Lilly's Plan to Launch "Branded Generic" Drugs: A Blueprint for Lower Profits

Eli Lilly (LLY) is going into "branded generics," just like Pfizer (PFE) and Abbot Labs (ABT). In theory, this is an attractive idea. Consumers may well want to pay a premium for Lilly's version of Cialis rather than a generic version made by Teva (TEVA) or Ranbaxy.

But can these branded Johnny Come Latelys succeed in fighting off the no-name hordes that currently dominate generic pill provision at the world's pharmacies?

One way to answer that question is to ask whether adding a generics business is likely to increase a company's profit margins. The more a company's brands have perceived value with consumers, the more a company can command a premium price for its goods.

Teva doesn't market its generics as brands, but as the largest generics maker on the planet it must know a thing or two about generic margins. If any drug company can eke out increased margins on generics, it should be Teva.

Luckily for us, Teva publishes its results in Excel spreadsheet form, allowing observers to manipulate its data. (Kudos to the company for this service.) I calculated the percentage of Teva's revenues that are its manufacturing costs ("cost of goods sold") and its overall profits ("net income"), over time, to produce its basic operating margin and its basic profit margin. Here's the chart I came up with:

(Note that the timeline on the chart is from right to left, not the usual way around!)

The first thing we can see is that the business seems promising: Over time, Teva has increased the margin of its sales to its manufacturing costs up to almost 60 percent, and the trend is steady. Perhaps Teva's economies of scale have given it a pricing advantage in its factories or raw materials. You can see why Lilly and Pfizer want in: underlying operating profit seems to be going up.

Now look at the second line, the net income or overall profit margin. It's all over the place -- a lot of different factors affect net income, so that's not surprising. But overall, the trend seems to be down. Where Teva once got a nice 30 percent profit on its sales, it now struggles to get 20 percent.

It's a surprise: If Teva's manufacturing costs are in a proportional long-term decline, why can't the company translate that into a long term net income increase? The answer, among other factors, is sales and marketing. Teva has tripled its sales and marketing budget since 2006, to $744 million. Its efforts to promote its products are slowly killing off its overall profits -- and this is a company that spends as little as it can on promotion, because they're generics not brands.

This is a warning to Lilly et al: The only way to get a premium price for a product that's identical to a generic competitor is to push it as a brand, and that requires a marketing and advertising budget. Unfortunately, as the Teva experience shows, it's precisely that factor which ruins your margins. Perhaps Lilly and Pfizer know something about the generic business that Teva doesn't. But I doubt it. If they want to get higher prices on their brands than Teva does, they'll have to do the one thing that demonstrably reduces their profits -- advertise.

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Image of generic beer by Flickr user miserloujones, CC.

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