Develop innovative medicines or promote existing ones?

Big Pharma at the crossroads
Valery Yudin, Weekly "Pharmacy"

Pharmaceutical companies, representatives of the so-called Big Pharma, are always forced to make a decision about how much financial resources from the available budget should be invested in the development of innovative drugs, and which – in the promotion of existing ones. Thus, this affects the coefficient of innovative medicines being developed, as well as state funding of biomedical research (Loscalzo J., 2006).

Currently, with the onset of the economic downturn, the solution of this problem has become even more important for pharmaceutical companies, since it calls into question not only their financial success, but also their very physical existence.

The emphasis on the company's activity in the field of innovation compared to marketing activity depends on how these actions affect the short-term profitability (short-term profitability) and long-term market value (long-term value) of this company.

//Short-term profitability implies that sales should make a profit covering expenses, for example, for the purchase of goods. The company's market value is the market value of the company's equity and liabilities.//

To understand why companies invest extensively in promoting existing products in their portfolio, when the development of innovative drugs, as it seems, is actually a generator of their main cost, was studied by several researchers – Dan Weiss from the Leon Recanati Institute of Postgraduate Education in Business Administration at Tel Aviv University (Leon Recanati Graduate School of Business Administration, Tel Aviv University; Tel Aviv, Israel), Prasad Naik from the Institute of Postgraduate Education in Management at the University of California at Davis (Graduate School of Management, University of California at Davis; California, USA) and Ram Weiss from the Department of Nutrition and Metabolism (Department of Human Nutrition and Metabolism) and the Brown Institute of Health and Medical Services of the Medical University of Israel (Braun School of Public Health and Community Medicine, Hebrew University School of Medicine). The results of this study were published in the journal "Nature Reviews Drug Discovery" No. 8, p. 533-534 (July 2009).

Within the framework of this study, investments of pharmaceutical companies – representatives of Big Pharma in scientific research (R&D) were studied in comparison with financial contributions aimed at increasing sales and marketing of products over the past 30 years.

INVESTMENT TREND

Pharmaceutical companies, the researchers note, allocate their resources between three priority areas:

• production activity,
• R&D (development and research of the latest medicines) and 
• increase in sales and market share of the company's existing products (through sales, general and administrative costs (sales, general and administrative costs – SG&A).

//Sales, general and administrative expenses – expenses incurred by the enterprise as a whole (remuneration of management personnel, rent, information, audit, consulting services, depreciation, etc.); in contrast to special-purpose expenses (production, sales costs).//

The costs of manufacturing medicines depend on the characteristics of the product portfolio and the distinctive technological properties of these products. It is well known that the cost of developing innovative drugs is very high (DiMasi J.A., Hansen R.W., Grabowski H.G., 2003), since this is a long process, moreover, associated with high risk and leading to the production of a small number of really promising products (Sewing A. et al., 2008). That is why companies are investing extensively in order to increase their profits from the sale of medicines already existing in the product portfolio, spending the budget on their promotion among doctors and consumers, patients (Gagnon M.A., Lexchin J., 2008; Donohue J.M., Cevasco M., Rosenthal M.B., 2007).

The study was based on statistical data from the Standard&Poor's Compustat market research system for more than 30 years for such pharmaceutical companies as Bristol-Myers Squibb, Eli Lilly&Co., Genentech Inc., Merck&Co., Pfizer Inc." and "Schering-Plough Corp.", which are traded on the American Stock Exchange (American Stock Exchange – AMEX), the New York Stock Exchange (New York Stock Exchange – NYSE) or NASDAQ66 (Wharton Research Data Services (WRDS), 2009).

//"Standard&Poor's Compustat" is a database with financial, statistical and market information of active and inactive companies around the world. NASDAQ (English: National Association of Securities Dealers Automated Quotation) – automated quotations of the National Association of Securities Dealers, one of the three major stock exchanges in the United States.//

The figure shows the trend in the costs of production of sold products (costs of goods sold – COGS), investments in R&D and SG&A for more than three decades – from 1975 to 2007. From this figure it can be seen that if at the end of the 1970s production costs accounted for 43% of sales, by the 2000s they had decreased to about 23%, while R&D costs increased from about 5 to 17% of sales, and SG&A – from 32 up to 39% of sales over the same period.

The trend of resource allocation of the 6 largest representatives of the pharmaceutical industry
at SG&A, R&D and COGS in 1975-2007.

R&D VS PROMOTION OF AVAILABLE DRUGS

Assessment of the investment market

Since the stock exchange rate (stock prices) also includes investors' expectations from the implementation of the tasks set for the future, it can, according to the authors of the study, serve as an indicator of the long-term market value of the company (Lev B., 2001). To assess the relative effects of investments in R&D and SG&A on the company's market value, the researchers resorted to the valuation theory and used a linear regression model with respect to the stock price of companies at the end of each year as a dependent variable and its annual expenses on R&D and SG&A as independent variables (Chan L.K.C., Lakonishok J., Sougiannis T., 2001).

The results of the study show that investments in R&D have a positive impact on the stock price and thus increase the long-term market value of the company, while investments in the promotion of existing products have a negative effect on the stock price.

To check the reliability of these results, 2 tests were performed. Firstly, it was checked whether these results vary depending on the size of the company, since large pharmaceutical companies (whose annual sales amount to $ 100 million or more) have There may be a completely different model of resource allocation between R&D and SG&A activities compared to smaller companies with a limited product portfolio. It turned out that investments in R&D have a positive effect on the stock price, and those in SG&A have a negative effect for both small and large companies (that is, they do not depend on size); at the same time, both effects were more pronounced in smaller companies.

Secondly, in order to fully assess the situation related to the investment of companies in the promotional activity of their existing products, the salaries and bonuses of five top managers of each of the evaluated companies were excluded in the calculations related to SG&A expenses. The researchers found that the effect of investments in R&D on the stock price remained significantly more positive, while that of investments in SG&A remained significantly less pronounced.

It is also interesting that the stock price declined after the size of the compensation package to the top executive management of a company increased. Thus, the researchers suggest that the high amount of compensation to senior management may negatively affect the long-term market value of the company (Bebchuk L.A., Fried J.M., 2006).

In general, the study shows that investors in capital markets expect that investments in R&D will increase the long-term market value of the company, and also believe that investments in the promotion of drugs already existing in the product portfolio reduce the long-term market value of the company; this happens regardless of the size of the company, but includes the amount of compensation to the top executive management within the SG&A expenses.

Why do companies spend resources on promoting existing products?

Given the negative effect of investments in SG&A on the long-term market value of companies, why do they continue to extensively promote medicines available in their product portfolios?

On average, during the analyzed period, pharmaceutical companies allocated approximately 36% of sales funds to SG&A compared to 12% spent on R&D (table).

Sales and distribution of resources by pharmaceutical companies in 1975-2007

As a likely explanation for this, the researchers hypothesized that top managers invest in the promotion of existing products in order to increase short-term profits in a reliable way. Despite the fact that the top executives of pharmaceutical companies are concerned about the long-term market value of the company and, quite likely, also own shares of their company or options, they care about short-term profits, since their reputation depends on it, as well as the size of their premium. //Option – a type of fixed-term transaction that does not have to be executed; the right to buy or sell securities (goods) at a fixed rate and at a certain time (up to a certain point in time) due to the payment of a premium.//

Next, the relative effects of investments in R&D and SG&A on annual profit were analyzed. Regression analysis showed that investments in R&D and SG&A have a positive impact on it. In other words, the annual profit increases with increased investment in R&D and/or SG&A (together or separately). By checking the reliability of the calculation results described above, it was found out that these effects apply equally to both large and small pharmaceutical companies.

So, in general, there is a positive (but risky) effect on profit in the development of new medicines by investing in R&D, whereas the promotion of existing drugs by investing in SG&A increases sales and gives a reliable short-term profit (Kothari S.P., Laguerre T.E., Leone A.J., 2002; Lev B., Sougiannis, T., 1996). Since the figure illustrates the situation for more than three decades, the standard pharmaceutical company, judging from this figure, has increased its investments in both R&D and SG&A. Interestingly, investments in R&D (increased by 240% during this period, from 5 to 17%) are large compared to those in SG&A (investments increased by only about 22%, from 32 to 39%).

resultsSo, the results of the analysis showed that investments in the promotion of existing medicines in the product portfolio have a twofold effect – that is, on the one hand, they increase the annual short-term profit, but on the other, they reduce the long-term market value of the company.

At first glance, the twofold effect of sales growth and an increase in the share of existing products (SG&A) implies that extensive investments in the marketing activity of the company are conducted in order to increase its long-term market value. One potentially possible reason to assume this is that short-term profits affect the prestige and size of the compensation package of senior management developing an investment strategy. Nevertheless, we should also not forget that short-term profit generates a cash flow that can be used to accelerate the implementation, boost R& D projects.

In addition, the results of the study show that investments in R&D have a positive effect on both short-term profit and long-term market value of the company. Thus, in order to maximize the long-term market value, pharmaceutical companies should allocate more funds to R&D activities instead of promoting existing products in their portfolio.

Indeed, over the past three decades, pharmaceutical companies have increased the amount of resources allocated to R&D to a much greater extent than was allocated to SG&A, assuming that this is somewhat obvious. Investments in R&D include both the almost intuitive selection of projects that seem promising, and the adoption of numerous decisions throughout the development of the drug development project, taking into account also possible risks for subsequent investments in a problematic project and other financial considerations (Cuatrecasas P., 2006).

The involvement of scientific supervisors in the investment decision-making process due to their foresight and insight can contribute to the promotion of drug development projects that would otherwise be considered only from a financial point of view, the researchers believe.

Summing up, they expressed the hope that the conducted analysis will contribute to increasing further investments in R&D projects, since its results show that investments in R&D benefit not only the health of patients, but also the material well-being of investors.

Portal "Eternal youth" http://vechnayamolodost.ru31.08.2009