MANAGEMENT INSIGHT - Business Lessons From the Salamander

When business models break, management teams get out the band-aids. I’ve done it myself. We take the scalpel to org charts, swallow pills to get the financial blood flowing again, and splint or amputate damaged business units. It’s not our fault. We’re mammals. It’s instinct.

We should repair our business models like a salamander would. When a salamander loses a leg, the reptilian body immediately loses a flood of stem-like cells to the area. Genetic coding contains a positional memory of the location and type of the missing body part. Tissue, bone, and blood form not only in the right place, but in the correct sequence to avoid defective regeneration.

I’m not going to argue with my ancestors. Mammals chose this evolutionary path for a reason. The theory is that to our bodies, the sudden rapid cell growth of regeneration is eerily similar to that of cancer growth. Faced with a choice, our genetic ancestors favored tumor suppression over regeneration. The result is that when we lose a limb, the body rushes in with scar tissue; a durable long-term band-aid. But do we have to deal with all of our problems with band-aids? In the business world, we could do with some out-of-the-phylum thinking.

This is the argument put forth by author Saul Kaplan in his book, The Business Model Innovation Factory. With the shelf-life of business models shrinking every day, Kaplan argues that today’s most successful businesses respond to trauma by regenerating new business models, not splinting the old one.

It’s a provocative assertion, and one that the pharma industry needs to hear. Under a full-scale assault of slowing R&D, generic competition, and declining profits, our industry is responding to this unending assault by throwing its entire rather well-stocked medicine cabinet full of pills and patches at the problem.

GETTING NETFLIXED

Let’s start with an illustration. How could a business like Blockbuster go from a market cap of $5 billion at its height in 2002, to bankruptcy 8 years later? Blockbuster saw Netflix coming, writes Kaplan, but management was so infatuated with their own bricks and mortar business model that they refused to let it go. They struggled to create a finer, better balanced sword, when Netflix had just introduced gun powder.

It wasn’t a new technology that took the movie rental behemoth down. The DVD itself, invented in 1995, was in fact a sustaining technology; one that would help Blockbuster deliver their model at a higher level. What took Blockbuster down was the new business model Netflix created around the DVD.

Netflix noticed that DVDs were small enough to stick in an envelope, so they began offering a mail order service. At first, the upstart company followed Blockbuster’s pay-per-rental business model, complete with late fees. It did only moderately well. But in 1999, Netflix launched a single flat fee for unlimited rentals, no late fees, shipping charges, or due dates. The new model rocketed out of the gate, quintupling sales to $5 million in a single year. In the same 8 years that Blockbuster went from peak to valley, Netflix subscriber base grew from 1 million to 14 million.

Inside the corporate hallways of Blockbuster, CEO John Antico moved in with an online offering that offered credible competition, albeit Johnny Come Lately. Given the resources Blockbuster wielded in those early days, this approach, called Total Access, might have had a shot, but for the iconic investor Carl Icahn, then a major shareholder of Blockbuster, who moved to protect the storefront business model, effectively keeping the band playing even as the ship listed and descended into frigid black waters. Icahn fought for a strategy of more stores, and succeeded in pushing Antico out as CEO. With Antico gone, so too were the forces of change, and the lights rapidly went out.

Now, to get “netflixed” is a verb in the urban dictionary. The dictionary defines it as “being taken advantage of, or getting swindled out of money,” but that’s not quite accurate. That definition implies that Blockbuster was a victim. There are no victims in the business world. Getting netflixed means your existing business model has just been trumped. Amazon netflixed Borders and Best Buy. Apple netflixed Tower Records. Craigslist is netflixing rapidly your local paper.

Some have argued that even Netflix is now in danger of getting netflixed, though I’m not sure the analogy works, because it’s more of a self-flagellation thing. Despite strong earnings and a remarkable recovery in its stock price this past month, Netflix has been stumbling since the summer of 2011 when the company decided it was operating two business models (DVD subscriptions and online streaming) under one roof. By trying to separate the models and simultaneously sharply raising subscription fees, the company undertook a business model regeneration when it wasn’t under threat of attack, and the market responded to the strategy like it would to a cancer – it fought back. I, for one, dropped my subscription in anger, though I reluctantly came back a few months later. No competitor proved capable of meeting my insatiable demand for obscure movies.

Like Lady Gaga goes through sequins, Netflix goes through business models. The latest ones are proving profitable again, as the company tries out content ownership, including the cult favorite Fox situational comedy Arrested Development and the hotly anticipated political drama House of Cards, which begins in February.

Introducing a new business model in a young, sapling company like Netflix is one thing, but changing business models in a mature corporation is quite another. Just imagine the excitement on the faces of the senior managers responsible for Apple’s distribution channels (then Sears and CompUSA) as they eagerly embraced Steve Jobs announcement that he was going to create the Apple Store.

Just kidding. I sincerely doubt it went that way. Apple insiders would’ve done what most managers would do – vehemently defended their existing business model and fought tooth and nail against the new concept. The entire organization, Kaplan writes, was in fact structured around that traditional distribution system, from job descriptions through performance management systems to incentives. Introducing a new business model always meets with resistance from the entrenched business model and its proponents.

REGENERATING THE PHARMA BUSINESS MODEL

Pharma, in the opinion of many, is long overdue for a business model overhaul. In all the other examples trotted out by Kaplan (Netflix, Apple, Amazon, Craigslist, etc.), the existing business model for the given industry was not broken. It was working just fine, thank you very much, until a new business model came along and made it obsolete. Our industry model is broken, and begging for a better model to allow it to descend honorably into obsolescence. Large Pharma converged long ago around the Blockbuster Business Model – in this case, not referring to the Blockbuster movie example, but rather to those blockbuster drugs that achieve sales over $1 billion. It’s a lottery ticket strategy, and it worked well in the past, earning over $1 trillion for Big Pharma in the past decade. That was then, this is now.

Declining R&D productivity, increasing commercialization costs, growing payor influence, and shorter exclusivity periods have inflated the cost of the average successful launch to somewhere in the range of $1-1.3 billion, depending on the source cited. Expected returns on new investments are now a paltry 5%. Even a mediocre hedge fund can beat those numbers.

Most Big Pharma executives see what’s happening, but they feel powerless to wrestle their companies away from the entrenched and powerful organizational proponents of inertia who call on them to maintain their immense investments in science and their 80,000 sales reps in the US alone, all geared toward maximizing sales of just a couple of products in the portfolio. It’s hard to argue internally against a system that, until 2002, generated average annual revenues of 13%, argue Gilbert Henske and Singh in “Rebuilding a Better Business Model,” in In Vivo magazine, published in 2003. This seminal article, while somewhat dated, remains no less relevant given how little business models have evolved since it was written, largely due to the recession of 2008 which put the brakes on business innovation.

Pfizer, GlaxoSmithKline, and Merck may, through their sheer size and resources, be able to outlast their smaller competitors, but market value is already beginning to shift to business model innovators like Novo Nordisk, Genentech, and Forest Laboratories. In these companies and others like them, Gilbert, Henske, and Singh see the stirrings of a new model (or maybe a number of models) in what they refer to as the four building blocks.

BLOCK 1: FOCUS, FOCUS, FOCUS…

Lucky breaks–the discovery of a blockbuster drug from R&D in an unrelated area–happen, but not as often as the media seems to think. Only about 30% of all blockbusters fall into the Viagra category. The rest make their discoveries the old fashioned way – by building on knowledge and experience. The fact is, prior experience does help companies increase the likelihood of developing a successful product, and with the increasing costs of failure, the old scattergun approach in which every molecule is given a fair chance is simply not feasible for most companies anymore.

Genentech has focused on biologics, Gilbert, Henske, and Singh write. They have since added small molecules as well. Vertex Pharmaceuticals uses a structured approach to drug design. Nova has zeroed in on particular patient/physician groups in diabetes. Big Pharma generally stays away from specialists, but these smaller drugs don’t require primary care sales forces, and that can significantly boost their profitability.

BLOCK 2: PARTNERSHIPS

The move toward more partnerships is a trend I see growing so quickly and providing such obvious advantages over in-house offerings that it’s practically unstoppable. Rapidly disappearing in the rear view mirror is the fully integrated pharma company, dependent on in-house specialists who have seen only a couple of products in their careers. In its place is a much more nimble industry, choosing from a range of specialists in each stage of product development. The choice is no longer whether or not to use a specialist, but how to partner with a chosen specialist – through a single, short-term contract? Through multiple contracts? Or joint ventures?

At a conference I was at in January, a speaker said he believes sixty percent of all products in development today are in-licensed. Actual stats are hard to find, because once a product comes inside it gets a new number and it becomes hard to trace back to its roots.

Gilbert, Henske, and Singh argue that pharma is headed the way of the movie industry, in which many blockbuster movies are made by partnerships of multiple studios and individual contractors who provide everything from screen writing and acting to directing and special effects.

Numerous other industries made the move toward partnerships years if not decades ago, most notably the car industry, but also fashion and information technology.

At Xcelience, we focus primarily on preformulation and formulation. Our scientists deal with new molecules every day and operate a broad variety of equipment. When dealing with a new drug, there is no substitute for this breadth of experience. Other specialist companies can say the same about their own services in other stages in the pipeline.

The more we work with Large Pharma, the more they recognize this specialist value. Not only is our business growing at a steady rate, but I’ve been approached with more joint venture opportunities in the past few weeks than in the past few years, combined.

BLOCK 3: SELL CUSTOMER SOLUTIONS

This building block, while advanced in other industries, is still in its infancy in the pharma market, and I find the idea particularly exciting. The premise is much like what we’ve seen in the computer industry, in which technology companies focus on selling solutions rather than products. The sale of products and ancillary products become part and parcel of the overall solution. In the pharma industry, instead of just selling the drug, the focus would be on selling the complete package required for the individual patient to manage his or her condition. This could include specific delivery methods, such as we are seeing developed for the diabetes markets, but it could also include products that improve compliance, nutritional requirements, over-thecounter products, and more.

Kaplan took this idea a step further in The Innovation Factory when he proposed to a pharma client in the diabetes market an outcome-based business model in which the company would structure its rewards based on patient success, rather than on providing a product. Such a model would represent a radical shift from selling drugs, to selling patient outcomes.

Kaplan writes that his team wasn’t particularly surprised when the CEO – despite having asked for “out of the box solutions” – quietly thanked his team for their input and then implemented only those ideas that supported the company’s current business model. Convinced the new model could be revolutionary, Kaplan begged the CEO, “Give me Rhode Island.” Rhode Island represented a tiny portion of the company’s overall market, and with it, Kaplan promised to test the patient-outcome business model, design a prototype, and demonstrate how it could make money. Still the company declined, and the model remains, to my knowledge, untested.

BLOCK 4: BUILD A BUSINESS UNIT

Pharma has generally operated along functional lines, organizing itself into units that reflect the different phases of the drug development pipeline. Other industries have moved away from this model, turning to a business unit model that focuses on a single product from birth all the way to marketing and sales. In the business unit model, IT and administration is generally shared or outsourced. Decision-making becomes tighter and quicker; more customerfocused. The profit contribution of an individual molecule/product is easily measured, making return transparent. It’s a more flexible model. Novartis is experimenting with specialty business units such as oncology. In Large Pharma, Elily Lily has set up its promising ‘Chorus’ proof of concept business units.

I’m sure there are many more building blocks out there that have yet to be discovered, but I feel certain that our industry is on the cusp of radical change. We simply can’t go on patching our rickety old blockbuster model. Industries all around us have learned the skill of regeneration while our industry has stalwartly refused. Our turn will come. The question is, who will lead the change? That will be the subject of my next installment.

Derek G. Hennecke is a Founding Member, CEO, and President of Xcelience. He has a long history of growing strong businesses around the world. Blending a scientific and business background, he has nearly 2 decades of international experience in the healthcare industry and a track record as a highly successful international turn-around manager in the global drug development community. Xcelience is the first company Mr. Hennecke has managed as an owner, having launched a management buy-out from MDS Pharma Services in 2006. The newly-formed company immediately embarked on a robust pattern of growth. Before founding Xcelience, Mr. Hennecke spent more than 10 years abroad working for the Dutch-based conglomerate DSM. In Montreal, he was GM of a 250-staff Biologics plant for more than 2 years. In Cairo, Egypt, as GM, he oversaw a turn-around in an anti-infectives plant that had been slated for closure. He spent 2 years in Holland developing new Pharma intermediates, and two years in Mexico as Commercial Director covering Central and South America. He also worked for Roche, both in Canada and Germany. Mr. Hennecke has a BSc in Microbiology