Why is Pharma industry so profitable

The pharma is industry is highly profitable. Between 2000 and 2003, the average
rate of return on invested capital for the firms in the industry was 22.6%. Put
differently for every $ of capital invested in the industry, the average pharma firm
generated 22.6 cents of profit. This compares with an average return on invested
capital of 15.9 percent for the firms in software industry, 11.9 percent for publishing
firms, 11.2 percent for retail firms, 6.6 percent for steel firms, 1.8 percent for air
transportation industry.

The high profitability of the pharma industry can be understood by looking at

several aspects of its underlying economic structure. First, demand for pharma is
strong and has been growing steadily for decades. Between 1990 and 2003 there
was a 12.5% annual increase in spending on prescription drugs in US. This strong
growth was driven by favourable demographics. As people grew older, they tend to
need and consume more prescription medicines and the population in the most
advanced countries has been growing older as the post world-war II babyboom
generation ages.

Second, successful new prescription drugs can be extraordinarily profitable. Lipitor,

the cholesterol-lowering drug sold by Pfizer was introduced in 1997 and by 2003
this drug had generated a staggering 59.23 bn in annual sales for Pfizer. The cost of
manufacturing, packing, abd distributing Lipitor amounted to only 10% of revenues
or under $1bn. Pfizer spent close to $400mn on promoting Lipitor and perhaps as
much again maintaining a sales force to sell the product. That still left Pfizer with
gross profit of $7bn. Since the drug is protected from direct competition by a 20
year patent, Pfizer has a temporary monopoly and can charge a higher price. Once
the patent expires, other firms will be able to produce generic version of Lipitor, and
the price will fall-typically by 80% within a year- but that is some way off.

Competing firms can produce drugs that are similar (but not identical) to a patent
protected drug. Drug firms patent a specific molecule, and competing firms can
patent similar, but not the identical, molecules that have a similar pharmacological
effect. Thus Lipitor does have competitors in the market for cholesterol-lowering
drugs, such as Zocor sold by merck and Crestor sold by Astra-Zenca. But these
competing drugs are also patent protected. Moreover the high costs and risks
associated with developing a new drug and bringing it to the market constitute a
formidable barrier to entry, limiting competition. Out of 5000 compunds tested in
the lab by a drug company, only five enters clinical trials, and only one of those will
make it to the market. On average, estimates suggests that it costs some $800mn
and takes somewhere from 10 to 15 years to bring a new drug to the market. Once
on the market, only 3 out of 10 drugs ever recoup their R&D and marketing costs
and turn a profit. Thus high profitability of the pharma industry rests on a handful of
blockbuster drugs. To produce a blockbuster, a drug company must spend a large
amount of money on research, most of which fails to produce a product. Only very
large companies can shoulder the costs and risks of doing this and it is very difficult
for the new companies to enter the industry.

Pfizer for example, spent some $7.13bn on R&D in 2003 alone, eq to almost 18% of
its revenues. In a testament to just how difficult it is to get into the industry
although a large no of companies have been started in the last 25 yrs however only
one of these Amgen was ranked among the top 20 in terms of the Sales in 2003.
Most have failed to bring a product to the market.

In addition to R&D spending, the incumbent firms in the pharma industry spend
large amounts of money on advertising and sales promotion. While the $400mn a
year that Pfizer spends on Lipitor is small relative to the drug’s revenues, it’s a large
amount for a new competitor to match, making entry very difficult unless the
competitor has a significantly better product. Thus promotional spending
constitutes another formidable barrier to entry.

In Sum, patent protection that grants a temporary monopoly to some

firms, high R&D costs, significant risk of failure and high marketing costs
make it very difficult for new firms to enter the pharma market. The
industry tends to be dominated by large established enterprises that have the scale
required to bear the considerable costs and risks associated with developing new
drugs and can afford to spend a large amounts of money to promote those drugs in
the marketplace.

Furthermore, there are some big opportunities on the horizon for firms in the
industry. New scientific breakthroughs in genomics are holding out the promise that
within next decade pharma firms might be able to bring new drugs to the market
that treat some of the most intractable medical conditions including Alzheimer’s,
Parkinson’s disease, cancer, heart disease, stroke and AIDS. But there are also
some threats to the long term dominance and profitability of industry giants like
Pfizer. Most notably, as spending on health care rises, politicians are looking for the
ways to limit health care costs and one possibility is some form of price control on
the prescription drugs. Price controls are already in effect in most developed
nations and although they have not yet been introduced in US, they could be.

Questions:

1.Do the analysis of the Pharma industry environment which including competitive
landscape and O-Ts

2. Porter’s Five Force Model?