City & Business: Long haul in drugs

IT IS a favourite joke of Sir Richard Sykes, chief executive of Glaxo, to talk about the 'good old days of the pharmaceuticals industry - as in about 18 months ago'. The quip is intended to make his audience aware of the pressures confronting pharmaceutical companies; the environment in which they operate is transmuting with a speed that amounts to revolution. Casualties are certain, some spectacular.

As always, change is being driven by the customer, who even in the rarified and highly regulated market of prescribed drugs is increasingly demanding better products for lower prices. Governments, doctors and patients are determined to get more for less.

For a while last year, pharmaceutical shares struggled with the delusion that somehow or other it would all go away - that the Hillary Clinton health- care reforms in the US, designed in part to cut the country's ballooning pharmaceuticals bill, would turn out to be so much hot air; that the transformation going on before its eyes was just some ghastly nightmare from which the stock market would eventually awake.

Over the past few months, however, reality has once more begun to take hold and the pharmaceuticals sector has been returned to the seriously sick list with a vengeance.

As is so often the case, change is being led from the US - where a new generation of highly cost-conscious health-care providers is increasingly dominant.

In 1986 fewer than a quarter of people in the US were covered by 'managed care' schemes which, for a per capita fee, take over all the health-care needs and costs of a company's employees and their families. By 1990 it was nearly a half. By next year it will be well over three quarters. A by-product of this change is that more and more pharmaceuticals are sold through carefully controlled lists of specified products - so-called 'pharmacy benefit management'. If you are a member of a managed care scheme, your doctor is only allowed to prescribe from a defined formulary in which cheaper generic drugs are increasingly substituted for the branded original.

As a result, the huge direct-selling forces once employed by pharmaceutical companies - essentially to go around knocking on doctors' doors - are becoming redundant. Pharmaceutical companies that don't get their products on to the managed care formularies won't be able to sell them. How then to achieve the trick of getting on to the formularies without having to cut prices to the bone?

One method, already pursued by Merck (which last year paid dollars 6bn for Medco of the US), is to buy into the distribution chain - vertical integration. Such an approach is fraught with dangers - a bit like a retailer that is exclusively linked to only one manufacturer - and on the whole British players such as Glaxo want to avoid it.

An alternative is to form strategic alliances across the industry capable of offering a range of products in specific therapeutic areas to the managed health-care schemes. 'Capitation', in which drug companies or a group of them provide the managed health-care schemes with all their pharmaceutical needs for a set fee per annum, seems to be the future.

Pharmaceutical companies have never had to deal with business risk of this sort before. It's easy to see why the stock market is so nervous. In Glaxo's case, the company's cash mountain of more than pounds 2bn provides a considerable cushion against the turbulence ahead. Sir Richard and his chairman, Sir Paul Girolami, can afford to stick with the favoured strategy of remaining a pure research-driven prescription drugs company in the hope that the vast amounts they plough into research will eventually produce innovations to replace Zantac and counter the downward pressure on profits. It's going to a long haul, however. Those who buy Glaxo, or any other pharmaceuticals stock, have to be prepared to take a five-year or even longer-term view.