Are Generics Back in Vogue?
Stabilizing pricing and improved efficiencies should lead to steady gains and needed debt repayments for the generic drugmakers.
Generic drug companies are not for faint-of-heart investors, given the elevated uncertainty, but their overall importance in the healthcare system and the potential to reduce debt-heavy balance sheets are often overlooked. The two largest generic companies, Teva Pharmaceutical (TEVA) and Mylan (MYL), have evolved with the drastic changes in the market, but they continue to make the necessary investment to leverage scale and come out ahead, all against the backdrop of ongoing litigation.
There have been notable changes to the North American generic market, with increasingly rapid U.S. Food and Drug Administration approvals and consolidation of sourcing entities that now manage over 90% of North American drug volume. The combination of these events has accelerated competition and temporarily increased pricing transparency for distributors through integration of pricing lists of acquired entities. This change in market dynamics caused a double-digit U.S. pricing decline in 2018 as well as a shift of mature volume to international manufacturers, which predominantly compete on price. This imbalance exposed the lack of operational integration and drew scrutiny to the significant debt balances incurred from the rapid race to gain share over the last decade. Although we do not anticipate the presourcing consolidation market environment to return after the pandemic, we believe the generic market has stabilized and the continued investments and focus on efficiency will benefit the leading manufacturers.
In parallel with the unusual pricing flux, litigation has hampered the largest generic manufacturers along with pharmaceutical distributors. However, we anticipate the litigation headwinds will subside over the next couple of years as cases are settled in or out of court. We estimate that Teva will be on the hook for approximately $2 billion in total considerations for the opioid and price-fixing matters, which will likely be paid out over a decade. When these matters are resolved, Teva will be better positioned to settle up, which we anticipate will alleviate much pressure on the shares as the focus of value shifts from debt to equity shareholders.
Within that period, we expect Mylan, a generic pure play, will have fully integrated with Upjohn, Pfizer’s (PFE) mature branded arm, and the new management team will be focused on executing operational efficiencies. The clean start and expanded infrastructure and capabilities with the merger should continue to help improve the company’s market positioning.
Generics Are Not All the Same
We believe scale and expertise are a gating factor in pharmaceuticals. Despite the negative sentiment on the leading generic companies, we believe their expertise and scale remain a critical factor in an increasingly competitive market where stakes have escalated notably. We view Teva and Mylan to be the best positioned to overcome industry headwinds to compete in generics with the capability and resources to expand into more complex portfolios.
Both organizations have diversified operations with infrastructure and resources to file and launch a significant share of generics to replace mature drugs that have lost market exclusivity. More important, both continue to make the necessary investments to commercialize complex drugs while expanding international footholds as utilization improves outside North America. We anticipate core strategies to include aggressive cost-saving initiatives to unwind unduly complex manufacturing and operational inefficiencies accumulated through the years and acquisitions. Longer term, we expect the less sophisticated generic peers with significantly smaller portfolios to stagnate as the value of maturing commodity generics will slowly deflate and these smaller peers cannot make the necessary investments to aggressively compete for complex drugs and global expansion.
Beyond the core competitive dynamics and the market nuances, we believe the market is overly pessimistic and overlooking the upcoming shift in value from debt to equity shareholders. We anticipate Teva will continue to drive operational efficiencies by further optimizing the sourcing and manufacturing process, which should generate enough cash flows to pay down debt while fending off outstanding litigation for the next several years. We expect the incremental traction of its relatively new branded drugs, Austedo (for Huntington’s disease) and Ajovy (for migraines), will turn the corner on profitability and potentially provide upside beyond management targets. As these initiatives and litigation overhang are resolved, the company should have the breathing room to extend its market lead. We realize the timing of key events will be critical, but the impressive operational improvement achieved thus far in conjunction with the dedication and experience of Teva’s management team provides us with confidence that the following phases will be rolled out and executed in a no-nonsense manner.
How Significant Are Generics Anyway?
A generic drug is defined by the U.S. government as a medication created to be the same as an existing approved brand-name drug in dosage form, safety, strength, route of administration, quality, and performance characteristics. The designation provides significant cost savings that in turn increase the likeliness of patient adherence and are a significant consideration in improving patient outcomes. Generics represent a significant share of overall volume in therapies when available. IQVIA estimates that generic drugs are 90% of prescriptions dispensed and 97% of prescriptions when generic alternatives are available. These figures imply that generics compete for 92% of prescriptions.
Competitive pricing of generics offers a compelling opportunity in reducing the cost of care. Studies conducted by manufacturers and the Association for Accessible Medicines estimate $250 billion-$300 billion in annual U.S. savings compared with branded drugs. The larger generic manufacturers have more sophisticated capabilities that enable them to compete in biologics, which have created efficiencies in that growing segment of the market as well. According to Matrix Global Advisors, Teva saved the healthcare system $54 billion globally and $41.9 billion in the United States in 2018.
The most recent Kaiser Family Foundation study revealed that 79% of the 1,440 adults surveyed have concerns that the price of prescription drugs is unreasonable, and a third of the participants taking pharmaceutical drugs have not taken a prescription as prescribed because of the prohibitive cost. The increased prevalence of generics continues to be a critical consideration for patients to adhere to recommended therapies to improve overall wellness. These health trends are a strong argument for generics, and longer term, we believe the market complexity and fierce competition will benefit the largest manufacturers with scale.
Regulators have also realized the growing importance of generic drugs as they improve access to safe, high-quality, and affordable alternatives to significantly expensive branded drugs. Generics were born from the Hatch-Waxman Act in 1984 and supplemented by the two phases of the congressional enactment of Generic Drug User Fee Amendments to improve the timeliness of generic reviews. Improved approval cycles increased drug approvals and competition, resulting in lower prices, as indicated by the FDA.
Generic utilization varies across geographies and is the highest in the U.S., with lower consumption abroad. The U.S. markets have been built up over the years with the higher demand and are the most heavily regulated. In the U.S., the government strictly manages the approval process required to market drugs. These regulations provide branded drug manufacturers years of market exclusivity, which allows them to recoup their development and research investments.
The first generic drug is provided 180 days of market exclusivity, which provides a head start with significantly better economics. The fierce competitive process requires significant up-front and ongoing costs to launch new generics with market exclusivity, which increases the stakes.
During 2011-16, generic pricing improved with federal initiatives to accelerate the review of generic applications benefiting the largest entities capable of submitting and launching at a rapid-fire clip. Toward the end of 2016 through 2018, we saw significant pressure from consolidation of sourcing entities. The largest manufacturers shed mature and less profitable small-molecule generics to refocus resources on areas of growth and profitability. These strategies fueled the growth of international manufacturers with less competency and lower overhead, which could subsist on manufacturing mature and commodity drugs. Many of these competitors were operating with bare-bones infrastructure and experienced many challenges with FDA inspections and quality controls.
Average generic pricing deflation peaked in 2017 with the close of the consolidation of sourcing entities. Although pricing deflation continued through 2018, market stabilization appeared across the supply chain as distributors had to manage throughput as well as quality. Mix is also a consideration.
Overview of the U.S. Pharma Market and FDA
The U.S. spends more than any other country on prescription drugs and has very complex market dynamics. Unlike most other countries, the federal government does not manage or negotiate drug rates for all its citizens. Rather, it’s a fiercely competitive environment consisting of many commercial and government payers and middlemen. To generate profits and growth, a generic manufacturer must have a long-term strategy and strive to be the first or second generic approval, then quickly execute launches within a very small window. Launches require aggressive negotiations with the large payers while convincing physicians and providers to make the switch. The many participant layers impair pricing transparency and benefit the largest organizations with reach and resources. To compete effectively, generic manufacturers need aggressive legal, clinical, and commercial platforms, resources, and continuity to execute very long-term strategies to survive in such a fiercely competitive market.
Conceptually, manufactured prescription drugs should be accessible to patients in need of the medication as prescribed by their providers, but in the U.S., the dispensing of drugs has several biases and limitations. Since the reimbursement for each drug is negotiated between the manufacturer and each payer and pharmacy benefit manager for employers and government coverage, and pharmaceutical distributor for health systems and providers, the drug with the most efficacy is often not dispensed. Instead, these aggressive negotiations are based on the manufacturers' ability to discount from the list price, with efficacy often a secondary consideration. Negotiations are typically the gating factors in drug launch traction and prevent patients from obtaining the best drugs for their situations unless they are willing to independently research and pay the premium difference as an out-of-pocket expense, which in most cases is significant.
In the case of payers and PBMs, a handful of companies manage the lion's share and have significant negotiating leverage. The payer infrastructure is made up of roughly 900 health insurance companies, with the top five managing more than a third of the market. The top 10 U.S. health payers are estimated to account for roughly half of the overall drug spending. Industry estimates suggest that there are more than 30 major PBMs, and three manage more than three fourths of the overall drug market. All payers and PBMs aggressively negotiate the pricing of each drug, which often varies with volume thresholds. As a result of these thresholds, management will more aggressively manage drugs by therapy, and manufacturers will need scale to efficiently produce this sheer volume. Conversely, drug manufacturers aggressively negotiate each drug under a very tight timeline to maximize the regulatory reimbursement. The timing of these negotiations of new generic launches is critical, as pricing of maturing drugs is highly discounted with the entry of new competitors after the expiration of the 180 days of exclusivity.
In addition to negotiations with the payers, certain volume is directly negotiated with the three largest pharmaceutical distributors, which manage over 90% of all drug volume and have notable overlap with the top pharmacy PBMs that manage 75% of all drugs. Both organizations have influence in the drugs dispensed and average price per drug. Certain reimbursement contracts are also managed directly with hospital systems, stand-alone hospitals, and physician practices. This last level of direct provider negotiations accounts for smaller volume and may be an emerging trend.
Manufacturers must operate with increased efficiency with the ability to scale up and down seamlessly. This was the most obvious observation with the demand spike of mature drugs and key shortages during the COVID-19 pandemic. This extreme situation highlighted the importance of manufacturers and the supply chain, which has led to the de-emphasis and rethinking of the importance of just-in-time inventory and manufacturing offshoring.
FDA’s Purpose Is to Drive Competition and Manage Safety
Much of the generic market was fostered by the Hatch-Waxman Act and supplemented with other legislation and regulations to increase competition with the intent of achieving lower net drug prices, including the most recent Generic Drug User Fee Amendments passed in 2012. The FDA and its drug arm, the Center for Drug Evaluation and Research, partner with the various health agencies under the Department of Health and Human Services, including the National Institutes of Health.
The FDA and CDER are responsible for the oversight of more than $2.6 trillion in U.S. consumption of food, medical products, and tobacco. Although the entity has a $5.7 billion annual budget, only 40% of the resources are allocated to reviewing human drugs and biologics; it has supported the approval of roughly 20,000 prescription drugs and about 400 FDA-licensed biologics products. The pharmaceutical regulatory arm is to ensure that branded and generic drugs function as advertised and that the health benefits outweigh the known risks.
The purpose of these governing bodies is well meaning, but their authority covers very broad and diverse areas, leaving them ill-equipped to manage. Further, we think this puts them at a significant disadvantage, especially with the rise of complex drugs. To compensate, we understand that the safety criteria and parameters are often set by the large pharmaceutical companies housing or sponsoring the highly specialized expertise and available resources. As with many federal regulating bodies, resources are often constrained, and inspectors of food facilities are also responsible for the review of complex drugs. The alignment with the large pharma companies is critical to the agencies, which rely heavily on their sponsorship outside of the published fees, especially in the case of more complex drugs. We believe these alignments naturally benefit the larger generic manufacturers, especially in light of the rise of complexity.
Generic strategies require careful planning, with very long lead times for each potential launch with considerations toward the addressable market, manufacturing capabilities, and logistical timing of the FDA application. The planning of each new FDA drug application is often planned over a decade and come with notable operational and overhead considerations and investments. Based on the posted fee schedule, the base registration fee to apply for a generic drug approximates $200,000 and is not comprehensive.
The application fee and incremental expenses throughout the approval process do not include the required legal, clinical, commercial, and manufacturing overhead needed to convert the approval into profits within a narrow window of exclusivity. More-complex applications require sponsorships to support the FDA approval process. In many cases, smaller generic peers without the scale or resources have very streamlined infrastructure and focus on manufacturing a small number of mature generic drugs, forgoing growth altogether. The cumulative investments for market approval drastically increase the stakes of each drug launch, and in certain cases, applications that are not approved first tend to be abandoned to mitigate any further losses beyond the incurred application fees and expenses. Application errors and operational delays are costly, and approval timing is highly critical in turning a profit.
Since the long-term preparation and timing of the FDA application, manufacturing, and commercialization capacity are critical, the successful execution of each incremental launch raises the stakes. The fiercely competitive and dynamic environment requires considerable scale and efficient use of resources. In the case of the largest manufacturers, management teams target the successful launch of 10-50 generics annually to offset the commoditization of mature drugs. With increasing competition, many approvals are not necessarily converted to launches, as the approval pecking order is critical in supporting razor-thin margins.
Teva and Mylan have the largest number of annual applications despite the large number of collective applications from smaller generic peers. The successful win for the first, and to a lesser degree second, generic approval is critical to win the 180-day exclusivity in order to maximize operating profits.
International utilization has been lower, historically, due to the focus on the U.S. with significantly more prolific use. As a result, the profits and returns have previously been more attractive in the U.S., and manufacturers have had less incentive to invest in building out commercial platforms abroad. We attribute the higher U.S. prices to the complex market structure and unnatural exclusivity of branded and newly launched generics. We anticipate international launches of mature drugs will become an area of potential growth for large manufacturers.
Growth Prospects Lead to International Expansion, Complex Drugs
The U.S. has been a key driver of growth, but in the last several years, the market has evolved, with a greater emphasis on international expansion, especially on the generic front. U.S. drug spending has always been adversely affected by the roughly 2-4 times higher prices, partly fueled by the complex market dynamics and high demand. Annual studies conducted by the Organization for Economic Cooperation and Development show U.S. drug spending per capita to be significantly higher than all other countries. In the most recent study of all pharmaceutical spending, the average OECD country spent roughly $564 per capita, or less than half of the $1,220 per capita for the U.S. This continues to draw much political attention, considering the relatively poor health of U.S. citizens and tightening state and federal budgets.
Over the past several years, industry spending forecasts have come down, largely reflecting the challenges in gauging the mix shift from traditional to specialty, which is partly offset by increasing utilization across less developed regions. We have observed an increase in utilization in less developed countries as individuals build wealth. As a result of this increasing wealth abroad and fierce U.S. competitive trends, we anticipate increased utilization in international markets will become a more important factor for growth. These will also provide offsets to the commoditization of mature generic drugs in North America.
In addition to the anticipated emphasis on global expansion, we expect drug manufacturers to continue to target smaller populations with branded drugs (Teva's hybrid approach) and biosimilars (Teva and Mylan). Many of these more complex drugs target care for the sickest populations. This trend provides a little more differentiation and faster return on investment, as these drugs are sold at significant premiums to generics or more commoditized drugs without exclusivity. To date, there are 20,000 approved drugs for marketing and roughly 400 licensed biologic drugs, and specialty drugs have an increasing majority in FDA drug approvals.
Soo Romanoff does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.