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.