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Drugmakers Struggle with An Addiction

By Amy Tsao Last year, Bristol-Myers Squibb (BMY) executives thought they had pulled off a delicate balancing act. Two of its top-selling drugs, the breast-cancer treatment Taxol and the antianxiety medication BuSpar, were expected to lose business to low-price generic competitors in 2002. No problem, the execs figured, since Bristol-Myers expected new drugs for cancer and congestive heart failure to be approved this year and take up the slack.

Things didn't go according to plan. Bristol-Myers admitted that it persuaded distributors to buy 56 weeks' worth of its existing drugs in 2001 -- leaving an inventory bulge that will ultimately lower this year's sales. Then came a string of bad luck. The drugmaker's much-anticipated cancer drug Erbitux, developed by biotech company ImClone Systems (IMCL), failed to get Food & Drug Administration clearance. And the heart drug Vanlev was shown to be only slightly better than a cheaper generic competitor, meaning its sales likely will be lower than originally expected and won't help offset the expected 2002 sales lost due to the inventory buildup.

"LIKE HEROIN." Bristol-Myers was victimized by a phenomenon known in the pharma world as "channel stuffing" -- overselling inventories for a quarter or a year to help boost sales numbers. The practice generally isn't noticed if sales of new products cover the oversold inventory, but that wasn't the case with Bristol-Myers.

"It's like a heroin addiction," says Richard Evans, an analyst at stock research firm Sanford C. Bernstein. "You've got to keep taking a little more and a little more to keep showing growth." He adds: "In Bristol's case, it didn't get the product launch that would have allowed it to recover."

The result has been unsettling for Bristol-Myers, which declined to comment for this story. Its share price is off 37% since the beginning of the year, to around $32. And since admitting to the overselling in a Securities & Exchange Commission filing in April, CEO Peter Dolan has announced the departure of several top execs and warned the Street that 2002 earnings per share will be about 25% to 30% below last year's figure of $2.41, on revenues of $19.4 billion. Net income was $2.5 billion in 2001.

MORE HITS COMING? Analysts think the forecast may be optimistic: Earnings-per-share estimates now average $1.43, down 41% from 2001. Evans, who is more skeptical than most, sees net income again coming in at around $2.5 billion, or $1.30 per share. He predicts that revenues will be down around 12% from last year, to $17.1 billion.

Even Bristol-Myers is warning that efforts to reduce wholesale inventory could result in an additional 35-cent to 40-cent hit on its earnings-per-share targets before it's all over. Dolan's future with Bristol-Myers may ride on the outcome of his efforts to right its course, say many analysts.

As a rule, drug companies try to avoid channel stuffing, although it's perfectly legal. The practice of forward-selling is common in just about any industry, from autos to consumer products. Yet companies know that overloading distributors generally comes back to bite them sooner or later.

"MANAGING" ORDERS. One former distribution manager at a major drugmaker says the movement of inventory gets so hectic that he used to carry a beeper during the last week of each quarter specifically to keep in touch with distributors. "Every quarter we [were] actively managing the last week's orders," the manager recalls.

The problems at Bristol-Myers show how easily things can get out of hand, especially when the new products in the pipeline aren't as sure a thing as they have been in recent years. The drug industry is at the end of a long and prosperous period of big-selling products. "In every industry in a down cycle, the temptation to use [things like channel stuffing] is not unusual, but there's a varying level of discipline," says Viren Mehta, an analyst at Mehta Global Partners, a drug-industry research firm in New York.

Smaller drug companies often sell more to distributors than they normally would in hopes of making themselves look more attractive to potential acquirers, says Weidong Huang, an analyst with Times Square Asset Management. Large companies now are doing it "because they have the need" to boost their finances, he says.

OTHER BUILDUPS. Bristol-Myers aside, analysts say Schering-Plough (SGP) has the most worrisome inventory levels of any U.S. drug giant. Reducing oversupplies of the allergy drug Claritin is essential to Schering, since the medication is due to move to the over-the-counter market by yearend. Generic versions will come out around the same time, likely putting heavy pressure on Claritin sales.

Schering-Plough says it's working down inventory over the year, but the hit on 2002 profits could be as much as $250 million, say analysts. "I would be much more alarmed if next year it says it has the same inventory levels," says C.J. Sylvester of UBS Warburg.

Some analysts believe that Merck (MRK) may have similar issues to deal with. "Merck's inventories are getting pushed around by wholesalers, rather than the other way around. [Distributors] could be speculating that the company is about to raise prices," Evans says.

MORE DISCLOSURE. In a recent conference call, Merck said it's aware that some customers are buying additional inventory in anticipation of future needs. "This is wholesaler purchasing behavior. We do not have sales incentives in place," a spokesman says. Merck estimates that its normal inventory at wholesalers is one month or less. That's about the average for the industry at large, Sylvester says.

Many companies are responding to such concerns by emphasizing how they manage inventory levels. Johnson & Johnson (JNJ) says a stock buildup at its distributors resulted in an $80 million rise in sales in the first quarter, vs. the year-ago period. J&J booked $4.2 billion in global drug sales in 2002's first quarter. In its quarterly conference call, J&J said it has started new policies and programs to help lessen inventory volatility, including collaborating with the largest wholesalers on forecasting and replenishment planning.

With any luck, new billion-dollar drugs will soon be approved, and the pharmaceutical companies will get a much-needed boost. In the meantime, investors might want to keep alert to the issue of channel stuffing. It doesn't necessarily presage trouble, but it's often a red flag that something is amiss. Tsao covers technology and the markets from New York

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