The structure of the pharma industry as everyone knew it a couple of years ago has changed. It is now marked by ruthlessness of the kind seen only in investment banking.There are some very tangible reasons behind this. Costs have blown devastating holes across balance sheets. A resurgent customer and cold-blooded competition have driven prices down. The consequent impact on margins has left companies clutching at any straw in sight. After all, spending over $300 million and 15-20 years on research to create a blockbuster is not funny. And at the end of it all, a company has very little time to recoup costs.
Patent protection lasts 20 years. Not beginning from the day a drug hits pharmacists' shelves. But from the day the compound is first registered with the patent office. In absolute terms, each day's delay, from the day patent is filed, costs a company $1 million .
Patent protection has led to an incredible amount of consolidation in the form of mergers. Analysts reckon it isn't over as yet. Within five years, the top ten pharma companies will control over 60 per cent of world market. The underlying motivation for this consolidation will not be market share, but cost reduction and fuller R&D pipelines (See chart, Funelling money)
This is also the reason why the Indian pharmaceutical industry is an incredibly interesting place. Terribly fragmented, till recently protected and devilishly innovative, changes across the world now threaten it with far-reaching changes of the make or break kind.
The Intellectual Property Regime (IPR), amplified MNC activity, a fresh emphasis on research and development (R&D) and an increasingly obsolete Drug Pricing and Control Order (DPCO) have all been factored into the future. What remain to be seen are the subtleties -- the structures that will emerge and where in the new matrix will companies fit?
Meanwhile, there are indicators of where the opportunities lie.
Opportunity ## 1: Dr Anji Reddy, chairman of Dr Reddy's Labs is a candid man. He admits that the trick in the long run lies not necessarily in original research, but in innovating. "One great man discovers for others to improve upon that work." (see page 8 for interview with Anji Reddy).
That about sums it all up. Indians have been quick to acknowledge their weaknesses primarily, lack of financial and infrastructural resources. Implicit to these handicaps is the fact that basic research in its truest sense is far too expensive and risky. But analogous research makes sense.
Analogues are superior modifications of original molecules. A typical analogue, for instance, may neutralise side effects or improve therapeutic efficiency of a drug. It is research of the kind Dr Reddy's Research Foundation (DRF) conducts. The unit has isolated three new chemical entities (NCE) -- two anti-diabetics and one anti-cancer. This was about as far Dr Reddy's could go given its existing resources. Which was why it licensed out these molecules to Danish major Novo Nordisk for further development and testing.
A few days ago, Nordisk paid Dr Reddy's a milestone payment because one of the molecules was cleared for phase two development. While details of the payment are not clear, analysts reckon it could be over $4.2 million, which was what the company had received when the molecule had entered phase one trials. Other payments are also in the pipeline (see key trends in the Indian industry on page 6).
Analysts argue that what Dr Reddy's has isolated are not NCEs in the strictest sense of the word. But, they are classic examples of successful analogue research. All said and done, what is important here is that such research shores up the bottomline by a couple of million dollars. And it is gaining prominence for a very simple reason. There is big money in it. "Me-too-drugs", for instance, represent nearly 75 per cent of the top 50 drugs selling worldwide. The real reason for their success is that "me-too-drugs" can offer valuable incremental improvements over breakthrough products.
As a McKinsey report on the industry puts it, the only true "me-too" products are generic compounds. All other drugs have the potential to be incremental innovation, that is offer tangible improvements over the original.
The report highlights how Norvasc was transformed from a "me-too" into an incremental innovator. Norvasc was a late-to-market calcium channel blocker in a market where Pfizer had the leading product, Procardia XL. But it had certain clinical advantages. And Pfizer sought to capitalise on them.
Its strategy of putting more resources behind Norvasc as Procardia XL faces patent expiration appears to be paying off. While Procardia XL lost market share in 1995, Norvasc more than made up for the loss -- it is now the third largest-selling calcium channel blocker.
Opportunity ##2: Generics. But it's the kind of business that separates the men from the boys. Competition is awfully tough. Margins threaten to be wafer-thin and costs need to be kept on a tight leash.
When margins are on the lower side, conventional wisdom dictates that success comes on the back of high volumes.
For any firm that seeks to leverage opportunities in generics, it means two things.
First of all, does it have
a presence in the various therapeutic segments?
the ability to innovate rapidly?
access to raw materials?All this is possible only when a firm has integrated strategically. Depending on where it is on the value chain, it will have to integrate backward, forward and ideally, vertically. Backward integration protects it from supply side shocks and forward integration helps in reaping the benefits of value addition. With vertical integration, it stands to gain the most like Ranbaxy, Cipla, Dr Reddy's and Wockhardt.
Secondly, where in the matrix (see The generic matrix) does it fit? Is it a brand developer, an innovator, a broad line generic supplier, or a contract supplier?
The trick lies in not being part of a single cell in the matrix. Rather, in being at different points simultaneously. Ranbaxy exemplifies the benefits. With operations in seven countries and exports to 40 others, it aggregates returns from several markets, thereby spreading risk factors across them too. It has set up strong marketing teams to build brands in key markets. Most importantly, it has gained a reputation for being among the dominant innovators in the industry.
In the long run, survival in this segment will be determined by size. Major players have already integrated or are moving rapidly towards integration which also creates an entry barrier. Therefore, fresh entrants will have to move in as integrated players or face severe disadvantages.
To that extent, integration and size may mean the end of smaller firms as they currently exist. Intense pressure will either force them to sell out or shut shop. Unless they demonstrate unprecedented competence in niche areas.
Opportunity ##3: There is a very tangible need across the pharmaceutical world to forge alliances. Considering the sheer volume as well as the pace of innovation happening outside the company funded labs. While results of such research are available for a price, there are other problems. The breadth of choices, for one, makes it almost extremely difficult to zero in on what is just right. There may be something better around the corner. Then there is the danger that such research will outpace in-house work, leaving large investments stranded.
These fears are creating three kinds of pharmaceutical companies, as defined by McKinsey in a recent report.
1. The discovery stimulator: The type of companies which are strong in basic research and have a highly integrated pathway to market.
2. The idea acquirer: Companies that have world class product development skills and want to leverage them by bringing in ideas from outside fit this mould.
3. The product acquirer: Companies that understand consumers and the marketplace thoroughly, cater to their needs by bringing in products in their later stages of development and adding value to them.
The second and third models hold significance in the Indian context. An idea acquirer, for instance, Dr Reddy's recently took over a pharmaceutical boutique in the US at a cost of $1.5 million. Such boutiques represent hotbeds of innovative research. However, these innovators lack the resources to take their products into the market.
Meanwhile, with this acquisition, Dr Reddy's gains instant access to a clutch of molecules, which can possibly be licensed out to a product acquirer -- like its arrangement with Novo Nordisk -- in return for milestone payments later. Such alliances, though, are only the tip of the iceberg and for a vast majority of smaller Indian companies they perhaps represent the only way out.
Bulk actives for instance. Their production costs in India are about a third of what they are in either North America or Europe. For a company operating in any of these markets, manufacturing operations can be painful, thanks to low margins.
The market, however, is too large to be ignored. Tie-ups with smaller Indian companies help. Or alternatively, taking over these units and leveraging their skills. This is true in case of formulations too (See charts Manufacturing cost comparison and Potential margin by sourcing from India).
What does it all add up to?
On the face of it all, there exists a huge potential for Indian companies. The market is still growing in double digits. Per capita spending on drugs at $3 is on the lower side and the upside potential is enormous.
The best part is that Indian companies are doing all the right things. Tinkering around with all the right molecules, making their presence felt on the global generic markets and forging the right alliances.
However, there is a flip side to it all. The stock markets provide interesting insights.
Indian bulk drug and formulation companies trade at approximately 40x. The glam boys like Dr Reddy's, Ranbaxy and Cipla command premiums way over the industry average. Ranbaxy leads the pack at 82x.
Take these three out of the basket, and the average industry P/E crashes down to a miserable 16x.
As against this, the MNC basket represents a lot more stability and averages a P/E of 38. That is after the three (mention the three MNCS) MNCs that command the highest P/E in the sector are taken out of the basket.
It could only mean two things. Either that Indian companies are horribly undervalued. Or that the markets don't fancy them too much. Chances are that the latter assumption is true. Because, the real innovators have got their dues as reflected in their valuations.
Which means, a vast majority will have to ask hard questions. Survival depends on that.
The market for generics is huge. It seems unlikely that the MNCs or the major Indian companies will keep themselves out of the battle for this turf. With competition, margins will get tighter. Do we have the steam to survive?Over medium to long term, with the opening up of medical insurance, health management organisations (HMOs) will make their appearance. Their ability to bargain and drive prices down is already known. Margins are bound to get thinner. What happens then? Can we create a niche, get into it, and stay there?Does it make sense to simply sell out? Isn't discretion the better part of valour?But it’s early days yet. Far too early to write epitaphs. Front-runners have emerged from an environment where there was no incentive to innovate. To that extent, they need to be applauded. As for those threatened with extinction, the blame does not lie entirely at their doors. The way things were in the fifties and sixties, nothing different could have emerged.
Some will die. Others will adapt. The fittest will survive. But then, isn't that what evolution is all about?