Emerging Medtech Markets Vivo Ventures Time Arrives As All Eyes Look To China

Special Reprint Elsevier Business Intelligence www.elsevierbi.com Emerging Pharma Markets Ironwood Adds A China Wrinkle To Regional Deal Strategy By Wendy Diller Emerging Medtech Markets Vivo Ventures Time Arrives As All Eyes Look To China By Tom Salemi DECEMBER 212 Vol. 3, No. 11 Biopharma Dealmaking Pharma Deals That Generate Lasting Value: A Roundtable Discussion By Christopher Morrison Medtech Business Strategies Innovation & Globalization In Medtech: An Interview With Medtronic s Omar Ishrak Building on the triple pillars of execution, globalization, and innovation, Omar Ishrak is positioning Medtronic for a new medical device marketplace. by DAVID CASSAK Also in this issue: Too Big To Succeed: Where Are Large Pharmas Heading? Renal Denervation Land Grab Continues Molecular Diagnostics M&A: Dormant But Not Done

TOO BIG TO SUCCEED: WHERE ARE LARGE PHARMAS HEADING? The biopharmaceutical industry s largest companies have grown too large to offer shareholders a compelling return. Historically focused on strategic adaptations to the market environment, large pharmas now need to address key internal issues such as scale as a core foundation of their growth aspirations. n Over the past 25 years, large pharmaceutical companies have scaled up operations to increase market share, competitive positioning, and global presence. But R&D productivity at industry s largest companies has declined significantly. n In fact, L.E.K. Consulting analysis shows that total sales and market cap of pharma companies are negative predictors of total shareholder returns. A pipeline productivity analysis also highlights that the number of product approvals required to achieve sufficient growth targets for large pharmas is most likely unachievable. n To address these challenges, large pharmas may further consolidate to externally fill pipeline gaps, diversify beyond pharmaceuticals to access adjacent profit segments, deconsolidate, or restructure around a smaller revenue base of high value therapeutic areas. n understanding the key challenges of scale and applying the learnings from this analysis will enable large pharma executives to sustain growth and maximize shareholder value creation. Executive Summary >> 98 BY David Barrow, Matthias Kleinz, Michael Gladstone, and Pierre Jacquet Diminishing R&D productivity, patent cliffs, pricing pressures, and tougher regulations have contributed to decelerated growth in the pharmaceutical industry. These challenges have forced large pharmas, defined throughout this analysis as the top 1 global pharmaceutical companies by 211 revenue, to rethink their business models. (See Exhibit 1.) Among these changes have been the evolution of pharmaceutical commercial models toward new customers (e.g., payors), increased externalization of R&D through consolidation and dealmaking, reorganization into smaller business units for increased productivity, and geographic expansion to access faster-growing emerging markets. But none of these fixes, all incrementally positive, addresses the fundamental dilemma facing large pharmas. L.E.K. findings indicate that company scale is a negative predictor of value creation among biopharmaceutical companies. And industry s largest companies have simply become too large to generate significant shareholder return going forward. Total shareholder return (TSR), calculated by combining share price appreciation with dividends yield during a period of time, has been inversely correlated to the revenue scale as well as to the market capitalization of pharma companies. (See Exhibit 2.) At the same time, sales growth has been the strongest predictor of positive TSR, which has been most often achieved by innovative companies off a smaller revenue base. Hence, the larger a company is, the more difficult it is to grow and generate positive TSR. Scale As Impediment To Growth Though the pharmaceutical industry recognizes that the health care ecosystem is irreversibly changing, and is beginning to grapple with the market access and reimbursement challenges that will be core to any future success, there are more difficult times ahead. As health care costs relative to GDP spending continue to rise in major markets, pressures on large pharma companies to demonstrate the value of their products will continue to increase. Furthermore, major classes of innovative molecules are still going generic, shaving off another $12 billion in branded revenues in the next five years and offering payors more choice for lower cost options, increasing the hurdle for the subsequent generation of therapies to demonstrate value. Lastly, while emerging markets will remain a major contributor to spending growth for pharmaceuticals over the next five years, their contribution will still be steered by generics as substantial out-of-pocket costs of brands and expensive newer medicines will dampen branded pharmaceuticals revenue growth in these markets. In this environment, large pharmas will continue to struggle for value creation. 2 December 212 IN VIVO: The Business & Medicine Report www.elsevierbi.com

Exhibit 1 Top Ten Pharma Companies By 211 Revenue 211 Pharma Revenue ($B) Company Pfizer 67.4 Johnson & Johnson 65. Novartis 58.6 Merck & Co. 48. Roche 47.9 Sanofi 46.5 GlaxoSmithKline 43.9 Abbott Laboratories 38.9 AstraZeneca 33.6 Eli Lilly 24.3 SOURCE: Company Reports Indeed, large pharmas consistently trailed broader market indices over the past decade and underperformed the S&P5 by more than 2%. (See Exhibit 3.) In contrast, mid-tier biopharma companies, defined as the next 2 biopharma companies by revenue size, outperformed most indices during the same period. A recent annual audit of the pharmaceutical industry by St. Joseph s University s Bill Trombetta, PhD, published in Pharmaceutical Executive confirmed this trend. The five best performing companies in 211 as measured against eight financial metrics were mid-size companies such as Biogen Idec Inc., Shire PLC, Novo Nordisk AS, Celgene Corp. and Bristol- Myers Squibb Co. Interestingly, none of the top ten pharmaceutical companies by 211 sales came close to this group of outperformers. This issue of scale will become more pronounced in the near future. Looking at the past decade, the scale and revenue base at which large pharmas grew has more than doubled. Today, a top 1 pharma generates average global revenue of $47 billion, including nonpharmaceutical revenues for companies like Johnson & Johnson, Novartis AG, and Roche. Market leaders such as Pfizer Inc. have today a revenue base close to $7 billion in a global pharmaceutical market that is just over ten times that size. It may take only five to seven years before we see the first large pharma with a revenue base in excess of $1 billion, a timeline that can be accelerated if further consolidation takes place. This increase in scale and revenue base for growth has become one of the major challenges for large pharmas to create shareholder value in an environment increasingly constrained by static or declining performance on drivers such as the productivity of organic R&D. Understanding the key challenges of scale and applying the learnings from this analysis will enable large pharma executives to consider scale so their business models evolve to sustain growth and maximize shareholder value creation. The Burden Of Scale Scale can be a competitive advantage when considering the lifecycle of a portfolio of pharmaceutical drugs, with its flow of new product launches. With 1-12 years of patent life typically left after market entry, size and speed to global peak sales have become increasingly important. Leveraging the global scale of clinical, regulatory, market access, and commercial capabilities can accelerate revenue and earnings growth by fostering synergies across a portfolio of products, accessing networks of key stakeholders across geographies, and accelerating timeline of launch and ramp-up to peak. (See The Value of Scale in Pharma s Future IN VIVO, September 21.) Scale also enables large pharmas to enter high cost-of-entry markets. These include the therapeutic interventions that require expensive primary care promotion as well as expansion into geographies like China that requires significant investments to address underdeveloped infrastructure and fragmented distribution systems. Lastly, there is growing evidence that scale may improve share of voice for large pharmas in their negotiations with payors for formulary status of their drug portfolios. However, scale also introduces its own challenges. R&D productivity is one area where scale has not enabled improvement. In truth, it may be counterproductive. A recent analysis of the R&D spend by Big Pharma (albeit not the exact cohort of companies used for this analysis) highlighted negative returns over the past decade as the share of drugs originated from those companies declined to barely a quarter of the industry pipeline, down from nearly 4% in 2. (See Pharma R&D: Doing the Same Thing That Didn t Work Before IN VIVO, April 29.) Although scale can enhance efficiency of R&D processes that are repeatable and can be industrialized, such as highthroughput gene sequencing or combinatorial chemistry in early discovery stage, these positive effects do not systematically apply to more complex R&D activities such as the design and completion of small proof-of-concept clinical trials. When companies are small, decision makers are able to make strategic choices Exhibit 2 Drivers Of Total Shareholder Return For Leading Pharma Companies (25-21)** TSR% 25-21 28 21 7-7 5 1 15 Market Captialization 25 ($B) *Historical datasets are less complete over the period due to mergers and acquisitions, resulting in weaker statistical significance; **Includes data for 42 of the 5 leading pharma companies by sales in 21; from multiple regression. SOURCE: S&P Capital IQ; L.E.K. analysis 2 TSR% 25-21 28 14 7-7 1 2 3 4 5 Total Company Sales 25 ($B) 6 212 Windhover Information Inc., an Elsevier company IN VIVO: The Business & Medicine Report December 212 3

Exhibit 3 Large Pharma And Mid-Tier Pharma Performance (21-211) Percent Large Pharmas S&P 5 Mid-Tier Pharmas 225 2 175 15 125 1 75 5 25 21 22 23 24 25 26 27 28 29 21 211 SOURCE: S&P CapitaI IQ; L.E.K. Consulting Exhibit 4 Need For New Product Launches To Sustain Target Growth Rate By Company Size SOURCE: L.E.K. Consulting NDAs/BLAs Over Next 1 Years Required To Attain Growth Target 2 18 16 Base Revenue $6B $4B 14 $2B 12 1 8 6 4 2 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 Annual % Sales Growth Target in a swift and flexible manner without getting caught in exhaustive processes. As size increases, the hindered knowledge flow and the addition of stakeholders call for increasingly analytical, organized, and time-consuming R&D procedures. Over time these discourage risk-taking, rewarding consensus-building over bold decision-making. To better illustrate this counterproductive effect of scale and R&D productivity one must look at the number of NDAs/ BLAs required for sustaining a targeted corporate revenue growth rate. (See Exhibit 4.) Accounting for an average revenue decay due to expiring patents, a mid-tier pharma company with a revenue base of $2 billion and an annual revenue growth rate target of 1% for the next decade would need to generate about 3 to 4 NDAs/BLAs with average peak global sales of $1 billion to meet the goal during that period. This R&D productivity requirement translates into three to four NDAs/BLAs per year, a goal that can be theoretically achieved given the current average flow of 3-4 annual FDA approvals, though admittedly one that very few companies are likely to achieve. Scaling up these numbers for a large pharma with a revenue base of $4 billion with the same revenue growth aspirations implies an even loftier productivity requirement, about six to eight NDAs/ BLAs per year. This estimate is even more confounding for a large pharma with a revenue base of $6 billion, bringing this requisite to 1-12 NDAs/BLAs per year to meet this growth target. For companies of this scale, achieving such high productivity is likely unattainable. Indeed, there have been about 3 total NDAs and BLAs approved over the past decade, and over the past three years not a single large pharma has accounted for more than 1% of approvals in a given year, well below the implied approval share of 2%-3% for a single large pharma with a revenue base of $4 to $6 billion. Heightening this productivity requirement is the shifting nature of drugs emerging from large pharmas pipelines. There is growing evidence that blockbuster drugs, defined as those with more than $1 billion in annual sales, may account for a smaller share of large pharma revenues in the near future. (See The New Face Of Blockbuster Drugs IN VIVO, May 211.) If this scenario holds true, the requisite productivity for large pharmas will balloon to levels never achieved before. In any case, the current scale of large pharmas has stretched R&D output requirement to untenable goals and suggests that large pharma growth expectations will not be achievable for the system as a whole, although there may be wide variation among individual companies. Keep Consolidating In light of these challenges, an obvious path to fill this organic R&D gap is asset externalization. (See Institutionalizing Externalization At Big Pharma The Third Leg IN VIVO, March 212.) The ground for such a strategic move has been fertile over the past decade as drugs initially discovered in biotechnology companies or universities accounted for more than half of the scientifically innovative drugs approved during that time. However, as much as relying on a few good licensing and M&A deals with these innovators was impacting growth for large pharmas a decade ago, mirroring the effect of this approach on current large pharma scale can only happen under two conditions. The first relies on a pool of external innovation expanding at a faster rate than large pharma growth targets. The second presumes that the consolidation process of integrating these assets within the wall of large pharmas does not exacerbate the challenges of scale in these organizations. 4 December 212 IN VIVO: The Business & Medicine Report www.elsevierbi.com

These conditions appear highly unlikely to hold true. When looking at the biopharma industry composition, one may see a contraction of the pool of external innovation available for large pharmas. First, at a private company level, investment has slowed. Venture capitalists invested $5.6 billion last year in comparison to $4.2 billion invested five years ago, according to data from CapIQ and BioCentury. Adjusting this figure for inflation during the same period results in anemic expansion of private financing for innovation. For publically traded biotech companies, the numbers do not look better. There were about 49 biotech companies in this group a decade ago. Today this number has only ramped to about 55 companies. Within this group, the number of companies with a market cap of more than half a billion dollars has shrunk by almost 2% during the same period. Furthermore, the mid-tier biotech group, defined as companies with a market cap of $2 billion to $2 billion, has been depleted through mergers and acquisitions. These companies have traditionally offered solid growth foundations for large pharmas as most bring either top-line revenue from a marketed product or equity appreciation from a late-stage asset. A decade ago, 112 companies were traded in this pool. Today, only 55 remain, while the pool has been only partially replenished by 37 new companies. (See Exhibit 5.) Large pharmas have acquired more than 5% of those companies. Worse, this pool is being replenished at a pace too slow to meet large pharmas revenue growth ambitions. These dynamics signal a looming gap between an increasing reliance of large pharmas on external R&D and a shortage of the innovation supply from smaller to mid-scale companies. At a larger scale, consolidation has also not solved large pharma growth challenges. Recent large pharma M&A activities had the unintended effects of magnifying the constraints of scale for these companies and further aggravated their declining R&D productivity. As a result, mega-mergers have delivered relatively flat sales growth, once the initial synergies were realized. Probable causes of this outcome include the complexities of managing larger scale organizations, integrating R&D sites from organizations entrenched in different cultures, and growing over-diversified portfolios of products. In short, regardless of its scale, consolidation proved to be a double-edged sword. It can fill organic productivity gaps while rendering these same R&D organizations too big and too complex to effectively deliver innovation. Consolidation cannot therefore provide a single, lasting solution to the growth challenge of large pharmas. Tapping Into Adjacent Segments The prospects for growth in pharmaceuticals may be confined. Large pharmas had a combined revenue base of about $35 billion in 211, excluding revenues from non-pharmaceutical businesses. Growing this revenue base at recent industry growth rate and offsetting the revenue cliff from loss of exclusivity would result in an incremental revenue need of $15 billion for the group by 216. Considering the overall industry is expected to grow by $22-25 billion during the same period, according to IMS, large pharmas may consider expanding the boundaries of the market in which they search for growth. Diversifying into health care adjacencies is not a new idea and has taken place at different points of life for large pharmas. Companies such as Johnson & Johnson and Abbott Laboratories Inc. a long time ago built their foundations on diversified businesses. Their goal was to balance the R&D and regulatory risk of their pharmaceutical operations with more predictable businesses. More recently, spurred on by macroeconomic woes and a renewed emphasis on delivering an integrated approach to patient care through a diversified portfolio of complementary products and services, companies such as Novartis, Sanofi, and Daiichi Sankyo Co. Ltd. have followed the same path by expanding into adjacencies like generics, consumer products, and devices. This strategy may suffer, however, from an economic flaw in the fundamental difference of operating margins and profitability across health care segments. Branded drugs remain the largest and most profitable health care segment, with operating margins in the 2%-3% range. Adjacencies such as generics or diagnostics offer smaller and less profitable opportunities for addressing the shortcoming of large pharma scale. Generics for example are today a global market of about $2 billion with smaller profit due to lower margins in the range of 15-2%. Certainly, large pharmas can address some of their growth Exhibit 5 Mid-Tier Pharmas (21-211) Number Of Companies 12 1 8 6 4 2-2 -4-6 112 SOURCE: L.E.K. Consulting 21 211 Acquired Mid-Tier Mid-Tier Pharma gap by broadening the horizon of health care segments in which they participate. However, diversification alone falls short of addressing large pharma bottom line. Rescaling The Base Facing the limited prospects of consolidation and diversification, large pharmas must turn their attention to rescaling their revenue bases through deconsolidation or scale realignment along key areas of competitive advantage. This is the industry s key structural issue. Rescaling the base would enable some large pharmas to focus on a smaller core of products, services, and customers. This strategy can first take place through deconvergence of diversified businesses across health care segments. Abbott s recent decision to split its innovative pharmaceutical business from its diagnostic, device, nutrition, and established products divisions calls for realizing the true value of its individual assets. The company will split into AbbVie Inc., an innovative pharma business that will continue to market pharmaceuticals, and Abbott, which will continue to focus on generics, devices, and diagnostics. Or consider BMS decision to refocus on biopharmaceuticals, selling its Convatec wound care unit, its North American OTC business, its medical imaging group, and its nutritional business Mead Johnson Nutrition Co. Pfizer has recently embarked on a similar path, with divestments of its animal health and nutritionals businesses. Other industries have successfully rescaled their operations to address their 37 55-57 New Mid-Tier 212 Windhover Information Inc., an Elsevier company IN VIVO: The Business & Medicine Report December 212 5

Exhibit 6 Leadership Position Of Large Pharmas In Major Therapeutic Areas (216) Oncology / Hematology Antibacterials, Antivirals, Vaccines Share of Global Brand Sales (217) Pfizer 18% 13% Johnson & Johnson Novartis Merck Roche Sanofi Glaxo Smith Kline Abbott Astra Zeneca Lilly Rheumatology 9% Diabetes 9% Cardiology 8% Respiratory 7% CNS 4% Multiple Sclerosis 3% HBV/HCV 3% Orphan Diseases 3% Therapeutic area leader Top tier leader Second tier leader No leadership Therapeutic area leader = largest market share by 217; Top tier leader = second or third largest market share by 217; Second tier leader = fourth to seventh market share by 217; and No leadership = No market presence or market share behind seventh. SOURCE: Cowen Biotech Research Team and Cowen Pharmaceuticals Research Team; L.E.K. Consulting growth challenges. Large media and telecommunications companies such as Disney, Time Warner Inc., and Viacom Inc. have recently adopted, after years of consolidation and convergence, a strategy of refocusing on a few core businesses through divestitures and spin-offs of non-core assets. The emergence of new technologies and new competitors were a major trigger for deconsolidation. But executives at those companies recognized the limitations of their companies scale and deployed rescaling strategies that reward long-term shareholder value creation over short-term bottom-line growth. It s unclear to what extent that realization has taken hold among the largest companies in biopharmaceuticals. Beyond deconvergence for large pharmas diversified across multiple health care segments, these companies may focus on redistributing resources and investments within their core pharmaceutical business in areas where they can displace established and emerging competitors by gaining the advantage of their scale within a focused area of expertise: for example, a core channel like hospital-based markets, a key customer segment like specialists, a predominant product type like biologics, or a set of key therapeutic areas like oncology and diabetes. Looking back at the five best performing companies of 211, four generated growth from their leadership position in a small base of therapeutic areas: Biogen Idec in multiple sclerosis, Celgene in oncology, Novo Nordisk in diabetes, and Shire in ADHD and human genetic therapies. In contrast, many large pharmas are over-diversified across diseases where they are underscaled and unfit for competing against market leaders. A close look at the expected leadership position of large pharmas in the 1 top disease areas by 216 highlights this uneven and asymmetrical portfolio distribution. (See Exhibit 6.) One solution for large pharmas is to refocus their disease coverage into fewer areas by divesting or risk-sharing subscaled therapeutic areas. GlaxoSmithKline PLC and Pfizer took this path in HIV by forming ViiV Healthcare joint venture in 29. AstraZeneca PLC and BMS, as well as Eli Lilly & Co. and Boehringer Ingelheim GMBH, are jointly building up their diabetes presences. Merck & Co. Inc. has repeatedly deployed this strategy, starting their joint venture in 1994 with Astra AB of Sweden in multiple therapeutic areas such as gastrointestinal and cardiovascular diseases and more recently the equally owned partnership with Schering-Plough in 2 to develop and market new prescription medicines for cholesterol. This scale-sharing model enables large pharmas to reinvest most of their R&D and commercial budgets in fewer therapeutic areas where they can build leadership while minimizing risks and investments in others by sharing assets, resources, and investments with peers. Choices for the Future This analysis suggests that large pharmas increase in scale and revenue base will become one of their major impediments to shareholder value creation. Fortunately, there are a number of steps executives can take. For some, leveraging scale to outperform competition in accessing external innovation and seizing the opportunities of high barrier-to-entry markets may remain a safe harbor until a renewed era of productivity and prosperity. But few large pharmas will win at this game. The majority should focus their efforts 6 December 212 IN VIVO: The Business & Medicine Report www.elsevierbi.com

on those therapeutic areas where leadership can be preserved or attained, while being more receptive to divesting or to risk-sharing arrangements for subscale franchises. Companies should design incentives, dedicate resources, and foster a culture of creativity that rewards innovative deal structures and risk-sharing collaborations that support the recalibration of their business around fewer areas of leadership. Meanwhile, the industry must continue to assess the real profit contribution of adjacent health care sectors outside branded pharmaceuticals and decide how much (if anything) to invest in businesses that do not clearly enhance the value of their core pharma businesses. Finally, large pharma must recognize the true productivity of their organic R&D as well as the landscape of external innovation in which they play. Only a sober assessment of the potential constraints of this supply of innovation and the competition for it will reveal portfolio gaps and provide insights into realistic growth targets and the limits of increased scale. [A#2128236] IV Pierre Jacquet, MD, PhD, and David Barrow are Vice Presidents and Matthias Kleinz is an engagement manager in the Life Science Practice of L.E.K. Consulting. Michael Gladstone is an analyst at Atlas Venture. Email the author: p.jacquet@lek.com RELATED READING The Value of Scale in Pharma s Future IN VIVO, September 21 [A#218177] Pharma R&D: Doing the Same Thing That Didn t Work Before IN VIVO, April 29 [A#29872] The New Face Of Blockbuster Drugs IN VIVO, May 211 [A#211874] Institutionalizing Externalization At Big Pharma The Third Leg IN VIVO, March 212 [A#212851] Access these articles at our online store www.elsevierbi.com 212 Windhover Information Inc., an Elsevier company IN VIVO: The Business & Medicine Report December 212 7

L.E.K. Consulting L.E.K. Consulting is a global management consulting firm that uses deep industry expertise and analytical rigor to help clients solve their most critical business problems. Founded 3 years ago, L.E.K. employs more than 1, professionals in 21 offices across Europe, the Americas and Asia-Pacific. L.E.K. advises and supports global companies that are leaders in their industries including the largest private and public sector organizations, private equity firms and emerging entrepreneurial businesses. L.E.K. helps business leaders consistently make better decisions, deliver improved business performance and create greater shareholder returns. For more information, go to www.lek.com. L.E.K. s Biopharmaceuticals and Life Sciences Expertise L.E.K. Consulting is a premier strategic advisor to the life sciences industry. Our clients include four of the top-five global biotech companies, nine of the top-1 global pharmaceutical companies, leading tools and diagnostics companies, and many of the most innovative emerging public and private companies in the industry. L.E.K. s team of international life sciences professionals has expertise across all major industry segments and therapeutic areas, and we provide support at each stage of the product life cycle, from drug discovery to post-launch. With a reputation for solving complex issues and helping clients to create lasting value, L.E.K. works closely with life science executives to guide strategic decision making and develop winning strategies in a dynamic global healthcare market. For more information, go to www.lek.com/industries/biopharma-life-sciences.com or lifesciences@lek.com.