Par Pharmaceuticals: Buried in the Generic Drug Battlefield

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May 12, 2011
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Generic pharmaceuticals as an industry that has very favorable demand dynamics. Several secular trends are converging that will benefit this market. For one, governments and health care insurers around the world and especially in the U.S. are aggressively seeking out ways to reduce skyrocketing health care costs. Since 1960, healthcare spending has expanded from 5% of GDP to over 17% in 2009. Prescription drugs account for about 10% of all healthcare spending, so this is an obvious area to target. Generic versions of branded drugs generally sell for half to one third of the price.

Given this, health care payers have often limited reimbursement to generic versions of certain treatments, raising the demand for them. From 2004 to 2009, generics market share rose from 56% of prescription dollars to nearly 75%. One of the 2010 healthcare bill's main goals was to increase access to the roughly 15% of Americans with no health insurance. By eliminating insurance denials due to existing conditions, preventing the dropping coverage for sick patients, and offering incentives to small businesses providing coverage, more people will be insured — and more people will be able to purchase prescriptions.

Finally, there is demographics. The number of Americans over 65 will increase 3% a year over the next 10 years, with an additional 14 million people entering Medicare. Naturally, older folks generally require more medical care, including prescription drugs.

Put it all together and the picture is bright for generics. This trend is set to accelerate over the next few years. 6 of the top 20 best selling branded drugs are set to lose patent protection in 2011 and 2012, with two additional drugs that have over a billion dollars a year in sales expiring in 2012. That's an astounding $43 billion dollars in branded drug sales that will be open to generic competition.

So it would seem to be a slam dunk to recommend generics maker Par Pharmaceuticals (PRX, Financial) as an attractive Magic Formula stock. Par generates 90% of its sales from generics, and all of its profits. Par has a two-pronged strategy. First, it targets smaller and less competitive drugs to develop. By doing this, the company can beat its competitors in filing abbreviated new drug applications (ANDAs) with the FDA, which provides 180 days of marketing exclusivity after the branded drug goes off patent. This is huge in the generics business — windfalls from high-margin sales in these 180 days can often generate several "normal years'" worth of profits.

The second prong of Par's generic strategy is entering into supply and distribution agreements with the maker of the branded drug to become the "authorized generic distributor." This gives Par a slight competitive advantage and also allows them to charge a bit more. On the downside, it usually requires Par to pay royalties to the branded maker.

Par is not quite the slam dunk it would seem to be. The company is not targeting any of the aforementioned blockbuster drugs — there is just too much competition for them. And that is one of the big problems with this industry. Scale is hugely important to generating economical gross margins and maintaining the legal talent needed to succeed in patent challenges. At just $1 billion in sales, Par pales in comparison to Teva (TEVA, Financial) ($16 billion), Sandoz (NVS, Financial) ($9 billion), or Mylan (MYL, Financial) ($5.4 billion), not to mention several similar-sized competitors. Once exclusivity periods end, competition usually floods into the marketplace, driving down sales and margins.

A good example of this is Par's largest product: a generic version of AstraZeneca's (AZN, Financial) Toprol XL (metroprolol). Par won the authorized generic agreement with AstraZeneca in 2006. Early on, competition was limited, and then there was no competition in first 2 quarters of 2009, driving a 100% sales increase over 2008. However, Watson (WPI) came into the market in late 2009, and since then an Indian generics firm has also entered. Pricing and volumes suffered. In the just-reported first quarter of 2011, metroprolol sales fell 65% over the prior year!

Competition can also lead to cheating. In Q1, Par recorded a $190 million charge to settle claims of the company over-inflating the wholesale prices they report to insurers. The alleged scheme is that Par (and competitors) charge less to pharmacies and report higher selling prices to insurers. Since the insurer is reimbursing the pharmacy at a higher rate than they pay for the drugs, it's a nice reason for the pharmacy to choose Par's product over a competitor's.

This is a difficult company to value. It is hard to predict the effect of new competition on existing sales, and if Par will be able to win exclusivity. The firm reports 12 first-to-file ANDAs, 2 potential first-to-market opportunities, and plan 5 to 7 new ANDA filings a year over the next few years. Revenues and profitability are very boom-and-bust. Par also has a branded drug unit called Strativa, but so far this unit has been unprofitable, and probably will remain so for several years.

There are a range of possibilities for Par, but a median case puts a fair value of about $40 on the stock. Since this is a very uncertain calculation, MagicDiligence has a neutral opinion. There are better Magic Formula stocks to consider.

Steve owns no position in any stocks discussed in this article.
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