An Overview of the Pharma Sector

Welcome to the 93rd Pari Passu Newsletter,

After the amazing success of last week’s edition about Triple Dip, this week we are learning more about an industry: pharma. With the global pharmaceutical market projected to reach $2.36tn by 2030, pharma is one of the most important and influential markets in the economy. At the same time, Pharma is also one of the most controversial, with top firms facing constant criticism for their immoral pricing strategies and lack of transparency.

In the article below, we will cover this industry: its origins, major players, market performance, key criticisms, and much more. This is a fascinating sector that most of us rarely interact with, so I hope this write-up will have many lessons.

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Origins and History

The origins of the pharmaceutical industry date back to the Middle Ages, when medieval apothecaries and pharmacies offered traditional remedies based on folk knowledge rather than science.

It would not be until the Industrial Revolution that major advances in the field would be made. German company Merck, founded in 1668, would be one of the first companies to move towards a scientific approach to pharmacy. This occurred in 1827 when Heinrich Emanuel Merck began a transition towards scientific concern by manufacturing and selling alkaloids [9].

In America, the pharma revolution also occurred during the early to mid-19th century. Pharma giant Pfizer was founded in 1849 by two German immigrants, initially as a chemicals business. However, when the American Civil War began, Pfizer saw huge demand for painkillers and antiseptics, and setting off the company’s transition to pharmaceuticals [9].

Interestingly enough, Pfizer’s involvement in the war would lead to the birth of another pharma giant. Colonel Eli Lilly, a cavalry commander serving for the Union, was also a trained pharmaceutical chemist who, after the war, set up his own pharmaceutical business in 1876. His company, Eli Lilly, would be one of the first pharma to focus on both R&D and manufacturing during a period in which early pharma focused on only one of the two [9].

1897 marked a breakthrough year for the pharmaceutical industry with the invention and commercialization of aspirin by the German company Bayer. Aspirin was one of the most successful drugs of its time and is still widely used today. However, in the aftermath of World War I, Bayer would have its aspirin trademark and U.S. assets seized while the American arm of Merck split off from its German parent company. These events would help propel the U.S. to the forefront of the industry while simultaneously setting back Germany for years to come [9].

Between the First and Second World Wars, arguably two of the most important pharmaceutical breakthroughs occurred: the discovery of insulin by Frederick Banting and colleagues in 1921 and the discovery of penicillin by Alexander Fleming in 1928. During World War II, an international effort between Merck, Pfizer, and Squibb mass-produced penicillin, saving thousands of lives. Furthermore, the scale at which penicillin was researched and manufactured set a precedent for how future drugs would be developed [9].

Post-war, the pharmaceutical industry entered a period of increase government involvement. With the arrival of healthcare systems such as the National Health Service in the U.K. that facilitated drug purchases and the National Institutes of Health in the U.S. that provided millions in R&D funding, pharma was booming in the late 20th century. Not only was pharma saving millions of lives, it was generating millions more in profit. In 1950, President of American Merck George Merck gave a warning about the purpose of the pharmaceutical industry: "We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we remember it, the larger they have been" [9].

The latter half of the 20th century would mark the beginning of a period of rapid development and innovation. The 1970s were highlighted by the birth of the first “blockbuster” drug, Tagamet, an ulcer medication that drew in over $1bn in revenue in a year. The success of Tagamet ushered in the blockbuster model (explained later), which most big pharma companies still use today [9].

The 2010s ushered in a new era of pharmaceutical advancements due to rapid parallel developments in science. With the completion of the human genome project in 2003, pharmaceutical companies have been focusing on genetic-based treatments as well as immunotherapies, which do not directly act against the disease, but support the immune system in defeating the illness [9].

This ultimately leads us to the modern pharmaceutical industry. Now that we have a basic understanding of its origins, we can begin to understand the modern pharma landscape.

Pharma Business Model

Definitions and Classification

By definition, the pharmaceutical industry is comprised of companies engaged in the research and development, manufacture, and distribution of drugs. These drugs are intended for use in the diagnosis, cure, mitigation, treatment, and prevention of illness and disease. Within the industry, there are few key subsectors that emerge [2]:

• Innovative/original pharma: Innovative pharma focuses on the development of novel, chemically synthesized drugs that are protected by exclusive marketing or patents. These companies invest heavily in R&D in order to discover new drug solutions. Examples include Pfizer and Roche [2].

• Generic pharma: Generic pharma focuses on the production of generics, which are chemically equivalent copies of name-brand drugs. Generics can only be produced after patent expiration. Examples include Teva and Viatris [2].

• Biopharma: Biopharma specializes in the production of biologics, which are drug treatments derived from living organisms. They are the biological counterparts of innovative pharma. Examples include Eli Lilly and Novo Nordisk [2].

• Biosimilar pharma: Biosimilars are the generics of biologics. Biosimilar pharma is the biological counterpart of generic pharma. Examples include Catalent and Amgen [2].

• Over-the-counter (OTC) pharma: While specialization in OTC medicines is rare, OTC pharma focus on the production of OTC drugs, which do not require a prescription to be purchased and used by consumers [2].

Do note that some of the companies listed as examples are not limited to their classification. Most, if not all, top pharma are widely diversified, meaning they have business lines in most of the above classifications. Furthermore, the distinction between innovative pharma and biosimilar pharma is minimal, and most top pharma can be classified as either.

Business Model

In our discussion of business models found in pharma, we will be focusing on innovative pharma. This is because a) the world’s largest and most influential pharma all have a very successful innovative pharma arm, and b) innovative pharma is the most unique type of pharma business due to the simple fact that there is no guarantee of a viable product.

Most modern pharma have adopted the “blockbuster” model. Statistically, only 10% of drugs that enter clinical trials ever make it to market. Of those drugs, the average return on invested capital (ROIC) is approximately 5%. However, blockbuster drugs, which are highly successful drugs due to their efficacy, can yield returns 10-20x as large as the average drug. Some of the most successful blockbuster drugs in history include Pfizer’s Lipitor with $164bn lifetime sales, AbbVie’s Humira with $137bn lifetime sales, and GlaxoKlineSmith’s Advair with $104bn lifetime sales. With the average cost of developing a new drug sitting at around the $1bn to $5bn range, each of these drugs generated handsome returns for their developers. Therefore, big pharma pours hundreds of billions of dollars annually into R&D in hopes of finding the next big breakthrough [5] [6] [14]. 

A quote from the Acquired podcast sums the pharmaceutical industry up perfectly: “Pharma is the most classic example of the venture business. It's super high risk, it's super high return if it works, and the winners need to subsidize all the failures”. In fact, approximately 10% of drugs that make it to market provide 50% of the profits in pharma, and most drugs do not even earn back their R&D costs, even after FDA approval [5].

Clinical Trial Process

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