The Patent Cliff's Cliff

The word "cliff" will probably go down as the most overused word of 2012. We've all heard the phrases "patent cliff" and "fiscal cliff" so much that we're ready to throw our television sets off a cliff. 

Therefore, it is with reluctance that I introduce yet another cliff to you. If you're an investor in the health care sector, you need to be aware of this looming lurch. What new cliff am I talking about? The patent cliff's cliff.

Decline of the decline
Yes, the patent cliff will soon fall off its own cliff. More than 40 drugs went off-patent in 2012. These drugs combined annual sales topped $35 billion. Credit Agricole estimates the total annual sales for drugs expiring next year is around $17 billion. That's certainly a steep drop-off.

Major pharmacy benefits manager Express Scripts (NASDAQ: ESRX  ) also foresees a major decline in drugs going from prescription to over-the-counter generic in 2013. While the company's data also shows a rebound from 2014 to 2016, those years won't come close to the levels for 2012. Also, Express Scripts projects another steep plummet in 2017 that will continue for years afterward.

Since generic drug companies tend to make their highest profits immediately after introduction of a new generic, lower availability of new entrants to the market could mean less profits. As a result, several generic drug manufacturers are already responding to the coming patent cliff's cliff.

Shop with the drop
Some companies have apparently decided to shop in response to the drop in new generic drugs. Teva Pharmaceuticals (NYSE: TEVA  )  already started its shopping spree. The Israel-based company acquired Cephalon for $6.5 billion last year. 

Recent rumors hinted that Teva could continue its expansion into the world of branded drugs. Israeli business newspaper Calcalist reported that Teva was considering an acquisition of Amarin (NASDAQ: AMRN  ) . While Amarin's decision to move forward with hiring its own sales force might have tempered expectations for a near-term deal with any third party, CEO Joe Zakrzewski didn't rule out the possibility of future partnerships or mergers.

Watson Pharmaceuticals (NYSE: ACT  )  has been in the shopping mood, too. Watson completed its buyout of Actavis in October. The $5.6 billion deal resulted in the combined company becoming the world's third-largest generic-drug company. 

Several weeks ago, Mylan (NASDAQ: MYL  ) CEO Heather Bresch indicated that her organization also was looking to expand by acquisition. Bresch said that Mylan would consider deals of more than $4 billion. She hinted that the company could buy other organizations that would help beef up its specialty drugs unit.

Cutting costs
Several generic manufacturers facing the prospects of the patent cliff's cliff are looking to cutting costs to keep healthy bottom lines. Teva announced recently that the company planned to cut costs as much as $2 billion over the next three to five years.

Watson Pharmaceuticals will decrease costs by $300 million over the next three years. The company intends to shut down 28 manufacturing plants. Watson expects the acquisition of Actavis will result in synergies that allow it to meet these cost-reduction goals.

Mylan is taking a different approach to holding down costs. The company announced a multi-year partnership with Pfizer (NYSE: PFE  ) to develop and market generic drugs in Japan. This could prove to be a shrewd move, considering that Japan is the second-largest market for pharmaceuticals and the sixth-largest for generics.

Diving for deals
Despite the slowdown in generics entering the market next year, the long-term picture should remain strong for the major players. Which is the best pick for investors?

Teva's forward P/E of 8 comes in as the lowest of the big three. However, the company faces its own patent cliff of sorts in 2015 with the loss of patent protection for Copaxone. The branded multiple sclerosis drug accounted for more than 18% of the company's 2012 revenue.

Mylan's forward P/E of 10 also appears to be relatively cheap. Like Teva, it faces a patent expiration in 2015 with its EpiPen allergic-reaction injection. The company obtains less than 13% of revenue from the EpiPen.

Watson's sky-high trailing P/E of 68 could scare off some. However, the company's forward P/E is below 11, which isn't nearly as frightening.Watson also could face challenges from its own branded drugs losing patent protection. Androderm and INFeD already went off-patent.

My view is that any of these three companies could be solid long-term investments. One strategy could be to buy shares in all of them, which would amount to a calculated bet on continued popularity of generic drugs in general. Even with the patent cliff diving off of its own cliff, that bet seems like a pretty good one. 

Another possible play on generic drug popularity is to invest in pharmacy benefits managers, which do well by controlling overall drug costs. The largest of the the PBMs is Express Scripts. The company's shares took a massive dive after a recent earnings report. Has the company's long-term outlook really changed, or is this a classic example of Wall Street being blinded by its short-term lens? In this brand new premium report on Express Scripts, Stock Advisor analyst Jim Mueller dives deep into the company's prospects. Here's a hint: There's plenty of room for growth. You'll understand why, along with an outline of the key must-watch areas of the company, if you claim a copy by clicking here now.


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