Although the generic drug market is fiercely competitive, it is a fast-growing sector, with a big surge in business expected down the road.

Between 2004 and 2009 alone, the generic drug market is expected to grow by an average of 10% annually to more than $90 billion (all dollar figures are in US$), according to Switzerland’s Novartis AG, whose Sandoz GmbH generics business is the second largest in the world. And while there are lots of players in the generics business, its tight profit margins mean that larger companies or those in the developing world — where wages are lower — have the best prospects.

Geographically, the fastest growth in markets will come from the U.S. and western Europe, forecast at 12.6% and 10.5%, respectively. Emerging economies are expected to see 9.3% annual growth. Generics’ market penetration varies widely, with generics accounting for 19.5% of all pharmaceuticals sold in Germany in the third quarter of 2004, 13.7% in Canada, 6.7% in the U.S., 5.6% in France and 3.4% in Italy. But, longer term, the greatest potential for generic drug penetration is in emerging markets as incomes rise, government coffers swell and health standards catch up to those of the industrialized world.

The affordability of generics is one reason for this expected growth. Once the patent comes off an original drug, the price of the drug can drop by a whopping 75%-80%. Because it is a low-margin business, manufacturers of generics try to boost sales by adding more drugs to their arsenal. One way they can do that is by challenging patents on original drugs before the patents expire. Although that costs a few million dollars, it’s a fraction of expected sales if the challenge is successful. This is particularly lucrative in the U.S., where the company that wins a challenge is the only one allowed to sell a generic version for the next six months.

As a result, there are many challenges and some successes, although none have been of critical importance — yet, says Andrew Waight, portfolio manager at Altrinsic Global Advisors LLC in Toronto and manager of CI Global Health Sciences Fund. But that could change.

An important challenge underway in the U.S. is to the patent of Lipitor, a popular drug for lowering cholesterol produced by New York-based Pfizer Inc. Lipitor accounts for 20%, or more than $10 billion, of Pfizer’s total sales. An earlier challenge in British courts was unsuccessful, and analysts believe the challenge in the U.S. — which accounts for 75% of Lipitor’s total sales — will also favour Pfizer when it’s decided in the next few months.

The fiercely competitive nature of this industry makes it an industry ripe for consolidation. That’s why Heather Peirce, a portfolio manager with AIM Funds Management Inc. in Toronto, thinks there will be “very few winners.” Because of the higher cost base U.S. generic companies face, Peirce believes most of the sector’s survivors will be in developing economies, such as India, where the costs, including those related to research, are much lower. But she does expects some of the big players to come through, including Novartis — one of her top 10 holdings — and Israel’s Teva Pharmaceutical Industries Ltd. , the world’s largest generics company.

In interviews with global managers, one other company was suggested as a good investment opportunity — Czech Republic-based Zentiva NV. Although it is a much smaller company, it has some favourable characteristics. Not only is it growing through acquisitions, as are Novartis and Teva, but it also has much lower costs because of its eastern European location.

A closer look

Here’s a closer look at the three:

> Zentiva. This is one of the largest — and highest-quality — generic drug firms in eastern Europe, a region in which there is a lot of catch-up demand, according to Charles Burbeck, head of global equities at HSBC Halbis Partners in London. In 2004, per capita expenditures for pharmaceuticals was $32 in Romania, $33 in Russia and $93 in Poland, vs $504 in western Europe, $516 in Japan and $801 in the U.S.

In the former Soviet Union, health care was not a priority and there was a shortage of quality drugs and health-care providers. But strong economic growth in eastern Europe and Russia has resulted in rising standards of living, making drugs more affordable to both individuals and governments. Burbeck says there will be five to 10 years of catch-up demand in these markets, much of which will be state-driven, thanks to public health-care programs. Non-prescription products are not covered, however, and governments may require co-payments on prescription drugs.

@page_break@Zentiva is in a good position to profit from increased demand, which should translate into 10%-15% annual revenue growth for the next five years, says Burbeck. The company already has significant sales in Poland and Russia, as well as in Slovakia and the Czech Republic, and it is moving into Romania with the acquisition of that country’s largest generic company, the publicly listed S.C. Sicomed SA.

The deal is structured in two phases: in October, Zentiva purchased Venoma Holdings Ltd., which owns 51% of Sicomed shares. On Nov. 9, Zentiva launched a voluntary tender offer for the remaining 49% of Sicomed shares. This deal will be completed later this year or in early 2006.

Burbeck says the $200-million price-tag for Sicomed and the Romanian market, which he thinks will grow by 15% a year for the next five years, are both very attractive.

Zentiva’s management, unlike that of many eastern European companies, is very investor-friendly. The company’s sales were 8.3 billion in Czech krona — almost $350 million — for the nine months ended Sept. 30, 2005, up 5.7% from the same period a year earlier. Net profit was 1.5 billion krona, or $63 million, up 24.8% from 2004. Long-term debt was negligible, but will rise as most of the Sicomed purchase is being financed by debt.

Sicomed’s sales in the six months ended June 30 were $35 million and its net income was $3.4 million. Zentiva expects to achieve $6 million in synergies over the next three years by bringing Sicomed’s margins in line with Zentiva’s. This will be achieved by introducing Zentiva’s higher-margin, modern branded generic products and increasing the efficiency of Sicomed’s operations.

Zentiva went public in June 2004 and targets an annual dividend equal to 15%-20% of net income. The shares, which trade as global depository receipts on the London Stock Exchange, are valued at almost $45 a share, more than double the IPO value of $19.50 a share. More than half the 38.1 million shares outstanding — 53.9%, as of Dec. 31, 2004 — are owned by global private equity investor Warburg Pincus LLC in New York; management and employees own 13.8%. Burbeck says the share price “is not particularly expensive.” He estimates the price/earnings ratio at 16 times 2006 estimated earnings and 14 times 2007 earnings.

> Novartis. Generics is only part of Novartis’s business. This is a full pharmaceutical firm that develops and sells its own patented drugs, as well as other health products.

A number of other pharmaceutical firms have generic divisions, but Novartis’s is the biggest, says Peirce. At $3.1 billion in sales for the nine months ended Sept. 30, its generics company, Sandoz, had higher sales than any firm except Teva. Sandoz bought Germany-based Hexal AG in June and two-thirds of Eons Labs Inc. in the U.S. in July. These purchases are complementary, extending Sandoz’s geographical reach and expanding its expertise into other areas, including higher-margin biopharmaceuticals.

Cutting-edge treatments

It isn’t just the generics that attract Peirce to Novartis. “Several of the Swiss-based companies have risen above the industry in investing in science and cutting-edge therapeutic treatments rather than launching another ‘me too’ drug,” she says.

With $23.6 billion in sales for the nine months, Novartis has thousands of patents on drugs and little exposure to patent expiry. It also has several drugs in late-stage clinical trials, providing a good pipeline in diabetes, hypertension and multiple sclerosis. Its biggest drug is Diovan, used for treating hypertension.

The combination of Diovan and generics “gives [Novartis] the ability to enter many emerging markets with an initial platform and, as the market develops, introduce branded drugs,” says Peirce.

Novartis’s net income was $4.8 billion in the nine months, up 13% on a 14% sales increase. Its Hexal and Eons acquisitions are expected to produce $200 million in synergies within three years. Long-term debt was $2.4 billion as of Sept. 30, not including the $8.6 billion to purchase Hexal. That is to be financed out of what Peirce calls “very strong” cash flow, running at $5.8 billion in the nine months.

Novartis had 2.4 billion outstanding shares as of Dec. 31, 2004, which trade as American depository shares on the New York Stock Exchange. In early November, an ADS was trading around $54.50, vs the initial price of $36 when the company was listed on May 11, 2000.

Novartis also owns 6.3% of Roche Holdings AG, another Swiss pharmaceutical firm recommended by Burbeck and Peirce.

> Teva. Sales totalled $3.8 billion in the nine months ended Sept. 30. But Teva is in the process of acquiring Florida-based Ivax Corp., which had $1.7 billion in sales. Once the $7.4-billion deal has been approved by both firms’ shareholders — it is expected to close late this year or early in 2006 — combined revenue will be $4.5 billion. Ivax shareholders have the option of taking cash or 0.8471 of a Teva ADR. Teva ADRs trade on Nasdaq.

The two firms first began discussing combining forces in the early 1990s, but their strategies didn’t mesh until this year. In the interval, both made a number of acquisitions. Besides scale, number and breadth of products, the deal enhances Teva’s expertise in the central nervous system and oncology research and development.

Teva’s profits for the nine months are $767.4 million, up from $53 million in the same period in 2004. However, 2004’s low profit figures were a result of $632.8 million in net costs related to its acquisition of U.S.-based Sicor Inc., another generic pharmaceutical company.

Teva’s sales are 60% in the U.S., 30% in Europe and 10% primarily in Israel. Although its main focus is generics, it also does research and development of patentable drugs, and it successfully launched the multiple sclerosis drug Copaxone in 1997, now its best seller. IE