Big Pharma just struck a big blow against its generic competition.

Fueled by a string of high-profile drug patent expirations, a wave of new generics has hit the market in the past few years. A few leading drug makers decided enough was enough and are now offering coupons to customers to reduce co-payments on prescription medication in order to combat the competition from cheaper, non-prescription alternatives.#-ad_banner-#

Pfizer tested the strategy in 2011 and has now implemented a coupon program for six of its drugs. The list includes cholesterol-lowering medication Lipitor, one of the best-selling drugs of all-time, which went off patent on Nov. 2011. Pfizer’s patent loss of Lipitor is part of a larger trend that is posing a threat to branded pharmaceutical companies.

Drugs with more than $110 billion in annual sales will hit patent expirations this decade, according to health care research firm IMS Health. This trend will likely drive more big pharmaceutical companies to follow Pfizer’s lead. With Big Pharma’s robust cash flow and better distribution network, the smaller generic drug makers will probably see their profit margins shrink.

Big Pharma is hardly rolling over and dying from the impending patent expirations. As it stands, the group is trending remarkably well against the recent wave of generic competition, just as I wrote about last month. In fact, the industry is using the generic threat as an opportunity to recalibrate, get more competitive and tap into new markets and customers. 

And that shows up directly on the chart. Look how the Market Vectors Pharmaceutical (NYSE: PPH) exchange-traded-fund (ETF) has outperformed the S&P 500 in the past two years.

Looking forward, Big Pharma stocks offer a unique combination of value and income. A number of these leading companies are trading with historically low valuations after capital flowed out of the sector over concerns about patent expirations. And with dividend yields above 4% in some cases, these stocks offer an attractive stream of income in a low interest rate environment. 

Here are my top three picks from the group:

1. Pfizer Inc. (NYSE: PFE)
Yield: 4%

After producing huge gains for investors in the late 1990s, Pfizer spent most of the 2000s disappointing Wall Street and trending lower. Now shares are once again on a bullish track, jumping 48% in the past two years and 10% so far in 2012. But even after the recent string of gains, Pfizer’s forward price-to-earnings (P/E) ratio of 11 is a solid discount to the industry average of 14. If Pfizer returned to the same valuation as the industry, shares would climb above $30, a 27% increase from current levels. Pfizer also pays a dividend yield of almost 4%.

2. Bristol Myers Squibb Co. (NYSE: BMY)
Yield 4%

What I like most about Bristol Myers is its dividend, currently yielding roughly 4%, which is more than twice what a 10-year Treasury note currently offers. The company has battled the patent expiration of its blockbuster blood thinner Plavix, but it’s fighting back with coupons and newly-created partnerships. Bristol Myers has also aggressively strengthened its product portfolio to compensate for lost revenue from its key drug. In spite of record sales, Bristol still trades at a 56% discount to its all-time high of nearly $77. Recovering only half of that would put shares above $54, which is an incredible 67% increase from current levels.

3. Merck & Co. Inc. (NYSE: MRK)
Yield 4%

Merck has also been a big winner in 2012, currently up more than 14% on the year. But in spite of this gain, the valuation picture looks compelling. With a forward price-to-earnings (P/E) ratio of 12, Merck also trades at a discount to the industry average of 14. This is a mature company with a market cap of $133 billion, but converging back to a valuation in line with the industry average would give Merck a 17% boost and push shares above $51. In addition to offering coupons for its major drugs, it has organized the Merck Patient Assistance Program, which offers substantial discounts for individuals that meet certain qualifications.

Risks to Consider: Offering coupons and incentives can weigh on margins. To compensate for some of that margin compression, Big Pharma companies will need to tap into new markets and customers, and grow unit volumes.

Action to Take –> Big Pharma stocks currently offer a unique combination of value and yield. These stocks will never be the high flyers they were in the past, but they have grown into stable industry leaders that offer an outsized stream of income. These are two very good reasons to take a serious look at Big Pharma, in particular the three stocks I mentioned above.