Perpetuating the pharmaceutical pipeline.

For the past several years, pharmaceutical companies have been merging rapidly in order to cut costs and improve access to markets. In 1998 alone, the value of industry mergers totalled $87 billion, almost eight times as much as in the previous year, and the merger parade has continued into the new century with a very international flavor.

However, while mergers may have allowed companies to gain certain efficiencies, they seem to have fallen short in their promise to create new drugs and improve shareholder value. These developments come at a time when stable revenue streams are being challenged on several fronts. Expensive patents are expiring, and companies are scrambling to replace sales that are being lost to generic drugmakers at home and abroad. Meanwhile, national health care budgets are shrinking in foreign markets, and the structure and functioning of a national drug program in the U.S. is uncertain.

In an exclusive interview, Charles Golden, CFO of Eli Lilly and Co.--the Indianapolis-based maker of the famous anti-depressant drug, Prozac --discusses these and other issues facing the industry and talks about how pharmaceutical companies must proceed to ensure continued growth and profitability.

FE: With the need to continuously step up the development of new drug products to maintain profitability, investors are now starting to wonder whether bigger is necessarily better in the pharmaceutical business. Is consolidation necessarily a good strategy at this time?

GOLDEN: To a great extent, mergers in the past have occurred out of weakness. Companies haven't had a good pipeline of products for the future, so the only way to grow their bottom line was to consolidate, and thereby reduce costs through combination.

However, in my view, the merged companies haven't been as successful as the non-merged companies. In fact, the mergers we've seen thus far in the industry are fairly destructive. It seems to have placed companies at a standstill in terms of innovation and R&D. We [at Lilly] don't want to be a part of it.

This is mainly because it's very hard to combine research and development organizations. It's one thing to rationalize two finance functions. It's a very different thing to rationalize two R&D organizations. I think the important thing is to find a formula for having a highly productive R&D organization so that the [drug development] pipeline continues to be robust. It's very important to remain consistent and maintain and improve that productivity, and consolidation really tends to upset that dynamic.

FE: Research and development of new drugs takes approximately 12 years from the time of inception to the time they're actually in the hands of the customer. How do you improve response times in an industry with such long lead-time requirements?

GOLDEN: What we do is re-analyze our portfolio of products every six months. There are a lot of stages in the drug development pipeline, from very early discovery all the way through to the large, what we call phase 3, clinical trials. Within any one phase, we want the process to be working at its absolute optimum.

We look at hard metrics in each phase. We look at what stage a molecule is in, what its resource intensity is, what the probability of technical success is, and last and most importantly, at the present value of the future income streams we can expect once it's launched. I think one of our advantages as a mid-sized company is that we can do that very efficiently and effectively.

FE: Is it true that the drug development technologies and the changes in methods of selling are changing the economies of scale in the industry?

GOLDEN: As long as you can reach what I refer to as a critical mass, you're okay. We clearly need to invest in new technologies all the time. But if you do it selectively, you don't really need a $7 billion R&D budget. On the other hand, in terms of sales and marketing, there is no doubt that if you add sales forces selectively to support a particular product, you will sell more of that product. We haven't reached that point of diminishing returns yet.

FE: Where can the greatest costs savings come from?

GOLDEN: We spend about 20 percent of our sales on R&D, so it's a large part of our budget--and that percentage is the highest of any pharmaceutical company. What we need to do, and what we have continued to do through the processes that I just mentioned, is to increase productivity. We have to increase the probability of technical success and shorten drug development timelines.

FE: What is an example of a new technology that would help shorten new development time for a drug?

GOLDEN: We have a very innovative concept that we have actually commercialized, called Innocentive. This is essentially using the Internet to invite scientists outside the company to come onto Innocentive's Web site to try to solve clinical and technical R&D problems that we haven't been able to solve internally. If they can solve them, then we reward them financially. In this way, we've been able to access a broad array of scientific expertise, beyond our own scientists. This will give a higher yield on the molecules that we are trying to develop.

FE: How do you maximize the efficiency of processes across over 60 countries?

GOLDEN: When we develop our drug candidates in R&D, we have global processes. We use international product teams that use common processes in clinical trials, no matter where they are being run. To have that uniformity is extremely important. We do the same thing with our IT platforms, and are two-thirds of the way through implementing a company-wide ERP [enterprise resource planning] project. This means that we will be putting everybody on a common software platform for our infrastructure, [and] the business processes will have to be uniform to work off that platform, whether it's HR, finance or the supply chain. That creates a great amount of alignment.

FE: Eli Lilly has been an innovator in the pharmaceutical industry, with the establishment of the brand Prozac as a household name. Can you explain how the role of branding has changed in the drug industry in the past few years and what we can expect to see?

GOLDEN: This is a really interesting area because I think it is changing quite a bit. In the past, the industry hasn't taken full advantage of branding and what that represents with its customers. In the pharmaceutical business, it can be very confusing as to who the customer really is. In other businesses, the customer is typically the person who is consuming your product.

We in the pharmaceutical business view the patient as the customer, but there are also all sorts of interventions in between. The doctor has to prescribe the product, so they have to be a customer; a regulator has to approve it, so [it is] a customer. Also in the mix is a payer, like an insurer, who is not the end consumer, so we have to figure out how to address all the different needs of these various customers. We believe that our brand has to be known to all of those constituencies.

FE: How was Prozac different from other pharmaceutical drugs, and what effect did this have on your ability to establish it as one of, if not THE, best-known prescription drugs in North America?

GOLDEN: t think it really started with having a breakthrough product, and that's exactly what Prozac was. Back in the 1970s, somebody said there is a big unmet medical need for the treatment of depression. When the drug was launched in 1986, there were no drugs that could address depression with a safety and efficacy profile like Prozac. It was first in its class, and it ended up being best in its class right through its patent expiration in 2001.

We started investing in direct consumer advertising in the late 1990s because we realized that depression was still substantially under-treated. However, initially, we had to start with the medical community regarding the recognition of depression. It would be very commonplace for a psychiatrist today to recognize the illness, but it wouldn't have been commonplace back when Prozac was being prepared for launch.

FE: Is there financial life after Prozac?

GOLDEN: If you look back at the history of the pharmaceutical industry, every one of us has gone through a patent expiring, and it's very taxing economically. We're just coming out from under the shadow of the Prozac patent expiration. However, so far this year we've launched three new products, [including] one that is a competitor for Viagra, called Ciallis. Our first-quarter results show that sales increased by 13 percent and our earnings increased, as well.

FE: Is there a way to financially plan for a patent expiration, given that you're not really sure of what kind of success the drug is going to have in the first place?

GOLDEN: It's difficult, but maybe Prozac is a good example to use. We started planning for the expiration of the patent in late 1996. We planned for this financially, knowing what a strain it would have on the company in terms of cash flow and on our income statement. But more importantly, we had an understanding of what we had to do in terms of accelerating products through our pipeline. It took a lot of forward planning.

FE: Pharmaceuticals, like many other companies in the health care sector, are highly dependent upon domestic health policy, both at the state and federal levels. In your opinion, what sort of impact will changes to Medicare have for the future of pharmaceuticals in the U.S.?

GOLDEN: This is very important not only to Lilly, but to the industry in general. The industry wants to see a prescription benefit for seniors in the U.S. Almost every other developed society has something like this, so the U.S. is clearly an outlier. How that occurs is also important, because we believe that patients should have choice about the type of benefit they want. There should be free-market principles that apply to how the benefit is provided and how our products are priced. It is clear that any type of price controls would have a detrimental effect on the investments we would be able to make in new medicines.

FE: What about in Europe, for example, where the funding is being cut for drug programs because of the current economic climate? Is this going to change how you operate in that market?

GOLDEN: Within the nationalized health systems, we have to go in and negotiate a price on our products for each country. We do that quite successfully in the majority of countries. However, as a result of the process, innovation reaches those countries on a much slower basis and will likely continue to do so as funding falls. But, an important fact that is frequently overlooked is that spending on pharmaceuticals represents only a modest percentage of overall health care spending in European countries--and in the U.S., for that matter.

However, it often happens to be one of the fastest-growing portions relative to other types of health care investments, largely driven by greater utilization. In our mind, pharmaceuticals are the most beneficial and cost-effective form of health care, versus something that is more invasive, like an operation. So, it's a matter of getting the whole system under control, not just the relatively small pharmaceutical piece.

In terms of cost-effectiveness, there actually needs to be a shift in resources from more traditional care to pharmaceutical care. Unfortunately, I think that this is a hard thing for national health care systems to do because traditionally, there has been a tremendous amount of sunk [costs] and fixed costs in hospital facilities. I'm hoping that in the U.S., health care policy will look toward health care solutions that are less costly in the long run and provide patients with the highest-quality care. We feel that in many cases, pharmaceuticals will fill this bill.

Ramona Dzinkowski is an economist and award-winning business journalist based in Toronto. She can be reached at rndresearch@/nterhop.net.