Maintaining the momentum: Dilip Shanghvi has turned Sun into one of the hottest pharma companies in the country

About a year ago, when executives at the Mumbai-based Sun Pharmaceutical Industries started drawing up budgets for the medium term, they were struck by the growth in spend in one cost centre: R&D. From just Rs 20 crore in 2000, the spend on R&D had soared to Rs 140 crore last year, and was projected to grow over 12 per cent annually over the next few years. There were two reasons why a galloping R&D budget was an issue for Sun. One, the company's size itself. With revenues of Rs 1,264 crore last year, it meant that Sun was already spending nearly 12 per cent of its topline on R&D versus an industry average of 7-8 per cent.

Two, as the experience of other bigger, research-intensive pharma rivals such as Ranbaxy Laboratories and Dr Reddy's Labs had shown, R&D investments-especially those on developing new drugs, or new chemical entities (NCEs)-don't immediately translate into revenues, thereby putting pressure on the bottom line. As a valuation-conscious Chairman and Managing Director of Sun, Dilip Shanghvi knew that he had to avoid the fate of players like Ranbaxy, which has lost 20 per cent of its market value over the last seven months, thanks to rising R&D costs and falling revenues.

Shanghvi's bold answer to the challenge: Take the risky innovative, or NCE, research out of Sun and put it in a separate company. While de-risking Sun was clearly one reason behind the move, the other was to create two sharply-focussed companies that would focus on generic drugs (reverse engineered copies of patent-expired drugs) and new drugs, giving each a chance to go their respective ways. As Shanghvi, 50, told analysts on a conference call a day after the company's board approved the plan on February 9, "Managing innovative products and businesses requires a very different skill set than generic...the key purpose of (this) decision is to be able to manage the business more effectively". Recently, Dr Reddy's created a separate company, Perlecan Pharma, to lodge some specific NCEs in it, but it continues to do innovative research. Point: Sun is the only pharma player to have completely spun off basic research.

Two To Tango

Traditionally, Sun has refrained from giving details of its new molecules. But now, it will have to reveal the specifics, since the new company (this will be announced at a later date) plans on listing on the stock market and for investors to be able to price its stock, they'll need to know just what potential winners it has shimmering on its Petri dish. Expect that information to come through in another month or so. For now, all that Sun is willing to reveal is that it has one NCE soon to go into phase two of clinical trials, and two NDDs drugs (that is, novel drug delivery system, which takes an existing drug and makes it more effective in terms of either dosage or drug chemistry) in trials.

Set up with Rs 200 crore in cash and Rs 50 crore in assets (equipment and buildings), the R&D company will have 120 to 140 people to start with and focus on a few specific therapeutic areas. Typically, the company will bring successful molecules past phase two of trials and then license them to another pharma company. In certain cases, it may try to take the drug to market on its own.

It will be at least two years before the R&D company sees its first dollar in revenue. The NCE will spend another 18 months in phase two, after which it will need to find a buyer. As for the two NDDs drugs, which are expected to go into phase two of trials in the US and Europe over the next three months, it will be another four years before they make it to the market-if at all. In effect, what Shangvi seems to be saying with the demerger is that, 'yes, Sun wants to be a drug innovator, but not at the cost of its generics business'.

R&D thrust: Innovation will now be a different ballgame

Generics All The Way

Compared to innovative research, the R&D (read: reverse engineering) for generic drugs is far cheaper, quicker and less risky. So that part of R&D will continue to be with Sun. At present, formulations (that is, finished drugs) account for 80 per cent of Sun's revenues and bulk drugs, the rest. Although Sun was a late-comer to the international markets, a good 40 per cent of its revenues come from overseas. With its focus clearly set on generics, Sun can now go after the global $50-billion market for generics (The us market accounts for a large chunk of this-about $31 billion). Says a company spokesperson: "Generics and branded generics would continue to be a business of predictable revenue and profit growth, as the model that has worked for us in India is rolled out across markets".

A string of acquisitions over the last 10 years (see A Decade of Dealmaking) ensured Sun's rapid growth in India and its diversification from speciality prescription products (for cancer and the central nervous system) to global generics to bulk drugs. The US has clearly been Sun's most important target market. In 1997, it bought an ailing $0.8 million firm, Caraco, which it slowly nursed to health over the years. Last year, Caraco logged $75 million in revenues and a loss of $1 million. Able Labs also needs a turnaround, but Shanghvi is counting on the fact that it will boost Sun's generics portfolio in the US. With Able, "we will have a presence in all key dosage forms compared to now, when we are present only in solid and oral segments," he says. Injectibles, ointments and creams are some of the forms Sun intends to tap shortly. Notes Saion Mukherjee, Senior Analyst at BRICS Securities: "They have niche products that are difficult to make, so they should have moderate revenues from the us with comfortable margins."

With $350 million (Rs 1,575 crore) in funds raised through a foreign currency convertible bond (FCCB) issue, Shanghvi has enough juice to keep the M&As going. By his own prediction, domestic business will account for just 30 per cent of Sun's revenues in another 10 years (compared to 60 per cent now). Says Ravi Menon, Director and Co-head (Global Investment Banking-India), HSBC Securities: "The motivation for acquisitions by Indian pharma companies is to increase their product baskets and offer niche products, which in turn enhance leverage with the distribution network." The other advantages, as Menon points out, are shifting corporate overheads to India, increasing offshoring possibilities and outsourcing from the country for production and product development.

Considering that Sun has a minuscule-less than 1 per cent-share of the us generics market, and almost no presence in the other regulated markets of Europe and Japan, it can only grow-provided, of course, it keeps its generics pipeline flowing. Shanghvi himself is very optimistic, stating at the February 10 analyst meet that "there are many, many products that are very interesting, very profitable, and can be genericised". By getting out of innovative R&D he may just have cut the drag on Sun.