Get Big Enough (But Not Too Big) To Source Innovation

Like all companies in the pharmaceutical industry, Eli Lilly and Company knows it needs to grow revenues, profits and shareholder value through constant innovation. When the internal R&D engine will not generate enough to meet growth demands, many industry participants pursue external sources. What we believe makes Lilly different from most of its peers is that it has pursued a collaborative strategy of innovation leverage over headline-grabbing merger and acquisition approaches. With the right critical mass internally, Lilly aims to build truly win-win relationships with other leaders and maintain a reputation of Partner of Choice. The Situation To better understand why this path makes the most sense to Lilly, let's begin with the situation that faces all pharmaceutical companies today. The drug discovery business is one of high risk. Less than 1 percent of drug discovery efforts will result in a commercial product. Those that succeed will take 10 to 15 years to reach the market, with an average invested cost of nearly $0.5 billion. Complicate this equation with the fact that only three of ten products produce a profit and you can see why shareholders expect a high return for this level of risk. Investors demand total shareholder returns on the order of 18-20 percent annually. The Complication The trouble with the products that pharmaceutical companies launch is that they have a limited patent life. Once the patent life expires, the company's return from that product plummets. If the product was a blockbuster, the impact can be enormous. For instance, when Prozac's patent expired, Lilly could expect to eventually lose this $2 billion investment--and as much as $1.6 billion in one year. The company must replace that income and build the business to maintain growth expectations. A further complication is the increasing competition in the pharmaceutical marketplace. In years past, a similar me-too drug launched following a competitive product could expect to produce sufficient return to warrant R&D investment. Today, the fast-moving market places much higher hurdles, which drives pharmaceutical companies to seek more innovative products. Innovation is the key to producing differentiated products and delivering expected shareholder returns. More and better means more shots on goal. As a result, pharmaceutical companies have a voracious appetite for innovation. So what happens when the pharmaceutical company realizes that its internal R&D engine cannot produce in sufficient quantity, quality and diversity to meet the needs of its growth plan? This is the industry's most critical problem, and the basis for this article's discussion. Expansion through Acquisition The merger and acquisition option has been the solution of choice for much of the industry's recent history, especially during the 1990s and up until today. The choice was, in part, based on the presumption that is scalable. That is, it assumes, first, that means more and better chances to develop the right molecules and technology, and second, that the bigger a company is, the more it can develop--almost in one-to-one increments that could be graphed as a simple, ascending straight line. After ten years, it now seems clear that for the most part this strategy did not work--or at least it did not get, and still is not getting--the results expected. Merged companies have generally enjoyed slower sales growth than non-merged companies. Companies that never merged, experienced sales increases of 15 to 20 percent between the middle and end of the 1990s. Merged companies in that period experienced sales increases between 2 and 12 percent. Most important, merged companies typically experience a decrease in innovation--not an increase. For instance, a study of 22 merged companies by the Boston, Massachusetts information services company Centerwatch shows a 25-percent reduction in products in the pipeline one year after a merger--and one-third fewer in the pipeline three years out--even with new innovations added to the pipeline since the merger. …