2011 Pharmaceuticals Industry Perspective Last year was an interesting one for the pharmaceutical industry.

While pharma emerged largely unscathed from healthcare reform in the United States, the industry was and remains under intense pressure because many of its customers, particularly health plans, did not fare as well and are facing meaningful declines in margin. Further, pharmas innovation rates are not high enough to drive growth, and prolonged reform and budget pressures in healthcare systems globally are producing accessibility and affordability challenges that also stifle revenue growth. In essence, what was once a consistent, high-growth/high-return business has matured tremendously, forcing companies to make fundamental decisions about their future direction. In our work and research this past year, a number of market truths have stood out in particular. 1. More than 70 percent of product launches in recent years missed their initial analyst sales forecasts. The traditional pharmaceutical marketing model has become less and less effective as payors use aggressive tactics to limit prescription utilization. The degree of challenge is well illustrated by this quote from a U.S. pharmaceutical benefit manager: Our goal is not to allow any more blockbusters. In a 2009 Booz & Company survey of European pharmaceutical sales and marketing executives, 77 percent of respondents indicated that unfavorable formulary positioning and other market access barriers were having a negative impact on their new product sales. Although efforts to manage in-market products continue, it is in the launch market, before there is real product momentum, that payor restrictions have been particularly impactful. At the same time, pharmaceutical companies direct contact with physicians is increasingly restricted and physicians see less value in sales calls, in part because they have convenient access to a wealth of credible information from other sources. And consumers, who are on the hook for a growing percentage of their healthcare costs, are demanding better information on the value of treatment.

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Budgetary evidence indicates that pharmaceutical sales and marketing leaders have already begun to shift their efforts from detailing products to physicians to focusing on a broader set of collaboration partners, including payors, and value creation in the disease state. That said, the one-off initiatives we have seen to date do not yet represent the paradigm shift from product selling to the value focus that is needed. Going forward, pharmaceutical marketing must aggressively promote product value creation to an ever-growing range of stakeholders. Five key imperatives will form the foundation for successful marketing models: Re-center marketing on value creation within disease states. Take a multi-stakeholder, multi-channel approach that uses an integrated marketing plan to target key value creation opportunities all along the patients journey with the disease. Incorporate a focus on value creation early in the product development cycle (ideally during Phase II). Accelerate the reallocation of marketing resources and align capabilities to support future market needs. Rigorously measure and manage marketing ROI.

The goal: Reorient the marketing model toward a holistic view of diseases, patient and other stakeholder needs, and outcomes, and position pharmaceutical companies as fully engaged and effective leaders in a sustainable, cost-effective, patient-centered healthcare system. 2. Tenders and contracts represent more than a quarter of the global pharmaceutical market, and their share is growing. The tender and contract market, which primarily consists of competitive, simultaneous procurement quote requests by institutional buyers, is large and growing quickly. It represents more than 25 percent of pharmaceutical sales worldwide, and in emerging markets, it represents over 40 percent of sales. Due to the local, and thus diverse, nature of procurement by tenders and contracts and their historically predominant focus on generics, most pharma senior executives do not yet have a good understanding of this market. For instance, most home office executives believe that these contracts are essentially awarded on price. However, our research suggests that this is true in only 40 percent of cases; in the majority of tenders, price is not the only

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consideration and real upside opportunities exist to maximize both volume and value. Another key finding is that tenders and contracts are quickly spreading to branded products, where these procurements now account for nearly 15 percent of global sales. While tendering and contracting systems vary significantly across markets, these sales generally require specific skills that most pharma companies have not yet developed into a dedicated capability. Tender processes are often highly regulated and thus require different expertise than traditional sales/marketing models. Tendering can create all or nothing scenarios, which need dedicated planning capabilities. And bulk volume contracts require particularly close coordination between the supply chain and commercial functions. Our experience and research suggest that the prerequisite for profitable expansion is a significantly upgraded tender and contract management process that yields these results, among other things: An explicit recognition of different market types, beyond country by country/customer by customer, in defining a manageable set of best-inclass approaches Longitudinal and global visibility into major tender buyers and tendering opportunities beyond best efforts optimized at the local level A fast, efficient process for evaluating major tender offers and setting price parameters with a systematic learning capability beyond the experience of the individual responsible for bidding A more dynamic planning and ongoing management capability between supply chain (volume/cost curves) and tendering (potential/progress against goals)

3. Between 2010 and 2013, half of the growth in healthcare will come from the E7 countries (Brazil, China, India, Indonesia, Mexico, Russia, and Turkey). Pharmaceutical companies seeking growth must find ways to win in the diverse E7 markets, which will not be easy. China, for example, is now embarking on major health reform that is likely to both create major growth opportunities and lead to greater complexity within the national market as different provinces implement it in different ways. The E7 markets require a strategic approach and way of doing business that differ from those of more developed markets. There are regulatory limitations

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on direct physician and patient access, along with widespread substitutions by pharmacists. There are compliance and adherence issues, particularly in markets with low levels of health awareness and high levels of out-of-pocket funding. There are weak links in the supply chain, sometimes extremely high wholesaler and distributor markups, and inconsistent portfolio coverage, particularly in markets with exclusive distributor relationships. Often, the most significant challenge for new products in these kinds of markets has little to do with the product and more to do with the infrastructure required to identify and treat patients efficiently. Finally, unique political and fiscal contexts add complexity to winning E7 tenders. While the fast-expanding middle classes in these countries and the increasing incidence of chronic diseases will fuel demand, there is also a need to meet the healthcare needs of the entire population, including the hundreds of millions of people at the bottom of the pyramid: Governments in these markets are concerned with identifying effective and low-cost solutions to improve the health of all of their citizens. Chinas Healthy China 2020 plan is one example. And not to be forgotten are the growth in local innovation and the emergence of new competitors: As E7 markets develop, their companies and governments will increasingly focus on generating local innovation, rather than relying on imports of leading-edge products and the local production of me-too and generic drugs. China and India stand out for their focus in this area. These issues occur in varying combinations within the E7 markets, which means that they cannot be addressed in a one-size-fits-all way. Rather, companies must move quickly to understand the specific characteristics of each market and tailor strong individual operational plans. To capture the opportunities in these markets and successfully navigate their diverse cultural and regulatory environments, companies should take the following steps: Undertake a thorough assessment of the full range of opportunities that these markets offer. Choose where to play based on market potential, appetite for risk, and strategic and capabilities fit. Bolster execution in these markets with a combination of deep local insight and adaptation, alignment with the social context, and deployment of global capabilities. Remain vigilant about local competitive challenges, both in home markets and as these new players move overseas, while searching out

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opportunities to acquire new assets and capabilities as these markets become sources of innovation themselves. 4. The rate of new drug discovery in the period from 2000 to 2010 was so low that the head of a major pharmaceutical company dubbed it the lost decade. Despite more than doubling its spending on research and development in the last decade, the pharmaceutical industrys success rate in finding new drugs has been disappointing. Why? Pharmas consolidation wave over the past 20 years saddled the discovery units of major players with bloated structures and a proliferation of middle managers who are ill-equipped to drive innovation. Middle managers (who often oversee 100 to 200 employees) can be key enablers in the cultivation of promising new ideas, as well as in the engagement and empowerment of the scientists who discover them. Strong middle managers in R&D depend on behaviors that are not often taught or developed in the academic world, but these behaviors are identifiable and teachable. Our research shows four differentiating behaviors that separate the best from the rest in scientific leadership: The most effective managers define a compelling destination for their scientists. In laying out a visionary manifesto, they provide direction and inspiration. They connect beyond boundaries. Recognizing that innovation comes from relating knowledge in new ways, these leaders encourage their staff to reach beyond departmental boundaries and functional silos to advance their work. They apply multiple lenses to problem solving. All organizations need to structure themselves and, in doing so, create a dominant way to view the world. For instance, organizations structured according to therapeutic area tend to view the world through a disease lens (as opposed to a technology lens, for example). Great scientific leaders minimize the risk of organizational blind spots by using alternative views to identify high-value solutions. They use informal channels to engage their colleagues. These leaders recognize that it is as important to know the scientists as it is to know the science when it comes to investing in projects.

In addition to enabling these behaviors manager by manager, the leaders of discovery organizations need to clarify (and then stick to) the definition of management roles within the structure. Too often, senior leaders end up

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playing middle management roles, thereby compressing and confusing responsibilities throughout the structure. In addition to the inefficiencies it introduces, this practice discourages the ownership necessary to foster the key behaviors of scientific managers. Strong scientific middle managers can be developed, and pharma companies that can build a sustainable capability for producing such leaders will have a leg up in meeting the R&D productivity challenge. 5. The cost of development from protocol design to patient enrollment continues to skyrocket. In industry-sponsored clinical trials in the U.S., for example, on average only 14 patients are enrolled for every 100 patients screened. Clinical development is still unnecessarily costly, inefficient, and timeconsuming, even though pharmaceutical companies are actively seeking to outsource and offshore the process. While these initiatives do offer cost and capacity management advantages, they too often do not address the underlying inefficiency of the process. In these cases, companies are missing a lions share of improvement potential because they are outsourcing a process that is not optimal in the first place. We believe that clinical development must be fundamentally transformed by leveraging electronic clinical data to address the inefficiencies of clinical protocol modeling, patient selection, and patient enrollment that exist today in order to accomplish the following: Create standardized, data-driven approaches for gaining access to potential patients. Enable more accurate site selection for trials. Raise awareness of clinical trials among patients and physicians. Ultimately improve the design of studies across additional therapeutic areas, including disease outcomes research, epidemiology research, and drug development.

Achieving such goals will require cross-industry efforts. One relevant initiative we are supporting is the Partnership to Advance Clinical Electronic Research (PACeR), sponsored by the Healthcare Association of New York State. PACeR is an innovative collaboration of pharmaceutical companies, most of the major medical centers in the state of New York, and health information technology companies. While there are many challenges to leveraging electronic data in

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support of clinical development, we believe the potential is well worth the effort. 6. Potential economies of scale in manufacturing and the supply chain remain unexploited. There is low industry concentration in pharmaceuticals today. The top three companies combined command less than a 25 percent global market share, creating unexploited potential for economies of scale in manufacturing and the supply chain, especially compared to other industries, such as automotive and mining. Such operational scale can be achieved through M&A (even though the primary focus of many acquisitions is not scale) or through less complex cooperative models that can create virtual scale in select areas. Other manufacturing industries that have faced substantial margin pressure have successfully built such cooperatives to leverage production scale. In pharmaceuticals, the first cooperative models have already begun to emerge, but mostly around specific technologies or in certain countries or regions, rather than on a global scale. In pharma, one of the most promising cooperative efforts could be the establishment of so-called manufacturing utilities, in which a consortium of companies own and operate shared manufacturing plants. Such utilities offer a host of benefits to the member companies, including the following: Lower operating costs through the consolidation of select production processes Increased utilization and enhanced flexibility due to the pooling of production assets The ability to maintain a close-to-the-customer production footprint due to lower costs Sourcing improvements due to the bundling of purchase volumes Lower capital expenditures and capital costs due to investment smoothing and reduced reserve capacity requirements

The creation of synergies in the management of regulatory compliance and supply chain resilience Manufacturing utilities are also an effective response to the upcoming challenge of establishing local manufacturing capacity in fast-growing emerging markets.

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7. Although income growth has been buoyed by multiple cost reduction initiatives, the sectors return on invested capital continues to decline. The last five years financial results for the top 10 pharma companies show a steady erosion in returns on invested capital (ROIC), in spite of successful efforts at improving EBIT margins by a compound annual growth rate of roughly 1.5 percent. Our analysis indicates that this disconnect is a direct consequence of the strong competition for acquisitions, which has bid up purchase prices and resulted in higher costs per every additional unit of revenue acquired. Scale alone will not solve the ROIC conundrum. Pharma companies must act now to fundamentally alter their cost structures in ways that will deliver lasting value and bring ROIC back to historic levels, independent of tweaks and tremors in the funding and organizing of the healthcare system. This implies that these efficiencies cannot rely too heavily on acquisitions followed by cost cutting because, for ROIC to improve, top-line improvement must outpace capital requirements. While many pharma companies have recently undertaken cost reduction programs, sales force reductions, and plant consolidations, they still have not achieved the level of operational excellence that is seen in other manufacturing sectors. Toward this end, pharmaceutical companies should take the following actions: Broaden cost reduction initiatives: Fundamentally attack cost structures across the value chain, reduce the overall cost base, and increase the ability to flex costs. Streamline portfolios and functions: Reduce product portfolio complexity, create leaner corporate functions, and restructure the supply base. Pursue operating modellevel initiatives: Use contract research and manufacturing operations, commercial trade channel management approaches, and innovative cross-company partnering in operations, such as collaborative manufacturing utilities.

Using these levers, pharma companies can significantly improve margins, counteracting the challenges they face with a means to drive profit growth and appease shareholders. ***

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These seven market truths ensure that the new year will be another interesting and challenging one for pharmaceutical companies. But we believe they also harbor valuable opportunities for those companies that can embrace and successfully address their challenges.