Should You Keep Buying These Beneficiaries of the Patent Cliff?

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Actavis has seen five-year stock gains of more than 600%, and on Tuesday, the company added additional gains of more than 5%. However, the backbone of these gains have been created from a paradigm shift that we're seeing in health care, but does this mean that Actavis is still a good long-term buying opportunity?

What happened?
The generic-drug maker Actavis continues to see unprecedented growth. In the second quarter, total sales exceeded $2 billion, creating 57% year-over-year growth.

However, some investors have suggested that the acquisition of Warner Chilcott played a role in this growth. While the acquisition did add quarterly revenue, Actavis' performance without Warner was equally impressive.

If we look at net revenue, Actavis saw $1.55 billion, or growth of 69% year-over-year. Moreover, the company saw its adjusted gross margin increase from 47.2% to 51.5% over the year, further proving that Actavis is not only growing rapidly but also improving in its business.

What's creating such growth?
If we look back at the decade prior to 2008, shares were essentially flat! So, what has led to Actavis' sudden and robust growth?

A key element to Actavis' growth has been the so-called patent cliff, a period where many of the world's best-selling drugs are losing patent protection. In fact, during Actavis' quarterly report, it specifically mentioned the new generic introduction of drugs such as Suboxone, Lidoderm, and Concerta as growth drivers.

But truth be told, Actavis has mentioned new drug introductions in all of its recent quarterly reports, as Actavis is always launching new blockbusters and continuing to gain sales from previously launched generic drugs.

As we look into both the immediate future and long term, Actavis will continue to reap the profits from the patent cliff. In a previous article, I explained why drugstore chain Rite Aid would continue to see large gains, and included a chart showing the number of blockbuster drugs losing patents in the next three years alone.

Between the years of 2011 and 2016, Evaluate Pharma estimates that more than $130 billion in drug sales will lose patent protection. In retrospect, 2013 has been a slow year for new generic introductions, but 2014 and 2015 is setting up to be great years.

Multibillion-dollar drugs such as Nexium, Cymbalta, Symbicort, Abilify, Copaxone, and Gleevec are expected to lose protection. This fact is a big win for generic-drug makers like Actavis -- and a reason to keep buying shares.

A new paradigm shift
Consequently, the rise of generic introductions also means trouble for large pharma and higher margins for pharmacies.

Of course, we have already seen Pfizer lose a great deal of annual revenue thanks to the generic introduction of Lipitor. Some large pharmas have already felt the wrath of the patent cliff, while others will have tougher days ahead.

For example, Cymbalta belongs to Eli Lilly , as does Humalog. These two drugs alone create nearly $7.5 billion in annual sales and will likely lose patent protection next year. Considering the fact that Eli Lilly has annual sales of $23 billion, a $7.5 billion hit could be irreplaceable, and could force the company into desperate acquisitions to try and keep shareholders happy.

The situation with Eli Lilly is just one example of what we're seeing throughout the large pharma space. However, one industry's pain is another's gain, and for both generic drug companies and pharmacies, the gains keep rolling in.

In particular, generic drugs pay higher royalties to pharmacies . In previous quarters, Walgreen, CVS, and Rite Aid have all spoken about this fact. Therefore, in a pharmacy industry that has held historically low margins, we have seen profits rise substantially.

For Rite Aid, it saw net income rise from negative $555 million, negative $368 million, and then to a profit of $118 million in the last three years. That's a difference of $673 million between 2010 and 2012, all the while, revenue increased just $200 million.

Then, if we look at the last 12 months, Rite Aid's net income has soared to nearly $300 million, showing the rate at which gains continue. Moreover, despite stock gains of 400% since December of last year, Rite Aid still trades at just 16 times earnings, and with 2014 and 2015 expected to be great for new generics, there is reason to believe that both net income and stock gains will continue to soar.

Final thoughts
Clearly, we are seeing a paradigm shift, one that is bad for large pharma but good for generic drug companies, pharmacies, and most importantly, consumers!

With Actavis, despite its large gains, it still trades at just 12.3 times next year's earnings, making it very cheap with a boatload of catalysts in the next few years. Given the strong performance of its quarter, its valuation, and its increased guidance, I think it's hard not to be bullish long term.

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The article Should You Keep Buying These Beneficiaries of the Patent Cliff? originally appeared on

Brian Nichols owns Rite Aid and Actavis. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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