Why pharma can't adapt to the changing health environment

In nearly every sector of health care, competing companies are acting aggressively to position themselves for prospering in a rapidly changing environment.

Consider first the provider segment. Hospital-based systems are gobbling up physician practices to the point where investment bank Credit Suisse estimates that two-thirds of practicing physicians are now salaried hospital employees. At the same time, these hospital systems – known as integrated delivery networks or IDNs – are furiously buying up one another. The number of such hospital mergers has grown every year since 2009. An all-time record number of hospital M&A deals occurred in 2013, yet the deal volume grew by another 18% last year.

IDNs own and operate almost every type of medical service: hospitals, physician practices, outpatient surgery centers, clinical labs, diagnostic imaging centers, physical therapy facilities, pharmacies, counseling offices and the list goes on. Senior executives at these networks acknowledge several reasons that are driving consolidation in their sector.

The first is their desire to gain dealmaking leverage over private payers. A substantial number of deals during the past few years have created something close to medical monopolies in several areas of the country. This has left private payers seeking to offer health coverage in those areas with no alternative to accepting IDN demands on contract pricing and terms.

A second reason for this provider consolidation stems from a falling demand for inpatient services in urban areas. Much of that has been attributed to the recession, but economic recovery to date has not reversed the process. IDNs in those urban areas see consolidation as necessary for offsetting this declining but hugely important part of their revenue base.

A third reason is that current and projected trends point to an increasing demand for outpatient services. This requires capital to construct and expand facilities for that purpose, as well as for hiring primary and secondary care personnel. The Affordable Care Act has stimulated this uptick in demand by bringing millions of people into the health care system. Consolidation enables networks to address this need by creating larger capital reserves.

Finally, there is the fact that Medicare payments to provider systems will decline slightly as a result of both the Affordable Care Act and the recent repeal of the Sustainable Growth Rate. The networks feel they must make up for this rate decline by increasing their volume of services.

A similar process of consolidation is now occurring among the largest private health insurers. The country's second largest insurer, Anthem, is pressing its case to acquire Cigna, the fifth largest. At the same time, number three Aetna is pursuing number four Humana, even as number one United Health is making a move for Aetna.

As discussed here last week, this pace of eat or get eaten among health insurers is driven by the fact that some of their product segments that provide large profit margins, such as Medicare Advantage, are growing while others, such as the traditional commercial plans, are declining because companies and municipalities are pushing more of their workers onto the exchanges.

On the manufacturing side of health care, the process of accommodating to the changing environment remains much slower.  A sluggish transformation in medical technology/devices is understandable, partly because competitive product lines there are relatively segmented from company to company. A competitor in blood glucose monitoring or vascular access probably doesn't also maintain a line of orthopedic devices and another line of cardiac devices. Since only a few companies compete in each product segment, a company that makes "sharps" and other hospital supplies such as New Jersey's Becton-Dickinson is likely to maintain its pattern of unspectacular but steady growth.

The same can't be said for pharma. Almost by definition, each of the larger pharmas competes in several different therapeutic areas. That means, in contrast to med tech companies, fifteen pharmas are standing around in a room with ten chairs. Yet with few exceptions, however, pharmas are adapting to the changing environments of their provider and payer customers at a pitifully slow pace.

Unlike hospital networks and insurers, where consolidation represents an interim step forward, pharma already overdosed on M&A in the '90s and the first decade an a half of this century. None of the aforementioned reasons that justify buyouts in those sectors apply to pharma.  To the contrary, at least two of the five biggest pharmas try to appease investors with the idea that they can raise share values by breaking themselves into two or three companies.

Financial hocus-pocus does not represent an effective, long-term solution for pharma. Instead, companies in this industry must rethink what business they're really in and revise their operations accordingly. For a clue about the way pharma is failing to meet the needs of the emerging health care environment, try to think of which if any drug companies are making major changes to accommodate the new forms of health care delivery such as retail health, workplace health, telehealth or any of the others.

A former marketing manager at a Top-5 pharma in this area offers a reason for pharma's reluctance to accept change.

"Several years ago," he says, "we were preparing to launch five new products in a period of twenty months," a productivity level that would make most pharmas today green with envy.

"At the time," he claims, "we had a 30 percent net operating margin. We were all geared up and had developed our budgets, marketing mixes, tactical programs and the rest of our plans for each product. Then the CFO called a meeting."

"Going in we had no idea what he wanted, but he laid it out for us in no uncertain terms. Whatever we did, he said we couldn't let our net margin fall below 27 percent. If we did that, then the stock price would go down and some hedgefund would swoop down to take the company away from us. So there we were, launching five new products and we had to underfund each one."

The root cause, there and among the company's Big Pharma peers, stems from this short-term stranglehold that finance, in thrall to the quarterly whims of Wall Street, imposes on the industry.

The ability to refocus in response to an altered environment represents a fundamental requirement for any organization or industry that wishes to sustain itself and prosper. Often in business, this kind of adaptive change requires companies to accept lower stock values and earnings until the transformation is complete. The good ones, those with bold, innovative leadership, manage to do it. Others wither away.

For a positive example, consider General Electric, which swallowed hard and decided to completely reorient its business. Under Jack Welch in the 1980s and '90s, GE became a financial services business that operated secondarily as a holding company for several manufacturing units. The company's stock price soared and its diverse stakeholders benefitted enormously. Then the financial meltdown of 2008 hit, followed by a major recession, and GE's earnings and share price took a major fall.

CEO Jeff Immelt decided that the best road for GE's long-term growth consisted of drastically reducing its financial services footprint and returning to its history as a diversified manufacturer.  Toward that end the company began selling its financing services in pieces.  It exited some lower-margin manufacturing areas such as household appliances, and expanded its industrial holdings by acquiring companies in other sectors such as power transmission.

GE is now making modest but steady progress in moving back toward its status of 2001, when it was the world's top company in market capitalization.

After Tiger Woods failed to make the cut at last weekend's U.S. Open, he attributed it to changing his golf swing. Kinks in the new swing caused Woods to make poor placements on many shots. "Have to do it, though," said Woods. "Short-term pain for long-term gain."

Pharma appears to lack the leadership, focus, guts and acumen for doing likewise.

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