Generic Drug Industry Headwinds Lead to Moat Downgrades

The generic drug industry has recently faced a number of challenges thanks to greater-than-expected pricing pressure, unfortunate capital-allocation decisions, increasing financial leverage, and concerns about collusion charges. Although fewer small-molecule patent expirations, increased competition in complex product categories, and increased consortium buying power are likely to make historical growth and profitability difficult to sustain, we think the recent accelerated pace of price erosion will diminish as the Food and Drug Administration backlog normalizes.

We advise investors to proceed with caution in the space, and we’ve shifted our economic moat ratings for all generic manufacturers we cover to none as the industry remains a low-barrier-to-entry market with relatively commoditized products and increasing competition from emerging-market players.

We now consider the generic drug industry as a whole as a predominantly no-moat industry. Barriers to entry are low, products are highly commoditized, and the industry remains fairly fragmented despite consolidation. While we previously thought manufacturers with global economies of scale and vertical integration helped support a low-cost edge, we think the continual rise of new entrants, particularly from low-cost emerging markets, diminishes the cost advantage of larger peers. Additionally, we had believed first-to-file pipelines at large manufacturers, especially Teva and Mylan, combined with manufacturing capabilities for more complex products helped differentiate these firms. Although we view some recent industry headwinds as temporary, we believe historical growth and margin expansion will be difficult to reproduce as tailwinds from products going off patent and an increase in generic utilization rates have diminished. We have less confidence that the historical attributes of scale, first-to-file pipelines, and complex manufacturing abilities can lead to sustainable economic profits over the long term as the abilities of challengers gradually improve. The decline in the large number of products going off patent and the increase in generic utilization rates seen over the past decade probably means that past growth and margin expansion will be difficult to sustain.

As a result of a number of these industrywide as well as company-specific issues, we’ve downgraded our moat ratings to none for most generic manufacturers under our coverage, including Teva, Mylan,

Competitive Advantages Declining We view the generic drug industry as a quasi-commodity industry. These products have no intellectual property protection, and once bioequivalency has been established, interchangeability between the brand and generic versions makes price the overriding determinant of market share. Regulatory factors do create some barriers to entry, especially on particularly complicated drug formulations. Additionally, in many global markets, the lack of efficient distribution infrastructure causes generics to be sold as branded products, which can create more stable market share dynamics. Nevertheless, the constant threat of new entrants and preponderance of undifferentiated products lead to hefty price competition that makes moats difficult to build.

Persistent Threat of New Entrants Erodes Economies of Scale Because most conventional generic drugs resemble commodity products with little to no differentiation and compete largely on price, economies of scale matter to create a competitive edge--to spread overhead and fixed costs over a large base of products to achieve greater incremental profitability. The ongoing emergence and market share gains of emerging-market-based competitors offset the economies of scale of large manufacturers like Teva, Sandoz, Mylan, and Perrigo. Generic manufacturers from India, in particular, as a whole represent close to 20% of the total generic market, by our estimate, a rate that has consistently grown over the years. While many emerging-market players can't approach the scale of larger peers, they do tend to have lower labor costs and inexpensive overhead, which help level the playing field.

First-to-file Pipeline Success Difficult to Replicate Although only a phenomenon in the U.S. thanks to the Hatch-Waxman Act of 1984, companies to first successfully file a patent challenge can earn 180 days of marketing exclusivity before other competition from generics once patents expire. These first-to-file abbreviated new drug applications can become immensely profitable, particularly for large multi-billion-dollar drugs coming off patent. After its purchase of the Actavis generic unit from Allergan in 2016, Teva continues to have the largest first-to-file pipeline in the industry. Teva historically lost ground in ANDA filings and, more important, first-to-file applications to competitors. While Mylan has significantly expanded its ANDA filings over the years, its first-to-file count has stayed relatively constant. We think competitors will make the first-to-file strategies at these firms difficult to reproduce. Additionally, fewer patent expirations than seen over the past decade suggest fewer growth opportunities to offset erosion of older generic products.

Focus on Complex Manufacturing Unlikely to Remain Safe Haven Complex drug products can lead to limited competition, greater pricing power, and higher margins, but the pursuit of these advantages suggests increased commoditization over time. Easy-to-manufacture pills make up the majority of generic drug market volume. These products, however, tend to see numerous competitors with prices falling dramatically. Each additional generic manufacturer in a market can lead to an additional 20% decline in price. More-complex products may only receive FDA approvals by one or a few competitors, leading to more stable pricing and significantly higher profits over extended periods. Complex products typically include drugs with unique formulations, complicated manufacturing requirements, higher regulatory hurdles, or sophisticated devices. Many injectable and ophthalmology drugs, for example, must be sterile, which requires more strict and expensive manufacturing processes. Some extended-release products might have unique formulations to attain correct dosing requirements. Topical creams and patches have a localized effect that must be adequately absorbed through the skin. Respiratory inhalers involve complex devices that must consistently administer the same dose. Additionally, while bioequivalency can be evaluated for most generic drugs through relatively simple blood tests, drugs like topicals, eye drops, and inhalers have localized effects that must typically be evaluated through small clinical trials, which are often more cost-prohibitive for smaller generic drug firms to meet regulatory requirements. These bioequivalency tests take longer and can cost more than 4 times as much as simpler blood tests for more conventional ingested drugs. Biosimilars represent the largest opportunity for generic drug manufacturers, but the legal, manufacturing, and regulatory hurdles represent significant barriers to entry that will keep most participants unable to compete in this market.

Recent pressure in the generic industry, including declines at Teva, Perrigo, and Akorn, has stemmed predominantly from new competition and price erosion among limited-competition products. We therefore think niche generic manufacturers that have benefited by focusing on niche products or markets face a more uncertain future.

Greater-Than-Expected Price Erosion Likely Temporary, but Challenges Persist A number of high-profile generic drug price increases over the past few years combined with considerable competitive price erosion in the U.S. for certain players beginning in late 2015 have made pricing a critical concern of the industry. Pricing issues seem largely a byproduct of unsustainable price increases over the past few years, which increased political scrutiny of the industry, along with other industry factors --fewer large launch opportunities, the FDA backlog reduction, and increasing consortium buying power--creating a perfect storm of sorts. While we rarely consider pricing as a growth driver for the generic industry, we anticipate recent greater-than-expected price erosion will eventually subside, leading to more consistent mid-single-digit year-over-year price declines on the base products of generic manufacturers. Because new product launches remain the life blood of the industry, we remain more confident in the potential for Teva and Mylan to continue offsetting these headwinds, thanks to their first-to-file pipelines.

There have been isolated pockets of price increases in the U.S. generic drug market that lead current pricing pressure as somewhat of a market correction, in our view. This is particularly true of certain drug categories, such as topicals, which have seen more steady price increases than other segments of the market. A recent U.S. Government Accountability Office report noted that 57% of topical drugs and 40% of ophthalmic drugs experience extraordinary price increases compared with 19% of oral drugs. In many cases, the price increases seem to result primarily from limited competition, players exiting the market, or competitors facing manufacturing issues. The topical price increases have particularly affected Perrigo, one of the three largest topical generic drug manufacturers in the U.S. Perrigo has witnessed approximately 10% price erosion in its topical segment in 2016 with a similar decline expected by management in 2017 as new entrants have emerged. Similarly, Endo and Mallinckrodt MNK have seen similar rates of price erosion in their base generic businesses, leading to double-digit declines in their generic segments as new launches don’t offset headwinds on older products. The larger diversified generic drug manufacturers seem to have faced more consistent mid-single-digit price erosion in 2016, but Teva has struggled a bit with new competition on some of its larger products.

Unusual price increases seem an exception to the rule in the generic drug industry, and we think isolated pressure on pricing will eventually subside. The GAO report, for instance, confirms our view that the vast majority of the generic drug market remains deflationary. An internal Centers for Medicare & Medicaid Services analysis found similar results in the Medicaid market, with 65% of generic drugs facing price declines in 2014. Despite what media headlines may suggest, generic drugs lead to reductions in drug spending.

With stable volume and an assumption of negative 5% price erosion on base generics industrywide, the ability to attain 5% total market growth comes from roughly 10% growth from new launch revenue, roughly split between price and volume, by our estimate. These numbers roughly match growth strategies outlined by firms like Teva, which has said the first-to-file pipeline and new launches need to contribute roughly 10% growth any given year to sustain 5% combined revenue growth and offset erosion on the base business. Based on numbers from the aforementioned GAO report and commentary from most generic company management teams, year-over-year price erosion does seem to traditionally settle in the midsingle digits, despite the likelihood of less erosion from 2013 to 2014 due to isolated price increases and higher erosion beginning in 2015.

In addition, the joint ventures of pharmacies and distributors (often referred to as consortiums) have increased customer buying power, which has added another factor in generic drug price pressure over the past few years. Based on management commentary, it seems some generic manufacturers have recently offered greater discounts in attempts to salvage market share with these customers. Since 2015, we estimate the consortiums have shifted distributor share from about 50% of the market to about 87%.

Opportunities Remain, but Fewer Small-Molecule Patents Expiring After a thorough evaluation of our modeled patent expirations and peak sales estimates across our biotech and pharma models, we think drug launches will continue help offset erosion of older products. We think the patent expiration outlook can help sustain low- to mid-single-digit generic market growth in the U.S. Regardless, we think some of the current price erosion and increased competitive pressure in the generic drug market stem from manufacturers adjusting to the shrinking of opportunities that peaked in 2009-14.

By our estimates, the next decade has roughly $144 billion in small-molecule branded drug value at time of patent expiration versus $197 billion over the last decade in the U.S. Although there remain a large number of patent expirations, the drug industry has shifted toward biologics, which diminishes launch opportunities for most generic drug manufacturers unable to meet manufacturing, regulatory, and marketing hurdles for these products. Biologics represent about 35% of total branded drug value coming off patent over the next decade in the U.S., compared with roughly 10% over the previous 10 years.

Lastly, U.S. generic market growth has an increasing correlation to patent expirations since generic volume utilization in the country has become very high. Once a product loses patent protection, generics gain a majority of market share, which has gradually shifted the U.S. prescription drug market to approximately 89% volume share. This is up from 67% in 2007. In terms of value, generics constitute approximately 27% of spending.

FDA Approval Rate Seems to Be Normalizing The Generic Drug User Fee Act began in October 2012 (the beginning of the U.S. government's 2013 fiscal year) to correct understaffing issues leading to the backlog of 2,866 ANDAs at the FDA. Industry fees paid by companies into GDUFA enabled the FDA to increase staff count and not only speed up application review times, but also release industry guidance documents on necessary requirements for product approvals, including bioequivalency requirements for more complex products. In exchange for the fees, GDUFA set up goalposts for reducing the backlog and addressing new applications within a set period. By October 2016, roughly 15 months ahead of schedule, the FDA issued first actions on 93% of applications from the original backlog. For new applications, GDUFA also began review clock requirements for first action of 60% of applications within 15 months in fiscal 2015, first action on 75% of applications within 15 months by fiscal 2016, and 90% first action on 90% of applications within 10 months by fiscal 2017. As a result of GDUFA, application approval times have improved considerably.

GDUFA has reduced the backlog and reduced approval times, but the FDA has noted that challenges persist. Combined first and multicycle approval time shifted from 1,012 days in fiscal 2013 to 467 days in fiscal 2015. Application quality remains an issue as the FDA works to set guidance documents and set standards and expectations for adequate applications. This has caused total review times to increase under GDUFA, which are currently close to about 40 months per application.

We think the FDA backlog reduction has been one of the key reasons new competition has suddenly entered certain generic drug markets, such as topicals, leading to higher-than-expected price erosion. The FDA’s advancements in working through the backlog and reducing first action time on applications has led to an increased rate of approvals. Combined approvals and tentative approvals picked up noticeably in the middle of 2015. We began to see first warnings of unexpected price erosion of certain generic products in early 2016, leading us to believe a cause-and-effect relationship exists. However, due to application quality issues, the FDA’s cumulative withdrawals, refuse-to-receive, and complete response letters have increased substantially, essentially leaving the status of a large number of applications in the hands of industry participants.

We’re fairly confident that the pace of ANDA submissions and approvals will return to more historical norms, which should help ease current price competition from the recent influx of new approvals. The pace of ANDA submissions slowed in 2015 and 2016. The low number of applications in 2015 stemmed from the large spike in June 2014 as generic manufacturers avoided new batch and data rules for stability requirements. Despite the obvious pull forward of some likely 2015 applications into 2014 as a result of the new requirements, the 852 submitted applications in 2016 is roughly on par with the annual average of 845 applications received over 2006-11. Growth in applications and approvals from 2016 into early 2017 continues to slow. The historical volatility of growth for ANDA submissions largely reflects the surge of applications received in June 2014.

Capital-Allocation Errors Have Depressed Returns on Capital In this relatively fragmented industry, M&A remains an important aspect of capital allocation, but several recent deals have soured returns on capital, particularly for Teva, Perrigo, and Endo. Teva's $40 billion purchase of Allergan's Actavis generic unit in 2016 enhanced the firm's first-to-file pipeline and manufacturing abilities, but management's overpayment will potentially lead to impairments. Perrigo has already taken impairment charges on its 2015 purchase of Omega Pharma's branded over-the-counter operations in Europe for $4.5 billion and tax inversion deal for Elan in late 2013 for $8.6 billion, which included the highly profitable Tysabri royalty stream. Besides overpaying for the deals, Omega's performance and integration has gone poorly since the deal closed. Endo's 2015 purchase of Par for $8 billion marked another poor use of capital, in our view, following previous purchases like Auxilium,

We think a few factors may have contributed to some of the recent value-destructive deals. First, many firms have become desperate thanks to concentrated product or geographic exposure. Second, many specialty pharma firms have become addicted to tax arbitrage. Following a string of tax inversion deals, many specialty pharma players have probably justified takeover multiples with easy gains from lower tax rates on acquired cash flows. Lastly, we think management teams used optimistic assumptions about growth opportunities, pricing power, and the outlook for limited-competition products when valuing takeover multiples. We’re uncertain if poor capital allocation will continue. Teva and Perrigo have new leadership, which potentially enables the firms to learn from past mistakes.

In addition, a number of generic drug manufacturers now possess high financial leverage, which has recently been exacerbated by declining profits. We still consider the generic drug industry as relatively fragmented with room for more consolidation, but the current state of balance sheets could leave little appetite for M&A over the medium term.

Branded Drugs and Investigations Are Concerns Branded drugs often represent the most serious risk for specialty pharma earnings. Copaxone still represents nearly 30% of Teva's earnings after the Actavis generic acquisition, and we anticipate a generic version of the 40 mg version in 2017 will shrink earnings. We estimate EpiPen represents close to 20% of Mylan's earnings and could face generic competition by late 2017 or early 2018. Many of Endo's higher-margin branded products continue to shrink, and the competitive outlook for Mallinckrodt's Acthar Gel, which makes up a majority of earnings, remains uncertain.

Most generic drug manufacturers have received subpoenas and civil suits related to antitrust and collusion matters, but we’re still skeptical that many of the large generic drug manufacturers will have large liabilities, given the burden of proof and less exposure to some of the drugs called into question over potential price fixing. It’s possible that additional charges could occur because of ongoing investigations, but the number of drugs, companies involved, timing of investigations, liabilities, or actual criminal charges remain unknown.

Valuations Reflect Market Headwinds Concerns about developed-market generic manufacturers' issues continue to depress valuations while emerging-market players look more accurately priced. There's a significant divergence in earnings multiples for larger, more developed-market-focused generic drug manufacturers like Teva and Mylan versus emerging-market-based peers like Dr. Reddy's and Hikma. Besides their higher exposure to headwinds in the developed-country generic drug markets, Teva and Mylan face major patent expiration issues for their large and highly profitable branded drugs Copaxone and EpiPen, respectively, which reflect most of the earnings growth pressure.

Most of the industry’s recent concerns--especially price erosion--stem from the U.S. market. Europe continues to face tough pricing dynamics as a result of government price controls, but we haven’t noticed any recent material shifts. With the exception of some specific country issues, as with Venezuela, or expanding tender systems in some areas, most emerging markets remain favorable for generic drug manufacturers primarily because of increases in healthcare spending as these economies develop and aging population demographics that suggest higher drug utilization rates.

We think it will be extremely difficult for most generic drug manufacturers to get a piece of the biosimilar pie, given the high manufacturing, regulatory, and marketing barriers for drugs engineered from living organisms. Additionally, we think most generic drug manufacturers will play a second-tier role to greater biosimilar advantages at Pfizer, Novartis, Amgen, and Biogen thanks to the latter firms’ manufacturing expertise and large institutional salesforces combined with more advanced biosimilar clinical trials. Biosimilars are likely to resemble a branded market, at least initially, with considerable salesforce requirements. As a result of these factors, we probability-weight revenue forecasts for biosimilar revenue in our models and include them in our branded segment forecasts.

Although we consider them second-tier players, Teva and Mylan possess the largest biosimilar pipelines among specialty pharma firms. Teva has been an early leader for initial European biosimilar launches, but it has lost ground to more capable peers in the U.S. It recently announced a partnership with Celltrion for biosimilar versions of Herceptin and Rituxan (both in phase 3 trials), however, and we think the company remains on the prowl for more assets. Merck KGaA recently announced the sale of its biosimilar program to Fresenius, which also plans to acquire Akorn. Mylan appears better positioned than Teva, as its partnerships with Biocon and more recently with Momenta give it a total of 16 biosimilars in development. Mylan has filed its applications for biosimilar versions of Herceptin and Neulasta with Humira, Avastin, Rituxan, and Lantus all in phase 3 trials.

We continue to think developed-market players like Teva and Mylan will grow below the market, but their focus on first-to-file launches and more complex formulations should help sustain some profitability. Actavis’ and Teva’s market share declines have been partially intentional, as these companies have pulled back from less profitable operations, especially in parts of Europe. Hikma and Dr. Reddy’s continue to look well positioned for earnings growth and market share gains, even though they compete in more heavily commoditized portions of the market. Mallinckrodt and Endo remain poorly positioned, in our view, due to concentrated exposure to the U.S. market and generic pain products.