Structural reforms
lead to weeding out unhealthy competition
During 2006 and 2007,
the India Rx market bucked the trend of the previous five years by growing at
18% and 13% respectively vs an average growth of 8-9% during 2001 to 2005. This
upward trend is the result of several reforms that have helped reduce fragmentation
by weeding out unhealthy competition from unorganized and small players.
By 2007, approximately
2000 units (40% of the unorganized sector, in terms of business units) closed
down following: (1) the implementation of stricter GMP guidelines from July
2005, (2) application of manufacturing tax (known as excise duty) to the
labeled retail price, as opposed to the significantly lower ex-factory price in
years past, and (3) large companies moving their manufacturing bases to
tax-free zones. The ~2000 units shut down were largely the ones that created
unhealthy competition by resorting to price undercutting.
Organized players to
benefit the most
The unorganized
sector’s business depends on cost arbitrage out of (1) supply of lower quality
(and thus lower priced) products, (2) lower manufacturing tax (excise) on a
lower manufacturing cost (when excise is levied as % of the cost), and (3)
frequent excise duty evasion. The resultant benefits from these are passed on
to the doctor and the chemist to help generate revenues out of these
‘generic-generic’ products. Since these products were also offered at a
significant discount to branded generic products, it created unwarranted
pricing pressure on the entire industry and a decline in average price of drugs
for several years.
The organized sector
derives its revenue from branding and sales promotion. It often cannot compete
in areas dominated by the unorganized sector (largely acute therapies in rural
areas) due to higher costs of manufacturing resulting from healthy
manufacturing practices and lesser chances of excise duty evasion.
These structural
reforms have now negated many the unorganized sector’s previous advantages,
leaving almost 2000 units unviable. This is allowing the bigger companies to
(1) expand their coverage to areas earlier dominated by the unorganized sector,
and (2) increase prices in therapies that earlier experienced severe pricing
pressure.
Longer lasting impacts
India previously had
~6000 formulation manufacturers, ~5000 of which are SSUs with investments of
less than Rs10m. Of these ~5000 SSUs, ~2000 closed in the post-reform period
2005-2008. While no reliable data source exists to verify the market share of
these SSUs, our industry sources estimate they account for ~10% of the total
market by value; it would be significantly higher in terms of volume.
The organized sector
currently remains heavily concentrated only in the Indian Metros and Class I
cities. A significant portion in the rural and suburban areas is thus catered
to largely by the unorganized sector and offers vast scope for further
penetration by the organized sector. While it is difficult to estimate the
potential customer population, we do know that the organized sector currently
serves ~50% of the population. The remainder currently uses either unbranded
generics or alternative medicines.
Furthermore, the
regulatory body is now coming up with tightened rules for in-house laboratory
practices (Good Lab Practices – GLP) that will put many of the remaining 3000
SSUs under severe pressure.
All in all, we expect
these changes to foster price increases as well as increased demand for higher
quality, ethical products produced by larger scale, organized sector companies.
The impact of these changes should continue to unfold over at least the coming
4-5 years.
Improving economy
provides additional impetus
Key policy reforms
have fortunately coincided with the robust economic growth in India. The
increase in disposable income means people increasingly (1) prefer private
clinics (that generate more prescription demand) over government hospitals, and
(2) opt for higher quality ethical products over low quality and low cost
products.
However the role of
improving GDP in the overall market growth should not be overstated nor should
the relationship between the two be assumed as simply causal. GDP growth is not
the sole force behind domestic pharma growth. As shown in Chart 1, the two
trends are not visibly correlated; there were times when pharma market growth
was at, below or quite exceeded the GDP growth. In 2005-2006, the GDP growth
remained around 8%, however the pharma market growth skyrocketed to 18%.
Certainly, a host of factors are at play. We believe the strongest factor
contributing to the above average growth of Indian pharma is the implementation
of structural reforms.
Domestic market thus
makes Indian Pharma a defensive sector
Although generally
speaking, pharmaceuticals are considered to be a “defensive” sector, most
Indian pharma companies lost their ‘defensive feature’ by focusing on exports
driven by cost arbitrage. This made them very vulnerable to commodity-style
competition and local currency appreciation.
The branded
formulation business offers companies the possibility to pass on the cost to
the consumer while enjoying a relatively inelastic demand. Although there is
also a risk the government could expand its list of products under price
control, this is a more political than real threat as Indian drug prices are
among the lowest in the entire world.
Finally, the domestic
formulation business remains insulated against (1) interest rate risks, (2)
risk of rising input cost impacting profitability, (3) foreign exchange risk,
and (4) oil price risk.