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19 May 2021

The Rise and Fall of Big Pharma

For many years, innovation occurred in significant, sequential stages, fully challenging the status quo at the time. Take the Ford Motor Company, its first use of the production line, now a staple amongst manufacturing companies globally, completely turned on its head the way in which products are produced. Since then, however, the wave of new technology companies has caused the once systematic approach to innovation to flow into a smooth and constant process. Software companies are now charging their customers a monthly licence fee and continually improving their products year-on-year, rather than charging for individual revisions of their packages. This trend has spilled over to almost every industry across the developed world as companies look to service the continually changing and evolving needs of their customers.

The healthcare and pharmaceutical industry is no exception. As big pharmaceutical companies have struggled with sluggish corporate structures and a serious lack of innovation despite record R&D budgets, brand new medical technology firms (or medtech for short) have emerged to take advantage of significant opportunities, often in niche areas, where they can dominate the market. This has led to a surge in not only the number of medtech IPO’s but also their valuations, as investors look to transfer investment from old economy assets to exciting and innovative businesses capable of producing strong shareholder returns while also providing a social good.
 
Large pharmaceutical companies were once all the rage amongst the investment community. Firms that were able to pass multiple drugs through clinical trials were rewarded with virtual monopiles within the segment in which they operated, essentially providing a licence to print money. During the late 90s, big pharma companies were producing revolutionary lifesaving drugs, pushing their share prices sky high and rewarding investors. However, many such companies have failed to advance with the times and often rely on the cash cows of their incumbent drugs to maintain large-scale shareholder pay-outs, all the while ignoring high-growth segments of the market. This comes despite a continuous and significant rise in global R&D spending, with the US pharmaceutical R&D market alone rising from US$2bn in 1980 to US$71.4bn in 2017. The kicker here, however, is not the increased expenditure, it is the severely declining returns from their R&D spend. A Deloitte study showed that between 2010 and 2019 the R&D returns from 12 selected large cap biopharmaceutical companies has steadily declined from 10.1% to just 1.8%. This highlights the lack of efficiency within an industry that relies on steady R&D productivity enhancements with a positive return on investment in order to drive future revenues and create value for shareholders.
 
However, it is not simply internal inefficiencies that have worked against such companies. The pharmaceutical industry has become increasingly controlled as regulators look to ensure the efficacy and safety of new drugs. A study in 2016 showed that the average time from U.S. Food & Drug Administration (FDA) application to approval of a drug was, at the time of its publication, 12 years, with the average estimated cost of bringing a drug to market from initial inception now exceeding US$1bn. The lengthy approval process and increasing cost of development has meant that companies have been forced to concentrate their R&D efforts across a smaller range of drugs, increasing the irretrievable financial damage dealt to the firm if a drug were to fail approval. This, coupled with the fact that large pharmaceutical companies are often known for, and in essence tied into, paying large dividends, it leaves little room for innovation and in fact encourages management to all but eliminate risk taking by continuing to squeeze sales of their current drug portfolios.
 
Since the rise of the technology sector in the early 2000s, new fledgling healthcare companies have led the charge in implementing the use of technology into their business models in order to tackle the rapidly evolving global healthcare market. Many such companies, now operating in the newly established medtech segment, have helped turn the sector from a purely secondary provider of finished goods in the form of drugs and medical devices, to a blended secondary and services sector, providing a wide range of expertise and products for consumers and businesses.
 
The medtech industry, and its services segment especially, has flourished since the start of the pandemic. Companies such as Teladoc Health, who provide virtual healthcare and telemedicine services, have helped improve patient accessibility and connectivity with doctors and nurses during a time when face-to-face consultations have been kept to a minimum.

In fact, the COVID-19 pandemic is the perfect example of why medtech companies are far better positioned in the market than traditional pharmaceutical companies. While the latter have scrambled to either create a COVID-19 vaccine, with some more successful than others, or encourage sales of their usual drugs, the medtech industry has been able to leverage their technological business models to better serve their customers during this time and, ultimately, reward investors. Companies such as Teladoc were already operating within a growing market and tackling the problem of poor rural access to healthcare professionals, but due to their agile business models they have been able to continue to tackle the changing nature of patient problems, even during a pandemic.
 
As for big pharma, the question of both its relevance in today’s society and its ability to thrive long term, remains. Many would argue that such companies have missed the boat, failing to invest R&D Dollars into innovative and growing areas of the market, leaving many medtech companies now either too large to purchase or unwilling to partner, afraid of being swallowed up and forgotten by upper management and happy with their growth trajectory. Coupled with shareholder demands in the form of buybacks and hefty dividends, it does not paint a rosy picture for the established pharmaceutical companies. The lack of early innovation and inability to now pivot means that they are effectively stuck in place, as many have been now for years, producing mediocre returns at best while their medtech rivals continue to grow, flourish and innovate.

This article was taken from the Spring 2021 issue of the publication, 1875. To sign up for our investment publications please visit www.redmayne.co.uk/publications.

Please note that investments and income arising from them can fall as well as rise in value. This communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned.
 
The Rise and Fall of Big Pharma
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