DRUGMAKERS UNDER ATTACK . Marketing muscle, patent protection, and a unique relationship with their customers have made them America's most profitable industry. That is changing.
By Brian O'Reilly REPORTER ASSOCIATE Joshua Mendes

(FORTUNE Magazine) – NO AMERICAN INDUSTRY has ever defied the laws of economic gravity like pharmaceuticals. For the past 30 years the drugmakers of the FORTUNE 500 have enjoyed the fattest profits in big business. They also evoke some of the most intense emotions, as anyone who has been to the drugstore lately knows: gratitude when a sorely needed medicine works -- and fury at what it costs. Drugmakers have rewarded shareholders with returns on equity 50% higher than the median for FORTUNE 500 industrial companies (see chart). In recent years the gap actually widened: Returns on equity for these investors' darlings climbed to 26% in 1990, double the FORTUNE 500 median. Part of that was the payoff from successful new medicines like Mevacor, a cholesterol cutter from Merck, and Prozac, an antidepressant from Eli Lilly. But part of it also came from hefty price increases on drugs that have been around for years. During the 1980s the average cost per prescription for established drugs climbed at double the rate of inflation. Small wonder that the industry is under assault. Patient advocacy groups, the federal and state governments, and large corporations, which feel the pain through mounting costs for medical plans, are asking hard questions about what drugmakers charge. Congressmen and Senators leap before the TV cameras to decry outrageous profiteering. One frequent critic, Senator David Pryor, an Arkansas Democrat and chairman of the Special Committee on Aging, ominously notes that the U.S. is the only major country that regulates neither drug prices nor drug profits. AIDS victims were among the first to protest. They raged at Burroughs Wellcome for putting a $10,000-per-year price on AZT, which slows the onset of the disease's symptoms. They got the price cut twice. Attorneys general for more than 30 states filed an antitrust suit against Sandoz, maker of the schizophrenia drug Clozaril. Patients who take it need weekly blood tests; Sandoz insisted they buy the drug and the tests from a California supplier, at a cost of $9,000 a year. Sandoz later dropped the requirement. Drug industry leaders think much of the criticism is unfair. ''We don't want to see a gem of U.S. industrial prowess hampered by limits on prices,'' says John R. Stafford, CEO of American Home Products and chairman of the American Pharmaceutical Association. Asks a more combative Edmund T. Pratt Jr., chairman of Pfizer: ''What industry would you rather have be the most profitable?'' Pratt has a point. The next-most-profitable industries in the current FORTUNE 500 sell soap, food, and soda pop. But this business saves lives. Even Pryor, one of its harshest critics, might not be around today without the medicine he has taken since a recent heart attack. ''It may be lifesaving,'' he says, ''but that does not mean you can charge whatever you want for it. I can afford to buy my drugs. Too many other Americans simply cannot.'' The industry produces powerful economic benefits. Pharmacies carry scores of new medicines that reduce the need for costly surgery and prevent the loss of work time to illness. Economic chauvinists can thump their chests over the industry's success as well: By one estimate, U.S. manufacturers account for 42% of the major drugs marketed worldwide. Don't expect this river of success to roll on forever. In the next few years, profits will almost certainly fall. While virtually every large pharmaceutical company is highly lucrative now, the business will get much riskier. By the mid-1990s, companies that turn out truly innovative products -- the possibilities include medicines for enlarged prostates and for joint deterioration from arthritis -- will make more money than ever. But those that have grown fat producing high-priced me-too medicines will face price wars and shrinking profit margins, bitter pills indeed. Upjohn won't be able to boost earnings the way it does now, by raising the price of some old drugs 25% to 30% a year. And Glaxo, a British company, will have to fight hard to show why doctors shouldn't start patients on over-the-counter antacids, at perhaps $50 a year, before going to Zantac ulcer medicine, at $500. How has the industry made so much money for so long? Drugmakers would like you to believe their earnings are the natural reward for brilliant science and gargantuan spending on research and development. Those are important -- they helped make Merck the largest seller of drugs in the world and will buoy the performance of Bristol-Myers Squibb and Pfizer in the next few years. Companies without them eventually fade away. But innovation doesn't explain all. While drugmakers funnel hundreds of millions into R&D (typically 15% of revenues, a much higher proportion than in other industries), they spend up to twice as much on sales and marketing. American Home Products, a superb marketer with one of the poorest records of innovation, earned a 46% return on equity last year, ranking it 16th on the FORTUNE 500, one notch behind Merck (with 46.5%). Those earnings flow from a peculiar combination of competent research, some genuinely innovative products and many that aren't, marketing muscle, and immensely valuable patent protection. Most important, says Robert P. Bauman, CEO of SmithKline Beecham, which makes Tagamet, one of the best-selling drugs in history, ''it's a business that has never competed on price.'' Many industries benefit from one or another of these qualities and conditions, but only drugs has them all in quite so potent a combination. FOR ALL its voluptuous profitability, the pharmaceutical industry is not huge. Americans paid some $50 billion for prescriptions in drugstores and hospitals last year (vs. $150 billion for cars and $100 billion for computers). The rest of the world paid $120 billion for prescription drugs. Nor does the industry command a growing wedge of the health care pie. Mainly because other medical costs have risen so fast, drugs and supplies as a percent of medical spending in the U.S. has declined sharply, from 16% in the 1960s to 7% today. That is far less than in Japan, the world's second-largest drug market, where doctors make money dispensing medicine themselves and drugs make up 17% of health spending (see box). In the 1980s the industry's already robust profits began to improve. Companies de-glomerated: American Home Products, Lilly, Squibb, and others sold off candy, cosmetics, and other less profitable nondrug lines. Sterling, Rorer, and Warner-Lambert cut administrative and manufacturing costs. Even more significant were new scientific methods that begot the first billion-dollar babies -- ulcer medicines Tagamet from SmithKline and Zantac from Glaxo, which each take in $1 billion or more annually at wholesale worldwide. They in turn opened a new era of drug marketing, in which armies of salesmen march across the globe drumming up demand. Says Paul Brooke, a pharmaceutical analyst at Morgan Stanley: ''The $50-million-a-year drug of the 1970s became the $500-million-a-year drug of the 1980s.'' BEFORE TAGAMET, pharmaceutical R&D consisted mainly of trial and error -- testing dirt samples for possible antibiotics or injecting plant extracts into laboratory animals to see what would result. Developing a $100-million-a- year drug typically required trials on over 60,000 compounds, says Jay Silverman of Nomura Research in New York City. But in the late 1970s scientists developed an understanding of receptors in the body that block or trigger biochemical responses; new laboratory tools made it feasible to tailor molecules to fit those receptors. Hence Tagamet, which works by blocking a histamine receptor in the gut that triggers acid secretions. Good for patients, it proved so effective that ulcer surgery was virtually eliminated. Good for SmithKline, it had impressive economics: At around 80 cents per patient per day wholesale, Tagamet generated far more sales than ordinary antacids. Introduced in 1977 in the U.S., the drug hit the $1-billion-a-year mark worldwide in 1986. Glaxo came up with Zantac in 1981. It has fewer adverse interactions with other drugs than Tagamet does. But Glaxo's real breakthrough was in marketing. Rather than rely entirely on its sales force, the company contracted with hundreds more ''detail men'' from Hoffmann-La Roche to promote Zantac all over the world. Despite a U.S. price 50% higher than Tagamet's, Zantac promptly shoved the original aside. Says Bauman, who was head of Beecham Group of London when it merged with SmithKline in 1989: ''History may show that SmithKline was a little complacent. But Glaxo was the pioneer in realizing the power of marketing.'' Zantac's sales last year totaled $2.4 billion, the highest ever for a drug. Tagamet sold $1.2 billion. In both cases, about half those revenues came from the U.S. The power of marketing turned out to be stunning indeed, especially for companies with new, high-priced drugs for chronic illness. The 1980s brought plenty, including cholesterol cutters, preparations for arthritis known as NSAIDs, and blood-pressure reducers known as ACE inhibitors. Says Marc Mayer, a security analyst at Sanford Bernstein in New York: ''There was an awakening, that the amount of marketing money you could spend on a high-margin drug for chronic illness was vast.'' Why vast? New drugs commonly sell at wholesale prices three to six times what they cost to make. The generous gross margins give drug companies loads of money to spend. Mayer cites Squibb's ACE inhibitor Capoten, another medicine with annual global sales of more than a billion dollars, used to treat high blood pressure. Druggists might pay $300 for a year's supply that costs only $50 to produce. Says Mayer: ''A person on an antihypertensive stays on it the rest of his life. That's often thousands of dollars over the life of a patient. It's an annuity for the drug company. It pays for a lot of sales calls.'' Mayer figures that if a salesman visits 40 or so doctors, and only one puts a single patient on such a drug, the company covers the salesman's cost. With arithmetic like that, the surprise is that the number of detailers only rose 50% in the late 1980s. ''Companies expand their sales forces until they run out of doctors to call on,'' Mayer says. Many drugmakers have three or four sales teams, so when a doctor gets fed up seeing one detailer, another can come pushing the same product. Detailers are often knowledgeable -- many are licensed pharmacists -- but dubious selling practices do occur. In 1987, American Home Products launched a program that allowed doctors to earn airline tickets by prescribing Inderal, a blood-pressure medicine facing competition from far cheaper generic drugs, and submitting patient profiles. Critics called it the Frequent Prescriber plan. Massachusetts Medicaid officials began an investigation; AHP let the program expire and refunded $195,000 to the state. Last December the American Medical Association issued guidelines that discourage doctors from accepting expensive gifts from drugmakers. The extent to which companies have cranked up what they charge for existing products is revealed in a Purdue University study of wholesale prices for 104 pharmaceuticals, which account for 80% of industry revenues from the elderly. The prices rose an average of 8.6% a year from 1981 to 1988, more than twice the average increase in the consumer price index. One barometer of the pricing freedom enjoyed by drug companies with patents: Generic drugs rose just 2.7% per year during that time. Every manufacturer would like to slap a fat pricetag on his product without worrying about customers switching to competing goods that cost less. How do drugmakers get away with it? Ask your doctor. In this business the person who makes the buying decision is not the person who spends the money and cares most about what a drug costs. Says Dr. Jerry Avorn, an associate professor at Harvard medical school: ''Prices are high because there's a unique relationship at work. The person who pays is not the person who prescribes.'' A student of prescribing habits, Avorn consults for cost-containment services, firms that help corporations hold down employees' medical bills. He says many doctors are influenced as heavily by pitches and brochures from salesmen as by careful reviews of pharmacological data. Avorn points to the NSAIDs, which include over-the-counter brands Nuprin and Advil, and prescription drugs with $5 billion in worldwide sales last year. The best-selling prescription versions in the U.S. include Feldene from Pfizer and Voltaren from Ciba-Geigy; daily doses cost around $2. Says Avorn: ''If you look at the data, for most patients there is no difference in effectiveness between the expensive new drugs and older generic products that cost a fraction as much.'' So why do doctors stipulate high-priced brands, and why have dozens of drug companies developed nearly identical products? ''There's a lot of switching between brands,'' says Avorn. ''For many patients, arthritis pain never really goes away, so when a patient complains, the doctor will say 'Mrs. Smith, you're not doing well on Feldene. Let's try Voltaren.' Many doctors have no idea what the new drug costs.'' In this market, ordinary economics seems not to apply. Since the real decision-makers -- doctors -- care little about prices, discounting neither wins market share nor stimulates overall demand. In fact, says Ramesh Ratan, former controller at a division of Bristol-Myers, the opposite may occur. Instead of turning a market with $200 million in sales into one with $400 million, price cutting can slash revenues in half. The upshot, says Ratan: ''Price wars don't exist in pharmaceuticals.'' DRUG COMPANY executives often deflect critics by complaining about the time and expense of getting new drugs approved by government bureaucrats. But for many companies, those hurdles wind up boosting financial performance. Producing a successful new drug probably costs around $200 million, if the cost of drugs that never make it is lumped in. The process usually takes 12 years, from the time a chemical is spotted as having a useful effect on cells in a test tube to the time of Food and Drug Administration approval. Only about 25% of a company's R&D budget goes for original, stab-in-the-dark research. Most is spent on three phases of testing spread over six to eight years, usually involving thousands of patients and hundreds of physicians and statisticians. Ever since the 1961 thalidomide scandal, in which a fetus-damaging German sedative nearly made it into U.S. pharmacies, the FDA has been the world's strictest review agency. Last year it approved just 23 new compounds, 15 of which were already being sold in Europe. The trials and reviews add enormously to a drug's cost, and since a compound is usually patented long before it is approved, the delay cuts about five years of useful life from a 17-year patent. Yet those same FDA hurdles help make drug patents worth far more than patents in other industries. Explains James Vincent, CEO of Biogen, a Cambridge, Massachusetts, biotech company: ''If a competitor changes a molecule even slightly, it can have a dramatically different effect on the body -- and he has to start the FDA approval process all over again.'' One consequence: Drugmakers that do fast and efficient R&D and get to market first reap enormous rewards. Stephen Schondelmeyer, who headed Purdue's studies of the industry and is now at the University of Minnesota, says companies with an innovative drug often enjoy years without competition, during which ''they can price any way they want.'' The lengthy development period provides years of advance notice about what competitors are up to and enables companies to plan way ahead. Pfizer came up with few best-sellers during the 1980s but now has a pipeline full of new products. In anticipation it has hired 900 salesmen and created a sales company, Pratt Pharmaceuticals, named after the chairman. THE BOOM WILL END for many drug companies in the 1990s. Price pressure from the federal government, insurance companies, and HMOs is increasing. Blockbuster drugs that in some cases account for more than half their makers' earnings will go off patent, and generic knockoffs will invade their markets. Sales growth in Europe, source of much new revenue in the 1980s, may slow sharply too. Last year, Congress passed a law that requires drugmakers to give rebates on prescriptions paid for by Medicaid, the federal and state program that helps the poor. If a manufacturer hikes prices faster than inflation, the rebate goes up. Medicaid is the industry's single-largest customer. By itself, the program accounts for only 13% of U.S. drug purchases, but the law has encouraged other big buyers to press drug companies harder. Elizabeth Dichter, vice president of PCS, a Scottsdale, Arizona, company that manages prescription drug benefits for 20 million corporate employees and dependents, describes the government as ''the fat boy in the canoe. When it leans, everybody else winds up on the same side of the boat.'' Until recently, organized pressure on pharmaceutical companies was rare, partly because there weren't many big buyers. Five years ago only 25% of the U.S. population had even part of its prescription costs paid directly by third parties. Now half the population is covered in that way, and Schondelmeyer of the Purdue studies estimates the proportion will climb to 65% by 1995. The rise of companies like Medco Containment Services could change the economics of the industry. Medco saves money for General Motors, Mobil, Southwestern Bell, and other employers by overseeing worker and retiree prescriptions -- $1.3 billion worth in the fiscal year ended in June. Lately it has been telephoning doctors who needlessly choose expensive drugs. In June it began sending pharmacists to visit doctors in Massachusetts and pointing out ways to cut unnecessary prescriptions. A primary target: Zantac. Medco President Martin J. Wygod contends that only rarely is it necessary to prescribe Zantac instead of other ulcer drugs. Some 35% of the doctors Medco calls agree to switch, Wygod says. Charles Sanders, chief of Glaxo's U.S. operations, doubts such programs will have much effect: ''If you attempt to practice medicine on the basis of price, you'll have a rebellion by doctors. They want to prescribe on the basis that they are giving the best medicine.'' Wygod's response: ''Say we told a doctor in Lansing, Michigan, we were calling on behalf of General Motors. Most of his patients are GM employees or retirees, and he knows who's paying the bills.'' Pressure of the kind Medco applies could make it necessary for drugmakers to prove to big customers that their medicines are cost-effective. Those that are not will sell for less, or not at all.

When the patent expires on a blockbuster drug, generic makers eat away its market faster than they used to. Until the 1980s, getting FDA approval to launch a generic was difficult: The newcomer had to spend tens of millions to repeat the same elaborate clinical trials as the original maker. The Waxman- Hatch Act of 1984 reduces the requirement to showing that the generic product's active ingredient meets the same pharmacological standard as the original and is delivered as effectively to the body. Scandals in 1989 over fraud and kickbacks by generic makers who wanted preferential FDA treatment slowed the law's implementation. But nowadays generics cut sales of major drugs by half within a year or two after the patent's expiration, much faster than before Waxman-Hatch. Makers of generics, such as Abbott Laboratories, Warner-Lambert, and American Cyanamid, can look forward to increasingly juicy targets. Patents expired last year on major drugs with annual U.S. sales of $363 million. This year the figure is $541 million, and it will leap to $1.9 billion in 1992 and $2.6 billion in 1993. PATENT EXPIRATIONS will whack some companies harder than others. Among the worst hit, analysts say, will be Upjohn, which by 1993 will lose drugs pulling in $550 million annually in the U.S. It recently developed a brilliantly original class of drugs called Lazaroids, which halt the spread of nerve damage when used shortly after an injury. But Rogaine, Upjohn's heavily advertised baldness remedy, hasn't met expectations, and other new drugs in the pipeline probably will not make up the loss from products on which patents are expiring. In an apparent effort to boost revenues, the company has jacked prices on some of those drugs through the roof. Xanax, an antianxiety drug, went up 25% between January 1990 and January 1991. Halcion, a sleeping pill, rose 30%. Other companies will fare better: Pfizer has a huge repertoire of new products on the way. According to projections by Mayer of Sanford Bernstein, they will generate $4 billion in worldwide sales in 1995 and account for 40% of the company's revenues. Merck won't lose any major products before 1997 and has new stuff on tap that is estimated to bring in $3 billion in revenues in 1995. At Bristol-Myers, says Mayer, new drugs will make up $3.5 billion of annual sales by then. The international environment won't get any better in the next few years. Largely because of varying government regulations, prescription prices in some parts of Europe are double those in others, says analyst Stewart Adkins of Shearson Lehman Brothers in London. The coming abolition of trade barriers could be a drugmaker's nightmare. To take advantage of price differences, wholesalers could buy drugs cheap in Barcelona and truck them to Stuttgart. By the time prices stabilize, says Adkins, revenues could fall as much as 20%. How will drugmakers keep margins healthy? Forget price increases, says Norman Selby, a drug industry expert at McKinsey & Co.: ''The days of pricing above inflation are ending.'' The best prescription for profits, of course, is to find cures for cancer, Alzheimer's, arthritis, and other unsolved banes. Unique medicines that cut overall health care costs will also be in demand. Example: Merck's Mevacor, which lowers cholesterol and reduces the likelihood that a patient will need heart surgery. COMPANIES will have to rethink the marketing practices that have paid off so well up to now. Those armies of salesmen aimed at doctors may lose some brigades. With gimlet-eyed review boards at corporations and insurance companies exerting more control over which medicines get prescribed, drugmakers must learn to pitch drugs on the basis of economy as well as therapy. Also indicated: more prudent R&D. Major firms today boast of pouring millions of dollars into the lab. But sheer bucks are a poor predictor of innovation. Much money is wasted on projects that fascinate scientists but have little commercial potential, or on low-risk, low-reward, me-too research. According to an Arthur D. Little study, Lilly and Merck spent about the same on R&D from 1980 to 1988, but Lilly has much less commercial success to show for it. In fact, companies that spent more on R&D didn't necessarily come up with more drugs, says Marsha Fanucci, the study's author. One company that did, says Fanucci, is Merck. Its dramatic success demonstrates that R&D can be managed well. The Rahway, New Jersey, giant shook up competitors in the 1980s, for example, by setting new standards in clinical testing. While most drug companies try out compounds on 1,500 patients, Merck uses more, sometimes as many as 5,000. That increases the reliability of the tests, helps the drugs through FDA review, and gets them into pharmacies faster -- payoffs that more than offset the added expense. The benefit for Merck: healthier patients and profits alike. Other drugmakers need to find equally clever ways to reach that dual goal.

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CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: MEDI-SPAN CAPTION: IS THIS COMPETITION? Drug companies don't compete on price. Zantac came on the U.S. market after SmithKline's Tagamet (above) and at a higher price, but Glaxo's aggressive selling helped put it on top. SmithKline raised prices 150% in nine years anyway.