Drug Companies and Their Pricing

There has been considerable angst among the people lately when it comes to drug pricing.  Hedge fund manager Martin Shkreli outraged the world when he raised the price of an AIDS drug produced by Turing Pharmaceuticals, one of his holdings, by 50 times.  $15 to $750 has attracted attention from many sides, one of whom is the US Justice Department.  Shkreli in handcuffs was a popular picture for a while.

The uninformed popular belief is drug companies are evil, profit gouging enterprises with no respect for the people they are supposed to serve.   In economics there is an explanation for why price gouging tactic works.  Some demand is inelastic.  Demand does not fall when you raise the price.

You may noticed that governments have also noticed that fact. Cigarettes, gasoline and alcohol are nearly immune to new taxes.  Coincidence?

But, maybe drug companies are responsible and Mr. Shkreli is not the norm.  Nonetheless, the cost of prescription meds is a driving force in the price of group insurance.  Most employers are seeing year over year increases that far exceed the rate of inflation. 

Some meds  are far more than expensive.

Consider Alexion Pharmaceuticals.  They make a drug called Soliris that deals with Atypical Hemolytic Uremic Syndrome (aHUS) and paroxysmal nocturnal hemoglobinuria (PNH) and no I had never heard of them either.  They are quite rare.   In the one in a half million range.

I discovered Soliris costs about $700,000 per year and does not cure the condition.  Sales are rising.  So what to do?  Be outraged? 

No, look up Alexion and see if it is an investment buy opportunity, of course.

What I learned is that the cost to manufacture Solirius is well less than $70,000 for a course of annual treatment.  Nice margins – over 90%.  Sales grew about 250% in the last three years.  Also delightful.  But net income has only increased by 30% or so.  Cash flow is immensely negative in the 2015 year.  Preparing for growth I suppose.

All in all I think I will wait, even though it is intuitive that a growing company with a gross margin over 90% should be attractive.

Prescription prices would be far lower now or profits far higher if the company spent no money on developing and testing new compounds.  To some extent the idea of lower prices now parallels the problem with socialism.  Distribute what we have now and pay no attention to developing more in the future.

The question becomes, “If a drug that sells for $700,000 per patient per year and sales are growing quickly and there is no excessive profit, and cash flow is negative, how should you price drugs?”

There may be no answer.

Drug companies are forward looking and spend a huge share of their income on R&D.  I like that because someone out there is busily inventing a drug I may need 15 years from now.  But that does not address affordability now.  How do you balance the future with the present?

I like the forward looking approach but others in good conscience could disagree.

I don’t think I want to owns shares in this company and if their business makes little sense, what must I believe about other drug companies.  New drugs are very expensive.  That means the price of the drug component in group plans and government funded plans will rise.  Maybe very quickly.

Responsible employers, plan providers and governments must address the problem with plan design.  Perhaps there are limits to providing a perfect medical world.

Perfect at any cost is a silly game.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com  705-748-5181

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