By Robert McKinnon, Ken Worzel, Greg Rotz and Harriet Williams

  

Just six years ago, the world’s major pharmaceutical companies were held up as the most potent shareholder value creators of the corporate world. Predicting that the industry’s strong performance during the 1990s would continue into the 21st century, investors piled into the sector. So eager were they to get a piece of the action that, in 1998, Big Pharma’s price/earnings ratio was more than twice that of the global stock market.¹

Today, equity analysts rate growth prospects for the largest players much closer to the broader market’s, and the price premium relative to the S&P 500 has all but disappeared (see Figure 1).¹ That’s quite a fall from grace.

Why has Big Pharma taken such a tumble? The prevailing explanation is that something has gone seriously wrong in the research labs; too few new products are emerging to replace older ones coming off patent. Most observers justify their generally bearish outlook by comparing the industry’s investments in R&D with the number of new drug launches. They point out that, despite a substantial increase in research budgets in recent years, the number of new compounds fell sharply in the late 1990s and has remained stubbornly close to historic levels of the ’80s and early ’90s ever since (see Figure 2).² As a result, the full cost of bringing a new drug to market has mushroomed from around $250 million in the early ’80s to around $1.5 billion today.

The fact that the rate of drug launches has remained fairly stagnant at a time of rising R&D spend does not, on its own, prove that pharma’s malaise is a decline in the "bang" it is getting from its research bucks. Our analysis shows that, contrary to conventional wisdom, returns on R&D investment have held up reasonably well compared to the levels achieved in the late 1990s. In fact, there are signs that R&D productivity (as defined by ROI) has improved from its nadir in 2000. That should come as some comfort to embattled pharma executives.

The problems reflected in the loss of pharma’s price/earnings ratio premium have more to do with a harsher commercial environment than with falling returns on R&D investment. The challenge pharma companies face, if they want to restore their positions as potent value creators, is not to reverse what turns out to be an illusory decline in R&D productivity, but to counter the margin squeeze from both greater pricing pressure and burgeoning marketing budgets.

R&D Productivity: The Real Story
Comparing R&D investments to the number of new compounds launched generates eye-catching headlines but takes no account of important changes in the commercial value of the drugs emerging from Big Pharma’s research labs in recent years.

This is the age of the blockbuster. In 1998, there were 25 blockbuster drugs (annual sales greater than $1 billion) and only two – Merck’s Zocor and AstraZeneca’s Losec – brought in over $3 billion. Just five years later, the market gave rise to 64 blockbusters and each of the top 10 broke the $3 billion barrier. Pfizer’s Lipitor reigned supreme with a stunning $10.3 billion in sales.²