The Best Pharma Stock to Profit from the ‘Patent Cliff’

Expiring patents are usually bad news for major pharmaceutical companies, especially if the patents are for popular “blockbuster” medications generating $1 billion or more of annual revenue. When those patents expire, the patent holders can usually expect revenue from their blockbusters to erode as rivals bring similar versions to market.#-ad_banner-#

Now, I’m not saying you should avoid the stocks of big drug companies like Pfizer Inc. (NYSE: PFE), Johnson & Johnson (NYSE: JNJ) and others simply to avoid near-term bumps in financial performance that may come with patent expirations. These companies have been around for ages, and they’re always working on new blockbuster drugs to replace those going off-patent. So I’m not too worried about their long-term profitability or investment merit.

Still, you can protect yourself against periodic performance blips resulting from patent expirations by investing in companies that know best how to capitalize on this vulnerability. In fact, there’s one firm I especially like because it has made a habit of turning brand name patent expirations into big profits.

I’m referring to Parsippany, New Jersey-based Watson Pharmaceuticals Inc. (NYSE: WPI).

You probably haven’t heard of Watson, but the firm has three decades of experience bringing generic drugs to market in a timely fashion. Among the latest are generic versions of Pfizer’s $5.3-billion high-cholesterol medication Lipitor and Johnson & Johnson’s $1.4-billion attention deficit and hyperactivity disorder (ADHD) treatment Concerta. Watson introduced generic Lipitor Nov. 30, 2011, the day the patent on the branded version expired. Generic Concerta became available May 2, 2011, also the exact date the original brand went off-patent. 

Sales have long been fantastic, rising 18.6% annually during the past decade from $1.2 billion in 2002 to the $6.6 billion they’re on track to achieve in 2012. Earnings have soared by 13.9% a year during this time, starting at $1.63 a share and on pace to hit $6 a share in 2012. As a result, the stock has rewarded shareholders with market-beating performance, delivering an annualized rate of return of 11.4% for the past decade, compared with 6.6% for the S&P 500.

And I feel confident shares of Watson still have plenty of room to run.

Because generic drugs are generally much cheaper for patients and health care systems overall, demand for generics should remain very strong in coming years. As the world’s third-largest manufacturer of these drugs, Watson is well-positioned to help meet that demand.

A key move to put the company in that position was the recent acquisition of Switzerland-based generic drug maker Actavis for $5.7 billion. Before this, many investors were concerned about revenue headwinds because of Watson’s limited international exposure and a slowing pace of patent expirations domestically. But the deal transformed Watson — which plans to begin operating exclusively under the Actavis name in 2013 — into a global force.

This is because Actavis was already a formidable player in the global generics market, with $2.5 billion in annual sales, more than 1,000 products on the market, several hundred new products in the pipeline and operations in 40 countries. Some of its better-known products include generic versions of the ADHD medication Ritalin and the sleeping pill Ambien. With this acquisition, Watson became the world’s third-largest generic drug manufacturer, up from No. 5 before. 

Based on a December 2011 announcement of a partnership with the well-known biotech firm Amgen Inc. (Nasdaq: AMGN), it appears Watson will also be entering what many investors consider the drug industry’s next frontier — “biosimilars,” which are near-equivalent versions of existing medications. Although the two companies haven’t yet revealed which medications they intend to imitate, analysts speculate the $9-billion arthritis drug Humira manufactured by Abbott Labs (NYSE: ABT) and the $3-billion cancer medication Rituxan made by Genentech Inc. are among the potential candidates.

Risks to Consider: Like the big drug makers, Watson faces heavy competition — particularly from low-cost generic drug producers in India and China.

Action to Take –> Because of Watson’s long history of success and recent growth initiatives, I think it’s arguably the best play on the highly profitable generic drugs space, as well as on potentially lucrative biosimilars. Indeed, analysts predict revenue will continue to expand quickly, rising 13% a year to about $11 billion in 2017.

Earnings are projected to climb to $9.50 per share during that time. If you multiply the stock’s historical price-to-earnings ratio of 14 by 2017’s projected EPS, then you get an estimated stock price of $133 (14 x $9.50). This implies the potential for a 56% gain from the current price of about $85 a share.