Generic drug companies under our auspices are lumped in with prescription drug companies in the Drug Industry in Issue 8. Generic drugs are facsimiles of prescription pharmaceuticals, which are sold at a deep discount. Their chemical and organic compositions are exactly the same as the prescription drug, except for one or two inactive ingredients. They can be sold at perhaps a quarter of the price. This is because generic makers don’t have to spend enormous amounts of money on R&D to develop the medicine, their packaging expenses are lower, and marketing, promotion, and distribution costs are less since they are sold through discount retail chains such as Duane Reade, and CVS Caremark (CVS). Over the past few years, generic companies have become increasingly audacious at trying to market their copies to the public before the brandname equivalent has lost its patent exclusivity. This is costing the brandname companies millions of dollars in legal costs as they battle to keep the generics off the market. Of course, it also costs the generic companies a lot of money in legal costs, too, and only the better-financed entities can play this game. Novartis’ (NVS) generic unit, Sandoz, already has tried to launch a facsimile of GlaxoSmithKline’s (GSK) Advair, called VR315, even though Advair’s patent doesn’t expire until 2011.

As has been heralded in the media, many of these heavyweight brandname drug manufacturers will approach a patent cliff in two to three years time.  Their flagship treatment’s exclusivity periods are expiring in a condensed timeframe. The FDA gives a drug company a certain number of years in which it can market its drug exclusively. A time in which it can charge patients as much as they like in order to recoup costs incurred in developing it, bringing it to market, as well as make a decent profit. After that exclusivity period ceases, it is a free-for-all for generic companies.  For years, pharmaceuticals giants like Bristol-Myers (BMY) have been preparing for this patent cliff by scrambling to develop “blockbuster” substitutes, making acquisitions, and diversifying their business lines, in the hopes of replacing lost revenue.  Even so, many companies are still likely to take a hit to earnings. This fact has not been lost on some investors, who are cycling out of drug stocks and looking for alternative growth sectors, such as the generic drug industry.

Many generic entities see huge potential from this “patent cliff”, and many smaller shops are hoping to jump on the bandwagon. Further incentive for generic manufacturers has come from recent passage of the Healthcare Reform bill. This has created a potential market of about 30 million previously uninsured Americans, many of whom have low incomes and, therefore, seek out the lowest cost drugs. In addition, hospitals, looking to keep their budgets down, are working more closely with their in-house physicians to reduce the cost of drugs and medical devices.

Pitfalls and obstacles to achieving the coveted position of being the “go-to” generic drug substitute of choice are many, and are outlined below. They separate the winners from the also-rans.

First, there are many generic drug companies competing to be the first to market the drug that is going off-patent. Second, generics invariably have to spend a great deal of money on legal costs to break down the layers of patent protection which the brandname drug makers have put in place to postpone the inevitable. Third, Brandnames spend a lot of time and money building patient and physician brand loyalty. This is not something that will disappear overnight, despite the selling price differential. Fourth, generic companies have to ensure their facsimile passes muster with the FDA, which can be a lengthy process. It can, therefore, be seen that many factors conspire to prevent generics from getting their copies to market.

Now we come to the companies that have been successful at navigating this process and are thriving. The highly acquisitive Teva (TEVA), based in Israel, is the most ambitious of the crop, and is the largest by global sales. It has tentacles in all major worldwide markets, but is particularly strong in Europe and North America.  Another good selection is Dr. Reddy’s (RDY), an Indian-based entity, with direct access to the huge and growing market in that country. That nation’s population is used to paying directly for its healthcare, rather than relying on insurance or government care. As such, the nation is constantly looking for the cheapest drugs. Pharmaceutical sales in India are expected to reach $8 billion in 2010, and double that by 2015.  Another major player is Sandoz, a unit of Novartis, and the second largest by volume to Teva. Should Sandoz ever be spun off to the public by Novartis, it would likely prove to be an interesting investment. Other U.S.-based heavy hitters are Mylan, Inc. (MYL) and Par Pharmaceuticals (PRX). These companies are worth taking a peek at because there is a good possibility they could be acquired (presumably at a hefty premium) by large brandname pharmaceuticals companies, searching for alternative sources of revenue. The maxim being: “if you can’t beat them, acquire them”.