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The high cost of medical care concerns everyone these days, from the President of the United States to the
ordinary citizen. In response, medical care firms and practitioners have taken a number of actions to reduce
costs. The 1990s witnessed the growth of health care management organizations (HMOs), mergers among
hospitals, the growth of for-profit hospitals, and the hiring of managers to run local medical practices.
Another way to hold down health care costs is to use generic drugs rather than the proprietary drugs usually
specified by doctors. Pharmacists frequently ask purchasers if they would like to have their prescriptions
filled with generics, which sell for 20 to 50 percent less than their brand name counterparts. Not only do
consumers win with lower prices, the pharmacists also win—generics usually have wider profit margins than
branded prescription drugs, so that pharmacists make more selling generics.

Where do these generic drugs come from? Some of them are made by well-known pharmaceutical firms, but
most of them are made by companies such as Mylan and Watson Pharmaceuticals, which specialize in
generic and off-patent proprietary medicines. Why would a firm specialize in generics? The most obvious
answer is that lots of consumers want them in order to lower their pharmacy bills. However, the market for
less expensive drugs has also grown because many HMOs and insurance firms want to hold down costs. One
way to do this is to specify that lower-priced pharmaceuticals be used to fill prescriptions. Given these
forces, the market for generics and off-patent pharmaceuticals has grown rapidly. That’s why Hoechst
Marion Roussel, one of the largest pharmaceutical companies in the world, entered the generics market. It
was convinced that the lower-priced segment would explode and wanted to capitalize on the segment’s
growth. Another reason for specializing in generics is the lower cost of operations. Major pharmaceutical
companies spend hundreds of millions of dollars each year promoting their products—primarily through
nationwide sales forces that call on doctors all across the country to convince them to prescribe branded
products. Pharmaceutical sales representatives also leave thousands of samples for doctors to dispense. This
personal selling effort is backed by lots of advertising in medical and trade journals. All this marketing
results in a hefty addition to the cost of branded products.

Watson Pharmaceuticals is typical of many firms that started with limited funding for marketing. By
focusing on the generic and off-patent prescription drugs market, they greatly reduced their marketing
expenses greatly. These firms engage in limited advertising and sell to distributors and drug chains
throughout the country. Their sales forces are more efficient because calls are made not to individual doctors,
but to buying agents who may purchase for many pharmacies located in a large geographic area. Watson not
only clamps down on marketing costs, it also minimizes research and development costs. Drug
manufacturers may take decades to develop a new drug, during which time the firm encounters heavy costs
but no revenues. Then, not all drugs developed in their labs become profitable. By selling generics, which
are basic versions of drugs developed by other manufacturers, Watson capitalizes on existing knowledge to
refine “sure winners.” The first generic offered in a product category usually sells for 60 to 70 percent of the
branded product’s price and captures about 40 to 50 percent of the market. The following, or second wave,
generic products have even lower prices and have less of the market open to them. Fifteen percent of
customers are likely to remain loyal to the branded product, and many pharmacists are not willing to change
from one generic product to another. Most pharmacists would think it foolish to stock two competing
generics, so they often buy from only one generic manufacturer per product category. Thus, to obtain market
share, the second-wave generic has to have a significantly lower price.

The key for the manufacturer of the first-wave generic is to get to market on time and keep its distributors and
chain purchasers happy. Otherwise, buyers might shift to another manufacturer who offers an even cheaper
product. Although generics and off-patent products sell for less, the generics firm does not wish to start a
price war that will reduce margins too much. To prevent customer defections, Watson must back its products
with good service, such as reliable, on-time delivery, and possibly flexible payment terms, such as longer
times to pay or bigger discounts for volume purchases. Another tactic used by Watson is to focus on niches
A niche is a market segment—usually a small one—that can be served adequately by one or a few firms.
Because the niche is too small to support many firms, it normally presents less competition. “Watson has
succeeded historically by rigorously executing its strategy of developing niche products with limited
competition and attractive margins,” comments Dr. Allen Chao, chairman and chief executive officer of
Watson. Watson has strong niche positions in pain relievers, feminine health care, and difficult-to-produce
pharmaceuticals. In September 1996, Watson purchased Oclassen Pharmaceuticals, which specializes in
dermatological products. “The addition of Oclassen Pharmaceuticals to Watson’s business provides Watson
with a developed platform on which to extend its proven strategy into the dermatology market. The market
for dermatological pharmaceuticals is highly fragmented and, as such, is perfectly suited to Watson’s niche
strategy” says Chao.

According to Chao, “Oclassen Pharmaceuticals has been successful with in-licensing compounds, completing
development, and bringing these proprietary products through the clinical regulatory process into the market.
Oclassen has a sales force of over 60 people specializing in the dermatology market segment. It has an
attractive product pipeline that presents near-, medium-, and long-run potential. Oclassen is a key structural
element for Watson in building a significant new business segment in an exciting pharmaceutical niche.”
Watson went on a buying spree in 1996 and 1997, when, in addition to Oclassen, it purchased Royce
Laboratories and the Rugby Group from Hoechst Marion Roussel. Both firms manufacture generic products.
According to Chao, “Royce was particularly attractive to us ... as their business complements our existing
business. This acquisition fits perfectly with our current strategy of focusing on the development, production,
and marketing of difficult-to-produce niche pharmaceuticals.”

This focus on niche positioning has been extremely important to Watson because of the price erosion for
generic drugs in the United States in 1996 and 1997, caused by wholesalers holding bloated inventories and
seeking price reductions. It was pricing problems that drove Hoechst Marion Roussel to sell the Rugby
Group. For Watson, purchase of a generic competitor helps shore up its position in the market. Another way
Watson is shoring up its market position is by entering the branded segment of the market. In late 1996,
Watson received approval to sell its first brand-name product, Microzide, which is used to treat high blood
pressure. The hypertension market in the United States is worth more than $500 million in sales, but market
size is not the only reason Watson is pushing Microzide. “Its significance relates to the fact that it’s their first
branded product,” says Steve Gerber, analyst at Oppenheimer & Co. He estimates potential annual sales for
Watson in the $10 million to $20 million range. Following on the heels of the Microzide approval, Watson
obtained a worldwide license to distribute Dilacor XR for the next four and a half years.

In October 1997, a subsidiary of Watson Pharmaceuticals, Watson Laboratories, entered an agreement with
CoCensys in which Watson Labs acquired the rights to hire approximately 70 sales and marketing personnel
employed by CoCensys Pharmaceuticals’ Sales and Marketing Division and the rights to two co-promotions
agreements. The co-promotions are for Somerset Pharmaceuticals’ Eldepryl (R), used for the treatment of
Parkinson’s disease, and Parke-Davis’ Zarontin (R), used for the treatment of pediatric epilepsy. In Chao’s
view, “As part of our strategy to diversify our revenue base, this acquisition adds an important dimension to
Watson’s existing sales and marketing capability. This sales force will complement both our existing primary
and recently established female health care sales forces, as well as Oclassen’s dermatological sales force….
[It will] be a key component in our expansion and diversification program.”

With Microzide, Dilacor XR, and other branded products acquired through recent purchases, Watson has
decreased its dependence on the price-oriented generic and off-patent markets. In 1993 all of Watson’s
revenue came from generic products; in 1995 only 86 percent came from generics. As Watson has
decreased its dependence on generics, its stock price has risen. In August 1996, before the purchasing
spree, Watson’s stock price was $44; by August 1997, its stock price had risen to $52.31. The firm’s
earnings per share also rose rapidly, from about 40 cents a share to 56 cents. Watson’s market
capitalization (number of stock shares outstanding divided by stock price) now exceeds that of Mylan,
which actually has more prescriptions written on its drugs. Thus, in a sense, Watson has become the
“biggest” generic manufacturer without increasing the number of generics and off-patents it sells.
Although the stock market applauds these moves, some analysts are skeptical. Watson’s strength is in its
ability to perfect formulations developed by others, its attention to cost containment, and its niche
strategy. Although the company has acquired sales reps and marketing personnel through deals with
Oclassen and CoCensys, it does not have strong marketing skills. Its skill at promoting, selling, and
distributing branded products has not been severely tested. Strong firms in the pharmaceuticals industry,
such as Parke-Davis, Glaxo, and Hoechst Marion Roussel, have the capital and marketing resources to
provide such a test.

Questions for Discussion

1. What internal and external factors affect Watson’s pricing?
2. What pricing approach does Watson Pharmaceuticals use? What pricing strategy does it use?
3. What sorts of price adjustments does Watson make? Why are these important?
4. “Watson’s product pricing strategy drives its corporate expansion strategy.” Is this statement true or
false? Why? In your answer, be certain to discuss Watson’s recent purchases.
5. In your opinion, is it wise for Watson to enter the branded segment of the market?

Sources: Don Benson, “Investors, Analysts Upbeat on Watson Pharmaceuticals of Corona, California,”
Knight-Ridder/Tribune Business News, July 14, 1997, p. 714; Don Benson, “Watson Pharmaceuticals Deal to
Expand Generic Line,” Knight-Ridder/Tribune Business News, September 1, 1997, p. 901; Julius Karash,
“Hoechst Marion to Sell Generic Drug Unit to Watson Pharmaceuticals,” Knight-Ridder/Tribune Business
News, August 27, 1997, p. 827; Don McAuliffe, “California-Based Company Expected to Get Go Ahead for
New Drug,” Knight-Ridder/Tribune Business News, October 14, 1996, p. 101; Don McAuliffe, “Watson
Pharmaceuticals Gets Okay to Sell Its First Brand-Name Drug,” Knight-Ridder/Tribune Business News,
December 31, 1996, p. 123; and articles from