Pharmas Need Pain Relief

Investors who have paid any attention at all over the past few years to the pharmaceutical industry are well aware of the so-called patent cliff that nearly every company in the sector faces. The patent cliff refers to the expiration of patents on pharmaceutical firms blockbuster drugs, opening them up to competition from cheaper, generic versions of the medicines. It is this patent cliff which has pushed the drug companies into a flurry of action over the past couple of years, ranging from licensing deals to acquisitions.

This is not new news to savvy investors. But here is what is different...the problems due to patent expiries are set to become much worse in 2012. The list of patents on blockbuster drugs set to expire in 2012 include Actos, Diovan, Geodan, Lexapro, Plavix, Seroquel, Singulair and Tricor among others. Among the major pharmaceutical companies affected are Pfizer (NYSE: PFE), Abbott Laboratories (NYSE: ABT), Sanofi ADR (NYSE: SNY), Astra Zeneca PLC ADR (NYSE: AZN) and Novartis ADR (NYSE: NVS) among others.

The pharmaceuticals analyst with Bernstein, Tim Anderson, said “Nothing like this has ever been seen before. In years past, the rates of erosion were substantially less.” Mr. Anderson is likely correct. Unlike prior patent expiry cycles, this one is so much larger. That means that sales from a single drug, even a blockbuster, will not be sufficient to make up for the series of expiring drug patents.

This fact may threaten the very business model that pharmaceutical firms have used for years to conduct business. Unlike other sectors like technology, the pharma industry faces stringent regulations on authorization and marketing of drugs by the US Food and Drug Administration. This results in higher costs and longer lead times to develop new medicines, making the companies highly reliant on patent monopolies lasting years to recoup their costs.

Now the pharma companies face an unpleasant cocktail of conditions – a patent abyss, stiff competition from generic firms like Teva Pharmaceutical Industries and pressure from insurance companies and governments to lower the price of their drugs. This combination may force drug companies to take their entire current business model and throw it out the window and develop new plans for survival.

One such change is already occurring. Due to the rising cost and falling productivity of research and development, some pharma companies are cutting way back on such research. They are simply farming out the research to specialist firms or plan to just buy promising drugs from the biotechnology companies which developed them.

This approach seems to meet with shareholder approval since companies such as Astra Zeneca and Eli Lilly which have remained focused on internal research efforts are trading at the lowest multiples in the pharmaceutical sector.

Another strategy which seems to be gaining approval among shareholders is diversification. The outperformers in the sector are companies like Novartis and Sanofi which moved into others sectors including generic drugs, medical devices, consumer health products and animal health. The question here remains whether these diversification efforts will pay off in the long term. For now investors seem to think they will.

This article was originally written for the Motley Fool Blog Network. Make sure to read all of my daily articles for the Motley Fool at http://blogs.fool.com/tdalmoe/.