New outsourced models in the pharmaceuticals business

Updated: Apr 29 2006, 05:30am hrs
To hive off or not to hive off Thats the Shakespearean dilemma before Indias leading pharmaceutical companies with large research and development, or R&D, operations. Yes, the question is relevant only to those few which have R&D divisions engaged in the pursuit of the holy grail in the drugs business: new chemical entities (NCEs).

Ranbaxy Laboratories, Dr Reddys Laboratories and Sun Pharmaceuticals at the top, and to some extent Glenmark Pharmaceuticals and Torrent Pharmaceuticals are the ones faced with the dilemma. Its an open secret that a majority of the rest in the industry are busy reverse engineering already-discovered molecules with the aim of breaching the generics markets abroad.

Last March, Dr Reddys decided to spin off its R&D division into a separate company, Perlecan Pharma with $52.5 million private equity funding from Citigroup Venture Capital and ICICI Venture Funds. This February, Sun spun off its R&D work into a wholly-owned subsidiary. Earlier this month, Ranbaxy told the stock exchanges that it had no plans to hive off its R&D business out of the company. Our R&D is a core in-house activity, it wrote. In the case of special projects, as is the practice, we may explore entering into cost-benefit sharing activities .

So, why are Indias top pharma companies following contrarian strategies when it comes to R&D Read on.

Drug development is a long and costly affair eating up to $800 million and 10-12 years meaning only companies with deep pockets can afford it. There could be little output to show after years of effort. For every 10,000 lead molecules that have potential to throw up NCEs only 5-10 enter the human trials stage. For Indian pharma companies, hiving off the R&D unit is one way to clean up their books. To get a perspective, Indias largest pharma company, Ranbaxy has sales of just over $1 billion.

Even the likes of Ranbaxy, Dr Reddys and Sun who on an average invest 10%-11% of their turnover in R&D spend maximum on the generics segment. No Indian company, till date, has launched a new molecule after completion of clinical trials. And the question of hiving off R&D units something which is considered core to the pharma business is unique to the Indian industry. Unlike in India, valuations elsewhere are done on the basis of R&D capability, says Sanjiv Kaul, director at ChrysCapital.

Yet, Indian companies derisively called copycats in the international pharma world do not have a great track record even when it comes to developing and licensing out drug leads at the human trials stage.

Dr Reddys two diabetic treatment molecules (ragaglitazar and balaglitazone) were dropped from clinical trials by Novo Nordisk as was Ranbaxys prostate cancer drug by Schawrz. Along with these failed attempts sank the milestone and royalty payments.

Derisking the companys R&D efforts is indeed one of the main motives behind these decisions. If the businesses had stayed together, R&D investment would have been 15%-18% of the turnover, says Dilip Shanghvi, chairman and managing director of Sun Pharma. Sun is one of the largest spenders in R&D in the Indian pharma industry. In the third quarter of 2005-06, Suns R&D expense increased 67%, to Rs 64.5 crore from Rs 38.6 crore in the comparable quarter the previous year. In financial year 2004-05, Dr Reddys spent nearly 15% of their sales, at Rs 252 crore, for R&D.

Besides, spinning off risky R&D divisions also makes the parent companies valuations appear rosier as can be seen from the way the stock markets reacted to the news of Dr Reddys and Sun demerging their R&D units. Even otherwise, there appear to be other benefits from separating the R&D function from manufacturing and marketing of drugs. According to Ernst & Youngs industry leader (health sciences) Utkarsh Palnitkar, formation of separate R&D entities helps the parent company to channelise saved costs for immediate requirements such as legal or marketing expenditures.

It also stabilises the drug discovery programme and allows it to grow faster by bringing in more money while spreading the financial risk. This partnership (with Citi and ICICI) provides Dr Reddys drug discovery program, a model to rapidly advance its existing as well as future NCE assets through phase II [trials on humans for efficacy] development without significant additional investments. And at the same time, will enable us to retain a substantial part of the benefits of out-licensing, co-development or joint commercialisation opportunities, says GV Prasad, Dr Reddys chief executive.

R&D expenditure mounts significantly after the phase 1 clinical trials a stage at which the potential drug is first tested on humans for toxicity and the money which partners bring is useful in accelerating the launch of the drug. It is here that analysts feel that Dr Reddys hive-off model might be more successful than Suns. Perlecan Pharma, the Dr Reddys unit, is managed by an independent board with representation from the two investors and Dr Reddys. On the other hand, Sun owns 100% of its R&D unit, exposing itself to the risks therein. Hiving off R&D division without ensuring the participation of a strategic investor would be meaningless, says Shahina Mukadam of IDBI Capital Markets. Sun seems to have taken note. We expect the R&D and innovative product company to attract sector investors who are familiar with investing in speciality pharma companies and who are familiar with both the risks as well as the reward associated with this, says Shanghvi. It (the demerged entity) will have enough funds to take projects ahead for the next few years and will have its own management team.

The downsides to this venture are a few. Not only will have the rewards have to be shared with companies but they will also have to lose out on tax deductions (like the 150% deductions of R&D expenditure and cuts in import duties in purchase of equipment).

Analysts feel that the pharma sector is witnessing a new trend that could define changes in the industry structure. These developments are just the beginning of newer partnerships being evolved to inch further towards minimising risk, focusing on core competencies, ensuring long-term revenues via stable product pipeline and becoming globally competitive, says Palnitkar.

However, companies like Ranbaxy still believe in R&D being a core function. The company has entered into relationships with other drug majors on specific projects like the case of a malaria vaccine with Genevas MMV. Besides, it has two molecules in the phase II trials and a host of novel drug delivery systems. Other pharma companies believe in the strategic alliance and outlicensing route wherein the chemistry skills of Indian scientists are leveraged to optimise molecule leads, which are then licensed out for further work. Example: Glenmarks Oglemilast, which it licensed out to Forest Labs in a $190-mn deal, and which entered phase II trials this week.

It is early to comment on which R&D model hived off or in-house will work for Indian companies.

With inputs from MG Arun in Mumbai