Few US industries demonstrate preeminent creative and financial world leadership year in and year out, but we can think of two that look forward to continuing blockbusters that will provide mountains of new cash followed by consistent follow-on revenues. In both arenas, an idea is calculated to be something that people everywhere will want, so it is launched with a huge bolus of cash and a cash burn that almost takes its company to the brink. Both industries capitalize on new intellectual property (IP), and both currently face unprecedented threats from counterfeiters. One is the pharmaceutical industry. The other allows us to draw some surprising parallels.
Background
Pharmaceuticals are products everyone needs, and their universality transcends borders. Today, the drug industry faces new and unprecedented competitive pressures. It is under assault on multiple fronts — from consumers, governments, and even from within. Patents on major drugs continue to expire while companies struggle to produce innovative breakthroughs that will offset the impact of generic substitutes. And in the United States, the drug industry has fallen out of favor partly because its lobbying and marketing strategies are infuriating Americans who are sick of paying higher prices than foreign consumers do in price-controlled countries. To them, it rings painful to give affluent Canadians and Europeans a better deal than those whose tax dollars defray the costs of drug development.
Government and consumers have a vital interest in supporting a robust prescription drug industry. A dearth of productivity in research and development combined with soaring development and launch costs has driven pharmaceutical companies to look for short-term solutions. But such strategies do not offer long-term, sustainable solutions, nor do they address root problems. Mergers and acquisitions can generate the scale needed to fund new research technologies and find new products internally, but the growth of “merged” R&D budgets has outpaced company management’s ability to control such activity. Increased sales forces can mine earnings from already in-market products, but besieged doctors increasingly avoid them. Partnerships and alliances with other companies can back-fill empty pipelines, but multiple alliances and partnerships create such a diversity of culture that management of cultural expectations often supersedes management of related processes.
Superior science will not guaranty success in the future market. The major therapeutic categories are crowded, and the needs of lesser therapeutic categories remain unfulfilled. As communications companies discovered a decade ago, without new markets to exploit, vertical integration through mergers and acquisitions just creates monopolies — and monopolies are by definition self limiting. For everyone facing increasing healthcare costs and diminishing insurance coverage, the industry must find a way to derive more equitable remuneration (and profitability). Reliance on blockbuster drugs, mergers, acquisitions, and price increases is not a sustainable business strategy. Reinvention is the clarion call and as the drug industry wrestles with various models to harness the capabilities of its organizational structures. A dynamic global business environment demands the ultimate objective of unleashing the human potential within. We need only look to the term blockbuster for help.
The Other Industry
The nebulous and ubiquitous “They” say that everything old is new again. And so it is that we must search the old for the new that will revolutionize our future. The “old” we refer to is not so old, and it is familiar to everyone. This “other” industry came of age just ahead of pharmaceuticals, and it was beset with similar problems decades ago. So we have a successful model to study.
This industry was started by a group of businessmen who lacked even the rudimentary skills required for their business. But they recognized the value of their product and the marketplace, so they overcame significant obstacles to create integrated organizations that would control the total value chain from conception to consumption, and they controlled every element of it. They made movies. Let there be no misunderstanding: Hollywood was a factory. The original studios were out to make money first and art second. They were efficient, productive, and profitable — and still creativity flourished.
In the 1950s, Hollywood faced a crisis very akin to the drug industry’s scenario today. Its distribution network was shattered by forced divestiture of theaters, and it no longer dictated market prices. It faced new competition from the developing television industry and myriad other leisure-time activities that were becoming available to increasingly affluent consumers. The industry overcame its dilemma, however, and today it remains highly productive and profitable.
In the beginning, there were five principal studios. They were vertically integrated, each having its own production space and theaters. They produced, marketed, and exhibited all their own films. On the periphery, there were the so-called “little three,” none of which was vertically integrated. Two produced their own films, and one distributed films made by other independent companies. All three had to use the “big five’s” theaters.
The studios kept those integrated theaters supplied with a steady flow of new films. They controlled each stage of a film’s life: production (making the film), distribution (getting the film to theaters), and exhibition (showing the film to paying audiences). They controlled all internal activities such as casting, contracts, and developing stories for editing as well. Each produced roughly 50 films per year (but could make many more), and each had its own style. The studios further focused their portfolios into subspecialized, genre-based productions, providing opportunities to improve on standard formulae, reuse sets/stars/costumes, maximize efficiencies, and generate audience loyalty. Distribution of movies was accomplished through a studio-operated bidding system in which, of course, the studios set admission prices for their films.
But in the late 1940s, things changed. First, a number of federal court decisions forced the studios to end their discriminatory distribution practices. In 1948, the Supreme Court ordered divestiture of their theater chains. Television began to deprive Hollywood of large segments of its audience, and the industry reacted timidly and late to the possibilities that new medium presented for diversification. Finally, the House Committee on Un-American Activities investigated the industry, which responded by black-listing several of its prominent screenwriters and directors — an action that called into question its reliability as a promoter of unfettered creative talent.
The effects of those developments were immediate and long lasting: Box-office revenues dropped. The number of films made yearly declined, and the industry desperately sought solvency in blockbusters rather than in the solid but unspectacular products that had brought it a mass audience before the age of television. Hollywood experienced unprecedented unemployment because those blockbusters were too few and too unpredictable to sustain a struggling industry.
The Changes They Made
In response to this cataclysmic loss of profits, Hollywood underwent a profound reorganization. Following the 1951 lead of United Artists, the major studios backed away from production (its costs having contributed heavily to their decline) and restructured themselves as loan guarantors and distributors. At the same time, most of them became subsidiaries of conglomerates that were looking to television sales and other entertainment contracts for supplemental revenues — a dramatic shift from vertical to horizontal integration.
Without vertical control, the studios could no longer stifle competition from and among independent producers. Creative by nature, such people were able to drive new models, so new relationships evolved. In these new contractual relationships, the independent producer assumed a central role replacing the studio mogul as chief executive. Producers brought together the various properties associated with their films (actors, directors, book rights, and so on) to create a “package,” often financed independently but distributed by a film company in exchange for a share of the rental receipts. This is the package unit system. Working with conglomerates and accepting the reality of a permanently reduced market, private promoters revitalized a declining industry.
The rise of independent production was accompanied by diversification of subject matter, with attention to the interests of specialized audiences. This trend, which began as an attempt to capture the “art house” audience and the youth market, is evident today in the success of martial-arts, rockmusic, pornographic, documentary, and comic book films, to name a few. Simultaneously, production has moved away from the Hollywood sets to location filming. For many producers, shooting in foreign countries (with less regulation) has given modern films a new international texture and appeal to foreign markets, which have also become increasingly important.
MAKING MONEY HOLLYWOOD STYLE
An example of unleashed potential is the 2000 film, Gone in Sixty Seconds, an action-thriller that was released to little acclaim and disappointing box-office returns. The company that produced it, Touchstone, is part of the Disney empire. That year, Disney touted the global box-office revenue of Gone in Sixty Seconds as $242 million — not bad. Even if theaters kept $139.8 million from ticket sales, Disney still took in $102.2 million. Surely there was a profit in there somewhere?
Not necessarily. The physical production of the movie cost $103.3 million. Prints cost $13 million. Insurance, taxes, and customs clearance came to almost as much. The studio spent $42 million for advertising in North America and a bit more than half of that for the rest of the world. Disney paid out $12.6 million in residual fees and figured in $17.2 million for overhead and $41.8 million for debt service — for a total negative cost of $265.3 million, more than double the studio’s take of the box-office receipts.
So how did Disney make money from this film? The answer is in the “clearing-house.” The company never expected to profit from theatrical release of Gone in 60 Seconds, but it did count on harnessing a whole river of money from the rights to the intellectual property it had created. By 2002, Buena Vista Home Entertainment International, another division of Disney, had reaped $198 million in sales and rentals from Gone in 60 Seconds videos and DVDs. Only $19 million of that sum was credited to the movie itself, though, thanks to the complicated royalty system that Hollywood uses — an important accounting trick because the movie’s star, Nicholas Cage, was contractually entitled to 10% of its video gross.
In coming years, Disney can expect a steady, if diminished, stream of income from home-video sales of the film. But there is more. HBO paid the company $18.2 million (of which only $2.7 million was subject to residuals) for rights to air it. Once that deal expired, Gone in 60 Seconds migrated onto cable’s TNT network for another payout. And Disney will continue to collect money whenever domestic cable or network television shows the film. In a few years, local TV stations will fork over to Disney still more millions when their window finally opens on purchase rights. Still later there will be cash from foreign TV markets. And don’t forget income from product licensing and soundtrack sales.
That’s making money Hollywood style (www.edwardjayepstein.com/wsjreview.htm).
A Model for the Future Past
Today the pharmaceutical industry faces three issues similar to those that almost destroyed Hollywood: Regulatory decisions are forcing the end of discriminatory distribution practices, generics are depriving industry of large segments of its market, and US Congressional scrutiny is increasingly focusing on prominent individuals and particular products (which calls into question the industry’s reliability as a provider of health needs). The drug industry has an opportunity to reinvent itself before government mandates force an unintended change. The package unit system model revitalized the movie industry at a critical juncture, and many of its attributes find corollary today in the pharmaceutical industry, albeit for different reasons and objectives.
Moviemaking is still a risky business. Only one in 10 films ever retrieves its investment from domestic exhibition, and four out of 10 movies never recoup their original investment. Compare this with the pharmaceutical industry, in which the average drug takes over a decade and several hundred million dollars to make it to market. Less than 1% of the compounds examined at the preclinical stage make it into human testing, and only 22% of those entering clinical trials make it to market approval. Of those, three of 10 new drugs make back their investment costs. Orders of magnitude may differ, but higher risk requires the prospect of greater reward to justify investment. Drug companies need to be profitable to generate the private funds that fuel their research. In the end, it’s all about money for the stakeholders.
The key to the package unit system model is in control of intellectual property, not manufacturing activity. Diminishing intellectual property is a root cause of Big Pharma’s decline. Outsourcing R&D, whether through licensing or acquisitions, is only a temporary stop-gap measure. Significantly, the biotech models used to defend the current business models actually demonstrate the feasibility of the package unit concept. Producers (or more correctly, entrepreneurs) assemble a script/drug, actors/operations, and director/project team, then seek the financial backing of venture capitalists. Along the way, distribution is usually negotiated with an existing pharmaceutical modality. The object realization of the simplicity of this model becomes increasingly more apparent as “virtual” companies appear with increasing frequency. The drug industry has adopted much from the California biotechnology experiment but sadly still seeks revenue much the same as it did in 1950 — from controlled distribution and prices.
Today, drug profits come in large part from patent protection and the maximization of profits during a protected period. To recoup enormous investments, the movie industry also relies on a carefully planned sequential release of movies, first releasing feature films in cinemas, then to home video, and then to other media. This release sequence not only provides the best financial return for the studios, but it also provides consumers with choices as to how they wish to view movies, and when. This carefully planned release sequence, which includes intervals for each specific medium known as distribution windows, are vital to the health of the industry. Companies strictly control the life-cycle of their products, too, by carefully managing the IP protections vis-à-vis economic return.
A Model for the Future Present
Digital reproduction technology is seriously affecting established IP principles, and today’s drivers for moviemakers parallel those of the pharmaceutical industry even more closely. The synergies are dramatic. The Motion Picture Association of America (MPAA) estimates that the US motion picture industry loses >$3 billion annually in potential worldwide revenue due to piracy, and that doesn’t include Internet piracy losses. Money is lost when piracy of a film occurs at any point in the release sequence, but when counterfeit drugs enter the distribution process, people can die.
Patent rights have been the heroes and the villains of the pharmaceutical industry. On one hand, they protect profits; on the other, they inhibit innovation whenever broad-based patents block the next generation of discoveries. Scientific research flourished under the academic models of the 20th century. Perhaps industry as a whole could do better when “content” gets spread far and wide and companies build off each other’s creative works rather than compete secretively. The patent holders of successful products bear the risk, make the investment, and see many other efforts crash and burn beside them — and some emerge with a successful product. They essentially earn the right to charge prices that maximize their monopoly profits. Patent protection, however, is not an all-or-nothing affair. Patents create only the possibility of monopoly. Individual companies prosper based on their acumen, management, and sometimes just good luck.
Other industries use patent laws for expansionary purposes rather than restrictive objectives. For example, radio stations deal with the IP rights in the songs they wish to broadcast by forming clearing-houses for the acquisition of such rights. Publishers do the same, and so do many movie companies. Even the fashion industry is based on intellectual property and creativity. However, designers realize that locking up such creativity is impossible — and even trying to do so only ends up doing much more harm than good. Instead, they constantly innovate and push the boundaries to create new and better things. More to the point, designers understand the power of brand and marketing — and they know that people will pay much more for a respected brand.
Because patents matter more to the pharmaceutical industry than to others, participation in patent pools that undermine the gains from exclusivity would require serious redirection. Nevertheless, there are venues to ensure fairness. IP relations between the United States and most foreign countries are governed by an array of multilateral treaties and conventions as well as bilateral agreements. Various trade agreements such as the Trade Related Aspects of Intellectual Property Rights (TRIPS) agreement and World Intellectual Property Organization (WIPO) treaties also ensure the free flow and protection of intellectual property among nations.
Congress created “Special 301” when it passed the Omnibus Trade and Competitive Act of 1988, which amended the Trade Act of 1974. This requires a US trade representative to identify those countries that deny adequate and effective protection for IP rights or deny fair and equitable market access for those who rely on IP protection. Countries with the most onerous or egregious acts, policies, or practices and the greatest adverse effects on relevant US products risk having trade sanctions levied against them.
Coda
Hollywood redefined itself as a clearing-house for intellectual property, not a factory for making movies. The marketplace is loudly proclaiming the failure of the present pharmaceutical business model, and Big Pharma’s efforts to maintain the status quo will likely fail. Wall Street can’t drive the needed change because it doesn’t really understand the drug industry — only learns about it from industry spokespersons, and analysts unanimously value the old model. Perhaps some forward-thinking analysts will “get it” and calculate the potential of a collective financially as well as socially. With their initiative, a forward-thinking pharmaceutical company could recognize the potential and lead us into the future (see the “Lilly” box). The new business would be at least as profitable as the old one, but the “product” on offer would be very different.
LILLY LEADS THE WAY?
On 7 August, The Wall Street Journal reported, “In a move aimed at delivering new medicines to market more quickly and cheaply, Eli Lilly & Co. struck a $1.6 billion deal with … Covance Inc.” The drugmaker “hopes Covance’s expertise in conducting drug trials will shave months off [its] early stage product-development timeline, which could help it make faster decisions about whether to kill a compound or prioritize its development.”
According to the Associated Press on the same day, “Covance will pay $50 million for Lilly’s 450-acre drug development campus in Greenfield, IN, while offering employment to about 260 Lilly employees.” The New Jersey–based company “will use the site to provide mostly early stage clinical trial work to Lilly as part of the 10-year contract. Covance also will do mid- and late-stage work and use the site to help other biotech and pharmaceutical companies.”
It appears that Lilly may be executing the strategy we advocate here. We circulated this years ago at the high levels of a now defunct pharmaceutical company before its demise. However, once an idea is shared, it never can be extinguished. People move around and take what they learn along with them. Will you be next?
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