Wellcome woos the doubters: Heather Connon reports on the challenges facing the pharmaceutical industry as the drug company ponders prospects for its planned issue

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The Independent Online
JOHN ROBB, chief executive of Wellcome, must be cursing the stock market. When the Wellcome Trust, the charity that owns 73.5 per cent of the drugs company, announced in March that it planned to sell up to two- thirds of its holding, the sale looked set to be one of the biggest and most successful international offerings ever.

Instead, the group and its advisers are spending their time fighting off speculation that interest in the pounds 3bn issue has been less than overwhelming, and that it may still be forced to abandon the issue. Wellcome's shares, which stood at 1,126p when the issue was announced, have fallen steadily and now stand at just 877p, cutting almost pounds 1bn off the amount the trust could hope to raise.

What is most frustrating for Mr Robb is that his company is exactly the same now as it was in March. The problem is that the market has fallen out of love with pharmaceutical stocks - the sector has underperformed the market by about 15 per cent since the start of the year. And that means it is not enough for Mr Robb to rely on his impressive record to persuade investors to take up shares; he needs to persuade them that their fears about the international pharmaceutical market are unfounded. And that is a daunting task.

It is tempting to dismiss the recent underperformance of drugs stocks, both here and in the US, as a mere blip as investors scent economic recovery and switch into cyclical stocks. There have been plenty of similar blips before, but that has not prevented US drug stocks performing more than twice as well as the market since 1980, and UK companies - helped by a spectacular performance from Glaxo - rising almost four times as fast.

Cyclical switching is undoubtedly one reason for the recent lacklustre performance. But investors are also starting to worry that the industry could be facing more fundamental problems, which will make it far harder to achieve the spectacular performance chalked up in the past. And that has led them to question whether drug companies deserve the premium ratings - 23 times prospective earnings for Wellcome, for example - they currently enjoy.

Top of the list of worries is pricing. Medical authorities around the world are introducing strict controls on how much companies can charge for their drugs - in many cases, even insisting on cuts. Italy cut prices by 1 per cent for lower-priced drugs, 4 per cent for higher, at the beginning of the year; the average cut in Japan was 8 per cent, Germany has recently introduced controls and France and Spain are considering new regulations.

Most worrying, however, is the US, the biggest pharmaceutical market, accounting for 30 per cent of all drug sales. Traditionally, it has been one of the most profitable markets as drug companies have been left to set prices with virtually no restrictions. But drug companies have grown so large that their 30 per cent-plus margins are starting to attract publicity-hungry senators - particularly as healthcare costs continue to soar. That means, as Wellcome's prospectus says, 'the pharmaceutical industry . . . is confronting the most challenging political environment in many years'.

So far, the pressure has been concentrated on Medicaid, the federally-funded healthcare scheme. Drug companies have been forced to offer rebates to bring down the price of certain drugs supplied to Medicaid to the lowest price available to other large drug purchasers. Smith New Court, the stockbroking firm, estimates that in 1991 Glaxo paid rebates of dollars 120m ( pounds 63m), SmithKline Beecham dollars 54m and Merck dollars 35m. Wellcome says in its prospectus that it paid dollars 11m in the six months to February and warns that it expects rebates 'will increase significantly in future years'.

Medicaid accounts for only about 15 per cent of the US market so, in theory, the effect should be limited. But the industry is worried that other large drug purchasers will be inspired by the success of the Medicaid initiative and press for similar cuts - with severe implications for drug company profits.

Wellcome, like many of its rivals, insists that it is used to coping with price pressure. It estimates that, in the past five years, only 3 per cent of its growth has been because of price increases, while volume has accounted for 19 per cent. For Glaxo, price rises accounted for 6 per cent of growth in 1987 but only 1 per cent last year.

But there are signs that medical authorities are widening their attacks beyond limiting price increases on existing drugs. Glaxo has a reputation for setting high prices for new drugs, cutting out the need for subsequent increases. This strategy is running into problems: France and Denmark have called for a European Commission investigation into Glaxo's pricing and some authorities are refusing to reimburse the full cost of Imigran, its migraine treatment, in tablet form.

Price pressure makes the second issue for the industry, the costs of research and development, even more worrying. Industry experts suggest that the average cost of introducing a new drug has increased from dollars 87m in 1982 to dollars 231m in 1990. Regulatory requirements - and scientists' salaries - continue to rise, pushing these average costs even higher.

At the same time, it is becoming more difficult to discover genuinely innovative drugs. New products in a number of therapeutic areas - anti-infective, cardiovascular and ulcer for example - are unlikely to be enough of an improvement on existing treatments to justify the costs of development. Two years ago, Wellcome abandoned development of TPA, a heart attack treatment, after spending pounds 45m, because it concluded that it was little better than an old - and much cheaper - treatment.

That was one of the first significant decisions taken by Mr Robb, who joined the group as chief executive-elect in 1989, taking the top job in July 1990. He hopes such problems would now be spotted earlier. And he is confident that the group can withstand the growing pressures of the industry by focusing its development effort on drugs with the greatest profit potential and expanding geographically - it is already growing its European interests and he is personally supervising the Japanese business. Japan has so far been a difficult market for Western drug companies, but Wellcome hopes it will be the next growth market.

There is little doubt that Mr Robb and his team have transformed Wellcome. He injected the commercial and marketing focus that the group lacked when it was floated in 1986: restructuring the management; cutting costs; refocusing R&D; and selling off less profitable businesses such as veterinary products and environmental health.

Margins have risen from 12.1 per cent in the year of the float to 25.1 per cent last year, and Mr Robb is committed to achieving margins of at least 30 per cent within five years. Development of drugs - the most expensive phase - is now much more tightly controlled, with the number of drugs in the pipeline cut from 66 to 34.

In the end, however, what counts is new drugs. In the next decade, as in the past, only those companies that can produce a string of innovative products with good sales potential will thrive. Pressure from patients for the best treatments available means that health authorities will still be forced to buy their drugs - albeit after a battle over pricing.

The rest, who can only emulate products developed by others, will be relegated to the second division. Eventually, investors will also appreciate that.

The problem for Wellcome is twofold. First, it has to persuade investors that it is worth buying some drug stocks. More important, it has to persuade them that its pipeline is good enough to put it in the first division.

As its experience with TPA demonstrates, nothing is certain until the drug is on the market. Its product pipeline - including successors to its herpes drug Zovirax and an immune suppressant for rheumatoid arthritis - looks more attractive than that of some of its competitors. But will that be enough for nervous investors?

(Photograph omitted)

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