Big pharma: Moving beyond the patent cliff

The expression “patent cliff” refers to the sharp decline in revenues resulting from the expiration of patents on brand-name drugs. For the past several years, large-cap pharmaceutical companies have struggled to deal with the effects of expiring patents. Based on our research through 2012, the loss of patent protection for branded drugs amounted to a loss of approximately $120–170 billion in global pharmaceutical sales.

In the following interview, Todd Bassion, a portfolio manager on the Global and International Value Equity team at Delaware Investments, discusses the effects of the patent cliff on the pharmaceutical landscape and how the team identifies companies that can grow “beyond the cliff.”

Q: How does the ongoing patent cliff affect your evaluation of pharmaceutical companies?

A: We believe the patent cliff has created several valuation distortions in the healthcare space. Our team seeks to take advantage of these mispricings by identifying what we believe are strong pharmaceutical companies that have a series of “levers” that can help offset the impact from losses caused by patent expiration.

Over the next three years, $56 billion of branded drugs come off patents, and $142 billion of branded drugs are expected to face generic competition over the next five years (Source: Merrill Lynch, November 2012).

We believe that one of the most important levers is free cash flow. High sustainable free cash flow allows pharmaceutical companies to undertake shareholder-friendly activities, such as buying back shares, making accretive acquisitions, raising dividends, and reinvesting in their businesses. Many of the companies in our portfolios have increased cash flow as a result of cost cutting initiatives, particularly through headcount reductions and by implementing more effective budgets for research and development (R&D) and information technology.

“Authorized generics” is another lever companies can use. By launching a generic version of a drug that loses patent protection, companies can help mitigate the negative impact from expired patents.

Q: Do generic manufacturers have an edge in the current environment?

A: We currently hold the stocks of two of the largest generic companies in the world. In our view, the scale, vertical integration, and technological expertise of these top generic companies can provide a competitive cost advantage and help allow them to produce generic biotech drugs successfully. Generic drug manufacturers are currently benefiting from the patent cliff and rising generic utilization rates around the world. Several overseas governments have put regulation in place to speed up the penetration rates for generic drugs. Japan and France in particular have been notable in this regard. Aging demographics, a sluggish global economic environment, and a continued focus on cost savings are the main drivers of generic utilization. Healthcare reform, which is currently promoting increased use of generic drugs, is also a positive for generic pharmaceutical companies.

Q: What is the effect on research and development as you see it?

A: There has been a tangible shift toward greater efficiency out of R&D pipelines. In our opinion, there used to be a lot of “wasteful” spending in R&D budgets, but now each project is being closely analyzed for its cost and the probability of the product coming to market. Several pharmaceutical companies are focusing on late-stage pipeline candidates that look more promising, instead of developing products from scratch, which involves a lot of funds and time. Many of the pharmaceutical companies we own are streamlining their R&D efforts away from early stage (Phase I) projects toward late-stage drugs, which have a higher probability of coming to market.

Q: How does growth in overseas markets factor in?

A: We believe emerging markets represent a huge growth opportunity for pharmaceutical companies. Emerging markets countries constitute 70% of the world’s population, generate 31% of gross domestic product, and are projected to account for 30% of global pharmaceutical spending by 2016. (Source: Bloomberg.)

Several of the holdings within our portfolio that are domiciled in developed market countries have significant positions in Emerging market countries. These companies have more than a decade of experience navigating challenges in these countries, such as distribution logistics and regulatory structures. We also believe there is a benefit in having access to western-based management teams, which provide us with a high level of transparency, disclosure, corporate governance, and access.

Thank you for your insights into the healthcare sector.

The views expressed represent the Manager’s assessment of the market environment as of September 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Diversification may not protect against market risk.

Past performance does not guarantee future results.

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