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Follow Novartis into generic drugs
But don't do it because recent deals will spur consolidation. Do it because new Medicare regulations coming in 2006 will generate long-term growth.
By Robert Walberg
When Novartis agreed to buy generic drug makers Eon Labs and Hexal AG late last month for a combined $8.3 billion, the entire generic group received a boost amid hopes that the move would spark a wave of consolidation. But for that assumption to prove correct, the rest of the branded drug industry is going to have to follow in Novartis footsteps and believe that embracing generics is a good idea despite the long-term pressure on profit margins.
That looks unlikely. Some generic drug makers, however, may be good bets thanks to a bigger trend.
Deals like the Novartis (NVS, news, msgs) acquisitions would represent a significant cultural shift for big drug companies, and there's no real reason to expect this to occur now. Instead, U.S. drug companies appear set on the tried-and-true course of building research and development or acquiring new drugs in an effort to maximize profits before patents on their drugs expire, bringing generic competition.
In addition, Big Pharma seems content to pursue "authorized" generics and/or in-house generics to combat the loss of revenue once a drug loses its patent protection.
The practice of authorized generics is relatively new, and how it works is simple:
When a branded pharmaceutical company is about to lose patent protection of a key drug, it will license distribution of the drug to one or more generics, thereby maintaining some of the royalties. The other approach is simply to release its own generic version.
In either case, the first generic company to offer the drug faces stiffer competition immediately, resulting in lower prices, declining profit margins and softer earnings potential. Though many generic drug makers have cried foul, especially about authorized generics, so far the courts have sided with the big drug companies.
Looking for lower costs
Pressure on Congress to change the laws to prevent the use of authorized generics is also unlikely to succeed given that the Bush Administration and Congress are seeking ways to keep health care costs down. So anything that serves to increase competition and lower costs to consumers is unlikely to be overturned. And as long as the practice of authorized generics is allowed in its current form, theres little reason to think that the big domestic drug companies will alter their strategy of dealing with generics by going on a buying binge.
In other words, investors buying generic drug stocks on the hopes of increased consolidation might want to reconsider. Theres little in the Novartis deal that suggests an impending wave of mergers and acquisitions. In fact, by increasing its exposure to the U.S. generics market, the Novartis deal simply heightens competition in an already fiercely competitive marketplace.
Thats the problem confronting the generic industry over the near-term -- margins are coming under pressure from increased competition. As a result, the industry was beset by earnings disappoints last year, and theres nothing that spooks investors more than weaker-than-expected earnings.
Though the group has managed to bounce back a bit since the year began -- due largely to bargain hunting and hopes of increased merger activity -- the industrys relative performance over the past 52 weeks remains dismal. The average decline over this period is an alarming 21%, with Barr Pharmaceuticals (BRL, news, msgs) the best performer with a loss of 5.9% and Par Pharmaceuticals (PRX, news, msgs) the big loser with a loss of 38.3%.
Beyond the obvious
This begs the question, what was Novartis thinking? Why is this major, branded pharmaceutical company gobbling up generic companies at a time when the industry is struggling? A larger footprint in the German and U.S. markets is an obvious answer, as is increased scale, expanded product pipeline and improved operating efficiencies.
However, Novartis deserves more credit than that. The companys management is looking long term and trying to elevate itself to a top-tier player in a rapidly changing environment. Though this year offers little promise of excitement and/or rapid earnings growth in the generic industry, the following year is full of promise, as are the next few years after that.
First, several big drug makers lose their patent protection on some of their biggest drugs in 2006. The list includes: Pravachol from (Bristol-Myers Squibb (BMY, news, msgs), Zocor from (Merck (MRK, news, msgs) and Zoloft from (Pfizer (PFE, news, msgs). Even in a highly competitive marketplace, these are the type of super drugs that spur nice earnings pops.
Second, and more importantly, is the change in the Medicare drug benefit beginning in 2006. Starting then, all Medicare beneficiaries will be eligible for the Part D drug benefit, which includes about 20 million beneficiaries that either have too little coverage or have no coverage. This will be a boon to the entire drug industry -- but especially generics -- as the government pushes the lower-cost advantage of generics.
Big growth
By some accounts, these two forces will result in generic drug revenues nearly doubling over the next five years. Global sales in the industry are projected to jump to about $93 billion in 2009 from $58 billion in 2004, with sales in the United States rising to $23 billion from $12 billion.
Despite the negatives of increased competition and the recent run of earnings disappointments, those are the kind of long-term growth numbers that most investors can get excited about. Betting on a wave of merger activity to lift the sector over the short-term seems foolhardy. But taking advantage of discounted valuations and the generally negative near-term news cycle to buy into the sector ahead of a significant industry upturn, as Novartis just did, could result in some healthy gains over the next 18 to 24 months.
Which stocks are best positioned to lead any upcoming rally? Ill stick with the three companies highlighted in my Oct. 14, 2004, column -- Barr Labs, IVAX (IVX, news, msgs) and Teva Pharmaceuticals (TEVA, news, msgs). Each is well managed, with promising product pipelines, strong financials, better-than-industry growth rates and discounted valuations. Interestingly, these three stocks have also held up best during the sector downturn. More often than not, those stocks that fare best during a cyclical downturn end up leading the subsequent upturn.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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