How to do Business Analysis of Pharmaceutical Companies

The current article aims to cover the key factors affecting the business model of pharmaceutical (pharma) companies. After reading this article, an investor would be able to differentiate pharmaceutical companies based on the strength of their business model. She would be able to have an informed view of the possible future business scenarios that any pharma company may face.

Segments of pharmaceutical industry: A detailed analysis.

Whenever any investor starts to analyse any pharmaceutical company, then the first thing she should attempt to know is what segment of the industry it operates in. There are different divisions of the pharmaceutical industry, which are primarily based on the place a company occupies in the supply chain.

It becomes important to know the segment of the company because; different segments of the pharmaceutical industry have different business characteristics and face different challenges.

1) Bulk drugs/active pharmaceutical ingredient (API) manufacturers: These companies make drugs as bulk chemicals and operate at the basic step in the pharmaceutical supply chain. For example, in the case of manufacturing Paracetamol, these companies make tons of pure Paracetamol and provide it to other companies (formulations manufacturing companies) for further processing.

2) Formulation manufacturing companies: These companies buy pure drug chemicals from bulk drug/API manufacturers and then convert them into tablets, injections, syrups etc. These companies make the pure chemicals into final drugs, which are ready for human consumption. Formulation manufacturing companies may sell the drugs in the market under their own brand names.

The formulation manufacturing segment is further divided into companies that do research and invent/discover new drugs themselves and sell these patented drugs (called innovator companies) and those companies that sell drugs invented by others, whose patents are expired (called generic companies).

Even in the generics segment, companies may sell patent-expired drugs by putting their own brand names (called branded generics) e.g. Dolo for Paracetamol, or sell only under the name of the chemical in the drug e.g. drug tablets labelled only Paracetamol (called generic generics).

3) Contract research and manufacturing services (CRAMS): These are companies who provide research services to innovator companies in their new-drug development programs and also provide contract manufacturing services where the innovator company shares the technology with them and then CRAMS companies manufacture the drug by putting the brand labels of the innovator company. Thereafter, the innovator company acts as a marketing agency that sells these drugs under its own brand using its sales and distribution channel.

4) Pharmaceutical distributors: These are the companies, which take the final drug from the formulation manufacturing company to the consumers. These include clearing and forwarding agents (C&F agents), CIF (cost, insurance, and freight) agents, super-stockists, stockists, sub-stockists and retailers.

Understanding the place of any company in the pharmaceutical supply chain is important because companies in each of the above-mentioned segments face different business dynamics. For example, API and contract manufacturers may act like commodity chemical manufacturing companies with efficient low-cost manufacturing becoming their main strength. On the contrary, formulation manufacturing companies act as “brands” where sales, marketing, advertising, and acquiring customer mind space become key determining factors.

In real-life situations, an investor would find companies that are pure API manufacturers, pure formulations manufacturers or pure CRAMS players. However, she would also find players who have integrated operations i.e. formulation companies who manufacture APIs as well and do CRAMS for other players as well etc.

Let us now try to understand the business dynamics of each segment of the pharmaceutical industry in detail so that we can understand the strengths and challenges faced by each of these segments.

1) API manufacturing business seems like any commodity chemical manufacturing business; fragmented industry, intense competition, capital intensive, and no pricing power:

When an investor analyses bulk drug/active pharmaceutical ingredients (API) manufacturing companies, then she notices that the business of these companies is similar to commodity chemical manufacturing companies.

API manufacturers produce the basic ingredients of the drugs e.g. Paracetamol in bulk, which is essentially a commodity chemical. Paracetamol made by one API manufacturer is indistinguishable from the Paracetamol made by another API manufacturer. Therefore, the buyers of bulk Paracetamol can easily switch from one API manufacturer to another without a significant impact on their business.

An investor would appreciate that the original patent to manufacture is owned by the innovator pharmaceutical company, which made Paracetamol for the first time. After the expiry of the patent, every API company is able to manufacture Paracetamol without any product patent protection. Therefore, every company, which can put in the required investment can enter the business without many technological challenges and add to the competition in the API industry.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020 (click here), page 3:

bulk drug (API) industry is also fragmented with low entry barriers

As a result, the API manufacturing segment is fragmented with intense competition. Apart from dedicated API manufacturers, these companies also face competition from the in-house API units of formulation drug manufacturers who apart from reducing their own API purchases, may also sell excess API in the open market.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 3:

The bulk drug players also face competition from in-house API manufacturing of large formulation players for captive consumption as well as sales to external formulation players.

The competition to the API manufacturers is not limited to domestic producers because; due to the commodity nature of their products cheaper imports also provide strong competition.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020 (click here), page 3:

bulk drug/API companies are relatively capital intensive & fragmented in nature with threats from cheaper imports;

An investor would appreciate that if a company operates in a commodity market with non-differentiable products, then the company loses its pricing power over its customers. This is because the customer can easily switch from one API manufacturer to another without a significant impact on its business.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 4:

API manufacturers may face pricing pressure on account of commoditization and face risks related to high capital intensity and usually limited product portfolios.

In such commoditised businesses with low pricing power, the key source of competitive strength comes from being the lowest-cost producer. In such cases, economies of scale help the most in lowering the cost of production.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021 (click here), page 5:

Factors affecting market position for bulk drug manufacturers: Given the intense competition, market position is largely determined by pricing ability that is linked to the company’s operating efficiencies and economies of scale.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 3:

bulk drug (API) industry…entities ability to develop low cost manufacturing, high process chemistry skills and requisite manufacturing facilities defines their competitive position.

To benefit from economies of scale in the volume-driven API segment, companies attempt to create very large plants to benefit from operating leverage. This makes their business very fixed-capital intensive.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 5:

Entities engaged in CRAMS / APIs business require significant upfront investments in creating manufacturing / research infrastructure

In addition, the companies end up having a lot of inventory to ensure uninterrupted supply to their customers to become their reliable partners.

An investor would appreciate that companies dealing in commoditised products with no pricing power have to give a longer credit period to their customers. This in turn makes their operations working capital intensive.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 8:

API players have relatively high level of working capital intensity led by the need to maintain critical raw material inventory levels for maintaining uninterrupted supply.

Further advised reading: Inventory Turnover Ratio: A Complete Guide

From the above discussion, an investor would appreciate that most of the bulk drugs/APIs are commodity products and the product of one API manufacturer is non-differentiable from another API manufacturer. As a result, they are price takers with very low negotiating and pricing power over their customers.

In such a situation, to create competitive advantages, API manufacturers try different methods like becoming the lowest cost producers (economies of scale and operating efficiency) and becoming the most reliable partner of their customers (keeping high inventory for uninterrupted supply, giving longer credit periods etc.).

Further advised reading: Receivable Days: A Complete Guide

Let us discuss other steps that API manufacturers take to strengthen their competitive position.

1.1) Expand the product portfolio:

API manufacturers try to expand their product portfolio so that customers do not need to deal with many API manufacturers for their needs. As a result, the customers can deal with only a few large API manufacturers for all their needs.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

Factors affecting market position for bulk drug manufacturers: Product range: According to CRISIL Ratings, diversity of the product range…mitigate competitive pressures and support performance in terms of sales growth and profitability.

1.2) Manufacture complex products:

To increase their competitive strengths, some API manufacturers attempt to focus on making chemicals, which are relatively complex to manufacture so they have to compete only with a small number of players that are able to manufacture those complex products.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2018 (click here), page 7:

A product that requires a high degree of complexity to manufacture, such as that involving fermentation technology, is typically characterised by high entry barriers and thereby, presence of fewer players.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

Factors affecting market position for bulk drug manufacturers: According to CRISIL Ratings…presence of molecules that are complex to manufacture significantly mitigate competitive pressures and support performance in terms of sales growth and profitability.

Therefore, an investor would appreciate that by way of expanding the size of their operations via large capital expenditures, using economies of scale to become the lowest-cost producers, opting for working capital-intensive operations to become a reliable supplier, expanding the product range and manufacturing complex products, an API manufacturer may gain competitive advantages in an otherwise fragmented industry with price-based intense competition around non-differentiable products.

To understand these strategies of API manufacturers, an investor may read our detailed analysis of Laurus Labs Ltd, which despite being the largest producer of HIV drugs’ APIs in the world had very low pricing power. Therefore, the company expanded its product portfolio to Hepatitis-C, Oncology, custom synthesis, formulations etc.: Analysis: Laurus Labs Ltd

2) Formulation manufacturers have two contrasting business models:

Formulation players manufacture ready-to-consume drugs and sell them in the market. They are at a higher level in the pharmaceutical value chain and are supposed to have a better business profile than API/bulk drug manufacturers.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, June 2017 (click here), page 7:

Formulation manufacturers, being closest to the market, are at a higher point in the pharmaceutical value chain compared to API and intermediate manufacturers and hence, are likely to have a superior business risk profile

When an investor analyses companies that manufacture formulations i.e. the ready-to-consume to consume drugs, then she notices that this segment consists of two very different sub-segments. One of these consists of the innovator companies, which invent/discover new drugs and the other group is generic companies, which sell old drugs whose patents have expired.

2.1) Innovator companies:

These companies are at the top of the overall pharmaceutical industry. They spend a large amount of money on developing new drugs, getting their patents registered, selling successful drugs in the market and earning high profits on the sale of those successful drugs.

However, behind the financial performance showing high profits from selling successful drugs, these companies face a lot of challenges in delivering a consistent line-up of successful drugs. This is because; out of about 5,000 new drugs discovered by innovator companies, only one reaches the stage of commercial launch. And out of all the commercial launches, only about one-third of the drugs recover the money spent on their research & development (R&D) i.e. only 1 out of 15,000 discovered drugs turns out to be economically viable.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January 2009 (click here), page 16:

Drug manufacturing is a high-risk business: For every 5,000 compounds discovered, only one ever reaches the pharmacist’s shelf. The odds against making a profit are steep: Less than one-third of marketed drugs achieve enough commercial success to recoup their R&D investment.

An investor is able to appreciate such a low probability of economic success of new drugs when she notices that it may take up to $500 million (about ₹3,750 cr @₹75/$) to develop, test and commercialize a new drug.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, (click here), page 4:

pre-funding of R&D, selling and distribution expenses can easily total more than USD 500m over several years before the first sales for the new drug come in.

The requirements of high-cost innovator-R&D have led to such companies spending about 15%-20% of their revenue on R&D.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014 (click here), page 6:

R&D costs are substantial, typically 15% to 20% of revenues.

Moreover, the fact that the patent protection period, which grants the exclusive rights to the innovator company for selling the drug starts from the date the drug is discovered and not from the date on which it is launched in the market as a drug safe for consumption. Therefore, all the years used by the innovator company in studying and testing the drug are reduced from its patent protection period.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 4:

A patent’s life usually stretches over 20 years. It starts at a ‘raw’ molecule’s invention, not at the drug’s approval – i.e. after an average R&D period of about 10-12 years. Around half of the patent life is already used up before the drug becomes lucrative (provided it clears the regulatory approval hurdle).

Therefore, an investor would notice that almost half of the patent life for any drug is used up in its development. Thereafter, the company gets an exclusive period of about 10 years to recover its R&D costs and earn profits. The limitation of this period is an important consideration for pharmaceutical companies because the generic companies, which sell old patent-expired drugs are always attempting to launch their products at the earliest opportunity.

Once the generic drugs enter the market, the price of the innovator drug (i.e. patented drug) in the market declines by 85-90% i.e. reduces to 10-15% of the original price.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

As a rule of thumb, generic prices in the US for traditional pills get slashed to about 10%-15% of the former protected drug price

Within one year of the entry of generic drugs into the market, they capture about 95% of the market share by volume.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

When patent protection ends, generic drugs can capture 95% of prescription volume in the first year.

Moreover, the generic pharmaceutical companies do not always wait until the expiry of the patent of the innovator drugs. Under Para-IV, they apply to sell generic drugs even before the patent expires. An investor would notice that such applications for approval of generic drugs within the patent period lead to many litigations, which increases the costs of the innovator companies.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January 2009 (click here), page 16:

The increasingly competitive industry environment is leading to an epidemic of legal challenges to the validity of patents, especially from generics manufacturers seeking to broaden their markets. This means mounting legal expenses for the companies defending them.

Therefore, an investor would appreciate that the business model of innovator pharmaceutical companies contains high risk. In fact, at times, inefficient R&D had been one of the biggest problems faced by the innovator pharmaceutical companies, which even led them to reduce their R&D budgets.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January 2009, page 8:

Large, expensive, and inefficient research programs have been a major issue for Big Pharma. Many companies have undertaken radical restructuring and cost-cutting in R&D, but the increasing complexity and cost new discoveries in a slower sales growth environment mean R&D cost pressures remain a major issue.

In addition, nowadays, the focus of most of the innovator drug companies has shifted to finding new drugs based on antibodies (i.e. biological drugs), which is more difficult to create/discover than traditional chemical-based drugs. As a result, finding new drugs has become more difficult and costly.

Rating methodology for the pharmaceutical sector by the credit rating agency Rating and Investment Information, Inc., Japan, (click here), February 2022, page 2:

With a shift in therapeutic drugs from low-molecular compounds to those derived from antibodies that are more difficult to develop, success rates of drug development are on a downward trend. Development is taking longer and becoming even more costly.

Despite all these challenges in the business of developing new drugs, the innovator pharmaceutical companies spend a high amount of money on R&D because; if the new drug becomes successful (a blockbuster drug with sales of more than $1 billion per year), then the profits compensate for the R&D spending.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January 2009, page 16:

However, when a drug maker launches a new compound that receives patent protection and is widely accepted in the marketplace, the economic rewards can be immense. This is the primary reason for the industry’s hefty profit margins.

The probability of making very high profits if the drug under-development becomes successful has led to pharmaceutical companies paying very high prices to acquire potential drug candidates that show a high potential of becoming a blockbuster drug (more than $1 billion annual sales).

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 3:

A new motivation for M&A activity in the sector is emerging in the form of the high multiples paid for single pipeline asset companies in ‘hot’ areas such as immuno-oncology or rare diseases. One example is Gilead’s USD 11bn acquisition of Pharmasset Inc in 2011 for one hepatitis C molecule, which later became known as Sovaldi after approval.

In light of the above discussion, an investor would observe that the business model of innovator pharmaceutical companies involves very high R&D costs, which may extend to multiple thousands of crores rupees in the development phase. Even after that, only about 1 out of 15,000 drugs becomes financially viable. The companies do get exclusive sales rights under patent protection. However, almost half of the patent period gets used in drug development and once the period is over, generic drugs flood the market leading up to a 90% decline in the market price of the drug.

In light of this high risk, most of the Indian pharmaceutical companies have stayed away from investing a lot of money in new drug development. As a result, the Indian pharmaceutical market consists of about 97% of drug sales (by value) from generic drugs.

The market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, (click here) page 7:

The pharmaceutical market within India predominantly comprises generics, which account for around 97% of drug consumption in the country in terms of value.

In contrast, in the US markets, instead of generics, the patented-innovator drugs constitute about 90% of the value whereas they form only about 20% of the volume. Looking from another angle, the generic drugs in the US constitute about 80% of the volume but only 10% of the value.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

Consequently, generic companies generate only 10% of market sales with 80% of the total volume, illustrating the considerable price differential between innovative drugs and off-patent copies.

This is because, despite the presence of generics, many physicians and patients continue to prefer the branded drug.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, pages 5-6:

Even after a drug has faced generic competition for years, it may still enjoy price flexibility on the remaining volume used by patients (and prescribed by physicians) who continue to prefer the higher-priced branded drug.

This shows that even if a large part of the pharmaceutical market in the US is dominated by generics; still, most of the value/profits are earned by patented-innovator drugs. Such market dynamics continue to motivate the innovator pharmaceutical companies to keep spending money on R&D to discover new drugs.

Further advised reading: How to do Business Analysis of a Company

2.2) Generic drug companies:

Another segment of formulations manufacturing companies is generic drug companies, which focus on manufacturing patent-expired drugs.

An investor would appreciate that because these companies do not have to spend money on inventing new drugs and instead rely on producing already existing drugs; therefore, their R&D costs are very low when compared to innovator drugs. As a result, they are able to produce drugs at a very low cost, which is the main reason for generic drugs selling at a discount of up to 90% from the original innovator drug price.

Due to the lower cost of generic drugs, they find wide support from governments, politicians and other entities who wish to replace branded drugs in the market with generic drugs.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

Third-party (government and private) payors, political leaders, distributors, and retailers encourage the substitution of generics for branded drugs.

From the above discussion, an investor would notice that due to a lower ability to spend money on R&D for new drug development, the Indian pharmaceutical industry primarily comprises generic drug manufacturers. Almost all the Indian formulations manufacturing companies are generics manufacturers.

An investor would appreciate that all the generic drugs are merely copies of the patent-expired innovator drugs. Therefore, effectively all the generic drugs are supposed to be similar in their therapeutic effect on the body. As a result, all the generic drugs are effectively non-differentiable commodities.

The market study on the pharmaceutical sector in India by the Competition Commission of India (CCI), November 2021, page 7:

By definition, generics have active ingredients that are identical to the patented/originator drug and are low cost, functionally undifferentiated products, which make generic markets structurally highly competitive.

Therefore, until the time, the generic drugs are produced as per the approved manufacturing process, one generic copy of any innovator drug should be exactly similar to another generic copy of the same drug i.e. a generic Paracetamol 500mg tablet from all the companies should lead to equal levels of Paracetamol in the blood of the patients and should lead to a reduction in fever.

An investor would appreciate that if the products manufactured by the generic companies are functionally non-differentiable from each other, then in a fair market, the generics companies would end up competing on prices because; the customer can easily switch from the generic drug of one company to the generic copy of the same drug from another company.

An investor would also note that preparations of generic formulations are a comparatively low-technology activity as the formulations manager has to take the API/bulk drug and mix it with inert material (excipients), pack and sell it. Therefore, an investor would notice that the generic formulation business is low on technology and investments.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 7:

making formulations involves mere physical processes such as mixing, adding binders and packaging, with relatively small capital requirement.

The traditional generics business model does not involve spending on R&D or innovation. Instead, it was focused on fast execution to bring a generic version of the patent-expired drug as soon as possible and to distribute it as widely as possible, which is a typical characteristic of commodity, non-differentiable products.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

traditional generic business model, which previously did not involve innovation or R&D costs and relied exclusively on fast execution and distribution as key success factors.

As a result, the generics formulations industry has low barriers to entry.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 3:

Indian formulations industry is largely a branded generic industry with presence of a limited number of patented drugs, predominantly self-reimbursing in nature, low entry barriers and largely physician-influenced.

Globally also, various countries have deliberately kept entry barriers to generics low and they actively promote and encourage generic drugs because these reduce the overall healthcare cost of the society.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

Barriers to entry are still lower in the generic industry relative to innovative pharma because the initial pre-sale investment is not as high. In addition, generic market penetration has political support in most countries, as it greatly alleviates the burden of ever-increasing costs of healthcare and drugs in the context of tight state budgets.

Therefore, an investor would appreciate that the generics formulations business is fragmented and intensely competitive with many players producing the same generic drugs.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 4:

formulators may face high competitive intensity on account of relatively less fixed capital intensity

In such a situation, the generics players would end up in a price war leading to continuously declining profit margins as they do not have pricing power over their customers.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 11:

One of the most striking differences between innovative and generic pharmaceuticals is the latter’s lack of pricing power, which gives it much lower attainable operating margins.

On average, the generics companies have an EBITDA (earnings before interest, tax, depreciation and amortization) margin of about 10%-25% whereas the EBITDA margin of innovator pharmaceutical companies may reach 45%.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

Generic companies’ EBITDA margins usually range between 10% and 25% in mature markets. This contrasts with EBITDA margins for speciality pharma companies, which can be as high as 45%.

However, generic companies use many strategies for creating competitive advantages and earning higher profits. Let us discuss some such strategies.

2.2.1) Focus on complex drugs like biosimilars:

As the common generics drugs have high competition and low profit margins, the companies have started investments in making relatively high-technology products like complex generics and biosimilars, injectable, transdermal patches, extended-release drugs etc. These drugs are relatively difficult to make and therefore, offer higher profit margins.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

Furthermore, companies are also focusing on niche segments of biosimilar and specialty pharma segments, which have relatively lower competition and high profit margins.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 14:

ability to produce specialized or more complex products, such as injectable medicines, topical drugs, transdermal patches, extended release drugs, and biosimilars is a positive attribute, which diversifies its business.

As complex generic drugs like biosimilars are difficult to make, therefore, companies need to spend a lot of money on R&D.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

Generic forms of biological drugs (known as ‘biosimilars’ as they do not overlap 100% with the original) are more complex to make and require the company to invest in R&D before regulatory approval can be obtained.

As a result, many Indian formulation companies have started to invest money in R&D in order to develop biosimilars, which provide a higher profit margin than simple generic drugs.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, May 2015 (click here), page 4:

Many of the large Indian pharmaceutical companies are allocating substantial budgets towards biosimilars.

However, an investor should note that getting approvals for biosimilars is equally tough as getting approvals for any new drug because; in the development of biosimilars the formulation companies have to conduct all the development steps like clinical trials.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

For makers of generic biologic drugs (a.k.a. biosimilars), for which clinical trials are required, the costs, risks, and entry barriers are similar to those for makers of branded drugs.

In fact, the Competition Commission of India found that the term biosimilars is a misnomer because; the regulatory authorities effectively treat biosimilars as a new drug while assessing it for approval. As a result, only a few large players have been able to get approvals for biosimilars.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018 (click here), page 21:

The term “biosimilars” is a misnomer: most national regulatory authorities insist that competitors not only conduct Phase 1 and 2 trials, but also comparative studies in the final phase, before they receive final regulatory approval. Often, this dual requirement of treating each biological medicine from a non-originator source as a new drug, with the additional requirement of proving bio similarity, takes so much time and investment that barely a handful of companies compete with pharma giants thereby muting competition and resulting in monopoly prices.

In addition, in the development of biosimilars, generic formulation companies face tremendous resistance from the innovator (patent-holder) pharmaceutical companies.

The Competition Commission of India found that innovator (patent-holder) companies nowadays start creating obstructions at the generic development stage itself. Patent holding companies even refuse to provide samples to the generic companies to test bio-similarity and even file cases against the regulators if they grant approvals to biosimilars.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018, page 21:

Traditionally, the patent holders used to block generic companies after applying for regulatory approval. However, now the patent holders seek to block generics at the development stage itself. The innovators block access to pharmaceutical reference products for bioequivalence testing by not providing sample of their products, thereby delaying/denying generic entry. Innovators using distribution safety protocols impede generic/biosimilar drug development; and challenge the marketing approval granted by the drug regulatory authority to prevent biosimilar products.

For example, in India, Roche sued Biocon and Mylan to stop them from selling the biosimilar of Trastuzumab, its breast cancer medicine. In addition to filing a case against Biocon and Mylan, Roche also sued the regulatory authority. (Source: Beyond IP Protection: New Tactics Blocking Generic/Biosimilar Market Access: Biosimilar Development, September 21, 2017)

Among the multiple opportunities that innovator companies now use is challenging the decisions of the drug regulatory authority.  In India, Roche sued Biocon and Mylan to restrain them from selling their biosimilar of breast cancer medicine Trastuzumab.  Roche also challenged the drug regulator for approving the biosimilar.  It won, but lost on appeal through an interim order.  The parties have sued each other for contempt.  Subsequently, Biocon and Mylan claimed abuse of dominance by Roche before the competition authority.  The competition authority ruled prima facie abuse of dominant position and ordered an investigation. Roche has challenged the investigation order

Therefore, an investor would note that due to tough processes in getting approval from govt. authorities and simultaneous severe hurdles created by innovator companies, only a few companies are able to produce biosimilars. As a result, the biosimilar field has less competition and high profit margins.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 13:

Lastly, speciality manufacturing capabilities, such as for generic vaccines or biosimilars, are further positive rating drivers, as this field is much less competitive and offers higher potential margins than the traditional generic business

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

Apart from focusing on manufacturing complex generic drugs, companies attempt to become the first ones to get approval for their generic drugs in the US market.

2.2.2) Target exclusive-sales period for the first approved generic drug in the US:

In the US markets, the first generic drug that is approved gets an exclusive sales period of 6 months after the expiry of the patent of the innovator drug where other generic players are not allowed to sell their products in the US markets.

As a result, the first generic drug is able to sell at a much higher price than the price when all the generic drugs enter the market.

On average, after an entry of generic drugs, the prices decline to about 10%-15% of the innovator (patented) drug price; however, during the 6-month exclusivity period, the first approved generic drug can enjoy 3x-4x price i.e. 40%-50% of the innovator (patented) drug price.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 5:

in the US, where the first generic company to file is rewarded with a six-month exclusivity period that blocks other suppliers from the market…As a rule of thumb, generic prices in the US for traditional pills get slashed to about 10%-15% of the former protected drug price, while the first generic copy in the market can retain about 40%-50% of the initial level.

Therefore, if a company is able to become the first generic company to get approval, then it can earn substantially higher profits than its other peers.

However, soon after the end of the exclusivity period, the high-profit margins witness a steep decline.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 5:

In the past, some of the Indian pharma entities focused on filings that targeted marketing exclusivity resulting in significant jump in revenues and earnings in the years such products were launched followed by steep contraction as other players forayed resulting in steep pricing pressure.

Usually, the generic companies wait to launch their generic drugs until the patent expiry date of the original patented drug. However, at times, they even attempt to invalidate the patent of the innovator company and try to launch its generic drug before the expiry of the patent.

2.2.3) Try to launch generic drugs even before the patent expires; Para IV filings:

An investor would note that the incentive for the generic drug makers to give competition to the patented drug is so much that generic companies do not wait for the launch of their generic drugs until the patent expiry date. The generic drug companies do file for approval under Para IV, which allows them to launch generic drugs before the expiry of the patent.

An investor would appreciate that the patent holder innovator pharmaceutical company would fight hard to protect its exclusivity rights under the patent. As a result, the Para IV filings lead to a lot of litigation and costs for both, the generic and innovator drug companies.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 7:

The companies having ANDA filing under Para – IV are subject to significant litigation risk as they look to invalidate the innovator company’s existing patent before its expiration.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, 2007 (click here), page 5:

Para IV filings, which provide profitability, have been aggressively and successfully challenged by patent holders, resulting in large R&D and litigation losses for Indian companies.

One of the well-known incidents of the legal dispute under Para IV approval was the first-to-file approval received by the Indian company Ranbaxy against Pfizer’s multi-billion-dollar cholesterol-lowering drug Lipitor (generic name Atorvastatin). It led to a long battle between Ranbaxy and Pfizer in courts in multiple countries. (Source: Ranbaxy Contests Pfizer Mega Drug Patent In US: Financial Express, Aug 23 2003).

However, as per credit rating agency, ICRA, nowadays, the attractiveness of Para IV filings is declining for the generic formulations manufacturers.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, May 2015, page 4:

The attractiveness of Para IV filings however have reduced in recent years, on account of 1) authorised generics supported by innovators; 2) shared exclusivity between multiple players filing on the same day.

Nevertheless, while assessing companies applying for approvals under Para IV that are involved in litigations, an investor should try to estimate their contingent liabilities because outcomes of patent litigations are uncertain and any penalty on the company may have a material financial impact.

Now, let us see what steps generics companies take to improve their profit margins in the domestic market.

2.2.4) Launch of branded generics in the domestic market:

From the above discussion, an investor would note that if made by following good manufacturing practices, then all the generic copies of a patented drug are supposed to be equally effective i.e. a tablet of Paracetamol 500 mg is expected to lead to the same effect of reduction of fever for the patient irrespective of which generic copy of Paracetamol she takes.

In such a situation, it is expected that all the generic companies that are selling functionally similar and non-differentiable generic copies of the patented drug would lose their pricing power and end up competing on price resulting in lower profitability.

However, an investor notices that the generic pharmaceutical companies have introduced a new product class called “branded generic”. Under branded generics, pharmaceutical companies give a name, a “brand” to their generic drug e.g. Dolo is a famous brand name for the generic drug Paracetamol in India.

Now, generic drug manufacturers spend money on sales & marketing, and brand building in order to sell them at a higher price for better profit margins.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 3:

CARE Ratings looks favourably at companies having branded generic formulation as they command higher margins with better market positioning in particular therapeutic segments in light of low entry barriers.

An assessment of the marketing strategy of the branded-generic manufacturers would reveal to the investor that the companies tend to create a differentiation for their brand based on an impression that the “branded” generic drug is better in efficacy (i.e. the effect on the patient) than other generic drugs.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018 (click here), page 4:

branded generics are marketed and prescribed based on the perceived higher efficacy and therapeutic advantage associated with them.

CCI, in its study, found that branded generics companies had created a false notion of branded generics being better in quality because CCI found that the same branded generics companies produced multiple brands of the same generic drug at significantly different prices.

The market study on the pharmaceutical sector in India by the Competition Commission of India (CCI), November 2021, page 12:

companies offering a portfolio of different brands of the same formulation with identical dose and strength…In other mature markets, such as amoxicillin & clavulanic acid, a combination antibiotic, there are multiple instances of five to six brands being supplied by the same company for the same formulation of same dose and strength.

One company which manufactures amoxicillin + clavulanic acid (125/500 mg, tablet), prices of two brands marketed by it stood at Rs. 18.27 and Rs. 73.17

Moreover, the CCI also found that most of the generic formulation companies act only as marketing companies and outsource the drug manufacturing to third parties who accept orders for making the same drug for multiple companies. In addition, there have been instances where the same generic formulations company manufactures branded generic and unbranded-generic drugs at the same plant.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 19:

the trend of multiple brands of the same molecule being marketed by the same company at different price points runs counter to the proclaimed brand name-quality correlation. They added that brand names of generic drugs can hardly signal quality, as several prominent players who market these brands often get their products manufactured through third–party or contract manufacturing, and the same third-party manufacturer accepts orders from multiple pharma companies.

often, the same companies produce unbranded as well as branded versions of the same generic drugs at the same plant.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018, page 17:

it is not uncommon that the same company manufactures the same salt (pharmacopeial name of the drug) on the same production line but sells it under different brand names at different prices.

Therefore, in its studies, CCI has found that the generics formulation companies have created the “branded-generics” based on the artificial notion of superior drug quality.

Further advised reading: Why We cannot always Trust What Management Claims

As a result, the CCI study recommended the implementation of a “one-company-one drug-one brand name-one price policy” to curb the practice of generic companies creating an artificial differentiation in the otherwise non-differentiable generic drugs.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018, page 5:

This practice of creating artificial product differentiation for exploitation of consumers, needs to be addressed through a one-company-one drug-one brand name-one price policy.

Therefore, an investor may note that the govt. authorities have recognized that the artificial differentiation created by branded-generics formulation companies is one of the reasons for high healthcare costs in the country and the authorities are in continuous discussion to reduce the cost of medicines. Steps like “one-company-one drug-one brand name-one price policy”, if implemented, may be steps in this direction.

If an investor analyses the pharmaceutical markets of foreign countries that faced a similar situation of increased costs due to branded generics, then she comes across the example of Germany, which used to be a market dominated by branded generics. In order to reduce the cost of healthcare in the country, the German govt. implement reforms, which converted the German market from a branded-generics market to a tender-based market. This change led to a significant fall in the prices of medicines and as a result, the European operations of many companies became financially unviable (i.e. loss-making).

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 5:

for instance, German market that was a branded generic market turned into a tender based market with healthcare reforms being implemented) on account of budget constraints of healthcare payors resulted in significant pricing pressures. Thus, the European operations of many players became unviable.

To judge the impact of such reforms that led to the change in the nature of the market from branded-generics to tender-based, an investor may compare the price of drugs in the Indian retail market with the price at which the govt. procures drugs directly from the manufacturers.

In its market study, the CCI found that the cholesterol-lowering drug, Atorvastatin, was procured by the govt. agency from the manufacturers at ₹0.21 whereas the manufacturer was selling it to the stockists at ₹3.43 and the drug was selling in the market at a price of ₹5.1.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 16:

Atorvastatin (10 mg tablet), a cholesterol–reducing agent, is procured by the procurement agency at Rs. 0.21 (21 paise) while the same is sold at Rs. 5.1 in the private retail segment…The manufacturer sells this product to stockists at a mean price of Rs. 3.43.

Therefore, an investor would note that if the govt in India brings in health reforms like Germany and moves forward to break the artificial differentiation created by branded generics in otherwise non-differentiable generic drugs, then the prices of generic drugs may decline by even more than 90%.

The same thing happened in Germany when the business of many branded generic sellers became financially unviable and loss-making.

Even in a country like the US, generic drugs primarily compete on price and the prices keep on declining as more and more competitors enter the market.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 6:

Generic drug producers typically have significantly lower margins than producers of branded drugs because generics, to a large degree, compete on price. Generic prices and margins follow a pattern that echoes the experience for branded drugs. Prices and margins fall as more competitors enter the market.

Therefore, an investor would appreciate that the Indian generic drugs market has been made inefficient by the artificial differentiation of generic drugs by “branded-generics” by the formulation companies. Moreover, the govt. has acknowledged that such a practice by the formulation companies is leading to higher healthcare costs for the country.

The credit rating agency, ICRA in its rating guidelines for the pharmaceutical sector in July 2020, page 2, highlighted this risk prominently.

Government focus on driving generic prescription through policy change may entail change in business model for domestic formulation companies.

An investor should always keep this aspect in her mind when she starts to project the current profit margins of branded generic players in India.

Apart from launching branded generics, companies use the peculiarities of the pharmaceutical trade channel to gain a higher market share for their drugs despite keeping their drug prices high.

2.2.5) High incentives to the supply chain/trade channel:

From the above discussion, an investor would note that generic formulation companies are able to charge a higher price for their branded generic drugs by creating an artificial differentiation based on brand names despite the ingredients being non-differentiable generic drugs. Such kind of artificial differentiation is possible because the end-consumer, the patient is not educated enough to make an informed decision about the product that she should buy.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 16:

As consumers are not in a position to make an informed choice and the quality/efficacy of drugs is intrinsically unobservable, they follow doctors’ brand prescriptions, which are often influenced by aggressive brand promotion by pharmaceutical companies.

Generic pharmaceutical companies have exploited the unawareness of the end-consumer by providing a higher incentive to the retailer and to the prescribing doctors so that the sales of their branded generic drugs increase despite the contents being non-differentiable generic chemicals.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 30:

High retail margins are set by manufacturers as financial incentives for chemists to stock and dispense their brands in the presence of multiple branded generic drugs available in the market for each molecule. Given their space constraint and/or the need to minimise cost, retailers/chemists cannot typically stock all brands available for a formulation. They have an interest in stocking brands that offer them the highest margins. For non-scheduled drugs outside the scope of price regulation, high retail margins can simply be ensured through higher MRPs. Thus, competition between manufacturers on retail margins does not imply competitive prices for consumers. Rather, this creates a systemic upward pricing pressure, eroding the benefits of generic competition

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 31:

The doctor-run pharmacies, on the other hand, reportedly dispense brands prescribed by the owner-doctors, which too, entail higher retail margins. Thus, in these set ups, high margins create perverse incentives that influence prescription patterns as well.

As a result of aggressive sales & marketing of branded generics by formulation companies, the generics formulation industry has created artificial differentiation in its products. This is despite the generic drugs being simply a copy of the innovator patent-expired drug.

Ideally, in an industry producing non-differentiable, commodity products, the manufacturers should compete on price leading to lower profit margins. However, CCI found that due to the artificial differentiation created by branded generics, in India, the highest-priced branded generic drug has been observed to have the highest market share.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 31:

As evidenced by the formulation-level data on prices and market shares, market leadership position is often enjoyed by brands that command the highest or relatively higher prices. On the other hand, the lowest-selling brands are often the lowest-priced.

CCI noted that the reason high-priced drugs sustain a high market share is due to financial incentives to the chemists that influence sales of drugs.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 45:

As mentioned earlier, setting high margins does not necessitate lowering of the manufacturers’ price, as it may be done by increasing the final price of the product. Such increases in retail prices do not lead to erosion of market share and rather, help increase share in the retail market by incentivising retail sale. This competitive tool focused on chemists is palpably not aligned with consumer interest.

In addition, CCI also observed that the high incentives given by the generic pharmaceutical companies to the trade channel are the reason for the high drug prices in India.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018, page 4:

One major factor that contributes to high drug prices in India is the unreasonably high trade margins.

In order to bring down the healthcare cost in India, the govt. has started to acknowledge the need to control the high trade margins. In this direction, it has implemented two steps to control the trade margins.

First, for the drugs under the Drugs Price Control Order (DPCO), the trade margin is fixed at 24%, which includes 16% for the retailer and 8% for wholesalers.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 28:

In India, scheduled drugs (under Drugs Price Control Order, DPCO) attract a statutory trade margin of 24% – 16% for retailers and 8% for wholesalers.

However, for the remaining drugs, which are outside DPCO, the generic pharmaceutical companies used to give a very high trade margin to the extent of 37%.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 29:

The median wholesale margin and retail margin were estimated to be around 9% and 28% of customer price respectively,

As a result, as the second measure to control the trade margin and thereby the cost of healthcare, the govt. has put up a reduced limit on the maximum trade margin for a few anti-cancer drugs. The govt. has implemented it as a trial case before it extends the trade margin caps to other drug categories.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 32:

In 2019, the National Pharmaceutical Pricing Authority (NPPA), India’s drug price regulator, invoked Para 19 of the Drugs Prices Control Order, 2013 to rationalise trade margins in select anti-cancer drugs… Under this price capping mechanism, trade margin was restricted to a maximum of 30%. This exercise of trade margin capping on oncology medicines was undertaken as a pilot for ‘Proof of Concept’ before further extension into other therapeutic segments.

Therefore, an investor may note that the govt. has been trying to reduce healthcare costs by limiting trade margins. As a result, going ahead, giving higher trade margins may not remain a sustainable strategy for branded generic formulation players. An investor needs to keep this aspect in her mind before she analyses generic formulation companies.

Let us now understand the business dynamics of another emerging segment of the pharmaceutical industry, CRAMS.

3) Contract research and manufacturing services (CRAMS):

CRAMS, CMO (contract manufacturing organisations), and CRO (contract research organizations) players act as outsourcing parties mainly for innovator drug companies. CMOs manufacture formulations (finished drugs), which are then sold by the innovator drug companies in different markets. CROs act as outsourcing points mainly for innovator drug companies who outsource research work in drug development including clinical trials to CROs to lower their cost of drug development.

In recent years, Indian pharmaceutical companies have been getting a lot of outsourcing in contract research and manufacturing field due to lower costs of production.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 3:

India is emerging as a major destination for CRAMS, driven by strong chemistry capabilities, skilled manpower, cost value proposition with low R&D cost and large patient population providing a diverse pool for clinical trials for New Chemical Entities (NCE).

The CRAMS players do not own any technology as the technology to manufacture drugs is provided by the innovator drug company. As a result, the key requirement from the CRAMS player is to put in investment in the manufacturing plant or clinical research setup.

As a result, the CRAMS field has low entry barriers and the market is fragmented, which leads to intense price-based competition among contract manufacturers.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 3:

the domestic CRAMS market remains fragmented.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 11:

CMOs generally have limited competitive advantages because the market is extremely fragmented, highly competitive, and price-sensitive. These market dynamics give much more bargaining power to pharmaceutical companies that outsource manufacturing relative to the contract manufacturers.

As the business of a contract manufacturer is capital intensive with low barriers to entry; therefore, generally, the CMO players have very low negotiating power over their customers and suffer from low profit margins.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 6:

CMOs generally lack pricing power, which contributes to their relatively low profit margins. Pharmaceutical company customers often have two CMO sources and have considerable power in negotiating contracts with CMOs. The CMO business is also fairly capital-intensive, which can hurt profit margins when revenues dip.

For any CRAMS player, winning a customer is a very tedious task as every customer performs a variety of checks on the CRAMS player before it shares its drug manufacturing technology with it. As a result, CRAMS players usually end up working with only a handful of customers resulting in customer concentration who bear a high negotiating power over them.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 5:

Customer diversification remains a challenge given the long lead time associated (on account of process validation, technology transfer and site audits by pharmaceutical marketing entities) for business awards.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 14:

CMO:…these companies are especially exposed to risks of customer and product concentration. A customer could cancel production of a product and select a different CMO for the next-generation product, or choose to manufacture it in-house.

An investor may note that in the CRAMS industry, due to the absence of own technology, lack of pricing power, and intense competition in a fragmented industry leads to low profitability. Therefore, CRAMS players focus on multiple strategies in order to improve their profitability and bring in competitive advantages.

Let us discuss these strategies.

3.1) Become large-sized players – economies of scale:

Due to the near commoditised nature of CRAMS services with very low pricing power, only the lowest-cost CRAMS players perform well in the market. As a result, similar to API manufacturers who also face the same challenges, CRAMS players also focus on growing large, benefiting from economies of scale and deriving other benefits.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 4:

for players engaged in CRAMS particularly, large scale enhances their ability to offer different product extensions / delivery systems and supports faster product filings on account of regulatory expertise.

In addition, if CRAMS players develop capabilities to serve their customers in multiple countries/geographies, then the customers prefer dealing with only a handful of contract manufacturers. Therefore, a large size with a presence in multiple geographies acts as a competitive advantage for CRAMS players.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

increasingly prefer fewer CMO vendors and they seek vendors that can provide a wide range of services in multiple geographic markets.

Apart from becoming a large player for any product they manufacture, CRAMS players also try to manufacture as many products as they can i.e. expand their product portfolio within their resource constraints.

3.2) Expand the product range:

CRAMS players who offer multiple products to their customers allow them the benefit of dealing only with a few CRAMS players for their needs.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, pages 4-5:

CRAMS players (contract manufacturers) with reasonably diversified product portfolio across growing therapeutic segments, delivery systems…ability to offer products across dosage forms (solids, liquids, injectables, creams, gels, ointments) and ability to launch new products/ combinations/ dosages are also critical.

Further advised reading: How to analyse New Companies in Unknown Industries?

Let us now discuss the key segment of the pharmaceutical industry, its distribution channel, which many times stays oblivious despite playing a very important role in the overall impact of the pharmaceutical industry in healthcare.

4) Pharmaceutical distribution companies:

In recent times, many corporates have entered retail distribution of drugs like Apollo Pharmacies. In addition, there are many companies that have entered the field of online pharmacies like 1mg, Pharmeasy, Netmeds etc.

In light of the same, it becomes important for the investor to understand the dynamics of companies making up the pharmaceutical supply chain.

From the above discussion, an investor would remember that the pharmaceutical distribution chain plays an important part in the sales and marketing strategy of branded generic drug manufacturers. This is because; such companies tend to offer a high retail margin to the chemists who then push these products to the patients.

For drugs outside DPCO, the generic pharmaceutical companies give a very high trade margin to the extent of 37%.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 29:

The median wholesale margin and retail margin were estimated to be around 9% and 28% of customer price respectively,

As a result of these high retail margins, many corporates have entered the pharmaceutical distribution; both offline and online.

Online pharmacies tend to source the drugs directly from the manufacturers or C&F agents representing them and in turn, cut down on the supply chain. In this way, they are able to save on the margins of multiple distributors, which they pass on to the customers in terms of discounts.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 35:

online pharmacies integrate their warehousing functions with carry and forwarding agents, who are the immediate front line for drug companies. The stocks that online pharma companies procure from manufacturers are delivered to consumers directly. The advantage of this model is a truncated supply chain with fewer intermediaries, allowing for higher margin and higher consumer discounts.

Let us now try to understand how pharmaceutical distribution companies are able to get high trade margins from drug manufacturers.

4.1) Anti-competitive practices of pharmaceutical distribution companies:

As per CCI, it has received multiple complaints (about 43) in the past against pharmaceutical distribution companies and their association for anti-competitive practices where after investigation, it found evidence of wrong-doing where the existing associations played the role of gate-keepers in the supply and thereby blocking the competition.

As a result, CCI has ordered them to stay away from anti-competitive practices like mandatory NOC from the associations for the appointment of stockists by drug manufacturers, collective determination of trade margin and control by the associations over discounts offered at wholesale and retail levels of sale.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 26:

With the purported goal of self-regulation, the apex association and its local affiliates were found to essentially play a gatekeeper role at various levels of the distribution chain, making pharmaceutical markets impervious to the incentives of competition.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018, page 13:

Self-regulation and lack of competition in the distribution and retail of drugs are major reasons why drugs are sold at printed prices, which are many times more than the manufacturers’ prices

In addition, an investor would also remember that the high retail margins to the chemists do not come at the cost of profit margins for the manufacturers because the drug manufacturers increase the maximum retail price (MRP) of the drugs. This nature of the arrangement of the supply chain in the pharmaceutical industry has led to a situation where high-priced drugs get sold the most by the sales channel and in turn, they get the highest market share.

Effectively, CCI stated that the current arrangement of pharmaceutical distribution channels is not aligned with the best interests of the customers/patients.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 45:

setting high margins does not necessitate lowering of the manufacturers’ price, as it may be done by increasing the final price of the product. Such increases in retail prices do not lead to erosion of market share and rather, help increase share in the retail market by incentivising retail sale. This competitive tool focused on chemists is palpably not aligned with consumer interest.

The govt has acknowledged that unreasonably high trade margins in the pharmaceutical sector are one of the key reasons for the high healthcare costs in the country. As a result, the govt. has started taking steps to control the margins of the distribution companies.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 32:

In 2019, the National Pharmaceutical Pricing Authority (NPPA), India’s drug price regulator, invoked Para 19 of the Drugs Prices Control Order, 2013 to rationalise trade margins in select anti-cancer drugs… Under this price capping mechanism, trade margin was restricted to a maximum of 30%. This exercise of trade margin capping on oncology medicines was undertaken as a pilot for ‘Proof of Concept’ before further extension into other therapeutic segments.

Moreover, when CCI studied 27 OECD (Organisation for Economic Co-operation and Development) countries, then it found out that all of these countries controlled the pharmacy margins.

Market study on the pharmaceutical sector in India by Competition Commission of India (CCI), November 2021, page 45:

study of 27 OECD nations suggested that all of them regulated pharmacy margins

Therefore, an investor may note that the govt. has been trying to reduce healthcare costs by limiting trade margins of pharmaceutical distribution companies. As a result, she should keep this aspect in her mind while analysing pharma distribution companies and while projecting their profit margins in the future.

To read more about an industry where the govt. has put heavy penalties for anticompetitive practices, an investor may read our article on the business analysis of cement companies: How to do Business Analysis of Cement Companies

Let us now try to understand the fate of pharmaceutical distribution companies in developed countries to assess whether the current scheme of things in the drug distribution channels in India is sustainable.

4.2) Consolidation in the pharmaceutical distribution companies in the foreign markets:

While analysing the fate of pharmaceutical distribution companies in overseas countries, an investor notices that the low profit margins of the trade channel have led to a consolidation in the supply chain in many countries.

In the case of Japan, the pharmaceutical distribution companies underwent consolidation and as a result, only four wholesale companies were left in Japan.

Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011 (click here), page 1:

With a significant market reorganization since the late 1990s in a bid to offset falling margins with cost cutting, there are now just four pharmaceutical wholesalers.

As a result of consolidation, the competition among Japanese pharmaceutical wholesalers has become very severe and there is price-based competition.

Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011, page 2:

Competition among the four integrated groups of pharmaceutical wholesalers is severe. When pharmaceutical wholesalers were the group companies of pharmaceutical manufacturers, their product lineups were weighted in favor of certain products. Following industry reorganization, however, each group now handles almost a full range of products of pharmaceutical companies. These changes also meant that, because pharmaceutical wholesalers cannot differentiate themselves from their competitors in terms of their product lineups, they often engage in price competition.

The Japanese wholesaler group have witnessed the prospective returns from their core business decline to such an extent that they are forced to venture into other business areas like drug manufacturing.

Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011, page 6:

Pharmaceutical wholesaler groups are expanding into the pharmaceutical manufacturing business and dispensing pharmacies operations. As a result of a peaking of the recent industry reorganization, the growth potential of the core businesses has, in fact, been falling.

The consolidation of the supply chain is not limited to Japan. Globally, in multiple countries, the pharmaceutical trade channel witnessed consolidation in order to improve their profit margins.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 7:

in the prominent developed markets, it is witnessed that the consolidation of supply chain in the hands of few large distributors also puts pressure on product pricing.

Even in the US market, the pharmaceutical distribution business underwent significant consolidation during FY2017-FY2019 to improve the bargaining power of the trade channel. It led to significant pricing pressure on the formulation companies.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 5:

Indian pharmaceutical entities with presence in largest generic markets of USA faced steep pricing pressure during FY2017-2019 period owing to supply chain consolidation

Therefore, an investor would appreciate that in many developed markets, the pharmaceutical supply chain companies earn much lower margins than what they earn in India. As a result, to improve their bargaining power, they undergo consolidation. However, despite consolidation, in Japan, the wholesalers are not able to earn a high return due to which they have to enter into businesses like pharmaceutical manufacturing etc.

As a result, while analysing pharmaceutical distribution companies, an investor should keep in her mind that as a business, the supply chain globally does not earn a high margin. As per CCI, the high trade margins in the Indian pharma supply chain are due to anti-competitive practices, which are now under the scrutiny of the govt.

Therefore, the pharmaceutical distribution companies in India might witness a decline in their trade margins. Going ahead, an investor should keep a close watch on the same.

With the above overview of pharmaceutical companies, let us now understand the key characteristics of the pharmaceutical business and the factors affecting the companies.

Key factors influencing the business performance of pharmaceutical companies

1) The pharmaceutical industry is less impacted by general economic cycles:

An investor would appreciate that the demand for drugs arises from the prevalence of sickness. Illnesses do not depend upon the state of economic cycles. If a person gets sick, then in all probability, she would go to a doctor/pharmacist and get drugs for health improvement. Therefore, the financial performance of pharmaceutical companies is relatively less dependent on the boom & bust phases of the general economic cycle.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 1:

pharmaceutical industry is considered as one of the defensive sectors, largely immune to the economic cycle.

Rating methodology of the pharmaceutical sector by the credit rating agency, Rating and Investment Information, Inc., Japan, page 2:

pharmaceuticals are products related to health and human lives, and demand is fundamentally unaffected by the economic ups and downs.

If an investor thinks deeper, then she may find a little correlation of demand for pharmaceutical products with the economic cycles in countries where insurance penetration is high and most of the healthcare expenses are paid by employers’ group health insurance plans. In such situations, during economic declines, there are job losses and people lose the coverage of health insurance. Such situations may lead to a decline in healthcare expenditure during economic declines.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 4:

In the U.S., demand can be slightly sensitive to the employment rate, in part, because lack of a job may mean lack of drug insurance for people of working age and their children…Patients may defer routine check-ups (where drugs are prescribed), ration drugs, or seek lower-cost therapies for economic reasons.

However, despite the above slight correlation, the cyclicity of the pharmaceutical industry’s revenue and profit margins has been very low.

As per credit rating agency, Standard and Poor’s, the average decline in the revenue of pharmaceutical companies from 1952 to 2014 had been 0.2%. The decline in revenue in the 2007-2009 global recession was only 0.4%. Moreover, the average decline in profit (EBITDA) margin of pharmaceutical companies from 1952 to 2014 was 4.0%. During the 2007-2009 global recession, the decline in EBITDA margin was 1.8%.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 4:

Historical data supports this view, showing very low cyclicality of revenues and low cyclicality of profitability, which are the two key measures used to derive an industry’s cyclicality assessment. Based on our analysis of global Compustat data, pharmaceutical companies experienced an average peak-to-trough (PTT) decline in revenues of only 0.2% during recessionary periods since 1952, and a PTT decline of 0.4% during the severe 2007-2009 recession. The EBITDA margin of pharmaceutical companies experienced an average PTT decline of 4.0%, and a modest decline of 1.8% in the 2007-2009 recession.

Therefore, an investor would notice that the performance of the pharmaceutical industry is less linked to the phases of general economic cycles. Instead, the variations in the performance of pharmaceutical companies are more linked to their own business performance like the life-cycle stage of its drugs, new drug launches and their success etc.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 4:

Volatility in a pharmaceutical company’s revenues and profitability is more likely to reflect its own new product launches and the market entrance of competing products, rather than broad macroeconomic conditions.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 4:

The pharmaceutical industry is not cyclical in a macroeconomic, short-term context. If anything, it is exposed to longer-term cyclicality which can result from a drug’s life patterns or patent expiry.

Therefore, an investor may keep in her mind that as an industry, the demand for the products of the pharmaceutical industry does not change much with the boom and bust phases of the general economic cycle because it is dependent on the health needs and prevalence of sickness.

2) Very high regulatory risk:

An investor would appreciate that the products of the pharmaceutical industry have a direct impact on human health. As a result, the industry is one of the most regulated across all the countries irrespective of developed or developing countries.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 3:

highly regulated worldwide, by virtue of its direct bearing on public health.

The regulations require the company to meet strict manufacturing and process standards, which impose significant costs on the companies.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

compliance with ‘current good manufacturing practices’ requires higher capital and R&D investments,

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 6:

Upgrading and maintaining a manufacturing facility that meets the standards of the regulated markets call for significant financial commitments.

If companies are not able to meet strict regulatory standards, then the cost of re-inspections for approval and the loss of business in the interim can lead to significant costs for the companies.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 6:

Since the legal cost of any such litigation and the time for re-inspection are high, the revenue and profitability of the companies may be impacted; hence, trigger of such regulatory-concerned events are critical from the credit perspective

Moreover, in recent times, even the most reputed Indian and global pharmaceutical companies have received notices of non-compliance by regulators indicating that the countries are going for very strict implementation of regulations.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 6:

With the heightened scrutiny levels and stringent product quality standards evident from imposition of warning letters/ import alerts by USFDA even for reputed Indian as well as global generic entities, maintaining manufacturing standards has become critical for players with sizeable exposure to the US and Europe

In the recent past, an increase in the strictness of regulations in China had a significant impact on the pharmaceutical sector in China as well as overseas markets like India.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2019 (click here), page 8:

Recent changes in environment rules in China have led to disruption in production in China and in turn increased the cost of raw material for Indian pharma companies.

Apart from the requirement of meeting strict regulatory guidelines, pharmaceutical companies also face risks of existing good-selling drugs and combinations coming under regulatory scrutiny, which may have a significant impact on their sales. In 2016, India banned many drug combinations, which impacted the business of pharma companies.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 4:

In 2016, the union health ministry banned 344 fixed-dose combination (FDC) drugs (including several antibiotics and analgesics) on the recommendations of an expert committee as these were allegedly irrational combinations.

3) Continuous pricing pressure on pharmaceutical products across the world:

An investor would appreciate that pharmaceutical products form one of the major portions of the healthcare costs. As a result, countries across the world attempt to control the prices of drugs either directly or indirectly so that the burden of healthcare costs on the govt. and the population can be reduced.

In countries like India, the govt. controls the price of essential drugs directly by way of the Drug Price Control Order (DPCO), which is implemented by the National Pharmaceutical Pricing Authority (NPPA). In India, by 2017, almost 20% of all pharmaceutical sales were under price control.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 4:

Subsequent revisions added more drugs to this list, and brought nearly a fifth of the pharmaceutical market by value, under price control by fiscal 2017.

Therefore, while analysing any pharmaceutical company, an investor should try to find out how much of its revenue is from the drugs under the price control list because; it puts limitations on its pricing power.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 7:

CARE Ratings analyses the company’s revenue and the percentage share of revenue it derives from NLEM products which restricts its pricing flexibility.

Nevertheless, in India, apart from the list of drugs directly under price control, for other drugs also, the pharmaceutical companies have limits on how much price increase can be implemented.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 2:

As for pricing controls…in the form of price cap on essential drugs…as well as maximum permissible annual price increases (price control) on rest of the portfolio.

An investor would note that the price controls are not only limited to India or other emerging economies. Almost all developed countries implement price controls on pharmaceutical products in one form or another.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 3:

All developed countries have been focusing on driving generic prices down through various price control measures such as faster approvals or compulsory price cuts or tendering system among others. This has led to high competitive intensity with downward pressure on prices

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 7:

The phenomena to bring down the prices of generics formulations through various price control measure is also observed in the developed markets

We noticed in our previous discussion how Germany made the business of many pharmaceutical companies unviable when it converted its market from branded-generics to tender-based. Similarly, other European countries also implement price controls.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

The European region also has policies on direct or indirect price control that vary across countries

In countries like Japan, the govt. directly controls the prices of drugs and revises them downwards every two years. This downward pressure on drug prices has made the Japanese market unattractive for its own pharmaceutical companies, which are now looking overseas for growth opportunities.

Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011, page 1:

Prices of pharmaceuticals (drug prices) are official prices that are set by the government and that are, in principle, revised once every two years…As the government aims to cut drug costs… the growth of the domestic pharmaceutical market has been sluggish. In response, pharmaceutical companies have been focusing on developing operations in overseas markets,

However, an investor gets to know that the price controls on pharmaceutical products are the least in the US.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

drug price controls exist in nearly all countries except the U.S.

Therefore, it does not come as a surprise when an investor notices that almost all companies across the world attempt to sell drugs in the US irrespective of their country of origin.

Let us now discuss another key characteristic of pharma companies, which is research & development (R&D) and the role it plays in their business model.

4) Focus on R&D, new drug development, and complex generics:

From the above-detailed discussion on understanding different segments of the pharmaceutical industry, an investor would appreciate that research and development (R&D) play an important role in determining the competitive advantage of all the pharmaceutical companies whether they are innovator companies, generics, API or CRAMS players.

4.1) In the case of innovator companies, the focus of R&D is to develop new drugs that may become blockbuster drugs (more than $1 billion annual sales) or find new delivery mechanisms of existing drugs like insulin delivery via nose instead of injections.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 5:

At the apex of the R&D pyramid is research pertaining to New Chemical Entity (NCE) and NDDS Novel Drug Delivery System (NDDS). This involves development of a novel drug which is a likely candidate for being granted a patent and becoming a blockbuster drug. This also may entail development of a novel delivery system for an existing drug.

Innovator companies, largely based in developed countries spend about 15%-20% of their revenue on R&D.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 6:

R&D costs are substantial, typically 15% to 20% of revenues.

The very high spending in R&D, as well as clinical trials and registrations in multiple countries needed for new drug development, creates entry barriers for new players and in turn, puts innovator companies in a position of significant competitive advantage.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 4:

These high costs protect the industry by creating relatively high, de facto entry barriers: pre-funding of R&D, selling and distribution expenses can easily total more than USD 500m over several years before the first sales for the new drug come in.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

A new branded drug must be approved by regulators in each country. Its efficacy and safety must be demonstrated in extensive clinical trials. The costly and time-consuming approval process, combined with patent protection, forms a major barrier to entry.

An investor would appreciate that for the innovator pharmaceutical companies, high R&D expense provides competitive advantages. However, the R&D expense apart from being the highest expense becomes a necessary expense. This is because an innovator drug company cannot reduce the R&D expenses for short-term profits without a significant decline in its competitive position.

Rating methodology of the pharmaceutical sector by the credit rating agency, Rating and Investment Information, Inc., Japan, page 4:

Cost structure: For a branded drug manufacturer, R&D spending is the largest expense category…Such outlays provide the lifeline for maintaining and enhancing competitiveness, and a company cannot significantly reduce R&D spending in order to gain short-term profits. The cost structure of branded drug manufacturers lacks flexibility.

4.2) In contrast, other companies like generics, API and CRAMS players do not have the financial strength to spend on R&D expenses needed for new drug development. However, these companies operate in business segments that make commoditised, non-differentiable products leading to intense price-based competition.

As a result, to avoid price-based competition and resulting low-profit margins, these companies focus on complex generics e.g. biosimilars, which are difficult to make and have lower competition. However, the development of complex generics like biosimilars requires spending money on R&D.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

Furthermore, companies are also focusing on niche segments of biosimilar and specialty pharma segments, which have relatively lower competition and high profit margins.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

Factors affecting market position for bulk drug manufacturers: According to CRISIL Ratings…presence of molecules that are complex to manufacture significantly mitigate competitive pressures and support performance in terms of sales growth and profitability.

Similarly, the API and CRAMS players also have to continuously spend money on R&D primarily for their process and operating efficiency improvements.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 6:

API entities R&D efforts is focused in the areas of new products for renewing product portfolio and introduce derivatives with market potential as well as improve process efficiencies to become more competitive as the products mature.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 5:

For companies offering CRAMS, R&D is focused on process research, synthetic chemistry and other services that they offer to global pharma companies for partnering them for early stage drug discovery and developments

Further advised reading: Operating Performance Analysis: A Simple & Complete Guide

As a result, an investor would notice that Indian pharmaceutical companies are also spending a significant amount of their revenue on R&D even though it is still lower than the money spent by innovator drug companies on R&D.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 5:

Generally, mid to large-sized pharmaceutical companies in India spend nearly 6%-9% of their annual sales towards R&D activities

Since the change of patent regime from earlier process-based patents to current product-based patents, some Indian companies have also started to invest in R&D for new drug development (NCE: new chemical entity). However, from the above discussion, an investor would remember that developing new drugs is an extremely expensive proposition where a company may have to spend up to $500 million (about ₹3,750 cr @₹75/$) before the drug can make any sales.

As a result, most of the Indian companies focusing on new drug development only participate in a part of the overall drug discovery process. They develop the molecule to a certain stage and then sell it to other innovator companies who develop it further and then take it to the market.

Due to such collaborative research, the financial risk of new drug development gets distributed across many firms.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 5:

Since new drug development activity is characterised by huge cost and low success rates, it is generally not feasible for a single company to take a molecule from the lab to market. Hence, it considers exploring for partners to do so by out-licensing a molecule after a certain stage of development to another company which takes up further development of the drug and eventually to the market. This arrangement helps the companies to mitigate the risk to certain extent.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 6:

While most Indian entities lack the balance sheet size to carry on NCE research, some of the entities have been somewhat successful in NCE research, adopting early monetization route for its investments by out-licensing or milestone based payments based on research outcomes

Collaboration with other companies to reduce the risks associated with new drug development has ensured that it is not only Indian companies who collaborate with other innovator companies. Instead, the big pharmaceutical companies of developed countries also actively look for collaborating with capable companies from emerging markets.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 5:

The costs and specialized skills needed for late-stage development encourage market entrants to seek established partners, rather than try to compete with them.

For example, the Japan Credit Rating Agency highlighted that Japanese pharmaceutical companies actively look towards acquiring new drug chemicals, which are under development and have the potential to become successful drugs.

Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011, page 3:

Often, pharmaceutical companies will acquire candidate chemical compounds externally to strengthen their drug pipelines. In these cases, the companies usually make initial lump-sum payments and milestone payments in accordance with the stage of development.

Apart from developing new drugs for formulation companies and new processes for bulk drug & CRAMS companies, R&D also helps in overcoming another key factor impacting the revenue and profitability of drug companies, the lifecycle of drugs.

5) Lifecycle of drugs:

An investor would appreciate that any new drug follows a typical lifecycle.

In the first stage, it is introduced in the market as a novel/innovator drug where the patent-holder company has exclusive rights to sell it at a price appropriate to recover its R&D costs and earn profits.

In the second stage, the patent expires and generic drugs enter the market capturing almost 90% of sales volume and leading to about 85%-90% decline in the drug’s price.

In the later stages, the innovator pharmaceutical companies develop drugs, which are a better alternative to the old drug and we witness a decline in the demand and profitability of the old drug, which slowly leads to its natural death.

While analysing any pharmaceutical company, it is essential to determine at the stages of the drug lifecycle where its products are.

Usually, any generics or API player, who manufactures products early in their lifecycle would be able to earn a higher profit than the players who manufacture matured/late-stage products.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 7:

For APIs and generics, profitability is also influenced by the particular stage a product has reached in its lifecycle (mature, commoditised products usually offer low margins) and the time of its market entry (early entry often yields a relatively large market share and hence higher margins).

Usually, the comparison of the annual volume as well as the value growth rate of the pharmaceutical products of any company gives an idea to the investors about the stage of the drug lifecycle of its products.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 3:

CARE Ratings also analyses the year-on-year growth rate of existing products in terms of value as well as volume which indicates the product’s life cycle.

An investor would appreciate that the stage of the lifecycle of any drug plays an important role in the profits that its manufacturers would make. Therefore, to make good profits sustainably, every company, be it an innovator pharmaceutical company or generics/API/CRAMS player, needs to continuously work on generating a pipeline of drugs at different stages of the product lifecycle.

To manage the drug lifecycle risk, the innovator companies continuously work on new drug candidates at different stages of development. In addition, they continuously work to extend the life of product patents by developing derivatives as well as new dosage forms of the existing drugs nearing patent expiry.

Rating methodology for pharmaceutical sector by Japan Credit Rating Agency, December 2011, page 5:

The basic strategies for companies mainly specializing in original drugs to compete with generic drugs are…to carry out appropriate lifecycle management (the extension of product lives mainly by adding new efficacy and improving dosage forms).

In the case of generics companies, in order to have a continuous pipeline, they start targeting innovator drugs whose patents are going to expire many years (7-8 years) down the line.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 6:

To develop a healthy pipeline of drugs, entities need to draw up their R&D investments well into the future, targeting products with patent expiry of upto 7-8 years into the future.

To assess the effectiveness of the product pipeline of any generics company, an investor may have to assess various regulatory filings done by it in different countries.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, December 2017 (click here), page 6:

A proxy for the product pipeline can be represented by regulatory filings (DMFs, ANDAs, NDAs, marketing authorisation applications, certificate of suitability of the European Pharmacopoeia or CEP, etc). Assessing the diversity of the pipeline (nature of filings, for instance, ANDAs with Para IV certification, NDAs filed targeting exclusivity under 505 (B)(2) for improvised/ new delivery systems in the US market etc.), however, remains critical.

Further advised reading: How to do Business Analysis of a Company

Now, let us take forward our earlier discussion on the benefits seen by drug companies on the sale of drugs to regulated/developed markets and why every company, be it formulation, API or CRAMS, wants to sell to developed countries, especially the USA.

6) Selling drugs in the regulated markets (especially US) offers higher profits:

An investor notices that most of the Indian pharmaceutical companies whether they are formulation manufacturers or API or CRAMS companies, attempt to focus on the developed markets, which have higher regulations like the US, European Union, Japan etc.

In fact, the Indian pharmaceutical industry (IPI) exports about 50% of its production and about 30% of exports go to the USA.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 1:

Exports form a significant portion of the IPI and account for about half of the industry’s sales…Exports to USA account for about 30% of the total outbound shipments.

The main reason for such a focus on regulated markets is that these markets provide an opportunity for high risk with high returns. The high risk is due to the challenges of meeting stricter regulations.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 4:

For exports to the regulated market, companies earn a higher profitability; however, they are required to follow more stringent regulation compliances related to patent and drug laws of those countries.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 5:

Regulated markets such as the US and Europe, which are characterised by high entry barrier, offer a substantial premium over realisations in other markets.

Due to the high returns offered by the exports to regulated markets over the Indian market, most of the pharmaceutical companies with good capabilities expand into export markets over time.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 4:

companies having better capabilities gradually diversify revenue stream to exports market over the years.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, June 2017 (click here), page 2:

Though the share of revenue from domestic market has been declining for most top pharma companies due to diversification to export markets,

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, July 2020, page 8:

In the recent past, many Indian pharmaceutical companies have acquired overseas assets for expanding their product/ market reach and gaining access to intellectual property of such companies.

An investor notices that almost all the govt. across the world put some price controls on pharmaceutical products. However, in the US market, these pricing controls are the lowest. As a result, companies that supply mostly to the US are in a better position to earn higher profits and are supposed to have a competitive advantage.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, April 2014, page 12:

size of the U.S. market and its absence of price controls make it especially attractive. Therefore a high concentration of sales in the U.S. is usually viewed favorably.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 10:

highest geographical diversification is achieved when a company’s structure reflects that of the global market: about 50% in the US, 25% in Europe, and 25% for the rest of the world…importance we place on the US segment is due to our belief that this market affords the potential for higher profitability – in turn a reflection of better pricing

Moreover, in a market like the US, generic drugs are promoted by the distribution chain as they get a comparatively higher margin selling generic drugs than branded innovator drugs.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January 2009, page 10:

In the U.S., generic drugs generate a much higher profit margin (more than three times) for drug wholesalers, pharmaceutical benefits managers, and drug stores than branded drugs, so there is an incentive along the distribution chain to promote generics over brand-name medications.

In contrast, the semi-regulated developing countries with lenient regulations provide low barriers to entry, which leads to intense competition. As a result, companies supplying to developing countries typically have low profit margins.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 7:

Margins are also typically moderate for players targeting less regulated markets, as relatively lenient requirements for product registration and manufacturing facility approval also imply low entry barriers and therefore intense competition.

Therefore, an investor would appreciate that the pharmaceutical companies, which have a higher share of the revenue from developed markets, especially the USA, are in an advantageous position.

Further advised reading: How to do Financial Analysis of a Company

An investor would remember from our previous discussion that for the companies dealing in API/bulk drug and CRAMS, becoming bigger in size brings competitive advantages. Let us now try to understand how becoming big creates a loop where size brings advantages, which help pharmaceutical companies to grow further.

7) Big gets bigger in the pharmaceutical industry:

From the above discussion, an investor would notice that pharmaceutical companies across the world are under continuous pricing pressure. In addition, multiple segments of the industry like API and CRAMS players do mainly commodity work and therefore, do not have any pricing power over their customers.

As a result, one of the ways for almost every pharma company to improve its profitability is to become the lowest-cost producer. In this regard, increasing the size of the organization helps the company in obtaining many competitive advantages, especially economies of scale.

Pharmaceutical companies’ rating methodology by the credit rating agency, Scope Ratings GmbH, Germany, January 2022, page 10:

size and market position, including market share, are strong rating drivers for generic companies. This is because the size of operations creates the potential to benefit from size-related economies for cost types, such as production and distribution, in a volume-driven industry.

Large pharmaceutical companies have comparatively higher bargaining power over their suppliers and customers. Due to their large size, they can invest more money in R&D, do more capacity additions, and fight litigations effectively.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, pages 3- 4:

Scale of Operations and Market Position: Large scale typically provides better bargaining power with suppliers and also allows improvement in competitiveness by way of entailing cost and manufacturing process efficiencies. Moreover, it enables better equity with prescribers as well as distribution channels for branded formulation entities. Additionally, large pharmaceutical entities are able to negotiate better pricing with the drug wholesalers and drug payors for their developed market operations. Ceteris paribus, a large scale pharmaceutical company is likely to be better positioned to

• make continued investments in R&D for maintaining a healthy product pipeline
• undertake capacity additions to support future growth
• allocate budgets for litigations relating to product filings (pertaining to Para IV in the US market) and

Moreover, the large companies are better able to spend the resources needed to meet the strict compliance requirements of lucrative regulated markets, which acts as an entry barrier for smaller companies.

Rating Methodology – Pharmaceutical Sector by the credit rating agency, CARE, June 2017, page 3:

Entry into regulated markets requires strict compliance with patent and drug laws of those countries and serves as an entry barrier for small and mid-size pharmaceutical companies.

In addition, large-sized companies whether they are formulations, API or CRAMS players, when they are backward or horizontally integrated, are able to have better pricing flexibility leading to significant competitive advantages.

Rating criteria for the pharmaceuticals industry by the credit rating agency, CRISIL, February 2021, page 7:

Backward integration helps improve operating margin, pricing flexibility and control on quality standards, compared with smaller players.

The integrated nature of operations of large Indian pharmaceutical companies has helped them report profits on the sale of generic drugs in developed markets despite a more than 90% decline in drug prices.

Rating methodology for entities in the pharmaceutical industry by the credit rating agency, ICRA, February 2020, page 7:

Backward integration is an increasingly crucial factor in sustaining cost advantages in exports especially for commodity generics in regulated markets. For instance, some Indian manufacturers have been able to sustain profitability even after over 90% price erosion on generics

In the pharmaceutical industry having a large size is so important that credit rating agencies like Standard and Poor’s have stated that it does not give its highest credit rating to small and mid-sized pharmaceutical companies despite their very good performance.

Key credit factors for the pharmaceutical industry by the credit rating agency, Standard and Poor’s, January 2009, page 14:

Smaller and medium-size companies usually are precluded from reaching the highest ratings levels, despite having strong profitability and financials characteristics, because of lack of products, market, and geographic diversification. Global operators usually have stronger diversification and economies of scale, which let them offer more comprehensive and varied services to varied customer segments.

All these competitive advantages ensure that large pharmaceutical companies perform better than smaller ones and in the long term, the big companies become bigger.

With this, we have come to the end of our elaborate discussion on the business dynamics of the pharmaceutical industry. Let us now try to revise our key learnings in the summary.

Summary

The pharmaceutical industry is one of the most essential industries that benefit from sustained demand across economic cycles. As a result, it is known as a defensive sector without boom and bust phases. The industry is divided into different segments like formulations, API/bulk drugs, CRAMS, and distribution, all of which show very different business dynamics.

The formulations segment, which sells the ready to consume drugs is the largest segment of the industry. It primarily includes the innovator drug companies that invent/discover new drugs, which have helped defeat many dangerous diseases for mankind. However, the new drug discovery process is very costly as it involves investments of thousands of crores of rupees before the drug can generate any revenue. As a result, countries grant patents to innovator drug companies, which provides exclusive rights to sell the drug at a profit and recover the cost of drug development. Successful drug discoveries have proved to be extremely profitable for companies; therefore, they invest millions of dollars in drug development despite a low probability of success.

After the drug patents expire, then another segment of formulation companies, “generic companies” come into the picture. These companies mass-produced off-patent drugs at a very low cost because they did not need to spend large money on drug discovery. As a result, once generics enter the market, the prices of drugs fall by up to 90% and drugs become affordable to the majority of the population. Due to the low cost of generic drugs, most governments promote them through policy initiatives.

Even though all the generic drugs are the non-differentiable replica of the original drug; however, companies create artificial differentiation by branding their generic drugs as “branded generics”. Govt. authorities in countries like Germany and India have found that artificial differentiation by branded generics leads to increased cost of healthcare and is not in consumers’ best interest.

As a result, Germany converted its market from branded generics to tender-based and the operations of many generics players became loss-making. India is also recognizing the harmful impact of branded generics and solutions like “one-company-one drug-one brand name-one price policy” are being discussed. An investor should keep in mind the impact of the elimination of branded generics on the business model of generic formulation companies while she projects their future performance.

As such generic formulation companies, API/bulk drug, and CRAMS players provide non-differentiated commoditised products and services and have low barriers to entry. Therefore, these segments are fragmented and face intense price-based competition. To generate competitive advantages, these companies attempt to make complex generics, biosimilars and technologically difficult APIs, which have less competition and a high profit margin. However, the innovator pharmaceutical companies create a lot of hurdles to restrict competition from biosimilars.

Pharmaceutical distribution companies have been earning very high trade margins over the years, which has attracted corporate players in offline as well as online pharmacy retailing. Govt. authorities have realized that the relationship between drug manufacturers and distribution companies, which provides unreasonably high trade margins due to which the retailers push the sales of high-priced drugs, is not in the best interests of the consumer. Due to this relationship, high-priced drugs have the highest market share and in effect increase the cost of healthcare. As a result, the govt. has started taking steps to control the unreasonably high trade margins.

In countries like Japan and the US, the distribution trade margins are minimal, which has led to consolidation in wholesalers and even forced them to enter other businesses like drug manufacturing because the core business of drug distribution is not very profitable. However, on the contrary, in India, the pharmaceutical distribution companies act as a cartel where they control the entry of new stockists by mandatory NOC and control the trade margins by directions of associations. These practices have been held anti-competitive by CCI and the distribution companies and organizations are ordered to stop doing it.

The pharmaceutical industry directly deals with human health; therefore, it faces stringent regulations. Drugs and their combinations routinely get banned if found unsafe. Getting approval for new drugs is very cumbersome, which acts as a barrier to entry for new players.

All the countries want to lower the cost of healthcare; therefore, each country attempts to control drug prices directly or indirectly. There is continuous downward pricing pressure on the pharmaceutical industry by way of direct govt. order or by generics approvals. As a result, the companies continuously need to invest money in R&D to keep discovering new drugs, delivery mechanisms, and new processes so that they may get patent protection and earn high profits.

Continuously high R&D costs are also necessitated by the drug lifecycle, which leads to a lowering of revenue and profits from a drug as it grows older and matures. Innovator companies work hard to find new blockbuster drugs and generics drugs work hard to make generics of drugs 7-8 years before their patents expire. The quest to gain profits leads to legal battles where generic companies challenge the patents of innovator companies even before expiry. The innovators create every possible hurdle to stop the entry of generics and even sue regulators who approve generic drugs.

Generic drug manufacturers attempt their best to gain entry in the developed-highly-regulated countries as these provide higher profits. However, it also necessitates a high investment in meeting stringent regulatory requirements. Despite spending a lot of money on meeting the guidelines, even the most reputed names have been denied approvals and issued notices of non-compliance. Selling in regulated markets is a high-risk-high-reward game.

Succeeding in the pharmaceutical industry is a highly expensive game. New innovator drugs are the most profitable but may need spending of thousands of crores rupees without any assurance of success. Meeting regulatory guidelines is costly. Creating large plants to produce non-differentiable generic drugs is capital-intensive. Becoming the lowest-cost producer in the segment is expensive. Creating a broad portfolio of drugs to diversify risks is costly. No wonder in the pharmaceutical industry, the big gets bigger.

In essence, when an investor analyses the pharmaceutical industry, then she notices some key characteristics:

• Stable demand: It is an evergreen sector with stable demand. People get sick and buy drugs whether it is an economic upturn or downturn.
• Regulatory risk: Getting regulatory approvals is difficult and expensive. Maintaining them is also neither easy nor cheap. On one fine day, authorities may ban your blockbuster drug and your business is shut down.
• Pricing pressure: Everyone wants drugs cheap, whether govt. or the consumer. Govt. directly orders to sell essential drugs at a cheaper price and controls price increases on others.
• R&D: The need to spend money on R&D never ends. A company cannot stop R&D even if it wants to.
• Drug lifecycle risk: Companies need to renew their product portfolio otherwise revenues and profits would decline.
• Selling in highly profitable markets comes at high risk: Regulated markets offer an opportunity to create higher returns but it comes at very high risk. Entry to developed markets comes after stringent approvals and intense legal battles with innovator drug companies that sell the original drugs at a very high price.
• Need deep pockets to succeed: Whether a company is an innovator or generics or API or CRAMS, it needs a lot of capital to succeed in its field. To reduce risks and lower costs of production (economies of scale) it needs to increase its size, which again demands more investment.
• Artificial product differentiation of branded generics may not last forever. Germany broke the practice of branded generics to kill this business model. India may follow suit.
• Drug manufacturer-distributor nexus of the manufacturer giving high trade margins to the retailer and the retailer pushing sales of high-priced drugs may not sustain.

Therefore, an investor may keep these points in her mind while she analyses any pharmaceutical company and projects its performance in the future.

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.