Few companies epitomise the challenges of their industry better than GlaxoSmithKline (GSK). For years, the UK’s biggest drugs company has battled with its need to innovate, while attempting to cling onto the strategy that made it one of the most profitable businesses in the world. It’s a problem that is mirrored across the entire global pharmaceutical market.
When the patent cliff hit in 2014 and many of the world’s biggest-selling drugs lost the intellectual property protection that had allowed them to generate huge margins, market experts worried that profits would come under pressure. Indeed, articles written at the time warned that "the biggest collection of patent expiries in history" would cost the industry as much as $150bn (£84bn).
But a lack of innovation means the patent cliff failed to have as much of an impact as many had feared. For example, GSK has been warning that its top-selling drug, Advair, is at threat from unbranded competition since its patent expired in 2010. But in 2018, the medicine was still unencumbered by a cheaper substitute and contributed 8 per cent of the company’s £31bn of sales. It wasn’t until February this year that US generics specialist Mylan (US:MYL) finally managed to gain approval for a copycat version of Advair. The launch of the generic medicine means Advair sales are expected to fall sharply this year, leaving GSK’s total earnings down by at least 5 per cent.
And so, finally, the company has been forced to change its strategy. At the end of 2018, management began the sales process of its low-margin consumer healthcare unit in a bid to focus more on innovative drug development. It isn’t the only company begrudgingly moving away from a long-held, conglomerate model. Last year, Pfizer (US:PFE) sold its consumer health business and Eli Lilly (US:LLY) ditched its animal care unit. Meanwhile, consolidation is beginning to mount as companies seek to plug the gap in their drugs pipelines. Japanese pharma giant Takeda (TYO:4502) bought Shire at a slight premium at the start of 2019 and Bristol-Myers Squibb (US:BMY) snapped up Celgene for $74bn and AbbVie (US:ABBV) has made a $63bn bid for Allergan (US:AGN). GSK recently bought cancer specialist Tesaro and invested in genetics specialist 23andMe.
As GSK succumbs to the changes that have been threatening its long-term growth for the last four years, investors in the wider industry should take note: the UK’s biggest drugs company certainly isn’t the only medicine maker facing a sharp change in dynamics. Innovation in pharma is long overdue. That could herald opportunities throughout the industry, but investors should beware of the pitfalls in a new era in the global pharma market.
A return to golden innovation
The pharmaceutical industry went through its golden age in the 1950s. Companies that had made names for themselves supplying painkillers and antiseptics during the war were being rewarded with tighter regulation and higher barriers to entry. Those that innovated the best made the most money. This led to the discovery of diazepam and Prozac for psychiatric conditions; ACE inhibitors for the improvement of cardiac health; and painkillers such as paracetamol and ibuprofen, which remain ubiquitous today.
But by the 1990s the cost of research and development (R&D) had scared many pharma companies into developing copycat medicines and marketing them under a new name. Pharma giants that had formed through major consolidation became too comfortable with incredibly high margins, supported by big sales volumes and tight regulation. Sales and advertising became more important than innovation.
AstraZeneca (AZN) was a key culprit of this trend: one of its top-selling medicines ever, Nexium, is merely a slightly altered version of an older drug that happened to be losing patent protection. But by 2014, management at the Anglo-Swedish giant had realised that ploughing money into marketing and patent protection rather than R&D was not going to help shield it from competition in the long term. After rebuffing an aggressive takeover approach from Pfizer, Astra’s management began a big innovation drive that has seen the company invest an average of 26 per cent of its revenue into R&D in the last three years. That has left Astra with a far more impressive suite of products than many of its peers. At the last count, the pipeline had 157 ongoing projects, compared with just 69 at GSK.
In hindsight, it seems obvious that the companies that have invested the most in drug development have the most impressive roster of new products. Indeed, most global pharma giants seem to have recently realised the importance of innovation – average R&D investment as a proportion of revenues has risen from 17.3 per cent to 18.8 per cent at the world’s biggest drug makers in the last three years.
Table: Pharma results from the last three years provide little evidence to suggest heavy investment in R&D can boost financial performance
Revenue CAGR (%)
Op. Profit CAGR (%)
R&D CAGR (%)
Av. R&D as a % of revenue
Johnson & Johnson
Source: data collected from company accounts
But there’s a large caveat to the argument that R&D investment should be a priority, one that explains why many pharma companies have been dragging their feet: evidence of the financial benefits of heavy innovation is inconclusive. While profits at Merck (US:MRK) and Eli Lilly have been boosted by strong investment in R&D (the companies ploughed 25 per cent and 23 per cent of their revenues, respectively, into innovation between 2016 and 2018), Astra and AbbVie earnings have had the opposite response. Both companies reported a 12 per cent average annual decrease in operating profits in the last three years, despite being two of the most innovative companies in the big pharma sector.
And therein lies the main problem facing pharma companies today. Lack of investment means companies get left behind and have no platform from which to grow, but investment is no guarantee of success. The importance of innovation is turning big pharma from a reliable, defensive market into the realms of high-risk investing.
Finding the cure is bad for business
The risks are exacerbated by the fact that R&D has recently become far more experimental owing to a rise in genetics and targeted medicines. Scientists might have cracked the human genetic code in the early 2000s, but it has only been in the last few years that they have known how to use that information. Now it is being used to create exciting new therapies that have the potential, not only to manage, but to obliterate major illnesses.
The good news is this has levelled the playing field between big pharma and small biotech. Today, any company with reasonable financial backing and sensible management can produce a ground-breaking new drug. Today’s most exciting medicines are not only rolling out of the factories of pharma giants but being carefully crafted by exciting new biotech companies.
Take Circassia (CIR), which is providing more innovation in the respiratory market than any of its big pharma peers. Earlier this year, it gained approval for two new medicines that will improve the treatment of asthma and chronic obstructive pulmonary disease (COPD). GW Pharma (US:GWP) – which was founded in the UK just 21 years ago – launched the first cannabis-based medicine in 2017, which is proving a huge hit today as more countries legalise the drug for medicinal purposes. Meanwhile, US biotech group Spark Therapeutics (US:ONCE) was the first company to gain commercial approval for a gene therapy when it launched Luxturna – a cure for progressive, genetic blindness.
Genetic progress is also good news for medicine. Today, scientists are creating therapies that are targeted to specific genetic profiles and these have been found to be far more effective in treating illness than the one-size-fits-all approach. Some novel medicines, such as Novartis’s (CH:NOVN) newly approved treatment for spinal muscular atrophy, Zolgensma, replace the faulty genes that cause illness; and others, including cancer cure Kymriah, genetically reprogramme the cells in the immune system so they attack the cause of certain diseases.
The problem for the pharma industry is that curing people is not a good business model. If a cancer patient is cured, they no longer need to keep coming back for chemotherapy and a source of recurring revenue has gone.
It’s a terrible way to think about patients, but it is playing out in the performance of drugs that recently gained approval in the US. In 2018 Novartis’s genetic cancer drug Kymriah generated $76m of revenue. That compares with £563m for GSK’s respiratory medicine Nucala, which is not much more than a reformulated, newly branded Advair. The ticker of Spark Therapeutics says it all: blind people who use Luxturna to correct the faulty genes that cause their illness only need to use the treatment “ONCE”. Luxturna generated just $27m in sales in 2018.
The politics of pricing
Genetic therapies are very expensive to develop and have an extremely high rate of failure because their experimental nature means safety can be compromised. As they are personalised, genetic therapies also cost a lot to manufacture and many of them require innovative delivery mechanisms such as the ones being developed by Oxford Biomedica (OXB) and MaxCyte (MXCT). The upshot is that genetic medicines are incredibly expensive. In May, Zolgensma, which helps cure children who are inflicted with spinal muscular atrophy – an illness for which there is no other treatment – became the most expensive medicine of all time. It costs $2.1m.
Historically, Zolgensma’s price would mean it was unlikely to be promoted by pharmacy benefit managers (PBMs) who act as the middle man between insurers and drugs companies in the US and therefore have a big influence on which drugs get prescribed and how much they cost. PBMs have been great promoters of generic drugs (cheap, unbranded versions of medicines that have lost their patent protection) and therefore have helped lower costs for patients with illnesses that can be treated by older medicines. But, like the wider pharma market, PBMs have evolved to reward lower innovation. In the past, novel drugs have rarely been promoted by these companies, meaning patients ended up having to pay huge amounts out of pocket for the best new medicines, including genetic therapies.
But politicians are attempting to support innovation by tightening regulation of the PBMs. Donald Trump’s new healthcare policy should stop these companies from prioritising older, generic medicines to help level out the playing field for more innovative treatments. The PBMs are also changing the way they operate to benefit from the wave of innovation that is building in the pharma industry. For example, Express Scripts – one of the biggest PBMs, which was bought by health insurer Cigna (US:CI) at the end of 2018 – is partnering up with pharma companies to promote new genetic medicines including Luxturna, Kymriah and Biogen’s (US:BIIB) $750,000 spinal atrophy medicine Spinraza. In February, Steve Miller, chief medical officer at Express Scripts, told Reuters that curative therapies will be worth their high price tags if they offset the huge costs required to treat patients of long-term illnesses.
And it’s not only in the US that sentiment is beginning to turn. Just this week, the BBC reported that the first genetic cancer therapy has been made available on the NHS. Yescarta’s list price is £240,000, but, reportedly, the NHS and Gilead (US:GILD) – which owns the drug – have managed to strike a deal. Simon Stevens, chief executive of NHS England, has echoed Mr Miller’s views that the high price tag will be worth it if it keeps patients out of hospital. "The start of this treatment marks the beginning of a new era of personalised medicine," he said.
Buy in bulk
The long overdue shift towards promoting innovation in pharma helps to explain the rising consolidation in the market as companies attempt to make up for years of underinvestment by buying smaller, more innovative biotech companies. In the first half of 2018 alone, the pharma industry reported 246 deals, totalling $176bn. And that was before Bristol-Myers Squibb made an unexpected leap for Celgene at the start of 2019, and thus opened the floodgates for musings about mega-mergers. AbbVie has finally managed to agree a blockbuster deal after many years of hunting: it is set to buy Botox-maker Allergan for $63bn. So, is major consolidation the only way big pharma can plug the gaping holes in its pipeline? And, if so, who is a target and who is a buyer?
Cancer seems to be a major area of high demand, with companies including GSK and Johnson & Johnson (US:JNJ) hoping to make up lost ground and ride the next wave of oncology innovation. That means Astra, Merck and Hutchison China Meditech (HCM) – with their impressive pipelines of new cancer drugs – could be targets. Like AbbVie, Pfizer has made no secret of the fact that it is on the hunt for an acquisition. It might be waiting for one of the major biotech companies – Gilead, Biogen, Amgen (US:AMGN) or Regeneron (US:REGN) – to fail a clinical trial before making its move.
At the other end of the pharma spectrum, there are the companies that have done very well during a period that has not promoted innovation. Generic specialist such as Mylan and Hikma (HIK) or smaller companies that take older medicines and improve the marketing to bulk up sales, including Alliance Pharma (APH) and Clinigen (CLIN), could find their business models under pressure. Indeed, earlier this year Alliance was forced to deny its involvement in the 700 per cent price hike of a nausea treatment. More consolidation is expected to help shield these smaller companies from the changing dynamics of one of the world’s most profitable industries.
BOX: What is your favourite pharma company...
At the recent European Mediscience Awards, I was asked a question that stumped me: what is currently your favourite company in the sector?
There are several reasons why I have never considered that question before. Firstly, because pharma is not an industry in which you should back just one horse. The binary nature of drug trials means it is best to invest in a wide portfolio of assets in the hope that at least one of them will strike gold. Secondly, pharma is an incredibly broad market: how can you compare $378bn Johnson & Johnson with £368m Alliance Pharma?
But the person who asked the question clearly did so because they had a good answer: Circassia.
Circassia is one of the only British pharma companies ever to gain two drug approvals in the US on the same day. Since then, its share price has fallen more than 40 per cent. That is partly because it is a very illiquid stock and there is a forced seller in the market (Neil Woodford had a big stake) and partly because investors still haven’t forgiven the company for its major clinical trial failure in 2016.
Both of these issues don’t impact the long-term growth available at a company that is creating a portfolio of drugs that can treat COPD patients for the duration of their illness. The pharma industry is going through a very difficult set of changes. We think Circassia should ride out the storm – it has managed worse before.
… and your worst?
That question is easier to answer. Since being rolled out of Reckitt Benckiser (RB.) in 2014, opioid addiction specialist Indivior (INDV) has spent more money on legal fees than it has on R&D. It’s over-reliance on one drug, Suboxone Film, was thrown into sharp focus last year when generic specialists managed to design a new version of the medicine that would steal market share and cause a catastrophic decrease in revenues. To make matters worse, in April courts in the US alleged that the company had fraudulently marketed Suboxone Film – more legal costs are expected to follow.
Reckitt Benckiser might have pre-empted the end of the road for this company when it spun it onto the stock market in 2014. We can’t see any way back.