A Rough Quarter for Generic-Drug Makers

For an industry that should be buoyed by the coming patent cliff, generic-drug makers sure took it on the chin after releasing earnings for their most recent quarter.

*Year-over-year growth for Sandoz, its generic-drug division.
Data from Google Finance and companies' press releases.

Branded drugs still rule
Novartis came out best in this list. Let's talk about why. Generic drugs make up less than 20% of its sales, and probably make up less of the bottom line since its generics likely fetch lower gross margins than their branded brothers. With its new stake in ophthalmology specialist Alcon, Novartis is becoming a more diversified health-care provider, with generic drugs being just one aspect of its overall growth plan. It seems that investors are warming to the idea.

On the flip side, Teva is mostly a generic-drug company, but its branded drugs also are doing well, with its multiple sclerosis drug, Copaxone, seeing a 35% year-over-year increase in sales. Whether it'll be able to keep up the growth in the face of newcomer Tysabri remains to be seen, but investors should be happy with the increased sales of a high-margin product in the meantime.

Doubled revenue? Big deal
Investors weren't all that excited about Mylan's year-over-year increase in revenue, because that's the inevitable result of a company swallowing a larger competitor.

Mylan's stock is down more than 40% since it announced that it was buying Merck KGaA's generic-drug business last May. Sure, the company has taken on a lot of debt and diluted shareholder value through secondary stock offerings to pay for the acquisition, but the company is much larger than it was before making the purchase, and the larger size should help it compete with the big boys -- Teva and Novartis -- in the future.

The smaller they are the harder they fall
Smaller generic-drug makers can experience wild swings in revenue as they take advantage of both FDA-granted 180-day exclusive selling periods and authorized generics (partnerships with branded-drug companies to launch a generic version after the drug loses patent protection). Because of their big impact on revenue, the situation can turn into a disaster if things don't  work out as planned.

Barr's stock price dropped this quarter because it lowered guidance considerably after the launch of its generic version of Merck's (NYSE:MRK) osteoporosis drug, Fosamax, didn't go as well as planned. It shared the 180-day exclusivity period with Teva, which seems to have outmaneuvered it. Barr will also have a 180-day exclusivity period for its generic version of Bayer's birth control pill, Yasmin, this year, but that probably won't help it reach its previously expected bottom line.

Dr. Reddy's on the other hand, could see its revenue drop coming. In its 2007 fiscal year, the generic-drug maker signed a few deals to launch authorized generics and had an exclusive period to sell its generic version of GlaxoSmithKline's (NYSE:GSK) Zofran, causing its revenues to go to the moon. With the deals and exclusive periods complete, Dr. Reddy's saw its revenue come crashing back to earth in its recently ended fiscal year. Fortunately the tough year-over-year comparisons are over and the generic-drug maker won't have the high hurdles in the coming year.

It's all about the future
Of course, it doesn't really matter how the generic-drug makers fared this quarter, what really matters is how they'll do in the future. Interestingly, the companies I highlighted have almost identical forward P/Es.

If the market is going to value them all the same, the smart move is to go with the one with the best multiyear growth prospects. I think Teva and Mylan are the two with the most straightforward growth potential. Teva is looking to raise its revenue to $20 billion by 2012 through an acquisition or two, and Mylan has already made a major acquisition. The synergies could create substantial growth in income for the companies in an industry that lives and dies by its margins.