One clear theme in the U.S. drug industry is the downward pressure on generic drug prices. The latest quarterly results at generics manufacturers Impax and Perrigo missed expectations by at least 20%, largely due to lower prices. Overall, the generic drug manufacturers expect prices to fall by as much as 9% this year. Teva thinks generics price deflation will accelerate in 2H17.
So what's causing the weak pricing environment, and what’s the end-game?
First, the government is closely scrutinizing drug prices. Federal regulators and several states have accused companies of price collusion, and the head of the FDA has made generic drug competition a key focus of his platform. Let's take a look at the number of Abbreviated New Drug Applications (ANDAs, applications for generic drugs) approved by the FDA so far. The fiscal year ends in September.
Clearly, more generic drugs are being approved (the data does not include tentative approvals). Looking more deeply, consider the types of generics that the FDA is approving. Let's look at the "first time" ANDA approvals. A first time generic is a cheaper copy of a branded drug for which there was no generic drug previously.
There is a clear, steady decline in first time ANDA approvals since 2012. This can explain some of the differences in pricing pressure seen in generics drugs versus branded drugs. Taken together with the total number of generics being approved, international equity investors can conclude the FDA is approving starkly more generics than target markets where cheaper copycats already exist, putting relatively more pressure on generics and less on innovator drugs. Interestingly, it seems the widely anticipated drug patent cliffs in 2015 and 2016 didn't result in higher first time ANDA approvals. This year, major patent expirations are expected to impact Roche, Glaxo, Eli Lilly, AstraZeneca, Pfizer, and Merck; let's see if first time ANDA approvals rise this time around.
Another cause for the pricing environment lies in the drug wholesalers. In 2016, wholesalers engaged in a pricing war with each other when they offered better drug prices to independent pharmacies, which are more profitable customers since they have less purchasing power than national chains. In turn, the wholesalers started to squeeze drug manufacturers on pricing. Not only that, but wholesalers also partnered with each other in order to get better leverage with the drug companies.
So what's the end-game? The textbook answer to stop a price war is to innovate, but that's hard in the generic drug business. Instead, there needs to be a rebalancing of negotiating leverage in the supply chain—one possible solution is for the manufacturers to consolidate. They've tried to respond with M&A; Mylan and Teva bought peers or drug portfolios, but that has left both with higher debt loads and both are still seeing weaker pricing. So who or what is left? We don't see a near-term equilibrium being reached in the current regulatory/business environment. Simply, generics prices may continue to decline until the manufacturers become attractive enough for an outsider to buy (and possibly consolidate). Potential candidates with capacity would include foreign drug companies and private equity investors.
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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF DAEIL CHA
Daeil Cha is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Daeil was an Analyst at Suffolk Capital Management.
Daeil received an MBA from Columbia University and a Bachelor of Arts in Psychology, with a focus on Neuroscience, from Princeton University.
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