Expiring Patents Ignite Biotech Boom

It’s tough to find anything positive to talk about in this market.

The U.S. Government stepped in and assigned Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) a value of zero through governmental decree.

Even a cutback in oil production from OPEC can’t stop oil prices from falling. Gold, silver, and fertilizer stocks are falling too. Even Brazil’s stock market, the top-performing BRIC nation of 2008, is starting to fall.

It’s bad out there for most industries. But there’s no sector worse off than the pharmaceutical sector. Big Pharma stocks like Pfizer (NYSE:PFE), Merck (NYSE:MRK), and Glaxosmithkline (NYSE:GSK) are having a rough time and it looks like more stormy weather ahead. And these companies are giants headed for a fall.

Big Pharma

But here’s the thing about the drug industry, bad times for the big guys can mean good times for the little guys. And that means great profits for savvy investors. Right now, Big Pharma is searching for new revenue streams, and that is good news for the shareholders of smaller innovative drug makers.

CNN summed Big Pharma’s problems up best when it said, “[The industry is] like rearranging chairs on the Titanic.”

Frankly, the situation is bad…real bad. Even 9-digit lobbying budgets and their hundreds of Ivy League-educated lawyers aren’t going to be able to stop it.

The cause of the problem is complacency. You see, Big Pharma lives on “blockbuster” drugs. A blockbuster drug is simply any drug that generates at least $1 billion in sales each year.

And it’s those drugs that make the big profits for the multibillion-dollar pharma companies like Pfizer, Merck, and GlaxoSmithKline.

On average, it takes about $800 million to develop a drug. That takes a moment to digest. It’s an astronomical price tag for a product that is difficult to “market test”. The $800 million covers everything from early pre-clinical trials, the three phases of FDA approvals, and marketing costs. As a result, it takes a big success to make any money in the drug industry.

So for these big drug companies, $1 billion is basically the break even point.

Keep in mind, that’s not including the costs to manufacture each pill…and the costs of any lawsuits, production delays, competition, patent disputes, and everything else that seem to pile up.

There’s another significant challenge the big pharma companies have to deal with: the length of the patent. New drugs are only patented for 20 years. That’s sounds like a generous amount of time. If they had 20 years, a drug company would have to sell only about $40 million of a drug to recoup those costs of developing a new one. But investors are not typically patient enough to operate on that time-line.

At the 20 year point, the patent expires and anyone can make the drug and sell it. The generic drug industry is founded on manufacturing drugs after the patent runs out. Generic drug makers wait for the patents to expire, take the formula that costs hundreds of billions of dollars to develop, and reproduce.

Since they have none of the $800 million in research costs to recover, they can easily undercut the prices of the original developer of the drug. The generics can cost as much as 80% to 90% less than brand name drugs. Consumers inevitably turn to the cheaper version.

But we’re discounting one technicality. According to U.S. patent law, patented drugs are protected from competition for 20 years. In reality, drug companies don’t have nearly that long.

The clock starts ticking when the patent is filed. That’s before the safety and development process even begins.

Since that process usually takes at least a decade, drug companies don’t have anything close to 20 years….they usually have only seven to 10 years to sell their drugs at top prices. They’re protected from competition by patents for a very short time. And once the patents expire, the generic manufacturers move in and take sales away.

In the next few years, the worst possible thing is going to happen to Big Pharma. The industry that needs vast amount of cash to fund high-risk projects knowing any payoff is 10 years away (at the earliest), is going to get cut off from their lifeblood….

The number of drugs going “off patent” in the next few years is alarming. According to IMH Health, more than $60 billion worth of drugs are going “off patent” by 2011.

Take Fosamax for example. Fosamax is Merck’s current top selling drug. It’s designed to help treat osteoporosis by making bones stronger. It brings in more than $3 billion in sales to the company each year. It WAS a huge success for Merck…

Emphasis on WAS. The Forsamax patent expired in February of 2008.

Fosamax accounted for more than 12% of one of the largest pharmaceutical companies in the world! Now, it’s all gone. Anybody can take the secret formula that made Fosamax a success, directly copy, and resell it for as cheap as possible.

Fosamax is just one example of the huge impact of a drug going “off patent.” It’s happening all across Big Pharma.

GlaxoSmithKline’s Advair came off patent in February, 2008. Advair accounted for 15% of annual sales for GSK.

Top selling anti-depressant Effexor, which accounts for $3.7 billion in annual sales for Wyeth (WYE), has gone off patent too. Last June, when the patented expired, 6% of Wyeth’s business was eliminiated.

Johnson & Johnson’s (JNJ) Topamax, which racks up $2.5 billion in annual sales, is going off patent in September. AstraZeneca’s $1.2 billion loses patent protection in October….

You get the picture. It’s happening now, and more and more drugs are going to go “off patent” in the next two years.

Big Pharma is going to be forced to buy small biotech companies just to survive, and the buyout frenzy could spark a very bull market in biotech.

In fact, it has already started. Earlier this week a rumor of an “imminent” takeover by Pfizer of Bayer sent shares of the German drug maker climbing 5%. Forbes reports the top cause of the buyout is Bayer’s extensive pipeline of new drugs in development.

Although any Pfizer/Bayer combo is unlikely and far from a perfect fit, the excitement surrounding it proves how desperate Big Pharma is becoming.

At the end of the day, the investing principals we stick to are pretty simple. You buy something (a stock) at a low price and hope to sell it at a higher price. And right now, you can buy small biotech stocks at a low price that are good candidates to be bought out by deep-pocketed buyers at a higher price.

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