There's Still Gold in Them Thar Pills 

Brian O'Reilly / Fortune 23jul01

The era of the blockbuster drug is ending--but genomics will take pharma to new highs.

In a queasy, headachy economy like this one, it's easy to understand why investors would reach for the medicine chest. Pharmaceuticals stocks have shone for decades as growth stalwarts relatively unaffected by economic turbulence--they've been beacons of dependability, like antacids or aspirin. Today the argument for loading up on such stocks seems stronger than ever. Baby-boomers are aging, for one thing, and older people buy more pills. Virtually every week newspapers carry headlines about breakthroughs in understanding and treating disease, and the exploding promise of biotech. The top companies have enormous reservoirs of scientific know-how and armies of effective salesmen. Medicines are playing an ever larger role in health care, which in turn accounts for an ever-growing part of GDP.

Yet so far this year, Big Pharma has done nothing but aggravate investors. The companies have been battered from all sides. With Congress debating whether to cover prescription drugs under Medicare, and Africa becoming increasingly paralyzed with AIDS, critics have railed against drug companies as greedy and callous. Individual giants face glaring problems: Bristol-Myers Squibb has had to pull promising new drugs from the market for years' more testing, while Eli Lilly is bracing for the day--Aug 2, to be exact--when Prozac will lose patent protection. Last month even bellwether Merck (see Can Merck Stand Alone?) let investors down, jolting Wall Street with the disclosure that sales of Vioxx, its blockbuster analgesic, have fallen seriously short of projections. All told, pharmaceuticals stocks are down this year by a sickening 15%, vs. 6% for the Fortune 500 index.

Don't call Dr. Kevorkian just yet, though. No one thinks drugmakers will go the way of dot-coms; in fact, never has an industry had brighter long-term prospects. But like a bottle of pills reaching its expiration date, Big Pharma faces a big problem: The business formula on which it built its recent success--inventing and selling so-called blockbuster drugs--is getting old. Though blockbusters aren't going away, they've become unnervingly costly and hard to find; new ones will be too scarce to keep Big Pharma growing at the double-digit clip investors have become accustomed to. So companies across the industry are scrambling to find new ways to hatch and sell prescription drugs that will let them cash in on the rich promise of 21st-century medicine. Just consider:

• Novartis has divided its massive R&D operation into semiautonomous units, aimed at central nervous system, cancer, cardiovascular, and other drug specialities. In May, its CEO declared blockbusters dead.
• Bayer, Germany's $28-billion-a-year giant, joined forces with a $20-million-a- year U.S. genomics pip-squeak called CuraGen to hunt for obesity and diabetes drugs. The size of the deal--$1.34 billion--rocked the industry. What rocked it even more: The unequal partners will split profits from any products they develop roughly fifty-fifty.
• Allergan, a rising Fortune 1,000 company that makes drugs to treat eye ailments, is showing how a tight focus on a niche can enable a "mid-pharma" to thrive where Big Pharma can't. Allergan's stock has risen 150% since early 1999.

While it is too early to tell which innovations will prevail, there are plenty of interesting ways for investors to bet (see A New Prescription for Your Portfolio). And two things are already clear: First, drugmaking will change as dramatically in the next ten years as it has in any decade before; and second, in that period pharma is highly likely to match or exceed the past decade's performance, in which it generated average annual returns of 25%. In a queasy economy, that's powerful medicine indeed.

Pharma stocks soared until 2001

The AmEx of large pharma companies has outperformed other indexes over the past five years. But drug company stocks have fallen faster than most industries' shares this year.

It Was a Decade of Blockbusters

Billion-dollar drugs known as blockbusters, like these bestsellers from last year, have accounted for a growing share of drug company earnings. But new ones are getting hard to find.

¹Wholesale prices, U.S. sales.
²Licensed from Amgen.

The Blockbuster Bust

Big Pharma seemed on top of the world until this year. Blockbuster drugs like Warner's Lipitor, Pfizer's Viagra, and Pharmacia's Celebrex propelled the U.S. industry's phenomenal sales growth, from $22 billion worldwide in 1980 to $149 billion last year. The industry's earnings rose 15% a year for much of the '90s, and growing shareholder expectations sent the market caps of the top ten pharma companies soaring too--up by $1 trillion in the decade. Muscular companies like Pfizer and Glaxo crafted takeovers and mergers to extend their research and sales power even further. Companies also bulked up on consumer marketing, after Schering-Plough made allergy reliever Claritin a multibillion-dollar seller by unleashing a barrage of direct-to-consumer TV ads.

Yet no truly dazzling medicine was rolled out last year, and nothing terribly impressive is in the wings for this year or next. Some giants have already concluded that the blockbuster era is ending. Dr. Daniel Vasella, head of Novartis, the $22-billion-a-year Swiss drugmaker, calls blockbusters a "losing proposition."

"The major companies don't have enough ... in their pipelines to keep the engines going at the rate they have been," writes Merrill Lynch securities analyst Jami Rubin. Adds Art Pappas, a former board member at Glaxo and now head of a biotech investment advisory firm in Research Triangle Park, N.C.: "In the last five years, every major drug company CEO said that to grow 15% a year his company would need to launch two genuinely original drugs a year. They said at least one would have to be a breakthrough, with sales above $750 million a year. It hasn't panned out. They aren't coming up with enough unique molecules."

Some companies, like Pfizer and Pharmacia, are better positioned than others to keep blockbusters coming--at least for a while. But all drugmakers share the problem to some degree, and pursuing such drugs is an increasingly high-risk undertaking. On top of the hundreds of millions of dollars that must be spent on a drug's development and clinical trials, the cost of all the pre-launch drum beating required to lure customers and impress doctors quintupled in the past decade, to around $400 million per drug. "It's like the movie business," says Michael Pearson, director of pharmaceuticals consulting at McKinsey. "The bulk of the companies' spending is done before they get a nickel back in revenue." And since blockbusters are almost always designed to treat a chronic ailment like high blood pressure or depression, and the number of such ailments is finite, developers tend to converge on similar problems with similar solutions at the same time. A company nowadays may have less than a year before a rival comes along with a nearly identical pill, "clinically proven" to be superior, if only by a decimal point. Celebrex from Pharmacia, Vioxx from Merck: Can your arthritis tell the difference?

The World's Top Prescription Pushers

Worldwide sales of prescription drugs and medicines continued their strong growth last year, but Merck, AstraZeneca, and others will face slowdowns soon, when some bestsellers lose patent protection.

*Includes U.S. mail order.

Create It, and They Will Pay

Rather than overdose on gloom, though, consider the drug industry's inherent vitality. There's no need to worry about the world's appetite for useful pharmaceuticals. Even if growth slows for Big Pharma companies as they retool development and marketing to make up for the blockbuster bust, they will enjoy a demographic tailwind in the U.S. and most other developed countries for decades. Baby-boomers are turning into wrinkly, postmenopausal ladies and balding, paunchy geezers with growing aches and ailments--and will stay that way a long time. Says Kenneth Kaitin, head of the Center for the Study of Drug Development at Tufts University: "Extended life span doesn't mean people stay young longer. It means people stay old longer. They suffer from high blood pressure, depression, arthritis, and so on for longer periods." Boomers, of course, are not known for suffering stoically. They will demand any pill that lets them exercise their God-given right to a pain-free, fun-filled, long life.

The opportunity lurking in all that extended morbidity has not gone unnoticed by the drug industry. "The fundamentals are massively positive," says Tom McKillop, head of AstraZeneca, maker of the world's best-selling drug, Prilosec, which is popular among seniors with heartburn. "We've got huge increases in the number of elderly. And we're at a new phase of pharmaceuticals. Discoveries now involve the chronic degenerative diseases, like Alzheimer's, cancer, and atherosclerosis. We understand them now. The science has never been more exciting." McKillop adds with a laugh, "I say everyone should die healthy!"

Did he say "healthy" or "wealthy"? The rising cost of new drugs sometimes seems destined to bankrupt all but the well-to-do. Will drugmakers have any customers able to pay for all these fabulous advances in medicine?

In a word, yes. For one thing, to label drug costs as soaring is an exaggeration. It's true that drugs are the fastest-growing part of health-care spending--in 1998 they accounted for 7.9% of America's medical bills, up from 4.9% in 1985. Yet increased usage of new drugs, not price hikes, caused much of that increase. In 1999, for example, U.S. prescription spending rose 19%, but just four percentage points of the increase were traceable to price increases. What's more, drugs can be highly cost-effective: It's well established that medicines like warfarin, which helps prevent strokes in people with heartbeat irregularities, save money by lowering other medical costs. Finally, the typical drug bill isn't so bad: In 1997 American consumers on average spent 64 cents a day on prescriptions--compared with 91 cents on alcohol, 92 cents on electricity, and $1.05 on car repairs.

Prices remain a political issue, though. Newscasts show busloads of seniors traveling to Mexico and Canada to save money on prescriptions. Says Tufts' Kaitin: "There is a strong public sentiment that the industry has been arrogant in pushing drugs out so fast and doesn't care if 50% of the population can't pay for them, because they just charge a lot to the other half." Too many people now, especially the uninsured elderly and the working poor, complain of having to choose between drugs and food. Annual spending per senior for prescriptions is up 116% since 1992, to $1,205 last year--and a third of seniors pay for all their drugs themselves. Absurdly, regular Medicare will cover hospital and doctor bills but not prescriptions. (That's because there were fewer drugs back in 1965 when Medicare was established, and they made up such a small percentage of total medical costs that Congress didn't bother to cover them.)

But drug companies appear to be betting that if they make a useful drug, someone will pay for it. And they're probably correct. For one thing, it seems inevitable that Congress will include a drug benefit in Medicare in the next few years. The managed-care industry will come around too. Indeed, it isn't a huge threat to the drug business. HMOs did try to limit drug costs, but a funny thing happened in the past decade: The number of people whose prescriptions were covered by managed care or some other private third party grew from 26% of the population in 1990 to 69% in 1999, according to a report by PhRMA, the drug industry's lobbying group.

That still leaves huge numbers of people without coverage, of course, who are squeezed ever harder by the cost of drugs. But it also means that there are more Americans whose growing appetite for medicine is barely dented by the rising price tag. Besides, managed care has discovered how difficult restricting drugs can be. Doctors hate being told by insurers which medicines they can prescribe. Even if docs were willing, keeping track of different prescribing rules from dozens of insurance companies would be a hopeless task.

Most important, it is employers, not managed care companies, that ultimately make the rules about medical benefits. Says Pearson at McKinsey: "During good times, when they are eager to attract people, corporations are willing to pay for good medical care. A generous prescription-drug benefit is often used as a recruiting tool." Big managed-care companies also think twice about limiting what drugs they will pay for. "The great irony," says Carl Seiden, a drug industry analyst at J.P. Morgan Chase, "is that managed-care companies often have to compete for patients. Companies let their employees choose among several HMOs, and the one with the most generous benefits generally wins."

That fact helps explain why the drug industry has shifted from vigorously opposing the idea of adding prescription benefits to Medicare, to supporting it--as long as the drugs are provided through competing managed-care companies. For eons, the industry feared that the federal government would become the biggest--perhaps the only--buyer of prescription drugs, and thus be in a powerful position to demand lower prices. That's the way it is in most countries, so brand-n