In the coming years, as the mass retirement of the baby boomer generation approaches, there will be huge growth in the need for health care. With employer-sponsored health-insurance premiums increasing much faster than inflation, at an average rate of 10.4% annually since 1988, there will be huge demands by retirees and insurance companies to reduce health care costs. Using cheap generic versions of costly name-brand drugs is one of the easiest ways to reduce those expenses, which should be good news to generic-drug manufacturers.

Generic drugs are pharmaceutically identical to their brand-name counterparts. The only differences are the marketing muscle involved and the name on their respective labels. Consumers can save anywhere from 30%-80% by using generic drugs, according to the Generic Pharmaceutical Industry Association.

Rising health-care costs, combined with the impending generic releases of brand-name drugs, such as the $4-billion-a year Prevacid and $2 billion osteoporosis drug Fosamax, will mean great opportunities in the generic drug sector. Global drug sales have grown to more than $600 billion in 2006, and nearly one-sixth of these sales (about $100 billion) represent brand-name drugs that will lose patent protection in the next five years. Health-care research company IMS Health expects the generic drug sector to expand 22% annually until 2010 in the five largest markets. Clearly, there's plenty of room for growth in this arena.

The largest drug companies in the generics sector are Teva Pharmaceuticals (NASDAQ:TEVA) and Novartis (NYSE:NVS), but neither of them are purely focused on generic drugs, and both also do large sales of branded drugs as well. I'll exclude them from my analysis here, but in reality, these two behemoths dominate the generic drug sector.

The more pure-play generic drug companies (in order of size) are Barr Pharmaceuticals (NYSE:BRL), Mylan Laboratories (NYSE:MYL), and Watson Pharmaceuticals (NYSE:WPI). These companies do engage in some degree of branded drug sales as well, but their fortunes are more tied to the generic drug industry.

Companies wishing to market generic versions of existing drugs get permission by filing a request known as an Abbreviated New Drug Application (ANDA) with the FDA. Many investors instinctively cringe at the possibility of putting their hard-earned investment dollars in the hands of a government agency like the FDA. Those fears are definitely well founded when it comes to branded drugs, since clinical trials on novel branded drugs take years and cost an average $800 million, according to the Tufts Center for the Study of Drug Development.

Even with all this expense involved, a branded drug candidate might still not gain marketing approval if the FDA is worried about the drug's safety or efficacy. In those cases, investors can face up to almost 100% losses on their investment if they're unlucky.

Fortunately, with generic drugs, the approval process is very straightforward. It requires only small, short, and cheap clinical trials to prove the generic drug's equivalency to its branded counterparts. For this reason, generic drug companies have no problem getting dozens of these drugs approved a year, whereas even the largest pharmaceutical companies only can get approval on a couple of drugs, at most, a year.

As seen below, revenues in the generic pharmaceutical industry are quite volatile, highly dependent on the volume of branded drugs going off-patent and the ability of the generic companies to gain the valuable six months of generic sales exclusivity that is awarded to the first generic company to successfully challenge a branded drug's patents. In addition, despite the perception that generics are low-margin products, it's clear by looking at the gross margins achieved by these three generic drug manufacturers that there is money to be made in this sector.

Rev. Growth FY 2003

Rev. Growth FY 2004

Rev. Growth FY 2005

Rev. Growth TTM*



Gross Margins TTM

Net Margins TTM




























*Trailing 12 months. Source: Capital IQ, a division of Standard & Poor's.

As I mentioned before, a generic drug company can only grow if it introduces new generics onto the market. On this front, Barr has approximately 40 ANDAs pending at the FDA; Watson has 49 applications pending; and Mylan plans to file 25 ANDAs for the fiscal year.

Of the three above companies, Barr is my favorite. It just acquired Croatian generic drug company Pliva, and I like the growth opportunities into emerging markets in Eastern Europe and elsewhere that the Pliva acquisition provides. In addition, I think Barr's management team is the most aggressive in trying to grow the business, and its larger scale relative to its two other rivals gives it better margins. Barr has further growth opportunities with the upcoming launch of generic Actiq, but the Pliva acquisition does pose some challenges, and its margins will be squeezed in the upcoming months with the integration of Pliva's lower-margin drugs.

Barr isn't the only one growing its business via acquiring competitors. Mylan and Watson have gotten in on the action earlier this year, each having made sizable acquisitions as well. This consolidation of the generics industry should continue as these companies try to expand their markets to new geographic reaches worldwide, and also keep up with the scope and scale of the much larger Teva and Novartis.

There won't just be plenty of opportunities in the regular generic drug market. The regulatory winds are shifting in Congress and the FDA regarding the approval process for biogeneric drugs, which will be equivalent to the much harder-to-reproduce drugs made by biopharmaceutical corporations. I'll discuss that topic in another article later this month.

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Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool has a disclosure policy .