Impact of Innovation on Financial Results Impact of Innovation on Financial Results in the Pharmaceutical Industryin the Pharmaceutical Industry

Benjamin JonenBenjamin Jonen

Kevin MabeKevin Mabe

Primary motivation: Exploring relationship between Primary motivation: Exploring relationship between innovation efforts and stock priceinnovation efforts and stock price

Innovation efforts reflected by number of patentsInnovation efforts reflected by number of patents(reason: industry specific problem of reverse innovation)(reason: industry specific problem of reverse innovation)

Granted patent Granted patent Success in the R&D raceSuccess in the R&D race Monopolistic market structure (USA) for a limited timeMonopolistic market structure (USA) for a limited time Expiration allow for generic copycats to enter the marketExpiration allow for generic copycats to enter the market

Stock Price = PV of future profitsStock Price = PV of future profits Approval of patent increases expected future profitsApproval of patent increases expected future profits

Idea: Due to industry peculiarities, patents are significant Idea: Due to industry peculiarities, patents are significant driving force behind stock pricedriving force behind stock price

IntroductionIntroduction

Interpretation of results necessitates basic Interpretation of results necessitates basic understanding of patenting processunderstanding of patenting process

Important fact to notice: Effective patent life does not Important fact to notice: Effective patent life does not begin until 8 years after discovery of compoundbegin until 8 years after discovery of compound

Background InfoBackground Info

HypothesesHypotheses

Hypothesis One: Stock PriceHypothesis One: Stock Pricett = ƒ(Patents = ƒ(Patentst-ht-h)) Granted patents in year ‘t-h’ are primary driver of stock price in ‘t’Granted patents in year ‘t-h’ are primary driver of stock price in ‘t’ Lag ‘h’ should mimic the expected empirical lag seen in industry Lag ‘h’ should mimic the expected empirical lag seen in industry between a patent’s grant and the compound’s introduction to marketbetween a patent’s grant and the compound’s introduction to market Intuition: Enhanced future profits are ensured only after FDA Intuition: Enhanced future profits are ensured only after FDA approval and successful introduction to the marketapproval and successful introduction to the market

Hypothesis Two: R&D IntensityHypothesis Two: R&D Intensitytt = ƒ(Profitability = ƒ(Profitabilityt-1t-1)) R&D expenditures this year should positively correlate with last R&D expenditures this year should positively correlate with last year’s financial performanceyear’s financial performance

Hypothesis Three: Patent GrowthHypothesis Three: Patent Growthtt ≠ ƒ(Patent Growth ≠ ƒ(Patent Growtht-1t-1)) Competitive environment creates difficulty for a firm to maintain Competitive environment creates difficulty for a firm to maintain prolonged innovative growth relative to the industryprolonged innovative growth relative to the industry

DataData

Group of seven major pharmaceutical firmsGroup of seven major pharmaceutical firms Pfizer, Merck, Johnson & Johnson, Bristol-Myers Squibb, Wyeth, Pfizer, Merck, Johnson & Johnson, Bristol-Myers Squibb, Wyeth, Eli Lilly, and Schering-PloughEli Lilly, and Schering-Plough All in top 15 of world industryAll in top 15 of world industry

Count of granted patents by firm, annual,1988 to 2005Count of granted patents by firm, annual,1988 to 2005 Study uses the ratio of granted patents for a firm relative to the Study uses the ratio of granted patents for a firm relative to the arithmetical mean for the group for a given yeararithmetical mean for the group for a given year Data transformation allows for inter-firm comparisonsData transformation allows for inter-firm comparisons

Stock price by firm, annual, 1988 to 2005Stock price by firm, annual, 1988 to 2005 Similar data transformation as patentsSimilar data transformation as patents Mitigates stock bubble effects and measures relative performanceMitigates stock bubble effects and measures relative performance

Data Data (cont.)(cont.)

Measure of commitment to innovation, 1994 to 2005Measure of commitment to innovation, 1994 to 2005 Ratio of R&D expenditures to total annual salesRatio of R&D expenditures to total annual sales

Measure of financial success, 1994 to 2005Measure of financial success, 1994 to 2005 Ratio of profit to total annual sales (profit margin)Ratio of profit to total annual sales (profit margin)

MethodologyMethodology Time series analysisTime series analysis Autocorrelation for a variableAutocorrelation for a variable Cross-correlation between two variablesCross-correlation between two variables

Analysis – Hypothesis OneAnalysis – Hypothesis One

Rise in relative patent grants for Johnson and Johnson between 1993 Rise in relative patent grants for Johnson and Johnson between 1993 and 1998 appears related to surge in relative stock price in the 1990’s.and 1998 appears related to surge in relative stock price in the 1990’s. Six of seven firms show statistically significant cross-correlation at Six of seven firms show statistically significant cross-correlation at lags of seven to nine years, corroborating the empirical time between lags of seven to nine years, corroborating the empirical time between the granting of patents and eventual drug introduction on the marketthe granting of patents and eventual drug introduction on the market Little evidence to reject Hypothesis OneLittle evidence to reject Hypothesis One

Year

Data

200520032001199919971995199319911989

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

JNJ Pat/AvgJNJ Stck/Avg

Variable

Time Series Plot of JNJ Pat/ Avg, JNJ Stck/ AvgTable 2: Cross Correlation values for patent and stock performance

Highest Associated 2nd Highest AssociatedFirm Correlation Lag Correlation LagPfizer 0.267 12 0.185 11Merck 0.343 2 0.190 9J &J 0.347 5 0.308 8Bristol-Myers 0.394 13 0.355 7Wyeth 0.478 5 0.198 8Lilly 0.363 1 0.338 7Schering 0.494 3 0.240 9

Analysis – Hypothesis TwoAnalysis – Hypothesis Two

Johnson and Johnson appears to adjust R&D expenditures based on Johnson and Johnson appears to adjust R&D expenditures based on previous year’s profitabilityprevious year’s profitability Mix of positive and negative cross-correlations for a one-year lag Mix of positive and negative cross-correlations for a one-year lag implies conflicting evidence against supporting Hypothesis Twoimplies conflicting evidence against supporting Hypothesis Two

Year

Data

20032001199919971995199319911989

0.18

0.16

0.14

0.12

0.10

JNJ R&D%JNJ Margin

Variable

Time Series Plot of JNJ R&D% , JNJ MarginTable 3: Cross Correlation values for R&D intensity

Firm CorrelationPfizer 0.285Merck -0.473J &J 0.740Bristol-Myers 0.882Wyeth insufficient dataLilly -0.565Schering -0.111

Analysis – Hypothesis Two Analysis – Hypothesis Two (cont.)(cont.)

Furthermore, the lag associated with the highest cross-correlation for Furthermore, the lag associated with the highest cross-correlation for each firm ranges from -1 to 1 year.each firm ranges from -1 to 1 year. Evidence shows sufficient support to reject Hypothesis TwoEvidence shows sufficient support to reject Hypothesis Two

Table 4: Cross Correlation values for R&D intensity

Firm Correlation LagPfizer 0.585 -1Merck -0.927 0J &J 0.740 1Bristol-Myers 0.882 1WyethLilly -0.565 1Schering -0.530 0

insufficient data

Analysis – Hypothesis ThreeAnalysis – Hypothesis Three

Johnson and Johnson’s patent growth oscillates about a zero mean, Johnson and Johnson’s patent growth oscillates about a zero mean, and doesn’t appear to remain positive or negative for long lagsand doesn’t appear to remain positive or negative for long lags Five of the seven firms show low autocorrelation for a one-year lagFive of the seven firms show low autocorrelation for a one-year lag Mild evidence to uphold Hypothesis ThreeMild evidence to uphold Hypothesis Three

Year

JNJ

Pat

Diff

200520032001199919971995199319911989

0.4

0.3

0.2

0.1

0.0

-0.1

-0.2

-0.3

Time Series Plot of JNJ Pat Diff

Table 5. Autocorrelation values for one-year

lag for first differences of patent performance

relative to the industry

Firm Autocorrelation Value

Pfizer 0.243Merck 0.224J&J 0.065

Bristol-Myers -0.276Wyeth 0.002Lilly 0.380Schering -0.396

ConclusionsConclusions

Hypothesis OneHypothesis One Past innovations positively impact future stock performancePast innovations positively impact future stock performance Lag between granted patents and future stock price movements Lag between granted patents and future stock price movements consistent with the lag between patents and drug introductionconsistent with the lag between patents and drug introduction Implication: Relative patent performance today can be used to Implication: Relative patent performance today can be used to help explain tomorrow’s movements in stock price help explain tomorrow’s movements in stock price

Hypothesis TwoHypothesis Two This year’s profitability does not necessarily drive next year’s This year’s profitability does not necessarily drive next year’s commitment to innovation and R&D intensity in the short runcommitment to innovation and R&D intensity in the short run Low sensitivity of R&D expenditures to profits most likely caused Low sensitivity of R&D expenditures to profits most likely caused by high costs of altering R&D capacity (firms plan years ahead)by high costs of altering R&D capacity (firms plan years ahead) Implication: Exploring the important policy issue of excessive Implication: Exploring the important policy issue of excessive profits in the pharmaceutical industry relies on a larger data set profits in the pharmaceutical industry relies on a larger data set

Conclusions Conclusions (cont.)(cont.)

Hypothesis ThreeHypothesis Three Relative patent growth in one year does not necessarily translate Relative patent growth in one year does not necessarily translate into continued superior performance above the industry averageinto continued superior performance above the industry average Lagging firms have ability to catch up to industry in R&D raceLagging firms have ability to catch up to industry in R&D race Implications: Implications:

Winning the lottery today does not guarantee winning tomorrowWinning the lottery today does not guarantee winning tomorrowFiercely competitive environment implies a pharmaceutical firm must Fiercely competitive environment implies a pharmaceutical firm must continuously fight to innovatecontinuously fight to innovate

OverallOverall Commitment to R&D drives measurable financial rewardCommitment to R&D drives measurable financial reward Link between R&D and profitability not strongly establishedLink between R&D and profitability not strongly established Patent race highly competitive and drives continued innovationPatent race highly competitive and drives continued innovation

Relevance to Industrial OrganizationRelevance to Industrial Organization

R&D race is an important research area in IOR&D race is an important research area in IOStock price (value of a firm) does not react significantly until patent Stock price (value of a firm) does not react significantly until patent is granted and drug is sure to enter the market (i.e. patents are the is granted and drug is sure to enter the market (i.e. patents are the lifeblood of a company)lifeblood of a company) Winning the lottery is random, confirming Oz Shy’s assumption of Winning the lottery is random, confirming Oz Shy’s assumption of model of innovation race which assigns the same probability of model of innovation race which assigns the same probability of discovery for both firms participating in the modeled race discovery for both firms participating in the modeled race

After patent expires, competitors flood the marketAfter patent expires, competitors flood the market Reverse innovation is a cheap way to enter the market: Reverse innovation is a cheap way to enter the market: combination of low sunk costs (low barriers to entry) and initial combination of low sunk costs (low barriers to entry) and initial prices above marginal costprices above marginal cost Patents are important tools to stimulate R&D behaviorPatents are important tools to stimulate R&D behavior

Patent count remains a convenient measure of innovation Patent count remains a convenient measure of innovation in the pharmaceutical industryin the pharmaceutical industry