Are "generics" a threat to drug companies?

Every time I read something about a drug company it always comes with warnings about fierce competition and the threat of generics. Fierce competition I can understand. There are many drug companies out there. But the threat of "generics" is something I started questioning recently.

The theory is that when patents expire, opportunistic drug companies will step in and produce the same drug for less and bring down the nice margins enjoyed by the original manufacturer of the drug. The nice margins were nice because the drugs were protected by patents. When this is no longer the case, goodbye profits. Or so goes the theory.

But does this really happen and is it really that bad?

Why can't drug companies lower their prices and compete head-to-head with generics when their patents expire? Are the big drug companies that inefficient that they can't lower prices enough to compete? They surely have better financial position than the generics. Given that they compete with other drug companies, I'd expect them to be reasonably efficient and be constantly lowering their cost structures.

Wouldn't some customers even pay a small premium to get a branded drug as opposed to a generic one? Of course some will, just look at sales of Tylenol compared to other generic cold and fever drugs. Anyone can mix paracetamol and acetaminophen cheaply. But Tylenol still sells more than others and people do pay a premium for the brand. Why wouldn't people pay a small premium for Plavix or Lipitor, two of the cholesterol-lowering drugs that are coming off-patent soon, the former by Bristol-Myers Squibbs and the latter by Pfizer?

Plus, is it really the case that big pharma companies cannot lower costs enough to compete with those like Teva, the israeli-based generic maker?

I simply don't believe that.

Assume the worst: big pharma is inefficient at running their drug factories (the plants that mix the powders and packages the pills -- all that is needed for a generic manufacturer). In this case, they could: 1) sell their "assembly line" and let a more competent operator run it, 2) buy one of the generic makers or 3) don't even bother with production and sales and worry only about development of new drugs. Many biotechs and smaller drug makers operate in the latter mode.

Now, suppose that this is not the case, that big pharma companies can lower their prices upon patent expiration enough to compete with generics. Then what happens? They now must compete on who has the most efficient sales channel, distribution and marketing teams, just like they had to do against their bigger rivals to begin with.

So, what does really happen? Let's see.

Let's look at three big-pharma: Bristol-Myers Squibb (BMY), Pfizer (PFE) and Merck (MRK) and compare them with generic giant Teva (TEVA), Watson Pharmaceutical (WPI) and Mylan (MYL).

What do they have in common?

BMY, PFE and MRK are all 3-star stocks as rated by S&P currently. Their analysts all "caution" us against "generic competition".

TEVA, WPI and MYL are all 5-star stocks as per S&P.

And yet, BMY, PFE and MRK trade between 9 and 12 price-to-earnings ratio, sport a 4 to 6% dividend yield and have return-on-equity that averaged from 22 to 34% over the last 9 years.

Compare these with TEVA, WPI and MYL trading between 14 and 43 price-to-earnings ratio, having dividend yields of zero to 1.29% and return-on-equity that averaged from 5 to 15% over the last 9 years.

The table below summarizes the comparison:

Note on methodology: I picked BMY and TEVA due to my own interest in them and then I randomly selected two others from each group. The big-pharma group I selected based on the first two names that came to mind and for the other two generics I picked the top two by capitalization. Of course, there are probably counter-examples to this situation too. P/E and div. yield from Google Finance. Avg 9-year ROE courtesy of S&P.

Conclusion: I don't buy the argument that generics are better investments (3 versus 5 stars), nor that generics create such a large threat. Sure, they eat into profits just like any competitor would. But the fear of generics does not justify, by itself, the low valuations of big-pharma nor a 5-star rating for the generics.

Disclaimers: None (no securities mentioned held long nor short at the time of writing -- though I'm considering starting a position in BMY, pending further analysis).

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