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JAMES FLANIGAN

What Ails the Drug Industry Has Little to Do With Politics

May 25, 1994|JAMES FLANIGAN

The Clintons are irrelevant to prospects for the drug industry. That's the blunt assessment of several Wall Street analysts as the President's year-and-a-half-long pursuit of health reform turns into the home stretch.

The President and First Lady Hillary Rodham Clinton criticized drug company prices and profits from the start, frightening investors and financial commentators. That's one reason the stocks of Merck, Pfizer, SmithKline Beecham and others are off one-third or more from highs reached in pre-Clinton 1992.

But now the truth is emerging: Drug stocks are declining because market forces are driving the air out of drug prices, forcing the pharmaceutical industry into a historic restructuring. Powerful trends in the business show that drug companies will continue to merge and consolidate and important drug research will increasingly be done by smaller biotechnology companies.

The Clintons have had little or nothing to do with those trends, even though their criticisms were on the mark.

Far more important has been the rise of discount drug distributors, firms such as Medco Containment Services and Diversified Pharmaceutical Services. These firms, known as prescription benefit managers, contract to supply health maintenance organizations and employers' insurance groups with prescription drugs. Then they go to the drug companies and negotiate steep volume discounts.

The prescription managers have taken drug purchasing decisions out of the hands of 400,000 to 600,000 physicians and driven prices down.

The trend is well established. For example, even before Tagamet--SmithKline Beecham's well-known ulcer remedy--came off patent last week, discounters were buying the same compound under its generic name, cimetidine, at prices 60% below Tagamet's old price.

Drug patents no longer mean pricing control, says analyst Steven Gerber of Oppenheimer & Co.'s Los Angeles office. The prescription managers simply command drug manufacturers to sell at lower prices.

Power has passed from manufacturers to distributors. "What is happening is classic capitalism," says analyst Christina Heuer of Smith Barney Shearson. "The drug companies were making 20% returns on sales while the rest of the Fortune 500 were making 5%. The market adjusts."

Drug firms for years have maintained that profits had to be high to help finance research, on which they lavished 10% to 16% of annual sales. If the flow of profits was disturbed, the companies and some economists warned, wonder drugs would go undiscovered.

But even Wall Street noted that big companies brought out many me-too drugs and had to slim down because huge expenditures on marketing--25% of sales--no longer made sense when a handful of discount buyers, rather than thousands of physicians, had become the customers.

Merck acknowledged the new environment last year by paying $6.6 billion for Medco Containment, the biggest prescription manager, and SmithKline Beecham followed two weeks ago by agreeing to pay $2.3 billion for Diversified Pharmaceutical Services. The drug firms' idea is that owning the distributor gets them closer to customers, giving their products at least a chance for consideration.

Even that is not the final chapter. The next step is for the drug companies to go beyond the middleman and make direct investments in health maintenance organizations and other hospital centers, says Dr. Schumarry Chao of SHC Associates, a Santa Monica medical consulting firm. With Merck moving on, Martin Wygod, who was running Medco, resigned from the company Tuesday.

The drug firms would buy into hospitals and HMOs, goes the industry thinking, to be able to test their products on patients and show cost benefits to drug purchasing authorities. For example, Merck might want to present evidence that its cholesterol-lowering drug Mevacor can significantly reduce heart attack and stroke risks and so is worth a premium price.

Still, pressure on prices from customers and competition will remain the overriding trend. As it happens, the big Swiss drug firm Sandoz Ltd. has just brought a cholesterol-lowering drug to the U.S. market at a 50% discount below Merck's Mevacor.

So analysts continue to predict lower profit margins for pharmaceutical firms but a bright future for biotechnology companies that have been producing the real wonder drugs in recent years. Chiron Corp., of Emeryville, Calif., has recently brought out betaseron for alleviating multiple sclerosis; Amgen Inc. of Thousand Oaks is doing well with Epogen, the genetic compound that helps dialysis patients by stimulating red blood cell production, and Neupogen, which stimulates white blood cell production in cancer patients undergoing chemotherapy.

And hopes for more effective cancer drugs lie now with the biotech companies, which are attracting investments to support research from big pharmaceutical companies in return for marketing rights to new drug discoveries.

What's biotech's secret? "More focused energy than the big companies," says Jim McCamant, editor of Berkeley-based Medical Technology Stock Letter. That means lower costs and an ability to work simultaneously in several disciplines, from biochemistry to computer science, as the frontiers of medicine demand.

"The biotech companies provide value added," says analyst Gerber of Oppenheimer. Which is why investors generally give them higher relative prices than older drug companies. While government ponders health reform, the market adjusts--and looks ahead.

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