Over the past few decades, the pharmaceutical industry has experienced a period of unprecedented growth. While this performance has been impressive, it also has many wondering if the market is nearing or has reached a peak. At present, the long-term outlook for drug stocks appears largely uncertain, in our view. Several factors are affecting investor perception including the newly passed healthcare legislation and upcoming patent expirations.

The newly passed healthcare legislation may be the biggest question mark facing the industry today. With more people now eligible to receive health insurance, it would appear as though the industry could be in line for a substantial increase in consumer demand. Estimates project that an extra 32 million Americans will be able to receive health benefits under the new law, essentially giving pharmaceutical companies an additional 32 million customers. However, it isn’t necessarily that cut and dried. Since the new law’s inception, several companies have been burdened with higher rebates, fees, and discounts associated with the reform. These higher costs have noticeably cut into profits during the first half of 2010, and have hurt several venerable drugmakers including, Eli Lilly & Co. (LLY) and Abbott Laboratories (ABT).  Although the projected increase in consumer demand is expected to offset these costs down the road, at this early stage it is difficult to judge if or when this may occur.

Another issue facing drug stocks is upcoming patent expirations. In the coming years, several major pharmaceutical companies will be losing exclusivity rights to some of the world’s top-selling drugs, opening the door for generic competition. These expiring patents are set to wipe billions of dollars in revenue off the books, leaving drug makers scrambling to develop and market replacement products to help fill the void. One of the most talked-about examples is Pfizer’s (PFE - Free Analyst Report) blockbuster drug, Lipitor, whose patent is scheduled to expire in 2011. Lipitor is currently the top selling drug in the world, generating nearly $11.5 billion in sales in 2009, accounting for roughly 20% of Pfizer’s total revenue. Despite Pfizer’s standing as an industry leader (currently the largest in the world based on global prescription drug sales), a loss of this magnitude could prove difficult to replace, especially during a time of broad-based economic weakness. Another major example concerns Bristol-Myers Squibb’s (BMY) top-selling product, Plavix. Plavix generated over $6 billion in sales in 2009 (27% of BMY’s total revenue) and will also be falling victim to generic competition in 2011. As a result, managements at these respective companies have reduced expectations somewhat over the next few years, with Pfizer recently lowering its revenue and earnings projections by 5% out to 2012. In our view, offsetting the patent blow will rely heavily on each company’s ability to successfully launch new products.

In conclusion, we believe drug stocks are probably best suited for venturesome investors at this time. Although the rewards may be large, it may not be enough to adequately compensate for the aforementioned risks among more conservative investors.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.