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How to Play Generic Drug Stocks

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As the patent cliff nears, copycats are gearing up.

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It seems every day a new lawsuit is popping up that accuses one drugmaker of violating another's patent rights. For Big Pharma, dealing with patent litigation has become part of the daily routine.

Late last week, Cubist Pharmaceuticals (CBST) announced that a trial date has been set for patent litigation against Teva Pharmaceuticals (TEVA) for the violation of its patent on the antibiotic Cubicin.

Meanwhile, Pfizer (PFE) is in the midst of a battle against Dr. Reddy's Laboratories (RDY) over a generic version of its blockbuster cholesterol drug Lipitor.

These are just a few of many suits that generic drugmakers prompt by filing abbreviated new drug applications with the US Food and Drug Administration. The suits keeps generic drug manufacturers from bringing the drug to market while the litigation is pending. These types of lawsuits often results in a settlement and can be beneficial to the first-to-file generic drug company, which usually works out an exclusivity deal with the branded manufacturer to launch the generic drug exclusively for six months after the patent expires.

At a time when most pharmaceutical companies are worrying about patent expirations, generic competition is thriving, and a small generic win can chip away at Big Pharma's revenue stream.

The major drugmakers have been making plans to deal with the patent cliff that's expected to leave many of them in the lurch as blockbuster drugs like Lipitor and Plavix lose patent protection and fall prey to generic competition in the coming years. (See also, Eli Lilly's Prognosis: Uncertainty)

Generics, which are lower-priced drugs of equal quality, are becoming more important than ever to the American consumer as the price of health care and certain medication increases. While Big Pharma will have trouble regaining its footing after the patent jump-off and faces some of the biggest risks posed by US health-care reform, the generic drugmakers like Teva, Watson Pharmaceuticals (WPI), and Mylan (MYL) stand to benefit greatly. According to IMS Health, a health care information and consulting company, $137 billion is at risk for generic competition in the eight key drug markets through 2013.

"All of the generic makers are well-positioned to continue to grow," said Sanford Bernstein analyst Ronny Gal. "But I don't think that the patent cliff will be the most important variable here, mostly because the larger products that make the cliff tend to be very competitive and pricing moves very quickly."

Gal recommends sticking your money in Teva. Gal said that this stock is appealing because it's the largest of the generic drugmakers and has the largest global footprint. He adds that the company is well-positioned to benefit from both health-care reform and the patent cliff.

"We think Teva is likely to make an acquisition but will not be surprised if it is in the generic space. As Teva is well-experienced in generic acquisition, we suspect the acquisition will be accepted favorably by the Street," he wrote in a recent note. He has an Outperform rating on Teva.

Gal wrote in another recent research note on the sector, "We expect the US commodity generics market to grow at 9% to 10% rate in 2009 to 2010." He adds that volume will increase at a rate of 12% to 13% during 2011 to 2012.

Gal attributes part of this growth to an increase in utilization of generic drugs, which has accelerated to 5.1% in 2008, from 4.1% in 2007.

Meanwhile, Miller Tabak analyst Les Funtleyder recommends Novartis (NVS), which has a large generic drug unit -- Sandoz Generic Pharmaceuticals. In May, it paid $1.2 billion to buy Austrian generics firm Ebewe Pharma, which deals primarily in generic injectable cancer treatments. The company is also developing a pipeline of biosimilars, biotech drugs that are harder to copy because they are produced using living cells.
No positions in stocks mentioned.

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