Sep 17, 2001:Patent Play: Generic pills will explode as lots of drugs lose protection (Forbes)
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Patent Play
Chandrani Ghosh and Andrew Tanzer, Forbes Magazine, 09.17.01
Generic pills will explode as lots of drugs lose protection. Winners: big wholesalers and drugstore chains.
These are heady times for the generic pharmaceutical industry as a deluge of branded drugs go off patent. And investors should do well with large drug wholesalers like Cardinal Health and AmeriSource Health and national pharmacies such as Walgreen and CVS, which stand to benefit enormously from the vast shift to cheaper generic pills and the fat earnings it should generate, (see table).
From now through 2005 a collection of branded drugs that pulled in $35 billion in the U.S. last year will lose their patents, more than twice as much as during the entire 1990s. In early August Eli Lilly's celebrated antidepressant Prozac saw its patent expire. Over the next year a wave of blockbuster drugs including Bristol-Myers Squibb's diabetes medicine Glucophage, Schering-Plough's Claritin for allergies and AstraZeneca's Prilosec for heartburn will face the rigors of generic competition, (see table).
Drugs usually enjoy 12 to 14 years under a patent's aegis; once that's gone, pill prices plummet. Within 12 months of expiration 80% of the business will migrate from drug pioneers to copycat manufacturers such as Barr Laboratories and Mylan. Generics' share of drug prescriptions (by volume) has swelled from 33% to 45% over the past decade.
Three groups benefit mainly from a patent expiration: the manufacturers of knockoff drugs, the taxpayers who pay for Medicaid and the middlemen who distribute prescription drugs. Those middlemen make more money on generics than on branded drugs. It looks like a good time to buy shares in these distributors.
In this middleman group are both wholesalers like McKesson and retail chains like Walgreen. The wholesalers mostly service small drugstore chains and independent stores, which lack warehousing space and bargaining clout. The monster retailers, deficient in neither, drive their own deals directly with the copycat pillmakers.
These big boys have vastly more bargaining power with the fragmented generic manufacturers than they do with the monopoly supplier of a branded drug. For instance, within two weeks of Merck's patent expiration on Pepcid, an ulcer medication, 17 generic manufacturers had launched copies, says Leonard Yaffe, a Banc of America Securities analyst.
For the big distributors, profit margins on generics are three to four times those on patented drugs, says Jeffrey Herzfeld, senior vice president for pharmaceutical product management at wholesaler McKesson. Why should this be so? The economic forces begin at the pharmacy counter. Patients are more likely to comparison-shop for an $80 prescription on a patented drug than for a $30 generic version. (Thanks to health insurance, they may be paying only 20% of the cost anyway.) So pharmacies can get away with a fatter markup on the generic. Enjoying his own comfortable profit margin on the generic prescription, the pharmacist is not going to fight over the last nickel of distributor markup.
Stephen Chick, a retail drug analyst at J.P. Morgan Securities, estimates that pharmacies take 80% gross margins on generics ($14 spread on an average $18 prescription) compared with just 15% on brands ($9 on a $60 branded prescription). Wholesalers also do well. Typical example, says analyst Yaffe: A distributor buys a branded pill for 96 cents from a manufacturer and sells it to a pharmacy for $1. The distributor's gross margin is 4%. When the drug goes off patent, the distributor buys a generic version of the medicine for 44 cents and sells it for 50 cents. He enlarges his margin to 12%, even earning a higher cash profit per prescription despite lower revenues.
The big four wholesalers--Cardinal, McKesson, AmeriSource, Bergen Brunswig--control about 50% of generics distribution. And their bargaining power with the pillmakers will become still greater, once a pending merger between AmeriSource and Bergen goes through.
The big retail chains account for another 30% of the generics trade: Walgreen, CVS, Rite Aid and Eckerd. You can't invest directly in Eckerd, but must buy stock in its parent, troubled department store outfit J.C. Penney (Eckerd furnishes 46% of Penney's revenues). So stick with the pure pill plays.
Caveat: These stocks are not cheap. Drugstore supremo Walgreen's shares change hands at 43 times trailing earnings, versus the S&P 500's 32; wholesale leader Cardinal's P/E is 39. Cheaper buys are CVS (20) and AmeriSource (27), strengthened by its merger with Bergen, which has undergone a restructuring and returned to the black.
Rite Aid and McKesson both have suffered from accounting scandals. But there are signs of a turnaround at each. Rite Aid has sold assets to pare a crushing debt load. McKesson, which took a big charge that pushed it into the red in the March-ending fiscal year, reclaimed profitability in its June quarter.
For long-term growth, it's hard to beat the prescription drug market, worth $140 billion at retail last year and compounding at 15% or more annually. Demography favors the industry: Society is aging and the elderly consume three times as many prescription drugs as the population as a whole.
© 2001 Forbes.com
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