After decades of success in creating new formulations and reaping the rewards, pharmaceutical companies are facing one of the most uncertain periods in their histories. The expiration of some major patents covering Lipitor, Plavix and Seroquel in the past year has caused the drug makers that marketed them to scramble for new sources of revenue. This has prompted some analysts to question whether pharmaceutical companies have even a chance of being as profitable in the future as they’ve been in the past.
The challenges they face, in addition to the expiration of patents on large or key franchises, include tighter regulations and global pricing pressure. In addition, historical areas of innovation like cardiovascular now have very good remedies or drugs available at low cost. What do these companies do for a next act?
In this interview, Alex Winogradoff, Managing Director and Senior Equity Research Analyst at TIAA-CREF, talks about the future for big pharmaceutical companies—including the recent patent expirations and what’s behind drug companies’ moves into areas like consumer healthcare and generic drugs.
The recent wave of patent expirations has put enormous pressure on drug companies’ earnings. How has the industry responded?
In many cases, by turning to mergers and acquisitions. Some of the biggest deals of the last decade (including Pfizer’s acquisitions of Pharmacia and Wyeth, Merck’s acquisition of Schering-Plough, and Novartis’s buyout of Alcon) were done partly to buy time, and allow drugs that were still in the pipeline to get into the market. These deals produced significant synergies and cost savings, but the sheer size of the combined research & development operations, and the added layers of management, have led to polarized decision-making. As a consequence, R&D productivity—the revenue per dollar invested in drug development—has fallen.
What has motivated large drug companies to move into adjacent businesses such as consumer healthcare and generic drugs?
It’s an attempt to diversify away from the higher-risk pure pharma model. This seemed like a sensible strategy at the time, but diversification has its downside too—pharma companies with multiple businesses sometimes stumble, as happened in the last few years when manufacturing problems led both Johnson & Johnson and Novartis to pull some of their most popular over-the-counter drugs off the shelves. Some companies are now actually “un-diversifying”—returning to a focus on proprietary drugs, or trying to. The companies that are embracing a purer pharmaceutical focus are doing so because of renewed investor confidence in traditional pharma-company pipelines. That confidence is reflected in price/earnings multiples that are higher for pure pharmaceutical companies than they’ve been in at least five years.
Does this retreat from diversification suggest there will be fewer big deals in the pharma industry?
For now, yes; the days of large M&A in the pharmaceutical arena are just about over. There will still be a lot of deal-making, but I think the next 10 years will be devoted to small- and mid-sized deals in more specialized areas of medicine.
What role will emerging markets play in the future of the pharmaceutical industry?
Emerging markets are critical to drug companies’ continued growth. As these markets move from emerging to developed, their increasingly wealthy middle classes will demand more high-quality, innovative medicines. This fact has not been lost on pharmaceutical companies, many of which have made substantial investments in emerging markets in the last two decades and are starting to reap the benefits. Altogether, emerging markets account for approximately 20% of the revenue of large pharmaceutical companies, and the percentage is growing. The most important markets are China, Brazil, Russia, Eastern Europe and India—some of which, it’s worth noting, offer tax advantages.
What trends are you seeing in R&D?
There is much more interest in specialty diseases, especially in ophthalmology, oncology and neurodegenerative diseases, due to the aging population and the maturation of research in the area. On the other hand, there is less research into cardiovascular disease, probably because the number of generic drugs in cholesterol and hypertension have made this therapeutic category intensely competitive.
In the development space, companies are spending more time in Phase 2 trials, in which they determine the lowest effective dose of a drug that minimizes side effects, while providing the necessary efficacy. By spending more time in Phase 2, they are seeing better success rates in Phase 3. This is important since companies can easily spend $250-$300 million on clinical trials in Phase 3 to register for regulatory approval.
Where do generic drugs fit in the mix? What will be their long-term impact on the industry?
In the area of small molecules—which is to say, drugs produced in the conventional way, through a chemical process, and available as pills—generics already represent between 80% and 85% of all prescriptions written. It’s hard to imagine generics having any more impact in this area than they have already had.
On the other hand, it’s an open question how generics will affect biologic drugs— medications, usually injected, that target a specific cell instead of running through the bloodstream and are therefore safer and more effective. There will doubtless be a push to come up with “biosimilars”—generic versions of biologics—but the impact on drug developers will likely be far lower because biological manufacturing isn’t nearly as easy to do, and generic versions of biologics won’t be substitutable at pharmacies. That makes the economics a lot more complicated and may provide some protection to those companies that innovate in this area.
The idea that a patient’s genetic makeup might play a role in determining his or her optimal drug therapy has generated a lot of excitement. When and how will personalized medicine change the playing field for drug makers?
The role of personalized medicine is already material and will become even more significant in the next five to 10 years. Here, I am talking about the use of biomarkers to identify patient populations in which a new drug will work. This is an improvement in diagnostics, and it has already produced a cascade of benefits. To begin with, companies don’t have to spend as much on R&D—the clinical trials are smaller and the results are better, so the FDA allows them to get to the market more quickly, sometimes without a Phase 3 clinical trial. And when the drug does get to the market, payors are more likely to reimburse it because it’s been shown to have a benefit in the specific population or for an individual. This also enables the pharmaceutical company to charge a higher price: There’s less doubt about the drug’s payoff.
The shift toward pharmaceuticals that treat more specialized diseases has also allowed drug companies to lower their sales costs. The breakthroughs nowadays are coming in areas like oncology, rheumatoid arthritis, lupus, ALS, and Alzheimer’s. These categories don’t need the massive sales forces that were put in place for areas like cardiovascular. The number of salespeople has gone down and will continue to, especially in the U.S. where there was just an enormous buildup over the years.
There have been differences of opinion over the Affordable Healthcare Act’s impact on drug makers, with some commentators seeing it as positive and others as negative. What’s your view, now that the legislation is clearly here to stay?
It’s not going to be a big mover for the pharma industry going forward. In fact, I’d argue that the most important effects are already in place, with the additional taxes that were implemented two years ago, and the larger discounts to the Medicaid population. Future reform is anybody’s guess, but it is likely to entail more government discounts and competitive bidding.
Dividends have become an important part of pharmaceutical equities’ appeal. Will that remain the case in coming years?
We think so. The level of yield—currently between 3% and 6% for most major pharmaceutical companies1—will obviously depend on each company's respective stock price in relation to its dividend, but the payouts themselves are sustainable, in our view. Cost reductions have helped these companies maintain very healthy operating margins, in the range of 35% to 40%. With the patent expiration cycle almost finished, and new products emerging from the pipeline, these margins could potentially expand even more. That could create a path to further dividend increases.
What qualities will pharmaceutical companies need to succeed in the future?
Innovation will remain important, but it will have to be real innovation. The days of the “me-too” drug are over—payors and regulators have caught up to this tactic, which involves the development of drugs that don’t really do anything different than drugs that are already available. Instead, companies will have to show that their products meet unmet clinical needs in the market, and provide both a pharmacological and an economic benefit to the system over the long term. This can happen, for instance, if a drug that costs $50,000 to $100,000 saves a patient’s life—and avoids months and months of much costlier acute-care treatment in a hospital setting. There’s a “pharmaco-economic” benefit in paying for a drug like that, because it saves the system money over time.
1Based on yields for major pharmaceutical companies including Pfizer, Eli Lilly, Bristol-Myers Squibb, Merck, AbbVie, GlaxoSmithKline, AstraZeneca and Novartis AG, per Bloomberg as of January 3, 2013.”
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TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).