Pharmaceutical Companies inc GlaxoSmithKline Hit By Generic Drugs

We got a lot of email about our claim that Apple’s products somehow indicate a fundamental lack of seriousness in the American economy. Today, since it’s Friday and the markets haven’t crashed yet, let’s take a closer look at the cycles that govern innovation, profitability, competition, and obsolescence.

All prices are governed by cycles. It’s not always what obvious those cycles are. But sometimes it’s painfully obvious. Take drugs (as an example).

Developing a best-selling drug takes billions of dollars and years of research and development. Most new drugs fail. So the winners have to be really big to subsidise all the otherwise unproductive effort.

That’s why drug companies typically get seven years of patent protection on their drugs, to recoup the investment and R&D. After the seven years, the market opens to generics. It’s a tight cycle. Lately, it’s not working so well for big pharmaceutical companies.

“British pharmaceutical giant GlaxoSmithKline (NYSE:GSK) will write down pound sterling 1.5 billion (US$3.4 billion) for restructuring costs during the next four years, as it braces for intensifying generic drug competition and further disappointing sales from its pivotal diabetes treatment, Avandia,” writes Andrew Jack in today’s Australian.

“Avandia and generics were not very good news but there were other positive surprises and we can carry out 'operational excellence' and reinvest intelligently without hurting the future of the company. We are not culling the bones and the muscle,” said Glaxo’s CEO Jean-Pierre Garnier.

Generic diabetes drugs are great for consumers and not so good for the makers of Avandia. In that sense, the drug business isn’t that different from any other. A market with few producers will tend to have higher profit margins. Those margins (and the expiration of patents or intellectual property protection) attract lower-cost producers.

We live in an age where there are more low-cost producers in more industries than ever before. That means, nearly everything you can buy has been getting cheaper in real terms for 50 years. True, some services are more expensive. But this raises an interesting point, if you care to bear with us.

The cheaper something becomes, the more of it is used (generally speaking). Price is not a barrier. Lower prices accelerate the use of an item. This is especially true of resources. But we know what you must be thinking: you can’t use an infinite amount of a finite resource. Eventually, low prices will have to give way to higher prices as scarce resources become scarcer through accelerated demand.

You would get a gold star for that observation. You would also be smarter than fifth grader.

Dan Denning
The Daily Reckoning Australia

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