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richard evans
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Richard Evans is a senior research analyst of global pharmaceuticals at Sanford C. Bernstein & Co. Previously he worked in business development for Roche, the Swiss pharmaceutical giant. He calls the pharmaceutical industry an "innovate or die" industry, and explains that companies need to fund research and development to replace patent-expiring products. Price controls, he says, would be very damaging to the industry. He also argues that if the federal government set drug prices, it would not solve the fundamental health care access problem in the U.S. FRONTLINE conducted two interviews with Evans, on Feb. 11, 2003 and Feb. 28, 2003.


Read a follow-up interview with evans, conducted in November 2003.

... So, in this story, here's what we're seeing. We have both sides yelling at each other. The industry says price controls are going to make the sky fall in. Critics say price controls aren't going to do anything. The truth must be somewhere in the middle, right?

Well, sure. I think it is like any debate. You have both sides squaring off on relatively extreme positions, realizing that the truth is somewhere in the middle. I think that is a characterization of this debate as well.

What is the debate? What is each side saying?

I think the debate is essentially, on the consumer side, over drug pricing. "I need this technology in order to stay well or become well, but I can't afford it." And then the representative of the consumer argument, I guess, would argue that you can cut drug prices and you're not going to pay a price for that in terms of access to medicine.

The drug industry is one of the most profitable industries in the world, absolutely.  But, if you look at the risk involved in being a drug company, it is substantial.  If you don't innovate, you die.

The industry argument is that if you cut drug prices now, you do pay a price in terms of access, in terms of medicine in the future. You are not as able to do research and development, and, accordingly, you are going to have fewer medicines discovered over time.

... I tend to be more on the industry side of the argument, to be quite honest. Having been an operating executive in the industry, I have felt from a seat of the pants point of view, the reality that if you're not making money on the top line, you're not doing R&D. And I've also felt the reality that how much you are able to spend on R&D has a direct effect on what type of new medicine you are able to bring out.

Currently I don't have a stake in either camp, because I'm no longer in the industry. I would tend to argue that the consumer side of the argument, for the most part, just doesn't take into account the operating reality of the drug business.

So drug companies like Merck and Lilly are very profitable, but they really earn most of their money on just a handful of drugs. They only have a few products. Is that an accurate picture?

Right. Drugs companies in general, Merck and Lilly as examples, are profitable. However, if you look at where that money comes from, it does come from a relatively small number of products.

How many for Merck? How many for Lilly?

Right now for Merck, this year, in terms of their actual growth, we've got five products that we focus on. Five products' performance in the marketplace really determines how investors think of Merck as a stock. For Lilly, you've got one product that is upwards of 30 to 40 percent of the value of the entire company. And you've got a couple of new products that have just come out, that are really two new products this year, that are a significant portion of the market cap as well. ...

[Where do Merck and Lilly make money on this handful of drugs?]

Most of the money that Merck and Lilly make on these drugs is made in the United States.

And why is that?

A couple of reasons. You tend to make more money on drugs in the United States for two reasons. One is you have higher prices and two is your cost of generating sales in the United States is typically lower per sales dollar than the cost of generating sales elsewhere in the world.

So because the U.S. is the last unregulated market, they're able to make these profits here?

The other markets outside the United States are typically represented by a government buyer and that buyer represents upwards of 80 percent or more of the demand. So that government buyer gets to set the price and typically sets the price to their own benefit. In the United States, that's not the case. You've got a free market and in that free market, you have adequate profit to drive discovery, drive research and drive profits for the business. If you lost that in the United States, you would dramatically change the profitability of the industry. ...

So, when these drugs that they rely on to generate profits go off patent, they're effectively worthless for the companies, so they have to continually come up with new drugs to survive.

Right. When products go off patent, and they do, they fall by 80 percent in a month in terms of sales. Relative to what they used to be, they are worthless. And to stay in business as a drug company, you have to replace those patent-expiring products with new products. ... The drug industry is an "innovate or die" industry, and more so today than ever before. If you don't replace your patent-expiring products with new products, you go out of business or you're acquired. ...

About how much money do they invest per a $100 dollars in research? And how does this compare to other industries?

... Research and development in a modern drug company on average costs about 13 percent of sales or $13 dollars out of every $100 sales dollars. Relative to other American industries or multi-national industries, that's a very high number.

It doesn't seem very high, $13 dollars out of $100 dollars.

But if you put that $13 dollars in context, if you think about everything else that you have to do to run a drug company -- you have to manufacture the drug. You have to distribute the drug. You have to market the drug. You have to support the drug from a regulatory point of view, a legal point of view. You have to have a financial infrastructure within the company, buildings, overhead, etc. So the 13 percent of sales is actually, at the end of the day, quite a big number. And if you compare that to what other industries are able to free up to spend on research and development, it is actually an enormous number.

An enormous number. So, in industry, in general, it seems that high R&D costs are tied to high profits in general. This is sort of the nature of all high-tech industries. Can you explain why that is?

Well, there are two points of view that would relate high R&D and high profits. One would be the sort of Maslow's hierarchy argument, which is once you become so profitable, you now have all this money left over to do research and development. I tend not to take that point of view as some do.

Rather, I would take the point of view that if I, as an investor, and my clients, as investors, are going to allow a company to spend that much of their money on something that is so risky, then I want an outsized return in exchange for that. So I, as an investor, am not going to gamble large amounts of capital on research and development unless I think the returns are sizeable. ...

So, price controls would change the picture, right? Is this statement true? By making expensive drugs affordable through price controls, that would increase access to people, which would be good for seniors. But there would be a downside. So price controls would be good for certain groups of people.

I would really break the statement in two. One is price controls are bad for the industry because you limit the return on R&D, and as you limit that return, I, as a shareholder, don't want you to do as much R&D. I would rather you give me the money as a dividend so I could do something else with it. That means you're going to do less R&D. That means you are going to get fewer drugs. So price controls are going to limit the amount of research and development that is done.

The other premise in the question is that price controls are going to increase access. I don't think that is necessarily true. If we look at what is the case for most Americans, most Americans have coverage. And if you change the list price of a drug, most Americans are still going to be paying the same amount at the pharmacy. It is not going to increase access. ...

If you lower drug prices by 20 or 30 percent, do you really eliminate the problem for somebody who doesn't have drug coverage? I don't think you do. You still go to the pharmacy. And let's say you cut price by 30 percent, instead of $60 dollars it is now $43 dollars. If I don't have any income and I've got dependents, $42 dollars for drugs is still a huge number. I need coverage. I think coverage is the answer to access. Price controls are not. ...

Well, what would happen? Say you're inside a drug company. You have price control. Your profits drop from 18 to 15. What do you do?

It depends. So you're in a drug company. Your profits drop. What do you do? If you are able to cut costs, you cut costs. But it is a competitive situation, right? If your profits were 20 percent last year and everybody else's were too, and then this year yours are 15, but everybody else's are 15. Are you desperate to cut costs? Not necessarily. That could just be a structural change in the industry and we, as investors, have to accept that this is no longer a 20 percent industry, it is now a 15. If you, as an individual company are the only one that cut that hard, what are you going to do? You have got to cut cost. You are going to bring it up to 20 percent to be competitive with your peer group.

Why not cut some marketing costs and cut the CEO's salary? The industries act like all cost cutting has to come out of R&D.

I actually disagree with the notion that industry feel that all cost cutting has to come out of R&D. Let's look at the competitive reality. Assume that you run a drug company and prices are cut and what you would really like to do, quite honestly, is fire salespeople. ... There're just way too many salespeople. We're spending as an industry far more on sales and marketing than needs to be done. ...

The best thing to do, for the industry model, is to pull back sales and marketing 5 percent and spend it on R&D. ... So, let's say you go ahead and do that, but you move first. This is a marketplace, this market responds to sales promotions. So you cut back your sales promotion first. The price cut is now your smallest problem.

Your biggest problem is your competitors have more share voice in the market and more product demand than you do. So, you not only lost price, you lost market share. If you cut your sales force, the market reality is it's a pathway to putting yourself out of business. It is not that the industry loves having a lot of sales reps -- I don't know a single CEO that wouldn't prefer to trade salespeople for research. You can't unilaterally disarm. ...

One of the drugs that we talk about is Singulair, which is a big seller for Merck but it took 19 years to get to market. It seems like a pretty long time.

Pretty long time.

So we're guessing that a drug that took that long to get to market probably had some setbacks along the way. Which projects are risky? I mean are you going to take some and they flunk out and they fail Phase I trials and you are going to yank them? Do you think that something like Singular might not have come to market, I mean if there were less--

It's tough. I mean it is really tough to categorize a single family of products that would not get to market if you cut prices. I think it is going to affect your whole research and development investment strategy. And whenever you look at the compounds that you do or don't want to develop, it's a balance consideration between risk and reward. So the clinical risk, the scientific risk is not going to change just because we cut prices. The financial risk is going to change. And, in particular, those products where you would face more financial risk, are the ones that you feel, in order for them to be commercially successful, you really need pricing freedom.

Let's take a Roche drug, Fuzeon, which was just priced in Europe at $22,000 dollars a year. It's the only drug for AIDS patients who have become resistant to other therapies. It is an exceedingly expensive drug to manufacture. Back in the days when you were just planning that drug, if you felt you wouldn't have the ability to set that price, in other words, if that price would be set for you, you never would have developed that drug.

Can you think of any examples from Lilly or Merck of drugs that may not be on the market now, if there were price controls?

Sure. I think a good example at Lilly is probably Xigris, which is a injectable drug for sepsis, which is quite expensive, somewhere in the neighborhood of $6000 to $8000 for a course of therapy. It was a very difficult drug to discover and develop. It is a very expensive drug to manufacture. If you didn't think that you were going to be able to set the price for Xigris or if you really felt that it was going to be set for you, I bet Lilly would certainly emphasized Xigris less and probably wouldn't even have developed it.

...

There are really three things in motion here, price controls, access, and future products. If we control prices today, then management is going to spend less on R&D and we're going to get fewer products tomorrow. So if we want price controls today, we've just got to realize that we're a capitalist society and we finance these companies and control these companies and measure these companies through the capital markets. [If you limit their profits through price controls], they are going to restrain R&D, which means you are going to get fewer products. It is an inevitable trade.

More importantly, or as importantly, I think you've got to distinguish between price controls and access. Price controls aid access, I think, on the margin but it does not solve the access problem. So, as an economist, someone who has been in the industry as a consumer, as an executive, who sort of sits and is paid to judge it, objectively, I think price controls are a mistake. I think we very much, we desperately need to solve the access problem. Price controls won't do it. But price controls will wreck future product flow.

So why don't they get together and call off their sales reps? Why don't they all get together and get rid of marketing?

Nothing would make me happier for these companies to get together and cut marketing and sales in half. Personally, I would be doing back flips. The competitive reality is two-fold. One is, at least through 1998 and for many companies through 2000, you were being paid to hire that next sales rep. You were being paid to do that next consumer ad. You were generating return for your shareholders by doing that. So that near-term historic reality is kind of tough to let go of. It is a strategy that worked financially. It doesn't work so well now.

Second, we are in this prisoner's dilemma. Everybody is beginning [to think] that that next salesperson is not such a good idea. It is really more of a defensive investment. Everyone is afraid to back down first. From a fair trade point of view, they can't exactly get in room and call a truce. From my point of view, it is probably not even legal. Either someone who is the lead, for example, Pfizer, has to unilaterally back down and set the pace so that other company's can pull back on their sales and marketing or you have got to have a third party come in, i.e., regulators.

Is that an answer? Is that a decision that this country should make, that the government should step in and tell them cool it on the advertising?

If you think of this from a structural point of view, it is tempting to move toward the conclusion that government should step in and regulate drug advertising. The problem is, you're then trading a regulator's decision on what is or is not a good advertising investment or what is or is not enough for the market's decision. Personally, I prefer to wait a while for the market to figure this out and pressure the companies to manage their own marketing and sales spending. I prefer a market approach to a regulation approach. I think it is more effective.

Are we in an intractable dilemma here in this country with the way things are? Not only are seniors not able to pay for their drugs, but, working people are starting to be hit with huge drug costs. How are we going to get out of this?

The issue of drug access is not an intractable dilemma. If you look at how much American consumers spend on pharmaceuticals relative to what they spend on other things, it is a manageable number, on average. The problem is we have individual consumers, many who have enormous drug costs that must be met. From a social point of view, you can't keep people out of the market. That's an insurance question. That's a coverage question. That's the way this should be answered.

Personally, I think it is a social-political deliverable of a society that cares enough to make sure that nobody gets left behind. And I think that is coming out of the tax base. I think we, on average, have to decide that for people that can't access private coverage, who don't have a job, who don't have coverage from their employer, that we buy them coverage. Then we would be rightfully concerned that we would have runaway drug pricing.

So do I think there is a middle ground here, where we as taxpayers buy coverage for people who can't afford it and the industry makes pricing concessions to those markets? I think there is a middle ground there. I don't think this is intractable.

Well, that's encouraging. It's also interesting that the United States is really the first place to face this decision. Other countries have not had to face this decision.

I think it is interesting that this problem really is left in the lap of the United States. Other countries that have decided to control price haven't had to face the prospect of having the industry cut its research and development investment because there was always another market. And the last one is the United States that produced enough profit to encourage companies to spend money on R&D. If you take away the profits in the United States market, you take away R&D. So as Americans we're the first country, society, to really face this fundamental trade off. If you cut prices in the hopes of encouraging access, you're going to cut R&D.

Do you understand why consumers are skeptical about R&D?

I can understand why consumers are skeptical, absolutely. I think the drug companies are complicated things. They are very hard to understand from the outside and the data points that you get are negative. You show up at the pharmaceutical counter, the prescription counter when you do need drugs. They are not cheap. In many cases, if you do not have coverage, you are probably going to have to alter your lifestyle to be able to afford the drugs you want. If that is the first impression of the industry, it is not going to be positive. That, plus the fact that the industry has done just an exceedingly poor job of managing its own image.

I think the industry has allowed itself to be vilified. I think that the industry has failed consistently to reach a consensus amongst themselves within their own trade and lobbying organization and accordingly have failed to speak with one voice. And it's particularly frustrating in that there are some very simple and important obvious messages that a better aligned industry can communicate such as, one of the themes that we've talked so much about here, which is the trade-off between drug pricing and future product flow.

I think that the average voter values future product flow. I think that average voter cares that R&D gets done, so that discoveries get made, so the drugs come out tomorrow. And I think the average voter can understand if, given the appropriate information, that there is a trade off, and I think that is the industry's message to carry and I think they have failed to carry it.

So there seem to be a couple of choices out there now as we face this problem. One is what's going on with Maine, this idea of price control. What if Maine Rx passes, this thing gets past the Supreme Court and other states pick it up. Do you think that will have a negative effect on the industry?

You bet. If Maine were successful in the Supreme Court, I think two years later you've got virtually every state doing the same thing. ... You are going to give the states a lot of leverage very suddenly over drug pricing and not just the roughly one out of six patients, or people that they buy drugs for today. But you might double that number so very suddenly the states would have a lot of power over drug pricing. It would hurt drug companies. You would cut sales. You would cut return on R&D and by extension you would cut R&D spending.

After all the smoke cleared, I'm not sure that you have cured the access problem. I think you still have people in Maine who would then be getting, say a 20 percent discount on drugs. So now, instead of being $60 dollars, it's $48 dollars. "I still cannot afford it. I still don't have access."

Now another possibility is an Oregon type of situation. There's evaluation of cost effectiveness. Is that a possibility?

I think the basic Oregon framework makes sense, which is you, as a large buyer, decide that you are going to make intentional decisions as to what technologies you buy and what technologies you don't buy. That, as a basic framework, makes all the sense in the world. The risk is that Oregon, as a state, is under extraordinary financial pressure and at least some of the decisions that seem to be coming out of that framework tend to have more of an economic motive than a scientific motive.

So there are plenty of drug categories where one drug is just as good as another one. You can play those drugs off of each other and get a lower price. God bless them. Go do it. It's a good thing to do. But I think if you're economically strapped, as Oregon and many states are, you can make inappropriate clinical decisions for just a short-term economic gain. So we get into the same trade-off. What you are trading off is today's access to good technology for current savings.

So then there is the possibility of the federal government doing something with Medicare. What about a drug benefit for Medicare? Would that [solve] the problem?

It depends. The impact of the Medicare drug benefit on the industry depends on what is passed. ... The senior drug benefit, from an electoral point of view, is exceedingly important. The seniors are the mostly like demographic to vote for a Republican. As a Democrat, you need that senior. One of the best way to grab that senior is with a prescription drug benefit offered. So the idea of which party can deliver a prescription drug benefit is taking priority over actually getting drugs to seniors who can't afford it. That is hugely disappointing.

So it has become a political debate rather than solving the problem.

Absolutely. It's ironic. [The fact] that seniors are 20 percent of the electorate and a huge voting block [is] actually working to their disadvantage right now. Because the wrangling over that voting block, using prescription drugs as a lure to both sides of the argument, is preventing the passage of what it needs most, which is a drug benefit for the poorest seniors.

America seems to be facing some big questions with prescription drugs. Are people asking the right questions?

I think as a society we've got two important questions here. One is: How do we make sure that everyone has access to the existing technology? And how do we make sure that we do that in such a way that we don't wreck our access to better technology tomorrow. Those two things are the things that we have to balance. ...

Marcia Angell, the former editor of The New England Journal of Medicine, [said to us], "The drug companies have made the case that their drug prices are so high because R&D costs are so high. It is as though they were just eking out, just barely managing to survive. But what we see is their profits are very much higher than their R&D costs and, therefore, they can spend more on R&D if they wanted and have plenty of R&D left over."

The amount of R&D that you can spend and the amount of profit that you can generate are directly related. If you are going to commit a lot of money in R&D, which is a very risky business, you've got to promise the investors a substantial future return in exchange or that. So let's take today's R&D dollar. The payoff on that is 10 years away. So I, as a drug executive, go to an investor and say, "Here's a dollar. I can give it to you today. Or I can give it to you in 10 years. What do you want?" Well, obviously, you want it today unless the one I give to you in 10 years is a lot bigger.

But, you know, 18 percent is a pretty good profit. Where else could they make more money?

Could investors make more money elsewhere? Sure. I mean the whole thing that investors really care about is the change in the stock price, as well as how much money they get as a dividend. Those are the two things you care about. ... You don't just buy a company because you like the margin. You buy a company because you think there is a surprise coming, an upside surprise that other investors don't see or you think this company's ability to deliver dividends is more secure than an alternative investment. So it is not so much the margin, right? It is the security of the investment and the opportunity for upside. ...

One more quote. This is from a state legislator in Maine. "You know, we are all completely committed to major advances in prescription drugs. We just need to even it out so that my grandmother who pays cash at the drugstore isn't the one subsidizing everyone else in the world and every innovation in the world. It is completely skewed and nobody could call this fair."

I can't disagree with that. I will even go so far as to back it up. If you look at the fact that American profits that derive from American drug market justify global research and development spending, I fundamentally believe that to be true, which supports that comment. The other thing I would argue is that a senior is 50 percent less likely to have drug coverage than a working age person. Their income is likely to be 50 percent lower and fixed, and they're substantially more likely to be sick.

So the people that can least afford are the people who are more likely to consume. Again, do you want drug companies to be responsible? Do you want to leave that woman's fate to the capital markets? No, you don't. But do you want to take the drug industry out of the capital markets and expect it to be healthy? No, you don't. So you leave the drug industry in the capital markets and you trim it up around the edges with a social program. You pay for her access. Should she have to pay on her own? No. I don't think so. I think we should pay for her.

That is interesting. It really comes down to this socialist-capitalist tug of war.

It does in a sense. I think you want a capitalist drug industry. You will get more discoveries per dollar from the capitalist drug industry than any model I know of, and any model that I have ever seen demonstrated anywhere in the world, or dreamed of. But, naturally, capitalist societies have members that can't afford to participate. Then it becomes the option for people that live in that society and pay those taxes to pay for those people to have access. And personally, I think that is the right thing to do. It is workable economic and a workable political solution. ...

 

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posted june 19, 2003

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