I’m a fan of the four Indiana Jones adventure movies, although the last one – Kingdom of the Crystal Skull – was the worst of the four in my humble opinion. A poor script and a ridiculously unrealistic plot doomed the third and final sequel, but the Crystal Skull had excellent special effects, particularly an awe-inspiring waterfall scene featuring the “Devil’s Throat” section of Iguazu Falls in Argentina. The time is 1957 and Indiana Jones is being chased by a bunch of Soviet operatives on the Iguazu River. The river looks completely calm, but that quickly changes as they approach the falls.

All of this waterfall imagery serves as a fitting introduction to the patent cliff many drug companies face in 2012 and beyond. Drug patents last for 20 years from the date of application and serve to encourage innovation by protecting companies from competition until they have earned back the cost of developing drugs and generated a healthy profit. Once the patent ends, generic drugs are free to compete and prices immediately drop by 70% or more, which causes precipitous drops in gross margins and net profits. A drug company can see billions of dollars in drug sales vanish overnight as consumers switch to generic versions of the drug.

Patent Cliff Means Tough Times Ahead for Drug Companies

According to Harvard Business School Professor Gary Pisano in his 2006 book Science Business:

For most of the postwar era, the pharmaceutical industry has been the most profitable sector of the U.S. economy by virtually any performance measure (return on equity, return on sales, etc.). This superior performance was based on four structural pillars: (1) latitude to charge relatively high prices, (2) long product life cycles, (3) ‘blockbuster’ drugs, and (4) relatively high R&D productivity.

These pillars have eroded significantly during the past decade and are likely to continue to do so in coming years.

In the five years since Pisano’s book was published, the drug sector – as measured by the SPDR S&P Pharmaceuticals ETF (NYSE: XPH) — has continued to outperform both the S&P 500 index (NYSE: SPY) and the small-cap Russell 2000 index (NYSE: IWM) significantly (by more than 50 percentage points):

Source: Bloomberg

Perhaps a bit premature when written, professor Pisano’s warning is coming home to roost now and times are likely to get much tougher for drug stocks in 2012. Between now and 2016, patented drugs generating more than $250 billion in global annual sales are set to go off patent, with 2012 considered the “steepest point” of the cliff because about $60 billion of drug sales will be exposed to generic competition over the next year. On November 30^th, Pfizer (NYSE: PFE) lost U.S. patent protection for the best-selling drug of all time – Lipitor – which generated $11 billion in annual sales last year and treats high cholesterol levels. Within a week, Pfizer’s sales of Lipitor dropped by half and six weeks later are now only 38% of what they were pre-expiration, with generic drug company Watson Pharmaceuticals (NYSE: WPI) picking up most of the business.

Lucky Amgen

Another example of how important patents are to drug companies can be seen in the price action of Amgen (NasdaqGS: AMGN) – the granddaddy of biotech stocks — which has  skyrocketed since late November and broken above its previous three-year high. The reason? On November 23^rd the company announced that it had been granted an additional 17 years of patent protection (until 2028) for its arthritis drug Enbrel, which generates $3.5 billion in annual sales and constitutes nearly one-quarter of Amgen’s entire annual revenue.

Drug Companies Are Cutting Jobs

Other drug companies have not been so lucky. Novartis (NYSE: NVS) – the Swiss drug giant  whose name means “new skills” in Latin – recently announced that it would be cutting almost 2,000 jobs and incurring more than $1 billion in restructuring costs in anticipation of the September 2012 U.S. patent expiration of its biggest-selling drug Diovan, which generates $6 billion in annual sales and treats high blood pressure. The company also warned that the next two years would prove “challenging” for its pharmaceutical division, which is a euphemism for terrible.

Other drug companies that have recently announced job cuts and restructuring charges include Astrazeneca (NYSE: AZN) – which faces 2012 patent expirations on two billion-dollar drugs (Seroquel for schizophrenia and Atacand for heart failure) — and Sanofi-Aventis (NYSE: SNY), which along with co-marketer Bristol Myers Squibb (NYSE: BMY) face a May 2012 patent expiration for Plavix, a blood thinning drug that is the second-best selling drug of all time with $9 billion in annual sales.

Avoid Eli Lilly

The drug company with the steepest patent cliff of them all is probably Eli Lilly (NYSE: LLY), which will lose patent protection on three drugs within the next 2 ½ years that represent nearly half of its total annual sales – Zyprexa (schizophrenia) in October 2012, Cymbalta (anti-depression) in mid-2013, and Evista (osteoporosis) in 2014. The prognosis for Lilly is so bad that Fitch Ratings recently downgraded the company’s credit rating.

(For a list of billion-dollar drug patent expirations in 2012 and 2013, click here).

Four Drug Stocks With Strong Drug Pipelines

Given the flood of patent expirations in the drug industry, the future winners will be those with the strongest drug development pipelines and/or make the smartest drug acquisitions. According to some analysts, the drug companies with the best drug pipelines include GlaxoSmithKline (NYSE: GSK), Novartis (NYSE: NVS), and Bristol Myers Squibb (NYSE: BMY). I’d throw in Bayer AG (Other OTC: BAYRY.PK) for good measure.