The history of fen-phen looms over the legal climate for Big Pharma. Wyeth has now reserved over $21 billion and paid out $14 billion of the reserve and it's not over yet. This is much higher than the worst case estimate made in 1999: $4.75 billion. What happened?
Fen-phen was a "cocktail" of three drugs. Each drug had been separately approved by the FDA years before, one as early as 1959. Combining them was thought to create the ideal weight-loss program, as the first drug suppressed appetite while the second drug reduced drowsiness. The appeal of "feel good while losing weight" was powerful. However, the combination was "off-label," meaning that it had not been studied or approved by the FDA.
In 1996, Wyeth sold $300 million of these drugs - not exactly a huge number for a company with $14 billion in revenues. But the revenues were growing quickly until doctors at Mayo Clinic published results in July 1997 that connected fen-phen with unusually high levels of heart ailments. After reviews of the FDA, Wyeth withdrew fen-phen from the market on September 15, 1997. Lesson One: use the FDA process.
Within months, Wyeth lost two dramatic cases. Alarmed, Wyeth set up a class action mechanism to address the thousands of fen-phen cases being filed. To attract participation in the class action, Wyeth defined generous benefits according to a payout matrix and, importantly, exempted participants from proving causation - expected to be a major difficulty for plaintiffs in this case.
Significant problems for Wyeth emerged both in and outside of the class action mechanism. When Wyeth lost two additional cases, the "headlines" caused more than 50,000 to opt out of the class action. Responding to widespread advertising, 80,000 others who were less sure of their cases chose to the class action mechanism. This number far overshot initial estimates of 35,000. Even worse for Wyeth, the severity was much worse than predicted. Lesson Two: generous class action terms simply create more claims.
With early estimates so incorrect, Wyeth undertook a study in 2002 and discovered widespread fraud. An audit of a claim group of $50 million revealed that doctors had exaggerated the heart ailments. The result was a reduced offer by Wyeth of $3.2 million. Angry plaintiffs fought back.
In subsequent hearings, the judge found a pattern of abusive practices, resulting in his ruling that payments should be withheld until claims were audited. After audit, over half of the claims were rejected. As the claims-paying of the class action ground to a halt, claimants opted out and pursued legal action individually. The docket of cases grew to over 50,000. Lesson Three: careful and efficient claims processing is critical.
To resolve the impasse, attorneys identified that the lowest level claims were the real issue, as they were subject to exaggeration. Without these claims, the original trust ($2.55 billion) would have enough to pay everyone. The result was an amendment to the original agreement so that $1.275 billion was taken out of the trust to be paid to the low level claimants on a pro rata basis. Lesson Four: moral hazards (no risk propositions) have to be addressed.
Audits of claims show that 70% of the claims should not have been paid. Nine years into the process, Wyeth is finally applying these fen-phen lessons. More importantly, so are the other companies.
Sunday, February 26, 2006
Thursday, February 23, 2006
H.& R. Block Tax Trouble
H&R Block (HRB) announced a restatement of its 2005 earnings. The company, which prepares the tax returns of one out of every nine American taxpayers, needed some some tax help of its own, though. Because of errors in computing its own taxes, HRB understated its tax by $32 million or $0.07 per share.
Big Pharma II: Marketing vs. Research
Big Pharma's "in-house" researchers are not simply bureaucratic. As stated in Part I, drugs come from three venues: internal development, alliances and acquisitions. Internal development can be more profitable, but those resources are more frequently directed to evaluate effective alliances and acquisitions.
Once a drug "candidate" is identified through one of these venues, it must be produced. Like the movie business, production is a capital-consuming process. In order for a drug to become available to consumers, the FDA defines an approval process which moves from the "candidate" level through three successive phases before becoming an "NDA" (New Drug Application) and then finally a "product."
The process typically requires a six year period of time, as each level has a higher hurdle to overcome. The success rate to move from "candidate" to "product" averages somewhere between 1 in 10 and 1 in 20. Given the level of competency and pre-screening to get to a "candidate," these are not favorable odds. (Here is where the movie studio analogy breaks down. If the movie business had odds of 1 movie in 15 being profitable, we would have few movies.) The resulting cost is somewhere between hundreds of millions or over two billion, depending on how many of the failures are included in the cost of a success.
Because of this extraordinary cost, the major pharmaceutical companies are very desirable partners. Just as a writer prefers a major movie studio's assistance in production, so too do governments, academics and small firms look to Big Pharma for financing, testing and developing the prospective drug.
But, like the movie business, the costs do not stop once there is a "product." Once a film has been produced, movie studios must advertise and sell through "windows" such as theater, cable, DVD and various networks. This is similar to the pharmaceutical process, where companies must advertise and then sell to doctors, consumers, government agencies and managed health care providers. Just as sales of movies may be supplemented through related CDs, toys or clothing so too,there are even supplemental pharma applications, as demonstrated by the reapplication of Viagara from pulmonary problems to erectile dysfunction.
The one critical exception is the limited life of the patent. At the very beginning, the patent is applied for and the "clock" starts running. By losing years to simply get the product into the marketplace, Big Pharma races to ramp up understanding and usage. Otherwise, the ability to fund the development and testing of drugs is impaired. Typically a company has just nine years left to recover its costs (which necessarily includes the failed attempts) and make a profit adequate to incent continued investment.
Once a drug "candidate" is identified through one of these venues, it must be produced. Like the movie business, production is a capital-consuming process. In order for a drug to become available to consumers, the FDA defines an approval process which moves from the "candidate" level through three successive phases before becoming an "NDA" (New Drug Application) and then finally a "product."
The process typically requires a six year period of time, as each level has a higher hurdle to overcome. The success rate to move from "candidate" to "product" averages somewhere between 1 in 10 and 1 in 20. Given the level of competency and pre-screening to get to a "candidate," these are not favorable odds. (Here is where the movie studio analogy breaks down. If the movie business had odds of 1 movie in 15 being profitable, we would have few movies.) The resulting cost is somewhere between hundreds of millions or over two billion, depending on how many of the failures are included in the cost of a success.
Because of this extraordinary cost, the major pharmaceutical companies are very desirable partners. Just as a writer prefers a major movie studio's assistance in production, so too do governments, academics and small firms look to Big Pharma for financing, testing and developing the prospective drug.
But, like the movie business, the costs do not stop once there is a "product." Once a film has been produced, movie studios must advertise and sell through "windows" such as theater, cable, DVD and various networks. This is similar to the pharmaceutical process, where companies must advertise and then sell to doctors, consumers, government agencies and managed health care providers. Just as sales of movies may be supplemented through related CDs, toys or clothing so too,there are even supplemental pharma applications, as demonstrated by the reapplication of Viagara from pulmonary problems to erectile dysfunction.
The one critical exception is the limited life of the patent. At the very beginning, the patent is applied for and the "clock" starts running. By losing years to simply get the product into the marketplace, Big Pharma races to ramp up understanding and usage. Otherwise, the ability to fund the development and testing of drugs is impaired. Typically a company has just nine years left to recover its costs (which necessarily includes the failed attempts) and make a profit adequate to incent continued investment.
Wednesday, February 22, 2006
Big Pharma: Marketing vs. Research
The major pharmaceutical companies, collectively known as Big Pharma, are often criticized for not enough new drugs and too much marketing. In my post "Changing Reaction to Drug Industry," I stated that only 20 new drugs were generated in 2005 for an aggregate R&D cost of $38 billion. Since at least that much was spent on marketing, critics assert that companies could double the number of new drugs if they would stop spending so much on marketing. To evaluate such criticism, let's look at the system of discovering, developing and delivering drugs.
The discovery of new drugs is similar to the initial development of movies. At times, a studio develops a movie from its own staff of writers. Successful "in-house" writing is ideal for profits as the material is much lower in cost. Unfortunately for the studios, much of the best material for movies comes from a popular writer like J.K. Rowling whose ideas are much more expensive. Despite the studio's preference for "in-house" writing, the seemingly disproportionate success of authors outside the studios is partially the natural result of so many more searching for that "great story" needle in the haystack of everyday life.
The same principles are at work in drug discovery. Big Pharma has many talented "in-house" researchers. Yet major discoveries have more frequently occurred outside Big Pharma labs. Criticism lodged against Big Pharma for this result ignores a basic dynamic: the sheer number of researchers in academia, government and small business naturally result in more discoveries. In the same vein, sheer numbers also benefit creativity.
Drug discovery is a long distance from developing and delivering a drug. To shorten this distance, academia, government and small business seek the capacities of Big Pharma. Alliances and acquisitions are necessary for the discoveries made outside of Big Pharma to impact society on a timely basis. Just as the primary purpose of a movie studio is not to write stories, but to produce and deliver movies, so the primary role of Big Pharma is not to discover drugs but to shorten the time from the discovery of a drug to its widespread use. In fact, marketing costs more than R&D provide Big Pharma's critical societal benefit: lowering "sickcare" costs while providing higher "healthcare" benefits through the safe, yet rapid application of our discovered drugs.
The discovery of new drugs is similar to the initial development of movies. At times, a studio develops a movie from its own staff of writers. Successful "in-house" writing is ideal for profits as the material is much lower in cost. Unfortunately for the studios, much of the best material for movies comes from a popular writer like J.K. Rowling whose ideas are much more expensive. Despite the studio's preference for "in-house" writing, the seemingly disproportionate success of authors outside the studios is partially the natural result of so many more searching for that "great story" needle in the haystack of everyday life.
The same principles are at work in drug discovery. Big Pharma has many talented "in-house" researchers. Yet major discoveries have more frequently occurred outside Big Pharma labs. Criticism lodged against Big Pharma for this result ignores a basic dynamic: the sheer number of researchers in academia, government and small business naturally result in more discoveries. In the same vein, sheer numbers also benefit creativity.
Drug discovery is a long distance from developing and delivering a drug. To shorten this distance, academia, government and small business seek the capacities of Big Pharma. Alliances and acquisitions are necessary for the discoveries made outside of Big Pharma to impact society on a timely basis. Just as the primary purpose of a movie studio is not to write stories, but to produce and deliver movies, so the primary role of Big Pharma is not to discover drugs but to shorten the time from the discovery of a drug to its widespread use. In fact, marketing costs more than R&D provide Big Pharma's critical societal benefit: lowering "sickcare" costs while providing higher "healthcare" benefits through the safe, yet rapid application of our discovered drugs.
Tuesday, February 21, 2006
Repatriation of earnings
On Pfizer's (PFE) fourth quarter earnings conference call, the size of PFE's "earnings repatriation" surprised me - $37 billion! Earnings repatriation has been driven by the American Jobs Creation Act of 2004 which provided U.S. corporations a one-time opportunity to repatriate foreign profits at the extraordinarily low tax rate of 5.25%.
There is a catch to this earnings amnesty: the earnings "must be invested in the U.S. pursuant to a domestic reinvestment plan..(other than as payment for executive compensation), including .. infrastructure, research and development (r&d), capital investments or the financial stabilization of the corporation for the purposes of job retention or creation."
My surprise appears well-placed. An article by Daniel S. Levine of the San Francisco Business Times reports that PFE is "by far" the leader in the repatriation of earnings. Overall, U.S. corporations are expected to repatriate $400 billion, making PFE's nearly 10% of the entire U.S. business sector. That's a huge financial resource for a company whose 2005 r&d expenses were $7.8 billion.
There is a catch to this earnings amnesty: the earnings "must be invested in the U.S. pursuant to a domestic reinvestment plan..(other than as payment for executive compensation), including .. infrastructure, research and development (r&d), capital investments or the financial stabilization of the corporation for the purposes of job retention or creation."
My surprise appears well-placed. An article by Daniel S. Levine of the San Francisco Business Times reports that PFE is "by far" the leader in the repatriation of earnings. Overall, U.S. corporations are expected to repatriate $400 billion, making PFE's nearly 10% of the entire U.S. business sector. That's a huge financial resource for a company whose 2005 r&d expenses were $7.8 billion.
Monday, February 20, 2006
Merck's Latest
The latest trial resulted in a victory for Merck (MRK) in the important category of alleged victims who took Vioxx for less than eighteen months. In this case, Richard Irvin had taken Vioxx for less than one month when he died of a heart attack.
A critical part of MRK's victory was a pretrial ruling by the judge that prevented an "expert" pathologist from attributing Mr. Irvin's deadly clot to Vioxx. This was a major departure from last fall's headline case in Texas where a doctor practically put Vioxx on the deceased's tombstone.
This legal process may go on for awhile. Another trial is currently under way in Rio Grande City, Texas (surprise) in what will certainly be a more plaintiff-friendly process. As headlines develop, investment opportunities may as well, allowing for increased investments on worse than expected verdicts.
A critical part of MRK's victory was a pretrial ruling by the judge that prevented an "expert" pathologist from attributing Mr. Irvin's deadly clot to Vioxx. This was a major departure from last fall's headline case in Texas where a doctor practically put Vioxx on the deceased's tombstone.
This legal process may go on for awhile. Another trial is currently under way in Rio Grande City, Texas (surprise) in what will certainly be a more plaintiff-friendly process. As headlines develop, investment opportunities may as well, allowing for increased investments on worse than expected verdicts.
Sunday, February 19, 2006
"Challenging" Times at Johnson and Johnson
On the 2005 fourth quarter earnings conference call for Johnson and Johnson (JNJ), CEO William Weldon characterized the current environment as "challenging." Just as "bling" was the hot phrase last year and "in the loop" a few years prior, so "challenging" seems to be now. Providing depth to his analysis, CEO Weldon further commented that the people at JNJ were "hard at work." The defensive tone of management on the conference call was echoed by the frustrated sound of JNJ analysts. This misery reveals what excessive expectations do. JNJ finished the year as only one of six industrial companies with a triple-A rating and $13.5 billion of cash on the balance sheet. Even more, earnings increased by almost $2 billion (over 13%) to a record $10.5 billion. These numbers were not generated by simply cost-cutting, as JNJ increased research and development (r&d) expenses by 21%. So what's the problem? Apparently, the stock price - which has moved from a high of $70 last April to the upper $50s currently. Investors bid the price of JNJ up on the news of the Guidant (GDT) acquisition. When JNJ exercised discipline on the GDT purchase price, allowing Boston Scientific to "win" the bidding war, JNJ's stock price dropped, reflecting the apparently widespread lack of respect for money and monetary discipline.
Thursday, February 16, 2006
Continuing Saga of Marsh & McLennan
Yesterday MMC announced results for 2005, a year that CEO Cherkasky described as "challenging." MMC has been under pressure since October 2004 when Attorney General Spitzer attacked a practice innocently termed "market services revenues," but more blatantly called "double-dipping" in Texas. The issue of representation is similar to the one I raised in yesterday's blog. Since MMC was receiving payments both from purchasers and sellers of insurance, it was unclear who MMC really represented.
The earnings conference call was unsurprising in its expressed "optimism" and its self-congratulatory tone. Also unsurprising, analysts spent their questions on updating their spreadsheets, not on understanding MMC's business model. Despite everyone's best efforts, some useful information came out anyway.
At the end of the presentation, the CEO commented that while the MSRs had always been around, they had actually been very small until recent years. Despite an acclaimed "new Marsh" (the "old" one being unaffordable), recent changes really imply a return to the more distant past.
I studied the issue and he's right. In reviewing the last twenty years, Marsh's operating margins were fairly stable at 20%, until about 1998. Suddenly, they started to push up to the mid-twenties. Based on Cherkasky's comments, the growth in MSRs caused the increase. So what's so bad about returning to "the good old days"?
Alot, if you bought the stock from 1998 to 2004. The seeming small increase in margins from 20% to 25% relates to an increase of about $500 million on $10 billion in revenue. But, in Wall Street's alchemy, the value of the company moved from roughly two times revenue ($20 billion) to three times revenue ($30 billion). That extra one-third value based on recurring MSRs is simply no longer there and represents a permanent loss for the 1998 to 2004 buyers.
The good news is that MMC is now moving to past margins. Large companies have had and will probably always need assistance in addressing their risk management needs. At those levels, MMC should be worth roughly two times revenues - a nice jump from today's one and a half times revenue valuation.
The earnings conference call was unsurprising in its expressed "optimism" and its self-congratulatory tone. Also unsurprising, analysts spent their questions on updating their spreadsheets, not on understanding MMC's business model. Despite everyone's best efforts, some useful information came out anyway.
At the end of the presentation, the CEO commented that while the MSRs had always been around, they had actually been very small until recent years. Despite an acclaimed "new Marsh" (the "old" one being unaffordable), recent changes really imply a return to the more distant past.
I studied the issue and he's right. In reviewing the last twenty years, Marsh's operating margins were fairly stable at 20%, until about 1998. Suddenly, they started to push up to the mid-twenties. Based on Cherkasky's comments, the growth in MSRs caused the increase. So what's so bad about returning to "the good old days"?
Alot, if you bought the stock from 1998 to 2004. The seeming small increase in margins from 20% to 25% relates to an increase of about $500 million on $10 billion in revenue. But, in Wall Street's alchemy, the value of the company moved from roughly two times revenue ($20 billion) to three times revenue ($30 billion). That extra one-third value based on recurring MSRs is simply no longer there and represents a permanent loss for the 1998 to 2004 buyers.
The good news is that MMC is now moving to past margins. Large companies have had and will probably always need assistance in addressing their risk management needs. At those levels, MMC should be worth roughly two times revenues - a nice jump from today's one and a half times revenue valuation.
Monday, February 13, 2006
More About Wal-Mart
Today's article in the WSJ about Wal-Mart in the DFW area highlights the extraordinary challenge that Wal-Mart presents to grocery stores. The DFW market is the fifth largest in the U.S. Yet, in less than ten years, Wal-Mart has a 32% market share of the grocery business. With 104 stores including 60 supercenters, Wal-Mart employs over 24,000 people in the DFW area. Further, unlike popular perception, Wal-Mart's dominance has not depressed wages.
Although I live in the DFW area, I had no idea of Wal-Mart's size. I had seen the closures of a local Tom Thumb and a Minyard's further north, but I had attributed both closures to the growing presence of Whole Foods. Clearly, I had misattributed these seismic shifts in grocer trends, mistaking my own spending habits for those of others. It is almost unbelievable that Wal-Mart can roll over HEB, Tom Thumb, Kroger and Albertson's as easily as it used to roll over the mom-and-pop stores in small communities.
Although I live in the DFW area, I had no idea of Wal-Mart's size. I had seen the closures of a local Tom Thumb and a Minyard's further north, but I had attributed both closures to the growing presence of Whole Foods. Clearly, I had misattributed these seismic shifts in grocer trends, mistaking my own spending habits for those of others. It is almost unbelievable that Wal-Mart can roll over HEB, Tom Thumb, Kroger and Albertson's as easily as it used to roll over the mom-and-pop stores in small communities.
Thursday, February 9, 2006
Where Do the Big Fines Go?
Today's WSJ announced that AIG will pay $1.6 billion for alleged accounting improprieties. This settlement will be the largest in U.S. history for a single company. The settlement will be divided between the SEC and New York authorities. What will happen with the money?
The SEC will receive $800 million, of which $700 million is disgorgement and $100 million is penalties. This money will "go to a fund designed to compensate investors who may have been injured or misled." Huh?
AIG's "alleged accounting improprieties" caused the earnings of the company to be smoother, but did not misstate the value of the company. So how are these "injured or misled" investors to be identified? How do they prove that they were "misled?" Is their investment incompetence alone adequate proof of injury? (This reminds me of the person injured by McDonald's for spilling coffee on himself.)
Next, about $375 million will go to AIG policyholders who may have been injured by the alleged bid-rigging in commercial insurance contracts. Huh? How does AIG's "alleged accounting improprieties" translate to paying their clients this vast sum? If my dry cleaners had false accounting that provided them with cheaper rent, should I get my shirts cleaned for free?
Then, about $344 million "is expected to be paid to state workers' compensation funds." Authorities allege that AIG short changed these funds in the 1990s. Rhode Island will get $100 million. Huh? So the poorly state run workers' compensation funds get replenishment for the mere allegation against AIG? What does state incompetence have to do with "alleged accounting improprieties?"
The remaining $81 million "will constitute fines." Where does it go? The Spitzer sue-more-companies and get elected-to-some-office fund?
The more I review this process, the more I admire Hank Greenberg's backbone for fighting these charges in court. If he had put directors on his board with similar backbone, AIG probably wouldn't be paying this ranson. Further, if these allegations were accurate (which is arguable), the resulting funds ought to be dedicated to strengthening accounting practices in the insurance industry and funding appropriate supervision.
The SEC will receive $800 million, of which $700 million is disgorgement and $100 million is penalties. This money will "go to a fund designed to compensate investors who may have been injured or misled." Huh?
AIG's "alleged accounting improprieties" caused the earnings of the company to be smoother, but did not misstate the value of the company. So how are these "injured or misled" investors to be identified? How do they prove that they were "misled?" Is their investment incompetence alone adequate proof of injury? (This reminds me of the person injured by McDonald's for spilling coffee on himself.)
Next, about $375 million will go to AIG policyholders who may have been injured by the alleged bid-rigging in commercial insurance contracts. Huh? How does AIG's "alleged accounting improprieties" translate to paying their clients this vast sum? If my dry cleaners had false accounting that provided them with cheaper rent, should I get my shirts cleaned for free?
Then, about $344 million "is expected to be paid to state workers' compensation funds." Authorities allege that AIG short changed these funds in the 1990s. Rhode Island will get $100 million. Huh? So the poorly state run workers' compensation funds get replenishment for the mere allegation against AIG? What does state incompetence have to do with "alleged accounting improprieties?"
The remaining $81 million "will constitute fines." Where does it go? The Spitzer sue-more-companies and get elected-to-some-office fund?
The more I review this process, the more I admire Hank Greenberg's backbone for fighting these charges in court. If he had put directors on his board with similar backbone, AIG probably wouldn't be paying this ranson. Further, if these allegations were accurate (which is arguable), the resulting funds ought to be dedicated to strengthening accounting practices in the insurance industry and funding appropriate supervision.
Wednesday, February 8, 2006
Buffett's Prescription for Managers
With wonderful simplicity, Warren Buffett outlined his approach to his managers in the BRK 1998 annual report. He tells them to 1) act as if the division is 100% theirs, 2) view it as the only asset that they or their family have or will ever have, and 3) view that it will not be sold for at least a century or so. This long term thinking can be applied profitably to almost every area of our lives and seems especially productive for investing.
Saturday, February 4, 2006
Technology Trends
In a recent presentation to students of the Stanford School of Business, Mary Meeker (Morgan Stanley, analyst) shared two overarching themes: 1) technology has recovered post 2000 meltdown and 2) the U.S. won't lead this time.
In support of her first thesis is the following startling pattern: the leading market capitalization of the top 5 global internet companies: was $ 2B of market value at pre-2000 IPO prices, $178B of market value at the Nasdaq peak (3/10/00), $ 32B of market value at the Nasdaq trough (10/9/02) and $262B of market value as of the presentation (11/11/05).
In support of her second thesis are the following facts. South Korea is the leading provider of broadband in the world with over 70% penetration. Denmark has VoIP minutes which are larger than landline minutes. The U.S. graduates 76,000 engineers annually compared to 1,007,000 globally (with China at 352,000). The U.S. corporations, in the latest study, spend more on tort litigation than on research and development (205B vs. 184B).
While her themes are arguable, her basic information is significant. I believe that technology market values are part of the broad bubble generated by low interest rates and high hopes. I also believe that the lower technology adoption rates in the U.S. reflect the presence of more defined structural development - giving rise to much of the tort litigation costs.
In support of her first thesis is the following startling pattern: the leading market capitalization of the top 5 global internet companies: was $ 2B of market value at pre-2000 IPO prices, $178B of market value at the Nasdaq peak (3/10/00), $ 32B of market value at the Nasdaq trough (10/9/02) and $262B of market value as of the presentation (11/11/05).
In support of her second thesis are the following facts. South Korea is the leading provider of broadband in the world with over 70% penetration. Denmark has VoIP minutes which are larger than landline minutes. The U.S. graduates 76,000 engineers annually compared to 1,007,000 globally (with China at 352,000). The U.S. corporations, in the latest study, spend more on tort litigation than on research and development (205B vs. 184B).
While her themes are arguable, her basic information is significant. I believe that technology market values are part of the broad bubble generated by low interest rates and high hopes. I also believe that the lower technology adoption rates in the U.S. reflect the presence of more defined structural development - giving rise to much of the tort litigation costs.
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