Health care policymakers may agree on little else, but they do largely agree that the industry’s cost structure is unsustainable.  The whole process of providing health care – including the prescription drugs that account for about 10% of total health care spending – is under the green eyeshade scrutiny of the cost cutting crowd.  Meanwhile insurance companies are increasingly uninclined to pick up the tab for a prescription drug where generic alternatives exist.  And end-consumers themselves are becoming a more central part of the economic equation, as even those with stable employee benefits find their health plans passing on more costs to them.  Prescription drugs then wind up a direct expense item on the monthly household budget, taking a place alongside traditionally more price-sensitive household staple categories like groceries and personal care products.  Those cheery pharmaceutical ads with happy, beautiful people attesting to the wonders of the latest anti-coagulant or cholesterol reducer that saturate the TV channels may seem a bit less compelling to families that have to weigh whether the factors that make those brands more expensive are actually worth the added burden to the household budget.

In particular, I see this as presenting a looming challenge to some of the current practices in managing one of the most (if not the single most) signal economic events for drug manufacturers: the transition of a brand-name drug from on patent to off patent.  Over $60 billion of on patent drugs are scheduled to go off patent between now and 2011, including such widely-known blockbusters as Pfizer’s Lipitor and Aricept, Merck’s Singulair and Sanofi-Aventis’s Xalatan.  If the fate of past blockbusters – Eli Lilly’s off patent experience with Prozac in 2001 comes to mind – is any indication of what is in store for these drug makers then we can expect to see revenue declines of 80% or more when the day of reckoning comes.

That almost looks like the pharmaceutical industry’s equivalent of the “liquidation event” so well-known in the consumer retail sector – but there is a major difference.  Virtually all of those off patent revenue declines come from volume reductions, not changes in price.  In fact, a variety of academic studies show evidence that, to the extent the drug companies actually change their prices in the approach to and immediate aftermath of exclusivity expiration, those are actually price increases, not decreases.  The calculus behind the industry’s preferred mode of competition to date has been based largely on maintenance of a significant price differential with generics based on brand loyalty and certain other means of differentiation.

This price differential is intuitively surprising given the relatively narrow scope of area for competition between originator drugs and generics (by law, generics in any molecular specification must have the same active ingredients as the originator drug, the same route of administration, similar bioequivalence and must have been produced in facilities that meet manufacturing process standards of adequacy).  However, much of the academic inquiry into generic drug price competition has affirmed the success of the drug firms to date in maintaining that differential, labeling it the “generic paradox”.  Essentially, the strategy is to identify that subset of the market to which it can continue to maintain brand differentiation, throw substantial amounts of marketing and sales dollars at that target segment, and live with the predictable revenue declines for off patent drugs while at the other end of the pipeline seeking to shepherd lots of new molecules through the FDA approval process in the hopes that the next Prozac or Lipitor will emerge onto the scene with a 14 year-plus patent protection.

What challenges this status quo more than anything else is the rise of the generic drug industry and its growing acceptance among healthcare providers, insurers and patients alike.  Generics account for about 60% of the drug market today and this sector is growing at just under 10% per year.  Wall Street analysts predict now that Teva Pharmaceutical, the world’s largest generics manufacturer, will see profits growth of 14% annually for the next five years as compared to generally flat earnings for the five largest pharmaceutical concerns.  This implies market share gains at Big Pharma’s expense.  Israel-based Teva already has a market cap ($45 billion) larger than Bristol Myers Squibb or Eli Lilly.  The company’s 37 production facilities generate over 8 billion pills each year.  The smart money seems to be saying that in a world where cost considerations dominate the healthcare landscape, the leading generic makers like Teva and Canonsburg, PA-based Mylan stand to reap the lion’s share of the benefits at the expense of the big brand names.

Unless, that is, Big Pharma figures out a different way to fight back.  The industry does not lack for the size of its marketing budgets, but those dollars are not necessarily being spent in the right places today given the trends described above – heavy sales force deployments to the offices of physicians and other health care providers, and those interminable ads we all have the dubious pleasure of viewing during virtually any prime time television experience.  The real question is: what is the most optimal way to squeeze the most revenue out of every marketing dollar allocated, factoring in the relationship between all the demand levers at the company’s disposal – price, product mix, sales force mechanisms and marketing spend vehicles?  There are potentially rewarding answers to this question, and those answers can be found through innovations in revenue optimization and micromarket science.  I don’t expect to see Big Pharma’s leaders collectively sit back and watch Teva and its ilk cut their markets further down to size.  A relentless focus on optimizing revenue may not be the industry’s historic strength, but I’ll be surprised if it isn’t a fixture in its immediate future.