General Electric's Secret Pharma Fail-Safe

By Markets Fool.com

Image source: GE.

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Locomotives. Jet engines. Turbines. These giant, complex machines are General Electric's signature products, and it makes a handsome profit selling them.

Slightly smaller, but no less complex, are the electronic machines GE sells through its healthcare unit, such as its MRIs and CT scanners. But GE Healthcare also has a hidden key that has already unlocked a major stream of recurring revenue from big drugmakers such as Johnson & Johnson andPfizer. And the stream is likely to only get bigger (much, much bigger) in the years ahead.

The future of medicine
Big pharmaceutical companies such as Johnson & Johnson and Pfizer have been investing for years in biopharmaceuticals. Unlike traditional drugs, which consist of molecules that are synthesized in a lab, biopharmaceuticals are engineered through biotechnology, often grown inside living cells, and then extracted.

The biopharmaceutical industry has already exploded. Seven of the top 10 medicines in the world today are biopharmaceuticals. These include vaccines such as Pfizer's pneumonia vaccine Prevnar, the best-selling vaccine in the world. It also includes insulin, as well as monoclonal antibodies such as Johnson & Johnson's Remicade, which treats rheumatoid arthritis and bowel diseases such as Crohn's. Other biopharmaceuticals can treat or help to prevent cancer, hepatitis C, and diabetes.

But not only is the development process for a biopharmaceutical very different from the one for a traditional drug. The approval process is different as well.

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The process is the product
When the FDA considers a drug, it looks at the drug's chemical structure, which for a standard drug is simple to do. Prozac, for example, is a molecule of fewer than 50 atoms. Contrast this with a monoclonal antibody, which consists of more than 10,000 atoms.

And the differences don't stop there. As Ronald A. Rader of the Biotechnology Information Institute explained in his article "(Re)Defining Biopharmaceutical," which appeared in the July 2008 issue of Nature Biotechnology:

Unavoidably, due to their manufacture by or from living organisms or cells, biopharmaceutical products and their active agents are largely defined and differentiated from one another by their identity and/or source, methods of manufacture and composition, and other specifications. This is ... often shortened to "process equals product." In contrast, high purity drugs (chemical substances) can usually be differentiated and identified simply by referring to their name or structure.

Rader adds that, for all but the simplest biopharmaceuticals, the FDA considers a "unique" product as being from one manufacturer, manufactured using consistent biological sources (e.g., cell lines), processes, conditions, and controls, and meeting a consistent group of final specifications. So as long as two biopharmaceuticals are manufactured differently, the FDA considers each a unique product.

Once the FDA approves a biopharmaceutical, the process to manufacture it must stay the same forever, including using the same equipment -- unless the manufacturer wants to undergo thedifficult and expensive process of reapplying, and proving that changes to the process haven't altered the final product, its safety, or its efficacy.

So if Johnson & Johnson or Pfizer specifies that it will be using GE equipment as part of the process, it must use GE equipment for as long as it makes the product, creating a recurring stream of revenue for GE. And if a particular product gets very popular, as Pfizer's Prevnar did after the CDC recommended it for universal use among senior citizens,GE is uniquely positioned to provide more and larger equipment to ramp up production quickly.

Cornering the market
Of course, none of this would matter if GE wasn't getting the business in the first place. But it is.

As I mentioned, seven of the top 10 medicines in the world today are biopharmaceuticals. All seven use GE equipment as part of their process. The FDA has also recently approved eight new monoclonal antibodies. All eight use GE equipment.GE technology is used to manufacture the majority of the world's insulin,andGE products appear in every biopharmaceutical lab in the world.

Even with such broad market saturation, biopharmaceuticals represent only a $4 billion-per-year business for GE.But as the industry expands, that number will almost certainly rise. In just five years, the market is expected to grow to $271 billion, from $187 billion in 2015.It may grow even faster as new disease trends emerge. For example, the World Health Organization just announced that nearly one in 11 adults across the world has diabetes,with further increases expected. That's bad for world health, but good for a company that helps to manufacture the majority of the world's insulin.

The Foolish bottom line
GE is so much more than its ubiquitous household appliances or its large-scale engines and turbines. The company's biopharmaceutical equipment business is a hidden gem of a business. With operating margins higher than 20%, a big share of a growing market with high barriers to entry, and major clients across the industry, GE is already poised for success. But the regulatory requirements that practically lock clients in to using GE equipment for the long term is the icing on the cake. This makes GE look like an even more attractive investment for the future.

The article General Electric's Secret Pharma Fail-Safe originally appeared on Fool.com.

John Bromels has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. The Motley Fool recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.