Understanding the Pharmaceutical Industry

So I recently had a long debate with a friend about my argument regarding the dangers of a monopsony in negotiating drug reimbursement costs. He did eventually come around, but I am posting the salient arguments here:

 

The initial claim was that Pharma has been the most profitable sector of the last decade (ahead of even oil and finance), and that the only people who take a hit by allowing Medicare to negotiate drug prices are the shareholders of the companies, and they are secondary to consumers. To support this, the arguer cites profit margin data on large drug companies - PFE, MRK, JNJ, etc - Net Income over Revenues. These are consistently in the Mid 20 %s, which seems to clearly be a high margin business, so pressuring those margins won't affect incentives.

 

 

My response, slightly edited for a blog audience:

 

"You're referring to pharma as big pharma. I'm referring to pharma as the margin on a drug from the beginning of the "drug creation process", which includes pharma killed earlier in the supply chain.

 

Let's walk through the pharma supply chain, and you'll see where I'm going with this, and why exact numbers are very hard to come by, but they're way smaller than you think they are.

 

Basic research and initial innovation happens in a number of places: universities, foundations, major pharmaceutical companies, and startups and entrepreneurs.

 

This research then moves onto the initial commercialization stages. If the basic innovation happens at a major pharmaceutical company, they develop it in-house; if the basic innovation happens elsewhere (as a large and growing portion of it does), it then goes to a startup.

 

Startups are capitalized with venture capital and bank loans. These startups generally lose a ton of money as they work to develop their one or two big horses.

Almost all of these startups fail long before we hear about them. A few manage to demonstrate clinical relevance, and once they have done so, these startups partner or are bought by big pharma companies, who inject massive sums of capital to help further commercialize the drug and get it through the tremendously expensive (many hundreds of millions of dollars) FDA approval process. Note that the cost of trials for FDA approval does not scale equally with the revenue/profit potential of the drug - something with 1/100 the potential market doesn't cost 1/100 the amount to take to trial.

 

Large pharma can do this because they a) can contribute tons of capital and b) can spread the substantial risk of FDA approval over lots of drugs. Thus, there are tremendous economies of scale in large pharma, which is why there are so few large pharma companies. They still face a lot of risk on individual drugs, rely on 4 or 5 drugs for all of their revenue (from a pipeline of many hundreds of drugs over the years) and when a drug doesn't get late stage approval, the stocks often drop 10, 15% in a day (and I've seen 40, 45%, or even higher).

 

The small pharma companies aren't often public, and when they are, they lose a ton of money and have midget market caps. Any statistics you're looking at are going to be isolating the large pharmaceutical companies only and market-cap-weighting the numbers (instead of weighting by actual book capital), which means the margins you're citing, 25%, are subject to colossal levels of survivorship bias and calculation error. The return expectation of creating a new drug from the get-go are tiny, possibly negative depending on what you're looking to treat, and certainly way less than 25% margins. It's impossible to "show you numbers" because private companies aren't subject to reporting with the SEC, but if you lower the expected profit of a drug from the get go, that doesn't stop with large pharma - that cascades through the supply chain. [Note: I later actually do cite some real numbers to approximate]

 

These large pharmaceutical companies then go and sell the drugs to consumers via insurance companies at rates negotiated individually with each health insurance company or organization. For this reason, large health insurance companies can receive drugs for cheaper than small health insurance companies. Foreign governments can negotiate prices WAY down, which is a major reason for the gap between foreign countries and the US in terms of drug costs. The pharmaceutical companies don't love it, but there's nothing they can do, and they still proceed with drug development because the US is a large enough market that they can still make money. Thus, incremental margins from US health insurance companies are substantially higher than those from foreign health insurance companies.

 

If the US pressures margins down, watch how that flows through the rest of the supply chain. All of a sudden, drugs aren't as profitable. Individual drugs are still tremendously risky and lowering potential profits doesn't equivalently reduce the cost of FDA approval, which means that big pharma necessarily has to be choosier about which drugs it purchases from small companies  - cholesterol, ED and baldness meds still get bought because the conditions are common and the potential number of customers are huge (they can become tentpole drugs, which provide those juicy 25% margins for large pharma) , so even if margins drop, they're still profitable on a units basis. Perhaps drugs treating rarer diseases, or commodities like vaccines, no longer have the margins to meet the risk-reward, return on invested capital guidelines that every major pharmaceutical company has when deciding what to buy.

 

Venture capitalists no longer fund startups in those areas because they no longer have a profitable exit strategy because big pharma isn't buying. Similarly, bank loan interest goes up, making them harder to get. Thus, the small companies no longer are able to start up. The basic researchers no longer have anyone to commercialize research on rarer diseases. On net, you have less research overall, and much less diversity in research. Innovation goes down and focuses on just the super profitable drugs at the exclusion of others. If you think this is a problem now, it'll only get worse.

It can get better, however, with some very simple policy regarding foreign healthcare monopsonies. You can see that America functionally subsidizes the world's medical costs, but you can't remedy that by simply forcing pharma companies to take lower margins, because that affects what the companies buy. The more useful way of dealing with it is to prevent foreign countries from exercising market power, so that pharma companies can spread development costs over a larger base of customers, bringing US costs down and raising the artificially-low foreign costs. You can do this by striking a nuanced form of reimportation that becomes legal when pharma cos and foreign insurance companies renew their contract - by universalizing the market, the pharma company has the power to walk away from individuals because the opportunity cost of a sh**ty deal goes up. This forces foreign insurance companies to cooperate.

 

Of course you don't actually want any reimportation to happen for security reasons, just the credible threat, which is why it's got to be such a nuanced policy and it's why it's difficult.

 

 

There are plenty of "bad" responses to this, but a smart one is "then negotiate prices down on things which are drugs for large numbers of people, and don't negotiate prices down on things that are small numbers of people". This is an economically legitimate argument with a few problems: firstly, do you really want to create any artificial disincentives to research drugs that affect a lot of people? Secondly, drugs for rarer conditions also tend to be drugs for more serious conditions and are thus very expensive for someone who has high medical costs already... do you really trust an elected bureaucrat with the power to negotiate some and not all drug prices when the political temptation to negotiate all drugs is so tempting?

 

Florida homeowner's insurance is an actual, living case study of what happens when you give politically motivated bureaucrats the power to decide premiums, payouts and risk. It started out fine, but political temptations got too large after a few years. Designed initially as the insurer of last resort, it has become the largest insurance provider in Florida, and although the government has put a tax on every property insurance that goes directly to capitalizing this insurance in addition to premium revenue, in the case of a big hurricane, the state will be put into a Greece-style fiscal crisis that makes California, Illinois, Michigan, etc. look like a joke and will probably require a massive Federal bailout and significant cutting of services. The Florida state legislature tried to raise insurance premiums, but Governor Crist, a certifiable idiot, blocked them.

 

(this gets way more interesting when you start talking about the health insurance companies, esp in light of the de facto price controls that Obama announced he wanted to include via commission in this week's version of the bill... needless to say, I'm not a fan).

 

I'm a fan of health insurance for all, and I'm a fan of trying to improve medical quality for reduced cost (hospital infections are a great place to start cuz they should be really, really simple), but if you don't consider the whole healthcare system as an interconnected ecosystem, you're going to cause a lot of unintentional trouble.

 

I'm not saying, btw, that big pharma won't keep profits up if you pressure prices - I'm saying that they'll focus on drugs that affect large numbers of people at lower per-pill margins (like viagra or lipitor) and less on drugs that either make no money anyway (most vaccines) or affect small numbers of people at higher per-pill margins (like drugs for rare cancers) because you can't easily pressure down the number of people, but per-pill prices can get pressured down easily. So innovation as a whole goes down, because the payoff is lower, but the impact is disproportionate among types of drugs. No matter whether big pharma takes this in-house or purchases R+D from outside, the cascade happens the same way, with the same negative consequences.

 

Actually, I thought of a way to approximate "true" margins - factor in acquisition costs for big pharma, because those are functionally r&d but they aren't treated properly in profit because goodwill isn't amortized. It's easier to calculate on a cashflow basis... It doesn't match up perfectly w revs but it should be close enough for a no backlog, no warranty, low working capital industry like big pharma. From morningstar, here is an approximation over the last 10 years (cash flow data is lumpy, so long terms smooth them out better):
 
1999-TTM (Operating CF - Investing CF)/Revenue
 
Pfizer,  16.4% (I started with PFE and AMGN cuz PFE, JNJ and AMGN are the best run companies in the space, and JNJ isn't comparable because of their large consumer goods segment)
 
Amgen: 17.0%
 
AstraZeneca: 13.8%
 
Bristol Myers Squibb: 12.6%
 
Allergan: 5.8%
 
This is just big pharma - if you think that big pharma pressures little pharma into taking lower expected returns for less uncertainty (which is absolutely the case) this margin for pharma as a whole goes way, way down - you're looking at under 10% overall cash margins. On a risk adjusted basis, there isn't a ton of room for pressure before they start cutting back.
 
These take me a while to calculate (they do overweight recent history ever so slightly but not significantly), but my source is morningstar.com, so if you're interested in other companies, you can find it there (again, with the exception of JNJ, because of their consumer goods division), but you can see that once you factor in acquisitions for R+D, these companies' margins drop sharply from the lofty mid 20%s you see on income statements.

 

There are places you can probably pressure to reduce drug costs, however. I think almost every major drug rep agrees that legalizing advertising for drugs has been mixed at best - the US used to illegalize drug commercials til the early-mid 90s, then legalized only "there exists a treatment for your condition, ask a doctor what it is" ads, and then legalized "buy viagra!" ads... the first legalization was important, because it got people to realize they didnt have to live with their condition. the second, however, massively ramped ad spending and actually didn't help spread usage that much... but every pharma co has to do it because all of their competitors are doing it, and if they don't they'll be relatively victimized. It's a prisoner's dilemma. If you wanted to argue that the US should make direct advertising illegal and only allow "there exists a treatment" ads, that's something I could get 100% on board with. Advertising to doctors is harder, but you could also do a lot of regulating on exactly how drug companies are allowed to advertise to doctors - something else I could get 100% on board with.

 

You have made a good point that the pipelines could dry up under these types of circumstances, by the way, because to an extent, they are. Bush cutting funding for stem cell research ("the next frontier") didn't help, certainly, and organizational inertia is probably part of the problem as well, but a lot of it is on the "basic research" side - nobody's really coming up with anything that gets through the FDA anymore (that includes universities and startups as well as the research components of big pharma). Foreign country margin pressure could produce this exact effect, as I've mentioned before, and that's one strong remedy. Reducing the cost of seeking FDA approval and make the FDA better at assessing drugs - that's another strong remedy. I don't know what the perfect solution is (who does), and perhaps this is somewhere economic policy could help with scientific research.