Market volatility affecting the price of generics

March 21, 2005

The certainty in the price of generic drugs is uncertainty, contend market analysts. For two years, 2001 through 2003, the price of generics rose at nearly twice the rate of brand-name drugs. In part that was because many best-selling brand products-for treating diabetes and allergies, for example-lost patents, so generic manufacturers enjoyed repeated opportunities for periods of market exclusivity mandated by the Waxman-Hatch Act.

The certainty in the price of generic drugs is uncertainty, contend market analysts. For two years, 2001 through 2003, the price of generics rose at nearly twice the rate of brand-name drugs. In part that was because many best-selling brand products-for treating diabetes and allergies, for example-lost patents, so generic manufacturers enjoyed repeated opportunities for periods of market exclusivity mandated by the Waxman-Hatch Act.

Last year, however, price inflation among generic drugs decelerated dramatically, as the cost of several leading nonbranded generics began to stabilize.

Generics' price inflation continued to outpace general inflation through most of 2004, according to an AARP study. Then it fell to half of general inflation by the end of last year. Market researcher IMS Health reports that generic sales were up by 10% in 2005, but that last year's sales represented slower growth than in the past. That's a reflection of the industry's volatility, according to IMS officials. "Generic dollar sales [represent] a dramatic slowdown from prior years, when generic growth topped 26%," according to Ana-Maria Zaugg, IMS corporate VP.

Prices were generally stable last year. A study by AARP's Public Policy Institute, based on changes in manufacturer list prices for 75 generic drugs widely used by Americans age 50 and older, found that fewer generics had increases in manufacturer list prices during the first three quarters of 2004 than in the first three quarters of each of the previous three years. In fact, only seven (9.3%) had an increase in manufacturer list price during the first three quarters of 2004. Of those, only three had changes in list price during the second or third quarters of 2004. And they were all different strengths of the same drug, Monarch Pharmaceuticals' Levoxyl (levothyroxine).

But recent stability notwithstanding, some analysts believe we are about to enter a renewed period of fluctuation, resembling that of two years ago. Generic price inflation could reemerge as several more best-selling brand-name drugs lose patent protection and generic manufacturers introduce versions at initially inflated prices. Another factor that may affect prices is what some analysts say may be a period of dramatic market consolidation, which would leave fewer companies to compete on older generics.

An event reflecting that trend occurred in February when Novartis became the world's largest manufacturer of generics upon its purchase of the German manufacturer Hexal and two-thirds of Hexal's American affiliate, Eon Labs. The sale brought the Swiss giant more than 120 new generic products, including painkillers and cholesterol drugs from Hexal and a generic antidepressant and diabetes medication, as well as a well-regarded pipeline of new generics from Eon. Novartis announced, when it made the deal, that Eon had a pipeline of drugs covering nearly all the products that would lose their U.S. patents from 2005 to 2009. These drugs, which include Merck's top-selling cholesterol medicine Zocor (simvastatin), represent an estimated $69 billion in product sales over the next five years, according to Novartis officials.

Novartis will merge Hexal and what it owns of Eon with its Sandoz unit, the company said. The result will be projected control of more than $5 billion of the world's $40 billion annual generic market. Experts predict that by the end of the decade, Novartis will continue to dominate at least 10% of what will by then be a $100 billion world market for generics. "Generics will continue to penetrate the market," Daniel L. Vasella, M.D., chairman and CEO of Novartis, told Wall Street analysts when the sale was announced in February, according to one published report.

No doubt he's right: Generics already comprise more than 50% of domestic drug sales. So in response to Novartis' move, market analysts confirmed the firm's AAA bond rating. But in public statements, several analysts pointed to factors in the generic market that details its volatility. Britta Holt, an analyst at Fitch Ratings in New York, said that although the Novartis purchase "improves its generic business, the margins are small, as is the return on capital."

Novartis' generic strategy carries risks because of high competition, which is what led to last year's price collapse in the United States, said Mark Clark, an analyst who covers European pharmaceuticals for Deutsche Bank in London. "You will get volume growth in this market, but it's a market that's characterized by cutthroat competition," he said.A significant portion of that competition is foreign. Low-cost generic manufacturers in India and China are gaining ground and will probably push hard into the American market as patents expire, according to Clark. Novartis' largest rival in the generic field is TEVA Pharmaceutical Industries in Israel, which posted $4.8 billion in worldwide sales last year.

Another pricing factor is that middlemen can greatly affect generics. "There are opportunities for lots of participants along the distribution channel to make a healthy margin off generics," according to a market analyst at Lehman Brothers. PBMs, for example, make significant profits on generics because lower prices to the PBM allow for greater mark-ups than available on branded drugs. David D. Halbert, CEO of AdvancePCS, one of the nation's largest PBMs, has said publicly many times that generic drugs contribute significantly to the company's bottom line.

And pharmacists rely on higher markups on generics because they are allowed so little profit on brand-name drugs under managed care, said John Rector, senior VP of the National Community Pharmacists Association. "The markup [on generics] for pharmacies is better, and consumers get a more affordable product," he said.

He has a point. The AARP analysis found that although manufacturer prices for some generics did rise rapidly between 2001 and 2003, the increases did not greatly affect aggregate consumer costs. That's because it was only a few drugs, primarily antihistamines and some antibiotics, that rose in cost so dramatically. More than half of the drugs analyzed by AARP showed no price increase or even a decrease in cost. The biggest decline among the 25 top-selling generics occurred for IVAX Pharmaceuticals' calcium-blocker verapamil: the manufacturer price for a 240-mg tablet of the hypertension drug fell an average of 21% annually. The biggest increase among the 25 top-selling generics was also for an IVAX drug, its diuretic hydrochlorothiazide. The average annual increase over the three years for a 25-mg tablet was 58%.

The fact that a single company had the biggest increase in price and the smallest reflects the single most significant phenomenon affecting price in the generic industry, according to Lawrence Rosenthal, president of Andrx Pharmaceuticals Inc., a generic manufacturer in Plantation, Fla. "Price competition is really still product specific and a function of product line," he told investors during a recent conference call with investors.

According to Rosenthal and others, it is how and when a specific product enters the market that determines the volatility of its price, at least for the first year or so. David Reiffen is an economist for the U.S. Department of the Treasury who has studied competition in the generic industry. He said that "two features of the entry process in this industry are important to understanding industry dynamics."

First, said Reiffen, in a Treasury Department report titled "Generic Drug Industry Dynamics," the timing of the generic's entry is "not fully under the entrant's control. Not only is the date of its approval by the Food & Drug Administration uncertain, but in addition, each applicant does not know when, or how many, other applications for that drug will be approved."

Second, the timing uncertainty of an individual drug's entry and the resulting profits are likely to be "highly dependent on when it gains approval relative to other generic producers of that drug," said Reiffen. "Firms that gain approval before rival generic firms are able to sell their product sooner and will face fewer initial competitors. In addition, there is some evidence that such firms earn greater profits even after their rivals have entered."

Reiffen's conclusion in studying competition in the generic industry reflects why prices for specific generics remain unpredictable. He said normal rules of market competition-in which market decisions are made based on perceived demand-generally don't apply to the generic industry.

"These two features create a kind of lottery for prospective entrants into producing a generic version of a drug," Reiffen said in his report. "If a firm obtains early approval, it is likely to earn a positive return on its application-related costs, while firms obtaining approval later in the process are likely to lose money. Thus, in contrast to markets in which entry decisions are sequential and competition results in the last entrant earning zero profit, here the number of firms [in competition to sell a drug] adjusts until the average firm earns zero profit." In other words, price battles continue among generics until most everyone is operating virtually at a loss.