How to make money from copycat drugs

The patents protecting several of today's big drug brands are about to expire, clearing the way for substitutes that could cost from 30% to 80% less. Big Pharma is set to suffer - but the future's bright for generic firms.

Growing old isn't what it used to be. Where once old age meant nursing homes and days in the park, a new generation of yuppy' pensioners are staving off decline with a cocktail of prescription drugs. Over the past 20 years, drugs such as impotence treatment Viagra and anti-cholesterol drug Lipitor have become regular fixtures in the average medicine cabinet.

But as the baby-boomer generation moves into old age, the labels on their pills will look very different, even though the drugs will be much the same. That's because the patents protecting several of today's big drug brands are about to expire, clearing the way for generic substitutes that could cost from 30% to 80% cheaper. "Over the next five years, analysts forecast a golden era for generic drugs, as patents begin to run out on brand-name medications with more than $60bn in combined annual sales," says Stephanie Saul in the New York Times.

This is bad news for big drug firms. When a generic substitute for Novartis's sleeping pill Ambien was introduced in April, sales in the second quarter plunged from $420m to $91m last year. Sales of AstraZeneca's Lipitor, the world's best-selling drug, have taken a 25% hit over the past year since a generic alternative was brought to the market. But this is a golden opportunity for generic drug firms. The sector made $24.7bn in US revenue last year, says a Frost & Sullivan report. That's set to rise to $49.5bn as 63 of the most popular drugs are made available in generic versions over the next five years.

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Generic players have other advantages too. Gaining approval from the US Food and Drug Administration is far easier than for new drugs. Generic producers can launch dozens of drugs a year as they plough through the short, cheap clinical trials needed to prove their drugs have the same active ingredients as branded versions. And big pharma isn't likely to stand in their way once a product comes to market. Some launch their own generic outfits, but most prefer to try to extend the life of the patent with new versions of the drug, such as a pre-filled syringe or inhaled version. Once a patent expires there is little incentive for firms to keep throwing their weight behind the drug.

But the real engine for growth as is often the case these days may lie to the East. As millions of Chinese and Indians are lifted out of poverty, their disease profile is shifting from the likes of malaria and water-borne diseases to the kind of chronic illnesses you find in the West. Heart disease is on the up and cases of diabetes in developing countries will rise from 84 million in 1995 to 228 million by 2025, says PricewaterhouseCoopers. By 2020, developing countries could account for 20% of global drug sales.

Governments are also behind generics. When Novartis tried recently to challenge India's patent laws over generic versions of its Gleevec leukaemia treatment, the case was thrown out of court a seminal judgment on the future of generic drugs in the country, says Amelia Gentleman in the International Herald Tribune. Generic producers are also assured the backing of US and European governments trying to cut down on spiralling public healthcare costs as the population in the West grows older, greyer and fatter. Ronny Gall, analyst for Sanford C Bernstein, reckons the industry will see 10% to 13% annual profit growth from now to 2010. We look at the main companies set to benefit in the box below.

Mylan back on track with acquisition of Matrix

Of the three biggest generic firms, Mylan Laboratories (NYSE:MYL) has had a hard time recently, as competitors such as Teva Pharmaceuticals raced ahead with blockbuster generic launches. But after snapping up the $7bn generic wing of Merck's business, Mylan is back on track, says Brian Orelli on Motley Fool. The firm has slashed costs by moving production to India after buying Indian generic drugmaker Matrix earlier last year. Brian Lawler on Motley Fool says: "In an industry where size really does matter, these deals give the new combined Mylan much more weight in terms of top-line sales than its competitors." Revenue rose 56% for the first quarter to $542.7m, with its generic version of Ambien among the big sellers. The shares trade on a forward p/e of 10.4 for 2008 with a price-to-earnings growth ratio of 0.72.

Of the smaller players, RxElite (OTC:SOUT) looks interesting, says Penny Sleuth's Jonathan Kolber. The group has tied up an exclusive licence to commercialise and market a generic version of Sevoflurane, an anaesthetic gas used in almost two-thirds of medical and veterinary procedures. The product already has approval from the FDA for human use. Kolber expects RxElite's revenues to grow from $14.2m last year to $70m within "the next year or two", and to around $219m by 2012.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.