Drugmakers Pfizer Inc. (NYSE:PFE) and Eli Lilly & Co. (NYSE:LLY) have seen profits squeezed this past quarter as lucrative blockbuster drugs came off patent and faced competition from low-cost generic drugs. Merck & Co. Inc. (NYSE:MRK) is set to take such a hit in the second half of 2012. 

Both Pfizer and Lilly, which reported steep declines in their fourth-quarter profits, experienced the initial impact from generics since they lost U.S. patent protection on several of their top-selling treatments.

Pfizer's profit declined 50 percent as its cholesterol-lowering pill Lipitor became exposed to generic competition in the U.S. on Nov. 30, resulting in a 42 percent decline in U.S. Lipitor sales during the fourth-quarter. For all of last year Lipitor brought Pfizer $9.6 billion, down from its 2006 peak of $13 billion.

Eli Lilly's profit dropped 27 percent in the fourth quarter, with the company's biggest product, anti-psychotic Zyprexa, facing generic rivals since October. U.S. sales of Zyprexa plunged 56 percent.

Merck did not have any major product going off patent in the fourth quarter and was able to swing to a profit on slightly higher sales. Sales of its allergy and asthma medicine Singulair rose eight percent to $1.46 billion in the fourth quarter. However, Merck's best-selling drug will face a generic challenge in August.

With the industry facing an unprecedented number of patent expirations -- sometimes referred to as facing a patent cliff -- big drug companies with deep pockets are acquiring biotechnology firms with promising drugs under development.

Most of the large pharmaceutical companies are going to be looking externally for assets to add to their (product) pipelines, said George Zavoico, managing director of equity research at MLV & Co., a boutique investment bank and institutional broker-dealer.

Potential biotech targets might have products in Phase I or II of development but do not have the resources to take them to the next stage. Moreover, many of these biotech companies' valuations declined after the recession, making them attractive targets.

The largest drug companies will either buy the biotech firm outright or form partnerships that require payments when specific developmental milestones are reached, Zavoico said, referring stages such as the drug under development performing well in animal tests, reaching human trials and getting Food and Drug Administration approvals.

Buying smaller biotech firms not only responds to the patent cliff, it makes an appealing alternative to spending money on research and development to create new drugs, a process that requires longer and longer time periods, higher expenses and greater risk than ever.

Merck reduced its R&D spending by 47 percent in the fourth quarter compared with the same year-ago period. Pfizer cut its R&D expenses by 17 percent, while Eli Lilly lowered its investment in innovation by six percent.

According to the FDA, most drugs that undergo preclinical (animal) testing never even make it to human testing and review by the FDA. Drugs that do must undergo the agency's rigorous evaluation process, and roughly 20 percent of them ultimately are allowed to be put on the market.

2011 Fourth-Quarter Earnings Results:

  • Merck earned $2.98 billion, or 97 cents a share, up from $2.76 billion, or 88 cents a share. The earnings topped analysts' expectations for 95 cents a share, according to Thomson Reuters. Revenue rose 1.6 percent to $12.29 billion, lower than the expectations for $12.52 billion. The company forecasts 2012 earnings per share of $3.75 to $3.85, excluding charges.
  • Pfizer reported net income of $1.44 billion, or 19 cents per share, down from $2.89 billion, or 36 cents per share, a year earlier. Excluding special items, Pfizer earned 50 cents per share. Analysts on average expected 47 cents, according to Thomson Reuters. The company forecast 2012 earnings per share of $2.20 to $2.30, excluding one-time items.
  • Eli Lily said it gained $858.2 billion, or 77 cents per share, down from $1.17 billion, or $1.05 per share. Excluding special items, Eli Lily gained 87 cents per share and six cents higher than what analysts called for, according to Thomson Reuters. The company expects to earn between $3.10 and $3.20 per share in 2012 on revenue ranging from $21.8 billion to $22.8 billion.

The large pharmaceutical companies at this point, with their existing pipelines and with a patent cliff, would certainly suggest a slowdown in growth and perhaps a drop in revenue growth, Zavoico said.

It certainly makes you wonder why one would want to invest in one of these companies, maybe for dividends, but not so much for growth potential, he added.

Merck & Co. Inc. (NYSE:MRK) dropped 59 cents to $38.04 in Thursday midday trading. Pfizer Inc. (NYSE:PFE) shares were down 45 cents to $20.86, and Eli Lilly & Co. (NYSE:LLY) were off 51 cents to $39.29. Meanwhile, the broader indexes increased slightly.