Pharmaceutical Industry

Historically, the pharmaceutical industry has been a profitable one. Between 2002 and 2006 the average rate of return on invested capital (ROIC) for firms in the industry was 16.45 percent. Put differently, for every dollar of capital invested in the industry, the average pharmaceutical firm generated 16.45 cents of profit.

This compares with an average return on invested capital of 12.76 percent for firms in the computer hardware industry, 8.54 percent for grocers, and 3.88 percent for firms in the electronics industry. However, the average level of profitability in the pharmaceutical industry has been declining of late. In 2002, the average ROIC in the industry was 21.6 percent; by 2006 it had fallen to 14.5 percent.

The profitability of the pharmaceutical industry can be best understood by looking at several aspects of its underlying economic structure. First, demand for pharmaceuticals has been strong and has grown for decades. Between 1990 and 2003 there was a 12.5 percent annual increase in spending on prescription drugs in the United States. This growth was driven by favorable demographics.

As people grow older, they tend to need and consume more prescription medicines, and the population in most advanced nations has been growing older as the post–World War II babyboom generation ages. Looking forward, projections suggest that spending on prescription drugs will increase at between 10 and 11% annually through till 2013.

Second, successful new prescription drugs can be extraordinarily profitable. Lipitor, the cholesterol-lowering drug sold by Pfizer, was introduced in 1997, and by 2006 this drug had generated a staggering $12.5 billion in annual sales for Pfizer. The costs of manufacturing, packing, and distributing Lipitor amounted to only about 10 percent of revenues. Pfizer spent close to $500 million on promoting Lipitor and perhaps as much again on maintaining a sales force to sell the product. That still left Pfizer with a gross profit of perhaps $10 billion.

Since the drug is protected from direct competition by a twenty-year patent, Pfizer has a temporary monopoly and can charge a high price. Once the patent expires, which is scheduled to occur in 2010, other firms will be able to produce “generic” versions of Lipitor and the price will fall—typically by 80 percent within a year.

Competing firms can produce drugs that are similar (but not identical) to a patent-protected drug. Drug firms patent a specific molecule, and competing firms can patent similar, but not identical, molecules that have a similar pharmacological effect. Thus Lipitor does have competitors in the market for cholesterol-lowering drugs, such as Zocor sold by Merck and Crestor sold by AstraZeneca.

But these competing drugs are also patent protected. Moreover, the high costs and risks associated with developing a new drug and bringing it to market limit new competition. Out of every five thousand compounds tested in the laboratory by a drug company, only five enter clinical trials, and only one of these will ultimately make it to the market.

On average, estimates suggest that it costs some $800 million and takes anywhere from ten to fifteen years to bring a new drug to market. Once on the market, only three out of ten drugs ever recoup their R&D and marketing costs and turn a profit. Thus the high profitability of the pharmaceutical industry rests on a handful of blockbuster drugs. At Pfizer, the world’s largest pharmaceutical company, 55 percent of revenues were generated from just eight drugs.

To produce a blockbuster, a drug company must spend large amounts of money on research, most of which fails to produce a product. Only very large companies can shoulder the costs and risks of doing this, making it difficult for new companies to enter the industry.

Pfizer, for example, spent some $7.44 billion on R&D in 2005 alone, equivalent to 14.5 percent of its total revenues. In a testament to just how difficult it is to get into the industry, although a large number of companies have been started in the last twenty years in the hope that they might develop new pharmaceuticals, only two of these companies, Amgen and Genentech, were ranked among the top twenty in the industry in terms of sales in 2005. Most have failed to bring a product to market.

In addition to R&D spending, the incumbent firms in the pharmaceutical industry spend large amounts of money on advertising and sales promotion. While the $500 million a year that Pfizer spends promoting Lipitor is small relative to the drug’s revenues, it is a large amount for a new competitor to match, making market entry difficult unless the competitor has a significantly better product.

There are also some big opportunities on the horizon for firms in the industry. New scientific breakthroughs in genomics are holding out the promise that within the next decade pharmaceutical firms might be able to bring new drugs to market that treat some of the most intractable medical conditions, including Alzheimer’s, Parkinson’s disease, cancer, heart disease, stroke, and AIDS.

However, there are some threats to the long-term dominance and profitability of industry giants like Pfizer. First, as spending on health care rises, politicians are looking for ways to limit health care costs, and one possibility is some form of price control on prescription drugs. Price controls are already in effect in most developed nations, and although they have not yet been introduced in the United States, they could be.

Second, between 2006 and 2009 12 of the top 35 selling drugs in the industry will loose their patent protection. By one estimate some 28 percent of the global drug industry’s sales of $307 billion will be exposed to generic challenge in America alone, due to drugs going of patent between 2006 and 2012.

It is not clear to many industry observers whether the established drug companies have enough new drug prospects in their pipelines to replace revenues from drugs going off patent. Moreover, generic drug companies have been aggressive in challenging the patents of proprietary drug companies, and in pricing their generic offerings. As a result, their share of industry sales has been growing. In 2005, they accounted for more than half of all drugs prescribed by volume in the United States, up from one third in 1990.

Third, the industry has come under renewed scrutiny following studies which showed that some FDA approved prescription drugs, known as COX-2 inhibitors, were associated with a greater risk of heart attacks. Two of these drugs, Vioxx and Bextra, were pulled from the market in 2004.[i]

Discussion Questions

1. Drawing on the five forces model, explain why the pharmaceutical industry has historically been a very profitable industry.

2. After 2002, the profitability of the industry, measured by ROIC, started to decline. Why do you think this occurred?

3. What are the prospects for the industry going forward? What are the opportunities, what are the threats? What must pharmaceutical firms do to exploit the opportunities and counter the threats?

----------------------- [i] Sources: Staff Reporter, “Pharm Exec 50,” Pharmaceutical Executive, May 2004, pp. 61–68; J. A. DiMasi, R. W. Hansen, and H. G. Grabowski, “The Price of Innovation: New Estimates of Drug Development Costs,” Journal of Health Economics 22 (March 2003): 151–170; Staff Reporter, “Where the Money Is: The Drug Industry,” Economist, April 26, 2003, pp. 64–65; Value Line Investment Survey, various issues. Staff reporter, “Heartburn: Pharmaceuticals”, Economist, August 19, 2006, page 57. P.B. Ginsberg et al, “Tracking Health Care Costs”, Health Affairs, October 3rd, 2006, published online at www.healthaffairs.org.