Drug Makers Face Evolving Marketplace

Since World War II, when penicillin was shipped to the boys at Normandy, the pharmaceutical industry has held an exalted place in American society, developing a continuous stream of wonder drugs while raking in profits.

Now all that is beginning to change.

The cost of prescription drugs has become so high--one new compound debuted at $12,000 a year per patient--that managed- care companies, politicians and some consumers are balking, demanding lower prices and threatening government regulation.

At the same time, scientific advances are beginning to change the way drugs are developed and marketed. In many cases, companies will have to spend more to develop drugs that would have smaller markets and lower profits than today’s blockbuster compounds aimed at a larger population.

Together with increased competition from generic drugs that will significantly lower revenues in the short term, these pressures add up to wholesale changes in the way the industry does business.

“Fundamental change is underway,” said Virin Mehta, an investment and research analyst whose firm, Mehta Partners, specializes in the pharmaceutical and biomedical industries. “And it is going to transform both the pharmaceutical industry and the health care industry.”

Of the forces currently at work in the business, pressures on pricing are the most visible.

Drugs needed to control chronic conditions such as high blood pressure or adult-onset diabetes cost so much that patients have begun to ration them, taking pills every other day or even waiting weeks before ordering refills.

HMOs and other managed-care organizations, whose profits have been squeezed to an average of 2%, are aggressively negotiating for discounts on drugs and are blaming pharmaceutical companies for recent increases in health insurance premiums.

Oddly aligned with consumers and regulators, the managed-care companies point to profit margins of 30% or more among the big drug makers, accusing them of gouging the nation’s infirm.

“I really believe that the pharmaceutical companies are pricing themselves into government regulation,” said Alan Jacobs, director of pharmacy operations for the managed-care company Healthnet.

Congress is expected to take up two initiatives this session involving drug costs.

President Clinton has asked that drugs be added to Medicare as a covered benefit, a move that would give the federal government enormous bargaining power with manufacturers. Millions of retail customers would no longer pay the full freight for drugs.

New Areas Coming Under Scrutiny

“It’s on the radar screens of the health plans and politicians, just like overall health care costs were in the ‘80s and worker’s compensation was in the ‘90s,” said Leonard Yaffe, a health care analyst for Nationsbanc Montgomery Securities in San Francisco. “Right now people are starting to focus on aspects of health care that haven’t come under the scrutiny of cost containment--and that includes pharmaceuticals.”

Gordon Binder, chairman and chief executive of Amgen Inc., the largest and most profitable independent biotechnology company, defended the industry’s practices.

“It’s because of better new products being put on the market at higher prices than the old products they’re replacing,” Binder said. “That’s a healthy thing. It’s the way the capitalist system works, and people are going to have to accept it. If they want better products, they are going to have to pay a higher price.”

Pressure to reduce those prices, Binder said, has been building for several years.

“I think in the beginning, the health care system had some relatively easy cost-reduction opportunities,” said Binder, whose company earned profits of 32% last year. “Now the low-hanging fruit has been picked.”

With little room to squeeze more savings out of doctors and health insurers, he said, attention has shifted to pharmaceuticals.

It’s not difficult to see why.

The pharmaceutical business is among the nation’s most profitable. Earnings since 1992 have grown more than 11% per year and outperformed the Standard & Poor’s Index by 90%.

Retail and wholesale drug prices have typically been set according to what the market will bear. The prices cover high research and development expenses, and the risk investors take when they put money into a pharmaceutical enterprise, in which only 4% or 5% of research ideas make it to market.

But the new drugs are so expensive that they are taking up an ever-increasing portion of the nation’s health care budget. The amount Americans spend on drugs has increased by 10% to 12% annually over the last three years, according to Yaffe. Last year, drug costs totaled more than $100 billion.

Those With the Least Are Charged the Most

Moreover, prices are not consistent. According to a report commissioned by Rep. Thomas H. Allen (D-Maine), older Americans who pay out of pocket are charged 1,446% more for a commonly used hormone treatment than big payers such as the Veterans Administration and some managed-care companies.

For the 10 most prescribed drugs, the study showed, seniors who do not have prescription drug benefits are charged twice as much as the pharmaceutical companies’ best customers.

“The industry . . . will give deep discounts to the federal government or big HMOs that can deliver market share,” Allen said. “And they will charge very high prices to people who can’t deliver market share. . . . The most profitable industry in the country is charging the highest prices to the people who are least able to pay.”

Allen plans to introduce a bill that would require pharmaceutical companies to give seniors who are not covered by HMOs or Medi-Gap plans with prescription benefits the same discounts that the federal government receives.

Pharmaceutical companies plan to fight Allen’s bill and are “watching very closely” the activities of the Medicare Commission, said Jeff Trewhitt, spokesman for the Pharmaceutical Research and Manufacturers of America, an industry trade organization.

Giving seniors the same prices as the federal government, Trewhitt and others in the industry said, would amount to price controls and affect 40% of the market for prescription drugs.

“We understand the concern,” Trewhitt said. “But we unswervingly favor expanded coverage through the private sector.”

Pharmaceutical companies are also negotiating hard with managed-care providers, which are demanding steep discounts and in some cases are threatening to withhold approval for certain expensive drugs.

Major Area of Increased Costs

Typically, managed-care companies negotiate drug discounts of about 10% to 15%, said Jacobs of Healthnet. Some discounts are as much as 30%, he said. Still, he and others said, pharmaceuticals represent the fastest-growing segment of health insurers’ expenses, increasing by as much as 16% last year.

Most health insurers raised premiums this month, citing increased prescription costs as a leading cause. Others became more restrictive, carefully rationing expensive drugs.

“While other plans have been hiking co-pays, we’ve been limiting choice,” said Susan Whyte Simon, a spokeswoman for PacifiCare Health Systems Inc.

Another tactic several managed-care companies use is to promise a pharmaceutical maker higher sales volume for a steeper discount. Under such an arrangement, patients are steered toward one drug company’s product in exchange for a low price.

In the end, pharmacy directors at several managed-care companies said, consumers will be expected to pick up a much bigger portion of the cost of prescriptions.

That, said several drug industry leaders and managed-care executives, will force consumers to better ration their own care.

This argument has won great praise on Wall Street. But it angers consumer advocates.

“The risk that you run is you have individuals on fixed incomes and you put them in a position where they may not take medication the way they’re supposed to,” said state Assemblyman Martin Gallegos (D-Baldwin Park), who chairs the Assembly Health Committee. “They may only take it every other day in order to make the prescription stretch longer. It’s a dangerous road to go down.”

Dr. Chuie Yuen, chief medical officer of Cigna Healthcare of California, said such rationing of medication is already happening.

“Members use up their pharmacy benefits, so they switch to another HMO to get theirs,” Yuen said. “Or they run out a few weeks before the end of the year” and are forced to wait until the new year starts to order more medication.

For their part, the pharmaceutical companies have developed new marketing strategies aimed at countering arguments that the prices of drugs should be lower.

Hoffmann-La Roche, Amgen and several other firms now enter negotiations with big payers armed with information showing how much their products save health insurers by reducing the need for doctor visits and hospital stays. The industry has also begun advertising directly to consumers, spending a billion dollars last year on TV spots, billboards and magazine supplements.

But even if such tactics allow the pharmaceutical companies to negotiate better prices with insurers and government payors, they will still face a significant revenue drop with the entrance of several new generic drugs into the marketplace.

Under patent laws, the right to be the sole producer of a compound expires 17 years after it has been invented and registered. At that point, generic equivalents can legally be made and sold.

That’s not unusual. But a fluke in the development timetables of several major drugs in the 1980s is causing an unusually high number of patents to expire over the next three years.

Good News for the Little Guy

The drugs set to expire, which include Pfizer’s cholesterol drug Lipitor and Merck & Co.’s Pepcid ulcer medication, represent $7 billion in annual sales.

The news is good for consumers, who will pay less for the generic versions of the drugs, but bad for the pharmaceutical giants.

Merck, for example, cited its cholesterol treatment Mevacor, which is among the drugs set to expire, as a key component of its $7.5-billion sales in the last quarter of 1998.

Another trend, outside the very public arena of pricing, comes directly from science.

The genetic science that is powering many of the drugs under development will lead, many in the industry say, to drugs tailored to small groups of genetically similar people--or people with specifically identified conditions--rather than blockbusters aimed at a wide market.

Already, according to Patrick Zenner, president and CEO of pharmaceutical maker Hoffmann-La Roche Inc., products are in development that allow doctors to more precisely diagnose diseases, then treat the specific strain of infection a patient might have.

For example, he said, his company, the New Jersey-based affiliate of the Swiss giant Roche Group, has twin products in development aimed at diagnosing and treating influenza.

With a diagnostic test, doctors will be able to tell within minutes if a patient has the flu or a different virus. Then the physician will be able to prescribe a new drug, aimed specifically at that strain of influenza.

“Instead of the blockbuster phenomenon, we will have suites of products,” said Gayatri Sondhi, a pharmacy analyst for the Boston Consulting Group. He recently co-wrote a study of stresses in the industry.

“We will be less in a world where one drug is for everybody and everybody buys it.”

And that, she said, will require change, and financial risk, as companies invest in tailored drugs while still competing in a marketplace geared to blockbusters.

Hoffmann-La Roche, a privately held company, is prepared to dive in, anticipating that although drugs may have a smaller marketplace, the new science will also make new products cheaper to develop.

But Binder, of publicly traded Amgen, was skeptical, saying that it would not be profitable for companies to invest in drugs with small markets.

Sondhi, the pharmacy analyst and consultant, said: “The pharmaceutical companies say, ‘Why should we do it? Why should we take a large market and turn it into several small ones?’ The answer is, because competition will do it. Drug companies will have to change.”

The pressures on the industry from pricing, competition and retooling will slow earnings growth for the top 20 drug makers to 7.7% in the short term, Sondhi said. And although that’s considered healthy growth in some businesses, Wall Street has come to expect nearly twice that from drug companies, she said.

The result, she and others said, could be continued mergers in the rapidly consolidating industry and lower returns for investors. Over time, however, companies that invest in new approaches now will find themselves more cost efficient in the future. They will be better able to handle both lower prices and the loss of markets for blockbusters.

“Unless you invest today, you won’t be able to get there tomorrow,” said Mehta, of Mehta Partners, even if it means enduring lower returns for several years.

“Both society and industry must find a happy medium that provides the industry with an appropriate level of profits without depriving society of its health care needs.”

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Double Standard

Millions of Medicare recipients--along with other consumers who don’t have insurance that covers prescription drugs--pay full retail prices for pharmaceuticals. By contrast, managed-care companies, the Veterans Administration and other big customers receive substantial discounts. Prices per typical dose for favored and retail customers:

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Price Prescription for favored Regular drug Manufacturer Use customers price Synthroid Knoll Pharm. Hormone treatment $1.75 $27.05 Micronase Upjohn Diabetes 10.05 46.50 Zocor Merck High cholesterol 42.95 104.80 Prilosec Astra/Merck Ulcers 56.38 111.94 Norvasc Pfizer High blood pressure 58.83 113.77 Procardia XL Pfizer Heart problems 67.35 126.86 Zoloft Pfizer Depression 123.88 213.72

Prescription Differ- drug ence Synthroid 1,446% Micronase 363 Zocor 144 Prilosec 99 Norvasc 93 Procardia XL 88 Zoloft 73

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Source: Minority staff report to Committee on Government Reform and Oversight, U.S. House of Representatives.