Courtrooms hold the key to big pharma's future profitability

Fears of a new wave of generic competition to blockbuster drugs following Augmentin patent defeat for GlaxoSmithKline

In just a week, the scales of US justice have tipped first one way and then the other in the global pharmaceuticals industry's war with the tiny manufacturers who produce cheap copies of the world's biggest-selling drugs.

In this battle, being fought in courtrooms in the globe's biggest drugs market, a judge's decision can wipe billions of dollars from a company's sales and, as one did for GlaxoSmithKline last week, wipe billions from its value.

Last Friday's decision by a judge in Virginia invalidated three of GSK's patents on its biggest antibiotic, Augmentin, and left generic rivals free to start selling copycat products. That decision has induced another wave of panic among shareholders in drugs companies, supposedly the most defensive of defensive investments in these times of stock market turbulence.

GSK said if generic Augmentin was launched in a few weeks, earnings growth this year would be 10 per cent, not in the "mid-teens" as previously forecast. Put more starkly, £260m of this year's expected profit will simply dissolve. One analyst yesterday calculated that almost £2bn of earnings could disappear over the next three years.

GSK's earnings guidance is based on a worst-case scenario, involving what Jean-Pierre Garnier, its chief executive, called a "Prozac-type decline" in sales of Augmentin as result of switching to generic copies. Prozac, the anti-depressant developed by Eli Lilly, an American group, went off-patent last year. Within three months, the drug had lost 70 per cent of its sales in a vicious price war with copycat rivals. High stakes. And GSK is far from alone in facing the generic threat this year. AstraZeneca is just weeks away from a fateful New York court decision that will decide if generics companies are free to make copies of its ulcer drug, Losec, which had sales of £10m a day last year (see below).

The industry has seen a wave of patents expire this year, exposing drugs with annual sales of $11bn (£7.5bn) to copycat competition – unless big pharma's army of lawyers can stop them.

Alistair Campbell, pharmaceuticals sector analyst at Schroder Salomon Smith Barney, says the industry is having to pay for a burst of scientific discovery in the late Seventies. Patents are valid for 20 years.

"The industry finds a new class of drug and two or three similar drugs follow – such as the cholesterol-lowering statins now, or proton pump inhibitors, which is what Losec is. These first entries become huge sellers, and that is what drives the waves of patent expiries years later," Mr Campbell said.

Generic companies are the "good guys", on the side of the consumer and pushing down the cost of drugs. The US healthcare system, paid for as it is by private insurers, forces doctors to prescribe the most cost-effective medicine, and in most cases that means generic copies of branded drugs.

But they face huge and increasing competitive pressures of their own. Margins on copycat drugs are wafer thin. Although 48 per cent of prescriptions are for generic drugs, they account for just 10 per cent of the US market by value. The competitive landscape for generics companies has tightened in recent years after the arrival of several new India-based companies, with lower wage costs and therefore cheaper manufacturing capabilities.

The first company to produce a generic drug gets a 180-day exclusivity period in the US and Andrew Pendrill, at ABN Amro, says it is a race that generics companies must take seriously.

"The first to market will start a price war, which will be carried on, if not by the second then by the third. If a firm is below third to market, it is simply going to make no money from the product. First mover advantage is critical," he said.

Generic companies have become more aggressive in challenging patents, and drugs companies' tactics for extending patent life.

These tactics – analysts and generics company bosses call them delaying tactics – include fighting to maintain patents on the formulation on drugs where the main molecule has already gone off-patent. These are seen as flimsier than the core molecule patents, and most analysts forecast that the courts will favour generics when the issues get to court.

There is evidence that the American courts are taking a more cynical view of these tactics. That was certainly observers' judgement on GlaxoSmithKline's defeat in the Augmentin case.

GSK claims the US Patent Office asked it to split some of the existing patents on the antibiotic, creating new 20-year patents that will protect the drug from competition until 2018. The Virginia judge agreed with the generics companies that the new patents were invalid, and all now rests on an appeal that could take more than a year.

Mr Garnier demurs from the view that courts are shifting the balance in favour of generics companies, arguing that there have simply been a few high-profile cases because of the latest wave of patent expiries and challenges.

But Max Herrmann, analyst at ING Financial Markets, said: "You have the US government talking about the need to reduce the cost of drugs. In the US there are no price controls on drugs, to get more pricing pressure, you have to encourage generic competition.

"Courts do reflect changes in the political and social pressures. It is clearly seen as unacceptable now that the big pharmaceuticals companies should be trying to get patent protection for 40 years rather than the usual 20."

In the Augmentin case, the generics companies may decide to wait to launch, scared of the damages they would face if they launched the drug now but lost on appeal. But there has been speculation in recent weeks that several of these companies are close to arranging insurance that will protect them from the cost of damages, should they lose on appeal.

Insured or not, SSSB's Mr Campbell believes generics companies have shown they are willing to take greater risks on all fronts. "They are becoming bolder and realising that the net present value of winning a court case far outweighs the costs of running these trials. They can mount five or 10 significant challenges on big drugs, and don't need to win that many."

But while it has looked as if the scales of justice have tilted in the direction of generics in recent months, a decision by the US Supreme Court earlier this week has given new heart to those who take the pharmaceuticals industry line. This is that intellectual property must be defended to the last even if, as in GSK's attempt to sue the South African government for infringing patents on its Aids drugs, the process can look heartless.

The US Supreme Court voted to overturn a lower court ruling that had limited a legal doctrine that lets patent holders sue others who make equivalent products. That court had said inventors should be limited to the literal wording of the patent, rather than being able to sue on the basis of "equivalence".

The Supreme Court said limiting patents to their literal terms would invite copycats to get round patents with only tiny modifications. ABN Amro's Mr Pendrill said the judgment "dramatically improves the hand of the big drug companies".

AstraZeneca: World's biggest patent expiry

Investors in AstraZeneca have been chewing their nails for months awaiting the long-delayed ruling on whether generic drug makers infringe its patents on Losec. The treatment for stomach acid-related disorders such as ulcers had sales of £10m a day last year, accounting for more than 40 per cent of AstraZeneca's turnover.

AstraZeneca says generic copies of the drug would infringe patents it has over the way it formulated the drug. Generics says these are invalid, and accuse the company of delaying tactics which have kept their cheap versions off the market since the main molecule patent expired in October last year.

Tom McKillop, AstraZeneca's chief executive, says that it took the company's scientists years to turn the molecule omeprazole into a stable molecule which did not break up in the stomach.

"Clearly we are not taking advantage of legal loopholes or engaging in any activities that are unfairly delaying the entry of generic omeprazole," the company says.

"Our approach throughout has been founded in the research of our many scientists, who deserve credit for the Losec inventions."

AstraZeneca's lawyers will begin the final stage of their suit against four generics companies in a court in New York on 10 June, and a judgment may be handed down within days.

But the legal fight is just one tactic among several AstraZeneca has used to try to keep earnings buoyant after omeprazole went off-patent.

The main one has been to create a purer drug, branded Nexium, which it claims is more effective than Losec, and which it is aggressively marketing, both to doctors and, through television advertising in the US, direct to the consumer. By March, Nexium accounted for 19 per cent of the market for such drugs, while sales of Losec had declined by almost a fifth since the previous year.