The headlines are starting to look encouraging -- but don't get carried away. After
last year's steep selloff, recent weeks have brought investors in the generic-drug industry some welcome relief. Shares of Ivax ( IVX) and Andrx ( ADRX) gained on solid earnings. Eon Labs ( ELAB) rallied after Novartis ( NVS) 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%.
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). "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.
Other companies with a strong Wall Street following include Barr Pharmaceuticals ( BRL) and Taro Pharmaceutical ( TARO). Mylan is one of the least-liked generic-drug makers. Also among the least-loved are Watson Pharmaceuticals and Alpharma ( ALO). 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."