For much of the 1990s, the pharmaceutical industry seemed bulletproof. Drugmakers enjoyed a string of blockbuster product launches, from the cholesterol-lowering drug Lipitor and erectile enhancer Viagra to a newfangled painkiller called Vioxx. Scientific breakthroughs--notably the revolution in genomics--held out the promise of even more novel medicines. And while economic cycles hammered other industries, investors found a safe haven in drugs through the late 1990s as the stocks posted heady gains.
These days, pharmaceutical companies look far from invincible. While the industry is fairly well insulated from the ups and downs of the overall economy, executives and investors alike have suddenly rediscovered that drugmaking is subject to a cycle dictated by the productivity of its research and development. With that cycle now heading into a trough, drugmakers face a nasty--and perhaps prolonged--downturn for two big reasons: Traditional methods of drug R&D are less productive than they used to be, and the payoff from the genomics revolution is taking longer than expected. And if that weren't bad enough, the industry is also confronting a wave of patent expirations, clearing the way for cheap generic knock-offs.
The resulting profit squeeze is likely to cause major industry turmoil. In the past, drugmakers could rely on price hikes or me-too drugs--essentially follow-up products to existing big sellers--to plug gaps. Now, those tactics don't work as well as they used to, in part because managed-care players are better at steering consumers to less expensive medicines. So drugmakers, to boost profits, are bound to explore more mergers and look increasingly to slash costs. But the former strategy has a dubious history, and the latter may be too tough a challenge for managers unaccustomed to lean times. Botched efforts could trigger turnover in executives suites. "For a while, the industry could patch the time between cycles," says GlaxoSmithKline PLC CEO Jean-Pierre Garnier. "Now, the cyclical nature of the industry is more visible."
How far have the mighty fallen? Consider the basket of eight drugmakers--seven big U.S. companies, plus Britain's GlaxoSmithKline (GSK )--that analyst Stephen M. Scala follows for SG Cowen Securities Corp. These players have racked up reliable double-digit earnings gains for the past five years. But this year, net income for the group will be up a meager 4.4%. And Raymond James & Associates Inc. analyst Michael Krensavage says the premium for U.S. drug stocks over the Standard & Poor's 500-stock index has dropped to a slim 5% based on projected 2002 earnings, down from the average premium of 14% since 1990. "They are no longer defensive stocks," says John Schroer, president of Denver-based health-care hedge fund Itros Capital Management. "Now, you're looking at them from a value perspective."
In essence, this fall from grace reflects a major productivity problem. While R&D spending for members of the Pharmaceutical Research & Manufacturers of America has more than tripled since 1990, ballooning from $8.4 billion to $30.3 billion last year, only 52 new drugs were approved by the Food & Drug Administration last year, vs. 64 back in 1990. That dip in productivity is a major problem now that drugs generating some $30 billion in U.S. sales are expected to lose U.S. patent protection or other forms of exclusivity over the next four years. And with the Federal Trade Commission taking aggressive steps to end drug company tactics for delaying generics, the generic onslaught will be unstoppable. "The payoff from R&D is not coming in time to fill this hole," says C. Anthony Butler, a managing director at Lehman Brothers Inc.
The productivity headache reflects a major transition occurring in pharmaceutical labs around the globe. Traditional methods of drug discovery don't yield as many drugs as they used to. In part, scientists say, this is because good therapies already exist for conditions such as hypertension or high cholesterol--ailments that are relatively well-understood. Now, scientists are going after increasingly complex diseases such as Alzheimer's, cancer, and diabetes, which have multiple causes and triggers that include genes, environmental assaults, and diet. "The low-hanging fruit have been picked," says Dr. Jeffrey M. Leiden, chief scientific officer.
The genomics revolution may eventually help tackle killers such as cancer. But most scientists believe that big payoff is five or more years away. For one thing, even when a gene is identified as being linked to a disease, it isn't clear how to design a drug to stop the progression of that condition. Take early-onset Alzheimer's and the form of the disease that strikes later in life. Dr. Steven M. Paul, group vice-president in Eli Lilly & Co.'s (LLY ) research arm, points out that genes linked to both forms had been identified by the early 1990s. But scientists are still trying to unravel how the disease progresses--and what stage in that process they should try to block with a drug. "There was an unrealistic expectation by some that this would be a hundred-yard dash," says Lilly's Paul. "It has turned out to be more of a marathon."
With that payoff far away, many pharma giants have thrown their considerable weight behind me-too drugs in an effort to bolster sales. Some of this year's launches are akin to the movie business trotting out Rocky IV--though the compounds are technically "new" and somewhat improved. Schering-Plough Corp. has already rolled out Clarinex, an allergy pill derived from its aging blockbuster Claritin. Pharmacia Corp. (PHA ) has launched another Cox-2 drug, Bextra, to follow in the footsteps of its arthritis hit Celebrex. And new competitors to Pfizer Inc.'s Viagra and Lipitor should hit later this year.
Even if they are slightly more effective, such wares are no solution to the industry's woes. For one thing, many of these categories are getting crowded, triggering expensive marketing battles. And unless the new drug has a compelling edge over existing therapies, companies bring them in at a discount to rival products--though still well above the price of generics. This discounting is almost always the case when drugmakers are trying to encourage patients to switch from a drug about to go generic--such as allergy pill Claritin--to a newer product with a long patent life, in this case, Clarinex. Clarinex costs about $1.83 per day, vs. Claritin's $2.33. That not only crimps Schering-Plough's revenue growth but makes it tougher for rivals who make products such as Allegra and Zyrtec to raise prices.
Compounding the pressure on prices, managed care and pharmacy benefit managers are getting more effective at restricting the use of new drugs where cheaper alternatives exist. More employers are now utilizing three-tiered co-pay systems for drugs, for example. Under those programs, a generic may have a co-pay of only $5, a preferred brand drug, usually with a moderate price, may have a co-pay of $10, while a very pricey brand name may have a $25 co-pay. As popular brands such as the antidepressant Prozac become available in cheap generic forms, three-tiered co-pay systems are steering more patients to these less expensive options. "Co-pays are near the point where patients are going to ask their doctor, `Is there a generic I can use?"' says Robert Seidman, chief pharmacy officer at insurer WellPoint Health Networks Inc. (WLP )
Admittedly, drugmakers still have pricing power. In fact, as they face slowing growth, they are increasingly pushing hefty price increases on products when they have major market advantages. Pfizer (PFE ), for example, was able to raise the price of the most commonly prescribed dose of Lipitor about 9% earlier this year, in part because the drug has been shown to be a more powerful cholesterol-lowering agent than competing medicines.
Still, the combination of reduced pricing flexibility and weak pipelines for new products is sending drugmakers scrambling to boost their bottom lines. Pradip K. Banerjee, partner in charge of the R&D practice at Accenture Ltd., figures many companies will slash overhead, look for savings in purchasing and manufacturing operations, and scrutinize marketing expenses. In fact, Merck & Co. (MRK ), which is projecting flat earnings this year as patents expire on big drugs, began a cost-cutting drive a year and a half ago that helped bring marketing and administrative costs down 3% in the first quarter, to $1.5 billion. Still, some observers warn that today's crop of drug CEOs aren't accustomed to intense cost pressure. The result may be turmoil among management ranks in coming years. "We don't have people with experience in running a tight ship," says Barrie G. James, president of Britain's Pharma Strategy Consulting.
Research and development will also come under scrutiny. The torrid growth in research spending is likely to cool from a compound annual growth rate of 13% from 1990 to 2000 to 7% over the next five years, according to SG Cowen. GlaxoSmithKline's Garnier says his company will make sure its investment goes toward hiring scientists and researchers, not adding infrastructure and support staff. "R&D had been a sacred cow," he says. "No longer."
Mergers, despite their weak track record in the industry, are also likely to increase. After all, they represent the easiest way to generate big cost savings. But the disruption and distraction of such deals could hurt new-drug output. In 1997, Pharma Strategy Consulting's James took a look at the companies formed by big mergers and found that almost all of them lost market share in the years following the deal. "This industry relies on creativity and speed," says Tom McKillop, chief executive of AstraZeneca PLC. "And those are not qualities you normally associate with very large companies." If drugmakers aren't careful, they may find the prescription they've selected to address their R&D ills could have dangerous side effects.
By Amy Barrett in Philadelphia, with Michael Arndt in Chicago