Patent Cliff II Is Here, But Do Pharmacy Chains Need to Worry?

The pharmaceutical industry is one of the most profitable and fastest growing industries, both globally and in the United States. US spending on medicines was forecast to be in the range of $377-384 billion in 2014, up 11-13% from the year before (official count from IMS for 2014 might available by spring 2015) ^[1]. While the industry has been growing steadily over the past several years, 2012 was an exception where the market declined. That year, patents of branded drugs worth $33 billion in sales expired, making way for generic manufacturers to make cheaper copies. Consequently, top lines of many pharma companies took a hit, as generics are priced significantly lower than their branded counterparts.

Pharmacy chains, whose bread and butter is sales of medicines, don’t have good memories of 2012 either. CVS Health (NYSE:CVS) which had otherwise registered very high growth rates (relative to its peers)  of 13% and 16% in 2011 and 2012, grew only 3% in 2013. However, it quickly recovered to 10% growth the following year. Rite Aid (NYSE: RAD), on the other hand, saw its revenues decline by 3% in 2013 compared to a 4% growth in 2012. The patent cliff coincided with the time when Rite Aid was recovering from a period of losses (due to high debt and operational inefficiencies), which aggravated their problems and pushed profits further into the future.

Sales of $47 billion Are At The Risk of Patent Expiry This Year

While only a little over 2 years has passed after the 2012 cliff, 2015 brings yet another patent cliff. According to an analysis by Evaluate Pharma, another $47.5 billion in sales (in the prior year) will come under threat of patent expiry this year. For perspective, this amount forms about 13% of the expected US spending on medicines for 2014 ($377 billion). Of the products that came off patent in 2012, seven drugs had US sales of $2 billion or more, compared to six of those in 2015. Though the total sales at risk is close to that in 2012, its not all doom and gloom this time around.

Here’s The Catch

Every year, not only do branded drugs come off patent, but new products are launched as well. In 2014, FDA approved 44 drugs in total, which is the highest level since 1996, when 53 drugs were approved. This trend is expected to continue in 2015 and sales of $58.4 billion are expected to arise from new drug launches alone, which is well ahead of the expected sales decline due to drugs coming off patent. Even in case of delays in the launch of a few drugs, 2015 will not be as demoralizing as 2012 for the pharmaceutical industry. In comparison, new launches in 2012 fell short of those coming off patent by about $8 billion in sales (refer to chart below ^[2]).

Effects of Increase in Share of Generics

Even though branded drugs contribute a significant portion to a drug retailer’s top line, generics have historically provided higher gross margins. For example, though CVS’ revenues grew only 3% in 2013 after the patent cliff, its gross margins improved to 14.6% compared to 9.3% and 1.1% in 2012 and 2011, respectively. Therefore, a higher share of generics in the total prescriptions would boost the margins in spite of a negative impact on sales.

However, generics have also been a source of negative margin pressure for most drug stores. As prices of generics tend to go down with time, primarily driven by competition among generic drug manufacturers, reimbursement rates on those drugs are reduced accordingly. However, the industry has been in a phase of generic price inflation, as seen in the past few years. While payers are quick to act on a price decrease, they can be very slow in readjusting the reimbursement levels when the prices go up. As a result, drug retailers have been making losses on generic drugs because the cost at which they acquire drugs exceeds the reimbursement they receive, leading to lower bottom lines. (Here’s a more detailed analysis of this issue)

Conclusion

Altogether, there are multiple effects of the patent cliff, with some weighing against others. While a temporary slowdown in top line growth is almost certain, the net effect of higher gross margins and low reimbursement rates will determine (up to an extent) which way the bottom lines will go. Projections indicate that good times will be back again after 2015. However, it will be a test of mettle for pharmacy chains to be able to weather the storm.

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1. US pharma market will top $377 billion in 2014; up 11-13%, Pharmaceutical Commerce, November 20, 2014 [↩]
2. Pharma learns to brave the patent cliff, EP Vantage, February 23, 2015 [↩]