Last December, Merck & Co., the world's third-largest pharmaceutical company, warned analysts that earnings would be flat for 2002, due to disappointing sales for arthritis drug Vioxx and expiring patents for other drugs. Stock of the drug maker fell about 15 percent on the news, which helped sink the shares of many other pharmaceutical companies facing similar patent expirations.
Yet, despite flat-lined earnings growth, Merck will increase research and development spending for 2002 to $2.9 billion, up 16 percent from 2001 levels. That money will support clinical trials of the 11 new drugs in Merck's pipeline. "It was a tough decision," says Judy Lewent, CFO of Merck for the past 12 years. "But we felt it was critical to continue investing in R&D, even if it contributed to flat earnings."
Long known in finance circles for her mastery of sophisticated modeling techniques such as Monte Carlo simulation, Lewent isn't about to take her money off the table now. "We had long discussions about it, and came to the conclusion that our job is to balance the long and short term," she says. "To delay the spending would have more serious repercussions than spending the money now."
As tough as the decision to increase spending was for Lewent, most CFOs would love to be in a position to make a similar one. Merck had a 2001 net income of $7.2 billion on companywide revenues of $47.7 billion, an increase of 7 percent over 2000's net income of $6.8 billion--healthy growth in a year when so many other industries took a financial bath. Still, by the standards of the pharmaceutical industry, Merck is lagging. On the whole, drug companies generate higher profits as a percent of revenues than any other industry, regularly topping 18 percent. Many of the major players, like Eli Lilly, Merck, and Pfizer, just paid the highest dividends to shareholders in company history.
But such success creates its own turbulence. The drug companies face intensifying price pressure, not from commoditization or competition but from, in essence, bad PR. Trumpeting multi-billion-dollar profits has made them a target for governments, corporations, and individuals eager to cut health-care costs. "Right now, the pharmaceutical industry has a bull's-eye painted on its back," says Ira Loss, executive vice president of Washington Analysis, an institutional investor research group.
And while justifying their profits to the critics, drug-company CFOs must also satisfy shareholders accustomed to those profits. Because of the high risks in pharmaceuticals, explains Eli Lilly and Co. CFO Charles Golden, shareholders expect high returns. In 2000, for instance, Lilly paid out $1.12 billion in dividends, out of net income of $3.05 billion. "I could lower my prices on products, but I probably wouldn't have many stockholders," says Golden. "We can't remain as vibrant as we are if we don't have the cash flow or income stream to absorb the risk."
Lewent articulates the conflict quite clearly. "One of the biggest issues I face right now is rebuilding shareholder confidence in future prospects for Merck," she says. "Another one is to continue to expand the understanding, on a global basis, of the critical role of pharmaceuticals and innovation, and the balance between innovation, intellectual property rights, and investor returns. One [issue] hits on the fiber and mission of the pharmaceutical industry, and the other one is critical to our shareholders and stakeholders."
Medicines for Melancholy
Ironically, much of the pressure Lewent and her peers face is a result of the enormous demand for pharmaceuticals. Retail sales jumped by 18.8 percent in 2000 (primarily from the increasing number of prescriptions, not price, according to the National Institute for Health Care Management, a nonprofit research group). New drugs are hitting the market to treat common illnesses that were formerly treated in other ways or not at all. For example, statins (like Pfizer's Lipitor), which reduce cholesterol, and antidepressants (like Lilly's Prozac) have opened up huge markets. These and drugs such as Vioxx for arthritis and Viagra for erectile dysfunction reflect the increasing demands of aging baby boomers.
Pharmaceutical companies have become much more efficient at supplying drugs to meet this market. Jonathan Symonds, CFO of AstraZeneca, which had sales of $16.4 billion in 2001, says R&D productivity has increased 50 percent since 1999. (Pharmacos spend only 15 to 20 percent of their revenues on R&D--in some cases, less than they spend on dividends. And once drugs are approved, gross margins soar to more than 80 percent.)
Drug companies are also sourcing new medicines from outside. Since 9 out of every 10 drugs in development are dropped during the lengthy (up to 10 years) clinical trial and approval process, big pharmacos are increasingly turning to in-licensing (buying rights to promising drugs already under development at other companies) or are taking equity stakes in smaller drug companies.
But extraordinary demand and efficient supply would mean nothing if the industry weren't operating in a free market. What pharmaco CFOs fear most are constraints on this market. "The proper system is a free-market system," says Lewent. "If there's value in it, there will be demand. Pharmaceuticals are not a cost-plus business."
Golden of Lilly points to Xigris, a treatment for severe sepsis that costs $6,800 per 96 hours of treatment, as a perfect example of the free market at work. "We try our best to determine what people think is reasonable," he says. "There is no other treatment today for sepsis [a massive, usually fatal infection]. You could define this drug as having infinite value, but if we priced it too high, it wouldn't be used too much. That's something we don't want." Golden says Lilly consulted with doctors, insurance companies, and its own sales staff to determine the correct price point.
Not many U.S. companies would put "maintenance of free market" at the top of their worry list, but the pharmaceutical industry has genuine reasons for concern. As global businesses, they find themselves at odds with the governments of many countries, especially in Europe. As Symonds of London-based AstraZeneca explains, "Medicaid and health-plan contracts in the U.S. are tough, but at least they're commercial. What you see in other countries is that the government is controlling health systems. You have price reductions without the ability to have discussions about the product benefits."
Pricing controls in European markets, such as France, which demands very low prices from drug makers, have pharmacos threatening to pull out of these markets. Developing nations and international health-care organizations are demanding dramatically reduced or free medicines to treat the AIDS pandemic. Largely due to price controls elsewhere, the United States funds development not only of the drugs it consumes but also of the drugs other countries consume at discount prices. "There's no question that we subsidize the rest of the world on this effort," says Loss at Washington Analysis. "This comes right out of our pockets." At least for now, drug companies are free to charge what they feel they must to make up for the foreign-profits constraints.
A Place for Profit
But that may change. Activists, government leaders, and consumer groups in the United States have begun to target the pharmaceutical sector for what they call excessive profits and for anticompetitive behavior. Historically, drug costs were largely hidden, thanks to broad insurance coverage, much of it paid for by employers. Today, individuals are increasingly called upon to pay some of their health-care bill. Health insurance costs are on the rise again (11 percent for 2001), and prescription drugs are the fastest-growing segment.
To cut costs, employers are increasingly moving to a tiered system in which a larger copayment is required for brand-name prescriptions than for generic versions. Besides the approximately 50 percent of insured employees facing these added costs, another 40 million Americans lacked insurance altogether for at least a portion of 2000, and that number is expected to rise in 2001-2002. Add an additional 15 million to 25 million people without adequate prescription drug coverage, including 27 percent of Medicare recipients, and a sizable constituency is born. Little wonder that prescription drug costs are under the most serious fire they've faced since Sen. Estes Kefauver held drug-company antitrust hearings in Congress from 1959 through 1961.
"There is a place for profit," says Larry D. Sasich, research director of the Public Citizen Health Research Group, "but it has to be controlled by the government. The companies have hidden behind the façade that their primary core is public health, [but] they make decisions based on the market."
Pharmaco CFOs claim they are unfairly being targeted for cost cutting, considering drugs represent a small portion of overall health-care costs and in many cases help consumers avoid more-expensive treatments. "Would our customers like lower prices?" asks Eli Lilly's Golden. "Of course, but they realize our therapies save lives. Mental health [drug therapy] is a great example. The price of the drugs is minuscule compared with the economic cost of the disease."
The critics argue that huge profits, like those at Pfizer, which saw net income more than double in 2001, to $7.79 billion (it took large merger-related write-downs in 2000), make them sitting ducks for cost-cutting initiatives--for fiscal and ethical reasons. "Some countries feel that it is wrong to make that much of a profit from sick people," says Sasich.
The drug companies have taken some steps to appease their critics, although to date most of their efforts have been overshadowed by their efforts to protect shareholder value. Take, for instance, their stands on federally and state-supported prescription drug benefits. With 25 states facing Medicaid shortfalls in 2002, pharmacos say they fully support Medicaid and Medicare prescription drug benefits. "There are certain segments of the population that aren't represented by insurance coverage," says Lewent. "We are as active as possible on efforts to find the solution to get coverage for those people. The answer is a federally supported Medicare drug reimbursement program."
Still, six drug makers, including Merck and Pfizer, refused to participate in another government-funded prescription drug program, the Michigan Medicaid formulary program. The industry has filed lawsuits attempting to block programs in both Michigan and Florida, claiming that the formulary program restricts patients from getting needed drugs. In fact, the programs don't block access, but they do force doctors who wish to prescribe drugs not on the formulary to get prior approval from a team of Medicaid pharmacists and doctors. The lawsuits contend that most doctors won't put in the extra effort.
Medicaid directors say the drug companies are just trying to protect their profit margins. Pharmaco CFOs say they fear a large, centralized prescription program would wield such immense buying power that it could unilaterally demand lower drug prices for an enormous market base--as is the case in Europe. They favor "market-based" systems instead--private insurance programs in which doctors are free to prescribe what they want and drug makers can negotiate with the prescription programs on the prices they charge.
While the suits have thus far yielded mixed results, at least one pharmaco has found a way to circumvent the issue. Pfizer managed to get all of its drugs on the Florida formulary without cutting its prices. Instead, it guaranteed that the state would get at least $30 million in savings by allowing Pfizer to underwrite a disease-management program, which closely monitors the care of the state's sickest Medicaid recipients. If the state fails to realize the expected cost savings, Pfizer has promised to pay the difference.
Almost all drug makers already offer some type of free or reduced drug program for low-income patients, administered largely through physicians. This January, Pfizer unveiled a new program called Share Card, which gives low-income Medicare recipients $15, 30-day prescriptions on any of its drugs (excluding one that is comarketed with another company). Both CVS and Wal-Mart have signed on to the program, which has received loud endorsements from some industry critics. Analysts also praise the move, saying that such programs may do more to defuse pricing pressures than any other measures.
"The Pfizer program is a masterstroke," declares Loss of Washington Analysis. "It's easy to understand, it provides a real benefit to people who need it, and I think a lot of the political pressure will be alleviated." Loss says the program "gives politicians who aren't already opposed to the drug industry a reason to continue with their support."
Unfortunately, the industry is giving politicians plenty of other reasons to be against it, most notably with its efforts to block generic competition. Drug patents are in force for 17 years, but since drug substances are usually patented about 10 years before a brand-name drug makes it to market, new drugs have only a 7-year profit window.
Drugs also often receive numerous patents, on everything from additional uses (called indications) to methods of manufacturing. AstraZeneca is currently embroiled in a court battle over ulcer drug Prilosec. Until last year, it was the largest-selling prescription drug in the world, with more than $6 billion in annual sales, but its substance patent expired in October 2001. Generic makers jumped in, but AstraZeneca sought to block them for infringing on a formulation patent that covers how the drug is protected from digestion by stomach acid. That patent was issued six years after the substance patent was granted, and CFO Symonds claims it is still in force. "Our belief is that we are dealing with nontrivial intellectual property," he says. "We have a very important obligation to protect it."
All the pharmaco CFOs agree that some companies have taken the issue of patent protection too far, which harms the entire industry. Bristol-Myers Squibb Co., called by analysts the most aggressive at pursuing patent protection, was recently sued by 30 state attorneys general for violating antitrust laws. The suits allege the company illegally kept generic versions of its BuSpar antianxiety medication off the market, costing consumers millions. It allegedly did so by making misleading statements to the Food and Drug Administration (FDA) about the scope of a new "last-minute" patent for BuSpar in order to gain a few more months of patent exclusivity. (BMS declined to comment for this story.) The Federal Trade Commission has filed a brief in the case, and has launched an investigation into similar anticompetitive practices in the industry.
"There is a point at which patent protection becomes frivolous protection of the product without substance," says Symonds. "There is a line that has to be drawn, beyond which all you do is undermine your company's credibility and the industry's credibility." Golden of Eli Lilly agrees, and even though that company is aggressively pursuing its Prozac patent, it has not attempted to patent additional indications for the product, or variations to the original substance, which would have given it further exclusivity. "We didn't think it was right to follow the path of getting a new patent on Prozac," says Golden. "We didn't think it was ethical."
Lewent says that Merck has a general policy of looking forward, not backward, for sources of growth. "For existing patents in place," she says, "we will defend them anywhere, anytime. With Vioxx, we had some cases that we fought, and we prevailed. However, our basic view is that our role in the future of medicine and therapy is to drive the R&D process and come up with the next generation. We believe that innovation is the way to further the enterprise."
As Seen On TV
With patents expiring, pharmacos need to make the most of the market exclusivity that they have, and they've done so to an increasing extent, using direct-to-consumer (DTC) advertising. But these ads have come under fire from consumer groups and from some corporations that claim the ads drive up drug costs by creating a desire for more-expensive drugs that consumers don't always need.
"Direct-to-consumer advertising drives unnecessary utilization," says Rob Minton, manager of health-care communications at General Motors Corp., which saw its cost for prescription drug coverage rise to $1.3 billion in 2001. "When someone walks into a doctor's office and asks for a drug they saw advertised on TV, most of the time the doctor will prescribe it, even if the patient doesn't need it."
A recent internal GM study seems to validate Minton's theory. The study examined hundreds of GM employees who used Prilosec. Over three years, 92 percent of plan members receiving prescriptions for the drug had no prior prescriptions or treatments for gastrointestinal (GI) disorders or heartburn. Most doctors think Prilosec is the drug of choice for only a severe form of GI acid reflux; in other cases, generic Tagamet, Zantac, or even over-the-counter Mylanta would work just as well--for a fraction of the cost. "In most cases, the most expensive drug was the very first therapy, when only a small percentage really needed it," says Minton.
There's no hard data to support that statement, but one thing is certain: drug advertising works. A recent study by the National Institute for Health Care Management showed that the increase in sales of the 50 most heavily advertised prescription drugs accounted for almost half of the rise in retail spending on all prescription drugs. The 50 drugs saw increased sales of 32 percent compared with 13.5 percent for all other drugs.
DTC advertising spending by pharmaceutical companies has skyrocketed in recent years. Ad spending alone (which includes advertising to doctors) rose to $2.5 billion in 2000 from $791 million in 1996. Pharmacos argue that the advertisements educate patients about their illnesses and may help more people get the treatment they need, or encourage them to stay on a prescribed medication. "The evidence so far is that direct-to-consumer advertising for critical disease has had a major beneficial effect," claims Lewent. "It's not bringing in people who don't need it."
The FDA is conducting a major study to determine whether this is the case. Some corporations aren't waiting, though. In mid-2001, GM sent its in-house pharmacist, Cynthia Kirman, and the company's former executive director of health-care initiatives, Jim Cubbin, to meet with representatives of the top five drug manufacturers. "We wanted to let them know that we think their marketing practices are inappropriate and that we are not happy about it," says Minton.
Defusing the Pricing Bomb
By their own admission, pharmaco CFOs haven't done a very good job of defusing the drug-pricing bomb. "I think some of the criticism of the industry is justified," says Lilly's Golden, "because we haven't done as good a job of making our case. Our ability to educate people about why we are doing what we're doing with our pricing is probably our hardest challenge."
The industry has spent considerable time and money making its case to lawmakers. Pharmacos hired 625 different lobbyists in 2000, and spent $262 million on lobbyists, political contributions, and issue ads during the 1999-2000 election cycle alone, more than any other industry, according to Public Citizen's Congress Watch and the Center for Responsive Politics. But programs like Pfizer's Share Card may be just as effective at swaying public opinion. "Any money they lose on this program should be viewed as an investment," says Loss of Washington Analysis.
Although programs help, it seems these CFOs are relying most heavily on the public goodwill generated from the industry's role as discoverer of lifesaving drugs--and the potential threats to that role posed by profit constraints--to eventually relieve the pressure to rein in prices. Says Lewent: "We hearken back to a quote from George Merck [former chairman and son of the founder]: 'Medicine is for the people, not the profit. If you take care of the people, the profits will follow.' That's the way we run our business."
In the final analysis, says Golden, pricing pressures are not as big a threat as shareholder alienation. "Ultimately, we exist with the support of our shareholders. If no one wants to buy our stock, we won't be in business."
On the other hand, "if they don't take control of the price problem, someone else will," says Loss. "And they're not going to like who the 'someone else' is."
Kris Frieswick (email@example.com) is a staff writer at CFO.