The Office of Generic Drugs estimates that by 2010 more than $20 billion of branded drug sales will lose patent protection, opening the floodgates a little farther for generic drug makers.
Generic drug manufacturers have already had a wonderful time of it. The stocks of many rose straight through the meltdown of 2000 to 2002. The Motley Fool Select considered the industry in December 2001, so why am I writing about it now? Because plenty of potential remains.
The factors that have led to success remain intact. Several big-selling, branded drugs are coming off patent; health-care costs are climbing at a record pace (double-digits annually), making providers and individuals seek relief; and legislation has lately favored generic drug makers over pharmaceutical giants that have attempted to block generic drugs through several means. On top of all this, the population is aging and living longer.
According the U.S. Census Bureau, the median age in the United States is 35.9 years, and approximately 34% of the population is 45 and older. By 2010, approximately 40% of the population will be 45 and older, while 13% will be over 65. By 2020, nearly 17% of the country will be over 65. Despite all kinds of attempts, not one of us is getting any younger.
Last year, according to IMS Health, the United States spent $193 billion on prescription drugs. That was more than double the amount spent five years ago. By 2010, the figure is expected to nearly double again. The country is aging, and the odds of needing new drug prescriptions begin to rise sharply once a person reaches the mid- to late-40s.
If all this talk about aging and needing drugs for our creaky bones is saddening you, look to the brighter side: There's opportunity in it for investors. If we're going to be older 20 years from now (and that may be the weakest "if" ever written), we might as well profit from it.
I'm a longtime believer in Johnson & Johnson (NYSE:JNJ) and Pfizer (NYSE:PFE), but the generic drug makers offer another way to invest in the health-care industry and our aging, longer-living population.
Benefits of being generic
Developing a novel drug costs hundreds of millions of dollars and takes a decade or longer. Developing a generic copy of the same drug can cost as little as $1 million and take only months. Generic drug makers have it easy because all the hard work -- the years toiling over beakers and test tubes -- is done by the innovator. The generic drug company needn't discover anything.
A generic drug maker only needs to prove that its drug is the bio-equivalent of the original drug, both in dosage strength and chemical composition. Where novel drug producers pay for years of expensive clinical trials and innumerable failures, generic drug makers often don't face any trials or suffer failed drugs. Since generics usually don't face clinical trials, they can receive Food and Drug Administration (FDA) approval simply and quickly.
I sense some readers already beginning to rethink generic drugs: "It sounds like they can be made in some guy's basement, right on his whiskey bar -- I'm not taking that!" But of course that isn't the case. The Food and Drug Administration regulates the generic industry and its factories just as it does with novel drug producers. In fact, FDA approval for generic manufacturing facilities is stringent enough to be a barrier to entry.
Downside of being a copycat
While there are strong positives aiding generic drug companies, they have their share of negatives to combat, too. For one, only drugs that come off patent may be copied. Patents typically provide a novel drug about nine to 12 years of market protection, depending on how soon the drug hits the market after receiving patent approval. (Patents are granted while a drug is in trials.)
Generic firms have prospered the last three years because several blockbuster, billion-dollar drugs have come off patent -- a small handful at Merck (NYSE:MRK) alone. Luckily for generic companies, blockbuster drugs are due to come off patent at a steady pace throughout this decade. That said, only some generic companies will benefit tremendously.
Once a novel drug comes off patent, the first company to file and receive FDA approval for the generic version has marketing exclusivity for 180 days. After that six-month period, any generic drug producer with the manufacturing resources can jump into the game -- and when dealing with popular drugs, many will jump in.
A company granted six-month sales exclusivity will often sell its generic drug at only 15% to 20% below the branded drug's price. During those six months, the generic drug company will make the bulk of its profits. When the grace period ends, competition usually pushes the generic drug price down 50% or more. Capitalism soon comes into full view. The generic drug often ends up selling slightly above its manufacturing cost, pushing profit margins down to slim.
So, a generic drug might reel in $100 million or more its first six months, but afterwards, income from the drug often becomes a relative trickle as generic competition abounds. This can make revenue and cash flow sporadic. Investors in generic drug firms should be prepared for some uneven financial results. Additionally, generic drug makers typically have modest profit margins.
Another downside to generics is that legal costs are a steady part of the picture. Large pharmaceutical companies will protect their drugs and ward off generics whenever possible. Often, this leads to legal proceedings. Still, as dozens of profitable generic drug makers attest, the benefits can outweigh the negatives.
Big pharma's just rewards
Large pharmaceutical companies get a bad rap for charging thousands of dollars for some popular drugs. For the most part, though, the money is deserved. The years of investment that go into discovering a drug are so long and expensive that most novel drugs never recoup their expenses.
The drugs that are big successes must pay for all the failures and unprofitable drugs, as well as fund future research. Generic drug companies are able to offer much lower prices only because they haven't paid giant sums discovering the drugs they sell. Plus, they don't need giant sums to continue discovering new drugs.
Both novel and generic drug companies play vital roles -- but if you could only have one or the other, obviously you'd be smart to say good-bye to the generics and keep the innovators.
It may sound as if big pharma donated millions of dollars to me as they did to politicians, but they haven't. (I wish they had!) Since so many people love generic drugs for their low prices, it's simply necessary to point out that generics wouldn't exist without the cost-bearing originators.
Next week, generic drug companies
Now that we know the basics driving the industry, next week we'll begin to study leading generic drug companies to see if we can find compelling value among the group. I'd like to find a company that looks promising based on at least a five-year timeframe, while offering a healthy return potential from the start. Some of these companies came public recently and aren't covered extensively yet, which is good.
[Add your thoughts -- discuss the potential of generic biotechs on the Fool on the Hill or biotech board.]
Jeff Fischer has a generic hair cut. He owns shares of J&J and Pfizer, but hasn't bought a generic drug maker yet. The Fool has a disclosure policy.
