The 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 10 and 11% 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” versions 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

risks 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, for

example, spent some $7.44 billion on R&D in 2005 alone, equivalent to 14.5% 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 spending on R&D, 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 to market new drugs 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, twelve of the thirty-five top-selling drugs in the industry were to lose their patent

protection between 2006 and 2009. By one estimate, some 28% of the global drug industry’s

sales of $307 billion would be exposed to generic challenge in the United States alone, due to

drugs going off 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 by volume of all drugs prescribed in the United States, up from one-third in 1990.

Third, the industry has come under renewed scrutiny following studies showing 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.c.

Case Discussion Questions

Answer
The pharmaceutical industry has historically been very profitable due to several
factors outlined in the five forces model:
1. Threat of New Entrants: The pharmaceutical industry has high barriers to
entry. Developing a new drug requires significant investment in research
and development (R&D), and only large companies can afford the costs
and risks associated with this. As a result, new companies find it difficult
to enter the industry, leading to less competition and higher profitability
for existing firms.
2. Bargaining Power of Buyers: In the pharmaceutical industry, the buyers
are typically large entities such as government healthcare programs,
insurance companies, and hospitals. These buyers have limited
bargaining power due to the essential nature of pharmaceuticals and the
lack of substitutes for many drugs. This allows pharmaceutical companies
to maintain higher prices and profitability.
3. Bargaining Power of Suppliers: The suppliers in this industry are primarily
the providers of raw materials and components for drug manufacturing.
Pharmaceutical companies have the power to dictate terms to these
 suppliers due to their size and financial strength, enabling them to
maintain profitability.
4. Threat of Substitutes: In many cases, there are limited substitutes for
prescription drugs, especially for specific conditions. This lack of direct
substitutes gives pharmaceutical companies pricing power and
contributes to their historical profitability.
5. Competitive Rivalry: The pharmaceutical industry is dominated by a few
large companies with significant market share. This limited competition
allows these companies to maintain higher prices and profitability.
Overall, the combination of high barriers to entry, limited bargaining power of
buyers and suppliers, the essential nature of pharmaceuticals, and limited
competition has historically contributed to the industry's high profitability.
SOURCES:
 Page 1: Historical profitability and declining trend
 Page 2: Barriers to entry and limited competition
 Page 3: Limited substitutes and bargaining power of buyers and suppliers

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

Answer
The decline in profitability of the pharmaceutical industry after 2002 can be attributed to several
factors:

1. Patent Expirations: Many top-selling drugs lost their patent protection between 2006 and
2009, exposing a significant portion of the industry's sales to generic competition. This
led to a decline in revenues for established drug companies as generic drug companies
aggressively challenged patents and offered lower-priced alternatives.

2. Regulatory Scrutiny: The industry came under renewed scrutiny following studies
showing that certain FDA-approved prescription drugs, known as COX-2 inhibitors, were
associated with a greater risk of heart attacks. This led to increased regulatory pressure
and potentially higher costs for compliance and risk management.
 3. Research and Development Costs: Pharmaceutical firms spend substantial amounts on
research and development, with most of the investment failing to yield a marketable
product. This high R&D expenditure, coupled with the challenges of bringing new drugs
to market, contributed to increased costs and reduced profitability.

4. Market Saturation: The industry faced the challenge of market saturation, with a limited
number of blockbuster drugs generating a significant portion of revenues. This reliance
on a few key products made the industry vulnerable to fluctuations in sales and patent
expirations.

5. Competitive Pressures: The rise of generic drug companies and the difficulty for new
entrants to compete with established firms due to high R&D and marketing costs added
competitive pressures, impacting overall profitability.

6. Potential Price Controls: As healthcare costs rose, there were concerns about potential
price controls on prescription drugs, which could impact the industry's ability to maintain
high pricing and profit margins.

7. Aging Population: While the aging population drove increased demand for prescription
drugs, it also posed challenges in terms of healthcare costs and potential changes in
healthcare policies, impacting the industry's profitability.

In summary, the decline in profitability of the pharmaceutical industry after 2002 was influenced
by patent expirations, regulatory scrutiny, high R&D costs, market saturation, competitive
pressures, potential price controls, and demographic shifts.

SOURCES:

 Page 1: Historical profitability and factors driving pharmaceutical industry growth

 Page 2: Industry reliance on blockbuster drugs and R&D expenditure

 Page 3: Patent expirations, regulatory scrutiny, and market saturation

 Page 4: Association of COX-2 inhibitors with heart attacks and potential impact on
industry profitability
3. What are the prospects for the industry going forward?

Answer

The prospects for the pharmaceutical industry going forward are mixed. On one
hand, there is a strong and growing demand for prescription drugs, driven by
favorable demographics and an aging population. Additionally, successful new
prescription drugs can be extremely profitable, as seen with blockbuster drugs
like Lipitor. Furthermore, new scientific breakthroughs in genomics hold the
promise of bringing new drugs to market that treat some of the most
challenging medical conditions.
However, there are also threats to the industry's long-term dominance and
profitability. Politicians are looking for ways to limit healthcare costs, and one
possibility is some form of price control on prescription drugs. Additionally, the
industry faces challenges from generic drug companies, as a significant number
of top-selling drugs are set to lose their patent protection, exposing a large
portion of industry sales to generic competition.
To exploit the opportunities and counter the threats, pharmaceutical firms must
continue investing in research and development to bring new drugs to market,
particularly those that address intractable medical conditions. They also need to
be prepared for potential price controls on prescription drugs and find ways to
maintain their competitive edge in the face of growing generic competition.
SOURCES:
 Page 1: Historical profitability and declining ROIC in the pharmaceutical
industry
 Page 2: Importance of blockbuster drugs and the high costs of research
and development
  Page 3: Growing demand for prescription drugs and the threat of generic
competition
 Page 4: Threats to the industry's dominance and profitability

What are the opportunities, and what are the threats?

Answer
The pharmaceutical industry presents several opportunities and threats going
forward:
Opportunities:
1. Aging Population: As the population in most advanced nations continues
to age, there will be an increased need and consumption of prescription
medicines, leading to a projected 10-11% annual increase in spending on
prescription drugs through 2013.
2. Scientific Breakthroughs: New scientific breakthroughs in genomics hold
the promise of bringing to market new drugs that treat some of the most
challenging medical conditions, including Alzheimers, Parkinsons disease,
cancer, heart disease, stroke, and AIDS.
Threats:
1. Price Controls: With rising healthcare costs, there is a possibility of
politicians implementing price controls on prescription drugs to limit
healthcare costs, as has been done in most developed nations.
2. Patent Expirations: A significant number of top-selling drugs are set to
lose their patent protection, potentially impacting the revenues of
pharmaceutical companies as generic drug companies aggressively
challenge patents and increase their market share.
SOURCES:
 Page 1: Historical profitability and growth of the pharmaceutical industry.
 Page 3: Threats to the long-term dominance and profitability of industry
giants like Pfizer.

What must pharmaceutical firms do to exploit the opportunities and counter the threats?
Answer
Pharmaceutical firms can exploit opportunities and counter threats in the
industry by taking the following actions:
1. Exploiting Opportunities:
o Invest in research and development to capitalize on new scientific
breakthroughs in genomics, which hold the promise of bringing new
drugs to market for conditions like Alzheimer's, Parkinson's disease,
cancer, heart disease, stroke, and AIDS.
o Focus on developing successful new prescription drugs, as they can
be highly profitable, especially with the aging population leading to
increased demand for pharmaceuticals.
o Strengthen marketing efforts to promote and sell new drugs
effectively, leveraging the potential for high revenues and profits.
2. Countering Threats:
o Diversify the drug portfolio to mitigate the impact of patent
expirations and generic competition, ensuring a steady stream of
revenue from a variety of drugs.
 o Engage in lobbying and advocacy efforts to influence policies and
regulations related to price controls on prescription drugs,
especially in the face of rising healthcare costs and potential
government intervention.
o Enhance operational efficiency and cost management to prepare for
potential price controls and generic competition, ensuring
profitability despite potential revenue pressures.
By strategically addressing these opportunities and threats, pharmaceutical
firms can position themselves for sustained growth and profitability in the
industry.
SOURCES
 Page 1: Historical profitability and growth of the pharmaceutical industry
 Page 2: Challenges of entering the pharmaceutical industry and the
dominance of large companies
 Page 3: Impact of patent expirations and generic competition on the
pharmaceutical industry
 Page 4: Risks associated with prescription drugs and the need for
effective marketing and sales efforts