Generic Drugs Continue To Challenge Big Pharma

 |  Includes: AZN, BMY, FRX, GSK, JNJ, LLY, MRK, PFE
by: Margin of Safety Equity Research

The Generic Pharmaceutical Association (GPhA) released a report on September 21, 2012, detailing the cost savings that have resulted from generic substitution in the US in the last decade. It commissioned an independent study, which was conducted by the IMS Institute for Healthcare Informatics and IMS Health.

The report will no doubt get attention on Capital Hil and the GPhA is already calling on the budget "Super Committee" to pursue policies that encourage generic drug utilization.
The key results are as follows:
  • The use of generic prescription drugs in place of their brand name counterparts saved the U.S. healthcare system more than $931 billion over the past decade (2001 through 2010).
  • In 2010 alone, generic use generated more than $157 billion in savings.
  • Savings from newer generic medicines—those that have entered the market since 2001—continue to increase exponentially and account for more than one-third of the total savings.
  • More than $1.3 billion could be saved annually from Medicaid by increasing generic use by just two percentage points.
The early twenty-first century will witness a wave of generic entries into the market as approximately 25% of the world’s leading drugs will go off patent. Indeed, the industry faces more than $250 billion in patent expirations from now until mid-decade. Although the 1984 Waxman-Hatch Act increased the time between FDA approval of a new drug and patent expiration, it practically eliminated the period between patent expiration and the entry of generic competitors into the market. The effect has been to reduce to less than 12 years the effective patent life, or, the time available for research-based drug companies to recoup R&D investment without generic competition.
Increasing emphasis on generic substitution by government payors (e.g. Medicaid and Medicare), health insurers, and other purchasers has led to faster market share decline for brand-name products once their patents expire. For example, it is reported that for originator drugs first facing generic competition in the 1989-1990 period, generics gained 47 percent of the market after 18 months. For products whose patents expire today, generic market share capture is closer to 72 percent of prescriptions after 18 months. The total share of the prescription drug units in the US accounted for by generic drugs has increased from 18.6 percent in 1984 at the inception of the act to 47.1 percent in 1999. According to Kaiser Healthcare, generic medicines accounted for more than three-quarters of the prescriptions dispensed by retail drugstores and long-term care facilities in 2010.
Zack’s Investment Research analyzed the patent exposure for the time period 2009-2012 for the major drug manufacturing sector and ranked companies based upon the exposure of sales to upcoming generic competition.
The results were as follows:
Patent exposure
sales of patent
as % of expected
exposed drugs
2012 sales
(NYSE:ABT) – Abbott Laboratories
(NYSE:GSK) – GlaxoSmithKline
(NYSE:JNJ) – Johnson and Johnson
(NYSE:LLY) – Eli Lilly
(NYSE:BMY)– Bristol-Myers
(NYSE:MRK) - Merck
(NYSE:AZN) – AstraZeneca
(NYSE:PFE) - Pfizer
(NYSE:FRX) – Forest Laboratories
Click to enlarge
As the table reveals, patent exposure is a major growth headwind for this sector.
Let’s take a brief look at Pfizer as an example. Pfizer simply cannot grow through patent expiration and generic competition for its $10+ billion blockbuster Lipitor, even with $~8.6 billion in projected 2011 R&D spending and a $68 billion acquisition of Wyeth. In addition to Lipitor, other key patent expirations expose 40% of its expected 2012 sales to generic competition. This should be a red flag, though not necessarily a deal breaker, for investors. With a 4.6% dividend yield, a forward P/E of 7.6, and substantial free cash flow generation, Pfizer looks somewhat cheap and may be of interest to income-oriented and value investors.
Generic drugs are here to stay and will take on an increasing proportion of global prescriptions. Analysis of a company’s ability to develop innovative compounds, grow through external acquisition, implement cost-containment measures, and tap into emerging markets is the key to assessing the long-term prospects for these stocks; and a solid strategy on these fronts can mitigate the impact of generic exposure.

Disclosure: I am long MRK.