Winners and Losers From the End of the Generic Drugs Wave

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Michael Waterhouse, who is an equity analyst on our health-care team. We're going to talk about generic drug makers. Michael, thanks for joining me.

Michael Waterhouse: Thanks for having me, Matt.

Coffina: The generics wave has really been the dominant theme in the pharmaceutical industry over the past decade or so. Where do you think we are in this wave right now?

Waterhouse: I definitely think we're in the back half, probably in the last few innings here. If you look over, as you mentioned, the last decade, you've had a lot of big blockbuster drugs coming off patent. Probably the peak of that trend was in 2012 when you had a lot of particular blockbusters, like Lipitor, coming off patent.

So following from 2012 and going forward, we see a declining trend for those kind of opportunities for generic drug makers to launch some of these drugs, but we see a relatively healthy situation until about 2015 to 2016, and then we think the market will fall a bit even further. So a few good more years for a lot of these companies, but then with the decline in patent expirations, really not a lot of growth opportunities beyond that.

Coffina: Manufacturing generics is a very competitive business. Wide moats are pretty much nonexistent. But for the handful of companies that we think have narrow moats, what are the primary sources of competitive advantage?

Waterhouse: We look at it in two ways. First, I would say the generic drug industry overall, these aren't patent-protected drugs. So they are really heavily commoditized businesses overall, and a lot of that competitive advantage then is driven by a low-cost advantage, primarily due to economies of scale where they can really apply those fixed costs over a broad base of drugs that they are selling on a global basis. But there are some other niche companies out there that can get into special segments.

You look at companies like Hospira or Perrigo, for example, where they are maybe in segments that are a little bit harder to manufacture, a little bit higher barriers to entry, and we do award some competitive dynamics for some of those companies as well.

The second thing I'd mention, though, is really over the consolidation you've had in this industry over the last 10 years or so, there are really not any more standalone generic drug manufacturers. When you look at your big players like Teva, Mylan, or Actavis, for example; all these companies have pretty significant specialty drug franchises that have drugs that are patent protected. So in that kind of situation, we have to evaluate what's the low-cost advantage on the generic side, but also what's the IP on the branded drugs, as well as how does the pipeline look for future potential of awarding shareholder returns.

Coffina: The U.S. market has some unique dynamics with what's called "first to file." Could you just briefly explain how this works and how important first-to-file opportunities are to generics manufacturers--particularly, as we're getting into the latter stages of the generics wave?

Waterhouse: The first to file was created in the early 1980s when you had what's commonly called the Hatch-Waxman Act that essentially gave 180 days of marketing exclusivity to any generic drug manufacturer that could win a Paragraph IV patent challenge on an innovative drug; that Paragraph IV just references the section of the act that it comes from.

That really incentivized all these generic drug companies to become a lot more aggressive in going after these patents. It has really been one of the major drivers of high generic utilization rates that you see here in the U.S. over that time frame.

Obviously, if you're the only drug manufacturer that is on the market for 180 days, it's a lot of profits for whichever company can get that exclusivity period. That does lead to pretty strong bottom-line gains for a lot of these firms. But as you mentioned, and what we've already discussed, because those patent launch opportunities are declining in the U.S. in particular, you do expect to see some margin contraction, in our view, for a lot of these businesses, especially in that U.S. segment.

So investors would want to be aware of how much exposure a particular generic manufacturer has in that market and other ways they can offset it through other global operations or the specialty drug franchises, for example.

Coffina: You mentioned that generics dynamics are a little different internationally. Some firms that have other operations that aren't just focused on generics, like Novartis and Abbott, are especially strong in these branded generic international markets. Can you briefly explain what's different about generics outside of the U.S.?

Waterhouse: [In] most, really all, international markets, there is no such thing as first to file. That's strictly a U.S. market dynamic.

But then also, it's important to point out when you're in a lot of these markets, they don't have the infrastructure that we necessarily have here in the U.S. Mainly I'm talking about consolidation among the pharmacies, as well as the PBMs and the managed-care organizations. So even though in a lot of these international markets, you may have government paying most of those drug prices, you really don't have the consolidation that drives lot of those markets as aggressively as you would here.

Also, in a lot of these markets, you don't necessarily have automatic substitution of generic drugs at the pharmacist level like you do here in the U.S. When all these factors are wrapped up, in general, you don't have most countries possessing a high generic utilization rate as you do here in the U.S., which is above 80%. You look at some countries, say, Southern Europe, some of those markets can be below 50% generic utilization rates. Those are probably the major factors that influence generic operations overseas.

Coffina: Lastly, one of the big topics on every biotech investor's mind is generic biologics. Historically, biologic drugs have been relatively insulated from generic competition. That's changing with new regulations that enable biosimilars to come to market. Where are we in that trend and how much do biotech companies need to be worried about generics in the future?

Waterhouse: It's really interesting that you bring that up. I would say the biosimilars market is still in its infancy, in our view. We're really only in early innings. There is still lot of uncertainty about how this market is going to play out, especially in the U.S. where you don't have finalized guidance from the FDA on how some of these will be approved.

But that said, it is a large opportunity for the few generic drug manufacturers that can enter the market. These drugs are very complicated to make. They're made from living organisms, and you also have very steep regulatory and marketing hurdles as well. So, we really don't see a lot of competition for those few people that can enter the market, which would suggest less steep pricing discounts and overall higher profitability for the few companies that can get into the market.

It's potentially pretty large. Even looking at just current biologic sales that are going to have patent expiration over the next 10 years, it would be alone in the U.S. about $26 billion by our estimate; obviously, taking in global sales it would be a much larger market. But for some of these products, we only expect maybe two or three competitors. So you're not going to see anything that you've seen, for example, when Lipitor goes off patent, where you have a lot of competitors enter that market.

Coffina: So are there any winners and losers that you can point to, that can take advantage of all these trends, whether the end of the generics wave, the potential for generic biologics, relatively stronger generics markets internationally, and so on?

Waterhouse: Of the companies we cover in the industry, we actually think most of the companies are fairly valued or a little bit overvalued. So, we wouldn't have too many that we would highlight for opportunity. One stock that is under substantial pressure, and we think is fairly attractive from a valuation standpoint would be Teva Pharmaceuticals.

There are probably two big negative headwinds for this company, potentially one being that we've already discussed on the generic side: You do have the patent cliff from the slowing growth from the generic business. And then also on the branded side, Teva has one of the largest drugs to come off patent in 2014, Copaxone, which is a multiple sclerosis drug--about $4 billion in sales for 2013.

So, obviously, a lot of investors are really focused on how this is going to play out, specifically for Copaxone, on Teva. But we think the market is maybe a little bit too pessimistic on this. We think the company has a nice, broad geographic exposure for its generics business and probably has a lot of room to grow in emerging markets as well.

Also I'd mention that Copaxone is not like your typical drug. It's fairly complicated to make. We don't see a lot of generic entrants on that product. So, probably a much longer tail of cash flows than what you have most conventional pills once they face generic competition.

We also think the pipeline is definitely going to be a challenge for earnings growth with Copaxone going generic, but we do think the pipeline for Teva on a cumulative basis can uphold that branded franchise for the company. And depending on how many generic entrants eventually enter, management has targeted about $2 billion in potential cost savings. We think the company has enough wiggle room there to get past this challenging time. We currently have a $48 fair value estimate for Teva. I think the stock currently trades at about $42.

Coffina: Thanks for joining me, Michael.

Waterhouse: All right. Thank you, Matt.

Coffina: In conclusion, the generics wave is reaching its latter stages. We talked with Damien Conover a couple of weeks ago about improving pharmaceutical pipelines, and branded drug makers should benefit as fewer drugs are losing patent protection.

On the generics side, I think you need to be careful, especially with first-to-file opportunities starting to disappear, that profits are going to be under pressure and for the most part we think that generics manufacturers are fairly valued to overvalued. But one name that stands out would be Teva Pharmaceuticals as potentially interesting as the market seems to be overestimating the headwinds posed by their Copaxone patent loss.

For Morningstar StockInvestor, I'm Matt Coffina.

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