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Hot Stock Generic Drug Companies
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Generic drug makers don't have the extraordinary margins of branded drug makers, but they are growing much faster as generic drugs become more It might sound strange to view megablockbuster drugs as a negative, but they can become a disadvantage. If a drug's revenues become a large enough piece of the pie, a company's fate can be linked too heavily to that drug. Because that drug will eventually lose its patent protection, we think it's wise for investors to account forthe single-product risk bj demanding a slightly larger margin of safety.

Pfizer's Lipitor brought in a staggering $8 billion in sales for 2002. By the time Lipitor loses its U.S. patent protection in 2011, annual U.S. sales could easily be more than $10 billion. That's such a huge amount that it will be nearly impossible for Pfizer to fill the gap once generic competition hits. In addition, just five drugs pull in half the company's revenue. Megablockbusters such as Lipitor not only contribute large portions of total revenue, but also are often high-margin products. When the patent expires, the maker loses a chunk of revenue and its profitability usually declines as well. These copycat companies usually have gross margins in the 40 percent to JO percent range, with operating margins around 15 percent to 20 percent. Returns on invested capital vary dramatically depending on the company's exposure to branded drugs. (Most generic drug makers also sell nonblockbuster branded drugs.) Teva Pharmaceuticals, the closest thing to a pure-play generic company, has ROICs around 10 percent, whereas Watson Pharmaceuticals, which generates a little more than half its revenue from branded drugs, has ROICs in the low to mid teens.

Ironically, generic drug companies can still benefit from some competitive barriers. The first company to file a legitimate patent challenge against a branded drug enjoys 180 days of marketing exclusivity, which allows the generic company to cash in before others join the party. The windfall can dramatically change the company's profitability in the short term; a 10-percentage point increase in operating margins isn't uncommon. Once the multitude is allowed to join the fray, the only company that comes out ahead is the low-cost manufacturer. Given the crucial importance of manufacturing scale, you're usually better off with an established player in generic drugs.

Generic companies have benefited from some longer term trends. As of mid-2003, nearly JO percent of all prescriptions were filled with generics, up from about 20 percent in the mid-1980s. This trend should keep moving up, thanks to the numerous drugs coming off patent each year, as well as pressure to rein in rising prescription costs. Even at lower margins, these drugs can be profitable with the right cost structure. Last, the political winds are blowing in favor of generic companies as politicians and the general public look for ways to lower health care costs.

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