The race is on for new sources of growth in the pharmaceutical industry, as blockbuster drugs lose patent protection and competitors join forces to cut costs.

Two opportunities are pointing the way: biologics and orphan drugs. Teva Pharmaceutical Industries (NYSE: TEVA) is a global drug-making giant that has a foot in both camps.

I first recommended Teva in an article on Investing Daily, posted March 29, 2013. From then through market close on Friday, March 28, the stock has generated a total return of roughly 29 percent. As the company aggressively pursues two of the hottest trends in the drug business, its stock should continue to rise over the long haul.

Israel-based Teva is the world’s biggest manufacturer and marketer of generic drugs. The company also develops patented biologic treatments, which are derived from humans, animals or microorganisms. Biologics can be composed of proteins, sugars, or living cells and tissues.

Biologic drugs are in the vanguard of cancer research and treatment, but as they lose patent protection the door is opening for “biosimilars,” which are generic, less costly copies of biologics. Teva is readying several new gene-based biosimilar drugs for market, to complement its existing pipeline of products.

Teva owns a global patent portfolio of more than 1,000 molecules. The company’s biggest selling products include Copaxone for the treatment of multiple sclerosis; Provigil and Nuvigil for narcolepsy and other sleep disorders; and Azilect for Parkinson’s disease.

Adopting Orphans

As patents expire, the pressure for drug companies to find untapped opportunities is fierce, compelling companies such as Teva to pursue treatments for rare diseases.

The development of orphan drugs is a booming niche and Teva has been muscling in. The company is developing cancer drugs in orphan indications for the treatment of patients who are failing to respond to existing conventional therapies.

The federal Orphan Drug Act grants special status to a product to treat a rare disease or condition upon request of a sponsor. An orphan drug is a pharmaceutical developed to treat a disease that affects fewer than 200,000 people.

According to the US Food and Drug and Administration (FDA) and the European Medicines Association (EMA), roughly 350 million people in the world suffer from a rare disease that qualifies for orphan drug treatment (see chart below).

Orphan drug designation from the FDA and EMA means that the manufacturer can sell the product without competition for seven years in the US and for 10 years in the European Union, respectively, after formal approval to go to market.

Drugs granted orphan drug protection must still adhere to the same regulatory gauntlet as any other pharmaceutical. However, government incentives hasten development of orphan drug candidates — and virtually ensure their future profitability.

In the US and Europe, the product to treat the rare condition must adhere to certain criteria to win orphan drug status, notably scientific documentation that demonstrates the rarity and severity of the medical condition and the possible benefit of the product in alleviating it.

This orphan designation is hugely valuable to biotech firms, because it streamlines and hastens the government approval process, removes copious amounts of red tape, and gives the drug enhanced patent protection, among other benefits.

Other companies that are notable for using orphan drug status to reap big profits from niche treatments include Aegerion Pharmaceuticals (NASDAQ: AEGR); Ironwood Pharmaceuticals (NASDAQ: IRWD); BioMarin Pharmaceutical (NASDAQ: BMRN); Forest Laboratories (NYSE: FRX); and Shire PLC (NASDAQ: SHPG).

The rationale for the orphan drug law is to encourage the launch of valuable drugs that might not make it to market because they’re too expensive to develop. Smaller firms, in particular, find the law useful because it allows them to devote time and money to the development of drugs without fearing that a larger competitor with deeper pockets will swoop in and compete against them.

Orphan designation also qualifies the sponsor of the product for tax credits and marketing incentives. For example, an orphan drug is not subject to a prescription drug user fee.

As a flood of patent expirations con­tinue to shake up the drug industry, the future winners will be those with the strongest drug development pipe­lines and the most innovative treat­ments. Teva is suitable for investors looking for a play on orphan cancer therapies, as well as a safer Big Pharma bet on generics, biologics and biosimiliars.

Demographic trends also favor Teva. One out of every five Americans— approximately 72 million people—will be 65 years or older by 2030, roughly double the number in 2000. As the US population ages, demand will increase for cancer surgeries and treatments, a greater number of which will now receive coverage under Obamacare.

Last year, Teva Pharmaceutical and Xenon Pharmaceuticals announced that the FDA had granted orphan-drug designation to the investigational drug XEN402 that the two companies are jointly developing for the treatment of pain associated with erythromelalgia (EM). Xenon is a privately owned biotech that focuses on rare diseases.

EM is a rare condition characterized by debilitating attacks of burning pain in the feet and hands, usually accompanied by elevated skin temperature and redness of the skin. The pain can be so severe that it has actually prompted sufferers to commit suicide. XEN402 has shown promise in early clinical trials.

Meanwhile, Teva has racked up stellar operating results. The company’s fourth-quarter 2013 earnings rose 8 percent, beating analysts’ estimates, on stronger sales from specialty medicines and US generic drugs.

Teva’s fourth-quarter earnings per share (EPS) came in at $1.42, compared with $1.32 in the same period a year ago. Revenue reached $5.43 billion, a year-over-year increase of 3 percent. Analysts had expected EPS of $1.40 on revenue of $5.19 billion.

Sales of Teva’s multiple sclerosis drug Copaxone, which account for about 20 percent of sales and 50 percent of profit, rose 8 percent to $1.14 billion in the quarter. Teva’s US generic sales rose 14 percent in the quarter to $1.2 billion, driven by new product launches.

With a trailing 12-month price-to-earnings (P/E) ratio of 33.2, Teva’s stock is a good value compared to the trailing P/E of roughly 50 for the drug manufacturing industry. Meanwhile, the company’s current debt-to-equity ratio of 0.54 is low compared to the industry average, indicating that debt is under control and the company can fund research over the long haul.

As Teva develops leading-edge drug treatments, it will tap sustainable growth whereas most of its peers will struggle with patent losses and industry consolidation.

John Persinos is editorial director of Personal Finance and its parent website, Investing Daily. Follow him on Twitter.

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