Novartis/Hexal: Generic Consolidation, and More

Buying Hexal shows Novartis' commitment to generics. The Swiss group also hopes the move will bring more credibility, and better deals, across all of its businesses.

Buying Hexal shows Novartis's commitment to generics. The Swiss group also hopes the move will bring more credibility, and better deals, across all of its businesses.

By Melanie Senior

Novartis AG 's generics division Sandoz had a troubled 2004. Although number two in global terms, it was fast losing share in key markets including Germany and the US. Reporting a drop in overall annual revenues, Sandoz appeared to lack competitive edge in an increasingly cut-throat market.

Hence Novartis faced a make-or-break choice with regard to its position in generics. With Sandoz accounting for little more than a tenth of Novartis's global sales, the Swiss pharmaceuticals group could either sell, as most other Big Pharmas have done over the years, or stay in and revive Sandoz's flagging fortunes.

Paying €5.65 billion ($7.38 billion) in cash to acquire German generics number two Hexal AG and most of its US partner Eon Labs Inc. makes it clear which route Novartis has chosen [See Deal]. The proposed move bounces Sandoz into the top generics position worldwide, ahead of Teva Pharmaceutical Industries Ltd. , and brings it a number one or two ranking in the most important countries. The deal will broaden Sandoz's portfolio and pipeline, beef up its development and registration skills, and hopefully lower production and processing costs by providing Sandoz with more extensive active pharmaceutical ingredient (API) manufacture. While offering the potential for significant synergy-driven cost-savings (up to $200 million over three years), the acquisition will also expand the enlarged group's expertise in formulation technologies and in specialist niches such as biogenerics.

Novartis's purchase is the latest, and one of the largest, examples of consolidation in a sector where Sandoz wasn't the only one struggling. Low barriers to entry have brought more competition to a field where prices and margins are already under pressure and which, according to many analysts, may now face a short-term downturn in the number and value of branded drugs coming off patent. In such an environment, only the biggest players, with economy-of-scale advantages and wide portfolios, or the specialists, with fewer competitors, will survive.

But the significance of this proposed transaction extends beyond the generics sector. By raising the contribution of generics to 17% of overall pharmaceutical sales, Novartis, whose core focus remains on novel, patented drugs, is making a statement about the role of generics in a wider environment where both pricing pressures and the hurdles to proving innovation are increasing. It's also making a statement about pharma firms' perceived image and credibility among payers, governments and patients. "One has to take a customer perspective," declared Novartis's CEO and chairman Dan Vasella, PhD, during a call following the deal's announcement. "You want the best treatment at the best price. Sometimes that will mean a single source, patented drug. In some cases it will be a quality generic. In some cases it will be something OTC."

Through offering low-cost generics alongside innovative drugs, Novartis hopes to more clearly delineate the place for each. Acknowledging different price levels, the theory goes, will help build payers' trust and understanding of the motivation behind premium pricing on patented medicines.

It's not clear whether Novartis will achieve the stated objectives of this deal, either on the credibility front, or financially: it's promising accretive earnings within 12 months of closing, expected during the second half of 2005. The Swiss giant paid a healthy, some say too-high price for businesses in two large, but tricky markets. Germany, although worth over half of Europe's generic market in sales terms, may prove a double-edged sword since it remains largely brand-driven, requiring higher-than-average sales and marketing costs. The uncertain regulatory situation may radically alter these dynamics, and Novartis may find it has bought in at a high point. The Swiss group also faces the ongoing challenge of successfully managing the very different businesses of branded and generic drugs--one few branded companies have overcome in the past, and which some feel has hampered Sandoz's competitiveness to date.

Whatever the outcome, though, Novartis's move is bold. And in that sense alone it demonstrates this firm's belief that Big Pharma needs to make some radical changes to its model in order to return to historical growth rates.

Bigger is Better, in Generics

The generics sector has had a good run over the last half decade, as payers and governments encourage generic uptake, patents expire, and as generics firms get better at challenging those that haven't. In the last year or so, however, life's gotten tougher. Increasing competition has pushed down prices and margins further; the growing presence of Indian firms across Western Europe has highlighted the advantages of vertical integration and the lower costs that result, putting yet more pressure on Western groups to improve their efficiency. (See "Indian Generics: Growing in Europe," IN VIVO, January 2005 (Also see "Indian Generics: Growing in Europe" - In Vivo, 1 Jan, 2005.).) Branded groups are beginning to put up better defenses, including through authorized generics, whereby innovator groups launch and sell a generic of their own drug and thereby capture some of the revenues they would otherwise have lost. (See "Authorized Generics: Band-Aid or Strategy?" IN VIVO, December 2004" (Also see "Authorized Generics: Band-Aid or Strategy?" - In Vivo, 1 Dec, 2004.).) Pointing to a series of missed earnings among generics firms in 2004, analysts are now talking of a cyclical downturn, wherein oversupply, slowing demand and falling prices are turning the tables.

M&A has continued all the while—through the good times, when firms had the capital expenditure that allowed them to expand, and now as tougher times force groups to get bigger, or diversify. (See Exhibit 1.) Sandoz had already used M&A to attempt both: in 2002 it fought hard for Slovenia's Lek DD , winning a stronger Eastern European presence, a relatively low-cost manufacturing base, and another US foothold [See Deal]. (See "Slovenia's Lek Calls Highest Bidder," In Vivo Europe Rx, October 2002 (Also see "Slovenia's Lek Calls Highest Bidder" - In Vivo, 1 Oct, 2002.).) Last year it acquired Canadian injectables firm Sabex Inc., growing its position in specialist niches [See Deal]. (See "Savoring Sabex: Sandoz's Play in Injectable Generics," IN VIVO, July 2004 (Also see "Savoring Sabex: Sandoz' Play in Injectable Generics" - In Vivo, 1 Jul, 2004.).)

But these hadn't been enough to insulate Sandoz from the competitive pressure. In Germany, in part because of a cut-throat rebate war instigated by a local firm, it could barely hang on to its fourth place. In the US it suffered price erosion and was perceived to be less aggressive than necessary in challenging and fighting patents. As a sure sign that something was up, a new CEO was appointed. Andreas Rummelt, PhD, previously head of technical operations at Novartis Pharma, was quietly appointed to replace Christian Seiwald as CEO of Sandoz in November 2004. He immediately announced a restructuring. The aims were to fill the pipeline, lower costs, better integrate business functions and accelerate decision-making; in sum, to improve competitiveness.

The restructuring occurred independently of the subsequent Hexal acquisition, insists Novartis. But it certainly proved timely, providing streamlined and simplified existing business structures, many of which will have come from past acquisitions. And it acknowledged Sandoz's weaknesses.

These in turn help explain why Novartis was prepared to pay a hefty price, in cash, for 100% of privately owned Hexal, Germany's number two generics firm, and for 67.7% of US-based partner, Eon Labs, which is owned by the Strüngmann family, founders of Hexal. Once the deal is approved, Novartis plans to acquire the remaining 31.9 million Eon shares for $31 per share, through a tender offer.

The move certainly solves the issue of strength in key markets: combining Hexal's $1.65 billion 2004 sales will make Sandoz number one in Germany, with nearly a quarter of that market. Eon's $431 million revenues will push the Swiss group to second place in the US. With pro forma 2004 sales of nearly €4 billion ($5 billion), Sandoz will push Teva off the top rung, though that's incidental: "It's more important to have strong positions in specific markets than to be number one or two worldwide," declares Vasella. Each market is different, particularly in Europe, and firms have to adapt their local commercial and pricing tactics to best effect. If the deal is approved, Sandoz will boast a top one or two position in seven European markets. (See Exhibit 2.)

The new status didn't come cheap: Novartis paid nearly 3.5 times sales for Hexal and more than four times sales for Eon (five times, including the offer for the remaining shares). This appears high compared with historic sales multiples for generic acquisitions; Sandoz acquired Lek for 2.7 times sales, for example. "On the face of it, they did overpay," opines Frances Cloud, an analyst at Nomura.

Or did they? Competition has pushed prices up since 2002: just months after Teva paid seven times sales for generic injectables firm Sicor Inc. in late 2003, Novartis followed suit with 6.3 times sales for Sabex (but, unlike Teva, it paid cash not paper) [See Deal]. Granted, both these deals were in injectables, a niche area that's attractive for having high barriers to entry. Granted, too, the price to sales ratio isn't a perfect measure, since it doesn't take into account pipeline strength or market position, nor any value-added in the products themselves. But given Hexal's position in Germany, a market that's notoriously hard to penetrate from outside, Eon's healthy operating income margins of about 40%, both groups' strong growth record over the last few years and healthy pipelines (together they have nearly 40 planned launches this year in the US and Germany), suddenly the price tag looks less outrageous.

Besides, Novartis had few, if any, alternatives means to a top position in Europe's leading market. "Only the Strüngmanns could offer Novartis a number two firm in Germany plus a US presence and pipeline," says Isabella Zinck, an analyst at HypoVereinsbank in Germany. Germany's leader ratiopharm, owned by Merckle GMBH , isn't for sale; to snap up publicly listed Stada Arzneimittel AG , ranked third, they'd have had to launch a hostile bid. Hexal was the only one up for sale—but the family wanted cash.

And Novartis had cash—$14.5 billion of it at the end of 2004—sitting there earning probably not much more than 3% in interest. It will pay for the deal from cash reserves and cash flow and management expects it to be accretive to earnings after just one year (including all acquisition-related expenses and amortization). "A price isn't high or low, it's what you pay at the time," comments one senior generics executive. It must also be seen in the context of affordability, and of what's being bought.

Beyond Rankings: Costs and Specialisms

Sandoz is buying more than just a solution to its German and US ranking problems. Hexal and Eon boost the pipeline and bring development and registration skills; development delays were another factor holding back Sandoz's growth. "Our management team will be substantially strengthened," declares Vasella. Importantly, the Strüngmann brothers have agreed to stay on for at least two years, according to Vasella. Thomas Strüngmann will run Germany, the Middle East and Americas, and his brother Andreas will look after the rest of Europe, Africa and Asia Pacific, markets where Hexal is already active. Eon Labs' CEO Bernhard Hampl, PhD, will be head of Sandoz's US operations. These added skills are particularly crucial since Rummelt's own background is in supply-chain and production rather than commercialization.

The Strüngmann brothers have certainly proven their ability to build and grow a generics business. They founded Hexal in 1986 in Germany and within five years had begun to internationalize, and acquire. In 2000 they bought Eon in the US, which specialises in "difficult-to-make" generics [See Deal], and last year became the first German group to produce their own API, at Hexal Syntech in former East Germany.

Hexal also built significant expertise in formulation technologies, especially oral, transdermal and inhaled delivery, as well as implants. It spends an above average 10-12% of sales on R&D. This has paid off: the group has launched more than 120 products over the last three years, many based on proprietary formulations which allow it to distinguish its products from the competition. It's about to launch a transdermal patch version of Johnson & Johnson 's pain drug fentanyl (Duragesic). During the same period, margins have remained consistently in double digits.

Hexal and Eon thus give the enlarged Sandoz more flexibility in the range of products it can launch. The combined entity plans to launch 70 products in the US and Germany this year. "We'll cover nearly all of the important products coming off patent during this period," claims Rummelt.

Economies of scale and a higher degree of vertical integration will help cut costs, and give the group more clout with purchasers who often prefer a guaranteed supply (and are sometimes prepared to pay more for it). For now, despite having some of its own manufacturing, "We rely significantly on external API," admits Rummelt, unwilling to provide further detail, but insisting this will change. Accessing raw materials typically comprises the largest part of generics firms' cost of sales, so lowering costs by producing API in-house is seen as a huge competitive advantage. By increasing the firm's product range, this deal allows Sandoz to justify investing in more of its own production plants and thus to produce a wider range of drugs internally. This will help bring it closer in line with Teva, which claims to be the largest generics API producer in the world. It makes 40% of its generic products.

Hexal's international scope—it derives nearly half of its sales outside Germany—across emerging markets including China, Southeast Asia, and Brazil will add to Sandoz's own growing operations in such markets, providing a further financial advantage, both in manufacturing and labor costs.

Beyond cost-cutting, this deal will take Sandoz more deeply into the specialist niches surrounding commodity generics, such as injectable antibiotics, where it already has a strong presence through acquisitions such as Sabex and Spain's Amipharma. Eon's above-average margins bear testament to the advantages of going specialist. Hexal, too, offers some generics-plus opportunities which Sandoz says it will pursue, although Rummelt describes this area as "opportunistic" rather than forming a key part of the strategy. Either way, balancing commoditized generics with more specialist products makes sense given the dangers of downward price spirals that can threaten even the largest players.

Biogenerics probably represent the potentially most lucrative specialist generic opportunity. Although the regulatory routes on both sides of the Atlantic have stalled, few doubt these bio-equivalent drugs will soon arrive. (See "FDA Hesitates on Biogenerics," IN VIVO, October 2004 (Also see "FDA Hesitates on Biogenerics" - In Vivo, 1 Oct, 2004.) and "Omnitrope Hiccup: How Not to File for Biogeneric Approval in Europe," In Vivo Europe Rx, May 2004 (Also see "Omnitrope Hiccup: How Not To File For Biogeneric Approval in Europe" - In Vivo, 1 May, 2004.).) Sandoz is already a pioneer, having filed its generic growth hormone Omnitrope in Europe in 2003, and received its first approval in Australia in September 2004. Hexal will supplement Sandoz's pipeline with its own genetically engineered protein unit, Hexal Biotech GMBH.

In sum, the deal arms Sandoz with stronger weapons on all fronts—cost-control, portfolio breadth, management and marketing strength, brand recognition, geographic presence and specialist skills. Yet the market hasn't exactly cheered—Novartis's shares were down 6% six weeks after the deal was announced.

Credibility and Bundling

The market's not a great gauge: it's influenced by broader trends including the pharma sector's more general woes. And one could argue that this is just a generics deal that bears no impact on Novartis's branded business, which still represents the majority of the group's revenues. But for Vasella this deal clearly isn't just about generics per se. It's about strengthening Novartis's group image among payers, governments and insurance firms (even, at a stretch, the general public) as a provider of a wide range of treatments, at different price points. (Novartis also has an OTC division.) This move shows that generics aren't just a nice little earner on the side for Novartis; they comprise a key part of its identity. "The deal shows that we're serious about generics," says Rummelt.

Offering both cheap and expensive drugs, and acknowledging the role for each, gives the group credibility and will lead to better business, Vasella implies, both in innovative and generic drugs. "The case one can build for innovative medicines which bring better therapeutic value to patients, if one combines that offering with generics, has given us an invaluable access advantage," Vasella claims. In other words, it's more likely to be able to sell expensive drugs to governments for certain diseases, and be guaranteed that patents are respected, if it's offering cut-price treatments as well.

He was referring in that instance to the firm's recent discussions with the Brazilian health ministry. There, branded drugs still represent only a tiny part of health care spend but Western drug firms are trying to encourage patent recognition and build markets for innovation as well as gain a share of the growing generics market. But both Vasella and Rummelt reckon they'll secure similar advantages, as a result of their dual stake in branded and generic drugs, in developed nations. Neither would expand on the nature or value of such advantages, however, prior to the deal's closing.

It's hard to speculate in the meantime on what those advantages will amount to in practical terms, and how they might benefit either division. In Europe, governments set prices and reimbursement levels for innovative products based increasingly on reference prices and cost-effectiveness associated with a particular drug class or therapeutic category. A company's other activities and products are unlikely to influence this decision. Novartis may benefit from bulk-selling to wholesalers but the scope will be limited by government reimbursement levels.

In the US, Novartis says it's already benefiting from cross-selling, providing the example of supermarket chain Walmart. The Swiss group sells more than $1 billion worth of products to Walmart across all of its businesses—branded, generic and OTC drugs. It can presumably afford, for instance, to offer the lowest price generic by selling branded drugs as part of a package. "We can now offer a joint portfolio and thus win advantages in the negotiations," Vasella illustrates. This fits in with Walmart's strategy to strengthen its pharmacy business which lags its far stronger OTC share. The trend's similar with chain pharmacies such as Walgreen and CVS, adds Vasella.

Offering a discount to customers that buy two or more products at once is referred to as "bundling." Insofar as it comprises bulk selling with a discount, bundling isn't new.

It's unclear what, and whether, bundling advantages across branded and generic drugs will be available to Novartis outside the supermarket chains, however. Even sticking within branded drugs, bundling to managed care organizations in the US will be tough according to Paul Nagle, a partner at health care consulting firm BioMedical Insights. MCOs are unwilling to force doctors to use certain drugs, preferring to deal on a disease or drug class basis. Plus any bundling that does occur is likely to trigger similar moves by competitors offering one or more of the products in the bundle, potentially with other drugs. "The scenario would get complex very fast," says Nagle. And it would probably ultimately benefit the MCOs, not the drug firms.

There are also legal restrictions on bundling. Where a player has a dominant position in a particular market, some forms of bundling are illegal, such as "pure" bundling whereby a buyer has no choice but to buy the bundle (the individual products aren't sold separately). In Europe there may also be concerns about portfolio power, where a strong market player is further strengthened because it can offer a wide range of products in a discounted bundle, according to Linklaters' EU competition partner Paula Riedel. (Even in the US, Novartis may find the FTC sniffing around its Duragesic franchise: Sandoz struck an authorized generic deal for the product in 2004, and Eon has an ANDA pending.) Still, insists Vasella: "We will only bundle where it is legal."

Novartis won't provide any further details of its bundling plans or future customers for them, other than to say that "a broader generics portfolio will allow us to offer more options to certain customers buying a range of products." But executives reportedly reckon that Part D of the Medicare Modernization Act, due to come into force in 2006, may encourage further bundling. Nothing's certain yet, but stricter laws on how much, and what type, of multi-product discounting firms are allowed to do are as likely to disadvantage as they are to benefit the suppliers. Another consideration is what effect such discounting may have on Novartis's and other firms'—patented product prices.

Gambling on Germany

Uncertainty around whether Novartis will in fact appear more credible and strike better deals—deals that will allow it to be competitive both in branded and generics markets—is part of what's fuelling critics' concerns. One US analyst claims Novartis would have better spent its money buying biotech companies and developing proprietary drugs. It's worth noting though that Novartis won't be decreasing its innovative R&D spend, and has recently transformed its discovery operations to promote more innovation, a stronger clinical and patient focus, and close ties with academia.

There are two further key risks to this deal paying off for Novartis however: the German situation, and how well Novartis can manage a branded and now a significantly larger generics business under one umbrella.

Germany may be a large market—sales of generics there were close to €5 billion in 2004 and are worth nearly 20% of total drug sales in value terms—but it's also a very particular one whose dynamics could be radically altered by regulatory change. Prices there are relatively high (about 50% higher than in the rest of Europe, according to some estimates), because the market is doctor-driven, rather than pharmacist-driven. Generics companies detail their products directly to doctors, relying on brand recognition more than price. In fact, to most doctors, price is irrelevant; "most are completely insensitive to the existence of generics" as a concept, claims one German-based analyst. Upper limits on doctors' spending were reversed some years ago following public outrage.

As for pharmacists, although they're in theory allowed to substitute a branded prescription for a generic equivalent via the 2002 aut idem ruling, in practice few do. This is for two reasons: first, doctors tend to either insist on a patented drug (overriding aut idem) or prescribe a specific generic brand (thanks to firms' detailing). Second, pharmacists aren't directly incentivized to dispense cheaper drugs; they often get reimbursed more (up to a certain limit) by the health insurance providers for dispensing expensive products, according to HVB's Zinck. Patients have to pay the difference above a certain limit, and few have any idea that cheaper generics are available. As a result, the market for multi-source generics--international, non-proprietary name (INN) generics--in Germany is tiny, just 1-5%. It's an inefficient market.

That's the reason Teva hasn't gone anywhere near it, points out Israel Makov, president and CEO of Teva. He's certainly had a close look—Teva was rumored to have considered buying Stada in 2004 (when its share price was little over half what it is now) and, more recently, Pfizer Inc. 's German generics business. "The market's not right for us yet," Makov told IN VIVO; he certainly wouldn't have paid the price Novartis did for Hexal. But it's certain that the Israeli giant will find its way in soon. "We'll be there when we feel it's appropriate."

Indeed no one, including Makov, doubts the market will have to change; margins—still above average despite marketing spend--and prices will fall. The question is how quickly, and whether it's worth paying a premium to get in now and buy a brand with sales and marketing expertise, or to wait, and access the market later on a price-efficiency drive. The uncertain German situation "is clearly a risk we have evaluated," points out Rummelt.

His conclusion: Germany won't radically alter any time soon, in particular while pharmacists can only own a maximum of four shops, and while the current government struggles for public support. "Germany will change, but only slowly," agrees Zinck. And in the meantime it continues to encourage generics usage; the introduction this year of jumbo groups (maximum reimbursement limits for four drug classes, including both patented and generic drugs) is one of the most radical examples. This has provided a significant fillip to generics providers, reversing their fortunes from 2004 during which they were hit by a mandatory rebate on all product sales. (See "German Health Care Reform: Raising the Innovation Threshold," IN VIVO, December 2004 (Also see "German Health Care Reform: Raising the Innovation Threshold" - In Vivo, 1 Dec, 2004.).) The rebate war also dampened 2004 figures, but did so for everyone involved, so there's little danger anyone will try that again.

Even when Germany's generics market does become more efficient, the likely shift in the volume/value equation will favor bigger groups, able to compensate more easily for lower prices with higher volumes. Hence by stepping in now to secure its position, Sandoz is guaranteed a strong (experienced) player at the table, whatever the rules prove to be.

Fighting Philosophies

The second, arguably more important challenge for Novartis is whether it can successfully manage its branded and generics businesses under one roof. Most other Big Pharmas have tried, but all failed, to run generics units alongside branded operations. The businesses are just too different, they found; one is driven by speed, thrift and IP aggression, the other by discovery, innovation and IP protection. Pfizer continues to sell off its generics vestiges; in August 2004 it sold its Scandinavian generics subsidiary to Merck KGAA , which, with Novartis, is one of the few pharma firms active in both [See Deal].

Novartis has bucked the trend in maintaining a generics arm, and done so reasonably well until recently. But critics say the mixed model is what has put it at a disadvantage alongside pure generics players by limiting its aggression in fighting patent challenges. "How often do you see Sandoz fighting a key court case?" asks Nomura's Cloud. Names like Teva, Andrx Corp. , Barr Pharmceuticals Inc. and Mylan Laboratories Inc. are more prevalent; Cloud and others claim Novartis's own patent philosophy has barred the Sandoz division challenging as much as it might. "Hexal as part of Sandoz may in fact be less effective competition," surmises Cloud, particularly in the current environment with fewer valuable molecules coming off patent, and more competitors filing many years ahead. "If you're not prepared to play the game, you probably won't succeed," she concludes.

It appears that Sandoz is prepared to play, though. "We recognize that these are different businesses and that you have to be aggressive in patent filings," says Rummelt. Besides, avidly fighting patent wars may not always prove the best or most lucrative use of time for branded firms in future. Pursuing authorized generics instead may make more sense for certain products, since this strategy typically cuts into the lucrative 180-day exclusivity period enjoyed by the first-to-file generic firm. Indeed, authorized generics are becoming so popular that specialist firms are appearing; Novartis, too, hopes to gain rather than lose. "We would expect through the combined strength of our companies to be a preferred partner for authorized generics," says Vasella.

As well as remaining competitive as a generics play within a bigger pharmaceuticals group, Sandoz also hopes to find a balance between the entrepreneurial spirit and speed to market within Hexal, and strong processes and controls necessary within a larger corporation. "We want to keep things simple," says Rummelt, and integrate processes, but maintain country-level flexibility when it comes to brand positioning and profiling.

Achieving that balance won't be easy; nor will playing the aggression game. Retaining Hexal's management provides a huge advantage, but the Strüngmanns won't be around for long—watching their carefully nurtured family business enveloped in large corporate bureaucracy won't be fun—and nor will Eon's pipeline last forever. Sandoz will then have to go out and decide what to develop from scratch without treading on the brothers' toes. "Eon allows it to sneak around the problem [of what new drugs to develop] with some new pipeline drugs that it won't just discontinue, which will help for a while. But the no dirty business could be a handicap in the US long-term," suggests one analyst.

More M&A

Most analysts suggest this deal will accelerate the already strong consolidation trend in generics. Shares in Stada rose by about 8% in the fortnight following the deal's announcement on takeover speculation, although some say those who looked last year are unlikely to buy a far more expensive target today.

Consolidation will continue outside Germany, however: Teva may move again soon, having been nudged from its top position and given its long history of M&A. Some analysts expect action from Mylan, Watson Pharmaceuticals Inc. and Andrx, all the more so following such firms' failed attempts to move into specialty drugs—most recently, Mylan's attempts to buy King Pharmaceuticals Inc. were thwarted [See Deal]. Smaller Indian players, though apparently unwilling to sell at the moment, may also come under pressure to consolidate as the trend continues at the top end.

It's less likely that the transaction triggers a rush among Big Pharmas to dive back headlong into generics. But all will be watching closely whether Novartis's gamble pays off. The growing influence of generic drugs affects them all, not just in court cases and after patent expiry, but indirectly too, by way of reference pricing. Although reference pricing is mostly confined to Europe, the forthcoming Medicare drug benefit will undoubtedly erode prices in the US as well.

Indeed, notwithstanding short-term, cyclical variations and localized differences in speed of uptake, generics are and will remain an important part of the pharmaceutical market. The demographics tell the story: as the proportion of older people rises, so must generics usage, particularly for chronic drugs that are well-suited to genericization. Teva's Makov paints a compelling picture: "The US market was worth $225 billion in 2004; 10% of that was generics, but these represented 50% of prescriptions. So, without generics, the bill would be $400 million—who would pay for that?" Vasella expects the sector to grow at a compound annual rate of 10% in the five years to 2009, reaching $100 billion in 2010. The US and Western Europe will grow fastest, according to Novartis.

Developing markets can't be ignored either: their rise to prominence is increasing competition as new, low-cost companies enter the fray. But these markets also represent opportunities in themselves for those players large enough to be able to compete on cost. And ultimately they will represent bigger markets for branded drugs, too; taking the advantage full circle for cross-breed groups like Novartis.

Hence the Swiss group's move makes sense. In theory this is a cautious, hedging move whereby Novartis straddles the fence to capitalize on growth in both generics and branded drugs, on reactionary trends like authorized generics, and on group purchasing trends like bundling.

Yet in practice this is a bold gamble that may have industry-wide implications. Novartis is betting that governments, payers, and most importantly investors will alter their traditional view of the branded and generics worlds as two competing, enemy sectors and replace it with a more symbiotic view, whereby one industry drives another, the yin and the yang, around patent lives. "The role of innovation is to make generics obsolete, the role of generics is to make branded products obsolete," illustrates Vasella.

The risk: a loss of competitiveness in both, with generics eroding Novartis's credibility as an innovator, and innovation blunting its generic aggression. The potential benefit: Novartis distinguishes itself from the ailing Big Pharma pack, supporting a responsible, credible corporate image by representing the full economic gamut of health care products. It maintains its reputation as innovator, but qualifies it by selling innovation only when innovation is called for, and, when not, by selling generics.