Pharmaceutical companies dream of blockbusters: drugs that quickly run up sales of more than $1 billion. But developing and marketing such drugs has become so expensive that only the largest companies can afford to do so; hence, the recent string of mergers within the industry. Notwithstanding such high-profile combinations as those between Glaxo Wellcome and SmithKline Beecham and between Pfizer and Warner-Lambert, the pharmaceuticals industry hasn’t consolidated very much: the 20 biggest competitors combined still have less than 60 percent of the global market. The next 50 or so companies, with revenues of $500 million to $3 billion, increasingly look like candidates for acquisition, mainly because their performance trails that of the leaders. If current trends continue, the global market share of midsize companies could shrink from 20 percent in 1999 to just 10 percent by 2010 (Exhibit 1).

Yet the midsize pharmaceutical companies do have a shot at reviving themselves. A clutch of emerging technologies would make it rewarding for them to develop and market drugs that tackle the less prevalent diseases big companies tend to overlook. At the same time, it will become easier—and more profitable—for midsize companies to in-license drugs developed by other companies for small-scale markets and to out-license potential blockbusters to big companies, which can market them more effectively.

Over time, of course, these developments should affect the economics of big companies too. They might respond by moving into the new territory of the midsize companies, which must therefore stake claims before the rush.

Blockbusters: Out of their league

In recent years, midsize pharmaceutical companies, on average, have had smaller operating margins and produced lower total returns to shareholders than have their larger counterparts. Although the individual situations of midsize pharma companies differ considerably, they do have a common predicament: an inability to play today’s blockbuster game. If you include the cost of projects that fail during development, researching and developing a new drug costs, on average, $700 million—three times what it did 15 years ago. The number of participants in clinical trials has tripled in 20 years. And the cost of launching a blockbuster has more than quintupled in only six years, from $75 million in 1993 to $400 million in 1999. Today, for a midsize pharma company, financing a full-scale blockbuster means betting the business.

Not surprisingly, the attempts of midsize pharmaceutical companies to launch their own blockbusters on the cheap have fared rather poorly: their drugs for depression and ulcers won only a few points of market share—not enough to recoup even a relatively meager investment. Midsize companies that happen to own a leading drug in a large and growing disease area now find themselves threatened by big companies attracted to the area’s potential profits.

But big pharmaceutical companies too are in a fix. The investment community has punishing expectations of their future earnings growth, as the sector’s high multiples indicate, and their R&D costs are spiraling upward. Competitors’ products can reproduce the effects of newly launched drugs within six months, instead of the two years it took to catch up a decade ago. And as soon as a patent on a drug from a big company expires, generic-drug manufacturers swamp its markets with cheap copies.

Only the revenues and profits from a steady flow of blockbusters can alleviate all of these pressures simultaneously. Consequently, blockbusters are increasingly the focus of big companies. The share of total pharmaceutical-industry revenues attributable to them grew from 6 percent in 1991 to 16 percent in 1998, and for some big pharmaceutical companies that share has reached more than 50 percent. Big companies now devote almost their entire marketing and sales budgets to blockbusters, leaving smaller-scale drugs only the scraps. Big drugs also demand an equally unbalanced share of the time and effort of managers.

A place for smaller products

The giants’ disdain for small drugs could work to the advantage of the midsize pharma companies

But the giants’ disdain for small drugs could work to the advantage of midsize companies. Although sales from treatments for disease areas that are well below blockbuster scale—such as epilepsy, hormone deficiencies, and multiple sclerosis—may range from only $150 million to $450 million a year, those are relatively large figures for a midsize company. For example, Schering’s revenues from Betaferon, the multiple-sclerosis drug the company launched in 1994, swelled to more than $450 million in 1999. The drug is now Schering’s most important product, contributing 12 percent of total revenue. Genentech’s drug Kogenate, launched in 1993 to treat hemophilia, a disease affecting a total of 35,000 to 45,000 people in Western countries, grossed $400 million in 1999. Sales of Gonal-F, a fertility-promoting hormone launched by Serono in 1996, grew to $350 million in 1999, widening the company’s lead in that treatment area.

Companies find that they can achieve high prices for drugs targeting small disease areas. Such drugs generally address significant unmet needs for a relatively small patient base, so spending on them still amounts to a small proportion of any health care payor’s bill. In addition, small drugs cost less to bring to market. They are cheaper to launch than blockbusters, and their ongoing marketing costs are lower, since their target markets are both much smaller and easier to reach, often comprising just one community of specialists rather than the mass of general practitioners. Development costs, too, are lower, for clinical trials of such drugs can use correspondingly small patient samples and take less time to complete.

Indeed, several emerging technologies are bringing down the cost of discovering, developing, and marketing drugs in general. The human-genome map makes it easier and cheaper to identify gene abnormalities that could cause disease. Advancing technology is making it simpler to replicate genes used in laboratory tests of new drugs. Combinatorial chemistry is speeding up the process of developing a wide range of drug candidates for each target gene. The use of robots to monitor the results of in vitro testing has cut the cost of tests to determine drugs’ efficacy. All these technologies are now available to midsize companies, which can apply them to small-drug research. Moreover, "e-trials"—the electronic monitoring and collection of data from trial participants—have already reduced the development costs of the typical small-scale drug by up to 20 percent, or $100 million. On the marketing side, the pharmaceutical companies’ World Wide Web sites are cutting the cost of giving doctors information, with no reduction in quality.

From about 2005 onward, pharmacogenomics will probably cut development costs further by permitting researchers to determine how a patient’s genetic makeup is likely to affect the way he or she responds to a particular drug, thus eliminating the need to amass patient samples (at the trial stage) that would be large enough to approximate the diversity of possible users.¹ In the future, it is conceivable that pharmacogenomics will fragment disease areas and thus make it possible to develop a larger number of smaller drugs better suited to the genetic makeup of each individual patient. Indeed, pharmacogenomics may spell doom for the blockbusters, and that would of course improve the viability of midsize companies.

The smaller disease areas open to midsize companies include "orphan diseases," so called because of the small number of people they affect and the correspondingly small profits that come from treating them. This category covers a wide range of disease types, including genetic diseases such as cystic fibrosis, unusual cancers such as retinoblastoma, neurodegenerative diseases such as Huntington’s chorea, and certain rare viral infections. Because caring for people who suffer from a condition of this kind as they slowly deteriorate is expensive, companies can charge high prices for drugs that offer some hope of cure or at least release from continuing hospitalization. Moreover, a number of laws, notably the US Orphan Drug Act of 1983, offer these companies tax credits, grants for clinical trials, and a seven-year period of exclusive marketing rights. (Exclusive marketing rights prohibit "me too" products from entering the market. Patent protection bans exact copies only.) The European Union is developing similar legislation.

Despite such initiatives, existing treatments for orphan diseases generate estimated revenues of only $3 billion to $5 billion a year. Yet the higher prices and lower R&D and marketing costs of drugs developed for smaller disease areas—orphan diseases included—generate better margins than small companies would earn if they attempted to develop blockbusters (Exhibit 2). New technologies will improve the margins even more. Should all such drugs, covering a large number of diseases, be developed, the market for them could be as large as $200 billion.² But the absolute returns from those drugs would still be too small to invite competition from big companies, at least for the time being.

Freedom to license

Midsize companies keen to develop and market drugs for small disease areas might consider increasing their reliance on in-licensing and marketing products that other companies have developed.³ They might also try to get bigger companies to market products they have developed themselves. In fact, however, as a proportion of revenue, midsize companies are now involved in 25 percent fewer licensing deals than are big companies. That proportion is likely to climb as the whole pharmaceuticals industry moves toward a "free market" in products, in which the company best equipped to develop and market a drug does so, regardless of where it was discovered.

Although midsize companies are hardly marketing powerhouses on the order of their big competitors, they do have a role to play as in-licensors of other companies’ drugs for smaller disease areas. Midsize companies will find that course more rewarding than developing such drugs by themselves (Exhibit 3), and they are probably more attractive partners than big companies for biotechnology firms or for other midsize companies. Midsize companies can often afford to pay generous royalties on sales of a small in-licensed drug. They are likely to work harder for small products, which form a greater proportion of their portfolios: their sales reps would tout a new $150 million drug first or second in a pitch to physicians, something a big company’s reps probably wouldn’t do. And a single $150 million success would be enough to lift a midsize (but not a big) company’s revenue growth above the industry average. In short, more in-licensing by midsize companies of small products owned by big ones would contribute to the well-being of both. Two midsize companies, Schwarz Pharma and Shire, are already honoring this reality in practice.

Furthermore, midsize companies that happened to develop potential blockbusters have found it more profitable to out-license them to big companies than to market them alone. For example, Zyrtec, an allergy drug from UCB (Union Chimique Belge) Pharma, and Pliva’s antibiotic Zithromax were both out-licensed to Pfizer. Zyrtec and Zithromax had 1999 revenues of about $850 million and $1.3 billion, respectively. By contrast, Luvox, the first Prozac-like antidepressant, was developed and marketed by Solvay Pharmaceuticals. Today, Luvox has sales of around $250 million; Eli Lilly’s Prozac, of some $3 billion.

Think small before big pharma does

In time, big pharmaceutical companies will realize that they are not getting satisfactory returns from blockbusters. When they come to their senses, they may seek to exploit smaller markets, possibly by spinning off units or acquiring midsize companies. Novartis has already announced that it intends to create separate business units (in effect, internal midsize companies) that concentrate on transplantation and oncology. At the other end of the spectrum, biotech firms may want to become fully integrated players—the logic underlying Celltech’s January 2000 acquisition of Medeva. Midsize companies therefore need to build defendable positions in smaller disease areas. Where should they start?

Choose the right diseases

Before concentrating on a particular disease, companies need to know its potential return—which is known, rather awkwardly, as the "disease profit pool"—and how easy it would be to capture and defend a sizable share of it. We define this pool as the difference between annual revenue from the treatment of a disease and the cost to the industry of providing treatment.

Consider multiple sclerosis. Today the total worldwide revenue for multiple-sclerosis drugs (mainly interferon drugs) is roughly $1 billion. The cost to the industry of providing the treatment is estimated at $500 million a year, leaving a current disease profit pool of perhaps $500 million. For the time being, this is too small to invite competition from big companies. What is more, the potential disease profit pool is much bigger, since at present probably just half of all potential patients actually receive the treatment.

A company can work out how much of any disease profit pool it can capture and defend by comparing its strengths in attacking the disease—its product and project portfolio as well as its marketing, licensing, and financial capabilities—with those of its competitors. Analyzing diseases in this way allows a company to plot them on a "disease choice" map (Exhibit 4). In general, a midsize company should avoid diseases that will put it in head-to-head competition with big companies. Similarly, it should avoid diseases that affect very few people and have generated little research, since R&D costs will be excessive and the returns small. These exceptions draw a boundary around the "solution space" of diseases that midsize companies could profitably tackle.

To get the most from an investment, companies should choose groups of diseases that have, for example, approximately the same pathophysiology, set of symptoms, or class of treating physician: the action of the drug or the therapeutic technology underlying the success of a treatment (or the marketing approach) for one of these diseases may succeed for another. Take the neurodegenerative diseases Alzheimer’s, Huntington’s chorea, and Parkinson’s. All three cause neurons to degenerate and disappear. The small Massachusetts-based company Diacrin developed a technique for replacing damaged neurons in Parkinson’s patients with neurons from pigs and has since found that the same treatment is effective against Huntington’s. Moreover, neurosurgeons are the decision makers on treatment for both diseases, simplifying Diacrin’s marketing task.

Over the next five to ten years, the shape of the solution space for all midsize players will change. Emerging technologies will make it profitable for them to develop treatments for more diseases and diseases affecting fewer people. But midsize companies will find it increasingly hard to protect disease profit pools, especially large and growing ones, from big companies, as the same technologies also lower their "profitable boundary." Thus a midsize company should choose diseases for tomorrow’s solution space, not just today’s.

Build partnerships

Few midsize pharma companies will be strong enough to tackle all of their chosen diseases alone

Few midsize companies will be strong enough to tackle all of their chosen diseases alone; most will need to find partners. Besides the usual types of partnership (see sidebar, "Conventional partnerships"), midsize companies might consider some novel forms. To discover drugs, for instance, they could join forces with leading biotech companies or with other midsize companies. Several midsize European companies (for example, Schering and Serono) have significant strengths in women’s health, owning birth control and fertility drugs as well as treatments for hormone deficiencies. If these companies shared their knowledge of this family of drugs, they could speed up its development and reduce their costs.

Similarly, by coordinating sales forces, midsize companies could market their respective products throughout a greatly expanded geographic area. Members of such an alliance might first sell each other’s products under license and then give responsibility for all sales in a region to the member based there. Eventually, the alliance might build a common portfolio of products (rather than collaborating only on particular items), co-develop new products, or share manufacturing capacity. That approach could achieve some of the scale economies that big companies enjoy, without sacrificing the small-market niche that midsize companies occupy.

Midsize pharmaceutical companies may have a bright future after all if they target smaller disease areas and exploit the new freedom to in- and out-license drugs. The most successful midsize companies will build on their strengths in specific disease areas or in functions such as discovery or marketing, and they will rapidly forge partnerships to secure defendable positions treating the most lucrative diseases. Executing these strategies could substantially increase the market share, the value, and, indeed, the sustainability of midsize companies.