Street Talk: Patent Issues Could Dominate Pharma Industry in 2006

How much of an impact does patent reform, real or imagined, have on biopharmaceutical stocks?

Plenty. Consider Pfizer as an example.

The pharma giant sent shock waves up and down Wall Street in December '05 when it announced that third-quarter profits had plummeted by 52 percent. That in turn sent company stock down almost nine percent, reaching a 15-year-low.

Brian O'Connell

While declining sales of linchpin drugs like Lipitor and Viagra had a lot to do with Pfizer's financial woes, analysts noted that many investors were jumping ship over the fact that the company has a slew of patents ending their run in 2006. Pfizer will have to battle it out with generic drug makers encroaching on its turf.

Investors spent 2005 nervous about Lipitor's patent, which seemed vulnerable after Ranbaxy Pharmaceuticals filed a patent infringement lawsuit. With $2.9 billion in Lipitor sales, Pfizer had a lot riding on the outcome of this patent case, which ended in Pfizer's favor.

Patent issues place Pfizer at a competitive disadvantage and help explain why so many investors are taking a dim view of the stock in 2006.

"The global pharmaceutical group multiple on 2006 earnings-per-share estimates is currently about 15 times, and Pfizer currently trades at 10.9 times," says Prudential Equity Group analyst Tim Anderson in a December 2005 analyst report.

In short, Pfizer has all the looks of an underperformer in 2006, due largely to worries over patents expiring this year.

Pfizer's patent woes are a big, red flag for the entire prescription drug industry this year. According to Express Scripts, a big pharma benefits manager, more than $38 billion worth of prescription drugs are losing their patent protection in 2006. That's good news for consumers, who will save an estimated $20 billion in drug costs this year (according to Express Scripts), but bad news for drug companies, who will lose that $20 billion in revenues.

Normally, drug prices fall around 20 percent during the first six months in a post- patent protection environment. According to a research report from Gilford Securities, which follows the generic drug market closely, brand name drug companies can expect prices to drop another 20 percent in the subsequent six months. Pfizer can expect to lose $10 billion in revenues due to expired patents over the next two years. A separate report from the Wall Street research firm WR Hambrecht & Company states than an estimated $100 billion worth of name-brand drugs will lose patent exclusivity by 2010.

It's tough to regain those revenues, and investors know that. Says Dr. Steven Miller, as quoted by CNNMoney.com, drug companies who lose patent protection have to come up with a new idea. That is not easy. "Obviously, they're going to have to discover unique drugs and it probably discourages a lot of investing in me-too drugs," warns Miller. The generic approval gap is squeezing profit margins tighter. According to the US Food & Drug Administration, the FDA has cut generic drug approval cycles from 17 months to 15.7 months.

This is grim news enough for the pharmaceutical industry. But it gets even thornier for drug makers. Generic drug companies are not just settling for quicker response times and larger market share — now they're going after the total patent process, actively and legally challenging patents of major drug companies, including patents that have years to go before they expire.

In a new study by the drug consultant Kline & Company, researchers conclude that generic drug companies are pursuing the patent process to further reduce generic drug approval times. It's a strategy that relies less on sledgehammers than on a hammer and chisel, allowing generic drug companies to chip away at the patent process and slowly bring brand name drug makers to their knees.

"In the past, generic companies just used to wait for the patents on brand name drugs to expire, but now they're being a lot more aggressive and proactive," notes Laura Mahecha, healthcare industry manager and participating research director on the study. "They're bringing legal challenges to try to break patents in order to bring generic versions to market sooner."

Kline & Company cites generic drug companies such as Teva Pharmaceuticals, Sandoz, and the afore-mentioned Ranbaxy Laboratories as pioneers in the patent reform sector. Note the omission of the Pfizers, Mercks, or Roches of the world.

Even so, using Pfizer as an example, generic drug companies have had some success chiseling away at a brand name drug maker's patent protection.

"[Generic drug makers] have been aggressive in challenging Pfizer's patents and so far have had only limited success, but they just keep chipping away at them, which is really their ultimate goal in many cases. Even if their case gets shot down and they only get to bring their product to market a few months sooner, they win big," Mahecha says. She notes that patent challenges will increase as more brand name drugs approach their expiration dates.

MORE TROUBLE THAN IT'S WORTH?

But is it a good idea to reform or even abolish patent protection? Doesn't that de-emphasize research on the part of biopharmaceutical companies who fear, rightfully so, that generic vultures will swoop in and steal their billion dollar ideas? And won't this practice hurt the financial prospects of brand name drug makers and make it harder for them to create environments for important prescription drug breakthroughs?

Well, "yes" on all fronts, to be perfectly blunt.

The US government has been in the patent protection business since 1793, ostensibly to provide people and companies with exclusive rights to their great ideas, and to build a wall that keeps those who would poach those ideas away.

In a thoroughly researched book on the topic, Innovation and Its Discontents: How Our Broken Patent System is Endangering Innovation and Progress, by Princeton University professors Josh Lerner and Adam Jaffe, the authors argue that the patent process has moved away from that original 1793 mission of idea protection to a 2006 environment of idea exploitation.

Said Lerner, in an October, 2004 interview with The New York Times, "The ability to litigate and expect to get substantial award from litigation (has) increased. As a result we've got somewhat of a vicious cycle. Once you get one firm in an industry beginning a strategy of aggressive patent enforcement, it creates an almost inevitable response — an almost arms-race dynamic — where everyone else in the industry says, 'We better be doing the same thing."

The authors want to jettison the current patent legal environment, which they say is highly jury-driven. They recommend a return to trials where judges are the final arbiters, as the complexities involved in patent law are better handled by trained jurists. "Over the last 30 to 40 years, there has been real replacing of judges by juries," Mr. Lerner told The Times. "Patent disputes by and large tend to be highly technical disputes, and in many cases a lay person without much training in the area is hardly an expert."

Some help for brand name drug companies may be coming down the pike from Congress, which is closing in on the passage of a bill called the Patent Reform Act of 2005 (HR #2795). The bill promises to make it easier to win patent approval and harder to litigate against patent holders.

The act changes the current "first to invent" standard to "first to file," which means patent rights go to the first inventor to file for a patent who can provide sufficient evidence for a claimed invention. It also reduces the scope of willful infringement by raising the standard of proof required, and limits the amount of damages a patent holder can collect from an infringer. Additionally, it limits the plaintant's ability to get injunctions against patent holders.

But Congress is also looking at ways to curb longer patent protection time periods. Right now, biopharmaceutical firms enjoy roughly 20 years of drug patent protection for their brand-name drugs. The Hatch-Waxman Act would limit the automatic extensions filed by drug makers.

So is it too soon to call 2006 the Year of the Patent? Maybe, or maybe not.

But one thing is for sure. For a heads-up on long-term profit margins for big biopharmaceutical companies and the generic drug companies chasing them, patent reform is well worth watching closely.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, 79 Radcliffe Drive, Doylestown, PA 18901, 215.230.3711, fax 267.880.1939, brian.oco@verizon.net.