If you've ever wondered why drugmakers run Phase I-II or II B clinical trials, how drugmakers like AbbVie (NYSE:ABBV) plan on keeping generic drugmakers at bay after their patents expire, or why pharmacy retailers like Walgreens Boots Alliance (NASDAQ:WBA) and CVS Health (NYSE:CVS) aren't making more money off aging baby boomers, you're not alone.

Listeners to The Motley Fool's Industry Focus: Healthcare podcast asked those exact questions, and in today's show, analyst Kristine Harjes and contributor Todd Campbell answer them. The two explain how interim clinical trials can save drugmakers money, how drugmakers use the court system protect billions of dollars in sales, and why falling generic drug prices are creating headwinds for retail pharmacy chains.

A full transcript follows the video.

This video was recorded on Sept. 20, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your Healthcare show host, Kristine Harjes. This episode was pre-recorded in late August and is scheduled for release on September 20th, at which point I will be in route to Greece. Calling in today to Fool HQ for a mailbag episode is healthcare investor, Todd Campbell. Ready to answer some listener questions, Todd?

Todd Campbell: Take me with you to Greece! Take me with you to Greece!

Harjes: You could, we're clearing the schedule for the whole week.

Campbell: What a great time! It's going to be a fun episode today. We're going to get a chance to directly answer back some questions that got thrown out to us. That's always a lot of fun.

Harjes: I think between the different show hosts here at Industry Focus, we all have slightly different styles of responding to questions. I tend to respond via email right away. Ask a question and I will either email Todd, like, "What do you think about this?" Or I'll come up with my own answer. But, I know some of the other show hosts prefer to compile them into entire episodes where they answer it live on the air. So, that's what we're going to do today. Hopefully it will get the people that wrote in the answers that they need, and maybe even encourage some more questions.

Campbell: Yeah. And, you have to imagine that if one person is asking the question, there are probably a few others who want to know the answer as well, right?

Harjes: That's what they always told me in school. There are no dumb questions, and if you're thinking it, everybody else is thinking it, too. I don't know if that's quite true, but that's what they told me. Anyway, one of our listeners named Brian wrote in, and he asked us, "How/why do companies do Phase I B or phase I-II studies?" What he's referencing here is, we talk about all the time on the show Phase I, Phase II, Phase III clinical trials to get a drug from being discovered all the way through to having the FDA say, "Yep, you are good to go, you can sell this to actual people for use." It doesn't actually always go in that specific order. Sometimes you get weird trials like these Phase I B or II B or phase I-II trial. What Brian was wondering overall was, why would a company choose to not go by the standard Phase I, Phase II, Phase III, submit?

Campbell: We're seeing a lot more of these, which probably prompted this question. It seems like we're getting a lot more of these, "In Phase I-II," or, "In Phase II B," or whatever. It's not like it's something that's so rare that you're never going to see it as a biotech or biopharma investor. I think it's an important question to answer. Probably the easiest way to explain it would be, if I told you, Kristine, to go to a certain location in your car but I didn't give you a map and you didn't have your GPS, it will be kind of hard to figure out if you really are on the right path to get there. What Phase I and II trials and II B trials do is they allow you to course-correct. Rather than going through all of the massive expense that is associated in jumping straight from a Phase I to a Phase II, and from a Phase II to a Phase III, you can then say, "I want to explore something before I spend all that money in Phase II, and make sure that I'm actually on the right track before I commit to a full study." Does that make sense to you?

Harjes: Yeah, absolutely. When you think about the differences in scale between the three different traditional phases, it's huge. It's orders of magnitude more people involved, it'll take more time, it costs more money to run the larger, later stage trials. So, I completely understand why one might want to course correct along the way. When you think about the intention behind some of the earlier stage trials, they're just to establish proof of concept, make sure that it's safe and you're seeing, not even efficacy. At that point, Phase I especially, you're really just focused on safety.

Campbell: Yeah, dose and safety, Kristine. Phase I and Phase II, dose and safety.

Harjes: Yeah, and it's entirely possible that you get all the way through Phase II and you're still not really convinced that this drug has the efficacy that you think it has. So, I can see how if I were a drug developer, I would be at the end of Phase II, I would be staring down my options, I'm looking at Phase III, I know it's going to be expensive. Maybe I don't have any positive cash flow yet so far, so I'm trying to keep costs to a minimum, at least not plunge into the deep end right away with a giant Phase III. That's when you might want to run a Phase II B trial. It's somewhere in between a Phase II and a Phase III, it's not quite as large and expensive as the Phase III, but it can allow you to make sure that you really have a promising drug candidate before you move forward.

Campbell: Right. I think to help put that in perspective a little more, research and development budgets have been under pressure for a decade now. You've had some pretty high-profile patent expirations that have hit the industry over the course of the last decade. And as a result, companies have gotten a lot more selective in what compounds they want to bring all the way through the clinic. The more that they can hone their process and their practice, the more that they can figure out what exact specific patient population, indication, etc. they should be targeting, the more likely it is that the R&D spending is going to translate into an actual approved, commercialized drug that's generating revenue. Just to put the expenses in a little bit more context for listeners, the average costs of enrolling a patient in a Phase II study is about $19,000. In a Phase III study, it's $26,000. So, significantly more per patient. And then you think about the fact that, Phase II trials, maybe they're only enrolling, what, 40 to 100 patients, something like that? Phase III trials will enroll hundreds of patients. And depending on the indication, they can enroll thousands of patients. These trials can end up costing, in Phase III, upwards of hundreds of millions of dollars into the billion-dollar range depending on what you're talking about and how many Phase III trials have to be studied. So, it makes sense to improve the odds of success. And that's especially important in indications like cancer, for example, where you'll definitely see a lot more of this Phase I-II stuff and this Phase II B stuff, and Alzheimer's disease, because those indications have such incredibly high failure rates already. So, anything you can do to improve those failure rates is a good thing.

Harjes: Yeah. So, some of these strategies that these companies can take when they go into Phase III, if they have more and more data behind them that they've already found, you can tweak your endpoints to say, "Oh, I'm going to use this very specific way of gauging mental function in Alzheimer's," or something like that, or you can also tweak the patient populations, where maybe in oncology, you know that if a tumor expresses in a certain way, it's more likely that this drug will have an effect, therefore when I go to enroll for Phase III, I'm going to actively select for patients that have the greatest chance of success.

Campbell: Yeah. There's so much information now. Thanks to technology, we can now record and analyze all the data from the trials that have been going on since 2000. And the more data points you get within your data series, the more useful the information or the output is in doing that analysis. So, these companies are getting smarter and smarter and smarter about figuring out, will this drug work in a broad patient population? If so, I'll go ahead with a full Phase III. Or, will it work in a limited patient population, so I'll do an exploratory Phase II B trial that I can still reference back to when I do my filing, and that may save me some money in having to do two Phase III trials, depending on what the FDA wants to see. So, I think from an investment standpoint, although having more trials sounds like, "This is going to increase total costs," the amount of money that you save by not running a trial that's going to be likely to fail more than offsets that. So, I think investors should review that as a good thing. And then, of course, keep it all in perspective because, even if you succeed in a Phase I-II trial or a Phase II B trial, yes it may improve the odds, but you still have failure rates that are so high across clinical trials that you need to still have a healthy dose of skepticism when approaching any clinical stage company.

Harjes: Yeah, absolutely. Brian's email also had a question for us about the creative ways in which drug makers can extend their drugs' patent lives. Todd, do you want to hit on that a little bit?

Campbell: I think many people probably already know that if you have a patent, it's going to protect you for about 20 years. The problem is, with drug development, is that you're filing that patent as you're doing the clinical-stage work, and that clinical-stage work can take years and years off of your patent period. So, you end up with a commercial drug that only has patent protection for maybe 7-10 years. And, obviously, that's not nearly as good as 20 years, especially when you consider that at the end of the patent life, you're going to face competition from generic drugs that are going to be priced as much as 80% or 90% less than the price that you were charging for your reference drug. So, I think more and more, companies are looking and trying to find ways to be able to get additional years added on to their patent protection for their drugs. Again, Kristine, to hammer this point home, if you have a $1 billion blockbuster drug, it has paid for itself probably within the first few years. And now it's all pure profit that you're using to fund your other R&D activity. So, every year, every six months, every one month that you extend your protection, that's big money to your bottom line. 

Harjes: To give a specific example of the numbers that we're looking at here, I actually pulled these numbers when I was looking at research for the last question that we just answered, but it's applicable here, so I'm going to share it. For a blockbuster drug, meaning $1 billion in revenue, when you break that down into a calendar year, each day is $2.7 million. I think sometimes it's hard to wrap your brain around just how big $1 billion is. But, if you do the math, that's still well over $1 million. $2.7 million every single day. So, even being able to extend your patent protection by a little bit, that's extremely helpful and extremely profitable. One way that the drug makers can do this is engage the generics in legal battles. There are a ton of different ways that you can do this. Typically, by challenging the generic drug maker when they try to come at you with their own generic formulation of your branded drug, it'll add a good 30-45 months of additional exclusivity.

Campbell: Yeah. And we've seen that. We've talked about AbbVie in the past on this show, and Humira, which is the world's top-selling medicine, and the fact that its patent is expiring, but it's using these other ways to try and maintain its market share in Humira sales over the course of the next few years. Generic companies have to tell the company that holds the patent that they're filing for FDA approval of the generic drug. And the drug maker then has 45 days of getting that notice letter to be able to say, "No, I'm going to challenge this in court." And as you said, between the court challenge and the appeals process, you're adding three to four years of protection to your medicine, which, in the case of a drug like Humira, that's tens of billions of dollars in sales. But, that isn't the only way, obviously, Kristine, that these companies can skirt the threat of generic competition.

Harjes: Oh, not nearly. One of the ones that you see all the time is by creating reformulations of the original drug. For example, a sustained-release formulation. This would be something like Adderall XR.

Campbell: Yeah. The example that I was thinking of was Teva's Copaxone, which is the most commonly prescribed multiple sclerosis drug with $4 billion in sales.

Harjes: And that's a fantastic example, just because Teva relies so heavily on Copaxone. They're mostly a generics company, that's their one big hitter brand-name drug. And as soon as generic competition hits for it, it'll be a huge hit for a company that's already struggling. 

Campbell: Right. So, what they did was to come up with the formulation that can be dosed less frequently, and then they began switching the patients over to it. So, I think by the time that you end up with generics coming out on the market, the majority of patients have already been transferred over to this extended release drug that has much more patent protection. Again, shares up billions of dollars in revenue. We see other examples, too. We see this with Gilead Sciences, what they did recently with reformulating their Viread to make TAF, which is safer. And now, including that in all their combination drugs to extend the patent protection on all of their HIV franchise. We also saw that with Biogen in creating Plegridy, which is a version of Avonex that lasts longer. So, yes, that's a very common way that companies can basically maintain market share and keep those dollars flowing.

Harjes: There's one more that I'll throw out there which is increasing the efficacy of the drug. An example of this is Nexium, it's a heartburn medication, and it's a form of a drug called Prilosec that only has the effective form of the active molecule. It's a lot of heavy duty science to describe exactly what that means, but it's a process known as chiral switching. Kind of interesting stuff. But with all of these different reformulations and maybe a different route of administration, Todd, how did these hold up legally? Is one method of extending the patent more useful than another? What do you think? 

Campbell: Well, manufacturing patents are pretty easily negotiated around by generics. So, I would rank that as being the bottom tier. I would say method of use, probably a little better than that. And then, of course the actual composition would be the strongest. So, the reformulations are probably the strongest way to go for these. You're also seeing combinations, you can also do combination drugs where you take your drug and combine it with another new drug, and that'll extend out your patent protection as well. So, there's a lot of different routes that they can go, and you can argue what that means or doesn't mean for society, if it's a good thing or a bad thing. But, I think from an investment standpoint, you have to know that, especially if you're considering some of these drugs, or buying shares of some of these companies that are making these blockbuster drugs.

Harjes: And as an aside, the composition of matter patent, that's the original, that's the hardest to challenge, that's what people mean when they say the main patent on a drug. Sometimes you'll do a quick search and say, "When does the patent on whatever expire?" And there'll be 50 different patents in there. The one that matters the most is the composition of matter patent. That's the one that Todd was mentioning is the hardest to challenge.

Moving on to our last listener question of the day, a listener named Rich wrote in via the Google form accessible on our Twitter account, @MFIndustryFocus, and said, "Lots of aging Americans and prescriptions, but drugstore stocks seem to be struggling even before Amazon hinted at trying to enter the Rx business. Why can't these drugstores and retail pharmacies grow or at least reward shareholders anymore?"

Campbell: That's a great question. You look at it and, 76 million Baby Boomers undeniably living longer, and therefore requiring more healthcare. How is that not a good thing for companies that are filling their prescription medicines?

Harjes: Absolutely, and there are a ton of different factors going into this situation for these. We're going to leave aside questions about the mergers -- well, I don't want to completely ignore the mergers altogether, but for this very specific example that I'm not going to delve into too much on the show would be Rite Aid. We will put that aside because I feel like we've talked about that a lot on the show recently. But even aside from that specific example, this is a space that's seen a lot of consolidation over the past decade or so.

Campbell: Yeah, CVS and Walgreens are at the Goliaths without a doubt. If you add the two of their market shares together, you would probably end up with 40% or 50% of all filling of drugs at retail pharmacies in the country. So, they're a great proxy to look at in trying to answer this question. I think one of the things that you look at it and say, OK, you have this great demographic tailwind, but you also have to say, wait a minute, there's a disconnect there between that tailwind and what we're actually seeing in the financial results of these companies. If you look at the trailing 12 months and year over year growth for these companies, you'll notice that year over year growth has been kind of range-bound at CVS since 2010, and it's been more than cut in half since 2015. And if you look at the trailing 12-month operating margins for CVS and Walgreens, you'll see that they peaked in 2014, and they've been sliding steadily ever since, and that's because the cost of goods has increased for these companies. So, you've got a tug of war going on. You have all of this demand, because they are indeed feeling more prescriptions, but you have to also recognize that they're facing headwinds tied to how much payers want to pay for these drugs, for example. And that's offsetting a lot of that growth.

Harjes: Exactly. If you're an insurer and you see this trend that more people are feeling their prescriptions for more and more drugs, more expensive drugs, and you're still taking in the same amount in premiums, you're going to push back and try to pay as little as you can for these. And when you look at the entire drug supply chain, there are a lot of players in it, and each one of them wants to take a cut, which really puts a lot of pressure on margins for everyone involved. But since we're specifically talking about the retail pharmacies, that is something that you can see in the financial results.

Campbell: Yeah. If look at Walgreens' most recent quarter, they had an 8.5% increase in prescriptions filled. They filled 255 million prescriptions. But comparable sales at their pharmacies only increased 5.8%. So, again, that disconnect, and that disconnect is due to reimbursement pressure. If you look at generic prices, Kristine, since 2008, they have been steadily declining. Brand name prices have grown. Brand name prices are up 200% since 2008, according to Express Scripts. But generic prices are down 74%. And more and more drugs are being filled with generics. So, as the generic fill rate climbs, and prices are falling, it's creating all these bottom line headwinds.

Harjes: Yeah. What is kind of surprising about the generics versus brand name drug, as far as margins go, when you look at what the pharmacy actually collects in margin, it's much, much higher for generic drugs. And that doesn't seem like it would be the case at first, but it is. The numbers support this. You see margins of about 43% on generic drugs, and yet only 4% on brand name drugs.

Campbell: Right. But if you're selling a generic drug for $10 and a branded drug for $1,000, which would you rather? You're getting rid of your margins, but it's on a smaller --

Harjes: Yeah, but then you also have the volume consideration, where most drugs that are dispensed are generic drugs.

Campbell: 85% of them now, up from less than half of all drugs in 2003.

Harjes: Yeah.

Campbell: I think, Kristine, what you and I are both saying is that the generic drug business is not necessarily a bad thing for pharmacies, because it's still providing growth. And, as you said, it's higher margin. But, because of the price compression that's going on, it is putting a little bit of a cap or a lid on the growth that it might enjoy otherwise. And since we don't know where prices are heading from here, and stocks are forward-looking instruments, that creates some uncertainty for investors. It's probably behind most of the reason that stocks have been a little lackluster.

Harjes: Yeah. So, that's the back of the store pharmacy segment of these companies. There are a couple of other business segments that I feel like we should also touch on. For example, Rich writes in his question that the stocks seemed to be struggling even before Amazon hinted at trying to enter the prescription business. Yes, that is true, but Amazon was a threat to these companies well before that, and that's because these companies also sell things in their physical store. Something that I'm sure listeners of the Tuesday Consumer Goods show know very well, brick-and-mortar retail is struggling quite a bit due to pressures from Amazon and other online retailers.

Campbell: Yeah. They get about 20% of their revenue from other parts of the store. So, any kind of a hit to that, even if it's a couple percent, over a course of billions and billions in revenue, it's going to create one more headwind that they have to overcome. And I think rewards programs help to provide some insulation longer-term. This is still a good business. I think that's an important takeaway. It's a good business. But maybe it's not going to grow as fast as some people thought three or five years ago.

Harjes: That's fair. The last part of the retail pharmacy business that I think we should touch on is the PBM services, the pharmacy benefits management. Do you think that falls into the same category of on the decline as the other business segments do?

Campbell: You mentioned that there's all sorts of different points in the distribution channel, and everybody is getting their cut. So, there has been an argument to say, what if we source directly from the drug maker, rather than drug distributor, rather than through the PBM using them to manage, what if we bring that all in house and do that all ourselves? Is there more cost efficiency there? I think the PBM business is still a good and important business, because you can do things like drive adherence and reduce emergency room visits, and mail order pharmacy is an important component of that. So, again, a very good business. But I don't expect that we're going to see any kind of meaningful margin expansion within that business, either. It's probably going to remain a single-digit margin business as well. 

Harjes: Yeah, that's just the nature of PBM, it's all based on volume and these really tiny margins. Alright, Todd, that wraps up our mailbag episode. Thanks for hanging out with me today and filming that's a little bit ahead of schedule. Listeners, if you have any questions like these for us, you can always reach out at industryfocus@fool.com, that's our email address. We're on Twitter @MFIndustryFocus. And we also have a Facebook group, it's called Motley Fool Podcasts, go ahead and request to join that and we'll approve you and you can be part of our Facebook community as well. 

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Kristine Harjes owns shares of Gilead Sciences. Todd Campbell owns shares of Amazon, Facebook, Gilead Sciences, and Twitter. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Biogen, Facebook, Gilead Sciences, and Twitter. The Motley Fool owns shares of Express Scripts and has the following options: short October 2017 $86 calls on Gilead Sciences. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.