FOOL ON THE HILL
How AIDS Threatens Drug Makers

That drug companies will allow South Africa to purchase AIDS treatments at greatly reduced prices amounts to an admirable humanitarian act. But it also opens the door for price and profit erosion worldwide, which could in turn damage the companies' ability to fund needed research and development. Pharmaceuticals investors should watch this story closely.

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By Whitney Tilson
April 24, 2001

Last Thursday, a group of 39 pharmaceutical companies dropped a lawsuit filed against the South African government in 1998, seeking to overturn a law that, among other things, allowed the government to purchase brand-name drugs at the lowest prices available anywhere in the world -- even from countries that are violating the companies' patents.

This decision and many related developments over the past few months are fantastic news for developing countries and their millions of citizens who are dying of AIDS and other diseases because they cannot afford the drugs to treat them. But these developments also pose enormous risks to the future profitability of drug companies, which is one of the reasons why I no longer hold any stocks in this sector.

AIDS in Africa
The entire continent of Africa is being wiped out by AIDS, and very few people seem to know or care. To understand what's happening, I urge you to read a shocking, sobering article that appeared in Fortune last November, Death of a Continent. Here is an excerpt:

"The HIV/AIDS epidemic moving through Africa is unlike any plague the world has ever seen. It is bigger: More than 25 million Africans have already contracted the virus that will kill them within a decade; millions more will die in decades to come. It is crueler: Most epidemics decimate a population with frightening but merciful swiftness. This one travels in slow motion, hiding in its victims for years before they die slowly and painfully -- but spreading all the while. And it is wreaking economic devastation in ways that epidemics rarely do, by attacking not the weak, the young, and the elderly, like most plagues, but killing off the most productive people in Africa: the well educated, the prosperous, the powerful, the parents of young children."

To better personalize this, let me introduce Kebede, who works full-time for my parents in Ethiopia, taking care of their horses. (He has the same job as Derege, who I discussed in last week's column.) Like Derege, Kebede is an intelligent, warm and hard-working person.

According to my mom, Kebede fell deeply in love with a young woman named Aster and married her a few years ago. Despite a combined income of less than $2 per day, they were very happy and were expecting their first child a year ago. But Aster had become infected with HIV long ago and, lacking treatment, developed AIDS. As her immune system weakened, she caught tuberculosis and started coughing and losing weight. Within two months, Aster and the unborn baby died. (Remarkably, Kebede is free of the disease.)

With death from AIDS, starvation and the like so common in Ethiopia and other African countries, you might think that people have become hardened to it, but that's not the case. Just thinking of my mom's description of Kebede's anguished howls of grief at his wife's funeral and his subsequent depression breaks my heart.

The African perspective on AIDS drugs
Imagine for a moment that 50 million Americans were infected with HIV and that the only drugs to treat the disease were made by Japanese pharmaceutical companies that charged so high a price that only a tiny fraction of infected Americans could afford treatment. The U.S. could try to reduce the cost by manufacturing generic versions of the drugs domestically or importing them from lower-cost countries, but then the Japanese companies and government would withdraw U.S. investments and apply global trade sanctions. Until quite recently, this analogy described the situation in Africa.

To their credit -- albeit under tremendous pressure -- the pharmaceutical companies, even before last week's capitulation, had slashed prices of their drugs in developing countries and made other major concessions. What I didn't understand until recently was why the drug companies had engaged in this battle at all. In terms of public relations, they've appeared positively evil -- they even sued Nelson Mandela, which has to qualify as one of the dumbest PR moves in history -- and for what reason? It's not as if Africa is a big market. According to IMS Health, more than 90% of the $3.8 billion in worldwide sales of AIDS medicines last year were in just five countries: the U.S., France, Italy, Germany, and Britain.

The executives at the leading drug companies aren't evil. They're simply terrified of the slippery slope that they're now on, and the ultimate implications for their companies' future profits.

The dangers to pharmaceutical companies
Over the years, pharmaceutical companies have fought quite successfully around the world to protect their patents, which has resulted in an ability to set very high prices. But the overwhelming AIDS tragedy in Africa and the pressure on the drug manufacturers has triggered previously unthinkable concessions.

Last December, Pfizer (NYSE: PFE) agreed to give away its antifungal drug, Diflucan, to certain AIDS patients in South Africa. (A daily dose typically costs $10.) Last month, Merck (NYSE: MRK) agreed to slash the price of its AIDS drug, Crixivan, to a "no profit" price of $600 per year (vs. a wholesale price of $6,016 in the U.S.).

And by dropping their suit in South Africa, opening the door for that country to import illegally produced generic versions of their patent-protected drugs, the drug companies are taking a major step back -- at least in this case -- from previous efforts to enforce patents worldwide.

If the concessions were limited to South Africa, or even to all Africa, and to AIDS only, the impact on drug companies would be immaterial. But now that the walls of the fortress have been breached, can the consequences be contained? Why won't drug companies soon feel pressure to cut prices on drugs to treat tuberculosis and a host of other terrible diseases? And what about the billions of poor people outside of Africa?

Other developing countries are already clamoring for similar concessions as those made in Africa. And what about needy people in the U.S. and other rich countries? To the dismay of drug companies, advocates for AIDS patients and for the poor and elderly in the U.S. are using the cost data that companies have revealed in Africa -- previously among the most closely guarded secrets -- to accuse the companies of price gouging and call for lower drug prices.

Where will it stop? Opponents of the drug companies may hope that it doesn't, but for all of our sakes, I hope it stops at some reasonable point. High profits -- exactly how high is open to debate -- are necessary to fund drug companies' enormous R&D spending ($26.4 billion last year), which yields new drugs everyone benefits from. (For more on the drug business, visit the Fool's InDepth: Pharmaceuticals page.)

Conclusion
The profitability of the pharmaceutical industry depends almost entirely on charging high prices in the major industrialized countries -- especially the United States. The developments noted above in Third-World countries will not have a meaningful direct impact on the industry's profitability since sales and price levels are so low in these countries, but should the trends now being established spread to the most developed countries, the impact on industry profits could be severe.

How severe? One expert, Dr. Patricia Danzon, testified last June before a U.S. Senate committee that "if prices are suppressed to the level of country-specific short run marginal cost in all countries, the revenue shortfall could be as high as 50-70 percent of the total cost of bringing new pharmaceuticals to market." I don't think an extreme scenario such as this one is likely, but it's a scary thought nevertheless for pharmaceutical companies and their shareholders.

While I no longer own any drug stocks, I wouldn't argue with you if you were hanging on to these stocks, as the threats I've outlined will take time to develop.  I suggest, however, that you keep a very close eye on these matters.

-- Whitney Tilson

P.S. -- I wasn't sure how readers would respond to last week's column about my experiences in Ethiopia, which really didn't have much to do with investing. I was truly touched by the overwhelming, positive response. Dozens of people inquired about making donations (please email me if you'd like information). One wrote to donate wheelchairs to the Cheshire Home, and another -- a recently retired urologist with experience repairing fistulas -- wrote to the Fistula Hospital with an offer to go to Ethiopia to volunteer his services. My faith in the inherent goodness and generosity of Americans has been reinforced immeasurably. Thank you!

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com.