A Grim Future? Here Are The Numbers

by: Derek Lowe

Here's a bracing look at the state of the pharma business, especially regarding R&D costs and return on investment. And let me warn you - it's not a feel-good sort of article, but the figures are hard to refute. The author, Kelvin Stott, comes out swinging:

Here for the first time, I introduce a far simpler, much more robust methodology to calculate Pharma's return on investment in R&D, which is based only on reliable and widely available high-level data on the industry's actual historic P&L performance. This new analysis confirms the steady decline reported by others, but here I also explore the underlying drivers and make concrete projections, which suggest that the entire industry is on the brink of terminal decline.

He goes on to calculate the average return on investment (IRR) by adding up the compounded annual growth in the value of past R&D investments (as they contribute to profits, on an earnings-before-interest-and-tax basis, and adding in future R&D costs (opportunity costs, since investing in a new R&D program is one option out of many for that cash). He then has a formula for internal rate of return, based on an average investment period of 13 years per project. It's true that project spend more money in the latter part of that period, but there are more projects in the earlier years, so it roughly balances out.

Unfortunately, when you do this over time, you find that the IRR has been declining at a pretty steady rate. This is (as Stott shows) completely consistent with findings from Deloitte and BCG, and it also looks consistent with a McKinsey analysis from a few years back. I know what you're thinking: "So if all of these consulting groups agree, can this conclusion actually be true?" Sadly, it probably is. The investment return on R&D has been decreasing, because the opportunities for big returns have been getting progressively harder to find, and the costs of exploiting them has been rising without interruption. This is what Bernard Munos and others have been pointing out as well; it's a hard conclusion to avoid.

Stott's line has the rate hitting zero in just a few years, and as he points out, there's no reason for it to stop there. Zero IRR means that you're breaking even, and as we all know, that's not the bottom at all. You can go on to lose money, at ever more exciting levels, and head into negative IRR territory. In fact, if you use these figures to project profit-and-loss for the industry as a whole, Stott says that we may well be at the peak right now (see the article for the graphs). Everything from here on is down, according to this analysis.

Diminishing R&D productivity and return on investment leads to diminishing growth in sales. Eventually, growth turns negative and sales start to contract. Reduced sales then reduces the amount of money available to invest back into R&D, which causes sales growth to decline even further. And so on, until the industry is gone altogether.

Good morning to you, too. But as the article goes on to say, this doesn't mean the end of the drug industry - just the drug industry as we know it. I've said something similar in recent talks I've given - I've told graduate students that I don't know what the industry is going to look like in 20 years, but I'm sure that it won't look just like it does today, because what we have going today is simply not sustainable. Stott makes the case that moving out of traditional small-molecule drug discovery looks like the only way out - cell-based therapies, immunotherapies, gene therapies, tissue engineering and so on are the current frontiers. And that doesn't mean just scientific frontiers, although they are that, but business frontiers to continue to run drug companies as going concerns.

So although this article is a cup of cold water to the face, I really can't disagree with its main conclusions, based on its premises. The only way out is to disprove some of those premises or come up with some new ones. As for the disproving part, you have things like success rates in the clinic, cost of R&D, number of good targets - we all know about the pressures on these factors. If something dramatic happens in these areas, this sort of analysis will have to look different, but if things continue as they are now (and as they have continued for the years up to now), then the picture laid out is the one that's coming. The "find some new premises" part is what's mentioned above - moving into totally new treatment modes and trying to make a go of them.

That's why Stott's graph looks a lot like the "peak oil" graphs from a few years ago. Those predictions didn't come out as grimly as forecast, mainly because of new technologies like fracking (both to release more oil and to provide a new supply of natural gas for the energy market as well). We are going to have to break through into new technologies to survive this, too.

As medicinal chemists, we ignore this advice at our peril. Hoping that things are just going to be able to keep chugging along somehow in the small-molecule world has not worked out so great over the last twenty years or so, to put it delicately. And it's not a good strategy for the future. Small molecule therapies definitely have a role to play, though, in these new treatment areas, and we had better be ready to pitch in, because those are the most likely areas for growth. And we could use some growth.