The Patent Cliff: What Big Pharma Investors Need to Know

Includes: BMY, GSK, LLY, MRK, PFE, SNY
by: Steven Breazzano

"For most of the postwar era, the pharmaceutical industry has been the most profitable sector of the U.S. economy by virtually any performance measure (return on equity, return on sales, etc.). This superior performance was based on four structural pillars: (1) latitude to charge relatively high prices, (2) long product life cycles, (3) 'blockbuster' drugs, and (4) relatively high R&D productivity."

The above quote from Prof. Gary Pisano’s book "Science Business" concisely sums up the sector and dives straight into the fundamental issues of the pharmaceutical business. However, as investors in big pharma over the last decade know, this success has not continued. Currently, Pfizer’s (NYSE:PFE), Eli Lilly’s(NYSE:LLY), Merck’s(NYSE:MRK), and Bristol Myers Squibb’s (NYSE:BMY) stock is trading at half of their value 10 years ago and GlaxoSmithKline (NYSE:GSK) is faring slightly better at a negative 25%. This is in stark contrast to a 15% increase in the S&P 500 over the same time. Evaluating each of the four points in the quote provides a background for the underperformance of the sector. A New York Time’s piece details some of the pricing issues. Medicare going forward will have the ability to negotiate prices, and while there is significant uncertainty depending on the healthcare overhaul, it is likely pricing power will diminish. Many of the blockbuster products with long product lifecycles are now coming to their anticipated end (detailed below). Furthermore, even though many of these companies have been on acquisition sprees, there is scant evidence to show that this is the most efficient use of cash and thus does not contribute to research productivity. Again, as Prof. Pisano cogently states,

"In pharmaceuticals, M&A may lead to onetime gains in eliminating redundancies (e.g. plants, sales forces, duplicate R&D operations), but once those savings have been made, there is still a growth problem to be solved. Furthermore, being twice as big sounds great, but it also means you have to grow twice as quickly in gross terms just to keep up."

Potential Catalysts: Not all hope is lost. Looking forward, there are tangible possibilities for reversing this trend. Pharmaceutical companies are flush with cash and offer high dividends (although as the Pfizer/Wyeth merger showed, these are not necessarily safe). Judging by the relative underperformance of these companies, clearly a significant amount of bad news has been priced in, and historically speaking, valuations are cheap. Along the same lines, the sector is out of favor with analysts; Morgan Stanley most recently downgraded the entire group of multinationals. Furthermore, the major pharmaceuticals have extensive and well-honed marketing teams, allowing new drugs to penetrate quickly and replace lost revenue. Sometimes pharmaceuticals have been successful in maintaining significant portions of revenue with extended-release formulations. While the "low-hanging fruit" may have been picked, there are numerous indications for which there are no suitable treatments, and with the baby boomers aging many markets continue to grow. With academic and non-profit institutions devoting significant efforts towards new areas and unexplored chemical and biological space including proteomics and genomics, these fields may live up to their hype and provide whole new classes of drugs and personalized medicine (although I’m not holding my breath on this one…).

In 2010, the pharmaceutical industry had sales of $860 billion worldwide, up 3% from 2009. Just 133 blockbuster drugs accounted for $295 billion of those sales -- about 34% of the market -- according to IBISWorld. Of those blockbusters, 13 are set to lose patent protection through 2013 (source).

Below, I have compiled a short list of major, multinational pharmaceutical companies that are currently in facing patent expiration, with a brief description (but not completely exhaustive). All of these companies have extensive R&D programs and numerous late-stage clinical compounds. For a detailed analysis looking at the field in 2016, see here. Time will tell if these are able to overcome the lost revenues and provide positive returns to shareholders. For a publication on generic competition, see here. For a large list of patent expirations, see here.

5 Companies Currently Facing Patent Expiration (2010 U.S. Sales)

GlaxoSmithKline, Inc. (GSK): Avandia expiring 2012: $367 million. Avodart, 2015: $523 million.

  • Merck and Co. (MRK): Singular,expiring 2012: $3.2 billion . Propecia, 2013: $447 million (worldwide).
  • Eli Lilly, Inc. (LLY): Zyprexa, expiring later 2011: $2.5 billion , Cymbalta, 2013: $2.77 billion . Roughly three-quarters of Lilly’s current revenue comes from eight drugs that will lose patent protection between now and 2017.
  • Pfizer, Inc. (PFE): Lipitor, expiring late 2011: $5.3 billion. Protonix, expiring 2011: $690 million. Viagra, 2012: $1.0 billion. Detrol / Detrol LA, 2012: $693 million.
  • Bristol Myers Squibb, Inc. (BMY): Plavix, May 2012: $6.7 billion or 34% of its total revenues of $19.5 billion. Avapro, expiration 2012: $1.2 billion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.