Big Pharma Comes Under Attack From a New Hedge Fund Strategy

Source: Teva Pharmaceutical, Facebook.

Forget retail short-sellers and angry message board posters, Big Pharma has a much bigger concern on the horizon: hedge funds.

I know what you're probably thinking, "Haven't various hedge funds already been betting against Big Pharma stocks from time to time?" The answer is yes. The primary method of discrediting a pharmaceutical company for decades has been to focus on increased competition, weaker earnings, pipeline problems, or any number of fundamental or technical metrics. However, one hedge fund has a completely new strategy meant to chop down Big Pharma at its knees and potentially drive down stock prices for their own benefit.

Big pharma has a new threatAs reported by The Wall Street Journal earlier this month, Hayman Capital Management, headed by Kyle Bass and partnered with intellectual-property consultant Erich Spangenberg, is targeting older drug patents that supposedly have little to no value and attempting to invalidate them, while simultaneously shorting the stock.

Why do this? Two reasons in particular come to mind.

Obviously, if Hayman Capital Management can get a potentially critical patent invalidated, it's possible the shares of a particular Big Pharma stock could come under pressure, validating Mr. Bass' short position.

Secondly, the idea of invalidating a patent should allow generic competition to enter the playing field. This would be a boon to generic drug developers (another area where Mr. Bass could profit were he to have long positions in generic drug developers), and could lead to falling prescription drug prices since generics often cost 80% to 90% less than branded drugs.

Source: Flickr user Bloomsberries.

The approach Bass and Spangenberg are using to attempt to get patents invalidated is also unique. The strategy involves filing patent petitions to the Inter Partes Review, or IPR, a three-person administrative judge panel that overhears patent dispute cases in order to keep patent trials out of costly federal courts. The IPR was actually put in place by the America Invest Act in 2012 to help corporations bearing patents better fight so-called patent trolls that would frivolously challenge corporate patents. Now it would appear that Bass and his hedge fund are turning the tables on Congress' action and using it to attempt to invalidate seemingly weaker pharmaceutical patents.

An analysis from the University of Chicago Law Review that was published last year suggests that 77% of patent cases brought before the administrative panel have resulted in invalidation of the patent in question -- not exactly encouraging news for Big Pharma.

In a presentation given in early January, Mr. Bass announced plans to take on 15 firms in the coming couple of years with a combined market value at the time of $450 billion. It's worth noting that he didn't mention which firms he'd be targeting at the time.

Kyle Bass takes aim We've discovered a few of the targets on Bass' radar recently includeJazz Pharmaceuticals and Irish-based Big Pharma giant Shire .

Source: Teva Pharmaceuticals, Facebook.

For Shire, Bass filed challenges, per the U.S. Patent and Trademark Office earlier this month, against patents covering ulcerative colitis drug Lialda and small bowel syndrome drug Gattex, which costs $295,000 per year and was acquired when Shire purchased NPS Pharmaceuticals earlier this year. Combined, the two drugs represent about 12% of Shire's annual revenue. The day the patent challenge was announced Shire shares shed about 3%, but have since gained nearly 12%.

Bass' challenge to Jazz Pharmaceuticals hits a much scarier note, as it challenges the patent covering narcolepsy drug Xyrem, which accounted for $778.6 million, or 66%, of the $1.17 billion in revenue that Jazz brought in last year. An invalidation of this patent would be absolutely devastating for Jazz and its shareholders, but it could be great news for privately held Roxane, which in 2010 filed an abbreviated new drug application with the Food and Drug Administration to bring a generic version of Xyrem to market.

Concerns are adding up for Big PharmaAs if patent challenges weren't a big enough problem for Big Pharma, the world's largest drugmakers are also struggling with timing running out on exclusivity patents.

Source: Pfizer, Facebook.

Pfizer lost its exclusivity on the best-selling drug of all time, Lipitor, a few years ago, and has witnessed the loss of exclusivity for Celebrex, Detrol, and Spiriva in select countries as well. Its full-year sales peaked at $67.8 billion in 2010, and Pfizer's full-year guidance for 2015, inclusive of negative foreign currency translation, is just $44.5 billion to $46.5 billion. Pfizer's share price has rebounded in recent years due to very generous share buybacks and dividend payments, but a potential patent challenge on a blockbuster drug (as a hypothetical example) could be the straw that breaks the camel's back, or in this case Pfizer's multi-year uptrend.

While pure speculation, one Big Pharma company that could be next on Bass' list is Teva Pharmaceutical . Teva is already facing the patent exclusivity loss of multiple sclerosis injection Copaxone this year, which generated nearly a fifth of Teva's total revenue last year, and it could (in my opinion) see a challenge to blood cancer drug Treanda, which it acquired when it purchased Cephalon in 2011.

Source: Teva Pharmaceutical, Facebook.

In Feb. 2014,Actavis filed an abbreviated new drug application to put a generic version of Treanda on the market, but Teva's Treanda is protected from competition into 2016 for indolent non-Hodgkin lymphoma (iNHL). What this shows is that there's already a generic version of Treanda ready to go -- and Treanda currently costs between $8,600 and $9,800 per treatment, depending on whether it's prescribed for chronic lymphocytic leukemia or iNHL. Again, this is pure speculation on my part, but Teva could be a logical target for Bass and his hedge fund, as invalidating the patent would have a pretty immediate effect on Teva's Treanda revenue.

What this investor thinksWhile Kyle Bass' strategy could prove fruitful for his hedge fund, I'm not sure I'd consider reading too much into his patent challenges. I much prefer to base my investments in the Big Pharma sector on the depth of companies' drug development pipelines and the quality of their free cash flow. Personally, a company that I'd want to own wouldn't be overly reliant on a single drug in the first place, meaning patent challenges to a single product wouldn't be too worrisome.

In other words, don't overreact if one of your holdings suddenly becomes the target of Kyle Bass' hedge fund. Instead, make sure your investment thesis remains intact and pay attention to patent disputes as they develop.

The article Big Pharma Comes Under Attack From a New Hedge Fund Strategy originally appeared on

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool recommends Teva Pharmaceutical. 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.

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