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 In the July 2001 issue: Despite record profits for many pharmaceutical companies, will the future bring leaner times as Medicare, Medicaid and other payers start to play hardball? And what about competition from generics?
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Big Pharma: Big Trouble, or Will It Weather the Storm? With most of the rest of
corporate America Despite these strong results, there are pockets of weakness. Shares of Merck (NYSE: MRK) hit a 52-week low in early July after the company’s June 22 announcement that it would miss analysts’ estimates for second quarter earnings by two to four cents per share sent the stock price downward. Just last April, management had stated that the company was comfortable with analysts’ estimates for the full year. In addition, Frankfurt, Germany-based Bayer AG said it expected second quarter and full year earnings to decline because of the global economic slowdown, as well as a sharp drop in earnings from one of its biotech products. Although not the result of some looming problems that will be discussed below, these weak spots demonstrate that the pharmaceutical industry is certainly not immune to risk. The question is, will the number of risks increase and will their spread result in a fundamental change in the pharmaceutical industry? No one will dispute the fact that the U.S. pharmaceutical industry is a critically important part of this country’s health system, nor that it is the most profitable segment of the health care industry. However, whether the drug industry engages in price gouging, as former Vice President Al Gore and the junior Senator from New York have alleged, enters a gray area of debate that has strong, and sometimes emotional, voices on both sides of the argument. What may matter most is not if "price gouging" occurs, but that there is a perception that it does. And when the elderly, who are the largest consumers of prescription drugs, are perceived to bear the brunt of the alleged gouging, every politician will find the nearest news camera to get in a sound byte or two prior to election time. Despite the calls for price controls from some political corners, drug companies will remain profitable primarily because society needs them to be profitable. Without profits, there would be little innovation, and without innovation, there would be fewer of the drugs that we have begun to rely on to cure many diseases. How much do the pharmaceutical companies need to make? The answer is somewhat irrelevant, because a cure for cancer would be priceless and few would worry about how much that lucky firm would make (except, perhaps, that junior Senator). How much they need to make will never be answered; the reality is that beginning in a few years, there is a good possibility that they will be making less, and that will have a chilling impact on equity prices. Some Wall Street analysts believe that the bad news about pharmaceutical companies is already out and has been built into current stock prices, so "let’s move on," as they like to say. Unfortunately, they are missing the point. While most of the risks to the drug companies are known (the news), there has been very little financial impact….yet. Although it may take a few years to be put in place, a Medicare prescription drug benefit is highly likely to be passed by Congress and signed into law. The details, however, will continue to evolve. If a new benefit becomes part of Medicare, as opposed to Medicare subsidizing seniors who in turn purchase their own insurance for prescription drugs, then the government will be in a position to exert its influence on the pricing of those drugs. The unknown, of course, is how much that discounted pricing would be offset by increased usage under a Medicare sponsored benefit. Our bet is that the former will be dominant, and that will put a dent into future profits. The second area of concern for the large pharmaceutical companies is the push for the use of generic drugs as opposed to the more expensive brand-name drugs. Over the next three years, patents for brand-name drugs representing more than $20 billion in revenues for the pharmaceutical industry will be expiring, unless individual extensions can be obtained. Generics First(SM), a nationwide sampling and education program designed to promote the use of generics, already has 7,700 physicians participating. In addition, the Food and Drug Administration approved 25 first-time generics in the second quarter this year compared to 10 each in both the first quarter and in the second quarter of last year. As pharmaceutical use continues to escalate, combined with increasing prices, generic drugs will take a stronger foothold in the pharmaceutical market and impact big pharma’s profit margins. A recent decision by a California judge to allow Kaiser Permanente to exclude Viagra from its basic prescription coverage could have larger legal and financial implications for both the managed care industry and pharmaceutical companies. The decision endorses the concept of allowing health plans to design different kinds of pharmacy benefits, which consumer advocates fear will result in more HMOs eliminating other drug benefits purely on the basis of cost. Consumers will have the drug companies on their side in this looming battle, but it represents the potential for just one more dent in big pharma’s dominance. Speaking of dents, and although it also is fairly small (at least for now), Abbott Laboratories (NYSE: ABT) has recently made substantial cuts in prices it charges various state Medicaid programs for about 50 different drugs. Even though many of the price declines were modest, the price for one antibiotic dropped by 92% for a 500-milligram vial. Illinois’ Medicaid program will be saving more than $2 million per year because of ABT’s price cuts, and it is likely other companies will have their pricing negotiated as well. Taking a different tact with the Medicaid system is Pfizer, which recently entered into an agreement with Florida’s state Medicaid program to ensure it could keep all of the company’s prescription drugs on the state’s new "formulary" without discounting their prices. In an innovative deal negotiated with the state, Pfizer has promised the state $33 million in savings over two years through a new disease management program. The company will hire and pay for nurses to monitor the care of thousands of Florida Medicaid patients, with special attention to the most costly cases, such as patients with heart disease or diabetes. If the savings do not materialize, Pfizer will reimburse the state, although accurately measuring the savings may prove difficult. Other pharmaceutical companies negotiated price discounts or, in some cases, failed to make the state’s formulary. Obviously, not everyone is happy with what Pfizer did, but if the agreement is successful, others will surely jump on the bandwagon. The issue of different pricing strategies for different payers brings up the topic of a two-tier pricing system. This can be the U.S. market versus the less developed countries, the private pay (insurance) market versus the government paid market or any other group that can be segregated for pricing purposes. In fact, nearly 20 years ago two pharmaceutical companies were selling vaccines to underdeveloped countries at prices far lower than what they charged in the U.S. This caused the geniuses in Washington, D.C. to complain in front of a microphone (at election time, of course) that these companies should not discriminate against U.S. children. Now, the pharmaceutical industry has been pushed to sell AIDS drugs at lower prices in less developed countries, resulting in a two-tiered pricing system all over again. It will not take long for someone to cry foul and prove once again that history does repeat itself. A Yale economist, Jenny Lanjouw, has come up with an idea that might make everyone happy, but does little to solve the potential problems of a two-tiered pricing system within the U.S. Under the theory that drug patents, resulting in high prices in wealthy countries, are necessary for new product innovation, why not require U.S. drug companies applying for patents abroad to agree not to restrain competition from certain generic drugs in countries below a certain economic threshold? In theory, they would not be losing sales, because very few people would be able to afford the brand-name drug, but a higher number could perhaps pay for a generic drug at a fraction of the price. At the same time, the pharmaceutical companies would be able to receive their normal return on investment in the U.S. and in other industrial countries. The problem comes, however, when this solution is tweaked in the U.S. to deal with the different levels of wealth among our own consumers. That is something the large pharmaceutical companies would have big problems with, to say the least. In the meantime, the U.S. pharmaceutical industry continues to produce record profits amid side-deals, generic drug competition, calls for a Medicare prescription drug benefit and a general attack on what some people say is an obscene level of profits. Like pornography, however, the definition of obscene is in the eye of the beholder. When the question of profits comes up, try to remember the last major drug discovery that came out of Russia, or Canada, for that matter. Big pharma profits will not, and cannot, go away; they will just begin to slowly erode as the industry tries to deal with a new environment. |
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