StreetTalk: Going Off Patent: Standing Pat or Getting Out

William Osler once wrote, "The desire to take medicine is perhaps the greatest feature which distinguishes man from animals." If Osler were alive today, he might have added, ". . . and the cheaper and more plentiful the medicine, the better."

With over-the-counter versions of prescription and generic drugs widely available, especially as prescription drugs go "off patent," American consumers now are able to choose from a wider, cheaper pool of favored medications. In the past 18 months, we've seen high-profile drugs — such as the allergy medication Claritin from Schering-Plough (NYSE: SGP) and the acid-reflux fighting Prilosec from AstraZeneca (NYSE: AZN) — attain over-the-counter status and hit store shelves along with a handful of generics that claim to offer the same benefits as the originals.

2002 Sales of 23 companies that make generic drugs and their sales growth from 2001 to 2002

Make no mistake, generics are big business. According to IMS Health and Reuters, worldwide sales of generic drugs will skyrocket 20% in 2004, as more premium drugs go off patent. IMS Health claims the generic drug market will rise from $29 billion to $49 billion in 2007, at ex-factory prices.

Good news for consumers? No doubt. From time to time, I walk into my local CVS pharmacy and grab a pack of Claritin off the rack, especially during allergy season. And I'm a faithful user of Prilosec, which has, to my delight, kept periodic bursts of heartburn at bay over the last year or two.

But does that good news for consumers like myself translate into good news for investors in companies like Schering-Plough or AstraZeneca? Not really.

Let me explain.

Government regulators have two key priorities regarding drug patents: encouraging innovation and maintaining accessibility. When pharmaceutical companies produce (after years of painstaking research effort) a popular and beneficial new drug, they can patent that drug with the US government and thereby protect their investment. No surprise there. Uncle Sam — especially the Bush administration, given its pro-business bent — wants to encourage risk-taking companies to keep right on taking risks and creating new drugs for the masses. In return for that risk, drug companies get market exclusivity for a period of time and rake in hundreds of million of dollars, depending on the product. In turn, investors buy mega-shares of the company because so many consumers are buying their drugs and because the drug company has the playing field all to itself. That's the innovation part.

But the US government rigs the patent game so that the company's new wonder drug has a limited shelf life, market-wise. Uncle Sam takes great interest in ensuring that popular new drugs are both affordable and widely available. By taking away the drug firm's exclusivity after a predetermined period of time, the government opens the door for generic drug makers to roll in and make their own version of the product and market it to the masses — usually at a significantly lower price. In some instances, the company that invented the drug and earned the patent can go ahead and offer the product on an over-the-counter basis, albeit at a reduced price and in a suddenly combative and crowded marketplace. This is the accessibility part.

Given that a single new drug might cost as much as $800 million to roll out (and there is no guarantee that it ever will roll out), the exclusivity feature in US patent approvals is understandable. Without exclusivity, there is no incentive for drug companies to shell out hundreds of millions of dollars to create a new drug only to see it mirrored, made, and marketed immediately by competitors. It's also easy to see why Uncle Sam uses patent time limits to prevent drug companies from hogging the market forever. Studies show that in 2001, the average brand name prescription drug costs $72 per bottle. The average price for generic versions of prescription drugs is only $17 per prescription.

So, by balancing innovation and access, the US patent system rewards drug makers for the risks they undertake in developing drugs, while accommodating the American public with an eventual and significant cut in the price of prescription drugs when they go off patent. Piece of cake, right?

Investors, unfortunately, are left somewhere in the middle. They're forced to dig deeper into a company's past, present, and future to determine whether it's a good idea to sell a company's stock when its drug goes off patent — or whether it's a good idea to buy.

What are the key criteria for investors in making the right call? Let's take a look.

Due diligence. Doing your own homework is part of any investor's life. Studying profit and loss statements, reviewing glossy annual reports, and generally kicking a company's financial tires are routine to any good investor. That's a good thing given an off-patent situation. Once you've invested in the drug-maker ABC Corporation, primarily because of its wildly popular new prescription drug, you are "on the clock," so to speak. Consequently, you have to consider possible expiration times. Patent expirations are not usually set in stone. In fact, there are myriad ways for drug firms to extend patent limits. For example, a pediatric study on bone marrow disease in children can lead federal regulators to grant more patent time to a drug company that offers prescriptive solutions to bone marrow disease. The key for investors is to consider the patent timeframes as best they can and examine whether the company could face a great deal of generic competition when the patent expires. Prilosec is a great example of a prescription drug for a common ailment (heartburn) where multiple generic counterparts are likely to emerge. It's easy to make, market, and manage — from a business point of view.

"New and improved" version? As I indicated above, part of the challenge in assessing a drug company's financial fortunes after its successful medication goes off patent is figuring out how much generic competition the company might face. One key indicator that can help you do just that is whether the company in question has a "new and improved" version of its popular prescription drug coming out that might limit generic competition. Schering-Plough did this with Claritin, rolling out Clarinex just as their patent on Claritin ended. Whether or not Clarinex significantly improved on Claritin wasn't really the issue. It was enough that devotees of Claritin had a "new and improved" prescription option that sold enough pills to keep sales up — and mitigate, if not eliminate, the number of successful generic counterparts to Claritin on the market. It's not rocket science. If doctors switch their patients from Claritin to Clarinex and patients like the new drug, the market for a generic version will shrink accordingly.

What's in the pipeline? Another key issue to examine is whether or not a giant drug company has any wonder drugs on deck to supplant successful drugs that are going off patent. Look at Bristol-Myers Squibb (NYSE: BMY), for example. With older drugs like Taxol and Glucophage going off patent, are there worthy heirs to the throne coming down the pipeline?

Consider the generics. With a host of blockbuster drugs going off patent and increased efforts on the part of generic drug companies to compete in the marketplace, it only makes sense to peek over the fence at the generic side of the industry and see if there isn't money to be made. True, the grass isn’t as green and the address might not have the cachet you like, but the price is usually right.

Right now, generic drug companies are pouring millions of dollars into new manufacturing plants and new plant infrastructure to ramp up drug manufacturing efforts. They also are beefing up resources for patent litigation as well as marketing, drug fulfillment, and distribution. Companies like Barr Labs (NYSE: BRL), the first to produce a generic equivalent of Prozac, have seen revenues rise significantly. Teva Pharmaceutical Industries (Nasdaq: TEVA), an Israel-based generic drug maker, is another company to consider. It has about 60 generic applications filed with FDA.

Admittedly, the story I've laid out here covers only the tip of the iceberg. Whole books can and maybe should be written on how investors view portfolio perennials that have drugs going off patent. But if you do your homework, know the lay of the land, and avoid surprises, you’re already well ahead of the rest of the market. BPI