Pharma's Kodak moment
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With the recent news of how Kodak plans to emerge from bankruptcy, it's easy to see the company's failure as another example of a conservative behemoth failing to lead in the "next wave" of technology. But a closer look reveals that Kodak was actually an innovator, having pioneered digital photography over four decades ago - and then chosen not to pursue it aggressively. Kodak's demise was not a result of being blindsided by new technology - instead, it appears to have been due to its slavish devotion to a extremely successful business model based on selling film:
For Kodak's leaders, going digital meant killing film, smashing the company's golden egg to make way for the new. [Company engineer Steve] Sasson saw in hindsight that he had not exactly won them over when he unveiled his toy: "In what has got to be one of the most insensitive choices of demonstration titles ever, we called it 'Film-less Photography'. Talk about warming up your audience!"
But was Kodak's key error an "innovator's dilemma", in which a company concentrates on serving its existing customers at the expense of capitalizing on a disruptive technology? Maybe not. Guardian columnist Jason Farago points out that the real "disruption" of digital has been to deconstruct the entire photography process into its constituent parts:
What Kodak feared, not incorrectly, was the loss of its vertically integrated system, which brought in massive revenues. Kodak enjoyed profit margins of 70 to 80% on photographic film, which customers bought over and over once they purchased a camera. Consumer electronics operate as a much lower margin. Digital cameras made things even worse, cameraphones worse still. "We do the rest," Kodak used to boast: but with digital photography there's no rest left to do, unless you count the addition of inane push-button filters to make it look as if you were eating your cronut during the Civil War.
Kodak's problem was not that it failed to bolt on a more profitable part of the value chain - its problem was that the links had become undone. As we now realize, with digital photography there's little value to one company selling all components of the end-to-end solution (camera, film, and the means of developing and printing). The "vertically integrated system" is less valuable, because there's less synergy between the parts. All that matters is a company's ability to win in each discrete sub-segment. Kodak's mistake - which, in fairness, may have been hard to avoid at the time - was in not realizing that integration was no longer key to success.
Pharma faces a similar challenge - to improve or lengthen the chain, or to tear it apart? According to the first view (most recently espoused by David Shaywitz of Forbes), pharma and med-tech need to embrace complementary services that can (hopefully) help them improve focus, productivity and profitability in their core businesses. But unless companies that have gone this route, like Medtronic, DaVita and Endo, can demonstrate to their customers and investors that these aggregations create synergistic value (as opposed to just diversification), this strategy could instead be a further propagation of the vertical integration myth.
In contrast, successful disaggregation of the pharma value chain is already in evidence today, and may be the "new normal". Biotechs, virtual accelerators, contract research organizations, and contract sales organizations have demonstrated that a company can successfully compete with large pharma by focusing on a specific part of the process (e.g., basic research, early development, late development, sales), and it may be just a matter of time before sub-specialists emerge more widely in the remaining links of the chain (e.g., contracting / market access). At the same time, global firms have been unable to convincingly demonstrate the financial or strategic value of the "fully integrated pharma company" - as illustrated most recently by an equity analyst's call for Merck to significantly curtail its in-house R&D activities.
Like Kodak, large pharma companies can either demonstrate the value of vertical integration, or accept the fact that each link is self-contained and needs to compete with "specialists" to succeed (or fail) on its own merits. Part of Kodak's problem was probably that it jumped into digital (cameras, photo-quality printers and paper, free-standing picture kiosks) too late to compete - but the bigger failure may have been in thinking there was any added value to having all of these pieces under one roof. By chasing bolt-on opportunities in "disease management", "practice solutions" and "digital health" without first defining the synergy value and how to realize it, pharma companies may be on the verge of making the same mistake.
Acknowledgement: Thanks to Frank Kumli of Ernst & Young for tweeting Jason Farago's Guardian piece on Kodak, which inspired this post.
Disclaimer: I formerly worked at Leerink Swann, which issued the Merck equity research report I cited above.