Traditional Values
Executive Summary
The rise of the large-volume purchaser of health care scared the industry's strategists into hyperactivity, prompting moves-most prominently by Merck, SmithKline and Lilly-into the service business. These services were designed to take pricing pressure off the companies' core businesses by putting the cost of products into a larger context and helping customers save money in other areas; in the process perhaps also creating another revenue stream for the manufacturer.
What a differnce two years can make. In 1994, the medical products industry had embraced a new set of customers: large, financially savvy organizations, whose executives, they believed, would control product-related decision-making for hundreds of thousands, if not millions, of patients. Such customers, technically astute, saw that there were few differences among drugs (or other products) of the same class.
Even where there were differences, they aggressively pushed the notion that no differences existed in order to win price concessions. Looking to save money they would create strict, closed formularies: only those drugs meeting certain price guidelines would be allowed. These customers would commoditize the industry’s products and, leveraging one against the other, wring ever greater discounts from suppliers.
The rise of the large-volume purchaser of health care scared the industry’s strategists into hyperactivity. The most dramatic attempts to combat the discounting cycle were moves—most prominently by Merck, SmithKline and Lilly—into the service business. These services were designed to take pricing pressure off the companies’ core businesses by putting the cost of products into a larger context and helping customers save money in other areas; in the process perhaps also creating another revenue stream for the manufacturer.
“Buy our product from us, at our price,” manufacturers told these big customers, “and we’ll do the work to save you the far greater expense you’ll incur in training people how to use the product, in over-use, in improper use, in ordering and logistics, in convincing payers to pay for it or in buying a more expensive product.”
In effect, their anti-commoditization strategy was to create a set of services which would be so valuable as to make the cost of the product itself irrelevant. They would sell not a product, but a process. Declared Lilly CEO Randall Tobias at the time: “Our customers aren’t buying insulin, but solutions to diseases” (See“The Club of Three,” IN VIVO, July/August 1994).
Two years later, the customer is still, by and large, the physician. The all-powerful managed care customer never really did have the power to enforce closed formularies (he was too busy worrying whether patients would sign up for his plan or whether hospitals would join a competing group).
The most admired pharmaceutical company in 1996 is Pfizer, which dabbled in, and then explicitly rejected, the services approach. Technology-intensive device and biotech companies enjoyed an unprecedented valuation splurge between September ‘95 and June ‘96, raising money at giddy valuations. For all the time and effort Johnson & Johnson put into the launch of its J&J Healthcare Systems supply-chain management business, the company’s impressive financial results came from product successes in its cardiovascular device and pharmaceutical businesses. Pharmaceutical sales forces, a few years ago sharply declining as managed care organizations threatened to make the traditional detail rep obsolete, are now growing again.
Meanwhile, rumors are that Lilly is ready to write-down part of its PCS investment. Acquisition-related costs are still a big drag on the companies earnings.
Nor has Lilly succeeded in finding partners to buy parts of PCS and thus return some of what Lilly paid. Why? Likely because potential partners haven’t seen the value Lilly saw in PCS—particularly after PCS’s failure to dramatically increase the share of Lilly products. In contrast, Pfizer—without a PBM—has dramatically increased its share of the key anti-depressant market, largely through traditional, aggressive detailing. As for SmithKline Beecham: it isn’t talking about its disease management strategy, the genesis of which came with its acquisition of DPS (bought for $2.3 billion in 1994). SB says it needs to keep quiet because the new management at its services unit is still getting a handle on the business. But it’s also clear that DPS, although successful in isolated cases, hasn’t managed to move the market shares of drugs it had promised to move. And the most daring move into services, Zeneca’s acquisition of Salick, remains the most enigmatic.
SmithKline executives would rather talk about promising products in their pipeline. If this sounds like a throwback to the ‘70s, it is. The contrast between the values accorded companies who base their strategies on developing and selling, through apparently traditional means, innovative products and those service businesses acquired by product companies to protect product businesses, couldn’t be more striking. It is as if the marketplace has given a resounding thumbs-down to product company strategies which don’t revolve around products.
Through 1993-94, managed care’s Amen corner, both inside and outside companies like Merck, Lilly and SB, applauded these bold moves as intuitively right for a radically changing marketplace—but never asked for specifics. Originally, these service ventures were merely to increase the sales of drugs. Following the FTC investigation of Lilly’s acquisition of PCS, the yardstick began to wiggle: the acquired service businesses would make money on their own, regardless of whether or not they increased the parent’s pharmaceutical sales.
Ultimately, investors are owed an explanation: how are they to value these investments in services? On what should they measure returns? And when can they assess the success or failure of these investments?
Is the rest of the market right or wrong?