Forget Big Pharma: This is the Drug Stock You Want to Own

If you follow the news avidly, then you’re undoubtedly aware the pharmaceutical industry is currently running off a so-called patent cliff.

Problem is, many of the drugs losing their patent protection also happen to be the blockbuster drugs driving the bulk of Big Pharma’s revenue.  It’s not that these large drug manufacturers aren’t working on ways to replace what will eventually become lost revenue. But, perhaps they’re going about it all wrong.


So what’s the right way… And how can investors profit?

Pharma’s two-edged sword
Back in 1996, when cholesterol drug Lipitor was first approved, Pfizer (NYSE: PFE) wasn’t thinking about its patent expiration in 2012. It was just thinking about the large sum of money it was going to make with the new drug. And sure enough, Lipitor became the best-selling drug of all time, generating sales of $125 billion during the past 16 years. Last year alone, Pfizer sold nearly $11 billion worth of the drug  — more than 15% of the company’s total revenue.

And now that the patent has expired, Pfizer is pretty much losing 15% of its annual revenue.

Liptor is hardly the only case of patent expirations apt to take a huge toll on revenue though. Blood-clotting drug Plavix, which generated $8.9 billion in sales for co-owners Sanofi SA (NYSE: SNY) and Bristol-Myers Squibb (NYSE: BMY), saw its patent expire this year too.It accounted for more than 13% of the companies’ combined sales.

On the surface, the problem appears to be too much reliance on only a handful of drugs. But that’s only the symptom, not the cause. The underlying problem is actually a lack of blockbuster drugs being created now.

The new reality
The era of mega-blockbusters is winding down. New-drug discovery has become much more difficult (not to mention more expensive), while more competition dilutes every drug’s revenue potential. To make troubles worse drug companies that became giants on the heels of mega blockbusters are having a tough time letting go of the old mindset that they need blockbuster drugs to succeed. Investors have this misconception too.

But look at AstraZeneca (NYSE: AZN) for instance. The company has been criticized for years because of what the market deems to be a lack of a pipeline. Yet, its top line has grown for eight consecutive years and profits were up in seven of those years, while net margins have grown from 13% in 2003 to a robust 26% so far this year.

How did the company overcome what most would argue is an alarming lack of blockbuster drugs? While AstraZeneca may be missing a clear cornerstone drug, it’s been building a library of small, nickel-and-dime drugs and ventures that actually add up to an impressive top line.

It’s an interesting contrast with Pfizer, Merck (NYSE: MRK) and GlaxoSmithKline plc (NYSE: GSK) — the kings of blockbuster drugs — which have been watching profits flounder for years, yet haven’t unveiled any new game-changing drugs in the meantime.

Built from the ground up

Not that old-school pharmaceutical companies are incapable of mastering the art of managing several smaller drugs, but let’s face it — they’re going to have to undo a lot of the old mindset first.

In the meantime, one company is being built from the ground up to manage many drugs that may not be blockbusters, but can collectively contribute to a surprisingly large top line.

This company is Sagent Pharmaceuticals Inc. (Nasdaq: SGNT), which most investors probably don’t even know.

Despite its rapid growth since the company’s beginnings in 2006, it’s still only a $295 million company. Yet, CEO Jeff Yorden has taken the company from a business that did $10 million in sales in its first year to $152 million in sales last year, with a plenty of growth in the cards.

Yorden’s vision for his company is almost the diametrical opposite of other large-cap pharma stocks — diffusing risk by bringing on more development partners instead of fewer, focusing on a wider scope instead of a narrower one and manufacturing more of the drugs we know we need right now rather than swinging for the fences on a drug that may or may not get FDA approval.

Sagent Pharmaceuticals invests its money appropriately. All told, it coordinates the activities of 48 different manufacturing and R&D sites, and can create therapies in a variety of formats (pills, injections, etc.). The end-result is a portfolio of 34 revenue-bearing products and 82 pending ones.

None of them likely will be blockbusters. Indeed, Sagent’s growth plan largely consists of acquiring drugs and divisions that generate less than $100 million in annual sales.

This isn’t an exciting strategy, that’s the point. It’s reliable and the business model rewards efficiency rather than good luck with a single new drug. That’s a lesson Big Pharma is having a hard time learning, which keeps the door wide open for Sagent.

Risks to Consider: With several dozen diversified drugs already in the lineup or on the way, it’s tough to imagine any pitfall that could trip the company up in a big way. Perhaps the biggest risk here is that as Sagent grows by adding more pharmaceuticals to its menu, it becomes more difficult to manage.

Action to Take –> Sagent is positioned to continue its march toward profitability, and at its current pace, that should happen sometime in 2013. Veteran pharmaceutical investors know how this works though: The market rewards pharma stocks well in advance of their actual success. Realistically, the stock’s got a potential upside of more than 30% between now and the end of 2013, which is just a little shy of the 44% revenue growth rate the pros expect to see during the same time. Past 2013, the fireworks could really start popping.