Mini Case: The High Profits of Narrow Markets
Cystic Fibrosis is a genetic disorder caused by genetic mutations that affect a protein called the ion channel which operates at the cellular level to move salt and moisture around the body. When these channels get “broken” by these mutations, salt and moisture can’t be efficiently distributed throughout the body and thick mucus accumulates in the lungs, pancreas and intestines, affecting breathing and digestion.
It is estimated that around 30,000 people in the US are affected by some kind of CF, as the disease is usually referred to, and between 4 and 5 percent of them (around 1,200 people) are affected by a specific mutation called G551D. In those patients, although the proteins are actually there, they are “turned off”.
In 2012, the US Food and Drug Administration (FDA) issued approval of Kalydeco, a new drug manufactured by Boston-based Vertex Pharmaceuticals, which treats the underlying cause of the condition in those affected by the G551D mutation. Simply put, Kalydeco “turns on” the channels that deliver salt and moisture.
The drug, which cost over $6 billion to develop, is provided to patients at a price of $311,000 per year, and the company offers a less effective product called Orkambi that sells at $272,000 per patient per year.
Since patients will be taking the drug for the rest of their lives, it costs millions of dollars to keep them on Kalydeco, but despite the exorbitant price, patients love it. “I still pinch myself everyday… I can take deep breaths. I can run without coughing,” said patient Emily Schaller, a user of the drug, to the New York Times.
While the target population for Kalydeco is pretty small (a bit over 1,000 people in the US), the company is still able to make profits from it and their stock has soared more than 300 percent over the last five years. Its customers love the product and since they pay for it through health insurance they don’t really care about how expensive it is.
Mark Sleeper, another patient, told Forbes “I hate that it’s expensive, because it makes it hard for people to get… but I kind of get it, because if they make money, they make better drugs. As someone who has CF, I see it both ways.”
A high-margin business helps compensate for a narrow customer segment. Legal advice, design firms and dental practices are all well known for yielding high margins. They are highly-skilled practices that are difficult to replicate which allows them to co-exist with other practices that target other customer segments or different geographies.
In contrast, low-margin businesses, retail for example, need to handle large volumes of demand and move inventory quickly in order to make a healthy profit.
When retailers like Walmart and Kmart entered the market in the late 1960s, they were able to make profits at gross margins of about 23 percent, a lame cut compared to the 40 percent that fully-staffed department stores were making at the time.
However, Walmart and Kmart were able to get higher returns on their investment by implementing a business model that allowed them to turn over their inventory more than five times a year, contrasted to only three times a year for large department stores and catalog retailers like Macy’s and Sears.
The discount retailers’ strategy was based on carrying low-margin items such as hardware, kitchenware, toys and sporting goods in barely-staffed stores. Because buyers of those items already knew what they were looking for, the companies could save a lot in staff costs and achieve higher turnover of inventory.
It is not that Walmart and the other retailers were less profitable than the department stores and catalog retailers, but instead their business models enabled them to make money at lower profit “per unit”. In other words, they were more “profitable” while having lower margins, and that’s how those upcoming players later came to dominate the retail space and became the new incumbents.
Understanding profitability and how its underlying mechanisms work is critical for strategy, because at the end, superior profitability, not market share nor margins or killing your competition, should be the final goal of your business’ strategy.
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Herper, Matthew. For Vertex Pharmaceuticals, Can One Billion-Dollar Breakthrough Beget Another? Forbes Website. August 2017. URL: https://forbes.com/sites/matthewherper/2017/08/08/vertex-pharmaceuticals-and-the-price-of-inspiration/
Nocera, Joe. The $300,000 Drug. The New York Times (opinion). July 2014. URL: https://nytimes.com/2014/07/19/opinion/joe-nocera-cystic-fibrosis-drug-price.html
Christensen, Clayton M.; Tedlow, R.S. Patterns of Disruption in Retailing. Harvard Business Review 78, no. 1 (January–February 2000): 42–45.
Henderson, Bruce. “The Pricing Paradox” (1970). The Boston Consulting Group on Strategy: Classic Concepts and New Perspectives. 2nd Edition. Edited by Stern, Carl W. and Deimler, Michael S. John Wiley & Sons, Inc. 2006.