The 2 Best Stocks for this $33 Billion Trend

David Sterman's picture

Monday, September 26, 2011 - 1:00pm

by David Sterman

For the millions of Americans who suffer from high cholesterol, Nov. 30 will be a big day. That's when Pfizer's (NYSE: PFE) blockbuster drug Lipitor will lose patent protection, promising massive savings for high-cholesterol patients. The $7 billion drug (according to projected 2011 sales) also represents a big deal for firms that make and distribute generic drugs. In fact, these firms are lining up for a banner year in 2012, because a whole host of other drugs are also on the verge of losing patent protection.

Here are a few:

  • Bristol-Myers Squibb's (NYSE: BMY) Plavix, a blood thinner that treats patients with high risk for heart attacks, will lose patent protection next May. It is projected to bring int $6.6 billion in sales this year.
  • Forest Labs' (NYSE: FRX) Lexapro treats anxiety disorders and is slated to go off-patent in February 2012. It generates about $2.3 billion in annual sales.
  • AstraZeneca's (NYSE: AZN) Seroquel, a schizophrenia drug, loses patent protection in March 2012. The psychiatric medication brings in $3.9 billion in annual sales.
  • Merck's (NYSE: MRK) Singulair, used for the treatment of asthma, goes generic in August 2012. It makes $3.6 billion in annual revenue.
  • Takeda Pharmaceutical Co.'s diabetes drug Actos will also lose patent in August 2012. The drug generates about $3.1 billion in revenue.
  • Novartis' (NYSE: NVS) Diovan/HCT, for hypertension, hits the generic market a year from now. Diovan generates about $2.2 billion in yearly sales.

These names are just a partial list. Citigroup figures the entire list of drugs that will lose patent protection next year accounts for $33 billion in sales, which will be a little more than double from this year. Keep in mind generic drug prices will be lower, so these generic equivalents will ultimately represent closer to $10 billion in sales once price discounts have fully played out.

This generic tidal wave is likely to prove to be a real boon for generic drug makers. Trouble is, it's hard to handicap which firms will get which contracts. The Food and Drug Administration (FDA) grants a 180-day exclusivity period to a select number of generic-drug makers that are able to dispute the patents successfully. This is usually when the drug price drops by 30-40%. Once this six-month period ends and other generic-drug makers enter the market, prices decrease to about 10% to 20% of the original branded prices. Profits from the manufacture of generic drugs are attractive for the drug makers, but really attractive for the drug distributors, as I'll explain in a moment.

So far, the best guess is that Watson Pharmaceuticals (NYSE: WPI) and India's Ranbaxy will share the exclusive upfront window for the production and distribution of generic Lipitor. For legal reasons, the FDA won't grant the 180-day exclusivity for Bristol-Myers's Plavix. As a result, the drug may immediately be subject to broad competition among generic-drug manufacturers.

But while we can't quantify how the generic bonanza will affect specific pharmaceutical companies in 2012, we can surmise the biggest players will also get their share. In order of size, the top five generic-drug producers in the United States are: Teva Pharmaceuticals (Nasdaq: TEVA), Mylan Labs (NYSE: MYL), Sandoz (which trades in its native Germany), Watson Pharmaceuticals Inc., privately-held Greenstone Generics LLC (a subsidiary of Pfizer). Other public generic-drug makers include Par Pharmaceutical (NYSE: PRX), Hospira (NYSE: HSP) and India-based Dr. Reddy's (NYSE: RDY). All of these companies are well positioned to take advantage of this trend.

Analysts at Citigroup are considering a different investment approach. They say investors should focus on drug distributors that will benefit from lower purchasing costs, because so many drugs are slated to go generic. In this light, they cite Cardinal Health (NYSE: CAH) and McKesson (NYSE: MCK) as the best investment vehicles. These two firms control, respectively, 36% and 37% of the wholesale drug distribution market (AmerisourceBergen (NYSE: ABC) controls the other 25%).

These distributors deal directly with drug manufacturers and garner best-in-industry pricing, thanks to their sheer size. Pharmacy chains such as CVS (NYSE: CVS) and Walgreen's (NYSE: WAG), for example, buy directly from these wholesalers, not the drug makers. So while Cardinal and McKesson will probably see lower revenue when prices of brand-name drugs fall, their margins are likely to expand, since as they would be getting better profit spreads on generics. "Within the customer base that buys generics from the wholesalers, generic drugs can be three to 20 times as profitable as their branded drug counterparts," note Citigroup's analysts.

Regarding Cardinal Health in particular, Citigroup has just boosted 2012 earnings per share (EPS) forecasts to $3.28, slightly ahead of the consensus. The analysts predict shares will rise from a current $42 to $51 by next year (a 21% gain). Their outlook for McKesson is even more bullish, predicting the company will likely earn $6.34 a share in 2012 -- the highest forecast in the consensus, while also predicting shares could move up to $101 from a current $73 (a 38% gain.

Most importantly, this positive outlook doesn't depend on the health of the U.S. economy, because drug sales are rarely affected by external economic forces. If anything, the switch to generics could be a boon for cash-strapped consumers. The typical branded drug sells for an average of $170, while the typical generic sells for $50. 

Risks to Consider:  Although the switch to generics represents major cost savings for the entire health care system, reimbursement pressures remain quite strong as Washington seeks further savings. Any major changes to Medicare could reduce the buying power of senior citizens, who are the largest consumers of prescription drugs.

Action to Take --> The generic revolution has been underway for quite some time, and many have profited from this theme before. But 2012 represents a whole new set of opportunities for generic-drug makers and for firms that distribute these drugs. McKesson and Cardinal Health look like sensible plays on the trend. It's also worth taking a deeper look at generic drug makers such as Teva and Mylan. They both have been trading well off their highs and have been sporting extremely low price-to-earnings (P/E) ratios in relation to projected 2012 profits.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.