Go Wild Over Generic Drugs, Consider These 3 Stocks

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

This year, the patent cliff has seen 40 brand-name drugs with $35 billion in annual revenue losing exclusivity rights. This been a huge boon for generic producers and can be seen in the 27% and 47.7% rise, respectively, of Mylan and Watson for the year to date--a bull run that has continued relentlessly over the past 5 years. Will this rise continue? More generally, what companies are a good hedge against the patent cliff? Below, I review 3 generic producers below.

Mylan (NASDAQ: MYL) Vs. Watson Pharmaceuticals (NYSE: ACT)

16 of 20 reporting analysts right now call Watson a "buy"--half of which say "strong buy." The Street is more or less as optimistic about Mylan with 12 of 17 reporting analysts calling the stock a "buy"--half of which, again, say "strong buy". Mylan is a bit cheaper at 9.8x forward earnings versus 10.8x for Watson; but, then again, the latter is forecasted for slightly more EPS growth at a rate of 12.2% over the next half decade. Both generic producers, however, ultimately have different market strategies that need to be factored into the equation before blindly investing an equal amount between the two. This is an important consideration to weigh, since there will be a need for more original innovation (i.e. fewer and fewer drugs will come off of patent cliffs in the near-term).

Just last week, Mylan received an FDA approval on its abbreviated new drug application for a generic version AstraZeneca's hypertension treatment, Atacand HCT. It is also rumored that the company is looking to acquire businesses with deals well over the $4 billion range. The intention is on expanding the product line and geographical footprint. As Canaccord Genuity rightly notes in its "buy" rating, "the message around potential for a sizable accretive deal will keep focus in the upside case." This is so because shareholders can still remember how much of a game changer Actavis was for Watson. Further, the implementation of a $500 million stock buyback after Moody's upgraded the crediting grating from Ba1 to Baa3 also should raise confidence over the long-term fundamentals.

Watson also received an FDA approval on its abbreviated new drug application for a generic version of Pfizer's pulmonary arterial hypertension treatment, Revatio. Watson will rename itself "Actavis" and become the third-biggest producer of generics following the integration of the $5.5 billion target. Even still, some analysts have lamented that the takeover doesn't do enough to expand scale in key high-growth markets, such as Brazil and Mexico. Targets with exposure to those regions are expensive in light of the competitive takeover market there. 

The CEO of Watson has said that he will have the company invest "very seriously" in research & development to pay off the $1.8 billion in loans and $3.9 billion in debt to buy Actavis. In particular, I like the company's expressed interest in biosimilars, which are, in layman's terms, the equivalent of generics for biotech drugs. Watson signed a deal with biotech producer Amgen to invest $400 million in developing biosimilars based around the core portfolio, which addresses urology and women's health. But, as we can see with the FDA rejection of Prochieve, a treatment to prevent pre-term births, playing this game isn't easy. With greater risk, however, comes greater reward.

Pros To Buying Lannett Company (NYSEMKT: LCI)

Buying generic producers may have already seen their upside factored into the stock price by now, so you may want to consider investing in their large small cap peers. Large BioPharma has a rich history of taking over smaller companies with promising catalysts that can hedge against slowing growth. So, let's take a look at one small cap pharmaceutical company, Lannett.

Early this year, the company received FDA approval for a treatment for high blood pressure. Management has increased its investments in R&D and is targeting higher margin products. Based on data in June 2009, the company is among the top 15 in prescription transactions for domestic unbranded generics. With already a strong growth curve and a focus on acquiring abbreviated new drug applications from other generic producers represents a high reward business model.

Analysts forecast 22.5% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to around $0.63. At a multiple of 15x, this translates to a future stock value of $9.45. This provides an average annual return of ~18--more than enough to justify an investment. The 1.2x price-to-book ratio is also at a substantial discount to the 4.7x industry average. This provides a winning combination of low risk and high reward.

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