Biomedical Frontiers: Winter 1995, Vol.2, No.2
Health Care Restructuring: Impact on Research

by Francoise L. Simon, Ph.D.
Professor, Graduate School of Business, Columbia University

The pharmaceutical industry has seen more change in the 1990s than in the past 25 years. Faced with global cost containment and escalating R&D expenditures, companies have engaged in a restructuring process which, in 1994, led to some $36 billion of mergers and alliances worldwide.

While some of the deals were driven by short-term "market Darwinism," most reflect long-term structural changes, such as the massive U.S. shift to managed care. The drive toward vertical integration that first focused upstream in the value chain, i.e., bought R&D capacity from biotech companies, has recently shifted downstream with acquisition of pharmacy distributors (see chart).

Designed to give companies disease management data on millions of patients and allow them to assess the pharmacoeconomic value of drugs jointly with their HMO customers, these acquisitions have nevertheless been criticized for possible overvaluation and conflict of interest. Merck spent $6.6 billion for Medco, SmithKline Beecham purchased DPS for $2.3 billion (or 57 times operating earnings) and Lilly is planning to buy PCS for $4 billion (as high as 130 times earnings.) The FDA also has begun to study the conflict of interest in these acquisitions, whereby a company might pressure a distributor to sell its own product rather than the best therapy.

The same drive to get closer to market also has influenced horizontal integration. While traditional mergers aim to build critical mass in ethical drug portfolios (including Roche/Syntex and Sanofi/Sterling Winthrop), as ethical drug profitability erodes, a new form of integration (such as the Warner-Lambert/ Wellcome consumer health merger) has focused on building mass in over-the-counter products.

What will be the impact of these massive structural shifts on R&D funding and specifically on the various links between pharmaceutical companies and academic research? It might appear that huge sums expended downstream (nearly $13 billion in 1993-1994 for three distributors vs. $25 billion in annual worldwide R&D expenditures) would negatively affect research funding, but it is not necessarily so. While growth has slowed, pharmaceutical companies still spent, in 1993, 15 percent of sales on R&D, more than any other industry.

However, economic changes are shifting research strategies. While many laboratories were staffed mainly to make low-risk improvements to existing drugs, new pricing constraints have put a premium on innovation and are driving two main trends: sharp research focus and R&D outsourcing, i.e., contract research.

Even though research funding rose steadily in the last decade, NCEs (new chemical entities) started declining in 1987. The number of megadrugs (those with $1 billion or more in annual sales) is projected by Lehman Brothers to drop from 21 today to 17 by the year 2000.

In response, leading companies now focus on specific therapeutic areas: Ciba-Geigy's list of 70 compounds under investigation in 1992 has been halved; similarly, Bristol-Myers Squibb has eliminated, since 1991, 50 percent of its basic drug discovery programs. Such reductions inevitably lead to a rise in outsourcing. SmithKline Beecham, for instance, envisions spending only about one-fifth of future R&D budgets in-house.

Most research outsourcing concerns biotechnology. Despite recent failures in areas such as sepsis, biotech has delivered four of the 24 top-selling drugs: Genentech's tPA, Biogen's alpha-interferon, and Amgen's G-CSF and erythropoietin (EPO). EPO, jointly developed with Johnson & Johnson, now reaches $700 million in annual sales.

While drug companies are increasing their biotech partnerships (100 in 1993, twice as many as in 1992), they and biotech firms are concluding more contracts with universities. Recent examples include Amgen's $3 million agreement with MIT, Merck's alliance with Washington University for gene mapping and sequencing, and Biogen's immunology licensing agreement with Columbia for T and B cell activating molecules and related monoclonal antibodies.

For areas requiring multiple technologies, such as advanced protein engineering, R&D consortia appear realistic. Since gene therapy requires new gene delivery technologies, companies such as Genetic Therapy Inc. and its partner Sandoz, as well as academia, are working on delivery systems ranging from modified viruses to synthetic compounds.

There is evidence that virtual integration, i.e., an alliance based strategy, may be more viable in the long term than physical, equity-based integration. While Amgen is seen as the only fully integrated biotech company, it is highly collaborative, and others, such as Biogen, owe their success to alliances.

Companies like Glaxo have adopted both upstream and downstream virtual alliance policies. Even Pfizer, with three potential megadrugs on the market, has increased its licensing activities and also chose an alliance strategy with pharmacy distributors Caremark and Value Health (see chart).

Virtual integration is emerging as a vehicle for sustaining academia's independence and biotech's entrepreneurship, while enabling companies to thrive in competitive markets. Companies may still pursue actual consolidation, but if they are not also virtually integrated, they limit their strategic options.