A Recent History Of The Pharmaceutical Industry - Based On All Five Forces

This case study is a recent history of the pharmaceutical industry based on all of Porter's five forces. If you would like to try this assessment on your own business then try out our Porter's 5 Forces Assessment

In the 1970s and 1980s, the average profit margin (as a percentage of revenues) of the Fortune 500 pharmaceutical companies was two times greater than the median for all industries in the Fortune 500. Each drug introduced between 1981 and 1983 ‘made at least $36 million more for its investors, after taxes, than was needed to pay off the costs to develop it . . . Such profitability was two to three percentage points greater than for comparable industries, even after factoring in the risks of new drug development’. Nearly two decades later, in 1999, the industry was still a star. The pharmaceutical industry ranked at the top in all three of Fortune magazine’s measures of profitability: return on sales, return on assets and return on equity. What made the global pharmaceutical industry so profitable for so long? Why has its profitability remained so strong, and will the industry remain so attractive?

Threat of entry

For an entrepreneur, high barriers to entry make it more difficult to launch a venture. But happily, for those who are somehow able to enter, these same barriers serve to protect their ventures once they have joined the party. Thus, while barriers to entry can be considered obstacles for the entrepreneur, they also serve to keep competitors out of the industry. A number of barriers mute the threat of entry into the pharmaceutical industry. These include barriers both financial and intangible in nature, ranging from high fixed costs to stringent intellectual property protection. Let’s look in some detail at conditions in the pharmaceutical industry in the 1980s.

Heavy expenditure on research and development were (and still are) required for the arduous processes of drug discovery, development, manufacturing, and approval through the various regulatory bodies, such as the Food and Drug Administration (FDA) in the USA and the Committee on Safety of Medicines (CSM) in the UK. The process of developing a drug was time-consuming, expensive and precarious. During the 1980s, it took an average of 12 years and $194 million to bring a drug to market. And the long and tedious process, which included research and development, clinical trials and government approval, did not guarantee favourable results, as more than 50 per cent of all development dollars were spent on products that never reached the market. The sheer size of an investment like this, coupled with the great uncertainty of whether there would be a payoff, was a powerful barrier to deter those who might have entered the industry.

Research and development were not the only exorbitant costs. Sales and marketing costs were also substantial, as pharmaceutical companies spent large sums promoting their drugs to hospitals and doctors. To compete effectively against the industry’s leaders, a new company had to spend millions of dollars annually on large salesforces and other marketing and promotional activities.

Substantial as these financial barriers were, they paled in comparison to the protection that governments placed on intellectual property. Companies generally won patents for their new drugs. These patents were issued on either the drug’s chemical structure or its method of manufacturing or synthesis. This highly favourable competitive environment, in which drug companies obtained patents to protect them from rivals, meant that competitors were effectively blocked from manufacturing and marketing drugs with the same chemical composition for 17 years, which equates to between eight and 12 years once the drug actually gets to market.

The result? In terms of threat of entry, the picture of the pharmaceutical industry in the 1980s was clear. Entry barriers were extremely high, resulting in little threat of entry, a very favourable condition for industry incumbents and for new pharmaceutical startups that could find a way to enter.

Supplier power

Pharmaceutical companies were flooded with raw material suppliers anxious to sell to such a strong and profitable industry. In 1982, there were over 12,000 chemical companies in the USA alone. Their products had long shelf lives, were readily available from numerous sources, and were bought largely on the basis of price and delivery. These conditions left the chemical suppliers with little power to set the terms and conditions under which their raw chemicals were sold to the drug companies. From the drug companies’ point of view, supplier power was virtually nonexistent.

Buyer power

How would you like to be in an industry where your buyers are uninformed about your product and almost 100 per cent insensitive to its price? Not only that, but imagine that there are few if any substitutes for your product, and that using it may be a matter of life or death for your consumer. These were, for the most part, the circumstances prevailing in the pharmaceutical industry through the 1980s. The industry enjoyed an almost powerless group of buyers. Drug companies reaped the benefits of unaware doctors who were partial to prescribing brand-name drugs to obtain the most medically effective solution, regardless of price; price-insensitive patients who did not care about the cost of their prescription medications; illinformed consumers who blindly trusted their doctors’ treatment suggestions; and few alternatives to prescription drugs. The weakness in buyer power contributed significantly to the profitability of the pharmaceutical companies.

These companies also benefited from consumer trends in Europe and North America towards health and nutrition. Consumers were increasingly eager to do whatever it took to become or stay healthy. Further, consumers had the luxury of being indifferent to drug prices because most of them did not pay full price for their medications. Rather, through the 1980s in most developed countries, government agencies, insurance companies or employers paid the patient’s prescription drug bill. And without easy access to information on medications, customers had little say in their treatment plans.

Threat of substitutes

Until the mid-1980s, the global pharmaceutical industry was largely unthreatened by substitute products. If a patient was ill, they took the medicine the doctor ordered. Patent laws prohibited companies from replicating others’ brand-name drugs for as long as 17 years, and other regulations deterred the development of chemically equivalent generic drugs. For most conditions treatable by prescription drugs, there simply were no substitutes for the medications the doctor prescribed.

Competitive rivalry

The pharmaceutical industry of the 1980s was populated by hundreds of companies, though none had more than 5 per cent market share. There were two main reasons the pharmaceutical industry was so fragmented:

Different companies focused on entirely different classes of drugs. These classes included cardiovascular treatments, antibiotics, central nervous system therapy, gastrointestinal treatments, etc.

The industry’s growth rate made it easy for competitors to grow without taking share from each other. There was little pressure to expand beyond one’s niche, given abundant opportunities for growth therein.

The result of this fragmentation was that most firms had few direct competitors. The lack of direct competition allowed drug companies to raise prices as they pleased. Couple this lack of competition with a weak threat from substitutes and little buyer power, and the industry experienced little dissent when raising prices to meet profit objectives. Competitive rivalry was almost nonexistent.

Summary of industry attractiveness

The result of these industry conditions was impressive profit growth through the middle of the 1980s. With significant barriers to entry, docile suppliers, powerless buyers, almost no threat of substitutes, and little rivalry, the pharmaceutical industry in the 1980s was just about as perfect an industry as one could imagine. Given its attractiveness, the industry attracted the attention of genetic and molecular biology scientists and the venture capital community, who saw its appeal and thought their revolutionary approaches to drug therapy could attract enough money to overcome the formidable entry barriers the industry enjoyed.

Thus, as scientific advances in biotechnology took hold, numerous entrepreneurial companies like Genentech and Amgen were founded to commercialize new scientific breakthroughs. Genentech, the first biotech firm having commercial success, developed a protein that broke up blood clots. Amgen’s famous molecular biology used recombinant DNA to produce erythropoietin, a hormone that increases the supply of red blood cells in anaemic patients under treatment for cancer and other diseases. By 2000, erythropoietin was generating $2 billion in sales and another $3 billion in licensing revenue for Amgen. Both of these new entrants fared very well in this attractive industry:

Genentech went public in 1980, and by 2001 its shares had appreciated 2700 per cent since its IPO.

Amgen shares, first offered in 1983, soared more than 16,000 per cent.

Was the pharmaceutical industry an attractive industry in which to play? The venture capitalists that backed Genentech, Amgen and other companies like them have not been disappointed. The scientists-turned-entrepreneurs whose technologies were backed have prospered as well. Thus, for entrepreneurs who can marshal the resources to overcome high barriers to entry – and who have something to sell that customers want – attractive industries like pharmaceuticals can be rewarding places to play, indeed.

The pharmaceutical industry at the turn of the twenty-first century

Alas for the drug makers, industries are not static places. Like the rest of the business world, industries are dynamic, subject to ever-changing environments. The pharmaceutical industry has not remained quite as cushy as it once was. Let’s look at what has changed.

Threat of entry

Starting in the mid-1980s, the barriers to enter the pharmaceutical industry began to show cracks. New legislation made it easier for generic drug companies to enter the market. In the USA, the 1984 Waxman-Hatch Act, which changed the rules for generic drug manufacturers, reduced the barriers to generic entry. Instead of having to prove the generic drug’s safety and efficacy, the act required companies only to prove their formulas were equivalent to that of the brandname drug. The subsequent growth in generic drugs was profound. By 1996, generic drugs accounted for more than 40 per cent of pharmaceutical prescriptions.

Aside from the influx of generics, the pharmaceutical companies also saw a wave of biotechnology competitors enter their industry – Genentech, Amgen and many others – suggesting that economies of scale meant less than they used to, and that barriers to entry, while still high in absolute terms, were dropping, thanks in part to the availability of venture capital. Further, the biotech companies’ new science-focused research model, known as rational drug design, stood the traditional approach to drug discovery on its head. These drug companies worked backwards from known disease biochemistry to identify or design chemical ‘keys’ to fit the biochemical ‘locks’ of that disease.

The result of these changes? Barriers to entry crept lower, increasing the threat of entry and making the industry somewhat less attractive.

Buyer power

Beginning in the mid-1980s, three developments gradually began to increase the power of the pharmaceutical industry’s buyers:

The growing strength of managed care in the USA, the industry’s largest market.

Increased pressure from governments, especially in Europe.

A better-informed patient population.

The American transition from an insurance-based healthcare system to one of managed care changed the dynamics of the pharmaceutical industry dramatically. By 1993, 80 per cent of the US population was covered by managed care organizations (MCO), compared with 5 per cent of the US population covered in 1980. These MCOs typically provided full coverage for prescription drugs. But, because of their sheer mass, these institutions had considerable bargaining power with drug companies, and exerted strong downward pressure on drug prices. Thus, while patients maintained their price insensitivity for drugs, their healthcare providers were far more price-sensitive.

To further increase drug-price awareness in the American medical community, health maintenance organizations (HMO) set up formularies (lists comparing the prices and benefits of various drugs). HMOs assessed these formularies, deciding which drugs to endorse. If the HMOs did not approve a certain drug, then doctors affiliated with the HMO could not prescribe it. Of course, it is not surprising that HMOs favoured the less expensive generic drugs over brand-name drugs. In 1995, a Medical Marketing & Media article claimed: ‘Pharmaceuticals appear headed for commodity status, pushed by generics, formularies, and other cost pressures’. The American HMOs were not the only ones putting downward pressure on drug pricing. European governments established price controls, limiting prices at which prescription drugs could be sold. In the UK, a new government agency, the National Institute for Clinical Excellence (NICE), was established to determine the cost-effectiveness of drugs before the National Health Service (NHS) would pay for them.

Finally, by the turn of the century, the coming of age of the Internet generated approximately 100,000 health-related websites. Powered with more information, patients became more knowledgeable and, consequently, more powerful. And, with new legislation that now permitted prescription drug advertising in the USA, patients there began taking a more active and knowledgeable role in their medical decision-making. Buyer power had increased considerably. The result of this increase in buyer power was downward price pressure on prescription drugs.

Threat of substitutes

Not only was direct competition from generic drugs impacting the industry, but trends toward more natural therapies led consumers to try substitutes for prescription drugs. Exercise, nutrition and herbal remedies all began to take market share from the prescription drug makers.

Competitive rivalry

Throughout the late 1980s and the early 1990s, rivalry in the pharmaceutical industry increased. Given the new pressures described above, traditional drug companies felt the pressure to consolidate to take advantage of economies of scale. By choosing to merge, rivalry among the top firms increased, as their areas of expertise began to overlap.

Additional rivalry stemmed from the flood of more science-focused drug discovery firms. While some biotechs were purchased by the large drug companies, others became strong competitors in their own right. Unlike the drug companies, biotechs were not burdened with high overheads, and they possessed superior product and disease knowledge in their chosen segments. Rational drug design enabled them to discover new therapeutic compounds more quickly and more efficiently than before. While traditionally these biotechs had discovered new drugs and then sold their discoveries to established drug companies, this pattern seemed to be changing, as some began not only to discover but also to develop and market their own drugs. Thus, the pharmaceutical industry found itself with a whole new set of competitors, some of which had lower cost structures and were more agile and science-focused. Competitive rivalry had increased.

Summary of industry attractiveness entering the twentyfirst century

How has the industry fared in light of these developments? A study by the US Congressional Budget Office concluded that, ‘since 1984, the expected returns from marketing a new drug have declined by about 12 per cent, or $27 million in 1990 dollars. That decline has probably not made drug development unprofitable on average, but it may have made some specific projects unprofitable’.

In spite of its decline in attractiveness, in 2000 the pharmaceutical industry still ranked as the most profitable industry in the USA:

Return on assets was 17.7 per cent.

The top 11 US pharmaceutical companies generated almost $200 billion in revenues that year and profits of $28 billion.

While not quite as attractive a place to compete as it had been in the 1980s, the pharmaceutical industry remained far more attractive than most. Why?

Threat of entry remained comparatively low, despite the incursion of generic drug makers and biotech firms. Starting a pharmaceutical company isn’t nearly so simple as, say, starting a restaurant.

Buyer power had increased – a genuine problem.

But suppliers to the pharmaceutical industry still lacked power.

Substitutes such as exercise, nutrition and herbal medicines were no match for prescription therapies for cancer and other life-threatening illnesses.

Competitive rivalry remained modest, as the drug companies, having common interests, sought to protect their traditionally high profit margins.

Thus, the pharmaceutical industry remained an attractive place to play, far more so than most industries, including the digital subscriber line industry, which we examine next. Will this continue to be the case, or will the pressure of these trends erode the industry’s attractiveness further? Only time will tell.

Lessons learned from the pharmaceutical industry

As the pharmaceutical industry example shows, regulatory issues can have powerful effects on industry attractiveness and the profitability of the firms that comprise it. Where regulation makes it difficult for competitors to enter and compete, and other forces are also favourable, it’s worth an entrepreneur’s trouble to find a way in, as the biotech companies have done. Both the long-established players and the biotech newcomers have prospered.

The pharmaceutical industry example also shows that high barriers to entry are good. Love and cherish them. And, once you get in, work to keep the barriers high. The same is true of weak buyer and supplier power, and of little threat of substitutes, as we’ve seen here. Even significant changes in some of these forces were insufficient to detract significantly from the drug industry’s overall performance.

Finally, entrepreneurs should note that industry performance data, like those cited in this chapter for pharmaceutical industry performance, are readily available in business libraries in most developed economies. It’s well worth a look at such data in the early stages of assessing an opportunity. If an industry is a poor performer overall, you should take a critical look at your opportunity to ask why it should fare differently. Without a persuasively positive answer to this question, I would suggest moving on to something more attractive.