A closer look at the returns and risks of pharmaceutical R&D

Journal of Health Economics 5 (1986) 153-177. North-Holland

A CLOSER LOOK AT THE RETURNS PHARMACEUTICAL R& Prafulla JOGLEKAR LaSalle University,Philadelphia,PA 19141, USA

Morton L. PATERSON Smith Kline & French Laboratories, Philadelphia,PA 19101, USA

Received June 1984, final version received December 1985 This study assesses the profitability of researching and developing new chemical entities (NCEs). A 36 year investment horizon is projected, based on a survey of R&D costs and on extensive U.S. sales data. Analysis is after taxes. The average NCE produces real internal rate of return of 6.1% and a net present value of $76 million in 1976 dollars. Break even with an opportunity investment in corporate bonds occurs on average after 12 years of sales. Risk is apparent in that after 24 years of sales some two-thirds of NCEs return no more than the bonds do. The median NCE, not recovering average R&D costs, produces a negative return. Alternative assumptions are tested. Results are highly sensitive to drug price increases and early replacement by generics.

1. Introduction Casual observers of the ethical pharmaceutical industry, aware of its relatively high return on equity, tend to assume that the industry’s research and development (R&D) must be highly profitable. However, one might equally speculate that several other characteristics of the pharmaceutical industry could together produce a high return on equity for a drug firm even if its more inn--v _____Q~ ative R&D activity is not profitable? That it may not be must be counted a real possibility, since the discovery and development of a marketable new chemical entity (NCE) often requires 12 years of R& ‘One such cha r acteristic is the upward bias in its ‘accounting rate of return’. Conventional accounting procedures fail to treat expenses of intangible assets such as R&D and advertising as capital investment. Ayanian (1972), Stauffer (1971) and Clarkson (1977) have argued that the corrected ‘economic rate’ declines from the acccrlmting rate by a greater amount in the pharmaceutical industry than in any other industry. Statman (1983) has argued that the accounting rate of return acts to disguise or delay the recognition of trends in the internal rate of return: during 1965 to 1978, although the expected IRR on drug innovations dropped from 22% to 10.3x, the accounting rate of return for drug firms remained in the neighborhood of 20%. Another characteristic is the riskiness of the investment in pharmaceutical R&D. Using a hypothetical example, Broxen (1977) has made a convincing case why surviving and successful pharmaceutical firms will have a higher rate of return than surviving and successful firms in 0167-6269/86/$3.50 @I 1986, Elsevier Science Publishers B.V. (North-Holland)

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expense, with approximately seven other NCEs abandoned along the way in various phases of research (e.g., animal testing, safety testing, etc. [Wardell (1982)]. While it may seem that a means exists to recoup these expenses and assure adequate returns on NCE investment - namely, patent protection not quite ten years of patent protection remain when the average NCE is marketed mansen (1982)]. In important non-U.S. markets pricing at introduction is dictated by or negotiated with government regulators; and price increases allowed in subsequent years often fail to keep pace with inflation. In various markets such policies as forced licensing of the NCE to local companies, tolerance of cheap duplicates ignoring the patent, and government-encouraged use of generics after patent expiration counteract brand exclusivity and loyalty. Certainly in the future it is not a given that investment in NCEs will provide an adequate, let alone a high, return for the pharmaceutical industry. A comprehensive and clear picture of what the returns on drug R&D actually are seems useful. The issue is not merely the efficiency of one area of pharmaceutical investment but a source of innovation in health care. In this paper, we present a base-case scenario utilizing a 1976 decision to invest in R&D leading to a marketable NCE by 1988. We assume that longterm historical trends - in R&D costs, general and industry-specific inflation, product sales patterns in U.S. and non4J.S. markets, for example - will other (low risk) industries. Conrad and Plotkin’s (1968) empirical work confirms that riskier industries display a higher rate of return. Yet another characteristic is the effectiveness of product differentiation as an entry barrier, even in the market for an old, patent-free compound. Bain’s (1956) theory of product differentiation as an entry barrier has been supported, in the ethical pharmaceutical market, by Steele (1962) and Reekie (1969) among others. Accordingto Reekie, ‘Product differentiation advantages of existing firms are the most obvious entry barriers in the industry and probably also the most effective. With over 2400 drugs available in U.K. and an average duplication of only 1.1 brands per formulation, the extent of product differentiation is vast . . . The extent of brand loyalty in the industry is no chimera; in 1965, 88.8 percent by value of all prescriptions were written out for products available only under a brand name. (Reekie’s references !omitted.) Differentiation often involves true technical differences between reformulations of a given active ingredient, such as alternate dosage forms (e.g., timed-release pellets, patches, suspensions), and combinations with other established drugs (e.g., cold remedies, skin creams). Reformulations serve as effective entry barriers because’of (1) physician loyalty to the first formulation, (2) the technical difficulty, sometimes impossibility, of duplicating the manufacturing processes of the original by the imitator, (3) the resulting suspicion that unfamiliar imitations provide unequal bioavailability and therapeutic effect, (4) the difGculty and expense of proving therapeutic equivalence, and (5) the expense of promoting mere equivalence relative to the expected marke’r share for the imitator. Even in the case of apparently ‘identical’ generics, physician loyalty to the original brand, or to its company, has been the rule in the past and could be expected to be so in the future were it not for the success of third party payers in mandating low price as the selection criterion. The concerted efforts needed to achieve this mandate are themselves evidence of effective product dflerentiation by brands. Avoidance of the risk of harm a.ld the attendant medical or legal liability, always present when a new drug produci is prescribed, seem to be the primary reasons for brand loyalty by physicians. Finally, drugs exclusively licensed from abroad, late in their development stage, hence bearing relatively low R&D costs, may be another source of high return on investment in this industry.

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continue over the 36 year horizon of research, development and marketing. However, a comprehensive sensitivity analysis considering alternative trends is presented. Lastly, we illustrate the use of our data and methods to explore the impact of alternative policies. Use of our model in a fuller assessment of future policies is the topic of subsequent research. 2.

Past

studie!s

Most studies suggest that the return from investment in R&D of NCEs is inadequate. Baily (1972) estimated a nominal (before-inflation) pretax return under 15% for the post-1962 period, compared to 30% pre-1962. Schwartzman (1975) found a real (inflation-adjusted) a!ter-tax return of 3.3% to 7.5% during 19661972. Virts and Weston (1980) concluded that before taxes the average NCE did not repay its cost of capital within ten years of market introduction, if the real interest rate on foregone use of capital (capitalization rate) were 8%. .4t the 8% rate, Grabowski and Vernon (1982) found a break even point in 12 years, and at a 10% rate in 19 years. Statman (1983) estimated that the expected average internal rate of return on drugs introduced in the U.S. declined from 22% in 1965 down to 10.3% in 6978, lower than his estimate of the industry’s cost of capital of 12.7%for 1978. These studies are based on limited data. Baily (1972), Schwartzman (1975) and Statman (1983) derived average R&D and sales from total R&D costs and sales of the industry, variously including old products, combinations of old Nf3Es, and even non-pharmaceutical products. Virts and Weston (1980) lacl . sales data on ‘hospital’ NCEs and on sales to hospitals of the NCEs studied; a;nd the longest product lifetime observed was ten years. Grabowski and Vernon (1982) were limited to 37 NCEs, observed at the longest for ten years. F&tidable assumptions were often required. Schwartzman (1975) assumed a 15 year product life with level sales during its middle two-thirds. Grabowsk.$and Vernon (1982) assumed sales in the tenth year would hold at that level for another five years. Virts and Weston (1980) considered simply ten years of sales. Methodologic limitations in one or more of these studies include ignoring the write-offs of R&D costs for tax purposes, use of only a single criterion of success, such as break even point, high (8% and 10%) real opportunity costs, and little or no sensitivity analysis. Finally, as Woltman (1981) points out, the pessimistic findings of these studies seem inconsistent with increazdng R&D investment by the pharmaceutical industry. 3. Present mdy 3.1. Overviewof method

.

Essentially, the present study, with more co reassesses the profitability and risks of NCE-relat

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P. Joglekar and ML. Paterson, The returnsand risks of plmnaceutical R&D

Using historical data, we project the future cash outflows and inflows of an NCE with R&D starting in 1976, with market introduction 12 years later (in 1988), and with the analysis en ng 24 years after introduction (in 2011). Thus, the total analysis horizon is 36 years. For presentational clarity we follow Mishan’s counsel (Mishan 1976) and cumulate (in constant dollars) cash flows of the R&D investment year by year and compare them -vith those cumulating from an alternative invvtment. This accounts ffor the opportunity cost of capital. Cash outflows are based on Hansen’s (1979) survey of major pharmaceutical companies on NCE-related R&D. We adjust Hansen’s data for inflation but we do not use his method of capitalization (i.e., discounting for the opportunity cost of capital), since we account differently for opportunity cost - i.e., we compare an NCE’s net cumulative earnings starting from the onset of R&D with those of a matching investment in corporate bonds. Since at the time a firm decides to invest in R&D for an NCE it cannot know how successful the NCE will be - there being no known correlation between R&D costs (including costs of abandoned investigations) and sales of an NCE - it is assumed that each marketable NCE incurs the average or ‘expected’ R&D cost. We augment the R&D cash outlays with reasonable assumptions for plant investment and working capital. These outlays are assumed to be related to the NCE’s sales success. Finally, we use standard accounting practices to arrive at after-tax cash outflows. 0n the cash-inflow side, our study makes a major contribution by constructing accurate product growth curves based on IMS America%(IMS) data through 1981 for each one of 218 NCEs introduced in the United States from 1962 to 1977. To these product growth curves, we apply a worldwide sales multiplier increasing at an historically observed rate. Net before-tax inflows are calculated by using a reasonable contribution margin towards R&D, plant investment, working capital and profits. Finally, after-tax inflows are calculated using a pharmaceutical-industryqecific tax rate. In the tables and figures of this paper cashflows are presented in 1976 constant dollars. However, to include accurate effects of depreciation, taxes, etc., required that a number of calculations be in current dollars: depreciation is based on book value; taxes are paid on nominal (current dollar) profits; bond yield is based on its face value. It is clear that for these computations we had to assume a specific inflation rate, drug-price-increase (DPI) rates, and an appropriately pegged bond yield. (The complete procedure is detailed in an Appendix available from the authors.) Since a single project-evaluation criterion can be misleading, three are brought to bear: net present value (NPV), internal rate of return (IRR), and break even point (BEP). The NPV represents the sum total of all cash outflows and inflows, during the NCE investment horizon, discounted for

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inflation? For comparison of investments with varied cash outlays, IRR is more informative? Neither reflects the risk of several years of cash outlay before compensatory cash inflow. The number of years to recover initial costs adjusted for inflation and opportunity cost is what we call BEP. Our projection is intended as a base case, derived from historical patterns but necessarily including assumptions about the future. Presenting findings in future terms helps open the study to specific alternative forecasts. While we test some alternatives, quantifying the impact of a full range of technical and policy scenarios covering such diverse possibilities as deflation or breakthroughs in biotechnology, for example, is properly a follow-up topic. Below are the details of our data and method. 3.2. R&D outlaysand FDA approvaltime, Hansen’s cost questionnaires, filled out in detail by pharmaceutical firms, comprise a benchmark survey, and we have used his data to calculate $32 million in 1976 dollars as the non-capitalized R&D cost of an average marketed NCE. This cost includes the allocated R&D outlays for NCEs failing to reach ,the market, failures representing seven out of eight NCEs entering human testing [Hansen (1979)]. R&D cost cumulates over a ten year period as shown in fig. 1, Tax credits reduce this cost to $21 million. In our analysis we have added two years, the 11th and 12th since the start of R&D, for FDA approval. (These years are not shown in fig. 1 but are in figs. 4 and 5.) Sales begin in the 13th year. While Hansen found a wide range in R&D costs by NCE as well as by therapeutic class, there is no apparent relationship between such costs and success in the marketplace. Our data show no relationship between sales per NCE by therapeutic classes and Hansen’s cost per NCE for those classes.4 Grabowski and Vernon’s (1982) profitability indices for these same therapeutic classes are inversely related to R&D costs by class, suggesting in their data as well a lack of relationship between sales performance and R&D costs. Thus, we use the cost of $32 million (pre-tax) as not only the average cost over a number of NCEs but as the ‘expected’ cost of any individual NCE. ‘NPV: The net present value of an NCE investment is the present (discounted) value of !;s earnings stream after market introduction minus the present value of the R&D and other costs, using a chosen rate of discount. In our study the discount rate is the same as the inflation rate of 6%. 31RR:The internal rate of return for an NCE is that rate of discount which makes the present value of its cash inllows equal to the present value of its cash outflows. If an NCE streamduring 36 years produces an IRR of S”/o,every dollar of investmentis earning a returnequivalent to 5% per year from the time it is spent until the end of the 36th year. 4Cost data by class do not appear in Hansen (1979) but were provided by him to Grabowski and Vernon (1982) in a privatecommunication.

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Fig 1 AverageNCE’scumulativeinvestmentin R&D. The R&D phases and before-taxcash outflow representHansen’s (19js)’data without capitalizati6n,i.e., not including the lost earnings of an alternativeinvestment.(opportunitycost of capital).With such capitalcost addedand compoundd at 8o/a,‘the before-taxcosts shown would cumulateto Hansen’soft cited $54 million. The presentstudy comparesopportunity costs directly(see fig. 5).

(Millions)

Oollats

DiscovetyPhase

Gi 00

Given the odds against large sales for most NCEs, the risk of not obtaining a desirable return on investment from any single NCE, based on its expected R&D cost, becomes important in any initial d,zcision to invest in the ‘NCE business’. ~on~uen~y, as have most researchers in this field, we find it useful ta show the distribution of returns on individual NCEs, with focus on the median as well as the average, based on the expected cost of an NCE. Clearly, any incremental marketing decisions made once an NGE is found need not be based on these prior expected costs, nor do these decisions determine the pro~~bi~ty and risks of the initial cost content required.

L,acking any definitive survey, we accept Blee’s (1978a) statement that, indus~d~ total plant investment is 24% of average annual sales. We assume that the R&D investor will invest 8% of its fifth year worldwide sales in each of years 9, 10 acd 11 since the start of R&U. We depreciate this investment at 20% per year using the declining balance method and write off its remaining book vahre in the last :fear of analysis. For working capital, we assume a similar 8% of ffth year sa!:s invested in each of years 10, 11 and f2 since the start of R&D. At! working capital is withdrawn in the last year of the analysis.

Since some NCEs sho-;u strong sales even in their 20th year after market ~n~~u~o~ we use a sties lifetime of 24 years. We include each of the 218 NCEs introduced in the U.S. from 1962 through 1977. Yearly drugstore-plushospital sales, from MS, were compiled for each through 1981. This gives 20 years of sales for the 19 NCEs introduced in 1962, 19 years for the 12 introduced in 1963, and so on, down to five years of sales data for the 16 NCEs introduced m 1977. Using the Firestone drug price index [PMA (1982)], we converted sales to constant dollars with 1976 as the base year. Next we aligned all first year sales, second year sales, and so on up to 20th year sales and fo\:nd th.2 average for each year since introduction. The resulting sequence giver t.ne 20 year sales pattern of the average NCE in constant dollars. A ctr&?e was fitted fR2=0.83) to the 20 points and extrapolated through the 24th year. Seen in fig. 2, that curve shows the average NCE’s sales in the US, rising steadily, peaking at about S11.3 million in the 15th year, and then de&ring steadily to about $4 million in year 24. This works out to $7.9 million in average annual sales over the 24 years (in 1976 constant dollars). However, an analysis of only the average NCE may be misleading, since the distribution of sales per NCE is sharply skewed. As fig. 3 shows, 67% of

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P. Joglekar and M.L. Paterson, The returns and risks of pharmaceutical R&D

25. 24

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1976

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16' 174 164

Average IUCE

Third Ode

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Year Since Market Introduction

Fig 2. Annual U.S. sales of selected NCEs. The curves shown are smoothed and, except for the average, represent individual NC&. Percentile rank is based on the NCE’s average annual U.S. safes during a sates fife extrapolated to 24 years. A decile is illustrated by one of its NCEs with at least 15 years of actual (pre-extrapolated) sales. Though all NCEs in a decile will not have this NCE’s pattern. variations are minor and the NCE shown is generally representative of its decile.

P. Joglekar and ML. Paterson, The returns and risks of pharmaceu+icalR&D

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100

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Median Annual Sales: $1.9 Million

40 e 33% of NCEs sell over $4 millionannually. 30 AverageAnnualSales: $7.9 Million Only 25% of NCEs sell more 20

10 Es sell morethan $50 millionannually.

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Fig. 3. Percent of NCEs exceeding a given level of averageannual U.S. sales.

the NCEs perform below $4 million in average annual sales. Only 25% of NCEs exceed the average NCE’s annual sales of $7.9 million. Thus, we present an analysis of the median NCE as well. Introduced in 1962, the median NCE in our sample had 20 years of IMS data and was extrapolated to 24 years. The median’s annual sales, shown in fig. 2, average $1.9 million. Also shown in fig. 2 are sales curves from selected deciles, the decile being represented by one of its NCEs with over 15 years of IMS data. It is apparent that individual NCEs show differing patterns but that more than 67% of them perform worse than the average NCE and peak at less than $11.5 million U.S. sales per year.

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3.5. Worldwide sales Although we did not have worldwide sales data for the NCEs in this study, data on the ratio of worldwide sales to U.S. sales for all pharmaceutical products for human consumption were available from Pharmaceutical Manufacturers Association* (PMA). PMA data from 1954 to 1978 show clearly an increasing trend reaching 1.66 in 1976. We fitted a straight line (R2=0.938) to the data and extrapolated it, reaching multipliers of 1.86 in 1985 and 2.44 in 2011, which were used for the appropriate years in our analysis? 3.6. Margins Various assumptions have been used for profit plus R&D costs as a percent of sales (contribution margin): Pretax 25.6% . Schwartzman (1975) Grabowski (1976) 40% Blee (1978a) Harell(l978) 34% statman ( 1983) 32% Virts and Weston ( 1980) 4oo/o Von Grebmer (1980) 25% (German firms)

After-tax 12.8% 12%-25%

Theoretically, such contribution margins are derived by subtracting from sales all manufacturing, marketing and administrative costs - including sSince the multiplier is based on sales of all pharmaceutical products, not just NCEs, it ignores daerences in the dates of introduction and sales growth patterns in various countries. While Wardell (1975) found that during 1971-1974 the U.S. lagged behind the U.K. in NCE introductions by an average of two years, in a study of NCE introductions in the U.S.,France, Germany, U.K., and Italy during 1960 to 1981, Hass et al. (1982) found that, compared to the date of first introduction on the five country market, each country showed an average lag. France, Germany, and U.K. showed an average lag of approximately two years between 1960 to 1972. In the U.S. the average lag was 1.7 years in 1960; it slipped to 4 years by the end of the sixties, but returned to 2.25 years in the early 1970s. More importantly, during the late 1970s all countries in the study showed lags of less than one year. Our own experience has been that while the U.S. lags behind several countries, other countries (e.g., Japan, Italy, Sweden, and many Third Worldcountries) lag behind the U.S. Thus, our use of a simple multiplier, implying the same year of introduction in all countries as in the U.S., seems reasonable. It may also be noted that since the multiplier is based on the ratio of dollar sales, one of our implicit assumptions is that historical trends in dollar exchange rates will continue in the future. Statman (1983, pp. 24-31) performed an analysis almost identical to ours but argued that, in the future, exports were not likely to continue to grow at a faster rate than the domestic market. Hence in estimating rate of return, he assumed that the ratio of global to domestic sales would stabilize at the projected 1980 level of 1.74.Given the high r2 value, we prefer to assume growing multipliers in the future. If Statman is right, our analysis would overestimate the rate of return on NCE investment.

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interest on working capital and depreciation costs - but not R&D costs. In our study, interest on working capital and depreciation costs are specified separately. Hence, we use a higher pre-tax rate of 45% as the contribution of sales toward profit and R&D as well as towards interest and depreciation. This rate may err in a direction favoring investment in R&D. 3.7. Tax rate Although a tax rate of 50% is commonly assumed, Federal Trade Commission data quoted by Blee (1978a) indicate that some drug firms have managed to pay an average effective corporate tax as low as 30% in recent years. However, in coming years tax incentive policies may well become less favorable. Also marginal tax rates are invariably @her than average effective tax rates. Hence, we use 35%. We assume for comparative purposes that earnings from an alternative investment will also be taxed at 35%. This assumes the bond investor has a diversified investment portfolio producing some tax-exempt income and lowering his effective tax rate. (In this study inflation, nominal bond yield and effective tax rate are mutually pegged assumptions. If one is changed, one must consider changing the other two.) 4. Findings of present study The findings of this study, based on the foregoing data and assumptions, are given below. The effect of alternative assumptions on the findings are reported in subsequent sections. 4.1. Thirty-six year cash flow and cost recovery Cash flows are cumulated in fig. 4 in 1976 constant dollars. Cash outlays consist of Hansen’s average R&D investment in an NCE after tax write-offs (transferred from fig. 1) plus assumed plant investment and working capital, also after-tax. Beginning in year 13, cash inflows represent the 45% margin on worldwide sales, less taxes of 35% of earnings after depreciation, plus interest generated and compounded from annual reinvestment (in bonds) of all prior year earnings. Average and median earnings curves are shown, as well as the curve of an NCE in the 35th percentile in order of decreasing sales (77th among the 218 NCEs). The year in which cumulative earnings change from negative to positive is the ‘cost recovery year’ from an accounting standpoint. This is the ninth year after marketing for the average NCE. The median NCE never recovers expected costs. The 35th-percentile NCE recovers expected costs early because of the fast sales rise particular to that product.

J.H.E.-E

1976 Dollars (Millions)

YearSince

Beginning of A&D

Market Introduction

Recovery Year

cost

No Cost Recovery Within Analysis Period

PercentlIe

Fig. 4. Cumulative worldwide after-tax earnings of average, medium and 35th.Percentile NCEs (ranked by declining average annual sales). Through year 8, R&D cash outflow for all NCEs is identical, i.e.,average. In years 9 through 1I, cash outflow varies because additional plant and working capital costs in these years are assumed greater for the higher selling NCEs. The median NCE does not recover its costs. The average NCE, earning much more than the median because of atypical ‘big winners’,recovers its non-capitalized costs in year 21after the start of R&D and by year 36 accumulates cash of $76 million (in 1976 dollars).

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4.2. Opportunity cost and break even point

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The prospective treatment of cash flow allows us to account for opportunity cost (the capitalization rate) by compounding an alternative investment, such as a corporate bond, at the going rate. This bond investment matches the NCE investor’s after-tax outlays and timing dollar for dollar and year for year. After taxes of 35”/, all bond interest is reinvested in bonds, just as are ali after-tax earnings of the NCE. The year in which the cumulated earnings of the NCE equal those of the bond represents the break even point (BEP). When the study was planned inflation was at 10% to 12% versus an historic rate near 4%. We settled on inflation at 6%; DPI was assumed at 4%; and corporate bond yields, reflecting their traditional premium, were pegged at a nominal 13%. More recently inflation has returned close to 4%. However, as long as DPI and bond yields are proportionally adjusted, our results remain the same: ‘e.g., an inflation rate of 4% with DPI at 2.2% and bond yields at 10% produce practically identical results to those under our original assumptions. We assume a nominal pretax rate of 13% for the interest on bonds, when inflation is 6%. This amounts to a nominal after-tax rate of 8.5% and a real after-tax rate of 2.3%. This rate is clearly less than the ‘10% real, after-tax’ interest rate suggested by Schwartzman (1975) and the ‘8% real, before taxes’ used by Hansen (1979) and Virts and Weston (1980). Compared to what an optimistic or self-confident investor may require, our rate is intentionally conservative. A higher rate would lengthen the NCE’s break even period. Yet, 2.3% is perhaps realistic, since an average investor in stocks earns about 6”/0,and an average investor in bonds about lSo/, after inflation but before taxes [Ibbotson and Sinquefield (1979)]. Based on the 2.3% capitalization rate, fig. 5 shows the cumulative earnings of a bond versus those of an NCE investor, should they be liquidated at any given point. (We assume that liquidation of the bond investment recoups the principal, whereas the principal for investment in an NCE can only be recouped through sales.) The figure illustrates payback as well as risk. The average .NCE, pulled upward by relatively few very successful NCEs, pays back the principal and the opportunity costs in its 12th year after marketing or 24th year after the start of R&D. The median appears unlikely ever to break even. Even the 35th percentile NCE does not break even by the 36th year. In other words, two out of three NCEs do not break even by 24 years after marketing. With higher capitalization rates (like the 5% or 10% used by previous authors), the picture would be gloomier. 4.3. Return on investment The foregoing break even analysis relates the time required for an NCE investment to equal and surpass the earnings of the opportunity investment.

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Fig. 5. Cumulative worldwide after-tax earnings of NCE compared to those of corporate bond. Superimposingon fig. 4 the earnings of an opportunity investment,corporate bonds, showsthe investor’sbreak even point, beyond year 36(apparently never)for the median NC%and in year 24for the average.The 3Sthqercentile(from the top) NCE, though recoveringcostsearlier than the average,approachesbut does not reach a break even point with the opportunity bond - meaning that through 36 years since the start of R&D about two-thirds of marketed NCEs earn less than does a matching investment in corporate bonds.

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P. Joglekm ad M.L. Paterson, The returnsand tisksof pharmaceutical R&D

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As such, it reflects the risk inherent in NCE investment. To account for varying profitability, however, alternative investments are often compared by their internal rates of return (IRR), either before inflation (nominal) or after (real). Our results show that for the average NCE the nominal titer-tax IRR on R&D investment is 10.7% through year 15 after marketing. For the median it is 2.6%. For the more successful NCEs, the IRRs clearly improve. The corresponding real (net of inflation) IRR’s are also presented in table 1. As shown there, some 65% of NCEs produce IRRs below those of the opportunity investment. The real IRR advantage for the average NCE is 2.2 percentage points through year 15 after marketing and 3.8 percentage points through year 24. The median’s real IRR represents a 5.5 and 4.0 percentage point disudvuntugerelative to the bond’s IRR.for these years. From the distribution of IRRs, we can calculate the odds that an NCE will produce a given IRR. These are shown for the 15 year period in table 2. If the investor judges anything over a 5.2 percentage point advantage in 15 year IRR to be adequate, there is a 14% chance of his succeeding. There is a 68% chance he will not succeed in improving on the return of an opportunity bond. Viewed optimistically, however, there is a 4% chance of outperforming the bond investor’s return by as much as 11.6 percentage points.

4.4. IvpIr Although an average NCE requires a cash outflow of as many as $27 million of after-tax 1976 dollars before FDA approval, by the end of a 36 year horizon it returns some $76 million (1976 constant dollars) in after-tax profits. In comparison, our matching bond investment would provide only $27 million in after-tax profits. Thus, on this criterion an NCE investment seems quite promising, provided one is willing to wait 36 years. As table 3 shows, shorter horizons alter the pro&abilities. If the horizon is 22 years (i.e., ten years of marketing), the NCE investor’s average NPV would be $7 million, the bond investor’s $12 million. NPV analysis confirms that the median NCE loses substantially regardless of the horizon chosen. Even at the end of 36 years since the beginning of R&D the median NCE shows a net loss of $0.78 million. During the same period the bond investor gains a profit of over $23 million. Thus, the median NCE shows an opportunity loss of approximately $24 million. In fact, table 3 shows that only one out of every three NCEs shows any NPV advantage over a 36 year horizon. Yet some 15% of NCEs would have outdistanced the matching bond investor’s NPV by as much as $8 million within ten years and by as much as $170 million within 24 years after market introduction.

20.75 13.96 10.83 10.73 9.24 5.94 8.45 6.44 3.80 2.58 0.62 - 3.86 - 8.69 - 12.89

17.67 9.87 6.94 7.22

6.66 2.16 8.45

6.67 - 0.42 - 2.91

- 2.39 6.41 - 10.89 - 15.57

3.7 percentile 14.2 percentile 20.6 percentile Average

28.0 percentile 31.7 percentile Corporate bond

35.3 percentile 44.0 percentile 50.0 median

57.3 percentile 67.0 percentile 75.7 percentile, 86.7 percentile

2.08 - 3.71 - 7.75 - 10.60

6.28 5.55 4.20

10.11 8.32 8.45

21.22 15.74 13.45 12.08

20

lOO+Nominal rate (“/o)_ 1 loo lQO+Inflation rate (“A) ’

15

10

NCEs ranked in declining order of average annual worldwide sales

“Real rate (c/o)=

’

2.60 - 3.63 - 7.45 - 8.95

6.18 5.96 4.21

10.18 9.56 8.45

21.21 16.47 14.83 12.44

24

-7.91 - 11.71 - 15.93 - 20.35

0.63 - 6.06 -8.40

0.62 - 3.62 2.31

11.01 3.65 0.88 1.16

10

- 5.08 -9.31 - 13.86 - 17.82

0.42 - 2.07 - 3.22

3.06 -0.06 2.31

13.91 7.51 4.56 4.46

15

- 3.70 -9.16 - 12.98 - 15.66

- 3.21 -9.09 - 12.69 - 14.11

not not not not

within within within within

24 24 24 24

not within 24 not within ivithin 24

0.17 -1.69 - 0.05 0.27 - 0.42 - 1.70

3.88 2.19 2.31

7 10 12 12 10 21

Break even year after market introduction

14.35 9.87 8.33 6.07 3.95 3.39 2.31

24

_

14.36 9.19 7.03 5.73

20

1ntemg.l rate of return of NCEs vs that of corporate bond after taxes of 35%: I Nominal IRR (“A) Real IRR (“/o) through years after marketing through years after marketing

Table 1

L #

? 3 P S

“a

P. Joglekw and ML. Paterson, The returns and risks o$pharmacetrtical R&D

169

Table 2 Probability of an NCE producing at least a given internal rate of return within 15 years after marketing.

Nominal IRR over (%) - 3.863 0.615 2.584 3.803 6.415 5.941 10.114 10.831 13.956 20.677

Percentage-pointadvantage in IFR (versus bond’s) over

Real’ IRR over (%) -9.305

Nchinal (“/o) Realb(“4) - - 12.313

- 11.615

- 7.835 - 5.866 -4.647 - 2.035 - 2.509 1.664 2.381 5.506 12.296

- 7.392

- 5.080 - 3.223 - 2.073 0.392 - 0.056 3.881 4.558 7.506 13.911

“Realrate (“A)=

-

5.534 4.384 1.920 2.367 1.570 2.246 5.194 11.60

Probability 0.67 0.57 3.50 0.44 0.35 0.32 0.28 0.21 0.14 0.04

lOO+Nomind rate (xi_ 1 1oo lOO+Inflation rate (“A) ’

bRealadvantage= (NCE’s real IRR-Bond’sreal IRR)= NCE’s real IRR- 2.31.

5. Results of alternativeassumptions Despite better historical data, we have had to make a series of assumptions in projecting .our base case. Other assumptions for the future are perhaps equally probable. Our model allows testing their. effects in a “sensitivity analysis’. Specific alternative assumptions and the results they produce are shown in table 4. Test 1 in the table presents our base case for the average NCE and thus summarizes many of the assumptions and results discussed above. For the other tests, in the assumptions columns we cite only those parameters [email protected] values from the base case, a blank meaning the same assumption as in the base case. Below we review the main results shown in the top part of table 4. 5.1. Cost of R&D (tests 2 and 3) It has been suggested by Conrad (1983) that the costs of bringing an NCE to market have increased faster than general inflation. If R&D cost estimates are increased by 30% over what Hansen reports (test 2), for the average NCE the break even point increases from year 12 up to year ‘14 after market introduction, real IRR drops to 4.8% from 6.1x, and ,NPV falls to $69 milllion from $76 million, while the matching bond’s NPV increases from $27 million in the base case up to $33 million.

NPV of NCE investor 140.141 20.915 5.637 6.874 4.806 - 8.266 -6.532 - 12.650 - 15.116 - 13.839 - 17.535 - 18.426 - 20.174

NCEs ranked in declining order of average annual worldwide sales

3.67 14.22 20.60 Average 28.0 31.7 35.3 44.0 Median 57.3 67.0 75.7 86.7

Year 10

20.583 12.933 12.003 12.139 12.126 11.289 13.094 11.012 10.804 10.916 10.717 10.619 10.555

NPV of matching bond investor 321.244 75.782 34.131 33.295 21.604 3.138 9.993 - 4.575 - 7.992 - 10.226 - 16.039 -s-17.852 - 19.952

NPV of NCE investor

Year 15

29.677 18.033 16.618 16.824 16.804 15.530 18.278 15.110 14.792 14.963 14.660 14.510 14.413

NPV of matching bond investor 427.842 146.890 87.281 59.247 35.286 19.259 14.115 2.858 -2.646 -7.015 - 15.371 - 17.380 - 19.731

NPV of NCE investor

Year 20

39.871 23.751 21.791 22.077 22.049 20.285 24.089 19.703 19.263 19.499 19.081 18.873 18.738

NPV of matching bond investor

472.412 212.996 155.224 75.725 42.067 36.478 17.897 6.891 - 0.777 - 4.827 - 14.789 - 17.006 - 19.534

NPV of NCE investor

Year 24

48.907 28.819 26.377 26.733 26.698 24.500 29.241 23.774 23.226 23,521 22.999 22.740 22.572

NPV of matching bond investor

Net present value (NW) of NCE investor and matching bond investor ($ million) at end of years since market introduction.

Table 3

2.2 6 2 2 2

2.2 6

4

2

4

9

6 9

4

4

13

10

13

45

40

45

20

20

35

25 0

35

100 50

100 130 70

R&D cost Tax (as% of Depr. rate Hansen’s (“/ (“/o) estimate)

Average NCE: alternatiwe policies 15 loao/, replacement by generics after 10 years of sales (otherwise standard) 16 50”/0replacement by generics after 10 years of sales (otherwise standard) 17 Compulsory licensing: 40% volume loss, 15% price cut, 4% royalty after 3 years of sales (otherwise standard) 18 Compulsory licensing: 15% volume loss, 40% price cut, 4% royalty after 3 years of sales (otherwise standard) 19 U.S. sales only (otherwise standard)

Median NCE 12(basecase)-6 13 14

Average NCE 1 (base case) 6 2 3 4 5 6 7 4 8 9 10 11

Test no.

NonContriInfla- U.S. U.S. Bond bution tion DPI DPI yield margin (“/ (%) (“/o) (“/o) &J

Assumptions

>24 12 24 >24 >24

24 36 >36 >36

>24 >24 >24

12 14 10 14 >24 13 12 10 14 12 9

>36

>36 >36 >36

24 26 22 26 >36 25 24 22 26 24 21

NCE’s BEP since R&D Mktng Years

The effect of alternative assumptions on results.

Table 4

6.4 8.3

8.5

10.8

7.6

4.2 7.9 7.1

12.4 11.0 14.4 12.5 12.7 11.7 10.6 15.0 11.2 12.8 15.6

NCE’s nominal IRR (%)

Results

0.4 2.2

2.3

4.6

1.5

- 1.7 1.7 1.0

6.1 4.8 7.9 6.2 6.3 5.4 6.3 9.0 4.9 6.4 9.1

NCE’s real IRR (%)

2.3 2.3

2.3

2.3

2.3

2.3 2.3 2.3

2.3 2.3 2.3 3.4 6.6 2.3 2.4 2.3 2.3 2.3 2.3

Bond’s real IRR (“/

12 23

27

50

22

-1 10 13

76 69 82 106 226 65 81 132 56 82 149

NW

27 25

27

27

27

23 12 23

27 33 20 57 239 27 28 27 27 27 27

NW

NCE’s Bond’s NPV NPV

: E

P 3 00 ip” g

172

P. Joglek

and ML. Paterson, The returns and risks of pharmaceutical R&D

On the other hand, analysts such as Faust (1984) foresee more efficient techniques in drug design and testing, compounds affecting fundamental causes of disease, or other changes favoring R&D productivity. If R&D costs for the average NCE are reduced to 70% of Hansen’s figure, its IRR rises from 6.1% up to 7.9% over 24 years of sales (test 3). Clearly, a 30% change in R&D costs results in a slightly smaller percentage change in IRR and NPV. ’ As such, our results are not highly sensitive to assumed R&D costs. 5.2. Tax rate (tests 4 and 5) A tax rate of 25”/,,perhaps appropriate for some drug companies, produces only very slight changes in return for the NCE investor, with IRR rising 0.1% (test 4). It should also be noted that although the 25% rate produces a significant rise in the NCE’s NPV, to $106 million, it also increases the bond’s NPV to $57 million, leaving practically no change in the net NPV advantage. Overall, our results are rather insensitive to small changes in the tax rqte. Test 5 shows the importance of after-tax analysis. With returns computed strictly before taxes - i.e., if the tax rate is zero - the NCE investor earns 6.3x, less than the bond investor’s 6.6”/,, does not break even during 36 years, and obtains an NPV lower than that for the bond investor. 5.3. Contribution margin (test 6) Reducing contribution margin to 40% from 45% increases the average NCE’s break even period to 13 years from 12 years, and its real IRR drops to 5.4% from 6.1% (test 6). There is a corresponding drop in the NCE’s NPV. Overall, results are not very sensitive to the assumed margin. 5.4. Drug price increases in U.S. and overseas (tests 7-11)

Test 7 confirms that when inflation, DPI and bond yield are proportionately adjusted, results show almost no change. However, as test 8 shows, if instead of lagging inflation by approximately 2 percentage points as it has historically in the U.S., worldwide and U.S. DPI keep pace with inflation, the NCE investor gains considerably: his real IRR rises to 8.5% from 6.1% (versus 2.3% for the bond investor) and his NPV to $132 million from $76 million. While recently DPI has exceeded inflation in the U.S. , the reverse remains true in most major markets overseas. If, as in test 9, non-U.S. price increases are held to 33% of inflation, reflecting common experiences of drug companies marketing worldwide, with everything else held the same as the base case, the real I of the average NC over 24 years of sales drops to 4.9%

P. Joglekar and ML. Paterson, The returns and risks of pharmaceuticalR&D

173

from 6.1x, versus the bond’s 2.3%. As test 10 shows, to bring the IRR back above 6.1”/, offsetting U.S. price increases equal to inflation are necessary. If the above DPI lag overseas continues but is accompanied by a DPI in the U.S. 50% greater than inflation (test 11) - a most optimistic assumption for the 36 years of our time horizon - the NCE’s real IRR rises to 9.1% and NPV to $149. .Overall, it is clear that our results are most sensitive to the DPI in the U.S. and abroad. 5.5. The median NCE (tests 12-14) Because of the skewed distribution of NCE sales, it is important to focus on the median as well as the average NCE. Test 12 presents the case for the median NCE, with all assumptions identical to the base case for the average NCE. One can see that under these assumptions the median NCE does not break even with the bond investment within the 36 year horizon, has an IRR of - 1.7%,and has an NPV of - $1 million. The risks associated with an NCE-related R&D investment appear more strongly when one looks at the results of tests 13 and 14: even under the most favorable assumptions, namely R&D costs at 50% of Hansen’s average amount or drug prices increases in the U.S. at Moo/, of general inflation, the median NCE does not break even with the opportunity investment during the 24 year sales horizon, always shows a negative real rate of return, and attains a net present value lower than that of the matching bond investment. 6. Assessing alternative pokies Below we illustrate briefly how our model and current data can be used to explore the effects of various policies or practices of governments and others on the return of NCE=related R&D. 6.1. Loss of sales to generics

Replacement by generic copies of pioneer brands whose patents have expired is increasingly advocated by many policy makers and encouraged by governments and third party payers for health care. Broad scale substitution of generics may be mandated in various countries, as it recently has been in England. ‘Allied to the tougher government lines on drug costs, the growing use of generic drugs is the biggest concern of drug makers’ [Calonius (1985)]. In the U.S., recent legislation extending the effective patent life for many future NCEs will postpone generic replacement until later in the NCE’s sales life; however, FDA approval and market entry of generics will be speeded considerably in the near term. sales life, We assumed generic replacement in the tenth year of the

174

P. Joglekat ad ML Paterson,The tetms and risksof phmmaceutical R&D

when on average patent protection has expired. Test 15 in table 4 shows that if generic replacement is virtually complete (100%) in all markets, real IRR drops from 6.1% to 1.5% over the 35 year horizon, making the average investment in NCE research far less attractive than a bond investment. Investment in pharmaceutical R&D should be scant under such circumstances.6 If, as in test 16, generic replacement after ten years of marketing is only 50% (a situation more consonant with the strength of brand loyalty), the average NCE’s real IRR drops to 4.6% compared to the bond’s IRR of 2.3%. This would mean that on average investment in NC&related R&D might continue to be suficiently attractive, although much more risky than in the past. 6.2. Loss of sales through patent circumvention Early replacement by generic drugs, well before product-patent expiration, is effected in some cotintries by such practices as toleration of ‘pirate’ copies of the NCE. One Western country requires licensing of the NCE to generic competition three years after market introduction; generally a token royalty of 4”/ of sales is decreed. IMS data show the pioneer NCE loses sales drastically. The degree of loss for each NCE out-licensed depends on its particular price reductions and volume losses. If this country’s policy is followed worldwide, with similar results, the IRR and NPV of the average NCE will at best equal the 2.3% and $27 million from bonds, with break even in the 36th year; and at worst IRR and NPV will drop to 0.4% and $12 million respectively, with no break even (tests 17 and 18). 6.3. Importance of foreign markets No specific policies are foreseen that would deny foreign marketing to NCEs approved in the U.S. Nevertheless, an implicit assumption underlying policies such as price controls, generic replacement, and patent circumvention outside the U.S. seems to be that companies may develop NCEs principally for the U.S. population, with non-U.S. sales a non-essential bonus - one that local policy can minimize without undue harm. For perspective, we eliminated non-U.S. markets entirely from the worldwide total. As test 19 shows, doing this reduces the IRR and NPV of the average NCE to below those of bonds, and no break even occurs within the time horizon. Clearly, NCE research is an international enterprise, and investors in it must count on worldwide sales for profitability.

61000/, generic replacement is now the policy of some American health maintenance organizations. All U.S. health insurance programs providing drug benefits are likely to have such . a policy, according to CongressmanWaxman (1985). _

P. Jogiekaa and M.L. Paterson, The returns and risks ofpharmaceutical

R&D

175

7. Conclusions

We have presented a base-case scenario, using the best available data and reasonable assumptions, for assessing the profitability and risks of a 1976 decision to invest in NCE-related R&D. A comprehensive sensitivity analysis suggests that the conclusions below are fairly robust. On the average, investment in pharmaceutical R&D for NC& ‘pays’ - at least more than does an investment in bonds. However, this is true only in the aggregate and over the long term. Underlying these conditions, the odds of the NCE investor matching the bond’s 2.3% real IRR are only one in three, and the odds of exceeding it by an appreciable degree are small indeed. The odds of attaining the average NCE’s return of 6.1% are less thatl one in five during a 15 year sales period (table 2). The risk of investing in NCEs, created by the rarity of big sellers, is thus apparent. Given this risk, a 6.1% real IRR for the average NCE seems modest. Yet, this estimated IRR is large enough, unlike the estimates of prior studies, to explain current levels of investment in pharmaceutical R&D. Confident company executives with a successful track record may be justified in expecting to do better than the average, and may also have adequate surplus from past successes to continue such an investment. A company might also hope to do better than the average by targeting its R&D at therapeutic classes affecting large segments of the population. At the same time, for a dispassionate stockholder comparing rates of return from alternative investments, a portfolio of stocks in pharmaceutical, and nonpharmaceutical, firms may be quite attractive for two important reasons: (1) the observed rate of return on pharmaceutical investment continues to be substantially higher than the estimate of this study because of several peculiarities of this industry,’ and (2) insofar as returns in the pharmaceutical industry are likely to be recession proof, a stock in a pharmaceutical firm complements other more volatile investments. On the other hand, for a new pharmaceutical firm or for one with a notso-successful track record, possibly not able to support a full portfolio of pharmaceutical and non-pharmaceutical investments, the situation is problematic. The result for the NCE investor who ends up having discovered the median NCE highlights the problem faced by such a firm. The point is, such a firm may not have the resources to introduce perhaps as many as three to six NCEs until one of them produces above average returns; and the firm may not be ab!e to wait 20 to 30 years since the start of R&D for the payback of its investment. Even for a succ:essful pharmaceutical firm, the fragility of the base-case average return on R&D is apparent. It depends heavily on (1) foreign markets, and (2) future government policies. An average-selling NCE intended for the U.S. population only would have the status of orphan drug. Returns are greatly affected by the rate of

176

P. Joglekar and M.L. Paterson, The returns ad risks of pharmaceuticalR&D

price increase (DPI) in all countries. In recent years, price increases allowed in overseas markets hdve lagged substantially behind inflation. Our analysis has shown that to offset these lags, a DPI in the U.S. at least equal to inflation would be necessary. In recent years, DPI in the U.S. has indeed exceeded inflation. This may have resulted purely from pricing drugs competitively to alternative therapies. Yet, regulators focusing on international comparisons of DPI could interpret this situation as a subsidy of overseas markets by U.S. payers for drug therapy. Consequently, a continuation of the current rate of DPI may be politically difficult in the United States. More extensive generic replacement when NCE patents expire would add an appreciableuncertainty to returns on R&D. In the severest of scenarios, worldwide circumvention or non-recognition of product patents early in the NCE’s sales life, as now observed in some countries, would favor generics to the point of denying the pioneer brand payback of its R&D costs. In kind, the spread of such policies appears to be the scenario most threatening to NCE investment within the pharmaceuticalindustry. Conceivably, offsetting positive developments might be a major reduction in the time and cost of researching and developing an NCE, discovery of NCEs of much greater or broader medical benefit than in the past, or a shift toward more favorable regulatory policies such as the recent ‘patent restoration’ in the United States.

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