The branded pharmaceutical industry can be thought of as a race against time. New drugs command premium prices, but one day they lose patent protection, and in generic form those same medicines sell for a fraction of their former price.
The traditional response of branded pharmaceutical companies to generics has been more research and development. Firms such as Pfizer (NYSE: PFE) and Eli Lilly (NYSE: LLY) are constantly on the run, feverishly developing new drugs to replace their patent-protected medicines before they become generics.
For a long time, the "pure branded" strategy worked pretty well. As long as insurers were willing to pay for the latest and greatest drugs, and pharmaceutical manufacturers pumped out new medicines, the branded drugs business was a good place to be. However, the landscape has changed. Pharmaceutical pipelines haven't been as productive as in years past. More importantly, employers, such as General Motors (NYSE: GM), are now super-conscious of their drug bills, and pharmacy benefit managers (PBMs), such as MedcoHealth Systems (NYSE: MHS) and Caremark Rx (NYSE: CMX), are directing their payor clients to buy more and more generics.
This new climate has led one branded pharmaceutical company, Novartis (NYSE: NVS), to try to redefine the race. The firm announced today that it will purchase two generic outfits: the U.S.'s Eon Labs and Germany's Hexal AG. These purchases, on top of the firm's acquisition of generic injectables outfit Sabex, will make Novartis the world's largest generics company, ahead of TevaPharmaceuticals (Nasdaq: TEVA).
Novartis' move to be a leader in generics makes a lot of sense. Next year, the Medicare drug benefit will kick in, and PBMs are likely to have a major hand in administering the program. That means generics penetration of the drug market will no doubt increase. Indeed, Novartis projects that the U.S. retail generic market will be among the world's fastest-growing in the near term, reaching $23 billion in 2009 from $12 billion in 2004.
Although the generics segment will remain highly competitive, Novartis will have a unique advantage. As a provider of both branded and generic pharmaceuticals, the company believes it will have an easier time cutting deals with large customers, including governments and retail pharmacies, which prefer to buy medicines from a single source. Relative to its peers, Novartis carries a premium valuation. Nevertheless, the company's strategy may make its stock worth a closer look.
Fool contributor Brian Gorman is a freelance writer in Chicago. He does not own shares of any companies mentioned in this article.
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