Size matters: Over the next three years, an estimated $50-billion worth of drugs will go off patent. And to tap this opportunity, Indian companies need to consolidate

Well, good morning, Monsieur Dehecq. Welcome to the new world order in pharma, where generics, or cheaper copies of branded drugs, is the name of the game. It's easy to see why Big Pharma companies like Sanofi-Aventis consider generic manufacturers as their Enemy #1. For about 10 years now, the number of new drugs coming out of the labs of Big Pharma has been steadily declining, even as the real spend on research and development (R&D) has almost doubled from about $17 billion to $36 billion at last count. As a result, there are fewer blockbuster drugs (those fetching more than $1 billion in annual revenues) hitting pharmacies and Big Pharma growth is stalling. Simultaneously, industry regulations have become far more stringent, raising the amount of time and money drug makers spend on developing drugs, even as consumers and courts get far less tolerant of faulty drugs. Result: Drug giants Pfizer and Merck alone have lost billions of dollars in combined market cap since 2000.

In contrast, the generic manufacturers have been booming. Take India, for example. Early 2000, the largest Indian drug maker, Ranbaxy Laboratories, had generic exports of Rs 1,209.6 crore. Today, 79 per cent of its revenues, or Rs 4,795.30 crore, come from international operations, most of which is generic-driven. On the whole, generic drugs have increased their share in global markets from 8-10 per cent three-four years ago to 12-14 per cent now. Over the next three years (2007-09), some $50-billion worth of generics will go off patent, creating a huge market for generic drugs. Indian players, who have the twin advantage of low-cost manufacturing and research, are among the best placed to tap this opportunity.

Bulking Up

Yet, things aren't as straightforward. Perhaps the biggest problem that Indian generic manufacturers face is of size. Compared to the biggest generic player in the world, Teva-ivax, the biggest Indian player Ranbaxy is less than one-fifth in size at Rs 6,070 crore. In this business, heft matters, particularly since the front-end-that is, distribution-is getting consolidated. That's why there has been a rash of mergers and acquisitions in the generic space. IVAX, for instance, was a separate American company until July 2005, when Israel's Teva acquired it for $7.4 billion. Earlier, Novartis had jumped to the #1 position when its generic arm Sandoz made two acquisitions (Eon Labs and Hexal) earlier in the same year.

Among the Indian generic companies, Ranbaxy has been the most active, making six acquisitions in markets outside India such as the US and Europe in 2006 alone. According to recent reports, it is mulling its most ambitious acquisition bid yet in the form of Merck's generic business. It will cost Ranbaxy upwards of $5 billion (Rs 22,500 crore)-more than three times its revenues-but catapult it to the #3 position behind Teva and Sandoz. "The generic business of Merck is a quality asset," says Ranbaxy's CEO & MD, Malvinder Singh. "It offers a strategic fit to our business and we would certainly be interested if it is available at the right price and enhances shareholder value," he adds.

It's not just Ranbaxy that's talking M&A. Smaller rivals, including Sun Pharmaceuticals, Nicholas Piramal, and Wockhardt, too have cherry-picked opportunities abroad. Wockhardt, for instance, has made four acquisitions in Europe (two in the UK, and one each in Germany and Ireland) for $190 million. Bigger players like Hyderabad-based Dr Reddy's Labs have also landed some big catch such as Germany's betapharm, which incidentally is the biggest pharma acquisition by an Indian company. Dr Reddy's is not ruling out further acquisitions to accelerate its global ramp-up. "Scale is becoming important because the R&D spend, if leveraged over a much higher amount of revenues and market share, becomes that much more affordable," says G.V. Prasad, Executive Vice Chairman and CEO, Dr Reddy's Labs.

The need to scale up arises from multiple factors, but everything links back to the changing competitive landscape. There was a time when the innovator companies (that is, those that own the patented drug) would sneeze at the flea-market business of generics. It was below them to get into a market where generic copies got sold for a fraction of the branded drug. However, their own dwindling pipeline of new drugs has forced them to either 'authorise' manufacture of generics by a Teva or Sandoz or to launch their own generic copies. With the result, generic prices in the US have come crashing down. Today, it's not unusual for a copy-cat drug to sell at just 5 per cent of the innovator drug price. What it means is that while $50-60-billion worth of drugs may be going off patent in the next three-to-five years, the actually opportunity is vastly smaller.

Understandably, that has heightened competition among the pure generic companies. It's not enough anymore to come up with a generic drug, but you must also be the first to file for the right to sell it and, ideally, challenge and win some of the existing patents of the innovator's drug. That has driven through the roof the cost of such exclusive generics, since the aspirant must not only battle the innovator company but also rival generic manufacturers. Even then, the risk of the innovator and a generic rival striking a deal for authorised generics remains. Says Dilip Shanghvi, CMD, Sun Pharma: "With new entrants, who have a different cost structure, preparing to enter the us market, we do not think prices are likely to stabilise as yet."

Market Diversification

Then, there's another problem with the US market. While Indian companies file the largest number of applications for generics (called ANDAS, or Abbreviated New Drug Applications), few of them are patent-challenging. That means most of the launches are destined to compete in the 'commodity' market, where both prices and profits are wafer-thin.

One way the Indian manufacturers have tried to beat the profit pressure is by diversifying into other markets such as Europe (see Europe is Promising...). Here, key markets like Germany and France are growing in value terms between 6 and 20 per cent annually, creating new opportunities. However, the governments here seem more inclined to control prices of drugs to keep medicare costs low. That's one reason why some analysts say, in retrospect, that companies like Dr Reddy's may have overpaid for their European acquisitions.

Needless to say, Indian drug makers will recalibrate their expectations, but persist in the European markets. At the same time, the US will remain their holy grail. No doubt, generic prices are under pressure, but the demand for them is growing. In fact, factors such as the Medicare Modernisation Act and an ageing population are encouraging the move towards cheaper generics, and it is expected that by 2010, the share of generics could account for 70 per cent of all prescriptions dispensed in the us, up from around 55 to 60 per cent at present (in value terms, the share is, however, just around 15 per cent today and this could marginally increase by 2010). Says Sun's Shanghvi, who owns a manufacturing unit in the us: "We continue to be primarily focussed on the us because it is still the largest market and we would want to get to a certain size there."

The road ahead will be trickier to negotiate. Until recently, few of the Big Pharma companies or generic giants were tapping the low-cost manufacturing or research opportunities in India. But now they have realised the need to do so. Teva has a captive bulk drug plant in India; Mylan Laboratories of the us coughed up $736 million last August to buy Hyderabad-based Matrix Laboratories to get access to low-cost bulk drugs and formulations. Chinese manufacturers, who still don't have any significant presence in the global market for generic drugs, are aggressive players in bulk drugs. That puts pressure on vertically integrated Indian companies such as Ranbaxy and Dr Reddy's to find ways of cutting costs further.

Some of the solutions that such players have come up with include spinning off their capital-intensive R&D activities into separate entities. But as Ranbaxy's Singh seems to have realised, the time now is for bold moves. Indeed, scale up or ship out may be the new reality in Indian pharma.