its penetration rate. Similarly, the notion that the aging population in Western markets will be a key driver for the pharmaceutical industry is a fallacy. A drug designed to treat conditions that arise more frequently in old age, such as diabetes, will not necessarily achieve greater commercial success than a drug aimed at severe illnesses that may manifest them-selves earlier in life (e.g., multiple sclerosis). Some senior citizens may be well controlled on generic drugs or considered too frail for intensive treatment, whereas

Industry Overview

a young patient suffering from a devastating disease may receive an expensive drug for extended periods in the absence of generics. Effective treatments for some of the most debilitating conditions frequently associated with old age, such as Alzheimer’s disease, are still largely lacking.

Price pressure is another trend that has persisted for many years and has acceler-ated recently as government-linked payers have felt the brunt of austerity while pri-vate payers have been affected indirectly by austerity and recessionary tendencies. Although one or more price increases a year remain the norm for many effective drugs marketed in the United States, price cuts and concessions occur with some regularity in many other regions. Pharmacoeconomic studies that demonstrate an overall cost benefit to the health care system are gaining in importance. Although they raise the cost of drug development and may be fraught with methodologi-cal challenges, they also allow for the price differentiation of highly effective new drugs. Recent and upcoming expirations of blockbusters’ patents are expected to result in tens of billions of dollars in savings for health care systems globally, thus providing some flexibility to reward innovation in areas of high unmet need. Aus-terity notwithstanding, it thus appears fair to assume that a safe and highly effec-tive drug for the treatment of a serious, underserved condition, such as Alzheimer’s disease or heart failure, would likely achieve peak sales well in excess of $1 billion. Where clinical differentiation is lacking, price pressure is likely to intensify further. For example, some generics markets, including Germany’s, are increasingly tender driven, with significant negative effects on price and profitability. In the United States, where substitution of generics is common, generics companies rely heavily on first-to-market strategies that afford short windows of opportunity to maintain relatively high prices until the onset of multi-source generics. The rising price pre-mium of truly innovative drugs that address medical areas of high unmet need over interchangeable products and those conferring only a modest benefit has resulted in increasingly focused strategies, with the most innovative pharmaceutical compa-nies pursuing differentiation rather than cost strategies in Western markets. Today, only a few of the pharmaceutical majors have significant generics operations in developed markets because the key determinants of success—including time to market, breadth of portfolio, and logistical capabilities—differ markedly from the core competencies required in the branded pharmaceutical space.

With respect to general industry dynamics, the relative lack of seasonality and cyclicality is worth noting. With the exception of some categories (e.g., allergy treatments and flu vaccines), most drugs are prescribed and administered year-round. The months of summer vacation as well as the holiday season are typi-cally somewhat lighter than other times of the year. To the extent that there is an element of patient self-pay, drug sales may be moderately cyclical. For example, patient co-pay requirements per drug pack may induce some patients to take “drug

holidays” in a tough economic climate, while those patients who have to pay part of the fee for physician office visits out of pocket may postpone a health checkup and, by implication, the purchase of medicines for the treatment of conditions they are unaware of. Where employers are a key source of private health insurance, rising unemployment rates may negatively affect consumption. Self-medicating individuals may replace expensive over-the-counter (OTC) brands with white label products in times of declining consumer confidence. However, all these factors tend to have only a very modest impact on industry sales; rarely do they visibly affect any sets of quarterly results.

Health care reform, usually in the form of price cuts, typically represents the main fallout from a bleak macroeconomic picture. In recent years, many com-panies have experienced low- to mid-single-digit annual price pressure across their European drug portfolios in the wake of austerity measures implemented by various governments. The US market is dominated by private health insurance and has thus been largely immune to government initiatives in most years. Begin-ning in 2010–2011, however, the US Affordable Care Act reduced companies’ US drug sales by a low single-digit percentage as a result of increases in the manda-tory Medicaid rebate rates and similar measures. It remains to be seen whether improved access to health insurance will have a positive effect on industry growth rates in the longer term.

Two key considerations in forecasting the impact of health care reform are worth highlighting. First, reform measures usually need to be ratified by legislatures and their implementation can be time consuming; it is possible that the first impact on the industry will not be felt until a year or more after the first observation of a decline in macroeconomic indicators. Second, the sensitivity of branded drug sales to reform measures rarely differs among the majors; although some drugs may be more negatively affected than others, the drug portfolios of the industry majors tend to be sufficiently diversified for the net effect on branded human drug sales to be similar across companies. Of course, exposure at the group level is partly deter-mined by diversification into areas other than patented human prescription drugs. However, care must be taken when assessing the impact of any reform measures on small and midsize players, which may face substantial exposure with respect to a particular drug or region. In extreme cases, health care reform has the potential to negatively transform the earnings of such companies.

THE DRUG DISCOVERY,

DEVELOPMENT, AND APPROVAL

PROCESS

Prior to launching a new drug, the sponsor (i.e., the pharmaceutical company or companies that own the rights to the compound) must extensively evaluate its efficacy and safety in order to obtain approval from the appropriate regulatory authority in each jurisdiction where it intends to market the drug. For example, US approval must be obtained from the FDA; European approval is usually obtained from the European Medicines Agency (EMA); and Japanese approval may be granted only by the Japanese Ministry of Health, Labor, and Welfare. The drug development process is lengthy, costly, and fraught with risks. Concerns over a com-pound’s efficacy, safety, or commercial viability may emerge at any point in the pro-cess; if such concerns are sufficiently serious, the company may decide to terminate development, which implies that the investment in the compound’s development will never be recouped. Pharmaceutical analysts regularly revise their forecasts in response to R&D-related news—notably revising sales forecasts for drug candidates to reflect their launch probability (which rises as drugs progress through develop-ment), the expected commercial positioning in light of emerging scientific data, and any potential changes to launch timelines. The progression of drug candidates to the costly advanced stages of development may also have a bearing on short- and medium-term R&D expenses. Since continuous rejuvenation of the drug portfolio is of paramount importance to a pharmaceutical company’s profitability, a thorough understanding of the drug discovery, development, and regulatory process is cru-cial to the accuracy of forecasts. This section explains the basic drug development process and the regulatory process in key geographic regions. Special emphasis is placed on the key US market, where the regulatory process is highly transparent and usually relatively speedy.

Drug discovery generally starts with ideas for a drug target and a lead molecule. The choice of target (e.g., a cell surface receptor involved in sending messages into the cell nucleus or a messenger molecule that binds to receptors as a ligand) is typically driven by a company’s understanding of the biology of a particular dis-ease. For example, a tumor might express cell surface receptors that are absent in healthy tissues, and a pharmaceutical company might endeavor to develop a medi-cine that selectively targets this receptor. Although many pharmaceutical majors work on elucidating disease mechanisms, substantial outside work—performed, for

example, by academic institutions—is taken into account when choosing a target. Translational medicine is the branch of science concerned with the clinical applica-tions of basic research.

Once a target has been identified, the company’s scientists study various approaches to blocking or modulating the target to reduce or ablate disease activ-ity. For example, they may use a compound that binds to and blocks the cell surface receptors found on cancer cells, thereby preventing them from receiving further growth signals. The compounds identified as having potential utility are classified as leads. Leads must satisfy various requirements—for example, they need to inter-act effectively with their target, but interinter-action with other molecules in the human body should be kept to a minimum in order to avoid side effects that may arise from off-target activity. Leads are often identified by screening molecules from existing “libraries” against the target. Optimizing the most suitable compounds identified in this manner typically requires substantial knowledge of chemistry or biochemistry. Owing to the complexity of the process, it is not feasible for any company to iden-tify and study each target and lead compound in-house. Therefore, co-operations between firms are announced with some regularity. For example, one pharmaceuti-cal or biotechnology company may supply the library to be tested against a target supplied by another company, or two companies that have identified drug candi-dates targeting the same pathway may join forces to develop these compounds together. Collaborations between the industry and academia are also common. Furthermore, pharmaceutical companies frequently in-license drug candidates that originated at biotechnology companies; the larger company thus bolsters its pipe-line while providing financing as well as clinical and regulatory expertise and mar-keting prowess.

Once a lead compound has been identified, it proceeds to the pre-clinical stage, which comprises various tests in vitro as well as in relevant animal models. Testing in humans, also known as the clinical stage, requires approval from ethics commit-tees, which is granted only after a compound has been fully characterized in the pre-clinical setting. Clinical trials are designed to fully elucidate a drug’s safety, efficacy, and key characteristics in humans. Thus, the design of clinical studies and the scope of the program vary with the type of compound being studied and the condition it is intended to treat. Simplistically, the clinical trial process may be divided into three phases. In phase I, the compound is typically tested in healthy volunteers. Phase II studies enroll patients and are usually designed to give pre-liminary evidence of efficacy and safety while determining the best dose(s) to test in phase III. Phase III trials are designed as pivotal, or registration, trials and are powered to yield statistically significant results on a drug’s efficacy and safety. Although regulators review the totality of the data (including the full safety data-base available at the time) before approving or rejecting a new-drug application,

Industry Overview The Drug Discovery, Development, and Approval Process

successful completion of phase III is usually a prerequisite for approval. Once a drug has been approved, its safety is monitored regularly and the sponsor may be asked to fulfill post-approval commitments; this post-marketing phase is some-times referred to as phase IV. Exhibit 1 outlines the basic process of getting a drug to market.

Exhibit 1 presents a conceptual framework; in practice, the drug development process may vary substantially. For example, most cancer drugs are too toxic to be given to healthy volunteers. Drug candidates for the treatment of conditions with a poor prognosis may receive regulatory approval after a pivotal phase II study. An adaptive trial design (e.g., a phase II study is rolled over into a phase III trial if certain criteria are met) is increasingly being used for some diseases. Regulators frequently provide sponsors with guidance and feedback on trial design in an effort to minimize the risk of inadequate trial design. Clinical trials are often large, with hundreds of patients typically enrolled in phase II studies and thousands, occasion-ally tens of thousands, recruited into phase III. Hence, the cost of clinical develop-ment is high: Depending on the therapeutic area under study, phase II trials may cost tens of millions of dollars, and the bill for a phase III program often amounts to hundreds of millions of dollars. The increasing focus on “outcomes” trials (dis-cussed later) puts further upward pressure on the cost of clinical development.

Consequently, the industry has concluded that the cost of failure in phase III is unacceptably high and has put in place extensive measures designed to identify potential problems in phase II or earlier. Although the industry now appears to

Exhibit 1. Getting a Drug to Market

Drug discovery and pre-clinical phase

Target and lead identification; testing in vitro and in vivo (animal model) Multi-year process Cost: millions of dollars Phase I Tests in healthy volunteers Duration: months Cost: millions of dollars Phase II Efficacy and safety in patients; dose selection Duration: typically >1year Cost: at least tens of millions of dollars Phase III Registration studies to establish safety and efficacy Duration: about 2 years (varies) Cost: often hundreds of millions of dollars Regulatory review Duration: typically 1year; expedited review maybe available Launch Within days or weeks of approval if reimbursement negotiations are not necessary; otherwise, up to a year or more

appraise the clinical and commercial potential of drug candidates in early- and midstage development more critically than in the past, the possibility of failure in phase III can never be ruled out. It is therefore prudent to risk-adjust sales forecasts until a drug has passed phase III and, ideally, received regulatory approval. Owing to the high cost of clinical development, studies are typically sponsored by the phar-maceutical firms themselves. Occasionally, investigators or cooperative groups may sponsor trials based on their own hypotheses. Although these studies may occasion-ally produce intriguing results, caution is warranted because they are not always comparable in size and quality to industry-sponsored trials and are often unsuitable as registration trials.

Because share prices tend to react to the results of pivotal trials, it is worthwhile to briefly review the design of typical phase III trials and touch on the interpretation of results. Many pivotal studies are designed as global trials, with clinical centers across the United States, the EU, Eastern Europe, Asia Pacific, Latin America, and other key regions. The FDA usually requires the inclusion of a meaningful number of US patients in the pivotal study, whereas other regulators may accept data from a smaller local study in addition to the pivotal data in order to ascertain that the drug is safe and efficacious in the local patient population. Generally speaking, the patient population enrolled in the clinical program must be representative of the patient population that will receive the drug after its approval because such factors as eth-nicity and standard of care may have a bearing on patients’ responses to a drug. Often, a phase III program consists of two studies; however, regulators frequently accept a sole pivotal study, notably for indications that require large and complex trials. For other indications, it may be advisable to conduct more than two phase III studies in order to demonstrate the drug’s compatibility with other frequently used drugs in different patient populations—diabetes being a prime example.

The study sponsor typically selects one primary endpoint, although co-primary endpoints are occasionally chosen in complex settings, such as acute care. The pri-mary endpoint is usually an efficacy endpoint and reflects the main hypothesis that the trial has been designed to test. For example, the primary endpoint of a diabetes trial may be a reduction in blood sugar or a composite score of heart health. Trials that assess a drug’s impact on the mortality and morbidity (M&M) of the patient population are often referred to as “outcomes” trials. Endpoints related to M&M are considered “harder” than so-called surrogate endpoints, which merely measure changes in a marker of disease severity, such as blood glucose or blood pressure. However, M&M trials tend to be lengthy owing to the requirement to enroll a very large number of patients and to follow them for a long period in order to observe statistically significant differences in rare events, such as death. Therefore, they are not usually part of the initial registration package. In addition to the primary end-point, the sponsor chooses secondary endpoints, which often include safety.

Industry Overview

Simply put, a study is considered positive if the primary endpoint is met— that is, if the main hypothesis is proved and the result is statistically significant. Although a positive study bodes well for approval of the drug, the regulators eval-uate the totality of the evidence and may reject a drug for other reasons, such as observed safety signals or weak results on secondary efficacy endpoints. If the primary endpoint is not met, the study is considered negative, making regulatory approval extremely unlikely. Choosing the primary endpoint well and optimizing other aspects of the trial design are thus of paramount importance to the success or failure of a drug. Secondary endpoints are generally considered merely support-ive, and even resounding success with regard to each secondary endpoint usually does not make up for failure to meet the primary endpoint. Some drug candidates have been doomed by poor trial design rather than by an intrinsic lack of efficacy or safety. Other aspects of trial design that may have a bearing on a drug’s chances for approval include whether the design is for an open-label trial or a double-blind trial (in which patients and physicians do and do not know, respectively, whether they are receiving the study drug, a placebo, or another comparator); the choice of comparator (a placebo or an active comparator that is commonly used to treat the disease); the inclusion and exclusion criteria; the statistical analysis plan; and numerous other factors.

Once the full clinical development of a drug candidate has been completed, the sponsor usually submits the entire dossier to the relevant regulatory authorities in the jurisdictions where it intends to market the product. Submission in the United States, the EU, and Japan is now virtually simultaneous for many drug candidates, although timing differences can arise from minor or major variations in regulatory requirements with respect to either the clinical development plan or the data analy-sis. The regulatory review process starts upon receipt of the dossier by the agency.

From the public’s point of view, the FDA offers the most transparent process. Nor-mally, the agency formally accepts an NDA (new-drug application) file for review shortly after its submission. On the rare occasions when a dossier is rejected— usually for technical reasons—the sponsor typically resubmits within a relatively short period. Under Prescription Drug User Fee Act (PDUFA) regulations, the FDA’s standard review time is 10 months, although the agency may extend the review period by up to 3 months if it requires more time to consider the vast amounts of data that generally need to be analyzed as part of an NDA review. Expedited review procedures may be available for drug candidates that target a medical area of very high unmet need, such as rare and lethal forms of cancer. Irrespective of the type of review process, the FDA sets an action date, also known as the drug candidate’s PDUFA date, by which the agency must communicate its regulatory decision. The FDA may either approve a drug or send a Complete Response Letter (CRL) stating that a drug application cannot be approved in its present form. On some occasions,

the deficiencies raised in the CRL may be addressed fairly quickly and the drug may be resubmitted for approval within a relatively short space of time. In other cases, new clinical trials may be necessary to establish a compound’s efficacy and safety to the FDA’s satisfaction, which can delay the product launch by years.

Before making a regulatory decision, the FDA may convene a panel of experts (also known as an advisory committee) who publicly share their views on the drug’s efficacy, safety, and overall approvability. The amount of drug-specific data and other information made publicly available in the context of advisory committee meetings typically far exceeds the amount of data that can be gleaned from any other source. Extensive briefing documents are posted on the FDA’s website, usu-ally 48 hours before the start of the panel’s meeting. These documents contain the FDA’s questions to the panel (tough questions have, on occasion, rattled investors’ nerves), both the sponsor’s and the FDA’s detailed review of the data, and a pre-liminary assessment by the FDA reviewer—all spread over hundreds of pages. The meeting itself typically lasts a full day, with presentations by the sponsor and the FDA as well as questions by the panel to both the sponsor and the FDA. The meeting also includes an open public hearing—where other stakeholders, such as patients and patient organizations, may express their views on the suitability of the drug for the targeted patient population—and a debate by the panel members on nonvoting questions, followed by yes/no/abstain votes on the voting questions. Typical voting questions seek to ascertain whether the drug’s efficacy and safety have been estab-lished and whether the drug should be approved.

The entire meeting is usually webcast and provides not only a glimpse of the FDA’s main concerns and the likelihood of approval but also a general sense of fac-tors that may have a bearing on the drug’s commercial potential. Nonetheless, the outcome of an advisory committee meeting should be interpreted with caution. Importantly, the FDA retains ultimate responsibility for the approval of a drug; a positive “adcom” vote does not guarantee approval, nor does a negative vote nec-essarily herald rejection. Pharmaceutical companies usually issue a press release on the voting results shortly after the panel adjourns; however, the votes may not give a full picture of the panel’s views on a drug. It is therefore advisable to watch the panel itself and to note the explanations of panel members for their votes. Some yes votes may be heavily “caveated,” while some no votes may relate to con-cerns that are easily addressed. The panel members’ opinions may not reflect those of attending physicians in the field; the panel members represent different areas of expertise and may include statisticians and practitioners of other disciplines who would not necessarily prescribe the drug after approval. Conflicts of interest, such as extensive consulting agreements with the pharmaceutical industry, may keep some of the most renowned opinion leaders off the panel. Finally, the committee is merely expected to weigh in on the compound’s approvability in general terms

Industry Overview

and does not consult directly on the label, although panel members periodically point out that they struggle to discuss the issue of approvability in a vacuum. For example, if a panel member believes that a drug should be withheld from patients with renal failure and that it should be approved if appropriate monitoring of renal function is mandated, that panel member would be expected to vote in favor of approval and to rely on the FDA to address contraindications and requirements for monitoring on the label. Therefore, a drug may receive approval, but a restrictive label may effectively relegate it to later lines of therapy and thus limit its peak sales potential.

The approval process of the European Medicines Agency (EMA) differs from that of the FDA with respect to various administrative aspects and is often less transpar-ent to the public. Many drugs are submitted to the FDA as part of the ctranspar-entralized authorization procedure, which results in a single marketing authorization that is valid throughout the European Union, Iceland, Liechtenstein, and Norway. Occa-sionally, national approval procedures may be chosen—either the decentralized procedure, whereby sponsors may file simultaneously in more than one country, or the mutual recognition procedure, whereby a drug is approved in one country with an option to subsequently request recognition of that authorization in other EU member states. Like the FDA, the EMA formally accepts or rejects the dossier. The actual review process takes up to 10 months; however, questions from the EMA to the sponsor trigger “clock-stops” until receipt of the answers. These interruptions are not formally communicated to the public, making the timing of the EU decision on the approval of a new drug difficult to predict. If the EMA’s queries cannot be addressed in the time frame specified, the dossier is typically withdrawn and later resubmitted. The EMA’s Committee for Medicinal Products for Human Use (CHMP) convenes monthly, usually after the 20th day of each month. Unlike FDA panel meetings, CHMP meetings are nonpublic to shield the committee from any lobbying efforts on the part of stakeholders. Following completion of the process, the EMA issues a European Public Assessment Report (EPAR), which summarizes its conclu-sions with respect to a compound’s risk–benefit profile. At the end of the review process, the CHMP issues a recommendation to the EU to approve or reject the drug. The EU generally follows this recommendation within three months of issue.

Whether the regulators, especially the FDA, have become more exacting and pos-sibly more politicized is a subject of intense debate. The FDA might be forgiven for being gun-shy, having taken flak from the US Congress in the wake of post-approval safety concerns that have led to product withdrawals. In contrast, the EMA appears to be relatively insulated from politics. The ethical dilemma faced by regulators is inherent in their mandate to make new drugs available to patients to halt or slow down disease progression and reduce sequelae while shielding them from drug-induced harm. Even the largest clinical trials may not unearth all the side effects

that may arise in the field, and imbalances in serious adverse events observed in clinical trials between patients receiving a study drug and those on a placebo or other comparator could either signal a potential safety issue or merely reflect the play of chance. Ruling out unacceptable safety risks is thus one of the main chal-lenges of both drug development and regulatory review.

Regulatory guidance documents that lay down the specific requirements to estab-lish a drug candidate’s safety to the agencies’ satisfaction have greatly clarified the statistical aspects of trial design and interpretation. For example, in the wake of concerns over heart risks associated with anti-diabetic agents, the FDA established clear rules on demonstrating the absence of unacceptable cardiovascular risk. Another point of contention is the responsibility that regulators are expected to assume for protecting patients from themselves. Although the EMA appears largely to trust physicians to prescribe drugs to suitable patients only and patients to take their drugs as prescribed, the FDA’s role in this regard appears more ambiguous. The question of whether FDA advisory committees ought to base their recommen-dations, in part, on the risks that may arise from off-label use and drug overdose has cropped up repeatedly but has never been met with a definitive answer. The extent to which sponsors are wary of FDA concerns in this regard is illustrated by the avail-ability of safety studies of drugs intended for use in chronic obstructive pulmonary disease (COPD) in asthma patients, who might conceivably be prescribed the drug for off-label use.

It is important to note that the mandate of both the FDA and the EMA encom-passes only the assessment of a drug’s clinical risk–benefit. Economic considerations are outside the scope of the regulatory review process, and regulatory approval does not guarantee that a drug will receive reimbursement at a price acceptable to the sponsor.

The drug discovery, development, and approval process is lengthy: More than 10 years can elapse between the first description of a potential drug target in the lit-erature and the launch of the first drug to interact with that target. Clinical develop-ment alone is a multi-year process; the duration depends on the scope of the clinical and analytical work to be performed, drug firms’ decision processes, and possible delays caused by such things as problems with the stability of a drug’s formulation or having to put a trial on “clinical hold” while an observed imbalance in adverse events is being investigated. Although timelines may vary widely as a function of various requirements, the following guide may be used as a starting point: Phase I studies can usually be conducted and analyzed in a matter of months, whereas a full phase II program can rarely be completed in less than a year because it often comprises multiple studies, with treatment durations of up to six months relatively common and even longer durations under certain circumstances. The phase III pro-gram usually lasts at least two years, with treatment durations of at least one year

Industry Overview

and additional time for patient accrual, follow-up, and data analysis. It may take significantly longer in the case of very large trials for which patient recruitment takes a long time or in the event of very long treatment durations or the need for extensive patient follow-up. But pivotal trials can also be much shorter (e.g., for anti-cancer drugs targeted at particularly lethal tumors).

Most clinical trials that are relevant to the analysis of the pharmaceutical indus-try majors are listed at http://clinicaltrials.gov, where expected timelines are usu-ally provided. The regulatory review process may amount to six months or less if an expedited or priority review is granted—for example, for drugs that have received the FDA “fast track” or “breakthrough therapy” designation. Standard review pro-cesses tend to take approximately one year in most key territories. In the event of a rejection based on major clinical deficiencies, it may take years to address the regulators’ concerns. Although a drug may be launched within days or weeks of approval, a delay of one year is not uncommon in regions known for drawn-out reimbursement negotiations.

INTELLECTUAL PROPERTY:

PATENTS, REGULATORY

EXCLUSIVITIES, AND OTHER

FORMS OF PROTECTION

As discussed in the previous section, discovering a drug and getting it to market is a lengthy and resource-consuming process. Manufacturing and distributing a drug are relatively straightforward by comparison, although pharmaceutical production has its own challenges, notably in the context of the industry’s shift toward bio-pharmaceuticals, which are typically produced by genetically engineered cells. To perform the significant amount of pre-clinical and clinical work required to estab-lish a drug’s safety and efficacy, originators of new drugs require incentives in the form of periods of market exclusivity during which they can earn a return on their investment. Essentially, there are two levels of protection: patents and regulatory exclusivities. These forms of protection run in parallel—that is, an off-patent drug may not be copied by generics players while regulatory exclusivities are in place, and generics companies must demonstrate that existing patents are invalid or not infringed by their product if they wish to launch a generic once regulatory exclusivi-ties run out. The rules and legislation around both forms of protection are excep-tionally complex, and readers should be aware that the following discussion merely scratches the surface.

Patents are issued by patent offices. The strongest protection is typically afforded by the patent on the active ingredient by which a drug exerts its biologi-cal effect. So long as the active ingredient is protected, the drug itself is protected; any drug containing a different active moiety would be considered a different drug, not a generic, and would need to complete a full clinical program before obtaining approval. However, substance patents tend to be the first to expire in the patent estate surrounding a drug. Although substance patents have a life of 20 years from the date of issue, they are normally granted at an early stage of the lengthy drug discovery/development process. By the time a drug launches, the active-ingredient patent is often less than 10 years from expiration. In the event of severe delays in the drug development process, a substance patent can even expire prior to launch.

Various provisions allow drug makers to extend their drugs’ patents by a number of years. For example, products marketed in Europe may receive supplementary

Industry Overview

protection certificates (SPCs) that add up to five years of protection; under the Hatch–Waxman Act patent term extension provisions, US patents may be extended by up to five years to compensate drug firms for some of the time that compounds spend in development or registration. Even so, the active-ingredient patent is likely to expire earlier than weaker forms of patents, such as formulation, pro-cess, or use patents. A generics company may be able to circumvent these other patents—for example, by changing the drug’s excipients or key steps in the pro-duction process. Use patents, which preclude generics from being used in certain disease settings, can be difficult to enforce. For completeness, trademarks are worth mentioning. Although they do not play a pivotal role in the protection of most drugs against erosion by generics, they may add an extra level of protection in some cases, especially for drugs administered in a device, such as an injection pen or inhaler. Over time, patients may become loyal to their device and balk at the notion of having to use a generic that comes in a device with a different “look and feel.”

It is incumbent on the sponsor of a generic to assert that its product is not infringing any valid patents. For example, when a company submits an abbrevi-ated new-drug application (ANDA), or generic file, to the FDA, the application must contain either a paragraph III or a paragraph IV certification. In the case of a paragraph III certification, the FDA holds off on final approval until all the pat-ents listed in its Orange Book database have expired; a paragraph IV filing reflects the generic sponsor’s conviction that unexpired Orange Book patents are either invalid or not infringed. The branded drug company is informed of all paragraph IV filings that are based on one of its brands as a reference product and may sue a generics company within 45 days of such notification if it concludes that its pat-ents are valid and would be infringed by the generic. In the event of a lawsuit, the FDA is banned for 30 months from approving the generic unless there is an earlier court decision in favor of the generic’s company. This stay is often referred to as a Hatch–Waxman stay.

The validity or invalidity, as well as the infringement or non-infringement, of patents is determined by the courts. A court may invalidate patents on such grounds as obviousness or prior art, or it may rule that a patent is unenforceable owing to inequitable conduct. If a court finds patents to be valid and enforceable, the generic may be launched only if it does not infringe them. The court’s rul-ing may be appealed. If a generic is launched while litigation remains ongorul-ing, the launch is considered “at-risk,” meaning that the generic’s company may be liable for damages if it is later found to have infringed any valid and enforceable patents. Owing to the high level of uncertainty around the outcome of litigation, it is not uncommon for the makers of the branded drug and the generic to settle their litigation. Settlements typically result in a launch date for the generic that

falls somewhere in between the assumed launch dates under various hypothetical court judgments. Settlement agreements must be structured so as to ensure that the health care system or consumer is not disadvantaged; “pay to delay” deals, in which the branded drug maker pays the generic’s company to hold off on a launch and delay the legitimate entry of its generic, are unacceptable because they deprive the health care system of potential savings.

A pharmaceutical company that embarks on the discovery and development of a new drug thus faces substantial uncertainty about its patent estate. The post-launch life of the active-ingredient patent may be difficult to predict, and there are no guarantees that the company’s patents will be upheld in court or that key patents will not be circumvented by generics companies. This uncertainty might conceiv-ably deter the drug maker from investing in large-scale clinical trials, especially if the patent estate appears relatively weak (e.g., in the case of a molecule that was discovered and patented early), with the result that the active-ingredient patent might expire before or shortly after launch. Similarly, a drug maker might refrain from developing drugs for niche indications if there is a high risk that the drugs’ sales might be too low to earn an adequate return on investment before their pat-ents expire. Of course, decisions against the development of drugs that hold prom-ise from a medical perspective risk being detrimental to patients who might face a dearth of treatment options.

Regulatory exclusivities offer intellectual property protection independent of patents in order to incentivize drug firms to invest in drug candidates. A plethora of regulatory exclusivities are available; the following discussion is confined to the most common forms in the United States and the EU. The FDA awards five years of exclusivity for new chemicals and three years for a “change,” such as a new formulation. If a drug maker establishes the efficacy and safety of its drugs in chil-dren, pediatric exclusivity is awarded, adding another six months to the exclusiv-ity period conferred by patents or other regulatory exclusivities. So-called orphan drugs, targeted at conditions that affect fewer than 200,000 people in the United States, receive seven years of exclusivity.

The EMA awards 10 years of exclusivity to new drugs, including 8 years of data exclusivity, during which generics companies may not reference the originator’s data, and 2 years of market protection, during which generics may not be approved; new indications may entitle the drug firm to a 1-year extension. Successful develop-ment of a drug for pediatric patients renders the applicant eligible for a six-month patent term extension. Orphan drug exclusivity—granted for drugs that target indi-cations affecting fewer than 5 in 10,000 Europeans or that would be unlikely to yield a sufficient return on investment for other reasons—lasts for 10 years, with a 2-year extension possible if a new orphan indication is added. Table 1 summarizes the main forms of protection for new drugs.

Industry Overview

Table 1. Summary of the Main Forms of Protection of New Drugs against Generics

Patents and Trademarks Regulatory Exclusivities Active-ingredient patents New-drug exclusivities

Formulation patents Exclusivities with respect to changes (e.g., new _{formulations or indications)} Process patents Pediatric exclusivity

Use patents Orphan drug exclusivity Patent term extensions

Trademarks

BUSINESS MODELS

The industry majors vary with respect to their degree of and approach to diversifica-tion. Some firms are essentially “pure plays” that offer almost exclusively branded prescription medicines for human use. Their success is thus inextricably linked to the growth trajectory and longevity of their marketed drugs as well as the success of their pipelines. The potential rewards are high, but so are the risks. Many players therefore seek to balance their business through exposure to other, more predict-able segments of the health care sector. Closely related fields that can be somewhat synergistic with the business of branded human prescription drugs include OTC drugs and products for animal health. These businesses are characterized by limited patent exposure and significantly reduced R&D risk, with shorter payback periods for R&D spend, steady growth, and organic growth rates typically in the low to mid-single digits. Thus, the management teams of large corporations tend to view these businesses as a natural extension of their core pharmaceutical operations.

In contrast, the core competencies required to compete effectively in other fields of health care, such as generics, diagnostics, and medical technology, may differ substantially from the skill set and know-how acquired in the course of branded drug development and marketing. Consequently, the industry majors tend to enter these arenas selectively, and many firms operate in these market segments for his-torical reasons rather than as a deliberate move in recent years. Industrial conglom-erates comprising both pharmaceutical and non-health-care operations are rare and usually result from historical developments. For example, the pharmaceutical industry was, to some extent, born out of the chemical industry; as a result, some pharmaceutical players retain chemical operations today. In such cases, the gradual divestment of non-health-care activities over time tends to be more common than deliberate moves to diversify away from health care. Table 2 reports the degree of diversification of various relevant business models.

Table 2. Pharmaceutical and Health Care Business Models: Degree of Diversification

Business Model Brief Description Company Examples Pharmaceutical “pure play” Focus is almost exclusively on branded prescription

drugs for human use AstraZeneca, Bristol-Myers Squibb, Novo Nordisk Balanced drug portfolio May include OTC drugs and products for animal

health in addition to branded human prescription drugs

Eli Lilly, GlaxoSmithKline, Merck & Co., Pfizer, Sanofi Diversified health care company Includes other health care segments (e.g.,

gener-ics, diagnostgener-ics, medical technology) in addition to branded drugs

Johnson & Johnson, Novartis, Roche Diversified industrial company

Business Models

INDUSTRY CONSOLIDATION

Consolidation has been a long-standing theme of the pharmaceutical industry and has given rise to a number of very large organizations with tens of billions of dollars in annual revenues. Nonetheless, the industry remains fragmented, with even the largest players commanding mere single-digit market shares. Although this situa-tion leaves room for future megamergers, the combinasitua-tion of two pharmaceutical giants is rarely the alternative preferred by the companies’ management teams. Managing extremely large organizations is fraught with challenges. Although syn-ergies may substantially decrease the combined cost base—notably, selling, general, and administrative expenses (SG&A)—the absolute amount of revenue expected to be lost to patent expirations in future years rises dramatically, thereby increasing the pressure on the combined pipelines to deliver. (For this reason, an “ideal” take-over candidate would typically be the mirror image of the industry majors, in the sense that it would combine a modest current revenue base with a potentially trans-formational pipeline. However, such acquisition targets are few and far between.)

Antitrust considerations are another potential obstacle to M&A that should not be underrated. Owing to the high degree of fragmentation of the pharmaceutical market, there is a high risk that the combination of two pharmaceutical firms could result in their having a dominant position in one or more market subsegments—for example, multiple sclerosis or a specific type of tumor. This result would trigger mandatory divestment of one of the drugs targeting that disease area, which could dilute the shareholder value of the merger transaction. Antitrust considerations are not limited to classical pharmaceutical businesses. In fact, the combination of two animal health businesses could be exceptionally problematic from an antitrust point of view, with mandatory divestments particularly hard to execute. A number of the major players have exposure to animal health, and a situation could conceiv-ably arise in which that business activity would effectively block mergers that might otherwise appear attractive with respect to the firms’ human drug businesses.

In light of these considerations, many pharmaceutical executives in recent years have expressed a preference for “bolt-on” acquisitions—for example, to reach criti-cal mass in areas where the company had previously been underrepresented—and for drug-licensing deals over large transactions. Owing to an abundance of small and midsize drug companies, this approach also offers more choice than megamerg-ers do. Numerous biotechnology companies are working on drugs for the treat-ment of conditions with high unmet need or offer platform technologies that may enhance the drug discovery process or the features of drug candidates themselves. These players range in size from small venture-capital-funded start-ups and vehi-cles spun out of universities to midsize and large companies that own the rights to cash-generative marketed drugs wholly or in part. Depending on the scale of their operations as well as their focus and outlook, these firms may rely to a significant

extent on large pharmaceutical companies to provide funding and clinical expertise in the drug development process and a commercial engine to sell the drug follow-ing approval.

Occasionally, the industry majors opt for the outright acquisition or purchase of a stake in biotechnology companies. In general, however, full ownership of R&D assets is not considered of paramount importance. In light of the plethora of scien-tific approaches being explored, it seems impossible to predict which technologies, mechanisms of action, and therapeutic categories hold the greatest promise. Unsur-prisingly, many large pharmaceutical companies seem content to “part-own” a large number of different assets and are reluctant to place large bets on unproven scien-tific approaches. Therefore, licensing arrangements are common in the industry. In a typical licensing deal, a large pharmaceutical player acquires commercialization rights to a biotechnology company’s drug candidate globally or in key territories. In return, the pharmaceutical company makes an upfront payment to the biotechnol-ogy firm and commits to further success-based milestone payments and a royalty on future drug sales.

The upfront payment usually compensates the biotechnology firm for work car-ried out to date and often amounts to millions or tens of millions of dollars. Mile-stone payments are typically linked to clinical, regulatory, or commercial mileMile-stones (e.g., the transition to advanced stages of clinical development, regulatory approval, or the achievement of prespecified sales targets following launch). Milestones may be structured to compensate the biotechnology firm for future costs (e.g., expenses for clinical development if the originator has agreed to bear part of the clinical costs under a co-development clause) or as success-based milestones.

Royalty rates are subject to negotiation and are determined by various factors, most importantly the drug candidate’s development stage, the quality of the pre-clinical and pre-clinical data available at the time the agreement is entered into, the compound’s commercial potential, and the relative balance of the total economics between upfront payments, milestones, and royalties. Tiered royalties, in which the royalty rate itself depends on product sales, are relatively common. Single-digit royalties are often agreed on for compounds licensed at an early stage of development, whereas double-digit royalties—usually in the teens, occasionally in the twenties or higher—are the standard for compounds in the advanced stages of development that come with impressive sets of clinical data. Although some biotechnology companies prefer to leave drug commercialization to their pharma-ceutical partners, others are keen to field a small force of their own, especially on their home turf, and may negotiate co-commercialization and profit-sharing rights or options. Licensing deals based on 50/50 profit sharing in major territories are rare but not unprecedented.

Business Models

A major pharmaceutical firm’s activity with respect to the licensing of drug can-didates and other collaborations with the biotechnology industry and academia reflects its commitment and approach to innovation. Across the industry, the majors acknowledge the impossibility of building in-house expertise in every sci-entific hot spot and increasingly rely on external innovation for that reason alone. In light of the restructuring initiatives taken in recent years in anticipation of the “patent cliff,” many players have sought to rebalance between fixed and variable R&D spend and thus, by extension, internal and external R&D expenses. In addi-tion, the jury is still out on “optimal” levels of R&D spend, both in absolute terms and relative to pharmaceutical sales. Some players reinvest more than 20% of their branded prescription drug sales in R&D each year, whereas others opt for an R&D-to-sales ratio in the low teens, with obvious implications for the budget amount allocated to drug licensing.

NOTABLE TRENDS

Three general trends with respect to business models have been observed across the pharmaceutical industry. First, geographic diversification has become a higher prior-ity for the majors in recent years, as a combination of such factors as patent expira-tions and a changing regulatory and payer environment has called into question the viability of a strategy that has historically been heavily reliant on Western markets.

Second, the composition of portfolios of marketed drugs as well as pipelines has shifted away from primary care and toward specialty pharmaceuticals. Even such therapeutic niche areas as rare cancers and orphan diseases have lately attracted significant interest from the pharmaceutical industry. Although many firms remain committed to the primary care business, they have embraced specialty care as a sec-ond pillar, with its lower marketing spend, higher margins, and often higher success rate in clinical trials making up for the slightly more modest peak sales potential.

Third, the industry has reduced its infrastructure and generally cracked down on fixed cost in recognizing that the top line may fluctuate over the years as a result of patent expirations. The industry majors are now increasingly relying on exter-nal suppliers while seeking ways to achieve more with fewer resources. Excess production capacity, duplication of infrastructure across countries, and even such comparatively minor items as the discretionary purchase of excess R&D supplies by individual teams are now buried in the past. Some companies continue to gen-erate hundreds of millions of dollars in procurement savings each quarter—an impressive demonstration of the extent to which these firms are eliminating waste. Whether this newly found cost-consciousness bears risks is open to debate. The management teams of pharmaceutical firms maintain that adequate quality con-trol procedures reduce the risk of outsourcing to the same level of risk as in-house

activities and attribute glitches (e.g., FDA warning letters or supply disruptions) to such factors as human error and heightened regulatory scrutiny. In general, any efforts to reduce the cost base or render it more flexible may carry an inherent risk of opportunity costs and diminished control. Consequently, a modest reversal of recent trends may be in the offing as the industry leaves its “patent cliff” behind and as pipelines deliver.