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How the Other Half of Pharma Lives

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In the drugmaker world, you've got big pharma, big biotech, and small drug developers that most people refer to as biotech, even if they aren't developing biologics.

And then there's this island that spec pharmas live on.

Specialty, not speculative
The "spec" refers to specialty, not speculative. In fact, some spec pharma could be considered the antithesis of speculative. (More on that in a minute.)

Spec pharmas tend to specialize in one specific area. Shire has specialized in treatments for ADHD. United Therapeutics (Nasdaq: UTHR  ) concentrates on heart drugs. Cephalon's (Nasdaq: CEPH  ) focus is a little broader, including central nervous system disorders, pain, and cancer. By specializing, the companies can leverage their sales force to the fullest and maximize net profits.

One of the other key traits of spec pharma is that they often don't have research and development activities of their own, but instead use their cash flow to license drugs that fit into their specialty.

The lack of R&D helps reduce risk, although each company has its own level of risk that it's willing to take in the licensing process. When Valeant Pharmaceuticals (NYSE: VRX  ) merged with fellow spec pharma BioVail for instance, Valeant cut half a dozen of the programs that BioVail had in-licensed.

Built to be acquired
The focused nature of spec pharmas makes them prime candidates for acquisitions by big pharma. If spec pharma can turn a handsome profit from six or eight drugs, then surely big pharma can find synergies by cutting upper management and combining the drugs with the ones it already has in its arsenal.

Pfizer (NYSE: PFE  ) , for instance, announced its purchase of King Pharmaceuticals (NYSE: KG  ) in October. The big pharma picks up Avinza, an extended-release morphine; Embeda, an abuse-resistant morphine; and a patch for localized pain called the Flector Patch, which complement Pfizer's pain drugs, Celebrex and Lyrica.

The acquisition will also beef up Pfizer's pipeline. King is developing Remoxy with Pain Therapeutics (Nasdaq: PTIE  ) and DURECT, and Acurox with Acura Pharmaceuticals (Nasdaq: ACUR  ) .

Spec pharma can also allow big pharma to get easy access to a therapeutic area that it didn't have any previous experience in. A big pharma might, for instance, buy a specialty pharma to acquire a sales force for an upcoming drug it's developing.

Be careful
While it seems like the potential for an acquisition would be a good investment thesis for buying any or all spec pharma, you have be thorough and ask why the drugs ended up in the hands of specialty pharma instead of a big pharma.

The drugs may have weak intellectual property, allowing for a quick entry by generic players. That's a headache that big pharma knows all too well and certainly doesn't need more of.

The drugs may also have limited market potential. Big pharma is looking for drugs that it can market the heck out of and increase sales. If there isn't a market, big pharma probably isn't interested.

Of the specialty pharmas out there, my guess would be that United Therapeutics would be the most likely to be acquired. Eli Lilly (NYSE: LLY  ) would be an obvious suitor, since United Therapeutics sells Eli Lilly's erectile dysfunction drug, Cialis, as a heart drug under the name Adcirca. Buying United Therapeutics would help Eli Lilly diversify into heart drugs, and it wouldn't have to share revenue from Adcirca.

Whether Eli Lilly pulls the trigger or not, United Therapeutics and the rest of the spec pharma industry is worth keeping an eye on.

Discover the "risky" health-care company Warren Buffett is quietly buying.

Pfizer is a Motley Fool Inside Value pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool has a disclosure policy.

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