Investors take stock of generics' growth

In the current bear market, few companies can be considered Wall Street darlings. But generic drug stocks are getting a respectable play from investors, as securities analysts tout the earnings prospects of a handful of leaders while remaining bullish on the longer-term potential of the industry as a whole.

Upbeat forecasts for industry growth are being driven by an array of favorable trends that are expected to hold sway over the next five years. These include the huge sales potential of drugs coming off patent, the rapid growth in the older segment of the population, and the push by managed care and government payers to restrain spiraling drug expenditures.

Tim Covington, M.S., Pharm.D., director of the Managed Care Institute at the McWhorter School of Pharmacy, Samford University, said the escalating prices of brand-name drugs were among the biggest drivers of growth of the generic drug industry.

Noting that the average price for a branded prescription was $72.70 in 2001, compared with $16.85 for a generic, Covington said the price differential "gets wider every year. I think that, finally, insurance realizes it has to create value for its clients. It has to drive generic utilization to achieve economies."

But it's not only outside forces that are fostering the generic industry boom. The generic companies are sowing seeds of their own long-term earnings growth. For one thing, they have merged and consolidated, and the result is larger, stronger specialty pharmaceutical companies better able to manufacture and market broad lines of generic drugs while also developing proprietary products more resistant to competition and thus with higher markups.

A handful of these companies have become masters at challenging the patents of blockbuster brand-name drugs, with an enormous potential earnings payoff for the companies that are first to challenge patent-expiring drugs, as Barr Laboratories showed with its generic Prozac launch last year.

Not least among the factors that are favoring the generic drugmakers is the positive light in which physicians and consumers have come to view generic drug substitution. Years of educational effort by pharmacists, the Food & Drug Administration, and consumer and trade groups have helped reinforce the message of the bioeqivalence and cost savings of generic drugs.

Many analysts believe that of all the trends, the drugs coming off patent will supply the biggest earnings punch. "The No. 1 thing driving valuations is the number of drugs going off patent," said Albert Rauch, an analyst with AG Edwards who currently covers eight of the top publicly traded generic manufacturers. "We see about $60 billion in branded drug products going off patent in the next five years. From that perspective, there are a lot of opportunities for companies to make products.

"Another factor driving valuation for these companies is the ability to challenge patents of the branded companies," said Rauch. He cited the example of Schwarz Pharma AG, the German pharmaceutical manufacturer whose American subsidiary Kremers Urban Development Co. won a court battle against AstraZeneca last fall and gained the right to market a generic version of Astra's blockbuster GI medication, Prilosec. "That's probably going to wind up being the largest generic drug ever, with the potential for Schwarz to generate over a billion dollars," he noted. "So, considering the small investment these generic companies have to make, that's a pretty leveraged opportunity." Schwarz's share price on the Frankfurt Stock Exchange soared after the October court decision and has remained at those highs through early March.

Rauch pointed out that when other generic drugs enter the market after the exclusivity period is over, the size of the revenues is reduced significantly. But "at least there is a big burst for these companies," he said.

While Schwarz has been able to leverage its Prilosec challenge into an enormously profitable revenue surge, another company that had hoped to ride the crest of a generic Prilosec launch has not been nearly as successful. Andrx Corp., after losing to AstraZeneca in the same court decision where Schwarz was successful, formed a partnership with Schwarz in which Andrx takes 15% of the German company's profits on the generic Prilosec.

But the legal battles over its patent challenges have strained Andrx's financial health. The company's stock price plummeted from a 52-week high of $48.20 at the peak of investor optimism in 2002 to a little over $8 the first week of March 2003. This decline followed the company's announcement of a bigger-than-expected loss for the quarter and a delay in approvals for its generic versions of two major drugs, Wellbutrin and Zyban.

Rauch pointed to another factor that is working in favor of the generic companies. Patents have been expiring, he said, on drugs that were given an additional year or two of protection under a loophole created by Congress when it implemented a new round in the General Agreement on Tariffs and Trade (GATT) in the 1990s. "There was a dry period when there weren't any large-cap pharma patents expiring," he added. "Now you have those drugs going off patent, plus a lot of others. So basically there is less competition among the generic drug companies for every drug that goes off patent. They can pick and choose what they want to be doing."

That has also helped give them more pricing power, according to Rauch. "And if you look at the gross margins, they're approaching over 50% right now. So from that perspective, it's becoming much more of a profitable industry." And profit growth is what drives share prices.

The cost of developing new drugs has also indirectly helped the generic drug industry. Brand-name manufacturers are forced to charge hefty prices to recoup their investments before their patents expire. To gain approval for a generic, a company has only to satisfy a much less demanding standard. Therefore, generic companies can keep their prices competitively low and still make healthy profits on their products. The ability to charge far less for products that meet FDA bioequivalency criteria has helped these companies in their battles for market share with branded manufacturers—that, and the fact that their marketing power has been given added muscle through consolidations.

"The generic drug companies have gotten so good that they can capture 60%-80% of the market six months after a drug goes off patent," Rauch said. "Back when the generic industry first started in the '80s, it was capturing only 15% of the market in an entire year." In the 1980s, he continued, "the generic companies were producing drugs that not many people wanted to use; they were basically commodity products. Now you look at the drugs going off patent, and they are really first-line therapies." The quality of the products has helped to gain physician and consumer acceptance, he added.

Managed care has been a strong force in increasing the market share of generic drugs, which, according to IMS Health, reached the 40% mark in 2002 but which other sources have said is now closer to 50%. Rauch pointed out that the approval of the generic equivalent of a single important drug like Prozac affects the substitution rate not only for that branded product but also for the entire category. He went on to say that companies like WellPoint and Express Scripts are developing programs pointed toward replacing a whole category of antidepressants with a single generic like Prozac. "So from that perspective, they're trying to genericize an entire class," he said. "These are numbers that are three or four or five times the branded revenues going off patent."

Rauch said three of AG Edwards' favorites in the generic industry today are the two market leaders, TEVA and Mylan, and Pharmaceutical Resources Inc., a holding company whose subsidiary Par Pharmaceuticals manufactures and distributes a broad line of generic products. "If you think of people using more and more generic drugs and you look at the leaders—certainly the two leaders are TEVA and Mylan—they each generate over a billion dollars in revenue."

He said Pharmaceutical Resources has been one of the companies that have been "very successful in winning lawsuits against the large-cap pharmaceutical companies." In February, AG Edwards upgraded the company's stock to a "buy," and within a month the share price had appreciated by about 18%. AG Edwards based its rating on the drugs that Pharmaceutical Resources expects to launch in the next few years, including generic versions of Catapres-TTS in 2003, Ribavirin in 2004, and Paxil and Ultracet in 2004-06.

Although Barr was another "great company with great management, in terms of valuation," Rauch believes it's "probably a bit pricey right now." Long-term, he added, "we think that Barr is very good. We like its Seasonale oral contraceptive. It's really grown the oral contraceptive franchise very well, and it is adding branded oral contraceptives. It has a really great women's health program."

In a macro sense, he concluded, the generic industry represents good long-term investment. "The [share] prices of these companies have increased, but a lot of that has been driven by earnings growth. We think they have a lot of opportunities in terms of [price-earnings] multiple expansion."

Bruce Buckley

The author is a New York-based pharmacy journalist.

TOP GENERIC PRESCRIPTION COMPANIES: 2002

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Bruce Buckley. Investors take stock of generics' growth.

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