The Myth of the “Patent Cliff” | Xconomy Page 1 of 2

The Myth of the “Patent Cliff”

Stewart Lyman 11/29/10

Doctors, patients, and investors who follow the biopharmaceutical business all recognize that the industry
is exceedingly complex and in the midst of change. Companies struggle daily with a multifaceted mix of
scientific, clinical, and business unknowns. Will a drug be medically effective and make it through clinical
trials? Will it get the thumbs up from the FDA? Will insurance companies pay for it? Will side effects turn
out to be a major problem? Will manufacturing ramp up without a hitch? Will drug sales meet
expectations?

All of these things are unknown in the early days of a research project. One can make informed
predictions, some better, some worse, but uncertainties abound at virtually every stage of the drug
development process.

Unfortunately, many predictions turn out to be nothing more than wishful thinking. There is only one dead-
on, absolutely predictable element within the industry that companies can determine with certainty: the
date on which their drug patents will expire. They can put it on the corporate calendar as soon as the
patent is awarded. So how can patent expirations be considered a surprise, and why do drug company
executives fail to adequately plan for them?

The current big bugaboo in BioPharma is the “patent cliff.” This phrase has become a neologism, which
Wikipedia defines as “a newly coined word or phrase ….. that has not yet been accepted into the
mainstream language.” “Patent cliff” certainly fits the bill. I have a sense that the word “cliff” was picked by
whoever coined the phrase to give it a sense of danger and foreboding. Picture Indiana Jones dangling by
his fingertips over crocodile-filled waters. For some, this phrase wasn’t sufficiently scary, so “patent
apocalypse” was fashioned to further invoke fear and terror. Thankfully, “patent armageddon” has already
been used in a different tech setting, so we won’t have to read about this one in the biopharma field.

So what, exactly, is the “patent cliff?” It is most often described as an industry-wide expiration of the
patents of a number of blockbuster drugs, resulting in their replacement with generics and the emergence
of a large hole in the collective financial pocket of the industry. Some define it as being in a single year
(2010), while others point to a multi-year drop off ending in 2015. The “patent cliff” casts a long shadow
over the bestselling new drugs (that is, those still protected by patents) on the market. Of the 50 top selling
medicines in 2006, only six of them were approved for sale before 1993.

During the current five-year period 2010-2014, the sales revenues of drugs having patents that will expire
are about $89.5 billion, according to data compiled by IMS Health Midas. The focus of the patent
expirations is on small molecules, not biologics, since the FDA is still developing a clearly defined pathway
for the approval of biosimilars in the US. At first glance, the $89.5 billion figure quoted above would seem
to be a pretty big cavity to fill in the industry’s collective revenue pipeline. However, to truly judge this
figure, we should have a comparator number, something we can gauge this against. The value of drugs
having patents that expired during the preceding five-year period (2005-2009) was actually slightly higher
at about $90.5 billion. On a five-year basis, there is no patent cliff. Not even a patent incline, patent slope,
or patent slant. It looks more like a patent plateau. Yes, there are individual drug companies where a
significant portion of drugs generating sales revenue will go off patent in the near future. However, as an
industry this is not the large problem that some would have you believe. A graph illustrating drug industry
revenues at risk due to patent expirations from 2001-2015 resembles the Rocky Mountains, with lots of
ups and downs, but no cliff. In fact, despite this loss of patent protection, IMS Health is forecasting that the
industry will grow some $300 billion in revenue during the 2010-2014 time frame, with global drug sales
topping $1.1 trillion in 2014.

The “patent cliff” is a red herring that distracts us from the real problem for the industry: the rate of new
drug approvals wasn’t just flat; it actually declined during the last decade. Data compiled by CMR
International and IMS Health show that while drug sales increased nearly 2.5 fold from 1997 to 2007, the
number of new drug approvals dropped nearly by half. The increase in drug sales paralleled the nearly 300
percent increase in direct-to-consumer prescription drug advertising from 1997-2005, according to the
Government Accountability Office. Prescription drug advertising dollars, once unshackled for television in
1997, went primarily to promote new drugs with the longest patent lives. Unfortunately, pharma R & D
spending from 1996 to 2007 looks to be inversely proportional to the combined number of new molecular
entities plus new biologics approved. The equations here are pretty simple. More spending on direct-to-
consumer prescription advertising has generated more sales. More spending on research and
development has generated fewer drugs. To paraphrase Bob Dylan, you don’t need to be a weatherman to
see where this wind is blowing.

So if Big Pharma company executives knew that they faced major patent expirations that would be
accompanied by large revenue losses, how did they deal with this? There were six basic approaches they
could take to fill the revenue hole:

1) Increase their investment in research and development (or revamp their efforts) and come up with new
drugs.

2) Update existing drugs with slightly different (often longer lasting) versions protected by new patents.

3) Acquire other companies and their pipelines for additional revenue growth.

4) Pay generic drug makers not to enter the market (so-called “pay for delay” agreements) to protect their
revenue streams.

5) Ramp up selling existing drugs in newly expanding consumer markets, like India and China.

6) Diversify their core business by adding over-the-counter drugs, veterinary medicines, and diagnostics.

Note that only one of these approaches (the increased (or revamped) investment in research) actually
leads to new (as compared to newly acquired or modified) drugs. I recognize that drugs acquired from
other companies that are still in clinical trials are often new. However, the other paths merely lead to new
revenues, or to block a loss of revenues. Given the lack of research productivity in the industry, the primary

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response to these upcoming patent expirations was to curtail research expenditures, cut headcount, and
ramble down the other paths.

Updating old drugs with newer versions certainly juices revenues and has a high likelihood of success.
However, this is only marginally helpful to patients, especially those with diseases for which there are
currently no available treatments. Acquisitions will account for nearly two-thirds of Big Pharma sales
growth from 1995-2014, according to Datamonitor. Of course, as companies get bigger, they require larger
and larger acquisitions to provide sufficient revenue to maintain their sales growth rates. This approach is
clearly unsustainable in the long run. Increasingly popular “pay for delay” agreements are lucrative for the
industry; ending them would save consumers an estimated $35 billion over the next decade. As a result,
the Federal Trade Commission is currently advocating legislation that will outlaw a practice that many
already find unethical and anti-competitive.

As the evidence for internal research inefficiencies continues to mount, Big Pharma will move forward with
an increased emphasis on acquisitions and on partnerships with academic institutions. However,
abandoning internal research programs, as Morgan Stanley advocated earlier this year, is not a viable long
-term solution. Molecules acquired from insufficiently funded startups should be viewed through a skeptical
lens, since these potential drugs are not likely to have been thoroughly researched or vetted. Engaging
academics to explore the detailed biology of diseases and drug candidates is likely to increase the
probability of future success in the clinic if done properly. Drug pipeline-challenged companies have found
many willing partners among academic groups strained by fewer grants, reduced government support, and
shrinking endowments. It should be obvious to those in the industry that developing a clear understanding
of the biological underpinnings of human diseases is the gateway to crafting new medicines. Difficult, yes,
and expensive, but clearly necessary. Rushing drugs into the clinic without a mechanistic understanding of
how they function is a often a prescription for failure, though even having such an understanding is no
guarantee of success. Similarly, non-mechanistic side effects can spell doom for small molecules being
developed against any disease. This is what’s helped lead the industry shift into biologics, as I have
previously described. Big Pharma, it’s time to heed the call. Keep the primary focus on new drugs, not just
new revenues. Don’t cut back on research, but narrow your disease focus if you have to. Remember that
even with all of your financial resources, your internal labors will still be dwarfed by the efforts of the
worldwide research community. Collaborative approaches may be the best, most cost effective way to
achieve this. As Led Zeppelin affirmed in Stairway to Heaven “…there’s still time to change the road you’re
on.”

Stewart Lyman is Owner and Manager of Lyman BioPharma Consulting LLC in Seattle.

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