July 22, 2002
From the desk of Jane Galt:All right, I've gotten enough
All right, I've gotten enough emails on the subject that it's time to explain something about pharmas. I'm afraid the explanation may be a snooze, since it's complicated, but hey -- I had to give it the old college try.
Question: But why can't the pharmas just cut their marketing budgets instead of R&D? Marketing is an even bigger expense than R&D is!
Answer: Because they're mean heartless bastards who want all of their potential customers to die so they can't buy pharmaceuticals from rival companies.
Ha-ha, just kidding. Well, the answer is in two parts. First of all, marketing isn't a much bigger number; its the same as, or less than, R&D. All those figures you see showing how marketing is twice R&D or more are using a figure called SG&A -- Selling, General, and Administrative expenses. This isn't just marketing, it's everything that takes place outside of a factory or a lab. Finance. Accounting. HR. Payroll. Sales. Purchasing. Distribution. IT. Internal auditors. Retarded children on Arthur Anderson's payroll who need to be kept well supplied with Tootsie rolls less they disallow the company's treatment of capital expensing. Hotlines to deal with customers calling to find out if going on Ortho-TriCyclin will really make their skin clear up. Lawyers to deal with customers who think that Ortho-TriCyclin made them gain eighty pounds and kill their mothers. And regulatory compliance officers to make sure the Feds don't shut the place down.
Actual marketing figures are somewhere in the neighborhood of half that -- whether they live next door or on the other side of the 'hood, we can't tell, because pharmaceutical companies keep a tighter reign on these figures than fathers of thirteen year old girls do on their daughters. Anyway, marketing expenses are either the about the same as, or less than, R&D expenses. They certainly aren't more -- even Qualcomm, which has no regulatory overhead and doesn't do anything but R&D, has SG&A about equal to R&D.
However, of that marketing figure, about half consists of free samples given to physicians. While that could potentially be cut, it wouldn't save the consumer much money, since drugs they don't get for free are drugs they have to buy on a trial basis. Since many drugs are packaged by the month, this wouldn't help us in our goal of lowering consumer drug costs through allowing drug reimportation. But we're getting off the topic, which is "Why can't drug companies cut marketing expenses instead of R&D".
The second answer is to do the math. The average savings on on-patent drugs, by my survey, is about 40%. The entire SG&A budget is 30%. Even if they shuttered the headquarters and somehow managed to operate without any of the services enumerated above, that still leaves 10% of revenues to be saved somewhere else. Either they stop making the pills, they tell the stockholders to go hang and thus cut off their access to capital -- or they cut R&D.
But the most interesting answer is this: R&D is not a budgeting question. It is an investment question.
What does that mean?
The people who are asking the question are looking at the static budget from a one-year perspective: prices have been cut, so we need to cut costs. Do we cut marketing or R&D? Since they know that pharmaceutical companies currently rely on innovation to drive future profits, and they have absorbed folksy aphorisms about not eating the seed corn, they are therefore assuming that the last thing pharmas will want to do is to cut R&D. That's not an unreasonable assumption, but it is ignorant of the way that companies make investment decisions.
How Companies Decide What to Invest In
When a pharmaceutical company decides whether to fund a project, the executives on the budget committee don't say to themselves "Well, can't eat the seed corn -- this year we're putting $2 billion into R&D". R&D is funded on a project-by-project basis. And each project that is funded goes through a valuation process that estimates the potential cash flows from a drug, and then discounts those cash flows by the risk that the drug will never make it to market. In pharmaceutical companies that risk is extremely high: 999 out of every 1000 compounds they explore never make it through the development, patent, and regulatory approval processes.
Now, when a project that you want to put, say, $1 million into only has a .1% chance of producing a successful drug, the size of the potential market for that drug has to be, in a totally risk free environment with no interest, $1 billion just to break even. Are we clear so far?
Okay, it gets more complicated still. Because pharmaceutical companies don't live in a risk-free environment. Nor can they borrow money without interest. So the market has to be even bigger. Assuming that time from initial research on a compound to a drug hitting the market is about fifteen years, and assuming a real interest rate of 5%, the market would have to be over $2.5 billion just to break even.
But of course, pharmaceutical companies don't just want to break even; if they did, they'd just park their cash in inflation-indexed bonds and go home. They need to make a profit. And they have a fiduciary duty to their shareholders to make the best profit possible. The rate of return on an investment therefore has to be better than the best alternative to making that investment: plunging it into the stockmarket, say, or buying a fur-bearing trout ranch in Iowa. Call it another 5% they need to make per year. Our $1 million investment now needs a potential market of $5 billion just to make the bare minimum profit that will induce the pharmaceutical company to invest.
But the pharmaceutical companies don't expect to earn back all their money in one year; they expect to earn it in the 7-10 years after it clears the FDA and before it goes off patent, using a complicated formula that takes into account the time it's been on the market and a host of other things. Based on the figures above, your $1 million investment would need to generate expected revenue of approximately (very approximately) $2 billion a year for seven years.
But these are just numbers for example. For one thing, pharma investment isn't quite that simple; put small amounts of money into a lot of things, and then when they see what looks promising, they put a lot of money into a few. But while these figures are jackleg, you can see the principle in operation: Investments are not priced on a budgetary basis. They are priced relative to the next best alternative for the money.
That is why the R&D budget now exists independantly of the marketing budget: this year's marketing budget was already priced into old projects.
Why Can't We Just Cut Marketing In the Future?
Now you're going to ask me why we can't factor out the marketing budget in the future on the assumption that doctors and patients will just find out about our product by word of mouth and drive over in their cars to pick some up. Let me 'splain.
First of all, if a lot of that marketing budget was gravy, companies wouldn't do it. Oh, there are junkets for the doctors. But most of the budget is getting the drugs to the doctors, and telling the doctors about them. Doctors need to find out about the drug somehow. Doctors will tell you how useless most of the marketing budget of a pharmaceutical company is. This is because doctors have absolutely no idea what the relative cost is of, say, doing a mass mailing or advertising in the AMA journal, vs. taking doctors to dinner, taking them to a hotel, or giving them free samples. Doctors in what I like to call the "lifestyle professions", such as dermatology or podiatry, are also quite vocal about the uselessness of free samples. Free samples, however, ease the transaction costs of taking a new drug for people with serious illnesses, who often have much less disposable income than someone spending time and money at the dermatologist's. For example, I'm now on Singulair. But Singulair only works at all for 65% of asthma patients, and it comes packaged as a one-month supply. Who wants to spend money on 30 pills to find out that you don't need 28 of them because the drug is useless? Fewer samples mean fewer sales to people who don't want to spend $200 to find out if that new blood pressure med works.
So let's assume that we can cut a wildly unrealistic 30% out of the marketing budget in the future. This amounts to, by current budgeting, 5% of revenue.
More importantly: Marketing is not an expense subtracted from the potential profits of R&D. It's a different investment.
Viagra didn't need marketing. Tell people it's there and they'll line up for hours in the rain to get their hands on it.
A project is generally anticipated to make most of its money in three or five years of its patent life; that's when the planners anticipate recovering most of the initial investment, before newer better drugs come on the market, or the patent expires. Much of the marketing happens outside of those 3-5 years, generating additional revenue that wasn't factored into the investment equation. This revenue is important as a source of profits to generate more capital for research -- but it is not factored into the initial calculation of the profits required to recover the initial investment, and therefore cannot be factored back out again.
Now, I need you to make another assumption: to wit, that most current projects in the pharmaceutical area are projected to return very close to the minimum needed for a company to fund them. Why should you assume this? Because economic theory tells us that if it weren't so, there would be tons of new entrants into the market, attracted by juicy profits. In fact, there have been just such entrants -- that's the biotech sector. And they have competed down rates of return -- that's those "me-too" drugs you hear everyone complaining about. Guess what? Those me-too drugs are making you pay less for your pharmaceuticals, not more. Now, if a compound looks like it will generate an especially outsized return, you can bet your bottom dollar that all the other companies are working on a compound for that disease too. Having two compounds on the market for the same thing will cut deeply into your expected return.
Okay, so most projects are expected to return very close to the minimum needed to make them a worthwhile investment. Now, let's assume that reimporation becomes law. Prices are expected to drop by 40%. What happens?
What Happens if We Drop the Price of Drugs?
Now, pharmaceuticals are different from, say, tube socks because there is an absolute limit to their market. Even if they're giving them away for free, healthy people aren't going to start taking Prozac or HIV drugs or blood pressure medication. In addition, a large portion of the people who are currently priced out of taking drugs will not start taking them even if you drop the price. Why? Because they can't afford the doctor's visit either. Dropping the price on a patented drug thus garners many fewer new users than doing so on a normal product. Losing 40% of the price therefore means that the firms also lose close to 40% of the revenue.
Let's say that they only lose 25% of the potential revenue. And let's say that they can cut their marketing costs by 30%, yielding a savings of 5-7% of total revenue. This cuts their total loss to 17-20% of revenue. Will the pharmaceutical companies invest in new R&D?
Not on most projects. The projects simply will not earn back the required rate of return to justify the investment of capital. Even though you may reason that pharmaceutical companies today could lose 25% of revenue and -- just -- survive, they still will not invest in projects in the future which do not return their cost of capital.
The projects that are invested in will only be for very large markets, where it is possible to remain profitable with volume, or lifestyle drugs where there is no downward political pressure on the price. Cancer is not a large market; there are many different kinds that respond to different things. AIDS is not a large market. Most markets, in fact, are not that big.
I know that those of you who wish, very deeply, to believe that we could make new drugs cheap if we just tried a little harder, cannot believe this. So let me explain why you can't, even with very deep cuts in the marketing budget, make R&D profitable at lower prices:
Time.
Because of the regulatory process, which eats 7-10 years of the patent life of drugs, Pharma has the longest development cycle of almost any industry -- the longest time between the initial investment and the payoff. The farther out things are in time, the higher the risks, the lower the time value of money, the longer the discounting has to work. So when the initial positive cash flows from an investment are very far out, the profit margin in the first years of positive cash flow must be very large to compensate for the length of time the capital is tied up. You simply cannot cut those revenues by 25% and still cover the profit margin, even if you manage to cut costs by the same percentage -- and you can't.
Think of it in terms of your own life. Imagine you currently make $100 K, and have living expenses etc. of $80K. You're offered a new job at $90K. When you point out that this is 10% less than you're making now, the interviewer replies that since you can live in a less expensive neighborhood close to your new job, you'll be able to generate savings of 10% on your cost of living, too. Do you do it?
Not unless you're stupid. If you do, you lose $2,000 of net income.
Even if the management of pharmaceutical companies wanted to take on projects the value of which doesn't exceed the value of the best alternative use of the capital, the shareholders wouldn't let them. They'll stop researching pharmaceuticals and invest in something else. Shampoo. Chemical solvents. Fur-bearing trout farms. Something that covers the cost of the capital required to make the investment.
Summary Explanation
So the reason that R&D dollars will be cut before marketing dollars is first of all, that it is mathematically impossible for most drugs to recover their cost of capital if their price is cut by 40%; and second of all, that cutting prices actually biases investment decisions towards marketing and away from R&D. Why? Because marketing has a very short time horizon. No discounting. So the dollar return required on an investment in marketing is lower by an order of magnitude than the dollar return on an investment in R&D. If you are faced with drastic cuts in prices and revenues, the first investments to go are going to be the ones that require a large revenue return for each dollar invested -- in other words, R&D. So while theoretically, it would be physically possible for pharma companies to substitute cuts in marketing for cuts in R&D, it would be irrational for them to do so.
It's a hard topic to explain, and I'm not sure I'm doing a good job. But this is why people doing back-of-the-envelope arithmetic are confident that they could still do R&D with the new pricing -- and investors and pharmaceutical analysts know that it won't happen.
Posted by Jane Galt at July 22, 2002 6:20 AM | TrackBack | Technorati inbound links"); ?>