Why Investors Need to Re-examine the U.S. and European Pharmaceutical Industry

The pharmaceutical industry is one of the strongest elements of the financial world, known mainly for its undying demand and extremely high barriers of entry. It also remains an industry that tends to often come under fire from the general public for not subjecting itself to a consumer price-making mechanism, and seemingly skipping away from any ideals of a free-market. The prices set by the manufacturing pharmaceutical companies often exceed the accessibility of most consumers without having much effect on their product demand. Casting poor light aside, the pharmaceutical industry brings the world miracles; products that change lives, reverse diagnoses, and give a second chance to many. The prices may be high, but the industry relies on established social infrastructure to aid those that need their products the most. Insurance companies and government programs alike allow many to receive the medical attention and supplies that they need to achieve better health. From a business perspective; investing in pharmaceutical companies offers one a chance to lend their capital to a company that will not only use it to grow, but to help create more solutions health issues of global importance.

 

Patent Protection

Patent laws stand at the heart of what allows pharmaceutical companies to capitalize on the saturated market of the sick, and protect their products from competition. U.S. patenting laws protect the exclusivity of production of a drug for an average of 20 years after its approval. After the approval of the patent the drug must also pass the clinical trials imposed by the Food & Drugs Administration (FDA) which makes sure to account for all of the drug’s potential side-effects and to decide whether it is fit for human consumption. The FDA approval process is known to take up to eight years with certain drugs, further eating into the patent duration and marketability of the product. Additionally, research and development of pharmaceutical products remains the biggest cost factor for all companies, and sets the tone for an approximate pricing scheme. However, it’s not enough for companies to merely divide their cost of production by the time period in which their product enjoy exclusivity in the market – no company is interested in merely breaking even, and especially not any pharmaceutical company. With inelastic demand and expert attribution at point of sale the price for a product quickly increases in the supply chain. Pharmaceutical companies are at liberty to mark-up their drug based on manufacturing process within certain guidelines and price ceilings established by the Centers of Medicaid & Medicare Services (CMS). Pharmacies stocking the medication also impose a Pharmacy Mark-Up fee, which is used to fund the business, and an additional administrative dispensing fee for when the product is finally sold to a customer. While over-the-counter (OTC) drugs may seem extremely over-priced, they are the only products that can be swayed by consumer demand even when they are branded. After all, OTC medication is used to treat malady that generally poses little risk to one’s life. Examining a list of the top 2016 prescription drugs by revenue brings insight into the true building blocks that make up this growing pharmaceutical industry.

The the list above outlines the highest selling pharmaceutical products of 2016, all of which have been proven to significantly increase the survivability of patients the suffer from the ailments that are listed. The demand for these drugs is especially inelastic and for many patients accessibility will mean the difference between life and death. 2017Q1 reported that 11.3% of the U.S. population still has no health insurance coverage, which means the costs of the products must be paid entirely by the ailing individual. Additionally, most insurance plans in the U.S. have very specific guidelines for the coverage of oral chemotherapy and will require the insurance holder to co-pay various amounts for the medication. The table below outlines average costs associated with the product revenue leaders of 2016.

 

Patent Expiration

A patent for a drug is able to protect the product from the emergence of bioequivalent generics in the same market. It also creates pressure on the manufacturer to use the market exclusivity while they still can. The top three drugs by sale in 2016 are all patent protected brand-name drugs, and only six of the top 15 have expired patents. This raises the question: How can there be any non-patented drugs in the top performing sales list?

Once a patent for a pharmaceutical drug expires the company should usually expect to lose around 70% of the sales associated with the product – but not immediately. In the same way that the original manufacturer had to go through the arduous process of patenting, and conducting FDA sanctioned clinical trials, the company tendering the production of a biosimilar product must do the same. Until the biosimilar producer has received all approvals their product will not stock the shelves of pharmacies and therefore makes no impact on the revenues of the original drug. Once the drug passes all of the tests it enters the market, but may still experience initial sales issues when attempting to compete with the market leader. Even if there is a large discrepancy in pricing it may still take months for the general population to become aware of it. However, once the market appropriately adjusts the original manufacturer is often squeezed out of their original revenue.

 

A Difficult Pricing War: Celgene vs Natco

The prices set by the competing biosimilar are most of the time unbeatable. Following a 2012 patent litigation lawsuit between Celgene Corp. and Indian biopharmaceutical company – Natco Pharma LTD, a settlement was reached where Celgene was to allow Natco to sell their Revlimid generic on the U.S. market five years before the patent expiry. A box of 28 capsules of the blood cancer drug, Revlimid, currently sells in the U.S. for $22,000, while Natco currently sells their biosimilar generic in the local Indian market (only to residents) for $230 per 30 capsules.

Dependent Patents

Pharmaceutical companies can also take other actions to ensure the protection of their product, such as patenting additional supplementing products to decrease the impact a patent expiration has on their revenue. For instance, British pharmaceutical company GlaxoSmithKline, known for their asthma medication, Advair Diskus, created several patents for their product. They patented the active substance used in the production of their asthma medication, but also patented the medication delivery system – the inhaler. While the patent on the drug runs out, the inhaler – a crucial component of asthmatic health management – remained protected and bought the company even more time in the green. This patenting trend can also be seen exercised by Sanofi in the patenting of their diabetes medication, Lantus, which is delivered through an auto-injectable pen.

Evaluating Performance

Despite the various methods used by pharmaceutical companies to protect the marketability of their products, eventually all patent options are exhausted and the product is swallowed up by the generic market. The only factor being time – it is important to consider exactly how a total patent expiration affects the manufacturing company. The list outlining the most sold pharmaceutical products in 2016 hides a problem that could upset the balance of the pharmaceutical world. It reveals one of the biggest weaknesses of the current standing of the pharmaceutical industry is also its biggest asset: patent dependency.

2016’s leading pharmaceutical product sales are split amongst the industry’s global leaders. AbbVie leading in terms of individual product sales with their Crohn’s disease and arthritis drug, Humira, but they do not hold the largest market capitalization in the list.

Roche holds the number one spot in terms of the top 15 prescription sales, with a 2016 total revenue of $20.8 billion, with three separate products in their inflows: Rituxan, rheumatoid arthritis; Avastin, for metastatic colorectal cancer; and Herceptin, for breast cancer treatment. Pfizer is the only other company to boast revenues from three different products in the list.

AbbVie, Pfizer, and Roche alone dominate the top of the pharmaceutical product sales chain by generating almost 50% of the lists total revenue.

While the sales figures for these products are impressive they lack revenue inflow diversification. The table below illustrates how much of the total revenue of each company came from the sale of listed products.

AbbVie Inc., Celgene Corp., and Regeneron Pharmaceuticals all rely on single product to make up more than 60% of their total yearly revenues. Coming in fourth; 52% of Roche’s total revenue is attributed to three products – which isn’t nearly as worrisome. It is not a surprise that the three aforementioned companies’ products are all still patent protected, however this puts immense pressure on the firms to keep up their quarterly revenues. It is not unheard of – or unfeasible – for a company to fully rely on the sales of a single product to remain afloat, but a few conditions should be met: high barriers of entry, lack of substitute goods, and strong consumer loyalty are all important factors to consider. Currently, the company has control over all three factors because they control the production rights for any perfectly competitive goods, biosimilar drugs. The patent expiration for companies’ dependent on a single pharmaceutical product acts as a countdown to the beginning-of-the-end of high sales revenues. Despite the fact that it sometimes takes years before a generic becomes available, it’s still only a matter of time before their revenues plummet.

This isn’t an internal problem, pharmaceutical companies are well aware of the need to develop further, come up with more innovative products, and find alternative means of expanding their business. Some pharmaceutical companies partner with clinics, acquire other companies, and do everything they can to diversify their inflows. However, the pharmaceutical industry suffers from investor anchoring and conservatism bias that pushes company evaluations higher until they are all overvalued.

 

 

12 companies are represented on the charts above which outline the historical price change of the firms over the past 5 years. All companies except GlaxoSmithKline have experience incredible growth. The investor sentiment regarding the pharmaceutical industry remains positive we quoted one investor saying “Growth in the big-name pharmaceutical sector is expected, if their revenues are increasing it must be because they’re curing more people. There’s always going to be sick people.” Unfortunately, although the demand for pharmaceutical products will always be there, not always the same companies will be profiting from it. The growth associated with these companies can only continue at the same rate if they are able to diversify their revenue stream enough before their patents expire, which – again – means finding alternative ways of coming up with revenue.

 

Finding alternative ways of generating revenue isn’t easy because it essentially means to find a way to make more money in a different way. Companies that do this increase their total revenues and grow, but you cannot expect the entire sector to succeed in diversifying their income. Unlike drugs, alternative revenue streams are not subject to exclusivity laws or patents, nor is the demand infinite. Additionally, further revenue growth would encourage even more positive investor sentiments – overvaluing the stock even further.

 

Pre & Post Expiration Drift

Having previously examined the growth chart for 12 companies listed in the 2016 sales report learning that all but one company experienced very bullish growth over the past couple five years an investors attention must turn to possible roadblocks – which there are many. Many of the companies represented in the chart experienced patent expiration, and patent litigations during that period of time. Due to the process by which a generic drug is introduced into the market, and the lack of an immediate effect on sales, investors fail to see the big picture when they are notified of a patent expiration and when revenue streams are not immediately impacted.

Examining the closing price 30 days prior to a patent expiration and 30 days after shows little volatility, and a swift correction.

Amgen Inc.’s Neulasta patent expires, but with no market substitute available yet on October 1st, 2015.
Roche’s patent for Rituximab expiring in September 2016, generating bearish signals in the market.
GlaxoSmithKline’s patent for their medical inhaler expired on August 23, 2016, the last patent protecting their drug’s delivery system. The patent on the medication had already expired in 2012 and substitutes were ready to flood the market.

 

While some investors view the patent expiration date as a strike order on selling their shares in a sooner-rather-than-later strategy to avoid future poor earnings, many other investors try to capitalize on the movement to increase their position and hold for future growth.

 

Rise of Foreign Generics

While “big pharma” has been leading the market with breakthrough treatments for serious ailments the generic market has not trailed far behind. When patents expire and the development of biosimilar substitutes begins, it isn’t only rival industry giants that are trying to get a share of the profits – they’re busy finding the next big cure and protecting their existing patents. The real opponent is the foreign generic market.

Most pharmaceutical companies holding valuable patents must also hold two sets of patent portfolios, for the U.S. market and for the European market. Generally, European patents expire earlier than U.S. patents for companies headquartered in the U.S., and vice-versa for European domestic companies.

 

Almost half of the global pharmaceutical market is represented by the U.S. sector, so most patents expire outside of the U.S. first. This has given way to the development of large generic pharmaceutical companies outside of the U.S. that focus on following up on foreign expirations. This also draws attention to India, a country often overlooked in the international pharmaceutical scene, but remains the origin of a lot of the R&D that is used by U.S. pharmaceutical companies. The Indian pharmaceutical market is expected to grow 15% per annum between 2015 and 2020. Although the market currently has a global value capitalization of 2.4%, it generates 10% of the world’s pharmaceutical volume. It’s highest pharmaceutical export: generic biosimilars – making up 20% of the world’s supply.

 

Several factors can be attributed to India’s huge growth potential. The cost of production of pharmaceutical products in India is 60% lower than in the U.S. due to cheaper labor, and accessibility to ingredients needed in production. Additionally, the domestic producers are in a constant price war against each other in the battle for producing the cheapest generic possible. The Indian pharmaceutical industry is also known to be a stickler for regulation, as barriers of entry remain extremely high and even foreign direct investment is viewed with skepticism in fear of being shut down by international companies backed by financial muscle.

Large companies, such as the 14 listed in the 2016 revenue report should fear development of these generics and consider the role that they will play in the years following their patent expirations.

Looking forwards at the major patent expirations for pharmaceutical products one can see that the next couple of years will prove to be a tumultuous for those companies that have failed to find alternative means of generating revenue. From 2017 until 2020, it is expected that 18 major drug patents will expire, with another 16 in the next 13 years. It is without doubt that this is the industrial movement that the Indian pharmaceutical companies are counting on to increase their domestic production and maximize generic exports. The Natco-Celgene litigation lawsuit over Revlimid is merely a single testament to the great operational schemes in play by the Indian pharmaceutical industry.

Given the bullish market movements over the past 5 years and the overvalued shares of the pharmaceutical industries industry leaders, the chart above represents a bearish forecast for the U.S. and European pharmaceutical industries. With the consideration of the year-to-year normalized moving average of 8 industry leading securities (PFE, ABBV, NVS, CELG, ROG, JNJ, GILD, AMGN), and the mean EPS responsiveness of each asset – normalized, one is able to deliver the following forecast for the next four years. This forecast also accepts that: India upholds their growth forecast, patents will have generic competition one year after expiry, investor sentiment will remain bullish through 2018Q2, and no M&A action is taken by any of the current market leaders in efforts to subdue the foreign markets.

 

Conclusion

The forecast may be farfetched in calculation, but the analysis stands firm. Investors must re-evaluate leading global pharmaceutical companies and focus their attention on the threat of foreign generics capitalizing on patent expiration. While nothing can be done to mitigate the patent expiration process – short of applying for an extension – investors must re-evaluate their positions in major pharmaceutical companies that have been overvalued.

 

Following the disclosure of this report the following trades are presented for each of the companies listed in this article for the readers consideration.

 

 

_________________________________________________________________

A full list of sources is available here. 

 

 

Leave a Reply