Patents Shine, but Don't Be Blinded by Them

Large drugmakers are in for a rude awakening in the next decade. Earlier this month, independent market analysis firm Datamonitor released a report saying that pharmaceutical companies will lose $140 billion in annual sales by 2016 due to the loss of drug patents.

Does this mean that investors should sell all their drug inventors and run out and buy generic-drugmakers like Teva Pharmaceuticals and Barr Pharmaceuticals? The latter might be true, but the former definitely isn't.

I'm not saying to ignore the patents of the companies you own. There will certainly be large declines in sales due to the loss of patents on blockbuster drugs like Pfizer's Lipitor, GlaxoSmithKline's Advair, AstraZeneca's Seroquel, and Sanofi-Aventis' and Bristol-Myers Squibb's Plavix.

On the contrary, investors should know the patent expiration date for each and every drug marketed by the companies they own. That knowledge is the only way to know which way sales -- and therefore earnings -- are headed in the future. A drug can encounter as much as an 80% drop in sales the first year it experiences competition from a generic equivalent.

But even with an increase in patent expirations, I don't think the paradigm for investing in drugmakers has changed. Perhaps it's because of my background, but I tend to attack investing from a scientific perspective. To find companies that will make money in the future, you have to look no further than their pipeline, and there are essentially two ways for companies to grow them.

The hard way
The hard way to increase a company's pipeline starts in the laboratory. Scientists come up with a disease they'd like to find a cure for and test numerous -- sometimes tens of thousands -- compounds on cells grown in tissue culture. Then the most promising compounds are tested in animal models to confirm the in vitro data. Finally the company can submit an investigational new drug (IND) application and eventually start phase 1 clinical trials. Some investors will count preclinical compounds as "in the pipeline," but I've seen enough of them fail that I don't count the drug as in the pipeline until it has an IND submitted.

The good
Here is a brief look at some of the many companies that have been successful in developing drugs for their pipeline:

Medarex (Nasdaq: MEDX  ) has a promising pipeline including anti-anthrax drug Valortim, and two drugs for treating melanoma. Larger companies like Bristol-Myers Squibb and Pfizer think its pipeline is promising enough to offer it licensing agreements.

Rule Breakers pick Vertex Pharmaceuticals (Nasdaq: VRTX  ) has made news recently about its hepatitis C (HCV) drug candidate, telaprevir. The company has also reported positive phase 2 trial data from its p38 MAP kinase inhibitor to treat rheumatoid arthritis.

Another Rule Breaks pick, PDL BioPharma (Nasdaq: PDLI  ) , has two promising drugs in late stages in the clinic. Nuvion is a T cell inhibitor in combined phase 2/3 trials for ulcerative colitis and a phase 2 trial for treating Crohn's disease. Its multiple sclerosis therapy daclizumab is also in phase 2 trials. Additionally, PDL is looking for a partner for its congestive heart failure drug Ularitide to help finance it through its large phase 3 trial.

With 16 compounds developed in-house in mid- to late-stage clinical development, as well as numerous homegrown drugs already on the market, Eli Lilly rounds out the list of companies that have developed a pipeline the hard way.

The ugly
Unfortunately for the biotech investor, there are plenty of companies to choose for the booby prize, but I'll give it to Introgen for enduring more than a decade of research without bringing a drug to market.

The easy way
The easy way to increase a company's pipeline starts in the front offices. Companies like ViroPharma (Nasdaq: VPHM  ) , with nearly $500 million in cash, or Endo Pharmaceuticals (Nasdaq: ENDP  ) , with $730 million in cash, look for promising drugs to buy. They either buy the whole company -- pipettes, centrifuges, and all -- or just the rights to the drug. A third option available to larger companies is to enter into marketing agreements -- giving the drug inventor a large cash infusion for a chunk of the profits after the drug gets to market.

This is the easiest way to get a drug into the pipeline, although it doesn't ensure that the drugs are going to have successful clinical trials. Investors are counting on smart managers to make decisions about where to invest the cash.

The good
Here's a pair of companies with track records of buying drugs to increase their pipeline:

Last year, Novartis (NYSE: NVS  ) picked up the rights to three different compounds from three different companies. Agomelatine and Valopicitabine are both in late stages in the clinic .while the BCR-ABL kinase inhibitor it licensed from SGX Pharmaceuticals will hopefully be on an IND next year.

King Pharmaceuticals (NYSE: KG  ) is awaiting pivotal phase 3 trial results for the abuse-resistant version of oxycontin that it is funding with partner Pain Therapeutics. While not a pipeline drug since it already had FDA approval, King's biggest steal came in 1998 when it bought Altace from Hoechst Marion Roussel for only $360 million -- Altrace had $157 million in sales, last quarter alone.

The ugly
AstraZeneca partnered with AtheroGenics to bring AGI-1067 to market, but it failed phase 3 trials. AstraZeneca has also seen the recent failure of the stroke treatment it funded through Renovis. It may have overpaid and underdelivered again last month when it announced the acquisition of MedImmune for $15 billion -- 63 times the midpoint of this year's earnings estimate.

Whether it's through the front office or the labs in the back, a company needs to grow its pipelines to increase sales. Since only one out of five drugs entering the clinic gains FDA approval, investors should look for companies with five times as many drugs in their pipelines as drugs coming off patents. Of course some of the drugs coming off patents have sales in the billions of dollars per year, so companies need to get a hold of some new blockbusters any way they can.

Want to know what the latest biotechnology picks are in the Fool's market-beatingRule Breakers newsletter? Grab a 30-day free trial and find out.

Barr is a Motley Fool Stock Advisor pick. GlaxoSmithKline and Eli Lilly are Income Investor selections. And Pfizer has been recommended by the Inside Value newsletter.

Fool contributor Brian Orelli, Ph.D., almost patented a cell line once, but decided it was too much trouble. He blogs about start-up biotech companies at Babybiotechs.com. Brian somehow managed to talk only about companies in which he doesn't own stock. But he would have told you if he did have a financial interest in them because the Fool has an ironclad disclosure policy.


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