The 2.6 Billion Dollar Pill

Pharmaceutical companies earned an estimated $300 billion in profits in 2024. In fact, pharmaceutical industry profits have grown unstoppably for more than 50 years, both as a percentage and in absolute numbers. Selling drugs is more profitable than ever.

And drugs are indeed the mainstay of Pharma: 75% of the industry's sales, and 90% of the profits, comes from prescription drugs – the rest being medical devices, diagnostic equipment, skincare, supplements, etc. And to be precise, it’s mainly blockbuster drugs (those with yearly sales of over $1bn): In 2023, just 50 products accounted for 600 billion dollars in sales, about 40% of the overall prescription drug business.

To the industry, these blockbuster drugs are incredibly lucrative: On average, they sell $4bn per year at margins of 40%. To the user, they are extremely expensive: Trikafta, the only available treatment for Cystic Fibrosis, costs about $326,000 per year in the US, and sells over $9bn per year with margins of around 90%.

Is that justifiable? Should we break out the pitchforks and head for the nearest corporate headquarters? Perhaps surprisingly, the answer is no. Yes, we're with the Big Pharma on this one: These astronomical prices are in fact justified by the economics of failed development, and they’re vital for innovation.

But that doesn’t mean that Pharmas are saints, not by a long shot. In fact, keep the pitchforks close by – they may yet come in handy.

Thanks for nothing, 1980s

Abusive corporate behaviour is not new to the world, as a quick glance at the East India Company's human rights record will confirm, but the particular flavor of ruthless capitalism we know today has its origins in the 1980's, when we handed the world over to, well, ruthless capitalists. 

The ascent to power of Thatcher, Reagan, and the Chicago School of Economics' ultra-liberal posse, combined with the fall of the Soviet Union in 1991, opened the current era of post-politics where where the market laws reign undisputed. “There Is No Alternative” (TINA), as Maggie Thatcher famously put it.  

I don’t mean to dig into the comparative merits of liberal economic policies (although you might guess I do have an opinion), but one thing is dead certain: the rich have gotten a lot richer ever since.

On the Pharma front, decreased government regulation meant increased drug prices, patent manipulation, and extreme corporate profits. Between 2000 and 2016 US drug prices grew by 300% (inflation was about 60%), and a vial of insulin now costs 14 times more than in 1996, while salaries multiplied by 2.3 in the same period. Patent laws were conveniently modified to prolong exclusivities, and Pharma companies started making extremely serious money.

* Most of these considerations are less extreme in Europe; our corner of the world, often criticised by its impenetrable bureaucracy, did not fully embrace these policies, and thus safeguarded drug prices. Today, prescription drugs cost in average 4 times less in the EU than in the US. Still, European Pharma profit margins are in the 15% range, which isn’t bad.

The Economics of Compensation for Failure: it's not greed, it's mathematics.

But let’s be careful: developing a new drug is indeed a financial black hole. On average, bringing a new medicine to market costs about $2.6 billion and takes 10 to 15 years. This includes R&D, clinical trials, regulatory approvals, and – most importantly – all the money that just vanishes into thin air when a drug prospect fails. And they fail a lot.

About 90% of drugs that enter clinical trials never make it to the pharmacy shelf. That’s nine out of ten projects flushing millions of dollars straight down the drain.

In the last ten years, the Pharma industry has lost a trillion dollars in failed drug developments.

Roche, for example, sank $1 billion into the failed Alzheimer drug Crenezumab in 2022, and lost 500 million more when its Semamipod treatment for Crohn’s disease failed to show efficacy in Phase III trials. BMS lost 800 million with the antitumoral BMS-986205, and Novartis’ Aliskiren for hypertension had to be cancelled due to safety concerns, burying 500 million.

The cost of those failures has to be recouped somehow, and - you've probably guessed it - they are simply built into the price of drugs that do work. Inflating the price of new drugs makes it possible to offset the costs of cancelled developments, and makes drug companies less afraid of failure. In this way, they can continue to invest untold amounts of money in potentially useless developments.

A good example of this is Alzheimer’s drugs: Since 1998, over 146 potential Alzheimer's treatments have failed, while only four have been approved. The failure rate is staggering, yet companies continue investing because a single successful treatment could bring in tens of billions per year.

Twisted as it may seem, overpriced drugs are an engine of progress, and without them, the rate of medical innovation would arguably be slashed.

* Cancelled drugs are not always a total loss for society: Regulatory and market changes brought the development of Sanofi’s Fexinidazole for Sleeping Sickness to a halt after an investment of over 350 million Euro. Sanofi then graciously donated the research to the non-profit organization DNDi, who continued the trials and eventually got it approved by the EMA. Today, the drug is administered at cost or for free to patients in endemic countries in Africa like Congo, Chad or the Central African Republic. Kudos to Sanofi!

Price hyperinflation: has Pharmageddon arrived?

Drug companies spend fortunes on R&D, and they need to recoup their losses; that’s undeniable. But it’s also apparent that governments across the world are stepping up the fight against what looks, increasingly, like rampant corporate greed.

For example: Pharmas spend 2 to 3 times more money on marketing than on research: 800 billion versus 350 billion on R&D (and that is if we include the money spent on acquisitions in the calculation). An inconvenient truth when arguing that inflating drug prices is necessary to fund innovation.

Take AbbVie's Humira, one of the best-selling drugs in history. Over the past 20 years, AbbVie has spent approximately $20 billion on R&D... but $40 billion on marketing and lobbying. The strategy worked: Humira generated $200 billion in revenue before its patent protections finally started expiring. Even then, US lobbyists managed to extend Humira’s patent protections five years after they had expired in Europe, raking AbbVie an extra $60 billion.

Or insulin: Discovered in 1921, it's  8 to 10 times more expensive in the USA than in most other high-income countries. Meanwhile, Eli Lilly, Novo Nordisk, and Sanofi – three companies that control 90% of the global insulin market – pocket 60-80 billion dollars annually at an 80% margin.

The situation has finally woken up governments and regulators, who are now pushing back by targeting inflated drug prices and extended monopolies.

In the USA, Medicare price negotiations are set to begin in 2026, and they will allow the US government to negotiate drug prices for the first time in history, a move that could significantly cut into Pharma’s profits and set a precedent that will force the industry to adjust its pricing strategies globally.

On the Old Continent, European nations are tightening price caps, regulators are tightening patent laws, and biosimilar approvals are accelerating: The global biosimilar market is projected to reach $100 billion by 2028, and as generics eat into Pharma’s most lucrative products, revenues will inevitably shrink.

It's pretty clear: the days of charging $77,000 per year for a drug in the U.S. while selling it for $23,000 in Switzerland are numbered. Companies that rely too heavily on blockbuster drugs will be hit the hardest, particularly those with major patent expirations looming.

All in all, Pharmas could indeed reduce their excessive margins, stop their aggressive lobbying, allow for competition (which would contain prices), and spend less money on marketing, all of that would still leave them with untold billions in profit, and would make healthcare a lot more sustainable.

But that's not going to happen, so what can a humble investor do about it?

Will this hurt Biotech investment? Not at all!

In fact, it will help. On top of pricing concerns, Pharmaceutical companies are facing a massive wave of patent expiration over the next decade (the "patent cliff"). As a lot of major drugs are going off-patent in the next 5 years, Pharmas can face loses of about $200bn – and the option of hustling governments into allowing them evergreening (“extending irregularly”) monopolies seems to be off the menu.

This is why Pharma will have double down on biotech acquisitions. Instead of relying on internal R&D, they will continue to buy innovation from smaller, agile biotech firms. Big Pharma's desperation to maintain profits is fueling a new wave of M&A and licensing deals; 2024 already showed a pace surpassing the previous six years, and the rate of startup acquisitions in 2023 was the highest since 2015.

With threats to its profits growing, the pharmaceutical industry's need for innovation is growing. If you own shares in biotech startups with clinical developments, this should be good news.