NJE-262622.366-20050606-jdonHR1

Working Draft Last Modified 6/6/2005 8:21:30 PM Eastern Standard Time

Printed 6/6/2005 8:16:47 PM Eastern Standard Time

Preparing for Productivity Transformation in Pharma

2005 Pharma, Biotech, and Device Colloquium

June 7, 2005

This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion.

NJE-262622.366-20050606-jdonHR1

2

TODAY’S DISCUSSION

• Industry context for the growing need to focus on productivity

• Practical challenges and constraints pharmacos will likely need to overcome

• Some of our perspectives on what it will take to be successful

NJE-262622.366-20050606-jdonHR1

3

PHARMACOS FACE GROWING INTERNAL PERFORMANCE PRESSURES . . .

*2003 sales levels **Over US $1 billion in WW peak salesSource: SG Cowen Pharma pulse; Pharmaceutical Executive; Evaluate; literature review; team analysis

Slowing US performance

Patent expiries • Over $65 billion in branded drugs* losing patent protection in 2004-2008

• 21 blockbusters** going off patent/exclusivity 2005-2007

R&D productivity • 13% CAGR for R&D spending 1970-2002, while total IND and NDA output remained relatively flat

• Survival rate in Phase II trials decreased from near 50% to less than 30% by some estimates

• Top 10 pharmacos’ share of industry development pipeline decreased by ~40% from 1997-2002

Legal challenges

• Expensive product and business-practice related litigation• High-profile product withdrawals

Blockbuster infrastructure

• Organization size and spending levels remain high in many situations despite slowing pace of blockbuster launch/discovery

• Pharma profit pool shrank by $10 billion in 2003, compared with 18% increase in overall US corporate profitability

NJE-262622.366-20050606-jdonHR1

4

. . . COMPOUNDED BY AN EVER MORE CHALLENGING EXTERNAL ENVIRONMENT

Source: Literature review; Evaluate; SG Cowen Pharma pulse; team analysis

Pricing pressures

Negative perception of industry

• Uncertain U.S. pricing environment – Re-importation – Medicare Modernization – Up tick in generic substitution

• EU reimbursement challenges – Directive price and reimbursement cuts (e.g. Germany, Italy)– Reference pricing within class or to generics (all EU5 markets

except UK)• Reimbursement of off-label use being challenged• Rising copays making consumers increasingly aware of prices

• Growing number of “follow-on’s” and “me-too’s” • Pharmaceuticals represented 11% of US healthcare spending and

58% of healthcare profits in 2002• Lobby from uninsured populations• Government drug spend roughly doubled every 5 years since

1990, resulting in increased pressure to manage costs• High-profile product recalls • Business practice inquiries

NJE-262622.366-20050606-jdonHR1

5

0.0

1.0

2.0

3.0

4.0

5.0

6.0

CAPITAL MARKETS SEEM TO BE RECOGNIZING AND RESPONDING TO THESE CHALLENGES

0.0

1.0

2.0

3.0

4.0

5.0Price index, Jan 1995-Dec 2004

TRS index, Jan 1995-Dec 2004

Jan 1995

Jan 2005

Jan 1997

Jan 1999

Jan 2001

Jan 2003

S&P 500S&P 500

S&P PharmaS&P Pharma

S&P PharmaS&P Pharma

S&P 500S&P 500

S&PS&P Pharma

1995-2000 21.0 27.6

2001-2004 -1.5 -8.1

S&PS&P Pharma

23.1 29.71995-2000

0.2 -6.32001-2004

*Based on average indices for each year

Source: Compustat; team analysis

CAGR*Percent

NJE-262622.366-20050606-jdonHR1

6

HOWEVER, EARNINGS EXPECTATIONS FOR TOP PHARMACOS REMAIN OPTIMISTIC

*Average includes Merck & Company, Eli Lilly, AstraZeneca, Novartis, Johnson & Johnson, GlaxoSmithKline, Bristol-Meyers Squibb, Abbott Labs, Pfizer, and Roche

Source: Evaluate; team analysis

15

7-9

2004-072001-04

Average EBITDA CAGR*Percent

Implications

• Driving productivity in the full P&L

–Topline –Cost

• Creating opportunities to fund growth, not only earnings

Implications

• Driving productivity in the full P&L

–Topline –Cost

• Creating opportunities to fund growth, not only earnings

NJE-262622.366-20050606-jdonHR1

7

TODAY’S DISCUSSION

• Industry context for the growing need to focus on productivity

• Practical challenges and constraints pharmacos will likely need to overcome

• Some of our perspectives on what it will take to be successful

NJE-262622.366-20050606-jdonHR1

8

130

34 24

230

42

SUSTAINING IMPACT FROM PRODUCTIVITY EFFORTS IS NOT EASY

Cost reduction sustainability among the S&P 500*Number of companies

Initiated cost reduction effort during 1999-2001*

Did not achieve cost improvement in Year 1

Did not maintain improvement through Year 2

Did not maintain improvement through Year 3

Sustained improvement

*Excludes 4 companies for which relevant comparison data was not available; based on costs as a percent of sales

Source:Bloomberg; Factiva; Transformation Compendium; Beer and Nohria (2000); Conference Board report (Fortune 500 interviews); Press analysis; McKinsey analysis

NJE-262622.366-20050606-jdonHR1

9

IN PHARMA, A LIMITED HISTORIC NEED TO OVER-EMPHASIZE MARGINS . . .

Weighted-average EBIT margins for selected industries, 1985-2003Percent

Source: Compustat; team analysis

• Pharma profitability is 5-15% higher than most industries and has seen sustained increases

• Other industries (auto, consumer packaged goods) already forced to re-invent operating models to sustain margins (late 80s, early 90s)

• Pharma profitability is 5-15% higher than most industries and has seen sustained increases

• Other industries (auto, consumer packaged goods) already forced to re-invent operating models to sustain margins (late 80s, early 90s)

0

5

10

15

20

25

30

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Pharma

CPG

Auto

Media

NJE-262622.366-20050606-jdonHR1

10

. . . HAS CREATED SOME UNIQUE CHALLENGES (AND OPPORTUNITIES) TO OVERCOME TO SUCCESSFULLY DRIVE PRODUCTIVITY

• Senior management attention and focus on productivity

• Institutional skills and capabilities (e.g., versus financial institutions)

• Focus on “across the board” process excellence (e.g., versus auto companies)

• Legacy of decentralized operations compounded with uncaptured M&A synergies

• Frontline mindsets and behaviors (especially when the “sky is not falling”)

• Effectiveness and efficiency of support functions (pharma rarely in the top quartile)

NJE-262622.366-20050606-jdonHR1

11

TODAY’S DISCUSSION

• Industry context for the growing need to focus on productivity

• Practical challenges and constraints pharmacos will likely need to overcome

• Some of our perspectives on what it will take to be successful

NJE-262622.366-20050606-jdonHR1

12

WE OBSERVE 7 FACTORS COMMON TO SUCCESSFUL, SUSTAINED PRODUCTIVITY PROGRAMS

1. Carefully thought out architecture to the program including focus on approaches and tools to use, aimed at getting cost out and keeping it out

2. Absolute commitment (in word and practice) from CEO, CFO and every member of the executive team

3. Meaningfully changing the way the business works, fundamentally redesigning the organization, and reducing/changing work

4. A “modus-operandi” of delivering on stretch targets, with zero tolerance and major consequences for under delivery

5. Building capabilities to transfer “one-time” experiences into on-going “ways of working”

6. Driving the felt urgency and the need down to the frontline employees with focus on mindsets and behaviors

7. Having rock-solid performance metrics that measure the right things, providing transparency around them, living up to consequences of not delivering against metrics

Illustrated in more detail

NJE-262622.366-20050606-jdonHR1

13

MAJOR DIMENSIONS OF A WELL-ARCHITECTED PROGRAM

• Aspiration and target setting

• Areas of the business to focus on

• Approaches and tools to use

• Role of senior management/program leadership• Decision-making processes• Resource deployment• Tracking and monitoring progress

• Engaging the organization, e.g., communication

• Skills/capabilities

A. Determining what to focus on and how to do it

B. Establishing the right governance and leadership

C. Communicating and gaining alignment around the program

Well-architectedproductivity

program

NJE-262622.366-20050606-jdonHR1

14

THERE IS NO PERFECT APPROACH TO FIT ALL INITIAITVES WITHIN A PROGRAM

. . . in our experience, simplicity works best

AVAActivity Value Analysis

TOPTotal Operational Performance

Corporate center optimization Lean

BPRBusiness Process Redesign/Core Process Redesign

Edict

Delta cash

IMInternal Market

6 Sigma

Zero-base

GBB Global Bureaucracy Buster

FORTFast Overhead Reduction through Triangulation

IRTSIntelligent Reduction Target Setting

Rebasing

Mini AVA

Growth AVA

BPOBusiness Process Outsourcing

There is no shortage of productivity approaches to choose from . . .

• No one right approach– Fundamental differences between

initiatives drive the need to tailor approach

– Breadth of analysis will vary

• Specific work should be easy to design and timely to implement

• Approach should be simple to communicate and institutionalize in the organization to ensure sustainability

• Should help identify inefficiencies in the system (e.g., redundant activities, low value products) to enable tangible action

NJE-262622.366-20050606-jdonHR1

15

EXAMPLES OF CHANGING THE WAY THE BUSINESS WORKS

Examples of potential initiatives Time to diagnose/launch

Time to full impact of savings*

Redesigning processes and practices

• Functional process excellence (e.g., portfolio prioritization in R&D and S&M)

• Support function optimization (standardization, off-shoring, demand management)

• ~2-3 months • Savings begin in 6-12 months with full impact in 12-18 months

Managing demand and supply levers on external spend

• Category by category business-driven procurement initiatives focused on unit price and demand (often >65% of savings)

• Typically in ~6 month waves but may differ by spend category

• ~2-3 month waves

Changing the operating model

• European regional models• Aggressively managing non-strategic

products• Global vs. regional vs. local marketing

models

• Differs by specific initiative but generally 3-4 months

• Could start in 6-12 months with full impact likely in 12-18 months

* Timing post launch of initiative

Issuing top-down mandates

• Travel• Hiring• Compensation• Meetings

• Less than 1 month

• Immediate – within ~3-4 months

NJE-262622.366-20050606-jdonHR1

16

“I will change my mindsets and behaviors, if . . . ”

SUCCESSFUL COMPANIES HAVE SYSTEMATICALLY CHANGED MINDSETS AND CULTURE FOR LASTING IMPACT

“. . . I have the skills and confidence to behave in the new way.”

Capability building

“... the systems reinforcethe desired change.”

Metrics and tracking

Leadership direction and role modeling

“… I know what I need to change and I want to do it.”

Communication

“ … I see my leaders behaving differently”

NJE-262622.366-20050606-jdonHR1

17

IN CLOSING . . .

•The need for productivity focus in the industry is real and will likely continue

•There is meaningful upside for those who can sustain productivity – particularly as a lever to fund medium to long-term growth (not only near-term earnings)

•Players who want to achieve sustained productivity will need to put in place a careful up-front architecture coupled with a real execution/implementation focus over time