In the pharmaceuticals industry, bigger doesn’t always mean better: the largest companies haven’t necessarily produced the highest long-term returns, and pharma remains one of the least concentrated of major global industries. Nonetheless, its largest players recently initiated a spate of mergers that created a new class of heavyweight with annual drug revenues of more than $20 billion. Despite the claims of the executives who cited the benefits of size as part of the rationale for making these deals, financial markets frowned on many of the combinations when they were first announced.

Yet for the largest drug companies—"Big Pharma"—size could bring advantages in several critical areas. Size provides an edge in launching blockbuster drugs, which can individually generate $1 billion or more in annual revenues; increases the number of bets a company can place on new technologies; helps it complete clinical trials more quickly; and increases its desirability as a licensing partner. Moreover, the biggest companies tend to back the most promising products, to enter key markets most quickly, and to deploy large sales forces to launch and market products most effectively.

Although becoming the next giant isn’t a pharma company’s only possible strategic path, remaining competitive will increasingly mean capturing the advantages of size through mergers or creative alliances. But realizing these benefits will force companies to manage this kind of scale carefully and to depart from current industry practice in organization and other important areas.

To assess the value of size in the industry, we analyzed and compared the performance of the 15 companies with the largest ethical-drug sales in 1999 and categorized these players into three "weight" classes (see sidebar, "The players"). Tapping industry databases for information about R&D projects, alliances, and the effectiveness of sales forces in promoting different drugs, we assessed the value of scale in several key areas, such as discovery, development, licensing, global launches, and sales. In addition, we synthesized the perspectives of dozens of industry experts, including McKinsey consultants who have broadly served the industry.

Why size didn’t matter . . .

Our research suggests that there is little long-term correlation between size and returns to shareholders (Exhibit 1). Since the late 1980s, pharma companies have consolidated to broaden their geographic reach and to enter new therapeutic areas, but the relative success of these suddenly larger entities depended on factors other than size. Throughout the 1990s, success was more closely related to the development of blockbuster drugs and to a strong presence in the US market. Three companies with significant growth in blockbuster sales in the past five years managed to outpace the industry: Pfizer, with its impotence treatment, Viagra; Warner-Lambert (now part of Pfizer), with its anticholesterol drug, Lipitor; and Schering-Plough, with its allergy drug, Claritin (Exhibit 2).

At first glance, it might seem that consolidation led to greater concentration of market share. The top 10 companies of 1999 held 46 percent of the worldwide market for ethical drugs, up from only 28 percent a decade earlier. But this comparison ignores the fact that 23 companies eventually merged to form the top 10 of 1999, and those 23 commanded 49 percent of the market in 1989. Between the years 1989 and 1999, their annual growth rate was 18.2 percent, trailing the industry average of 19.3 percent. The implication: a number of pharma mergers were anxious responses to the weak earnings outlook of one or both participants.

. . . and why size matters now

Although no guarantee of success, size is becoming more and more beneficial in several areas. One is the process of discovering drugs. Emerging technologies—involving bioinformatics, greater automation, and new screening approaches for genomics—may help "industrialize" drug discovery. But first, pharma executives must figure out which technologies to bet on, the amounts to wager, and how to balance the cost of investments against competing R&D needs.

Take genomics (see "Splicing a cost squeeze into the genomics revolution," on page 15 of the current issue). Should a company try to "own" a disease area by, for example, acquiring the intellectual-property rights to all of the biological targets identified through the unraveling of the human genome? What about investing heavily in the development of new screening techno-logies and thereby gaining exclusive access to them? Or would it be smarter to piggyback on the investments of others?

In fact, companies with enough resources to keep their options open and place a number of bets have an advantage. Interviews with R&D executives in the pharma and biotechnology industries suggest that companies may have to spend at least $100 million annually even to play a conservative game in these emerging technologies. Spending at the most aggressive level might require a $300 million annual investment.

To be sure, some smaller companies have managed to place significant bets on emerging technologies: Bayer’s $465 million, five-year deal with Millennium Pharmaceuticals for hundreds of drug targets represents a significant investment in an unproven approach. But the price tags for such deals keep growing: Novartis recently signed an $800 million agreement with Vertex Pharmaceuticals for compounds generated through its proprietary chemo-genomics approach to drug discovery.

An average drug company spends about 25 percent of its R&D budget on discovery. An aggressive strategy would consume more than three-quarters of a middleweight company’s discovery budget but only one-third of a super heavyweight’s. As more and more of the human genome is understood, these stakes can only rise, further compromising the smaller players’ other important discovery activities, such as hiring more chemists to improve the efficacy of drugs further downstream. Unexpected research developments could intensify the challenge. If, for example, the genome’s secrets can be unraveled more quickly than expected, the advantage will go to companies that have the resources to respond rapidly.

Product development and in-licensing deals

Size may also help Big Pharma develop drugs more rapidly. The cost of development has leaped upward in recent years, since more drugs compete in the same treatment areas, regulatory scrutiny is tighter, and drug makers want to launch drugs with more indications. One result: more trials, as well as more patients in each of them, are needed. In addition, the cost of recruiting patients and investigators and of analyzing the results has gone up: the time needed to enroll patients, for example, now amounts to half the length of a trial.

The cost efficiency of trials doesn’t vary substantially with the size of the company conducting them. But larger pharma companies may succeed in building better networks of investigators who can cut the time needed to enroll patients. Such companies can also cultivate more intensive relationships with more and better clinical investigators, who are the source of patient referrals to clinical trials. Merck and Pfizer, for instance, are giants in the cardiovascular area, and they can be tough competition for any other company trying to find investigators and patients for that purpose.

Moreover, the growing pressure to find blockbusters means that more companies are in-licensing drugs that other companies have discovered or developed.¹ And the biggest companies do better at gaining access to winning drugs. It is true that from 1997 to 1999, the middleweights in-licensed an average of six drugs, while the heavyweights in-licensed only four—a difference that held for both early and late-stage licensing. The heavyweights, however, licensed more of the top performers: the 100 drugs with the highest sales in 1998 and 1999. Of the 29 percent of these top drugs that were in-licensed, the heavyweights had the rights to four times as many as the middleweights did, and the heavyweights on average earned about 15 percent more revenue for each licensed product. This pattern suggests that heavyweights are regarded as the most desirable partners.

Operating on a global scale

In the global pharma marketplace, three key measures of competitiveness are the number of products launched, their value, and how quickly they enter top markets. In each respect, larger companies appear to exploit their scale to enhance performance. During the past three years, the heavyweights launched more products globally than did the middleweights: an average of 4.7 drugs to 3.5. Furthermore, the heavyweights collected more than twice the middleweights’ revenue, on average, for each product launched. In addition, the bigger drug makers entered the seven most important global markets faster than did smaller companies.

Finally, the large sales forces of the biggest pharma companies are essential in achieving the customer penetration required for a blockbuster. In general, the more sales representatives a company employs, the smaller their territories and the more numerous their contacts with each physician. This advantage translates into higher revenues resulting from stronger demand from physicians; we have observed a correlation between growth in the number of details and growth in revenue. The impact of the sales forces maintained by Big Pharma is particularly powerful during the critical six months following a launch, when contacts with physicians build large markets and sales momentum.

The challenge of mergers

Moving into the drug industry’s heavyweight class often calls for a megamerger, but companies caught up in one are vulnerable to the usual integration hazards. Integration is especially difficult for R&D operations, which are likely to have different degrees of risk tolerance, different scientific "tastes" reflected in portfolio decisions, and different approaches to governance and decision making. Companies distracted by integration often launch products poorly and miss licensing opportunities, and these failures jeopardize earnings and longer-term growth.

Dealing with the complexities of size itself may be even more difficult than navigating the pitfalls of M&A and integration (Exhibit 3). Managing an enormous number of discovery and development programs is a formidable task, and so are maintaining a heavyweight’s strategic vision, steering a large number of marketing initiatives, and running huge sales forces. The biggest pharma companies can prepare to meet the challenge by reconsidering their organizational structure, their processes for making decisions and allocating resources, and their accountability and incentive systems.