Pressures on the U.S. pharmaceutical industry has built over the past few years, stemming from an increasingly stringent drug regulatory environment and the global economic downturn. Drug developers have also contended with expanding government efforts to contain healthcare cost burdens during the past year. While attention has been focused toward overcoming these challenges, a building wave of key drug patent expiry that began in 2010 is anticipated to crest over the next two years, which is the final element to an unprecedented set of challenges that lay ahead for the industry.

Patent Expirations to Impact Specific Drug Makers

A period of significant drug patent losses is upon the industry that is expected to accelerate erosion of revenues to record levels in 2011 and 2012. The patent cliff encompasses the loss of patent protection for seven of the world's 10 best-selling pharmaceuticals by the end of 2014. This year, three major drug patents potentially expiring are Pfizer's cholesterol-lowering medicine, Lipitor, in November; Eli Lilly's schizophrenia treatment, Zyprexa , in October; and Bristol-Myers Squibb's anti-clotting medication Plavix - in November. Not surprising, U.S.-based drug developers with the highest risk of patent losses over the next three years are Pfizer, Eli Lilly and Bristol-Myers Squibb, as each faces the potential expiration of their top-selling drug products.

While the patent wave looms over the entire industry, in reality, it is specific to the companies that are tasked to mitigate the negative affects to profitability resulting from aggressive generic drug competition subsequent to key patent lapses. Drug manufacturers employ various strategies to counter the market exclusivity losses, notably by bolstering research productivity, implementing restructuring programs and cost efficiencies and deploying diversification measures including mergers and acquisitions.

Pharmaceutical Innovation Not Pacing Patent Expiration
New medicines arising out of R&D programs are not likely to solely supplement revenue losses due to the more limited nature of maturing drug portfolios over the next two years. This is especially evident for those drug manufacturers with the weakest intellectual property positions.

On the bright side, a positive trend of the U.S. Food and Drug Administration (FDA) approvals - one proxy for innovation of the pharmaceutical industry - has been sustained since 2008. Examining the current late-stage pipelines of major industry participants in the U.S. and Europe indicates the continued upswing in marketing clearances that may be granted during 2011, including the promising metastatic melanoma treatment ipilimumab from Bristol-Myers Squibb and the novel anti-coagulant Xarelto developed in partnership between Johnson & Johnson and Bayer.

Historically, large pharmaceutical companies focused on successful commercialization of novel medicines arising from internal research and development efforts in order to replace lost revenues from expired drug products. However, drug manufacturers have eased the stress on once-sacrosanct research programs through risk sharing agreements with external researchers.

Development and marketing partnerships afford a reduction of the risk and cost of advancing experimental drugs through the drug regulatory approval process while still reaping the benefits upon market introduction. For example, Bristol-Myers Squibb and Pfizer established such an agreement pertaining to the potential anti-coagulant medicine, apixaban, whereby the research investment is divided, thus easing the cost burden on both companies. Business development activities directed to filling R&D and product portfolio gaps are expected to be favored over major industry consolidation.

Reimbursement and Demand Challenges Ramp Up

Across the globe, governments are taking steps to control federal budgets including measures aimed at minimizing the rise in healthcare spending, most notably U.S. healthcare reform efforts legislated in March 2010 and European austerity measures. The drug industry typically sees a modest gross impact to revenues on an annual basis due to various government cost containment policies instituted throughout Europe. However, focus on incremental cost control arose in 2010 as certain European countries faced ballooning deficits, which led to reimbursement cuts for brand name pharmaceuticals, specifically in Greece, Spain and France. The new policies are expected to double the historical impact on revenues.

Much uncertainty pertaining to the outlook for the industry was alleviated early last year with the passage of the Patient Protection and Affordable Care Act (PPACA) in the U.S., whose impact has proven to be relatively innocuous to the industry given the exclusion of direct price negotiations between the government and pharmaceutical manufacturers. Pharmaceutical companies will bear the brunt of the cost of implementing provisions of the new law prior to expansion of healthcare coverage in 2014 to approximately 34 million presently uninsured patients. Net sales have been dampened by increased rebates under Medicaid in 2010 and will be further influenced by partial filling of the coverage gap under Medicare Part D starting this year. Also, this year a fee of $2.5 billion will be levied on the industry split by market share. Collectively, the influence of the healthcare reform will essentially double in 2011 from the low single digit growth impact in 2010.

Further demand pressure on brand name pharmaceuticals comes from greater use of generic drugs. Managed care organizations and third-party payers use generic drug substitution as a primary means to contain pharmaceutical spending, effectively shifting prescription drug volumes from brand name medications to generic copies. The generic substitution rate in the U.S. already approaches 75% of total prescriptions and is expected to expand in the midst of the current period of record drug patent challenges.

Weak Macroeconomic Conditions Lead To Treatment Avoidance

Exacerbating the pricing and demand effects of reimbursement cuts by various governments and drug spending control by third-party payers, the lagging effects of the U.S. recession will hamper branded prescription drug demand throughout the coming year as people focus on containing disposable income including reducing healthcare expenses and delaying non-essential care. Despite the end of the recession in the U.S. in the third quarter of 2009, unemployment will continue to weigh on the prospect for the industry. Fitch Ratings forecasts U.S. GDP growth of 3.2 % in 2011, yielding a somewhat improved unemployment picture at 9.1% in 2011, still far above historical levels.

Treatment avoidance is only partially eased through another potential extension of unemployment benefits in the U.S. and patient-assistance programs offered by drug manufacturers. Moreover, greater cost burdens are placed on patients from increasing drug co-payments for prescription drugs and expanded use of co-insurance for specialty medicines. Resultant demand reduction is expected to pressure top-line growth for large pharmaceutical firms.

Profitability Supported By Cost Containment

Most large brand-name pharmaceutical manufacturers in the U.S. have reduced operating costs over the past few years as the industry faces prospects of lower top-line growth from near-term patent challenges, government reimbursement changes, and patient treatment avoidance. Restructuring actions have gone beyond headcount elimination and facility consolidation to remaking entire organizations into smaller, more nimble business units and to refocus corporate R&D programs toward specific disease states or therapeutic areas. While some drug manufacturers have redefined their organizational structures, others have chosen to consolidate in order to confront the many industry challenges.

The benefits gained from merger and acquisition activities may bear out through incremental margin support attained from integration synergies, notably Pfizer's estimated annual synergies of $4 billion by 2012 from the Wyeth acquisition, and Merck & Co's annual savings of $3.5 billion to be achieved beyond 2011 arising from the merger with Schering-Plough.