Carried Away

Europe "Lagging Further Behind" the U.S. On Drugs R&D

One of the main arguments that is used for science spending crosses all frontiers in the developed world:  Our country/group of countries is falling behind others in a particular science area!  Today's Financial Times has an article (subscription $) falling into this familiar category regarding European prescription drugs R&D.  In my opinion, the argument is nothing more than scaremongering, even if true.  The argument annoys the hell out of me, because it is a rather crude attempt to manipulate base emotions.

By way of background, Americans spend about twice as much as do Europeans for prescription drugs.  Pharmaceutical companies doing business in the US have fat profit margins that they seek to protect by discovering new drugs and patenting them.  In simple terms, if a country spends more on patent drugs, the country will get more R&D on new drugs.  We need not prepare any expensive reports to know that this is cause and effect, although the European Commission presumably spent a lot of money for one that leads with the following argumentation.

The US is increasingly dominating new medicine development at Europe's expense, when measured by labour productivity, influential patent filings, research collaboration and new drug launches, it says.

Recent EU efforts to reduce the gap in "high value-added" pharmaceutical and biotechnology work have been ineffective, Fabio Pammolli, author of the study and professor of economics and management at the University of Florence, told the FT.

With that rhetorical scaffolding, you can see where this is headed.  A tale of continetal woe versus the United States...

Prof Pammolli also calls for greater collaboration and competition between European research institutes. He proposes a shift from work carried out in isolation by companies, to US-style market-driven "virtuous networks" between companies, hospitals and universities.

"The [French] Pasteur Institute co-operates more with the [US] National Institutes of Health than with the [German] Max Planck Institute," he said. At the same time he argues that there should be more EU-wide competitive research funding, rather than member states largely funding their own national facilities.

And...

Based on data in the period 1996-2002, his new findings include: 70 per cent of world drug research and development collaboration originated in the US against 25 per cent in Europe; 70 per cent of "new chemical entities", the basis of innovative medicines, were launched first in the US - normally one to two years ahead of in Europe; More than half of total global patents were registered in the US, and their influence was disproportionate, representing 70 per cent of academic citations.

All of these reported results are obvious before the writing, even if the numbers are unknown.  But the debate would be much better served by raising the most fundamental question in a neutral manner -- i.e., should Europe spend more money on drugs R&D based on the needs and curiosity of the people in Europe?

As an aside, over the last 5 or 10 years, the United States federal government shifted several tens of billions in R&D funding away from defense and aerospace to basic and applied life sciences research at the National Institutes of Health without such scaremongering and with broad political support.  It was done because the life sciences are proving to be fruitful subjects to research right now and our longer human life cycles may benefit disproportionally from this fruit.  This is an argument that is reasoned and relies on the better angels of our intellect.

So should Europe increase spending on drugs?  From this side of the pond, our system is amazingly expensive.  I hesitate to suggest that Europe shift the fantastic sum of 1% to 2% of its economy per annum to patent drugs to be on roughly equal footing with the U.S., considering that the life expectancy in the U.S. is approximately no better (or worse) than that of developed Europe.  Further, Europe is successfully riding the coattails of U.S. research.  Meanwhile, American consumers are shopping in Canada for their drugs.  Is this the system that Europe wants?

A better discussion would focus on the opportunities available.  Are there very many areas in life sciences that currently do not have sufficient coverage?  Are there any potentially high payoff areas with which Europe has longer and deeper experience than anybody else?  Are there any areas with which Europeans are more curious?  Are there other areas of science of higher payoff in which Europeans can participate?

I wish the debate on all government R&D was done on such a basis.

SpaceX Wins Open-Ended Air Force Launch Contract

According to the Santa Maria Times, SpaceX has won an "indefinite delivery, indefinite quantity" contract contract with the Air Force for launch services.   This was announced about a week ago, but I missed it then.  The contract, which apparently includes both Orbital Sciences and SpaceX as competitors (i.e., it is not a sole-source contract), totals up to $100 million and ends in 2010.

This is an excellent piece of business for SpaceX and goes a long way toward paying for the development of its Falcon I launcher.  It also decreases the market risk of its business case substantially.  It seems likely, given the $30 million list price for the Orbital Sciences Pegasus launcher versus a $6 million list price for the Falcon I, that SpaceX will win a majority of the business available under the contract.  Of course, the Air Force, once it decides it likes what it is seeing from SpaceX or Orbital Sciences, can increase the amount, or let another contract.

The article also puts the date of SpaceX's test firing of the rocket at next Tuesday.  I assume that the engines have passed the acceptance testing.  Additionally, the article updates SpaceX's headcount at 110 among other items, which implies a modest and sustainable burn rate for Musk's cash.  If SpaceX can launch its rockets safely, everything appears in place for Musk's third successful start-up in a row.

Hats Off to Google, Inc.

Why is Google doing so well?  The question is begged, when a small company like Google has profits of $369 million in only one quarter.  That's over $100,000 profit for each employee in only three months and is on track for a Return on Investment of at least 50%.  Google has net profit margins of about 30%, which is much better than the monopolist Microsoft's 22% net profit margins.

The answer to the question is really simple and is two-fold.  First, of the 140 or so hits that I received in the last 24 hours, 92 were new readers referred from Google, or 2/3rds of all of my traffic.  In comparison, Yahoo referred 6 new readers and AOL referred 2 new readers.  In other words, Google has huge amounts of traffic and is crushing its competitors.

Second, it has found a way to turn that traffic into revenue.  While Google doesn't make any money by referring people to Carried Away, it makes a whole lot of money by selling targeted ads that complement referrals to Carried Away.

I see little to stand in the way of jaw-dropping growth for Google for a while.  The worldwide advertising market is gigantic and it would be difficult to accuse Google of being a monopoly, even if Google were to mushroom in size.  Compare to Microsoft as an enterprise resting on sales in the software market, which is a market a whole lot smaller than advertising.  It's clear that even Microsoft is at a rather large disadvantage, if it were to try to compete with Google.

My hat is off to Google for a more than fantastic quarter.  Google is a jewel of American entrepreneurialism.

Gasoline Pocketbook Economics

Gasoline and diesel are pretty cheap commodities most of the time and represent a minority cost of owning and operating a vehicle.  For example, if you drive your car 15,000 miles a year and your car gets 30 miles to the gallon, at today's price of about $2.25 a gallon you will be paying $1,125 per annum for fuel.  On the other hand, when $1.25 per gallon fuel comes around, as it does from time to time, you will be paying $625 per annum for fuel.

While most consumers can afford either $625 or $1,125 per annum per fuel, the variability between the two seems to hit pocketbooks disproportionally hard.  Consumers don't know what to expect from month to month and year to year, and therefore have to factor in the risk of a price spike in their spending decisions.  They have to reserve more of their income in case the price of gasoline goes up.

Higher degrees of confidence in the expected expense may be valuable to consumers.  Indeed, they may be willing to pay more for the entire fuel proposition on average.  I wonder if Detroit is factoring in this potential willingness when it rubbishes the long-term viability of hybrid cars.  Consumers may be willing to spend more per month on their car loan to pay for the additional electric motor and batteries in part because it will reduce the variability of their fuel expenses.

On a related note, the cost of owning an old used car versus a new car follows the same principle.  Many people will decide to get a new car when the variability of the maintenance expenses becomes too high for their tastes.  On an overall basis, a $2,000 occasional expense may well be worth paying for a dirt cheap set of wheels.  But that expense isn't scheduled and it may throw a kink in all but the most stalwart of pocketbooks.  People go out and buy new cars all the time under such circumstances.

Musk versus Demisch

Today at the Commercial Space hearing, there was a very funny and interesting culture clash between Elon Musk, the CEO/CTO of SpaceX and Wolfgang Demisch, a veteran aerospace financial analyst.  Musk started by testifying that SpaceX was ready to launch a series of rockets that would cut the cost to orbit by about 1/5 right out of the gate and well over 1/10 over time.  Then Demisch testified that...

That commitment to space based communications however does not invalidate the painful reality that access to space remains too costly for most commercial endeavors.  At present, the price per pound to low earth orbit is in the $10,000/lb class, depending on the vehicle. It is not much changed, on an inflation adjusted basis, from the roughly $1000/lb achieved by the Saturn V booster in the 1970’s. Today’s price translates readily into the $20 million fare paid to Russia by the first space tourists, who arguably got a bargain, as their life support and training was included. NASA would have to charge several times as much to cover its costs, if the Congress were ever to encourage such a use of NASA’s fleet.

Clearly space launch costs are on a much lower productivity track than the microelectronics or computing sectors. This is so despite Congress’ solid support of cost reduction efforts, first with the reusable Space Shuttle, then with the commercially derived EELV, neither of which achieved the savings anticipated. Regrettably, I am unaware of any credible proposal to achieve the desired substantial cost reductions. The propulsion breakthrough, which would be a prerequisite for a much better cost performance, is not in sight. Hence it would seem prudent to set policy on the basis that no substantial launch cost reductions are to be expected.  (Emphasis added.)

To which Musk must have thrown up his hands, because Calvert, the chairman of the subcommittee, and Dana Rohrbacher chuckled and remarked in a friendly way about his gesticulations.  The fun starts at 2:01:00.

By way of background, Demisch is the real deal as far as financial analysts go and commands respect.  He was an aerospace analyst at Bankers Trust when I was in the aerospace industry a decade ago right out of college.  At that time, Demisch was always willing to listen when entrepreneurial ventures with which I worked wanted to talk with Wall Street.  But of course, he is a financial analyst and his evaluation necessarily involves as a starting point a cold calculation of how the industry works now, not how he wishes it would work, and not how he is going to change the way it works -- that's Musk's job to demonstrate.

(As an aside, I have talked about the launch productivity track in a previous post.)

Musk was capable in the back-and-forth.  After Demisch testified that...

While the benefits of commercial space are now so embedded in our economy that they are taken for granted by anyone who goes on a hike with a GPS, to give just one example, they have not been well rewarded in the financial arena. To highlight the problem, over the past four years, the bulk of the world’s civil communications satellite fleet has changed hands, for an aggregate price roughly equal to one year’s NASA budget. This represents a disappointing return to the industry sponsors; even without factoring in the additional losses on restructured projects such as Iridium or the costs of now quiescent launch ventures such as Beal or Kistler. (Emphasis added.)

...Musk pointed out that currently space is a highly cyclical business.  Essentially, he implied that these businesses were exchanged at artificially depressed prices versus the underlying business fundamentals.  I can buy this argument and maybe Demisch did as well.

I would love to have been part of the discussion between those two after the hearing.

About As Good As It Gets

It should be noted that in my previous post regarding stock market valuations, I didn't stress an important aspect of the economic events of the next few years:  corporate profits are high and likely will not grow very fast.  This is about as good as it gets for profitability, unless our post-depression economic structure changes for some reason.

Companies are already starting to miss overoptimistic profit targets.  This will likely get even worse.  Companies will try to drive sales by investing in new markets or to increase profits by investing in new equipment.  The labor market should tighten, driving up labor costs, and driving down profit overall.

On the whole, this is the time in the business cycle where the employees get their due portion of the pie.

The Stock Market is Expensive, Maybe a Little Worringly So -- Updated

Updates and supersedes November 23, 2003 post.

Since the stock market took a dip over the last couple trading days, I thought it might be worthwhile to update my research regarding stock market valuations.  In short, the question is:  is the stock market overvalued?

I will use a modified Warren Buffett approach to analyze the situation. Warren Buffett is the second richest man in the US and by far the most successful US investor. Using my modified approach, the stock market appears too expensive by about 23%. This suggests that you probably shouldn't invest in the overall stock market, and the correction underway could continue.

Keep in mind the definition of investing. An investor pays money now so that in the future he will be paid a greater amount. The difference between this "greater amount" and what he paid orginally is called interest or return on investment, which is expressed in annual terms as a percentage of how much he originally paid.

An investor can invest his money in a number of interest-bearing assets, the least risky of which is a long-term US government bond, which currently pays 4.66% per year. Presumably, he can rest assured that the US government will always pay the interest, so investing in US government bonds is said to be "riskless."  In order for an investor to invest in a riskier asset, he requires a premium to be paid on this riskless rate. For stocks of large US corporations, the risk premium that was required by investors since 1926 has been 5.0% per year on average (2004 SBBI). Given this risk premium, an investor investing now would require a 9.66% return on his investment to invest in stocks for large US corporations (4.66% + 5.0%). If he doesn't think he will get this return, he shouldn't invest. The question then becomes whether or not large company stocks are likely to pay 9.66%, given the current price.

Finding out how much large company stocks are likely to pay an investor is easier than you might think, if you use a couple of solid assumptions. First, as a measure of the combined value of large company stocks, we will use the Standard & Poors 500 Index, which includes the largest 500 publicly-traded companies in the United States, and represents about 80% of the total market value of all US companies traded on US stock markets. The index ($spx) is at $1,142. Second, we know how much profit the companies in the S&P 500 are making. In 2002, core earnings were $55.00. Let's assume that all of this profit is paid back to the investor.

Third, we know with fairly good precision how much profit 2004 would have produced if it were an average year for profitability. Over the last 70 years, corporate activity as a percentage of our economy has stayed very stable at around 51% (it is now 53%). So we keep that variable constant. Further, over the last 50 years, after-tax corporate profit as a percentage of our economy as measured by GDP has ranged from 3% - 6.5%, and averages 4.9%. It very rarely deviated from this range in the post-war period, as you can see from the following plot for 1929 through 2002 (NIPA Table 1.14, Line 13 divided by NIPA Table 1.1.5, Line 1).

In 2004, after-tax corporate profit as a percentage of GDP was 6.14%. An average year would have yielded 4.9% in profit, or 23.8% less than it actually did. If the S&P 500 were adjusted downward to an average year in equal measure as the rest of corporate America, 2004 core S&P 500 earnings would have been $41.92.

Fourth, we know with fairly good precision how much this profit will grow over time. Since corporate profit as a percentage of our economy is range-bound and corporate activity as a percentage of our economy is stable, average corporate profit will track our economic growth, which is likely to be about 5% per year -- 2% inflation and 3% real growth.

Using these assumptions in a spreadsheet, we see that an investment in these stocks is likely to earn about 8.7% per year. That's great, right? Well, not exactly. As detailed above, an investor requires a 9.66% return on his investment in order to be adequately compensated for the risk that he undertakes in investing in large company stocks. If he were to invest in the S&P 500 at these levels, he would be undercompensated for the risks that he is undertaking. That's no good!

This suggests that the stock market is expensive, and may be due for a long-term correction. My calculations put a fair price of $930 on the S&P 500 index while, as stated above, it is selling for $1,142, or 23% higher.

You could also make a reasonable argument that economic growth will be 5.5% a year (or whatever) rather than 5% a year, but this still wouldn't make the current S&P 500 price reasonable.

Sources:  Please see the underlying US corporate profits spreadsheet and S&P 500 cash flow spreadsheet.  I hereby release both spreadsheets under the Creative Commons License -- Share and Share Alike.

The risk premium is calculated from Ibbotson Associates' 2004 Stocks, Bonds, Bills & Inflation (SBBI), page 33. This serial is only available in print. The geometric mean is used for both government bonds and large-company stocks. The 2004 SBBI includes information from 1926 through 2003.

Please note that I used the figure for corporate profits that includes the inventory valuation adjustment and capital consumption adjustment, whereas I did not include these items in the profits in my November, 2003 post.  The analysis doesn't change, but the numbers are a little higher when we include these items.

"Cheating" On the Way to Orbit

John Jurist, Sam Dinkin, and David Livingston have a good paper on the limitations to a reduction in the cost per pound to low earth orbit.  In the paper, the authors detail what it costs in broad terms to put 1,000 pound payload into orbit under various scenarios.  The conclusion is that it is difficult to get costs under $2,000 per pound on a 1,000 pound package, if only because range fees and insurance equal over $1,000 per pound.

Their conclusions on the costs of these systems seem broadly reasonable, although I would emphasize that there are several ways to "cheat" to minimize development costs and maximize revenues on a reusable launch system, of which SpaceX likely is taking some advantage.

(1) Spreading R&D over several vehicle models.  Engines and other components may be shared across vehicle models, depending on design.  SpaceX is sharing many components across at least two models:  the Falcon I and Falcon V.

(2) Getting the government to pay for one or more demonstration flights.  The market risk and therefore the discount rate decline rather steeply when the government is promising money for demonstrations.  SpaceX is getting about $6 million apiece from DARPA for its first two launches against about $50 million - $75 million in total R&D for the Falcon I.  The article mentions an 18% discount rate as an assumption for a start-up rocket company, but I think it rightly should be much higher than that -- more like 25% per annum if you don't have any customers signed.

(3) Getting customers to pay for other things beside launch.  SpaceX may get a contract with the Air Force for "responsive launch."  By this, it means that SpaceX provides the capability to launch on 48 hours notice and do quick turnaround to launch again.  NASA, Bigelow Aerospace, and others may find it worthwhile to pay a modest amount of "insurance" for responsive launch service guarantees in case of emergency.  In the start-up phase, DARPA is paying some small millions to SpaceX for a study on responsive launch, further reducing the risk in the business proposition, if DARPA doesn't require much paperwork.

(4) Opportunistic R&D.  SpaceX has an expendable system that they are designing for reusability, when it is cheap to add to the design.  If the reusability doesn't pan out, then nothing is lost.  If the reusability turns out to work, then they have all of the cost reduction of reusability without the assumed large associated R&D costs.

Anyway, good luck to SpaceX and here's to the hope that it can climb the mountain of R&D one step at a time.

U.S. Government Spending As a Percentage of GDP -- Updated

Updates and supersedes October, 2003 entry.  (This entry still consistently receives the most hits of any entry on this blog.)

I have found that one of the most useful ways of looking at the government's role in society is by examining how much the government spends as a relation to the economy, measured most often by the Gross Domestic Product (GDP). For the United States, we calculate this on either or both the national and state/local levels using Table 1.1.5 and Tables 3.1 through 3.3 in the National Income and Product Accounts (NIPA) published by the Bureau of Economic Analysis (BEA). Here is the historical information. Federal subsidies for state/local programs (e.g. block grants for welfare programs) are counted as spending at the federal level.

Click on the following thumbnail for a clearer view.

Here is the underlying Excel file, released under the Creative Commons Share and Share Alike License.  I will try to update this file from time to time as the data is released.

It appears that the government has turned the corner on spending and the deficit is now shrinking as a percentage of the economy.  I would like to see a continual gradual reduction in federal spending to pre-Cold War  levels.

Note:  Currently, my calculations run off of total receipts and total expenditures, whereas my previous expenditures ran off of current receipts and current expenditures.  The instances where this makes a big difference is during war time.  See, for instance, World War II and Vietnam.