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If you have not read part one of this three part article, please find the link here.

As I have already highlighted, the health care industry is subject to many swings that are caused by macroeconomic variables, regulation, trends, and beliefs. These changes can be hard to pick up on, especially if you are new to the health care industry or if you are not as familiar with it as with more experienced investors. In the first part of this article, I explained how the Obama Administration and the FDA are shaping the environment for health care companies. It is very important to understand the relationship between companies and their stakeholders and the major forces in the industry in order to properly evaluate a health care company.

Major M&A Activity

Recently, there has been some major consolidation within the industry as companies are positioning themselves to swallow major patent expirations and unfavorable economic climates. Within the past year, Pfizer (NYSE:PFE) and Wyeth (WYE), Merck (NYSE:MRK) and Shering-Plough (SGP), Gilead Sciences (NASDAQ:GILD) and CV Therapeutics (CVTX), Teva (NYSE:TEVA) and Barr, and J&J (NYSE:JNJ) and several smaller companies have already partnered up to weather the storms. The first half of 2008 was stagnant with M&A activity, but throughout the second half of 2008 and the first half of 2009, Big Pharma and Biotech companies have been taking advantage of attractive prices created as a result of the recession. With $150 billion worth of drugs coming off patent protection by 2016, companies are looking to beef up their pipelines to prevent a shrinkage in revenue.

I speculate that most of the big biotech and pharmaceutical companies will complete at least one acquisition when their cash position increases to combat this hardship. Over the next few years, M&A activity will pepper the industry making smaller, flourishing companies attractive targets. Much of a company’s valuation is based upon its ability to replenish the pipeline with successful drugs, and as we move forward, large companies with a strong cash balance and smaller companies with blossoming pipelines will be companies to keep an eye on as far as branded pharmaceutical drug manufacturing goes.

Generic Competition

One man’s loss is another man’s opportunity. The companies that will profit most from the $150 billion in patent expirations by 2016 will be the generic drug manufacturers like Teva, Watson (WPI) and Mylan (NASDAQ:MYL). U.S. drug patents last 17 years, and after expiration, generic companies compete to be the first to file for an Abreviated New Drug Application (ANDA), which gives manufacturers a 180-day period of exclusivity to market the drug. Being the first to file an ANDA can make or break some companies since much of the market share is determined by that 180-day period. A lot of the revenue generated by brand drugs will be shifted to generic manufactures as there will be a generic drug for most major brand drugs within the next seven years.

I am very bullish on the generic drug industry because it also complies with Obama’s health care plan. Since health care insurance companies, pharmaceutical distributors, pharmacy benefit managers, and pharmacies all benefit from people switching to generic drugs, they will be the companies to focus on as we close in on 2016. And if you don’t already know, generic drugs have the exact same Active Pharmaceutical Ingredient (NYSEMKT:API) as their branded counterparts, they just use different fillers.

Contract Research Organizations ((CRO))

Oftentimes, Biotech and Pharmaceutical companies use the help of CROs to aid in the research and development of certain products. The implementation of CROs in the development process allows companies to get an added expertise in a certain field while lowering costs. Furthermore, CROs have historically reduced the amount of time that drugs are tested in clinical trials by roughly 30%. However, more recently, CROs have been overlooked by Big Pharma and Biotech as they choose to use the cash on hand to complete acquisitions after stocks were beaten down in the last quarter of trading in 2008. As M&A settles down in the drug industry and when companies focus on expanding their pipeline organically, look for CROs like Covance (NYSE:CVD) and Icon (NASDAQ:ICON) to succeed in that atmosphere.

By now, you should be getting a quick understanding of what is shaping the current and future environment in the industry. Many investors shovel money into health care companies even if they do not know what factors influence the company’s performance. This mistake is prevalent now more than ever since it is typically thought that health care companies are recession-proof. This is not the case for many companies within the health care industry. In my next and last article on the subject, I will be briefly finishing off the rest of the major trends and forces that have a significant impact on the operations and outcomes of health care companies that some investors may overlook when they invest in a company.

Part three of this article will be released on June 7th.

Disclosures: The Fund the Author is associated with is currently long TEVA and GILD