by Michelle Russell, Ph.D., Marin Gjaja, Ph.D., and Pete Lawyer
Boston Consulting Group
April 2008

The pharmaceutical industry has enjoyed a protracted winning streak in which it has scored a decade of tremendous growth and profits on the back of novel and important medicines. But where will the victories come from in the next ten years? The pharma industry has entered a period of significant uncertainty and transition, characterized so far by higher R&D costs and fewer new drugs against a backdrop of calls for price controls and access restriction as society reaches the limits of willingness and ability to pay for pharmaceutical innovation. Add to the mix the 10-20 year investment horizon for research-based pharmaceuticals and a U.S. presidential election in which the industry is often under attack, and one thing becomes abundantly clear: The traditional pharmaceutical R&D business model will not generate adequate returns on today’s expenditures to discover, develop, and bring the next wave of new drugs to market. As a result, the model will need to either: (1) evolve significantly; (2) reduce investment to focus on those areas with sustainable returns; or (3) incorporate a combination of both.

By any historical standard, 1995-2005 was a frothy one as the worldwide pharmaceutical market doubled in size from $280 billion to $600 billion. In spite of this, the industry as a whole has created limited shareholder value since 2000, underperforming the S&P 500’s own tepid results. Total shareholder return (CAGR) from the beginning of the decade through year-end 2007 was only 2.7% for the pharmaceutical industry versus 3.6% for the S&P as a whole and 5.9% in the relatively low-growth consumer goods sector. The apparent contradiction can be explained by pharmaceutical P/E ratios, which have tumbled by 50% as investors have done their own math on rising R&D and marketing costs and declining productivity in terms of R&D expenditures per NDA. In financial terms, investors have “shorted” the industry—placing their bets that pharma R&D has excess capacity and that today’s returns are unlikely to be matched as the traditional research-based pharmaceutical business model grinds out the next decade of new products.

There is nothing simple about the pharmaceutical industry, and efforts to reduce its essence to a mathematical model will inevitably miss the nuance, brilliance and serendipity that explain many of the industry’s stellar successes. Nevertheless, one can aggregate inputs across the industry to assemble an average industry return on investment for a new drug. The results are illuminating. Ten years ago, research costs totaled approximately $70M per pre-clinical molecule, the probability of success from this stage to launch was about 18 percent, and peak sales per successful drug were roughly $1.0B. Over a commercial lifespan of ten years post-launch and a net margin of 50 percent, this average successful molecule yielded a 15 percent internal rate of return (IRR)—enough to compensate investors for tying up capital for so long in such a risky gambit.

Today, on the positive side, research costs have been shaved to $50 million per pre-clinical module as advances in genomics have vastly boosted the number of targets and as robust computing power has given the industry many more “shots on goal.” Alas, putting up more shots hasn’t raised the score, since the probability of clinical success has plummeted to only 8 percent. Looking forward, assume peak sales advance a bit to $1.1 billion, but net margins shrink to 40 percent as managed care and government payers flex their purchasing muscle. Under such a scenario, the payback tumbles to an estimated 11 percent IRR. This is not bad in the abstract perhaps, but is a far less favorable return than investors have come to expect for the long and risky wager involved in funding the traditional pharmaceutical model. By contrast, a lower-growth area like consumer goods—insulated by brand power rather than patent power—starts to look like a more attractive bet for investors.

What is pharma’s best bet for recouping investment in drug discovery and innovation? By cross-referencing therapeutic areas with high unmet need (as indicated by low generic penetration and strong price levels) against international markets with access and pricing policies more favorable to innovation, an opportunity map for the researchbased pharmaceutical business comes into focus.

For a larger version of the graphic click here.