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Pharmaceutical Industry Analysis

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U.S. Pharmaceutical Industry Analysis Julianna D. Mosier, Fima Vaisman, Prema Windokun, Victoria Zdor, Scott Zycher California State University, Northridge November 29, 2011

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Table of Contents

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Executive Summary

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Introduction Worldwide pharmaceutical sales hit $856 billion in 2010 and are expected to surpass $1 trillion by 2015 (IMS Global, 2011). The US pharmaceutical industry accounted for about 36% of 2010 worldwide sales and represented 2.1% of US GDP (Keehan, 2011). The US market is attractive because of its uncontrolled pricing structure, rapid approval processes, private and public insurance reimbursement policies and government support for basic research. Additionally, the industry enjoys many tax benefits not available in other countries (IRS, 2011). Historically a high profit industry, with an average return on invested capital of 31.7% between 1992 and 2006 (Porter, 2008), the industry faces numerous challenges. Unprecedented patent expirations, accelerated generic competition, shrinking drug pipelines, growing payer power and an onerous regulatory environment are shrinking margins and compelling firms to change business models and strategy. Demand for medicines in the US is forecast to increase significantly in 2014 due to the legislated expansion in access to health care and moderately thereafter due to growth in diseases affecting the aging population. By capitalizing on this, the industry will be able to realize higher absolute profits even as margins decrease. This paper will define the US Pharmaceutical industry specifically the US market, analyze and evaluate the industry using PEST and Porter Five Forces and provide a 5 -10 year forecast with a recommendation for investors. US Pharmaceutical Industry - Definition, Dimension, Structure, Sectors The US pharmaceutical industry (NAICS 3254) includes companies that manufacture inorganic, chemically synthesized pharmaceutical substances as well as those that manufacture biologically based pharmaceutical products (US Census Bureau). There are six product sectors in the pharmaceutical industry: originator chemical drugs, generics, over-the-counter (OTC) drugs,

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active pharmaceutical ingredients (APIs) and excipients, biologicals, and biosimilars (ITA, 2010) (See Appendix??). See Appendix ??? for the top-selling prescription medications. According to the 2008 census, there were an estimated 1,555 such companies in the US and less than a third of them publicly-traded (Mergent, 2011). According to the Bureau of Labor Statistics (BLS), the industry employed 289,800 wage and salary earners in over 2,500 places of employment in 2008, which represented 0.2% of the US civilian labor force. There are four main types of pharmaceutical companies. There are large, established firms that have many approved drugs already on the market, like Pfizer, Merck & Co., Johnson & Johnson, and Lilly (ITA). There are biotechnology companies, such as Amgen, Gilead Sciences, Celgene, and Biogen Idec, that are gaining market share. Both of these types of companies run the full cycle from research and development (R&D), to production, to sales. They rely on the 20 year patent protection period to recoup their initial R&D investment, which is approximately 19% of sales (ITA). There are also a number of small, start-up companies that focus primarily on R&D. Increasingly, once these smaller companies have a promising product candidate, they are acquired by or form partnerships with the larger firms to finance the costs of moving the product candidate through the US Food and Drug Administration (FDA) approval process. Finally, there are companies like Mylan, Watson Pharma, Par Pharma and Hospira that focus on manufacturing generic drugs that are no longer protected by patents. The industry services a number of customers including, retail pharmacies, hospitals, medical offices, public health bodies, and consumers. Demand for products is heavily influenced by healthcare professionals and insurance companies. Customers continue to demand readily available, effective drugs at reasonable prices with limited side effects. Shrinking government budgets and looming budget deficits have lawmakers looking for savings by reforming

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Medicare, Medicaid, and other government health care assistance programs (Langel, 2011). Differentiation Strategies To remain competitive, pharmaceutical companies incorporate many differentiation strategies. Although the industry is still heavily dominated by conventional pharmaceutical drug manufactures like Abbott Laboratories, companies like Amgen are gaining market share by focusing on biotechnology. A number of companies in the industry focus on niche markets and selected classes of therapeutic drugs. The top five therapeutic classes based on 2010 US spending include: oncologics ($22.3 billion), respiratory agents ($19.3 billion), lipid regulators ($18.7 billion), antidiabetes ($16.9 billion), and antipsychotics ($16.1 billion). In addition to product differences, pharmaceutical companies differentiate from one another through advertising, sales, manufacturing, warehousing capacity and global reach (Langbert, et al). Companies also distinguish themselves by being socially responsible. For example, Merck created and donated in perpetuity the drug Mectizan to treat victims of river blindness in poverty-stricken African communities (Langbert, et al). Recent Industry Trends The industry is facing a patent cliff; a significant number of patents for blockbuster drugs are set to expire over the next 3-5 years. 2011-2012 are forecast to be the worst years for patent declines (Appendix K) with $54 billion in brand sales expected to be lost to generic competition. Generics represented 63% of US sales in 2006, 78% in 2010, and are expected to further increase by 2015 (IMS Global, 2011). The US industry has been marked by a significant increase in spending on R&D even though the number of new products hitting the market has declined. Drugs have become more expensive to develop as research has shifted toward biotech. The relatively simple ones have

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Emerging countries, like China, (Appendix Q) are experiencing significant growth (IMS Global, 2011). Emerging countries are expected to double pharmaceutical spending by 2015. Pharmaceutical manufacturers are increasingly turning to emerging markets to increase revenues. Other significant trends are merger and acquisitions (M&A), outsourcing and operational consolidation. The industry has cut 300,000 jobs over the past ten years (Herper). Companies are outsourcing more of their manufacturing to countries with less expensive labor pools. The global market for pharmaceutical contract manufacturing is expected to rise from about $20.4 billion in 2008 to more than $31 billion in 2012 (PWC, 2009). PEST Analysis There are significant macro-environmental factors affecting industry growth and potential. Political: The Patient Protection and Affordable Care Act of 2010 (PPACA) expands health insurance coverage for an estimated 32 million uninsured by 2020 and encourages preventive care which will likely generate additional sales. These additional revenues will be offset by mandates for the use of generics and by additional taxes and fees on pharmaceutical firms (Daemmrich, 2011). With the upcoming US elections in 2012 the full implementation and future of the PPACA remains uncertain. Medicare Part D, which went into effect in 2006, provides prescription drug insurance to people eligible for Medicare who were finding it increasingly difficult to afford the high prices of prescription drugs. Over the last five years, prescriptions filled under Medicare Part D have increased and accounted for 22% of the total prescription expenditure in 2010 (Appendix 1). There are a number of other state and federal health care aid programs and prescriptions filled under all government-sponsored plans accounted for 30% of prescriptions sales in 2010, up from

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22% in 2006. The US industry is primarily regulated by the FDA which monitors testing, production and marketing to ensure that drugs, vaccines and other biological products intended for human use are safe and effective (FDA, 2011). In 2010, the FDA approved only 20 new drugs, down from 37 in 2004. The Prescription Drug User Fee Act (PDUFA) of 1992 allows the FDA to collect user fees from companies in an effort to expedite the drug approval process (FDA, 2011). The user fees increase costs, but also help expedite the drug approval process, allowing companies to recoup more quickly their initial outlay for drug development. The US government has announced its intent to allow biosimilars to be marketed in the US in an effort to reduce health care costs. The FDA is currently developing a regulatory pathway for these biosimilars (Coloring, 2011). This will decrease profitability as biosimilars take sales away from brand biologics. The US government has also announced plans to allow the importation of drugs from safe countries such as Canada and the European Union to open up the US market to greater competition (Pharma 2020, 2011). Although the US pharmaceutical industry has partnered with and supported various government policies, like Medicare part D, it strongly opposes both the importation of drugs into the US and drug price regulation. According to the Center for Public Integrity (2011), the industry has one of the strongest lobby groups in the US. It is estimated that the industry has spent more than $800 million in federal lobbying and campaign donations at the federal and state levels in the past seven years (1998-2005). Economic: The recent and sustained economic downturn has impacted the industry in a number of ways. Small firms, which usually have the technical know-how to produce a new drug but not the expertise for the sales and marketing of the drug, have found it increasingly difficult

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to acquire funds from investor and capital venture companies. Larger companies with significant cash reserves, but shrinking drug pipelines and expiring patents, have started acquiring smaller companies with promising product candidates in an effort to compensate for lost revenue. Companies are reducing costs by scaling-back R&D programs and are also outsourcing drug development to countries with less expensive but still highly skilled labor forces. The cost advantage of skilled labor in India and China has increased the number of drugs developed in Asia . . . the number has been growing due in part to the abundant supply of trained scientists and a significant cost differential for product development (FDA, 2011). Countries like India and China have become the primary producers of API for drugs manufactured and sold in the US. Sourcing API from these two markets has enabled manufactures to bring down costs (IMS, 2011). This has significant implications for the FDA which struggles to monitor and inspect foreign sites. The GAO reports that the FDA had a budget of $13 million in 2009 vs. the estimated $71 million needed to inspect the foreign drug sites (IMS, 2011). In an effort to offset this cost, the proposed FDA Globalization Act will impose a fee on companies importing into the US. This will drive the cost of drugs higher. Pharm-emerging countries, such as China, Russia, Brazil, India, and others, are characterized by increased government health care funding, expanding coverage for their citizens and improved regulatory climates. By 2013, pharmaceutical sales in these countries are expected to grow by 17% and their combined pharmaceutical markets will hit $1 billion (IMS, 2011). These countries will present challenges for the US industry as large companies shift their focus and spending to these emerging markets. Social: Changing demographics is having an enormous impact on demand in the industry. Life expectancy in the US is increasing (Appendix 4) and the proportion of the

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population over the age of 65 is projected to increase from 12.4% (35 million) in 2000 to 19.6% (71 million) in 2030 (US Census, 2011). This will create additional stress on health care and social services as the increases in chronic illness associated with old age contribute to disability, diminish quality of life, and increase health and long term-care costs (Public Health, 2011). It is estimated that this segment of the population will account for over one third of the countrys prescription medication consumption (Pharmaceutical Industry, 2011). There is also a shift in how patients participate in the management of their health care. Patients had been passive participants, allowing their health care provider to make major decisions for them. Websites such as WebMD and Patienlikeme, are providing consumers with greater access to information and they are becoming active players in managing their health care. An educated super consumer, armed with new mobile phone technologies and apps, will take a more active role in managing their own health care (Progressions 2010, 2011). With an increased focus on ethics in the industry, the role of sales representatives is coming under scrutiny. There are approximately 81,000 pharmaceutical sales representatives in the US and they play a significant role in marketing products by providing information about the benefits and risks of newer, and typically more expensive, drugs (PhRMA, 2011). A positive correlation has been found between the cost of physicians treatment choices and their amount of contact with pharmaceutical company representatives (Dana & Loewenstein, 2003). Growing criticism about the use of promotional incentives to influence health care professionals led PhRMA to institute the voluntary Code of Interactions with Healthcare Professionals in 2009 (Pharma 2020, 2011). By making a commitment to maintain high ethical standards in marketing their products, companies will have to search for innovative methods to promote their products. Technology: Technology is playing an important role in containing costs and providing

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ease of access to patient information. The HITECH Act of 2009 provides financial incentives to encourage the adoption of Electronic Health Records (EHR), which will lower health care costs and provide efficiency. One of the advantages of EHR is the availability of data through value mining. Large volumes of data can fundamentally alter how evidence is gathered (Progression 2010, 2011). Previously, pharmaceutical companies had control over data on the efficacy of drugs which helped to maintain prices, but with value mining, knowledge about efficacy will move into the public domain and become unbundled from the pill with significant implications for the pharma companies and the prices of their products (Progression 2010, 2011). Cloud computing is changing the way data is shared. Companies can increase capacity or add capabilities quickly without investment in new infrastructure, personnel and software (Brown et al, 2011). Bio-IT World (2011) states that the vast amount of data from next generation sequencing, the growing importance of biologics in the research process, is making cloud-based computing an increasingly important aspect of R&D. The ability of research companies and pharmaceutical customers to access data securely, anywhere, makes cloud computing very attractive to the industry. Social networking sites, such as Facebook, Twitter, and YouTube, allow the industry to inexpensively disseminate information and to collect feedback from a large number of online users. However, the industry has been slow to adopt the use of social media and the Internet. since the FDA does not have regulations to address Internet promotion (Tweet Nothings, 2011). Companies that learn to effectively navigate social networking can use the platform to market and drive demand for their products. There are also a number of networking websites for physicians to share information on drugs and to stay informed about new products. Sites such as Sermo and Medscape Physician

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Connect can be used to collect data and get an insight into prescribing and other behaviors of physicians. Additionally, such media can be used for tracking patient experiences with drugs thus providing information that can be used for effective drug development. The industry faces a number of challenges but is responding new business models and methodologies to remain successful: M&As, collaboration with other companies, sharing R&D information, and partnerships with regulators and government agencies. The industry remains intensely competitive with significant forces affecting profitability. Future success will depend on how companies adjust to the changing environment. Porters Five Forces Analysis Threat of new entrants: Although the opportunity for huge profits in the industry continues to attract new entrants, the overall threat of new entrants is low because barriers to entry are very high. Supply-side economies of scale favor the incumbents, as multi-billion dollar firms manufacture more than 80% of pharmaceutical products. Experience effects are also very high as capital requirements in the industry are enormous and so are the risks. The need to invest large financial resources to compete can deter new entrants (Porter, 2008). R&D spending levels average 18.4% of sales (Appendix P) and R&D cycles average 8-12 years to bring a drug to market. Even with such a large investment, the probability of surviving the trial phases and getting FDA approval is less than 5%. Product differentiation in the pharmaceutical industry is high. Many patents are filed to protect new drug formulations. Patents raise barriers to entry, boosting industry profit potential (Porter, 2008). However, given the looming patent cliff, Porter also states, The expiration of a patent, for instance, may unleash new entrants (Porter, 2008). Industry brand identification is high. Consumers do their own research and request brands by name. Concerned with potential

U.S. Pharmaceutical Industry Analysis side effects, consumers are influenced by a companys reputation for quality. However,

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consumer switching costs are very low. Consumers will switch to a different brand if a particular medication is not effective or is too expensive. The power of incumbents over distribution channels is somewhat low, since three large US distributors control 75% of drug distribution in the US. However, the largest companies, such as J&J and Pfizer, enjoy unequal access to these distribution channels based on volume of business. Highly restrictive FDA regulations and guidelines substantially impact the ability for new companies to enter the industry. FDA mandated multi-phase clinical trials follow the initial R&D process and the total cost to develop a new drug is approximatley $897 million. On average only 5% to 10% of drugs entering clinical trials were ultimately approved for marketing, often after several attempts (Tufts, 2003). The FDA also regulates sales, marketing and distribution practices. According to Gwen Fisher, spokesperson for Pfizer, a delay in regulatory approvals and limitations on prescribing labels means a delay in the time patients will be able to benefit from a medicine and in the potential earnings a company can receive. Despite high entry barriers, an increasing number of foreign pharmaceutical manufacturers are entering the US market. Most of these new entrants come from Western Europe and Japan. However, over the past few years, companies from countries such as China, India, and Israel have also started entering the US market in search of high profits. Bargaining Power of Suppliers: Key suppliers to the bio-pharmaceutical industry include raw materials suppliers (e.g. chemicals, agro products), third-party manufacturers (e.g. plastics) and contractors (e.g. calibration services, packaging suppliers). Since the quality of the supplied chemicals is an important aspect of the pharma product, suppliers will try to differentiate based on quality, for example, by having ISO 9001 certification (Evans, ??).

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However, most chemical and agricultural products used in the industry are undifferentiated commodities and as such are available from many sources. Vendors of these commodities are price takers having little influence over market pricing. Switching costs for these types of products are very low. In addition, the cost of these supplies is relatively low in comparison to the cost of the final product. As such the bargaining power of suppliers is very low. Human resources demand in the industry is high. Pharmaceutical companies require skilled scientists and bio-science engineers for all facets from R&D to production and quality control. They also require a significant number of human patients willing to participate in clinical trials. For companies involved in drug development, no area is more resource intensive than clinical trials Clinical trials, though, fail in one major way: 80% of failures are caused by the inability of research sites to find and enroll sufficient patients and meet timelines . . . the trial's patient recruitment and retention goals were not achieved (Moench, XX) Bargaining Power of Buyers: The bargaining power of buyers is medium. Buyer concentration is considerable. About 30% of all pharmaceuticals go through distribution channels and these distributors buy in large volumes. Of the hundreds of pharmaceutical distributors in the US, McKesson, AmeriSourceBergen, and Cardinal Health, control 75% of distribution and are able to negotiate lower prices. Appendix E illustrates the distribution channels used by pharmaceutical companies. Buyer switching costs in the industry are low when an appropriate better or lower cost medication is available. The current economic downturn has consumers looking for every opportunity to save money. Generics represent a inexpensive alternative for consumers and a potentially devastating loss of revenue for name brand pharmaceuticals. To battle this, over the past five years big pharma has increasingly targeted its promotional efforts directly at the

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consumer to increase brand awareness. The power of the consumer is increasing in this industry. The Internet has enabled more informed consumers who are influencing demand by asking for specific types and brands of drugs (Appendix I). The Internet has also enabled consumers to benefit from the law of large numbers by turning to low cost-online sources for drugs, such as Canadian online pharmacies. Appendix E shows that 17% of all purchases are now via mail-order. Insurance companies influence the buying patterns of medical infrastructure and individuals by the inclusion of certain drugs into their formularies. Through their tiered formularies, insurance companies manage the level of reimbursement. This has a direct impact on revenues and profits of the industry. The US Government is also a major purchaser and influencer in the pharmaceutical industry. Federal and state governments purchase for the military, VA, and other sectors and greatly influence drug selection and payment levels through Medicare, Medicaid, and other government insurance programs. Shrinking government budgets and looming budget deficits have lawmakers seeking to find savings by reforming Medicare, Medicaid, and other government health care assistance programs (Langel, 2011). Threat of Substitute Products or Services: The industry is extremely competitive and there are a number of alternatives available to consumers. Generics represent the greatest threat to brand drugs in the US industry. However,the threat of substitutes also includes competition from foreign drugs, illegal drugs, natural medicines and vitamins. Additionally, some consumers abstain from using pharmaceuticals to treat their ailments or focus on prevention through lifestyle changes, such as diet and exercise. Healthcare bundling is an emerging market trend which emphasizes a holistic approach to treatment. Health care payers are emphasizing the importance of prevention and expecting the

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industry to go beyond medicines by providing prophylactics and health care packages designed to help patients manage their health (Pharma 2020, 2011). The bundle consists of a package of drugs and services that work as an integrated system. Such packages represent a substitution threat to pharmaceuticals which are not selected as part of the bundle. Me-too drugs are competitive offerings that copy successful formulations making minor changes to skirt patent protection. These drugs increase competition and drive prices down. In response to the threat of substitutes, companies are increasingly merging with or acquiring their competitors. 2009 was a bumper year for M&A with three mega-mergers completed: Pfizer-Wyeth, Merck-Schering-Plough and Roche-Genentech (Raeside, 2011). There were an additional 152 M&A deals in 2010 (See Appendix ??). The trend will continue and there is expected to be a significant increase in joint ventures and licensing agreements. For example, Amgen has entered into a collaboration agreement with Pfizer to market the drug Enbrel in the US and Canada, while Pfizer maintains the right to market and sell Enbrel outside the US and Canada (Amgen 2010 annual report). Rivalry Among Existing Competitors: Rivalry and competitive concentration in the industry are very high (Appendix M). According to EvaluatePharma, pharmaceuticals represent a large, growing, and highly profitable industry with net margins for the largest companies ranging 23-49% (Appendix O). Since most industries do not enjoy such high margins, the industry attracts aggressive competition. Rivalry among existing competitors is fierce and large sums are spent on R&D to develop the most competitive products. To temper profit-eroding price rivalry, companies can invest more heavily in unique products, as pharmaceutical firms have done (Porter, 2008). Companies spend a lot on advertising to end users. Appendix H illustrates that in 2010 pharmaceutical companies spent $4 billion, or 40% of their promotional budget, trying to

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influence consumer buying preferences. One sustainable competitive advantage that large pharmaceutical firms possess is their market power and global reach. While every drug is eventually copied by generics, large pharmaceutical firms can rake in billions in profits during the patent-protected period (Appendix O). Most emerging pharmaceutical companies with small portfolios do not have the financial staying power to last through the years of trials. If they do get their drug approved, those companies do not have the economies of scale to keep costs low, the brand recognition, nor the market reach required to turn their product into a financial success. Companies with promising product candidates will therefore partner with larger companies for financial support. Once they move through the clinical trial phase and receive FDA approval, they are often acquired by the larger company (Appendix J). Forecast In spite of the dreaded patent cliff, a tough regulatory environment, the diminishing power of doctors and the increasing power of payers, the industry with continue to grow albeit at a slower pace. IMS Health Inc., the industrys leading information provider, projects a 3-6% CAGR for the global pharmaceutical industry through 2015 (IMS Outlook, 2011). It projects the US share of the world market will decline from 36% in 2010 to 31% by 2015 (IMS Outlook, 2011). Health Affairs, the leading peer-reviewed journal of health policy thought and research, projects a similar growth rate of 5.8 percent per year for the period 2010 through 2020 in its recent study of national health expenditures (NHE) (Keehan et al, 2011). These two forecasts site similar trends in the micro- and macro-economic environments that are tempering growth. On the micro-economic front, the Internet is making patients better informed and demanding cures, as opposed to treatments, while their insurance plans are making

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them pick up a larger share of the bill. Healthcare payers, including private insurance companies and the government, are shifting reimbursement models to pay-for-perfomance, requiring measurable positive health outcomes before authorizing payment (PwC, 2011). Additionally, payers are establishing treatment protocols, combining procedures with pharmacological agents. This bundling will impact how medical providers will treat and prescribe medications, which will impact the industry. The US pharmaceutical industry is maturing and facing greater pressures which are constraining profitability. The old business model enabled the industry to profit alone for many years and to profit very successfully, as its track record in rewarding shareholders shows. The top companies saw their market value soar 85-fold between 1985 and 2000. But this model is now under pressure and, by 2020, it will not work (PWC, 2011). By adapting and shifting business models from the traditional siloed approach to pharmaceutical development to an open innovation environment with collaboration between traditional and non-traditional partners, the industry can respond to political and market pressures and improve its performance in the lab, reduce its costs, serve the emerging markets more effectively and make the transition from producing medicines to managing outcomes (PwC, 2011). The industry will continue to create its own profitable paradigm and will remain highly lucrative for investors.

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References

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X. Diagram of Porter's Five Forces with bullets Fima

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Table 2 (Prema 11/12/2011)

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APPENDIX D IMS Total Pharmaceutical Companies by U.S. Sales

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APPENDIX E IMS Channels of Distribution by U.S. Spending

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IMS Top Products by U.S. Spending

Lipitor (cholesterol) - Pfizer Nexium (acid reflux) - AstraZeneca Plavix (anti-blood clot) - Bristol-Myers Squibb/Sanofi Partnership Advair Diskus (Asthma/COPD) - GlaxoSmithKline Abilify (depression) - Bristol-Myers Squibb/Otsuka America Seroquel (bipolar disorders) - AstraZeneca Singulair (asthma) - Merk & Co Crestor (cholesterol) - AstraZeneca (under license from SHIONOGI & CO, LTD, Osaka, Japan) Actos (diabetes) - Eli Lilly in US for Takeda Epogen (anemia) - Amgen Remicade (TNF blocker; arthritis; immunosuppressant) - Janssen Biotech

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Enbrel (TNF blocker; arthritis; immunosuppressant) - Amgen / Pfizer Cymbalta (depression) - Eli Lilly Avastin (cancer) - Roche/Genentech Oxycontin (pain killer) - Purdue Pharma Neulasta (white cell booster) - Amgen Zyprexa (anti-psychotic) - Eli Lilly Humira (TNF blocker; arthritis; immunosuppressant) - Abbott Lexapro (depression, anxiety) - Forest Laboratories Rituxan (monoclonal antibody; cancer; RA) - Biogen Idec / Roches AG Genentech

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IMS Top Therapeutic Classes by U.S. Spending

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IMS Top U.S. Promotional Spending by Type

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PWC Trends and Implications in Pharma

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EvaluatePharma Top 10 M&A Deals in 2009

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IS THIS WORLDWIDE SALES? SHOULD WE HAVE A CHART ON US SALES? EvaluatePharma Top 20 Pharmaceutical Companies in 2010, Ranked by Value

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EvaluatePharma Top 20 R&D Projects

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EvaluatePharma Net Margins

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EvaluatePharma Top 20 Companies R&D Spend

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