In pharma, incremental innovation lives on

By David Grainger, Ph.D.

In 2010, I declared the death of incremental innovation and wrote the obituary. It didn't seem a very bold statement at the time--increasing payer pressure was beginning to bite, and it seemed obvious that the entrenched practice of paying a premium for small (often imperceptible) improvements was passing.

If payers, whether governments, private insurers or even patients, were unwilling to pay for incremental innovation, then the inescapable logic seemed to be that the industry would have to stop developing such products and instead seek bigger improvements in clinical performance.

But three years later, the market for late-stage products that show little, if any, differentiation remains as frothy as it has ever been. As if to prove the point, AstraZeneca ($AZN) invested a little over $1 billion in two such products in one month: another LABA combination from Pearl, and another prescription fish oil capsule from Omthera ($OMTH).

With deals like this on the table, why not develop another me-too product against a well-validated human target? After all, the technical risk is very low. So as long as you are confident someone will acquire the product, it looks like an excellent investment.

In common with Mark Twain, then, reports of the death of incremental innovation were clearly exaggerated.

How then can you square the circle? If payers increasingly refuse to pay for incremental innovation (even before "pay for performance" really takes off, as it surely will), yet pharma companies are paying big bucks for poorly differentiated products, then someone has to be making a costly error.

The answer is that pharma companies (or some of them at least) are using their gargantuan balance sheets to absorb the pressure from payers rather than transmitting it to the early-stage discovery efforts (whether internally or externally). While they continue to buy poorly differentiated late-stage products, the drive to discover and develop really risky assets that might deliver a step change in outcomes remains impotent.

The big question has to be why do they do it?

After all, it is a strategy that is likely to end badly. If you fill a pipeline with products displaying little real innovation or improvement in outcomes against a landscape where increasingly no one will pay for such products, then you are setting yourself up for catastrophic failure. You can only ignore the demands of your customers for so long, even in the Alice in Wonderland world of pharmaceuticals. A big balance sheet only provides so much insulation.

But that failure is a long time coming. And if you are very big, it could be a decade or more away. It seems that there are much more short-term concerns that demand action--and lead to behaviors that are ultimately close to suicidal.

Elias Zerhouni, the eloquent R&D chief at Sanofi ($SNY), recently hinted at the underlying cause of these conflicting behaviors: Large pharma companies are principally motivated by fear and expend 90% of their effort on defending existing revenues rather than on generating new sources of income. Such defense is prudent and necessary, but the balance is wrong, he says--maybe half and half between defense and innovation would be a healthier mix, with maybe 10% on the really wild-eyed vision.

This defensive attitude causes pharma to acquire products that are less risky (and hence less innovative) than their customers are demanding. That is a very dangerous mismatch--and one that becomes more severe the emptier the pipeline is perceived to be.

For a publicly traded company, the spotlight falls heavily on the late-stage pipeline. And bad news translates quickly into a falling market cap. Faced with a choice of two kinds of bad news--a Phase III clinical trial failure or the failure of a product to win a substantial market (products that my blog DrugBaron has previously called "busters," as opposed to "blockbusters"), then the defensive executive will always choose the latter. After all, market failure will only be obvious nearly a decade down the line. A Phase III failure could hit the value of the company tomorrow.

Far better then to acquire a product with so little innovation that it can hardly fail to be approved--and then sweat about whether payers will actually pay for it in any kind of volume--than it is to acquire a genuinely innovative, first-in-class product and then discover it has feet of clay.

And the more your innovative bets tumble--as Lilly ($LLY) experienced recently--the greater the pressure on the executives to flex the balance sheet and acquire "safe" bets.

The result will surely be a vicious downward circle, where acquisitions of undifferentiated products that cannot fail in the clinic lead to too few sales to justify the purchase price. There has to be a very real risk that some large pharma groups are already uncomfortably close to this "death spiral."

Avoiding this fate isn't just about taking more risk, even if the public market investors would tolerate it. The industry has to get smarter at taking these risks. Right now, too many innovative, first-in-class programs are failing in Phase III.

The problem is not that real innovation is risky--of course it is. But a way has to be found to fail these programs much earlier. DrugBaron has already examined the factors that led several pharma companies to progress anti-amyloid drug candidates into Phase III (and indeed to keep on trying) when all the data (even from Phase II) suggested that this class of agents was doomed to fail. The same story applied to Merck ($MRK) with the CETP inhibitor anacetrapib, and most recently to AstraZeneca with fostamatinib. To his credit, at least AstraZeneca CEO Pascal Soriot and his team accepted the failure, killed the fostamatinib program and moved on. Anti-amyloids and CETP inhibitors, though, continue to consume vast resources with little hope of eventual success.

Taking the risks necessary to deliver real advances in patient care is only economic if the discovery and development costs can be shrunk--not just 20% to 30% as has been widely accepted across the industry but by twofold or even more.

That kind of cost reduction cannot be achieved by evolving the old model--a model that in any case grew in a very different world, a world of "gold rush economics" where any approved drug automatically garnered sufficient sales to justify discovering a new drug at any price. Discovery was optimized for success, not productivity.

A change in the way we design and interpret Phase IIa studies, the key gatekeepers in the drug-development process, lying between relatively low-cost early development and the megabucks of late stage, is the most pressing need. Studies must be able to distinguish those products that will succeed, not just in later development but also in the marketplace, from those that are doomed to fail sooner or later.

Yet again, though, the conservative mindset in large companies makes such changes difficult. If a study is borderline, or yields a gray result, it's better to keep the pipeline full and delay the bad news for another day. After all, it might work.

And it's not just large companies. The defensive mindset can permeate even the smallest operations if the management feel that their jobs, or even their careers, are in peril should the product they are developing fail. The incentives to delay failure until later in development, or even into the marketplace, are very strong indeed--even while repeating the "fail early, fail cheap" mantra, executives in drug companies large and small are, it seems, still behaving in exactly the opposite fashion.

So incremental innovation is alive and well. Even as it's starved of oxygen by the tightening purse strings of the eventual customers, it is being sustained by the stronger imperative to avoid clinical failures, or any kind of imminent bad news, by pharma companies that failed to grasp the need for a leaner discovery and development model a decade ago. Those that did start that process earlier, and whose late-stage pipeline looks healthier as a result, need to stick with it--and cut costs even more aggressively, allowing them to keep up the level of risk they can take to deliver real innovation.

Only they will survive. Any that are caught in the trap of doing low-risk incremental innovation when the customer demands a step-change in outcomes, defying logic through the sheer power of their balance sheets built up on historical successes, will end up completely drained.

For early-stage investors, then, there is a real conundrum--should they back poorly differentiated products because they offer good returns at lower risk as long as pharma keeps buying? That depends on how long the largest companies continue to use their financial muscle to warp reality. DrugBaron was three years too early calling the death of incremental innovation--and he is not about to repeat that mistake. Incremental innovation ought to be dead, but it looks like it will be around for a while yet.

David Grainger, Ph.D., who is the author of DrugBaron, serves as a biopharma consultant and venture partner at Index Ventures. Read his blog.