Financial Analysts Roundtable: The Safety Climate, Portfolio Management, And More Restructuring In 2005

Three large-cap pharmaceutical analysts sat down with "The Pink Sheet" in January to discuss the future of the drug industry. Below are excepts from a conversation with Goldman Sachs' Jim Kelly, Morgan Stanley's Jami Rubin and Deutsche Bank's Barbara Ryan.

All three analysts provided "The Pink Sheet" with extensive ¹ disclosure statements, which can be accessed by reading the Almanac online at ² www.thepinksheet.com.

FDA Safety Regulation Fallout

"The Pink Sheet": One big issue in the second half of 2004 was drug safety regulation at FDA. What effect do the recent safety questions over antidepressants and COX-2 inhibitors have on how the market perceives the drug industry?

Deutsche Bank's Barbara Ryan: The withdrawal of Vioxx from the market was clearly a shock from a number of perspectives. First, we rarely see a drug that has been on the market for five years and as widely used as Vioxx be pulled due to safety off the market. Often, that's something that happens within a much shorter period of time when there are surprises in terms of side effects that were not obvious in clinical trials. That was very shocking....

The additional issue related to that are questions about how is the FDA going to view drugs in the future, both drugs on the market that have questionable side effects and new drugs that may be coming down the pike in that regard. Investors are fearful that we're going to see a major change at the FDA....FDA tries its hardest to guarantee or protect the safety of individuals given the information that they know. Unfortunately we live in an imperfect world and sometimes new information comes out, which then they have to respond to. But we have seen a consistent trend by the FDA, particularly in crowded therapeutic categories, to be much more risk-averse.

For example, Crestor, in the statin category, was delayed by two years. The FDA forced Astra to do more clinical trials over longer periods of time with more patients. If you have drugs that go into crowded therapeutic categories that are already viewed as relatively well served and there may be a safety consequence associated with that drug, there is already a very high bar and that will continue to be the case.

But where the value [is shown for] a new drug in a therapeutic category which is not well served, the FDA is more tolerant of risk. From a generic perspective, we're going to continue to see what we've already seen at FDA. Clearly, on those close calls, they will likely, as any human being, be even more risk averse than had the Vioxx situation not happened.

Are Longer Review Times Coming?

"The Pink Sheet": Will this cause drug manufacturers to re-think what they have in their pipeline and focus their research into disease categories that are relatively untapped?

Morgan Stanley's Jami Rubin: It's very difficult to generalize. But very clearly, the FDA does bow down to political and congressional pressure. We saw that in the early '90s. There was actually pressure to speed things up. And then the FDA, after the PDUFA [user fee] legislation was passed, sped up approval of drugs. In the late 1990s, there were a number of drugs that were pulled from the market and that led to a period of slow-down. The same thing will happen going forward. The very high-profile therapeutic setbacks in 2004 will clearly lead to a renewed emphasis on safety, and with that probably a call for more expensive clinical trials. There's no question that the timeline for new product approvals will likely be lengthened.

The question is, will this aggravate the pipeline problem? The answer is probably yes. Although at the same time, let's not lose perspective....It's not that uncommon that we see blow-ups in clinical trials. Keep in mind that Vanlev five years ago, the Bristol-Myers drug, was thought to be a very unique new approach to treating hypertension. It had an efficacy profile better than some drugs on the market. Because of an idiosyncratic safety issue, it never saw the light of day. That was well before the market became hysterical about safety issues.

That's typical of the risk-reward of any drug pipeline. Will this hinder the drug approval process? Probably in the near term, but the pendulum will swing back to a more normal, middle of the road in the next couple of years. What we need to watch as analysts is what happens not so much as the products that were recently approved....What we need to watch carefully are the products that are in late-stage clinical trials today, products that are currently being filed by the FDA.

We're watching very closely what's happens to the regulatory pathway for [Bristol-Myers Squibb's] muraglitazar...and obviously of critical importance to the market is torcetrapib- Lipitor , the combination product that Pfizer's developing. The company anticipates, as well as the Street, that the FDA will accept two-year surrogate endpoint studies. That's what we need to watch. The fallout will probably occur over the next couple of years, as opposed to the first or second quarter.

"The Pink Sheet": Do you think we would see manufacturers taking more time before submitting an NDA and/or longer review times at FDA?

Goldman Sachs' Jim Kelly: Products that are not bringing incremental efficacy advantages but are supposed to be removing a side-effect issue, that has been an issue for the marketplace. Then bring along some sort of idiosyncratic side-effect risk, as we saw with Exanta [and] as we saw again, five years on the market with the COX-2s.

The FDA is going to be very concerned about those sorts of products without an efficacy advantage on top. It's probably going to be the role of the industry to take a look at this from an R&D risk management strategy and work a little more closely with the FDA to get the products on the market with better post-marketing surveillance so we can clear up the log jam on some of these drugs and maybe even potentially reduce the cost of getting to market.

Do you really need to have tens of thousands of people for a fifth-in-class product? If there is a special issue outstanding, yes, but maybe the right answer...is to get the product out there with better risk management strategies and then prove the merits of the product and then grow from that point. That involves a real shift in thinking.

A Change In Tone For Sales And Marketing

"The Pink Sheet": How will the safety climate affect the way companies market their products through both direct-to-consumer advertising and detailing to physicians?

Rubin: I don't think DTC is going away, but clearly the tone has to change. In some ways, the industry brought this upon themselves. That's not true with Exanta, that's not true with Vanlev, but clearly to some extent, it might be true with the COX-2 inhibitors. There was a tremendous amount of over-utilization of these drugs, and the big winners in the coxib fallout are the HMOs.

Part of that was driven by very aggressive marketing tactics by the industry, and these companies have to re-think that approach, and come up with a much more measured approach to marketing their drugs, especially in this period where product litigation happens every other day. Clearly, part of Merck's decision to withdraw Vioxx was to limit the amount of product liability. Whether or not it aggravates it, it's hard to say.

Because of these increasing concerns, because of the problems of public perception, because of the risk of product liability, industry needs to re-think the way they are communicating to physicians and consumers. I would anticipate the tone to dramatically change going forward.

Ryan: The most immediate impact, particularly from a regulatory standpoint is exactly on that. Whether it's self-regulation or inflicted on them, we've already seen this play out. One of the ways that the FDA has addressed the fall-out from Vioxx - and Pfizer has stepped to the plate and recommended that as well - is to drop their direct-to-consumer advertising for their COX-2s.

This addresses it from a public perspective for the agency. It makes them look like they're responding, and obviously takes the pressure off of them and Pfizer from the perspective that these companies have "railroaded" these drugs into people's living rooms. Physicians have also been aggravated by the fact that patients don't only come in with their own diagnosis, but they also come in with exactly what drug they want their doctor to write for them.

That has been the fallout from, or the benefit of, the marketing efforts of pharma. But now we're seeing sort of the underbelly of that. A lot of these drugs were probably used more broadly then they should have been. Certainly the benefits of the COX-2s to some patients are clear, but whether all patients really need COX-2s is a big debate....

We felt Arcoxia would never see the light of day. That became obvious when Vioxx was pulled, but we think that even if Vioxx hadn't been pulled, Arcoxia didn't bring anything to the table, and there was a signal of a higher cardiovascular risk. Industry needs to be much more careful in how they spend their money. To just pursue something to the bitter end and spend good money after bad is not something that they can continue to do, because the regulatory climate will not permit those products to get to the market.

Transitioning To A Lower Cost Base

"The Pink Sheet": Independent of the recent safety issues, we've seen some companies, like Pfizer, suggest that they may be open to reducing the size of their sales team. Are drug companies a prisoner of the sales force or can anyone make a transition to a smaller cost base without losing their market share?

Kelly: Inside your question is a very important point. While the public discussion is happening from the top down, from the CEO level, we look from the bottom up and how these companies end up competing in these different therapeutic categories. When field force efforts are cut on some heavily promoted [products that are] heavily dependent on detail efforts in other types of categories, we do see that they end up losing share and that the competitors are taking advantage of those opportunities. So there is a bit of a prisoner's dilemma problem in doing this.

It's going to take a company making a cutback and the competitors understanding that the long-term benefits are there not to keep the battle going in that market. That will help everyone else relax a little and, as you said, get away from this prisoner mentality.

Rubin: No doubt, there is a sales force arms race, and given that Pfizer is in the leadership position, companies are waiting. Other companies have less flexibility; they're in a position where they're waiting to see what Pfizer does, and if Pfizer starts to cut back, that action would give everybody else cover.

The different models clearly have to change. The industry has faced declining returns for the past four to five years, and that's as revenues have come under pressure from patent expirations. There have been few new product approvals to replenish those maturing portfolios, and this on top of the very high fixed-cost structure that continues to grow. That has led to a disproportionate hit on the bottom line.

Feeding into investors' frustration over this sector is that the world has changed; the companies haven't. The business models have essentially remained the same. The sales forces, while they're no longer growing, they aren't being cut back in any meaningful way. The problem here is that the cultures are so ingrained in these companies. There's no real culture of cost-cutting, and there's no real discipline being implemented anywhere that I see.

Some companies are not waiting for Pfizer and are taking actions into their own hands. For example Bristol-Myers, probably because they are facing a crisis period, have elected to increase their focus on critical care medications, which allows them to downsize their primary care sales force. They have started to do that, not meaningfully, but enough so that over the next couple of years their share of critical care should expand much more dramatically than where it is today....

We've also seen that with other companies in Europe. For example, Roche has focused more on critical care, they've cut back their primary care sales force, and other companies are striving for a greater balance on the top line. These companies aren't waiting for Pfizer....In Pfizer's case, there was tremendous pressure in the early '90s, tremendous pressure from analysts and investors to cut back the sales force. Pfizer bucked the trend, they didn't listen, and they were right. But I fear that times are very different today. The revenue bases have come under tremendous pressure, but at the same time, the fixed cost structure hasn't changed.

There is tremendous opportunity and inherent value in that opportunity for cost-cutting initiatives. I don't know if that means cutting back the sales force, but certainly, squeezing out greater efficiencies and restructuring the sales force to improve returns....It's hard to see how these guys are going to find their way out, but there's clearly an opportunity, because SG&A expenses are the single largest expense line item in the P&L, and something has to change.

Fundamental Restructuring Is Needed

Ryan: It is absolutely obvious that the industry has suffered an assault to its revenues on a number of fronts. The lack of new products - which may or may not be cyclical - it has proven to be a cyclical effort over the course of time in this industry, but through the decimation of brands within several weeks after they are generically available. That has, as Jami said, made the earnings stream of this industry cyclical, and it had been fairly predictable over time. So that's a fundamental change that these companies have suffered....

What hasn't happened, as my colleagues have said, is any appropriate and commensurate response from industry. It's a little bit like the deer in the headlights. You suffer one blow and you're running around trying to figure out what the appropriate response to that is. This blow has been profound, and obviously coupled with a lot of other blows. The power of persuasion, whether it be the sales force or the commercial on TV is having less and less impact, and the payor plan designs are having more and more impact, so just the return on those efforts is declining....

It is unequivocally obvious that this industry will be forced to change its business model. Where there's smoke, there's fire. We've got Lilly restructuring, we've got Merck restructuring, we've got Bristol-Myers restructuring. The 800-pound gorilla, Pfizer, which was not going to cut its sales force to help out all the competitors below them, they're sitting there like the Cheshire Cat gaining market share at their competitors' expense. Because it was forced to cut first, now it is going into a period where it will face punishing generic competition. It also has seen a setback in the COX-2 franchise....That's the ingredient by which Pfizer will be forced to restructure....

The other thing that hasn't been said is that there is rampant over-capacity in this industry. These companies literally have detail people body-tackling each other to get - no kidding - one minute of a physician's time. It is also obvious that the cost structures will come down through consolidation as well, so some of these companies become worth more dead than alive, because it's always easier to cut someone else's cost than your own. Both from the perspective of internal restructuring, as well as consolidation, we will see a response from this industry....

Rubin: A wholesale change of the business model is a little bit of cat-and-mouse. It is keeping up with the Jones's. If you are selling a drug in a crowded therapeutic category, you have to keep your noise level at the same place as your competition, or you will lose market share. So you get into a death spiral; every time you cut costs, you lose revenues.

We've seen a bit of that, particularly in the cholesterol market for Bristol-Myers. It also means that they have to lower their returns by giving up products to companies that can afford to put the appropriate expenses behind it like they did with muraglitazar....

The successful pharma company of the future will be the best portfolio manager. I don't care as a shareholder whether Merck develops drugs from its own lab or it gets them outside. All I care about is the risk and the return associated with that effort. The companies who are the best portfolio managers, putting their money in competition with the best research out there, who can put their money in the best opportunities [will be successful].

What Merck did is they took an extraordinary risk internally. It blew up, that's bad luck, it could have happened to anybody. They took zero risk externally. Pfizer did the opposite. Now Merck is obviously doing a deal a minute to change that....

Consolidation Will Continue, But Is It Worth It?

"The Pink Sheet": The past year we saw the Sanofi/Aventis merger play out and other companies struggling to stay afloat. Will we see further consolidation in the market, or are there no more good deals to be had?

Rubin: Bottom line is the industry is still hugely fragmented, and so I do think consolidation will continue. The U.S. market still remains the best market, the most profitable market in the world, albeit it's changing, but it's still where you need to be, especially for R&D. European pharma stocks are trading at, in some cases, much larger multiples than the U.S. stocks. Many of the U.S. companies have really struggled, and are in far more vulnerable positions than they've ever been before. I would not rule out a trans-Atlantic deal or two....

There is a debate, though, as to the value of large mergers. It's no accident that we haven't seen another big merger after the Pfizer deal, and there's a real question as to whether or not scale creates value. Scale stifles innovation and creates just a larger base from which to grow. The companies in the industry that are likely to be the most successful are the companies that have more flexibility in their organizational structure, have the ability to be more nimble.

That's not the behemoths of the world. Pfizer had some spectacular earnings growth over the last several years, but at the same time, the returns on invested capital have come under tremendous pressure because the earnings aren't real earnings, they're manufactured earnings, and now they've got to show improving organic growth when it's extremely challenging to do. There's a real question about being bigger. I'm not sure that it's better. It probably has put some of these companies in a worse position because they're so big and they've got farther to fall.

Mergers for the sake of getting bigger, I don't think it will happen. We will see more consolidation along strategic lines. We're going to see more divestitures of non-core businesses. Bristol just announced that they're selling their consumer business, they sold OTN a couple weeks ago....There's going to be more emphasis on portfolio management, companies getting in and out of other businesses to help defray some of the risks of pure pharma. There's not one answer for all companies. This industry is not homogeneous, but we will see more deals, probably along product lines, in-licensing, strategic acquisitions. I wouldn't rule out a major trans-Atlantic deal given the relative strength of some of the European countries.

Ryan: [Consolidation] always coincides with a very difficult period, so these deals are clearly done defensively and not offensively. They are driven by a number of phenomena. There's no question that it is far better to innovate and drive your revenues as a means to grow, but when individual companies and the industry reach a point where that is not happening, and their returns are declining, as we see today, they need to find a way to improve their returns and reduce their risk. That's what mergers have accomplished....

The growth in this industry may be much tempered and low, but what the industry has to do is lower the risk to be commensurate with that. You can't have it be that you have binary events that take the stock down 30%, and you have no opportunity. That's why this group has been uninvestable. It's not defensive because it's blown you up, and it isn't growth. We all know that if we buy a biotech stock, it could get cut in half if a drug fails. But it could be a five-bagger if that drug works. That's what's lacking here....

AstraZeneca was going to be a growth stock based on its pipeline; it's a broken growth stock. Lilly is a wobbling growth stock. Schering-Plough is a growth stock based on a pipeline opportunity, whether that's your cup of tea is another debate. No one could have ever fact-tested what would have happened to these organizations if they hadn't merged, and they all merged out of weakness, and their shares are in decline. They protected the "e" better than they had if they hadn't done the deal. Would the prospects of those merged companies have in fact been worse, had they not done the deals? Not that in an absolute best sense, they were better.

"The Pink Sheet": Is there still room for organic growth now that all the "easy" targets have been identified?

Kelly: There are two essential questions. Is it time to change the business model? With a lot of these management teams who were around for the last time, several people said "yes, this situation is bad enough, let's change the business model." But as both Barbara and Jami have noted, people who took the risk then were not rewarded, and people who held on tight were the ones who were rewarded. So that institutional memory is still sitting out here and has colored a lot of the decisions.

And then, this element of restructuring. There's restructuring, meaning we're going to take costs out, but we're not really changing the business. Firing someone else's sales force does save you some money over time, but it's not going to change the long-term growth projectory, which is why there's that question about whether or not becoming big for big's sake does add value. Or is it time to really restructure, and really change the way that the selling model works for these companies?

M&A is something that is still with us, and still will be part of how the industry works, but these two major questions could be answered maybe through some sort of strategic deal, but also has to come organically as some of the way the management thinks the business should be conducted....

Ryan: The major problem among many of these companies is that they're still in denial. A reason that we haven't seen a more significant restructuring initiative, a change in the business model, a wholesale re-think on the size of the sales force is that many of these CEOs still think they're in a growth industry, and they think that their companies are growth companies. I would beg to differ.

For example, I don't think Pfizer is a growth company. Pfizer hasn't been a growth company for several years. There are ways to hedge their risks. Hedge their risks would imply re-thinking the way they do business and re-thinking the size of their sales force. Ultimately, that, along with a renewed focus on R&D productivity, will lead to improving returns. Pfizer's returns started to decline the day they did their deal.

I don't believe large-scale mergers improve returns. They delay the inevitable. It's during that period while you're buying time that creates the opportunity to improve internal organic growth and internal returns on R&D. We haven't seen that yet. It's hard to find examples throughout the industry where large-scale mergers have created improved returns for shareholders.

It's possible that you can make that case for Novartis. Novartis spent the first three years of the Ciba-Sandoz merger reorganizing, restructuring its internal costs and a refocus on R&D activity, and now they're finally benefiting from organic growth, and we see that in the multiple. It can be done, but for the most part, most mergers have not led to shareholder returns....

AG Investigations Not A Major Issue For Wall Street

"The Pink Sheet": Another big PR issue for the drug industry this year were investigations into various company practices. What kind of impact do investigations like Eliot Spitzer's inquiries into off-label uses have on the market and how do they help you determine whether a company is a good investment?

Kelly: There are a couple that are more broad-reaching, like pricing, and a couple that are more focused on individual therapeutic categories. As far as the investment community goes, it is not as important as some of the other things that we've talked about, but it's important to see how the industry structure might change somewhat on this, with more disclosure about what's happening inside the pipeline and more disclosure with the clinical trials databases....When I see the investigations involved in pricing, I look at that more as a structural change for what's happening with pricing transparency as the government gets more involved as a large buyer of pharmaceuticals, rather than the investigation itself....

Rubin: In some ways [the investigations have] faded as an investment risk, because there are so many other big risks looming. We haven't yet talked about some of the patent litigation risks, and as Barbara said, Merck was down about 30% in about five minutes. That does not happen very often, not only in the drug sector, but anywhere. There's a tremendous amount of risk aversion over issues that could create that kind of sell off in about five minutes. So investors are very focused on the upcoming Zyprexa patent verdict as well as Plavix and Lipitor....

So yes, the sales and marketing, the investigations by attorneys general have been a worrisome trend. My sense is that - I'm hoping that this is not wishful thinking - but it feels like it's run its course. Attorneys general have basically targeted every company that's been exposed to the Medicaid "best price" program, and I'm sure that most companies probably exploited that program to their advantage. It's a real gray area as to how to determine "best price," but it's also been very difficult to prove any wrongdoing.

But in the area of sales and marketing practices, the AGs have been more successful, and we're seeing the fallout of that. Companies are being much more careful. Schering-Plough basically does everything with their hands tied behind their back. They've completely changed the way that they've marketed and sold drugs, and we've seen that probably across the board. So the only point that I would make is, those investigations aren't over, everybody's on the radar screen, that has been the case over the past several years. But there are so many other major risks out there that with respect to companies and investors, I think the focus has shifted.

Medicare: Looking Ahead To 2006

"The Pink Sheet": Based on what we know about the Medicare prescription drug benefit, what effect will the law have on the industry? What are investors looking for in drug companies to show that they are taking steps to be prepared for the benefit, while remaining flexible for whatever the Centers for Medicare and Medicaid requires?

Ryan: This is largely a passive insurance product set up by the government, and the funding will come both from the government as well as individual Medicare patients. They will choose whether to participate or remain in the programs that they're currently in. Two-thirds of the Medicare patients already have coverage outside of Medicare, and they may choose or may not choose to be a part of that....

What becomes important there is your positioning on formulary, and we've already seen a number of efforts which have been successful in that regard. There are some categories that are obviously much more crowded and sensitive to pricing and rebates than others. We have also seen that companies, conspicuously Pfizer, who is...more important by size and expense to any of the customers, that they can go in and negotiate a package that could be good for Pfizer and good for their customer....

Unfortunately, we all look at list price, because it's the only thing that is known to us. But list price is increasingly absolutely irrelevant. It's [more important] what goes on behind the curtain. Now we don't know what goes on behind the curtain, we can only imagine, but we can judge the results. So we see that some companies, like a Pfizer, have been more successful behind the curtain than others. The breadth of your product portfolio and the importance of that portfolio to any payor certainly plays a role. If you have a one-off drug that you're trying to position and it might be in a therapeutic category that's quite crowded, it is very difficult to have any traction.

I don't think there's going to be any major change from the industry. I think some of the investigations by Medicaid were somewhat of a fact-finding nature, so that the government could understand the basis on which pricing was established, and put the companies on notice that they better not jerk around with the system or there will be consequences. I think they've been successful in that effort.

"The Pink Sheet": Will companies' pricing strategies for 2005 be affected with companies knowing that the drug benefit is coming in 2006?

Kelly: The pricing strategies in 2005 are still going to be linked to looking back in the rear-view mirror at what happened in 2004 and how companies that did have inside the categories, strong supplemental rebates did gain share. We've seen shifts in power. Some companies did get hurt inside the proton pump inhibitor market and then recover with better supplemental rebates, and that's going to be the main driver right now going into 2005 as far as the pricing goes.

Taking a look at 2006 and how the pricing is going to come in here, right now we see the first generation of the Medicare drug benefit looking a lot like a commercial type of plan. So the prices for those members that do not have a form of commercial benefit today are coming in line with the current commercial market.

Drug Discount Card Is A "Colossal" Failure

"The Pink Sheet": What about the Medicare discount card - were there any surprises or lessons learned? Does the discount card website tell us anything about the drug benefit's potential to increase competition in the industry?

Kelly: I don't think that it does. We were watching to see if there would be some response inside the prescription trends in the second half of the year, and we had not seen one. It would be hard to attribute that directly to the discount card or not, but we were looking for some form of acceleration or something, and nothing really changed there.

What's important is how the patient perceives their price point. Taking down their price point by 30% of course saves somebody a lot of money, but in the sense of keeping up with the Jones's, people look around and they compare themselves to whomever they feel is getting a very good deal, and say, "Someone I know still has a good co-pay because of a retiree drug benefit. I want that, I don't what 35% off a $100, $65 is still too high, I want $20, because I know someone who has $20."

As we think about the Medicare drug benefit, and the Medicare drug benefit has its structure where a plan must be offered that is actuarially equivalent to that, they're not going to exactly have that structure for each individual on their benefit. We're going to have to watch and see how the consumer feels this product is doing something for them with their pharmaceutical costs. Twenty-five to 35% off may not be enough, it has to be felt as a more significant impact, and the discount card didn't take that far enough, which is probably why we didn't see a large response in the units.

Rubin: I don't think we can really read anything in the discount card, because I thought it was a colossal failure. Fewer beneficiaries joined the card than was expected, I don't remember the numbers, but it was not as many as were eligible. Secondly, it was incredibly confusing. I went online myself, trying to navigate through it, and I consider myself pretty computer-knowledgeable and I thought it was really complicated. I can't imagine somebody 65 years old who isn't as computer efficient getting on there for the first or second time, and you can understand why it turns so many people off. A lot of those issues will be resolved.

More importantly though, with this Medicare drug benefit, there's obviously a lot more transparency to price, and a lot more opportunity for consumers and the elderly to shop around for best price. That was one of the alarming, more worrisome aspects of the prescription drug card and the website that allows you to go on and literally look at all the different statins, all the different drugs and all the different price points....

That is the concern that we have, that Medicare beneficiaries will have much greater access to the actual price point and will have the ability to shop around. It's unclear how that all plays out as they become folded into the overall commercial Medicare plan program with an HMO or a PBM. They'll have less opportunity to do that and their prescription drug benefit will be managed by that particular plan....The next 12 months the focus will be on the implementation of the plan, and the greater the involvement of the private sector, the greater the chances of success.

A key risk with this bill had been that HMOs weren't going to come forth because of the fear of this patient population, that's completely changing now and we're hearing that there's a tremendous amount of interest.

While this bill is structured in such a way that is relatively attractive to the industry, and it relies on private sector mechanisms to control costs versus government intervention, it's the long term that has most investors concerned. Every time the government's been involved before that has, generally speaking, led to some form of price controls. In the near term, it's really important that this plan does not have a federal fall-back option, and it won't if there's enough coverage around the country....Longer-term, if the cost of the benefit spirals out of control, and the government runs out of options, it's very likely there will be some form of price controls.

Importation On Back Burner For 2005

"The Pink Sheet": Regarding the issue of improving access to prescription drugs, the Bush Administration has indicated that it would accept a Canada-only importation program under certain conditions, but cautioned that it would ultimately lead to fewer new drugs on the market due to declining revenues. Do you agree with this outlook?

Ryan: The reality is, while it's against the law today, lots of people do it. The industry has been able to control the impact of that because Canada is 3% or 4% of the world demand, so they certainly can't supply the United States, with 40% of the world's demand, its drugs. The consequences of much broader enabling of the importation of drugs from Canada unfortunately would be the availability of many more counterfeit drugs. Where there is a market void, somebody will sell that, and it won't be Pfizer, Lilly or Merck sending more supply to Canada, but rather there will be counterfeit drugs, and that will have an ugly ending.

The graceful way politically to address this is to have so many caveats that we have the same people who don't have access to any other kind of negotiated discount taking advantage of that opportunity....If the senior citizens move to a co-pay, even if a drug is much less expensive in Canada...it's still going to appeal to such a limited base of the population and can be controlled and maybe allow the politicians to look like they were enabling people to get a good deal with safety precautions rather than looking like they're obstructionist and in the pharma industry's pocket.

But it's bad legislation, and not just because of what it does for pharma companies, but primarily because it opens up the opportunity for a lot of counterfeit products. If you go to 42nd Street and you pay $1,000 for a piece of glass, you may think that you got a good deal, but you didn't buy a diamond....

Kelly: We do not acknowledge Canada as an actor in this whole thing, it's just viewed as a source. Canada, if things get tight, will not allow this to continue. They are not required to be a source of pharmaceutical product to the U.S. and it will become a political issue for them. It's one thing if a single city or town tries to do this sort of importation and you have a very small draw on the available product in Canada.

But if you, even in a limited manner, try to turn it onto the United States, there will be a response that will change the price gap, either because the parallel importer takes the price gap away, as they do very often in Europe, or because Canada will take it away, because they can't afford for their citizens to have this happen to them.

I don't think that this is very workable....Wyeth has a very nice comment on this. When they import Protonix , who's Protonix is it? It's Altana's, because Wyeth doesn't sell Protonix in Canada. So who's on the hook if something goes wrong? So how are we going to pick which products are going to use this mechanism? It's a lot more complicated and it's really hard to see it be a workable solution.

Rubin: The report that came out in December from HHS to some extent put this issue to rest. It raised a lot of these problems that have been discussed by my colleagues as issues that may be unworkable. It's important that the focus shift to the Medicare Modernization Act, because the question is about access. The reason why we're having this debate about importation is because of the cost issue and the access issue, both of which should be addressed by the Medicare benefit, assuming that's successful.

While it's still a political issue, the noise level on importation will be considerably lower than it was last year, largely because we're one year away from [implementation of] the Medicare bill, which will provide access to many more people who are going across the border to Canada to import their drugs....

It's not dead, but it's certainly far from alive like it was last year. There was a tremendous amount of legislative focus on reimportation last year and Bush is more focused on taxes this year.

Second Bush Administration Takes Heat Off Industry

"The Pink Sheet": The potential for a Kerry Administration weighed heavily on Wall Street this year, but the November elections saw Bush re-elected to the White House and Republican gains in the House and Senate. What effect will a second Bush Administration with a stronger Republican base in Congress have on the industry?

Rubin: Relatively speaking, we expect the political environment to be much more benign going forward, at least over the near term. That's largely because the focus of this Administration is on the successful implementation of the Medicare bill, based on private-sector pay. The fear with a Kerry Administration was that while he couldn't change the legislation, we had heard that he would have found ways to dismantle the private-sector...incentives to get the...third-party payors to participate, increase the role of the federal fall-back option, so essentially increase the visibility and the likelihood of government intervention over the next couple of years. The industry dodged a major bullet by Bush's re-election victory....

On the issue of the FDA, we need a new FDA commissioner. We have an acting commissioner who wants the job, but essentially it's a headless FDA. Congress, even with Republican control, will focus on safety at the FDA. It is possible that there could be bills floated around this year suggesting the establishment of a new division within FDA that focuses on safety. I don't think that's going to happen, but that will be a focus of discussion. There may be new requirements in the...whole NDA process to be discussed, which will be a negative, but overall, the second Bush Administration is more of a positive.

Everybody acknowledges the long-term impact of the Medicare bill remains a major uncertainty over the sector and people are holding their breath. At some point, some time down the road, there is risk of price controls. Over the next four years, these companies have an opportunity to work closely with Congress to improve their public perception and advocate going further in terms of Medicare reform, such that prescription drugs aren't viewed as a special benefit, a carve-out benefit but part of overall health care....

Ryan: It's the devil we know. He's put in place the Medicare drug benefit, and his goal is to see that implemented and see it be successful and work. From the perspective of what they can do in that regard, that's been done....The focus of this Administration is going to be domestically on taxes, Social Security and the war in Iraq. This is kind of viewed as something that's been addressed. Given their dominance in Washington, there is virtually no likelihood that that's going to be changed.

As Jami said, the risk would be that the Medicare reform bill does not go well, the implementation is not successful, and then in '08 we have another election, and this will, as in the case in past election, be a political hot potato. In their heart of hearts, the Democrats really want to socialize medicine, and so the fear is that without a successful Medicare drug benefit, we have a risk of a Democratic administration and ultimately the government taking over the health care system, and specifically drugs. That's tantamount to price controls.

The direction of pricing when the government gets involved is only one, and that's down. The question is what is the trajectory - is it slow and steady and incremental, or is it revolutionary? It's not going to be revolutionary up until 2008, but beyond that, it's going to be largely a question of two things: how successful this bill was and who's our next president.

Kelly: I agree with what my colleagues have said about the Medicare drug benefit, I would just add one thing. We will be getting new looks at the estimate of the size of the new Medicare drug benefit over time, so it does keep the political side of this in play, maybe even before we see the drug benefit come in 2006. That's something that we will be watching out for as we go through 2005 because it will end up covering the debate on this and also on other things that are major claims on the overall federal budget.

As far as the FDA goes, I agree completely with Jami. We need to get someone in there very quickly, and it's our understanding from our Washington research team that this is something that's a top priority.

- Kate Rawson