‘Well, in our country,’ said Alice, still panting a little, ‘you’d generally get to somewhere else — if you ran very fast for a long time, as we’ve been doing.’
‘A slow sort of country!’ said the Queen. ‘Now, here, you see, it takes all the running you can do, to keep in the same place.
(Through the Looking Glass)
While India had millions of its citizens in need of basic healthcare, Israel was seething under an embargo from its Arab neighbors making access to medicines difficult. Although under different circumstances, both countries adopted the same approach – they made their patent laws lenient. India was already an established outsourced API manufacturing base due to low manufacturing costs and large pool of scientists.
It was only some time before local drug makers started churning out generic drugs (inexpensive copies of patented drugs recreated by reverse engineering their molecules) and started exporting the same to the world. Thus the behemoth known as the Indian Pharmaceutical Industry was born.
An important component of India’s exports, (contributing 6% to total), the presence of multiple issues today endanger the movement of the pharma juggernaut. Below, we discuss the 2 major challenges plaguing the industry –
1. Stringent Regulation-
Considering that India has the largest number of USFDA approved manufacturing facilities outside of the United States, the USFDA opened its India office in 2008. The US Government increased the resources at the disposal of the USFDA in 2012 through amendments to GDUFA Act , which resulted in higher number of inspections in India as can be seen from the graph below –With an increase in resources, the USFDA was also able to undertake surprise inspections, in place of pre informed ones. This led to USFDA discovering multiple lapses in maintaining cGMPs (current Good Manufacturing Practices) by Indian pharma companies, as can be seen from below –Our Assessment: The increased regulatory scrutiny (though decreasing in 2017) is here to stay. With the rude awakening of standards and the regulatory mess in the aftermath, a lot of companies have come under a dark cloud. However, these issues appear to be largely fixable for the industry as a whole.
2. Price Erosion in US Market-
Generic pharma companies have seen a decline of 5-6% in their base business (yearly revenues excluding new launches) for many years now. However this decline has increased to double digits since 2016 for established pharma companies on account of the following –
Consolidation among purchasers of generic medicines –
Over the years, PBMs (Pharmacy Benefit Managers – third party administrators of prescription drug programs) have grown in clout on account of multiple mergers and acquisitions in this sector, to such an extent that the top 3 PBMs – Express Scripts, CVS Health and Optum Rx (controlled by UNH) controlled almost 65-75% of the claims processing in US by 2016.
The mounting pressure from the US Government to reduce the rapidly rising drug costs as well as higher bargaining power of the PBMs led to consolidation among large US pharmacies. As pharmacies grew larger, they could extract much better prices from generic drug manufacturers than drug wholesalers themselves, which then led to consolidation among drug wholesalers with top 3 wholesalers buying 80% of all generics as of 2017, thus creating accelerated price erosion among generic pharma companies.
(Refer to the Infographic on The Drug Distribution in US)
Is there a Competitive Advantage?
Ultimately, a sustainable competitive advantage is a hallmark of a good quality business, which in our opinion, seems to be missing from US focused Indian generic pharmaceutical companies. Our understanding of the same stems from below –
A generic pharma company earns superior returns from the following three pillars of business-
- Research – an ability to reverse engineer innovator drugs (Cost of developing a drug – 1 million USD – 5 million USD).
- Litigation – invalidating the existing patent through litigation (outsourced) to gain a 180 day ‘First to File’ exclusivity in the US market. (OPMs of 55% – 65%).
- Distribution – Medical Representative Network and Customer Relationships – only useful for Chronic / lifestyle ailments and OTC (Over the Counter) drugs due to generic prescription rule.
It becomes very difficult for a company to achieve economies of scale in any one of the functions above and further transfer it to other two functions because the competition is dependent on molecules and the above three functions are disparate from each other.
Low material costs and lenient patent laws, which gave a fillip to the early industry participants, no longer pose an entry barrier since a large number of companies now benefit from the same.
Thus, we see that an advantage stemming from transitionary barriers to entry could have appeared to a number of market participants as a sustainable competitive advantage while genuine barriers continued to remain absent.
Moving up the Value Chain:
With more and more pharma companies moving up the value chain (from API to formulations), the incumbents continue moving from traditional generics to Specialty Generics (same medicine, different mode) and Branded Generics (Brand Driven), as can be seen from below –The diversification in revenue streams for these companies (Teva and Mylan) comes from acquisitions and higher R&D spends, the effects of which have been detrimental to the returns of the company as can be seen from the graph below-
1. RoCE and Revenue Growth over last 10 years; 2. Circumference represents the Market Cap
Our Assessment: With the channel consolidation, and increasing number of pharma companies getting approvals, the pricing pressures and the subsequent competition has the ability to erode long term returns of the generic pharma companies.
Historically, the Indian pharmaceutical industry has been one of the best performing investor baskets along with lower drawdowns as can be seen in the below figure –
Please note that in this entire blog, we have spoken only about the US driven generic pharma companies and not the plethora of pharmaceutical companies with niche business applications that derive their advantage from strong customer relationships, patented processes, strong domestic business or a sustainable cost advantage. It would be wise to not throw the baby out with the bathwater.
Also, we see limited ability in the smaller/mid-sized pharma companies that are moving up the value chain, to earn super normal returns over a long term since their business model is similar to the larger pharma companies. These companies also lack the first mover advantage enjoyed by the incumbents in US generics.
On a concluding note, it has been an illustrative case study for us which re-affirms our perception that – extended periods of above average returns on capital tend to dissipate in absence of genuine barriers to entry and misinterpreting business quality of companies that have a temporary advantage can pose a capital preservation risk.
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