Yves here. Many have explained why big drug companies, despite wrapping themselves in the mantle of R&D, really are not much if at all in the innovation business. They have long spent more money on marketing than research. They also in aggregate spend more on buybacks than research. On top of that, for decades, the overwhelming majority of new drug applications are in reality minor reformulations intended to extend patent life. The large level of patent-driven “research” and other creative accounting1 contributes to the dominance of major pharma companies in reported R&D spending, as opposed to other measures of genuine new drug investigations.
This paper usefully points out that small biotech companies, which are not affected by drug price curbs, are responsible for the majority of clinical trials, which is a decent proxy for innovation.
By Fred Ledley, Professor of Natural & Applied Sciences and Management, Bentley University and Director, Center for Integration of Science and Industry, at Bentley University; Henry Dao, Researcher & VP of Portfolio Management, Bentley University; and Cody Hyman, Assistant Professor, Accounting, Bentley University. Originally published at the Institute for New Economic Thinking website
The two years since Congress passed the Inflation Reduction Act (IRA) have seen a barrage of commentary from both public advocates and industry debating its effect on drug prices and development. Some analysts celebrate the dawn of public representation in drug price negotiations; others bemoan the loss of shareholder control over pharmaceutical markets. All sides, though, have stepped up their efforts to achieve political influence.
But while the last two years have been a bonanza for pundits, lobbyists, and lawyers, scholarship has struggled with the paucity of publicly available data on details vital for forming judgments about all the claims: drug prices and the costs of pharmaceutical innovation; the fundamentals driving biotechnology and pharmaceutical companies; and the appearance of conflicts of interest among authors and publication venues.
Two papers this week from the Center for Integration of Science and Industry at Bentley University show how fundamental scholarship can reframe the debate around the IRA. The first paper, published in the journal Clinical Trials, examined the finances of 1,378 public biopharmaceutical companies to understand their contributions to pharmaceutical innovation, their primary sources of innovation capital, and how R&D spending has varied in response to changes in revenue or new investment from 2000 to 2018. The second, our new INET working paper, examines the association between indices of drug prices (consumer or producer) and investment in the biotechnology industry.
These studies demonstrate that about 5% of public biopharmaceutical companies are large, profitable pharmaceutical manufacturers, which collectively account for around 90% of global pharmaceutical sales, revenue, and R&D spending. They also distribute more cash to shareholders through dividends and stock buybacks than they receive from stock sales. For these companies, revenue serves as the primary source of innovation capital and R&D spending varies in proportion to revenue.
In contrast, 95% of public biopharmaceutical companies are smaller biotechnology firms, which typically have no products, little revenue, and negative earnings but sponsor about 60% of clinical trials. These companies raise much of their capital for innovation through equity offerings, rather than revenue. Importantly, analyses show no association between indices of consumer or producer drug prices and either investment or valuations in biotechnology companies.
These results suggest that analyses of the IRA’s impact on the pharmaceutical industry cannot be framed around the assumption that valuations and strategy can be predicted from discounted cash flows, revenues, or earnings. While these principles may be applicable to large, profitable pharmaceutical companies, they do not describe smaller, science-based biotechnology companies or the biopharmaceutical sector as a whole. Nevertheless, as we document in our INET paper, most of the studies that have informed debate over the IRA are based on analyses of the largest pharmaceutical manufacturers and neglect the distinctive nature of most biotechnology firms.
Reframing the debate around the empirical evidence suggests that the biopharmaceutical industry and investors should not be adversely impacted by the drug pricing provisions of the IRA and may benefit. Our models suggest that large pharmaceutical companies could maintain both their profits and the number of new drug approvals at current levels by reallocating R&D spending to later phases of clinical development and refilling their pipelines through licensing or acquisition of clinical-stage products from smaller biotechnology firms. One immediate impact of such a strategy would be to increase the asset value of these large companies relative to their R&D expense, which could improve their fundamentals in traditional asset-based valuation models.
For small biotechnology companies, our analysis suggests that changing drug prices is not likely to have any negative impact on either investment or valuations. At the same time, increasing demand for licensing or acquisition of their clinical-stage products by larger pharmaceutical firms could create greater competition for these assets, driving up the price of these transactions and potentially the returns to investors.
By itself, reducing drug prices could have a positive impact on markets. High healthcare costs have been shown to have negative effects on consumer spending and debt. Healthcare costs are also a significant drag on corporate finances, with employers covering 73-83% of employee healthcare costs or an average of $8,435 per individual ($23,968 per family). While prescription drugs account for only about 9% of total healthcare costs, any reduction in healthcare costs would benefit companies and their investors across the broader economy.
It may be argued that diversified, institutional investors, who hold substantial equity in the large pharmaceutical companies, could create value for their broader portfolios by advocating for reduced drug prices in their pharmaceutical holdings rather than by opposing the reductions anticipated under the IRA.
While our research may not justify a blindly Panglossian view of the IRA’s impact on the biopharmaceutical industry or equity markets, it should put to rest the unwarranted claims by industry that the drug pricing provisions of the IRA represent a significant threat to their firms, their shareholders, or pharmaceutical innovation. In fact, the greater threat may be persistent claims by the industry that the IRA will have a negative impact, which could cascade into negative sentiment among investors and negative market dynamics.
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1 This factoid is dated but easy to understand and I am highly confident, representative. A long time ago, Bristol Myers owned Clairol. Hair color is a grotesquely profitable business (and it actually does have barriers to entry, there’s a lot of chemical tech involved). Product that is made for pennies a box sells for dollars a box. A C-suite member told me years ago of the many games Bristol used to shift as many overheads from the drug business over to Clairol as possible, both to boost reported drug profits (which Wall Street gave a higher multiple than color or OTC meds) and that similarly, as many drug overheads as possible were classified as research-related.
