The 'new age of thrift' will benefit copycat drugs

America has been gripped by a new spirit of thrift. After 20 years of frittering away every dollar that came their way, US consumers are now cutting up their credit cards. Consumer spending is falling faster than at any time since World War II. As The Economist announced this week: "A new age of thrift has begun."

This will affect all aspects of American life. Take drugs, for example. Many baby boomers have got used to meeting each day with a cocktail of pharmaceuticals. But with Medicare funds running dry just as the population greys, both patients and the government are in need of a cheap alternative to expensive brand-name drugs.

That's where generic drugs come in. One piece of good news for US consumers is that between now and 2012, nearly $70bn-worth of brand-name drugs will lose their patent protection, according to IMS Health. This will pave the way for generic substitutes that are 30%-80% cheaper. It'll also mean massive growth in the generic industry. Globally, generics made $24.7bn in 2006, but that's set to rise to $49.5bn as 63 of the most popular drugs are made available over the next five years, according to Frost & Sullivan.

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Barack Obama has already latched onto the promise of generics, putting them at the top of his health-care plans. About 65% of prescription drugs sold in public programmes in America are now generic; Obama has pledged to lift this to 70%.

But the big money for generic drug makers lies abroad. 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 chronic illnesses you find in the West. By 2020, developing markets could account for 20% of global drug sales, reckon PricewaterhouseCoopers.

In Europe, too, there is huge opportunity. In Britain penetration is high generic prescription numbers rose at a rate of 6% a year in the UK from 1995 to 2005, with generics accounting for 64% of drugs dispensed by volume in 2006. Spiralling healthcare costs have seen the uptake of generics rise sharply in Germany too, which is now the world's second-biggest generics market, according to a report by Datamonitor.

But penetration in other big EU markets, such as France and Spain, is relatively low due partly to a lack of consumer awareness and scepticism by doctors. And Italy, where the percentage of the healthcare budget spent on drugs is the biggest in Europe, also has the lowest generic drug usage. However, just as happened in Britain and Germany, rising healthcare costs are likely to encourage governments and consumers to increase their use of generics where possible.

That's why the big players in the generics industry have been snapping up smaller Asian and European producers. This year saw a record level of buyouts valued at over $25.1bn, up nearly 80% on last year, says Matthew Perrone for Associated Press. In this business, size matters. Because their drugs sell cheaply, generic manufacturers have to keep development costs down. Economies of scale mean that "being bigger often results in better margins", says Brian Orelli on Motley Fool. We have a look at two of the biggest players below.

The two best bets in the sector

"A pro-generic age is here," Kris Jenner of the T Rowe Price Health Sciences Fund told Barron's this week. And the "800-pound gorilla" of the industry is Israel-based Teva Pharmaceutical (Nasdaq:TEVA). While North America accounts for 60% of total pharmaceutical sales, Teva has a strong position in Europe (25% of sales) with Spain and France recently contributing to a 10% jump in quarterly sales on last year. Teva has lots of cash, doubling its cash flow from operations to $710m in the third quarter, and has 145 products awaiting FDA approval. The branded versions of these drugs amount to annual sales of over $96bn, says Ryan Savitz of Bullish Bankers.

It's also set to merge with the $7.12bn Barr Pharmaceuticals by the end of this year. Teva trades on a forward p/e of 13.8, but has the global reach to lead the "wave of growing opportunities" over the next few years, says Jenner. Another generic titan, Mylan Laboratories (NYSE:MYL) has had a tougher time. It has fallen 42% since we tipped it last August on fears it could violate its debt covenants. A large short position (investors betting against the stock) has built up as a result. But with at least $750m of cash, Mylan is well able to meet its obligations, say Morningstar analysts. In fact, the $2.66bn company "looks dirt-cheap at these levels". Mylan trades on a forward p/e of 8.9.