Finance managers plague the pharmaceutical industry


By guest blogger Daniel Hoffman

Wall Street nearly wrecked the global economy by hiring mathematicians and physicists to design complex models for financial instruments that defied common sense. Now pharma has sought to emulate these Rain Men.  No matter that the folly of running pharma companies by financial management is apparent to people who don't dream in numbers. It now appears other finance-minded types have started to criticize the stewardship of their brethren for an insufficient detachment from reality.  

The trend is not confined to pharma.  Millions of undergraduates have stayed awake at night reading Freakonomics and its sequels.  As evidence of the popularity behind idiot savant management, the Wall Street Journal in its Marketplace section regularly bestows this sort of analysis on some upcoming sports contest to show why one team or another is more effective and should win.  A typical story might claim, "What's not appreciated is the average yards per carry on first down during the first three quarters when the team is not behind in the score."  

Usually these finance riffs are just ad hoc, back of the envelope calculations that usually say very little about how well management is running a company.  In a recent example, an equities advisor took Merck to task for delivering lower margins than a few of its key competitors.  The author compared Merck to Novartis, GlaxoSmithKline and Dr. Reddy's Laboratories on measures of gross margins, operating margins and net margins over the preceding 12 months.  Ok, equity analysts are usually in the business of getting buy-side managers to churn their holdings, but the only ones likely to be impressed by this analysis probably leave the office early to see a reruns of Judge Wapner at four o'clock.
In the first place, gross margin is so far down the list of success factors in pharma, people rarely even consider it.  The very nature of the industry argues against it.  The big money in pharma is spent in development before launch and Selling, General & Administrative Expense (SG&A) afterward, while competitive pricing usually exists within very narrow bands.  This means the relationship between sales revenue and Cost of Goods Sold (COGS) doesn't reveal much of anything.  Furthermore, if a company is spending a bit more than competitors on its manufacturing costs, that's not necessarily bad because it may enable them to avert the kind of meltdown J&J has been going through.

Operating margins and net margins can be more useful but they also have to be examined in context, instead of the experience-free way encouraged by PowerPoint charts.  Does a company have several compounds in late-stage clinicals?  Has it launched several new products within the past 18 months?  Affirmative answers will drive down those margins, but both activities are good things that can propel earnings in the future.

Now some actions by Merck's current management certainly raise questions.  For example, the CEO's drumbeating for the company's cardiovascular compound, voraxapar, raised eyebrows about management's credibility and competence.  His puffing occurred at two investor conferences, just days before Merck was forced to halt a clinical trial and exclude some test patients, thereby jeopardizing the entire voraxapar program.  At the same time, the company's decision to adopt an agency-of-record approach for selecting its business research suppliers clearly indicates that it only wants yes-men.  The latter move was doubtlessly made at the behest of Finance and its myrmidons in Purchasing.  

So criticize a company's management for its actual missteps, not for irrelevant ratios and formulas concocted by nerds who would otherwise be sitting in their parents' basements.  Even Judge Wapner would agree with that.

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