The Pharmaceutical Industry

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Strategic Management 1 Instructor: Hisham Sabbagh

Case2: External Analysis for 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%. 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% for firms in the computer hardware industry 8.54% for grocers, and 3.88% 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%; by 2006, it had fallen to 14.5%.

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% 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 baby boom generation ages. Looking forward, projections suggest that spending on prescription drugs will increase between l0 and ll% annually through 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% 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" versio ns of Lipitor and the price will fall-typically by 80% 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 risk associated with developing a new drug and bringing it to market limit new competition. Out of every 5,000 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% 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,...
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