(Editor’s note: This is the first in a continuing series of articles that seeks to unearth “the metrics behind the metrics.” Rather than cover the numbers that most concern the broad range of finance chiefs — earnings or p/e ratios, for instance — each story will discuss the unique financial gauges most on the minds of CFOs within a given industry.)

When CFOs in the pharmaceutical industry discuss what’s unique about the way they look at finance, invariably the conversation turns to “the pipeline.”

The intricate and lengthy process of bringing a new drug to market puts a distinctive strain on those companies’ economic resources. The process starts with efforts to discover the molecular basis for a new drug, followed by lab and animal tests. Then the company must get the OK from the Food and Drug Administration to enter the drug into clinical trials, perform and analyze a long battery of tests on humans, and win final regulatory approval to market it. End to end, this process averages roughly 14 years.

Even for those drugs that reach the human-testing stage, about three-quarters don’t make it all the way through. In short, the risks of developing a product in the pharmaceutical business are unlike those in any other industry.

One overriding result is that senior finance executives who work in this sector, especially at smaller companies, seem to focus more on corporate potential and less on its quarterly and annual results than do their peers in other industries.

Take the example of Xanthus Pharmaceuticals, a “pre-IPO” company that has licensed three small molecules it hopes to hatch into marketable cures for various types of cancer. Chief financial officer John McCarthy says his approach is one of “strategic finance, instead of operational finance,” and that product-oriented metrics — like the costs involved in helping a drug to clear regulatory hurdles — are “much more important than absolute expenditures or earnings per share.”

The story is similar at Myogen Inc., a Nasdaq-traded company specializing in cardiovascular treatments. When senior vice president of finance and CFO Joseph Turner thinks of financial reporting, the first measurements that spring to mind are current cash balance, cash spent in the company’s most recent period, and the nature and duration of future projects. “What you won’t find is revenue, net loss, net loss per share,” says Turner. “Those fall away.”

To be sure, many such small companies have little or nothing in the way of sales to think about, relying as they do on the capital markets and on grants from organizations like the National Cancer Institute. “Revenues are something we aspire to,” jokes McCarthy. Large pharmaceutical companies, on the other hand, tend to rake in huge amounts of revenue, and their finance chiefs are as focused on managing the top line as are CFOs at large.

But CFOs at the bigger drug companies also have much in common with their small-company brethren, including the need to assess the prospects of medications that may be many years away from the drugstore or hospital. At pharmaceutical giant Wyeth, for instance, between 15 and 20 percent of pretax income goes into research and development, according to chief financial officer Kenneth Martin. Nurturing a specific product from the idea phase to FDA approval costs an additional $500 million to $800 million, according to industry CFOs.

Those expenditures don’t come with a guarantee. Far from it: According to a study of 3,000 drugs by NERA Economic Consulting, the average drug has just a 26.4 percent chance of successfully completing clinical trials and reaching the market. And the uncertainty can last a long time: an average of 96.6 months, or eight-and-a-half years, from the start of a drug’s clinical trials to its arrival on the market, reported NERA.

Accordingly, pharmaceutical-company strategists must continually introduce experimental drugs into the pipeline, even as others pass or fail at later phases of the process. During 2004, Wyeth’s pharmaceuticals division — the company also has units producing over-the counter-drugs and animal-health-care products — entered 12 new compounds into development for the fourth year in a row.

To assess the effectiveness of Wyeth’s R&D outlays, Martin scans a variety of measures, including the number and kinds of exploratory studies being performed and which products have cleared which regulatory hurdles. A company whose pipeline is too empty, he says, might consider licensing additional projects spawned by institutes or small companies. Fortunately for Wyeth, however, the company has “projects in search of funding dollars, as opposed to dollars searching for projects,” says Martin. “You can’t have too many projects.”

Trials of the Clinic

Typically, the pharmaceutical pipeline starts with the discovery of a promising compound or molecule and then progresses through a series of laboratory, in vitro, and animal tests. The preclinical testing period lasts about six years, according to Merck & Co.’s most recent annual report.

For Xanthus’s McCarthy, deciding which projects get the green light to begin clinical trials is the most exciting part of the process. At this early stage, his concerns have “less to do with financial productivity than clinical program productivity”; later, he adds, the work is more about “managing to your budget, the day-to-day management of trials.”

Budget management can have challenges of its own. For Russell Skibsted, CFO of Hana Biosciences Inc., a small-cap biopharmaceutical company focusing on cancer treatment, the most significant metric is “cash flow, especially as it relates to clinical trials.” When a company begins testing a drug on humans, it heads into a much higher cost bracket, he adds.

Hana Biosciences has three compounds in clinical trials, each with its own cash-flow schedule related to a range of considerations, including the amount of drug that must be manufactured and the cost of recruiting, treating, and caring for the individuals who take part in the trial. Before each trial phase, Skibsted estimates the number of patients who will participate and the associated cost, and he continually monitors the trial status of each product to help inform Hana’s plans for raising capital. “If patients accrue faster than we expect, we’ll [need to] be accruing cash faster…and vice versa,” he says. Hana expects to take its first product to market in 2007.

To win final FDA approval, a drug must complete three trial phases, according to ClinicalTrials.gov, a website developed by the National Institutes of Health in collaboration with the FDA. In the first phase, researchers test a drug on a small group — 20 to 80 people — to determine a safe dosage range and possible side effects. Even though the first phase is focused entirely on safety, finance chiefs often can get some idea of whether the drug actually works, according to Skibsted; that information can factor into overall budgeting decisions.

The second phase, which focuses on the drug’s effectiveness and further confirms its safety, typically involves 100 to 300 people. In the third and by far the costliest phase, the drug is administered to 1,000 to 3,000 people to confirm its effectiveness, monitor its side effects, compare it to frequently used treatments, and cull other information that will enable its safe use. (In a fourth phase, after the drug goes on the market, researchers gather additional facts about risks, benefits, and best ways to use the drug.)

Besides patient-related costs, clinical trials may include the fees paid to an outsourced provider of clinical trials services, as well as the costs of mixing medicines, managing data, and much more, according to Skibsted. (See chart.)

For a small, revenue-less company like Hana, it’s important to hold the line on such costs, notes Skibsted, since booking a profit as soon as possible is a high priority. At least as important, however, is developing the value of the company’s products in the eyes of investors. Companies that are talking to Wall Street all make projections about their future, he says, “but in pharmaceuticals, we really have to talk about the prospects of the company.”

The Fate of the Reception
At the same time, the CFO of even the most research-oriented drug company, large or small, must mull how the marketplace will ultimately take to its products.

At Wyeth, Martin continually pores over syndicated data to find out how many prescriptions U.S. physicians are writing for the drug company’s key products in the last week, in the last eight weeks, and in the year to date. Those prescription trends are the best predictor of Wyeth’s performance, he maintains. “If prescriptions are going faster, sales will go faster,” says Martin; “if prescriptions are going down, sooner or later sales will go down.”

That prescription data can be quite specific. At Cary, North Carolina-based Cornerstone BioPharma Inc.— which develops pain and respiratory medications and an antibiotic, which have already been licensed by the FDA — chief financial officer Alastair McEwan examines the reasons the company’s drugs are prescribed and the kinds of doctors who are more likely to put pen to prescription pad.

The link between prescription data and corporate revenue, however, is less direct for McEwan than for many of his large-company peers. Cornerstone doesn’t sell straight to pharmacies or the public; instead it generates its revenues through storage companies that themselves keep track of prescription data, make their inventory requests accordingly, then buy Cornerstone products and ship them to drug stores.

That sort of roundabout sales path can wreak havoc on an income statement. “You could have the silly situation [in which] we could have a million prescriptions for our drugs and then have no revenue for that month because our products had already been shipped to the pharmacy,” says McEwan.

To help avoid such possibilities, McEwan compares how much of a product is in the delivery channel with how much is being prescribed. Of course, he adds, Cornerstone also keeps tabs on the shelf life of medications that have been shipped so “we can swap them out” if they expire.

Further, the finance chief factors those measurements into his short-term cash forecasting and medium-term strategic predictions. Without such marketplace data, financial predictions “drift away from reality,” he says, noting that “a substantial disconnect between prescribing and revenue” data can result.

If a company is unaware that more doctors are prescribing its drugs than it predicted, the company might stint on inventory, and if such a scarcity persisted, doctors and patients might seek other cures, McEwan notes. That “can permanently damage that product’s future.”

Most finance executives in the pharmaceutical industry would probably agree, however, that the greatest financial risks arise long before products become warehouse inventory. Indeed, what most sets drug companies apart “is the exposure to development failure,” says McEwan.

Despite the huge costs of producing a new drug, he observes, companies don’t know until the conclusion of clinical trials whether it will make it to market. And even if it does, if the drug isn’t used by significant numbers of patients for significant periods of time, it won’t succeed — and even then it might turn out to be unsafe. “I don’t think any other industry is in the same position,” he adds.