Bright future for generic drugs

NEW YORK (Fortune) -- The pharmaceutical industry is one of the few areas of the economy, whether it's cola, canned beans, or computers, where generic products outsell name-brands. Drugs are the rare exception.

That fact was clearly not lost on investors last week who shrugged at Teva Pharmaceuticals' poor third quarter earnings. The generic drug manufacturing giant posted third quarter net profits that were down 13% compared to the same quarter last year. At the same time, sales in the company's largest market - North America - fell 4% compared to the summer quarter of 2006.

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But although Teva's shares opened 3% lower on the day of the earnings announcement, the stock finished the week with an overall 1% drop. Investors appear to understand that Teva has brighter days ahead.

Teva's future success sits in direct contrast to Big Pharma's woes. Over the next five years, many of the industry's top blockbusters will lose patent protection, making them vulnerable to companies like Teva, the world's largest maker of generic medicines.

Says Aaron Gal, a pharma analyst with Sanford C. Bernstein & Co.: "The lackluster quarter should not deter investors from owning Teva." Teva shares are currently trading around $44. Gal has set a one-year price target of $50, which is the average price target among the analysts who cover the stock. The main reason for Gal's bullishness? "Teva will enjoy the growth of generic utilization," he told investors in a recent note.

Indeed, Teva (Charts) is poised to reap rewards from the rising demand for cheaper medicines in the U.S. and around the world. The $8.4 billion (revenue) company has all the hallmarks of a good generic drugmaker. Its lawyers are aggressive, constantly filing legal challenges to patent-protected drugs. As a result, the company currently has over 150 so-called abbreviated new drug applications (ANDA) pending with the Food and Drug Administration.

The company is also fast. Executives told investors last week that they believe Teva was the first generic-maker to file in 40 of those ANDA cases, which, in each instance, would give Teva 6 months to market a newly off-patent drug without competition from other generics.

"The holy grail for all generic companies is visibility," says Ken Cacciatore, an analyst with Cowen & Company. "In other words, do we have a handle on what the big growth drivers are going to be in the generic pipeline. What we are coming up with is a pretty good long term growth story for them."

Demographics certainly favor the growth of Teva's generic medicines. Currently, one in every 15 prescriptions written in the U.S. is for a Teva-made drug. The United States is the world's largest market for pharmaceuticals. And last month, the first American baby-boomer signed up for Social Security benefits. That opens the floodgates, as the largest-ever cohort of Americans moves into official maturity.

In 2000, the U.S. Census identified about 33 million elderly citizens, or 12% of the population. By 2030, the ranks of the elderly are expected to double to more than 70 million people or 20% of the U.S. citizens. As Baby-Boomers age, a larger portion of the population will rely on medicines to stave off the health complications.

The U.S. government has a real challenge ahead of it, as it faces intense pressure to oversee health benefits for boomers while exercising frugality. Those factors combine to portend phenomenal growth in generic medicines.

Teva has diversified beyond generics in recent years, placing resources into research and development of proprietary drugs. Teva has two promising branded drugs approaching the final stages of clinical testing. Both are the result of joint ventures.

The first, created in collaboration with TransPharma, is a human growth hormone that has the potential to garner sales of nearly $500 million annually. The second, a joint venture with StemEx, is a system for enriching umbilical cord blood stem cells. This product too, analysts believe, could generate sales of $500 million a year at its peak.

The company already has experience marketing its own branded drug, Copaxone, a multiple sclerosis therapy, which took in $950 million in sales in 2006.

Perhaps the only downside for Teva? The company could have more formidable competitors in the future. In 2005, Novartis (Charts), the world's fourth-largest maker of branded drugs, became the second-largest generics manufacturer in the world with its acquisition of Eon Labs and Hexal AG of Germany. Other branded drugmakers could follow suit, hedging their bets with generics.