The pharmaceutical industry is experiencing a deepening productivity crisis. The industry's preferred escape mechanism from this predicament has been to increase investment in current business activities—primarily R&D and sales—to sustain productivity levels or, ideally, to exploit economies of scale. This has been implemented through organic growth of critical resources and/or M&A. The fact that productivity continues to decline after a decade of vigorous growth in investment levels, and against a background of increasing company size, bears testament to the fallibility of this strategy.

Why is R&D and sales productivity important? It's because productivity in these parts of the pharmaceutical value chain is intimately entwined with profitability. To boost profits, pharmaceutical companies can manipulate three strategic levers: increase prices, increase volumes or decrease costs (see Figure 1). In the heavily regulated pharmaceutical industry, prices (and, in the UK, profit margins) are kept in check by direct and indirect cost controls and containment. This focuses profit growth strategies on increasing prescription volumes and/or reducing internal cost inefficiencies. To date, growth has been achieved by continuously investing more in sales and R&D since, as this paper shows, revenues are directly proportional to S,G&A expenditure and the value of a company's pipeline is linearly related to its R&D investment. Reducing costs in these operations will, therefore, force a corresponding decrease in output. Only productivity gains will actually improve profit margins over the long-term by breaking the relationship between volume and costs. The effect of declining productivity on pharmaceutical profitability is unambiguous.

Figure 1: Only productivity improvements can break the direct relationship between volume and costs in the traditional pharmaceutical business model Click on the image to see an enlarged version.

A merger or acquisition can only be justified if it offers economies of scale that create higher margins. Pharmaceutical companies have failed to recognize this; when two leading companies merged in 1999, the explanatory document produced for shareholders stated that, "Size is an increasingly important competitive factor in the pharmaceutical industry." However, Datamonitor's analysis, presented in this discussion paper, indicates that:

• size alone does not improve productivity, despite the theoretical potential for
  greater efficiency or more successful new product development;
• there are no, or negligible, economies of scale in pharmaceutical R&D or sales.

The implications of this are profound. Larger companies are no more productive and no more effective at increasing productivity than smaller companies. An alternative growth strategy is required—one that does not rely on purported economies of scale—if companies are to live up to investors' growth expectations. To this end, Datamonitor presents a potential solution to the productivity crisis, networked pharma, in which value creation is a function of scope, not scale.

M&A Does Not Drive Margin Expansion
Pharmaceutical companies often publicly champion efficiency improvements in R&D and sales functions as key drivers of mergers, even if their private aims are to reduce blue-collar headcount and manufacturing facilities. One large company's merger document, for example, alleged benefits to sales and marketing through faster product introduction and higher penetration through more effective promotion. It also stated that a larger R&D budget would accelerate product development and enable more followup trials to be conducted to maximize a drug's market potential. Contrary to expectations fuelled by such claims, Datamonitor's analysis reveals that, among the major players:

• there are no significant economies of scale in sales activities—the revenues
  a pharmaceutical company generates are directly proportional to its
  S,G&A spend, and U.S. ethical revenues are linear to the number of U.S.
  representatives (reps);
• there are no significant economies of scale in R&D investment— the
  value/ quality of a company's pipeline in 2001 is directly proportional to R&D
  spend in 1998 and the number of R&D staff in the same year.

Revenues are directly proportional to investment in sales
Investing more in sales activities does not generate a proportionately higher return. The revenue achieved by a pharmaceutical company bears a linear relationship to its S,G&A expenditure (see Figure 2), implying no/negligible economies of scale of higher expenditure. Even though Merck &Co. and Bayer are outliers in Datamonitor's analysis, there is still a clear linear relationship within each set of variables. Therefore, while a larger company that can afford to invest more in S,G&A will generate more revenue than a smaller company, its revenue will still only be proportional to its expenditure. This strongly suggests that two merged companies will not achieve a higher return on S,G&A investment (and, therefore, will not be more profitable) than they would have independently.

Figure 2: Revenues of the top 15 western pharmaceutical companies are directly proportional to investment in S, G & A Click on the image to see an enlarged version.

Selling pharmaceuticals is capital intensive due to the need for a large, highly compensated and well-trained workforce. This results in S,G&A costs having a greater impact on profitability than in many other industries, a fact that is highlighted when companies with pharmaceutical interests change their business models. In Figure 2, the strong positions of Merck and Bayer are not due to the higher efficiency of their sales operations but to their business models. They are unique among the companies included in Datamonitor's analysis because they derive less than half of their revenues from ethical pharmaceuticals. However, Figure 3 shows that the U.S. pharmaceutical representatives (reps) employed by Merck and, especially, by Bayer are not significantly more efficient in generating revenues than those of other leading pharmaceutical companies.

Figure 3: Larger sales forces are no more efficient at revenue generation than smaller sales forces Click on the image to see an enlarged version.

Ethical revenues are linearly proportional to number of reps
A large sales force, measured by number of reps, is no more efficient at revenue generation than a smaller one. This is despite the fact that a company with more reps can theoretically achieve a higher share of voice and awareness with physicians, and thus result in more prescriptions per rep. Synergies between field forces detailing similar products may also justify mergers. However, the relationship between U.S. revenues and number of U.S. sales reps is linear for those of the 15 leading pharmaceutical companies for which data are available (see Figure 3). This indicates that revenue generation in larger companies is no more profitable an activity, in relative terms, than in smaller companies.

Variability in the relationship between the number of U.S. reps and U.S. ethical revenues suggests that the number of reps detailing a company's products is not the only factor that affects sales. Two companies with similar numbers of reps can achieve very different revenues. Investing in more reps is not, therefore, the complete solution to turning around low revenue growth. For example, familiarity with, and brand equity in, a market are also important to revenue generation and, more importantly, to increasing the return on investment in sales.

R&D investment is directly proportional to pipeline productivity
R&D spend in 1998 and, less closely, the number of R&D staff in that year both display a positive linear relationship with 2001 R&D pipeline value (see Figure 4) as measured by Datamonitor's pipeline productivity index1. Despite the theoretical potential for greater scale in R&D to increase the probability of successful product development, in reality it does not translate into improved pipeline value.

Figure 4: The commercial value of leading companies’ late-stage pipelines is directly proportional to their R&D spend Click on the image to see an enlarged version.

In contrast to sales, the late stage contents of a pipeline are a result of investment made a number of years previously. Datamonitor assumes that the strength of the current pipeline is a result of investment made three years ago in 1998, since the most costly part of R&D is late stage clinical trials . Since phase III trials last approximately three years, comparing the pipeline of 2001 with investment three years ago should capture the majority of products that received that investment. Using R&D spend from further back would mean that many of the products that received R&D investment would already be launched and, therefore, excluded from the analysis.

Size alone does not increase the ability to achieve higher productivity. Analysis of the two key areas, sales and R&D, shows that companies with a higher investment in these functions only generate higher revenues, not higher returns.

For shareholder value to increase, companies must consistently achieve profit margin growth or, more simply, increase revenues at a greater rate than costs. However, the relationship between investment and output is no more than linear for either sales or R&D. Data presented here show that each additional dollar invested in either function will generate only as much as those already invested, but no more. Profitability will not increase by merely increasing investment in current business activities. Similarly, two companies merging will find (and have found) that the returns they generate will not improve post-merger, after considering one-time cost savings. Every dollar spent post-merger will generate as much as but no more than it did pre-merger. Datamonitor believes, therefore, that pharmaceutical companies are in need of an alternative growth strategy to solve their productivity crises. The following section presents a strategic business model for the pharmaceutical company of the future: ‘networked pharma.'

Transforming the Business Model: Networked Pharma
Consolidation defines the traditional business model in which wealth and value creation are built on economies of scale. We have shown that this premise does not hold true and that there are no significant economies of scale in pharmaceutical R&D and sales. This being the case, is there another way in which margins can expand? Datamonitor suggests that networked pharma is one such solution in which a new, more productive and more profitable organization is crafted from a physically dispersed set of operations (see Figure 5).

Figure 5: Outsourcing non-core capabilities enables networked pharmas to be more productive and profitable organizations Click on the image to see an enlarged version.

At one end of the networked spectrum, companies outsource tactically, buying-in capacity when required. At the opposite extreme is strategic outsourcing in which all of the sponsor's deliverables, not just overheads, are contracted out. This new breed of networked pharmaceutical company grows by downsizing. It keeps in-house only the intellectual capital that is critical to its competitive advantage and outsources the rest in the form of temporary and long-term, domestic and international, strategic alliances with peers and vendors. To the company's customers, this alliance network is invisible. It works because specialist vendors and (bio)pharmaceutical companies are now arguably more efficient and progressive at what they do than are many pharmaceutical companies.

The model of focusing on core areas of expertise while outsourcing those in which other companies specialize is already widely used in other industries. For example, mobile telephone manufacturers outsource the production of cases, concentrating instead on innovation and sophistication in electronics. Cisco Systems has an Internet-based networked manufacturing system that can fill 70% of orders without a single Cisco employee being involved. The company claims that this saves $700 million annually compared to conducting manufacturing itself and anticipates that savings will further increase as it refines its eHub supply chain management system.

Transitioning to a Networked Growth Model
Ideally, a networked company needs a focused and consistent strategy, superior communication and effective risk management. As such, a management team sets and maintains the ‘big picture' and directs communication. Compared to the traditional business model, this is a more complex procedure, since investment risks are shared and migrate between partners. However, it is precisely this feature that allows a networked company to adapt rapidly to changes in the marketplace. By mixing temporary and permanent contracts, the ‘boundaries' of a networked organization can be defined differently over time and space, facilitating management of fluctuating resource demands and increasing profitability through cost savings.

In the traditional pharmaceutical business model, an average of 80% of the burden of fluctuating resource needs is borne in-house. In the networked model proposed here, only 40% of resource needs are retained in-house. Outsourcing additional requirements transfers a significant proportion of otherwise fixed costs into variable costs. When industry dynamics change, or at times when performance exceeds expectations, a networked company can respond quickly and optimally, without being constrained by investments that have already been made in-house (see Figure 6). Equally, when revenue growth is slow or erratic, or when diluting the risks of R&D, lowering variable costs protects gross operating profit margins. This is a particularly valuable strategy for small (bio)pharmaceutical companies that have yet to start, or have only just started, generating revenue. By building a network of alliances, the sponsor company can access resources where and when required.

Figure 6: Networked pharmas respond rapidly to fluctuating resource needs by outsourcing to cost-efficient specialist vendors Click on the image to see an enlarged version.

The specialization of a vendor may enable it to generate efficiencies that it can pass on to clients in the form of lower costs. However, even if the unit costs of outsourcing are higher, a networked company is still more efficient if its vendors offer greater flexibility than would be achieved by investing the same amount in-house. As one executive from a mid-sized European pharmaceutical company commented to Datamonitor:

"We now outsource 80% of our [R&D] work. At present, it's more expensive, but it's certainly more efficient. I would say that we are a virtual pharma company. Additionally, the concern and emotional attachment over a drug's success is taken away so that project managers can concentrate on driving a drug's development from early stage to late stage to marketing."

Expanding Profit Margins Through Networked Pharma
While no major pharmaceutical company has yet committed to networked growth in its purest form, several have implemented it at specific parts of the value chain. Current examples of best practice from across the product lifecycle are brought together in Figure 7 to show how, relative to the traditional business model, a truly networked pharmaceutical company could realize productivity gains across all of its operations. Selected examples are analyzed in more detail below.

Figure 7: Networked pharma can achieve more productive discovery, faster and cheaper drug development and commercialization, and more efficent sales Click on the image to see an enlarged version.

Networked Pharma in R&D Facility Ownership
Hoechst Marion Roussel's (HMR) sale of its Kansas R&D facility to Quintiles in January 1999 (as part of its merger agreement with Rhône-Poulenc to form Aventis) is typical of the transactions that Datamonitor envisages of networked pharmaceutical companies. With only Aventis' products to develop, the facility was operating below capacity, resulting in high overheads. Selling it eliminated these costs, transferred approximately 500 experienced scientists to Quintiles and generated a $93 million payment. Quintiles continued uninterrupted development of Aventis' products and, in a five-year contract worth $436 million in revenues, became Aventis' preferred strategic partner. Aventis believes that such outsourcing is cost-effective; when the former HMR conducted a detailed internal audit , it found the costs of in-house and outsourced trials to be comparable.

Networked Pharma In Manufacturing
Therapeutic proteins are notoriously difficult to manufacture. In an attempt to overcome this, Lilly is working with Lonza Biologics to speed the progress to market of its activated protein , Xigris (drotrecogin alfa, previously branded Zotran). Through Lonza, Lilly has the following opportunities to improve its productivity:
• reduced costs and risks of long-term investments in potentially under-utilized production capacity or excessive inventories. Proteins require considerable expertise and expensive facilities to produce. Datamonitor's primary research reveals that a new 10,000 liter fermentor (capable of producing approximately 200kg of protein) costs around $100 million, excluding the costs of FDA approval;
• access to process development expertise and manufacturing technologies;
• removal of time required to gain cGMP certification of new plants for emerging
  products, thereby expediting product launch.

The potential rewards are high: Lilly received an approvable letter from the FDA in October 2001 and Xigris later became the first approved treatment for severe sepsis. According to Lilly, 700,000 new cases of sepsis are diagnosed in the U.S. every year, accompanied by treatment costs of $10-25 billion and a 30-50% mortality rate. Datamonitor notes that such high unmet need means that Xigris could justify a price of $3,000-6,000 per dose.

Networked Pharma In Sales
Outsourcing sales force headcount to contract sales organizations (CSOs) is not a new phenomenon. However, it is rare for it to be a strategic rather than a tactical decision.
Typically, CSOs provide reps to detail products that are already established on the market, relieving a pharmaceutical client's in-house reps to detail newer products. In Datamonitor's networked growth model, a pharmaceutical company's relationships with CSOs extend throughout the product lifecycle and are integral to profitable portfolio management. Lilly's October 2001 agreement with the CSO PDI represents a step in this direction.

Lilly's selective estrogen receptor modulator, Evista (raloxifene), will be co-promoted with PDI in the U.S. until 2003. Evista has underperformed in the osteoporosis market, where it should be a strong competitor to Merck &Co.'s bisphosphonate, Fosamax (alendronate), and generate sufficient sales to replace the patent loss of Lilly's lead drug Prozac (fluoxetine). Evista was launched in the U.S. in 1998 and detailed by Lilly's in-house sales team, which was expected to drive sales in excess of $800 million annually. By 2000, Fosamax's sales had reached $1.3 billion compared to Evista's $522 million, despite expansion of Lilly's sales force.

Evista's poor performance is likely to have prompted Lilly's agreement with PDI. Lilly chose a hard-selling team to increase its share of voice with physicians. Since Lilly had not been able to achieve this when it increased its own rep headcount, it clearly sees the agreement with PDI as a more cost-effective strategy. Lilly has also reduced the risks involved in promoting Evista because PDI's disbursement depends upon net sales above a predetermined level.

Networked Pharma In Specialist Services
Innovative Internet service applications are prime targets for a networked business model. The level of expertise and speed of innovation available externally offers substantial benefits compared to building new internal capabilities from scratch. Aventis is a leader in implementing eBusiness both in- and out-of-house. In July 2001, Aventis announced that its new eDetailing facility was operational. It was developed in collaboration with eDetailing specialist iPhysicianNet, which offers videoconferencing services linking pharmaceutical reps with physicians. The vendor already has relationships with 8,000 physicians and has access to the broadband Internet access technology that is required for videoconferencing. While Aventis could have set up a new eDetailing system itself, by in-licensing the intellectual capital owned by iPhysicianNet, it reduced start-up time and risk by taking its pick from a range of available eDetailing services.

Among the greatest influences on the productivity of detailing are the number of prescriptions written for the detailed product, the number of interactions with physicians and the costs of these interactions. iPhysicianNet claims that its videoconferencing systems increase prescription volumes by 14% more than traditional rep visits and paper-based information. Reps using iPhysicianNet also experience longer details, and can manage a total of more than 400 physicians and daily call rates of 15 to 25 detailing sessions. Datamonitor's primary research suggests that the duration of an eDetail ranges from 10-28 minutes, with the exact length generally reflecting the time of day of the eDetailing ‘visit.' This contrasts directly with the two minutes that are typical of traditional rep visits. Despite the longer length of eDetails, they are cheaper per minute than face-to-face detailing, at $50-170. It is even more cost-effective for some companies to incentivize physicians with a $20-25 payment per eDetail than it is to conduct face-to-face visits.

Although ROI data relating to eDetailing are currently scarce, the HyGro Group claims that its ‘Physicians Interactive eDe-tailing' program, when used to promote a mature branded drug to more than 400 physicians (all high prescribers but low brand prescribers), significantly increased overall productivity. As Mark Gleason, principal at HyGro Group, told Datamonitor: "In addition to achieving a 480% ROI for the eDetailed group, the change in market share of the brand was so dramatic, we were surprised." Specifically, the market share of the brand increased from 3% prior to rollout of the program to almost 10%.

The Future Decoded: a Vision of Networked Pharma in 2015
Future pharma will be about health networks, not health companies. In 2015, networking will be the industry's preferred competitive strategy, with peers working together to gain market share. Successful networks will derive value from the links between partners, not merely from the partners themselves. Extension of such networks will be driven by the need to expand their scope, not physical size.

Compared to the industry in the early years of the 21st century, in 2015 the peripheral interests of individual companies will be substantially reduced. Well-defined core capabilities of networked organizations will grow organically and by the acquisition of complementary specialists, supported by multiple long-term relationships with vendors and peers. Core competencies will also expand through the acquisition of entire therapeutic franchises divested by other companies as they streamline their activities.

Diverse sets of synergistic relationships will be managed and extended by a cohesive management team that operates on a global scale (see Figure 8). The central ‘brain' of the networked company will set the global vision, evaluate alliance opportunities and ally with local centers of excellence. Its outsourcing decisions will no longer be tactical and reactive but strategic and proactive. Critical to the company's long-term growth, they will account for 70% or more of its resource demands. For example, at one end of the value chain, a company will rely on networks of drug discovery alliances. Moving downstream, sales and marketing will be a more collaborative process, as the company takes advantage of specialist vendors for services such as eDetailing, reducing the risks of in-house investment and increasing its effectiveness. Copromotion will also be used to gain rapid and cheap access to experienced sales forces in new therapeutic and geographic areas.

Figure 7: Networked pharma can achieve more productive discovery, faster and cheaper drug development and commercialization, and more efficent sales Click on the image to see an enlarged version.

Networked pharmaceutical companies in 2015 will simultaneously enjoy the benefits of being big and of being small, exploiting productivity improvements by:

• reducing the risk and the time taken to achieve productivity improvements;
• increasing the range and flexibility of productivity solutions;
• negating M&A integration costs that partly erode one-off productivity gains;
• eliminating the need to coordinate vast global operations and employees.

These benefits will be available to all companies implementing networked strategies. However, very few firms will exemplify the ultimate expression of networked pharma in which a management team coordinates a series of dispersed capabilities but owns no physical resources. Such organizations will not have evolved from the specialist entities that exist in 2002. Instead, entrepreneurs will identify new commercial opportunities by coordinating existing companies and assembling management teams that are able to exploit their synergies.

Notes
1 Datamonitor's pipeline productivity index assesses the value of companies' R&D pipelines. Each product at phase II or above in every company's pipeline is commercially assessed. The index for each company is simply the sum of these scores. A product's score is based on the size of the patient population and unmet need for the indication it addresses, the degree of innovation it displays and the probability of it reaching the market. While many of these factors influence the revenues generated by a product, a sales forecast is not included, since this is dependent upon factors other than R&D, such as a company's marketing capabilities. Thus, the pipeline productivity index for a given product is the same irrespective of company.