Market Transition - When we think about the patent cliff, an image along the lines of a massive waterfall, with companies' revenues in free fall comes to mind. What we usually forget to consider, though, is that the waterfall is nourishing a fertile, green valley below. While big pharmaceutical companies are scrambling to bolt-on smaller biotechs with marketed drugs to protect themselves, generics manufacturers are reaping windfall profits.

While the industry has been nervous about the patent cliff for years, it is turning out to be a blessing in disguise. Patients are benefitting the most by gaining access to the innovative drugs of the past few decades at generic prices. Biotech companies are benefitting from a frenzied M&A environment, and generics companies are reporting record profits. Big pharmaceutical companies, meanwhile, have been forced to respond to the challenge by refocusing their attention and honing their business strategies.

Pfizer vs. Watson

As an example of this phenomenon, it's worth looking at the biggest loss of the edge of the cliff, Pfizer's cholesterol drug Lipitor. The company recently released its first quarter earnings, and reported Lipitor sales of $1.4 billion, a 42% plunge from the same period in 2011. The drugmaker can hardly complain, though, as the drug recorded cumulative sales of $128 billion for Pfizer through the end of 2011. Meanwhile, Watson Pharmaceuticals was the first to begin selling generic Lipitor in November, 2011. As a result of strong generic Lipitor sales, as well as other generic launches including generic versions of Concerta and Lovenox, Watson's first quarter revenue increased 74% to $1.5 billion, compared to $877 million for the corresponding period in 2011.

Increased sales drove an 87% increase in net income, from $112 million in Q1 2011 to $209 million in 2012. As a result of its newfound financial heft, Watson was able to expand its geographic reach with the purchase of the European generics firm Actavis. Watson announced the €4.25 billion ($5.6 billion) acquisition on April 25, and should lead to 2012 pro forma revenue of $8 billion for the combined company in 2012, compared to $4.6 billion for Watson in 2011 and $6 billion in 2012 based on annualized first quarter revenue. Mylan, another major generics company, reported an 18% increase in earnings for the first quarter compared to 2011, to $0.52/share from $0.44/share. This gain was due to a 9% increase in revenue from $1.45 billion in Q1 2011 to $1.58 billion in 2012.

New Strategy

Pfizer and other big pharmaceutical companies, meanwhile, appear to be on course to successfully navigate the rapids. Although Pfizer saw its earnings drop 19% in the first quarter compared to 2011, there are bright lights on the horizon. The FDA is set to decide on its rheumatoid arthritis drug tofacitinib by August 20, and the drug has the potential to eventually generate up to $1.5 billion in revenue per year. The company has another drug before the FDA for review, with a decision expected by June 28. Eliquis was co-developed with Bristol-Myers Squibb for the prevention of strokes in patients with arterial fibrillation, and also has blockbuster potential. Finally, Pfizer is flush with cash after selling its infant nutrition unit to Nestle for $11.9 billion, and ready for another round of acquisitions that could range from small, bolt-on biotech purchases to another pharmaceutical mega-merger.

Rising Stars

Through a continuing wave of lucrative biotech buyouts, two small companies with approved drugs are now the focus of major pharmaceutical M&A efforts. Human Genome Sciences Inc. (HGSI) received approval for its first drug, Benlysta, last year. The drug was the first new therapy approved by the FDA for lupus in almost 50 years, but so far the launch has been much weaker than many had expected or hoped. Despite three promising, late-stage pipeline programs for treating infectious diseases, cardiovascular disease, and diabetes, HGSI's share price has suffered since the March, 2011 approval of Benlysta. On April 19, HGSI disclosed a rejected take-over bid from GlaxoSmithKline of $13/share, or about $2.6 billion, causing the company's shares to rocket to an 81% single-day increase. Although the bid was rejected, we believe that GlaxoSmithKline will eventually acquire its target. The company has gone hostile with a $13/share bid with the belief that their partnership with HGSI, which covers Benlysta and two of HGSI's late-stage clinical assets, will deter other potential bidders.

Another company on the pharmaceutical auction block is Amylin Pharmaceuticals, which possesses a series of lucrative diabetes drugs, most notably two drugs related to the exenatide franchise. Exenatide, sold in a twice-daily version as Byetta and a once-weekly version as Bydureon, is an incretin mimetic, GLP-1 receptor agonist that helps type 2 diabetics control their blood sugar. The other approved drug is Symlin (pramlintide), an analogue of the human hormone amylin (the company's namesake) that helps type 2 diabetics control glucose with the potential for weight loss. Amylin had been involved in a long-term partnership with Eli Lilly for the promotion and sale of the exenatide franchise, but that agreement ended in a messy divorce last year after Lilly began co-promoting a competing portfolio of diabetes products along with partner Boehringer Ingelheim.

As a result of the break-up between the two companies, Amylin found itself with complete ownership of its approved drugs, making it an attractive takeover target. The company went public with its intention to be acquired after rejecting a $22/share, $3.5 billion buyout bid from Bristol-Myers Squibb in February. Amylin shares jumped more than 50% the day it announced the rejected acquisition. It has since begun an auction-type process to sell itself, and it has reportedly drawn bids from Sanofi and Merck & Co., as well as potential interest from Merck, Pfizer, Roche, AstraZeneca, Takeda, and Bristol-Myers Squibb. AstraZeneca, with a weak portfolio of diabetes products and a dire need to bring in new sources of revenue, is an obvious candidate to purchase Amylin. While any of these companies would likely benefit from the blockbuster exenatide franchise, Takeda and Sanofi are other drug makers who we believe might go after Amylin with intensity. When the process is completed, we will not be surprised to see Amylin sell for well over $4 billion, perhaps approaching $5 billion.

Outlook

With deals like these on the horizon, the biggest development regarding the patent cliff will be watching large pharmaceutical companies' attempts to maintain growth in the face of expiring patents. But regardless of how or whether Big Pharma stays atop its mountain or goes over the cliff, generics firms will continue to reap the profits of major pharmaceutical patent expirations.