A Bitter Tonic For Drugmakers?

Judging from the hue and cry in Washington these days, pharmaceutical makers are the greatest threat to America since the Evil Empire. Senator David H. Pryor (D-Ark.) kicked off the latest drug-industry bashing on Feb. 3, accusing companies of "unadulterated greed." The Clinton Administration immediately joined in. Senior officials ripped into the industry's practices and motives, while the President denounced "shocking" prices.

The Administration is committed to paring the share of gross domestic product--14%, or $835 billion, last year--consumed by health-care costs. Drug prices, which are 7% to 10% of that and have risen faster than inflation for a dozen years, make a tempting target. So it's no surprise that Clinton and Congress are preparing plans to restrain prescription- drug costs. "Price controls and profitability constraints are coming," says Kurt Landgraf, executive vice-president for pharmaceutical operations at DuPont Merck Pharmaceutical Co.

The question now is: Can prices be tamed without crushing innovation in a leading-edge industry? Many economists and industry executives say no--particularly if it means strict controls on new-product prices. That would "be a disaster," says Joshua Boger, president of Vertex Pharmaceuticals Inc. in Cambridge, Mass. Without hefty prices and profits, the investors who finance biotech will flee, as they've done since talk of controls began. Large drugmakers, meanwhile, say lower prices and profits will mean cuts in research and development, the wellspring of tomorrow's advances. Price caps "will wound the industry," declares health-care expert L. John Wilkerson, chairman of the Wilkerson Group Inc. "America and the world will lose by not getting better medicines." And though the jobs impact would be small--total industry employment is just 297,000--there's no sense in harming an industry with a $1.3 billion annual trade surplus.

COPYCATS. Even so, considerable evidence suggests that well-designed price restraints wouldn't have to be a prescription for disaster. It seems likely that large drugmakers could absorb lower increases on existing products by developing drugs more efficiently and scaling back overhead and promotion budgets: Those amount to 25% of sales, vs. R&D's 16%. If companies did both, "a 25% reduction in prices wouldn't hurt," says Mayo Clinic oncologist Charles G. Moertel, a drug-development veteran.

Such cuts would bring plenty of pain to companies. But even industry executives say that innovation will be the last area to feel the knife. "The industry will react by cutting costs in ways that don't undermine R&D," argues Randy Thurman, president of Rhne-Poulenc Rorer Inc., the U. S. arm of the French-owned drugmaker. "It will emerge better and healthier than ever before."

That would be some trick. From 1980 to 1992, net margins of U.S. drugmakers rose nearly four points, to 12.8%. To achieve these results, the industry raised prices by 128.4%, according to figures from Pryor. On the surface, drugmakers make good use of their profits. Over those 12 years, the companies boosted R&D spending from 10% of sales to 16% (chart). Obviously, says Duke University economist Henry G. Grabowski, higher revenues and profits go hand in hand with higher R&D spending--and, theoretically, more innovative products. The experience in some countries with price restraints seems to support this position. Studies by Lacy Glenn Thomas III of Emory University, among other economists, show that countries like France and Austria, which have the toughest price restrictions, also do the least research.

Still, there are plenty of examples to the contrary--enough to make it "wrong to say that price controls are incompatible with innovation," says Thomas. In Britain, where the government allows higher profits for companies that produce innovative compounds, drugmakers have become more competitive in world markets, Thomas points out. And though Canada began controlling price increases in 1987, drug R&D there has risen from less than 5% of sales to more than 10% on average. Even in France, Synthlabo, the drug unit of France's L'Oral, spends up to 20% of sales a year on R&D on the theory that only innovative drugs will pay off under price restraints. One benefit of controls, argues industry analyst Ian Broadhurst of BNP Securities in London, is that the "crap is cleared out, and the innovators are coming to the surface."

Such prodding may not hurt U.S. drugmakers. Consider all those wonder drugs the industry is presumed to turn out. In fact, the Food & Drug Administration classified some 80% of the drugs it approved from 1985 to 1990 as copycats, or those offering only small improvements over existing products. In the past five years, up to 65% of sales upticks among large drugmakers have been the result of price hikes on existing products, says Hemant K. Shah, an industry analyst and president of HKS & Co.

HARD SELL. U.S. drugmakers also have fat they can cut to compensate for holding down prices. "Most major corporations have trimmed down," says University of Minnesota pharmaceutical economist Stephen W. Schondelmeyer. "Pharmaceutical companies haven't faced that music yet." When they do, they will "try hard not to cut R&D because it distinguishes one company from another," says Paul E. Freiman, CEO of Syntex Corp. So far, that's true: In the past 18 months, Merck, Syntex, and Warner-Lambert started downsizing programs that will cut up to 10% of their jobs: All plan to do it mostly by trimming marketing and administrative slots--almost entirely exempting R&D.

There's room for further reductions. Traditionally, drugmakers have used armies of "detail men" to persuade physicians to prescribe their products. These well-paid salespeople waste hours waiting to see doctors, then ply them with free samples, trinkets, and honorariums to attend dinners pitching their drugs. As more buying and prescribing decisions are made by health-maintenance organizations, hospitals, and the government, there's less need for detail men and their largess. The resulting savings are "tremendous," says Philip P. Gerbino, vice-president of the Philadelphia College of Pharmacy & Science.

There are ways, as well, to boost the efficiency of R&D. Clinical trials, for instance, account for two-thirds of R&D costs: Paying doctors less to run them--Canadian physicians get thousands less than U.S. doctors--would save millions. Drugmakers are also shaving costs by inking R&D deals and licensing agreements with biotech companies. And if the FDA delivers on its promise to cut drug approval time by 50%, companies will not only save millions in R&D, they'll also reap, on average, $65 million in revenue for each extra year that the average drug is under patent.

Given that potential, Congress' likely action on existing drugs--limiting price increases to inflation--wouldn't seriously hurt the industry. Of greater concern is what will happen on new-drug prices. Pryor's staff predicts that Congress eventually will set up a review board to negotiate wholesale prices for new drugs, much as other countries do. The critical issue is what criteria it will use to make decisions.

Currently, the price of a new drug bears little relation to its development cost. Take levamisole, a Johnson & Johnson product used for decades to de-worm sheep. When it was approved in 1990 as a colon-cancer treatment, J&J immediately raised its price one-hundredfold--bringing it closer to what similar products on the market cost.

The formula is different on breakthrough drugs. Prices for those are often set as a sizable fraction of the cost of alternative treatments that the drug renders obsolete. Even at sky-high prices, there could be a net saving. Ulcer drugs such as Glaxo Holdings PLC's Zantac have helped patients avoid billions of dollars' worth of surgery. Studies show that $1,000 worth of Amgen Inc.'s Neupogen can save about $7,000 in hospital costs by preventing infections in cancer patients. And "if we ever come up with a pill for Alzheimer's disease, it will represent cost containment, regardless of its cost," argues Alan Steigrod, chief executive at Cortex Pharmaceuticals Inc., a biotech company in Irvine, Calif.

TOUGH NEGOTIATORS. The enormous potential profit from one of these new drugs gives companies the incentive to pursue innovative treatments and fund other research projects. So a government policy that limits revenue to R&D costs plus a "specified amount of profit" would crimp innovation. It would also cripple biotech companies by inhibiting their ability to raise investment capital. "It would ruin us," says G. Kirk Raab, president of biotech star Genentech Inc.

One solution, economists suggest, might be for Washington to let companies charge high prices for breakthrough products while holding down prices of me-too drugs. "We could stimulate innovation" that way, says Peter Arno, professor of social medicine at the Albert Einstein College of Medicine in New York. So far, the hints from Washington on this point are reassuring. "We will factor in cost-effectiveness," says a top Pryor aide. "We want companies to do more innovative research."

Ironically, Washington may find itself trying to catch up with market conditions. One reason drugmakers became so profitable was the lack of real price competition. Doctors don't have to pay for what they prescribe, so "physicians don't respond to lower-cost drugs," says Mick Kolassa, research associate at the Research Institute of Pharmaceutical Science at the University of Mississippi. In fact, he says, companies have often unsuccessfully tried to win market share by undercutting competitors' prices. When that didn't work, they raised prices to match the competition.

Those days are ending. Faced with tough negotiators at HMOs, hospitals, and government agencies, companies have started to give discounts of up to 80% off list prices. The list price for DuPont Merck's painkiller Percocet went up more than 10% in 1992, for example, but the average price dropped 6.6% because of discounted volume buying. Beyond that, as a large number of key drugs lose patent protection over the next few years, they'll face fierce price pressure from generics. "The way the marketplace is unfolding, Senator Pryor's policy goals will be met without any action by Congress," says DuPont Merck's Landgraf.

It seems, in short, that drugmakers face much the same fate either way: Companies will be under pressure to charge a premium only for breakthrough treatments. That could spur innovation, not hurt it, and provide more Americans with drugs at a price they can afford.

Before it's here, it's on the Bloomberg Terminal.