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California's Drug Demands

Given recent news, it's hard not to think that makers of prescription drugs will face ongoing pressure over the price of their medicines. To maintain profitability levels, companies will have to make changes that should bode well for firms selling services to the sector.

The latest sign of change comes from California, the nation's most populous state, where the government is nearing approval of a plan for heavy-duty state involvement in the drug market. The California Prescription Drug Initiative is designed to provide uninsured, low-income state residents and those with high unreimbursed medical expenses a 40% discount on branded drugs and a 60% discount on generics.

The plan is pretty straightforward: Drugmakers have five years to negotiate a deal with the state to offer discounts. If they don't, they face being locked out of Medi-Cal, the state health-care program for the poor.

The California Prescription Drug Initiative appears to have a good shot at becoming law, since Governor Schwarzenegger and legislative leaders have agreed on it. But even if the measure doesn't pass, the issue isn't likely to go away. Just last year, drugmakers spent $100 million to defeat a ballot proposal that would have forced drug companies to offer discounts immediately, according to Bloomberg.

For pharmaceutical manufacturers, the writing seems to be on the wall. Eventually, they will be forced to offer deeper discounts. How can giants like Pfizer (NYSE: PFE  ) maintain profitability levels when faced with this challenge? The sector has already undergone lots of consolidation, so that doesn't seem likely. Some companies predict greater productivity from their research, but so far, it hasn't materialized. The number of new molecular entities, or totally new drugs, approved by the Food and Drug Administration last year was the lowest since 2002.

The answer appears to be even more cost-cutting and greater outsourcing. That's good news for large outsourcing companies with established client relationships, like Covance (NYSE: CVD  ) and Pharmaceutical Product Development (Nasdaq: PPDI  ) . It also helps explain why a smaller company like Kendle (Nasdaq: KNDL  ) was in rush to expand by buying Charles River's (NYSE: CRL  ) struggling phase 2-4 clinical trials business. As the pressure grows on drugmakers, growth and consolidation in the outsourcing business seem likely.

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Freelance writer Brian Gorman does not own shares in any of the companies mentioned.

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