Generic-Drug Makers Feel the Pain - TheStreet

The headlines are starting to look encouraging -- but don't get carried away.


last year's steep selloff, recent weeks have brought investors in the generic-drug industry some welcome relief. Shares of


( IVX) and


( ADRX) gained on solid earnings.

Eon Labs

( ELAB) rallied after


(NVS) - Get Report

made a surprising takeover offer.

Analysts see the bounce as overdue. "The concerns in late 2004 were overdone," says Richard Watson of William Blair & Co. "There was an overreaction that took on a bandwagon effect starting in the middle of 2004."

But hold your applause. Despite the run of good news, the industry's profit-draining fundamentals -- multiplying competitors, cutthroat pricing, litigation with brand-name drugmakers -- haven't changed. And worse yet, some observers doubt a wave of consolidation will lift all these struggling vessels.

"Unfortunately for generic-drug businesses, increasing the volume of generic drugs sold is not necessarily going to grow earnings or revenue to the same extent," says a recent report from Prudential Equity Group. "Competition has increased from new entrants coming into the U.S., from smaller players enhancing their capabilities and from the branded pharmaceutical players themselves."

Ironically, the unfavorable trends hampering the generic-drug makers are caused in part by a big positive for the industry: increasing generic drug usage. Seven years ago, generics accounted for 38% of U.S. drugs, according to IMS Health and Prudential Equity Group. By 2007, that percentage could be 48%.

Deals in the Future?

The clash of potential positive trends -- an aging population, a greater drug role for Medicare, cost controls by managed care firms -- with negative trends of intrageneric industry warfare, has prompted many analysts to suggest that it's time for consolidation.

The consolidation rumor mill was energized in late February when Novartis said it would pay $8.3 billion for Eon Labs, of Laurelton, N.Y., and the German drug firm


. Eon and Hexal are both controlled by a German holding company.

It's not just Wall Street talking about mergers and acquisitions; so are people on the front lines like Robert J. Coury, vice chairman and CEO of

Mylan Laboratories

(MYL) - Get Report


"We continue to believe that the generic industry needs to consolidate to mitigate current negative trends," Coury said in a telephone conference call with analysts and investors earlier this month. "These trends include the increasing number of generic pharmaceutical companies, competition from lower-cost regions like India and other emerging markets, the continuing consolidation of the wholesale/retail sector

and recent FDA rulings."

Coury cited the Novartis bid for Hexal and Eon Labs as "just the beginning of consolidation in the industry." When asked if he would be a buyer or seller, Coury said he would act in the best interests of his shareholders.

But some analysts aren't so sure there will be many big deals. Picking the next takeover target or the next successful deal isn't easy -- as investors learned with Mylan's

failed attempt to buy

King Pharmaceuticals

( KG).

"Consolidation is likely but hard to bet on," David Woodburn says in his Prudential Equity Group report, which was published Feb. 17, four days before the Novartis announcement. "The majority of the deals will be smaller technology acquisitions, or acquisitions in the developing pharmaceutical markets of Latin America."

By Prudential's count, Ivax made 10 acquisitions between 2000 and 2004. Only three were based in the U.S. and Puerto Rico. Novartis' Sandoz unit acquired seven companies during the same period; only one was based in the U.S.

Richard Watson of William Blair doubts that a Big Pharma company will try to emulate Novartis by inhaling a bunch of generic-drug makers. Why would a Big Pharma company, whose profit margins are being squeezed, seek out a generic-drug maker whose margins are even thinner, he asked.

Takeover candidates in this field, Watson adds, could be companies with proprietary technology such as drug delivery systems and niche market expertise such as dermatology or respiratory care. Other takeover targets could be companies that would give acquirers greater geographic clout.

Future Trends

Takeover talk gives generic-drug companies and analysts something to ponder as the industry endures one of its down periods. Many analysts figured 2005 would be a weak year because relatively few big-selling, brand-name drugs are going off-patent. A report last year from A.G. Edwards noted that only $5 billion in brand-name drug revenue will be at risk this year, "the first major decrease in patent expirations for branded drugs since 1998."

Generic-drug companies, counting on the recent trend of $10 billion a year in patent expirations, figured on facing tough times. "It's a somewhat cyclical pattern for this industry," says Herman Saftlas, a pharmaceutical industry analyst for Standard & Poor's. "But we can expect a ramp-up in 2006 and 2007."

However, Watson warns investors that the generic-drug industry remains unpredictable. He says 2005 "won't be as bad as people make it out to be, and 2006 won't be as good as people make it out to be."

In the U.S. market, 10 companies produce 62% of the generic-drug revenue, according to 2003 data from IMS Health. The biggest generic-drug player is

Teva Pharmaceutical Industries

(TEVA) - Get Report

, the Israel-based company that had 12% of the market in 2003.

Mylan Laboratories is next with 10%.

The third-biggest player is the


division of Switzerland's Novartis, with 9%. Then comes Germany's

Schwarz Pharma AG

, with 7%;

Watson Pharmaceuticals


, with 6%; and

Par Pharmaceutical

( PRX), with 5%.

Bigger doesn't necessarily mean better, although Teva is considered to be the gold standard for product diversity and management skill.

Other companies with a strong Wall Street following include

Barr Pharmaceuticals

( BRL) and

Taro Pharmaceutical

(TARO) - Get Report


Mylan is one of the least-liked generic-drug makers. Also among the least-loved are Watson Pharmaceuticals and


(ALO) - Get Report


As generic-drug companies wrestle with changes in the industry, individual companies are employing different strategies to stand out among the crowd. Mylan wants to expand its brand-name business, while Andrx recently said it wants to sell its small cache of brand-name drugs. Barr Pharmaceuticals continues to build a franchise of generic and brand-name women's health care medications.

Despite the individual strategies, there are some common themes that distinguish the leaders such as management skill, patent litigation skill and picking strategic targets, says Saftlas of S&P. They'll need every edge, he adds, "because pricing is tough."