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Big pharmaceutical companies typically have wide moats and some of the most attractive financial characteristics of any industry. Branded pharmaceu­tical companies (as opposed to generics, which have a lower return business model) generally boast top-notch profit margins. Most global pharmaceutical companies have returns on invested capital (ROICs) in the mld-20s. Top- notch companies such as Pfizer are often in the 30s. Drug-company margins are also worth salivating over, with gross margins often near 80 percent and operating margins between 25 percent and 35 percent. What's more, drug companies offer plentiful free cash flow and virtually debt-free balance sheets. But innovation isn't cheap. It takes money to make money, and the average cost of taking a drug from discovery to the pharmacy shelf is $Soo million. Only a third of those drugs ever return their costs of development. Plus, drugs take years to develop. The clinical testing phase (trials in humans) alone can take a decade. All the while, the company is pumping money into the research process with no guarantee of a return.

There's also budgetary pressure in the United States to reduce health care costs, specifically the dollars spent on prescription drugs. Since 1980, prescription drug costs have increased faster than every other health care cost, al­most doubling as a percentage of total health care dollars, from 4.9 percent to 9.4 percent. But if political pressure leads to lower drug prices (as a Medicare prescription drug plan might), big pharma could see its margins come down.

Demystifying the Drug Development Process

Drugs are discovered in many different ways. Sometimes they're discovered by mistake, like Viagra. (Pfizer scientists noticed the "side effect" from a blood pressure drug.) Other times, they're discovered only after an exhaustive process of testing thousands of compounds in petri dishes and lab rats. This process of identifying possible targets and determining whether they should move down the development chain can take five years or more and cost in the hundreds of millions of dollars.

With new technology and supercomputers, scientists are finding ways to "virtually" test molecules against different genes to narrow the number of compounds before they start testing in live animals. But for now, drugs still go through years of initial research before being tested in mice, let alone humans.

Drugs typically take the path outlined in Figure 14.1 before they get to the pharmacy shelf.

Preclinical Testing: This animal testing phase is called preclinical testing. The primary objective Is to evaluate potential toxic effects. Before a drug gets anywhere near a human, scientists must have a clear understanding of the possi­ble damage it could do. It takes two to three years on average to discover a viable drug candidate and another year to find out if it is fit for human test­ing. For the small percentage of drugs that survive, an investigational new drug ( IND ) application is filed "with the Food and Drug Administration (FDA). Approximately 85 percent of INDs move on to Phase I.

Human Clinical Trials (Phase 1): Phase I is the first of three stages of human clinical testing. In Phase I, a drug is tested in a small group (fewer than 100) of healthy volunteers with the goal of gathering initial data on safety and efficacy—whether the drug has the ability to produce the desired

effect. Safety is the number-one concern here, though scientists and physicians also evaluate the body's reaction to the drug. A drug in Phase I has only a 20 percent chance of eventual approval but can still cost a few million dollars, including the cost of development, clinical trials, and continuous communication with the FDA.

Trials (Phase 11); In Phase II, the drug is tested in a larger population (usually 300 to 500) of patients afflicted with the targeted disease to get a more comprehensive profile of how well the drug works. The managers of these trials use them to compile additional data on safety and side effects. Here, physicians and scientists test for how much of the drug to give and how often to give it. This phase often costs more than $5 million, and more than half of all drugs in Phase II fail to move to the next phase.

Human Clinical Trials (Phase 111): The final testing hurdle is Phase III. These trials involve testing the drug in a much larger group of afflicted patients over longer periods. Safety is still an issue—Phase III trials are the first trials to focus on long-term patient safety—but efficacy gets more attention. Because of the number of patients (often 5,000 patients or more), administrative needs, and time and resources involved, Phase III trials are very expensive. These tri­als consume the bulk of the $800 million cost of developing the average drug, and a drug in Phase III has about a 60 percent chance of eventual approval.

Role of the United States Food and Drug Administration

So far, a drug has spent two to three years in preclinical testing, 8 to 12 years in clinical testing, and still hasn't brought in dime one. And its toughest test is still to come. Once a drug clears Phase III testing, the company files a new drug application with the U.S. FDA (and other regulatory agencies around the world) to be able to place the drug on pharmacy shelves and actually market the drug. An FDA filing is a tome that may weigh more than some small cars, so preparing it can take months. According to PhRMA, the U.S. pharmaceutical industry's trade group, it takes about 17 months for the FDA to review an application, and a drug under review "with the FDA still has only about a 70 percent chance of approval.

Each filing typically seeks approval in a single (and highly specific) indi­cation. For example, Rkuxan is a drug approved to treat specific types of lym- phoma patients who no longer respond to other forms of treatment. Once Rituxan was approved, that particular indication was the only one for which its maker can market the drug (although physicians can prescribe it for anything they choose, often referred to as "off-label usage").

The FDA has advisory committees that meet several times per year to discuss the applications. These committees submit their opinion to the FDA, which then decides the fate of the drug. The FDA can exercise any number of judgments for a new drug application, including granting marketing approval (which means the company can market the drug for the specified in­dication), requesting additional data or another round of testing, or denying the application.

The last outcome is definitely bad for the company filing the application. It comes as a "not-approvable letter" and means that the information in the filing did not convince the FDA of the drug's merits. It's not always death for the compound, however. Drug applications can be re-flled, but if an application gets all the way through the FDA review process and is rejected, it's likely the company has no more information to back its claims. That means it's back to the drawing board. Another filing is probably years away, and millions more will have to be spent researching the compound. Or the company can scrap the project and move on. Either way, it's painful.

Patents, Intellectual Property Rights, and Market Exclusivity

Once a drug gets the nod from the FDA, the marketing can begin. Brand name drugs enjoy patent protection for 20 years from the date the company first com­pletes the patent application (or 17 years from the issue date). However, because a patent application is usually filed as soon as a drug is identified and not when k hits the market, drugs rarely enjoy 20 years of monopoly profits because a significant portion of the protected period is eaten up by trials and the approval process. Many drugs enjoy only S to 10 years of patent protection after they are launched in the marketplace. During that period, no other company can market the same chemical compound, although competitors are still free to de­velop different compounds that treat the same condition.

To find out about a drug company's patent protection, look at the 10-K report, under the section titled "Patents and Intellectual Property Rights." Yim should find a discussion of the company's patents and "when they expire, but because drug companies often engage in fierce legal battles to try to ex­tend their patents, you'll likely need to visit the company's Web site for complete information. The 10-K also discusses any pending lawsuits, which can be a sign of trouble on the horizon.

Generic Drug Competition

After a drug goes off patent or loses market exclusivity, whichever comes later, the field is open to competition from generic medications. Generic drugs have the same chemical composition as brand name drugs but cost significantly less—usually 40 percent to 60 percent less. Generic drug makers can charge much less because they don't have to recoup the $800 million in per drug research and development costs. And for most drugs, the manufac­turing costs are nominal (20 percent to 25 percent of sales), so the price can be nominal as well.

The entrance of a generic competitor in the United States can be devastating for its brand name counterpart. Drugs have been known to lose as much as 80 percent of their sales in the first six months after going off patent. Eli Lilly's famous depression drug, Prozac, is a case in point. In 2OOI, when Prozac lost its patent protection, the drug's quarterly revenues dropped from $575 million in the second quarter to $96 million two quarters later. So if you're considering buying shares in a drug company that depends on a spe­cific drug for a significant percentage of its sales, don't bank on the money continuing to come in after the patent expires.

Hallmarks of Success for Pharmaceutical Companies

Branded pharmaceutical companies have historically offered high margins, little debt, and cash flow galore. To find companies that can continue to provide stellar performance, focus on these traits:

Blockbuster drugs (typically defined as drugs "with more than Si billion in sales): Companies with blockbusters gain manufacturing efficiencies by spreading fixed costs over more products. Selling the drug at high prices, driven by strong demand, inflates a drug maker's profitability and provides more bang for the buck. Pfizer is the perfect example: In I997> only two Pfizer drugs had annual sales greater than $1 billion, but by 2OO2, eight drugs surpassed the Si billion mark, with four drugs breaking the $2 billion mark. Thanks in part to these blockbusters, Pfizer's operating margins improved from 20 percent in 1997 to 38 percent in 2OO2.

Patent protection: All drugs eventually lose patent protection, but the companies that manage those losses the best will generally provide investors with a steadier stream of cash flows. Bristol-Myers Squibb showed what can happen when a drug firm loses patent protection on large products without replacement drugs waiting in the wings. Between the second quarter of 2OOO and the first quarter of 2OO2, Bristol lost the U.S. patents on three heavy hitters, and nearly 20 percent of the firm's total revenue evaporated in less than two years. On the other hand, when AstraZeneca's Prilosec was about to lose its U.S. patent in 2001, the company had already begun switching patients from the first- generation drug to the patent-protected second-generation version. By the time a generic competitor entered the market, AstraZeneca's new drug had established itself in the market and was bringing in 35 percent of the revenue of the first-generation drug.

A full pipeline of drugs in clinical trials (and the larger the population those drugs serve, such as cancer and arthritis, the better): Merck is a decent model for this strategy. It generally has had an abundance of products in development and has directed research efforts toward unmet medical needs with millions of potential patients. Merck's five top-selling products in 2OO2 had a combined potential market of 138 million Americans.

Strong sales and marketing capabilities: Physicians rely on pharmaceutical salespeople to learn about new products, and a salesforce that has successfully penetrated the physician market in the company's core therapeutic franchises already has physicians' ears and often their trust as well. Pfizer's relationship with cardiologists, Wyeth's access to gynecologists, and Eh Lilly's close ties with psychiatrists shouldn't be ignored. This expertise is so valuable that biotech firms often partner with large drug firms and give up a sizeable chunk of their profits just to leverage the marketing resources of their drug-company partners.

Big market potential: Drugs that treat conditions affecting a large percent­age of the population (such as erectile dysfunction, high cholesterol, depression, or high blood pressure) typically have better potential than niche products. So do drugs that treat chronic conditions, because patients must continue taking the medication to stay healthy.

All of this Information can be found in the company's IO-K. Specific disease Web sites (such as the National Kidney Foundation or cancer.gov) also often have information on clinical trials and drugs available to treat a disease or disorder as well as the number of patients suffering from those diseases. Being able to analyze the depth and breadth of a company's drugs and development pipeline is half the battle when looking at pharmaceutical and biotechnology stocks. So, roll up your sleeves and dig into the IO-K to get the details on the strength of the company's drug pipeline.

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