May 17, 2007

Business models of Pharma industry

I have written (see here) earlier on the pharma industry in 2005. A few high profile patent challenge losses in 2005 and 2006, brought down the valuations for several companies. My basic thoughts about the industry have not changed

I have been analysing the industry further recently and can see two different business models.

The Domestic market focussed model

Most MNC’s like novartis, merck, pfizer come under this model. The key characterisitics of the model are

1. Subsidiary of a global MNC operating in india for the last few decades
2. The subsidiary operates as an extension of the global company and due to the patent law in the past, has introduced mostly the off-patent drugs.
3. Strong brands, marketing network and good return on capital and strong competitive advantage.
4. Possibility of introducing the drugs from global portfolio. However in some cases the parent company has an unlisted subsidiary and hence treats the listed one as a cash cow. In such cases the market is rightly giving a lower PE multiple due to the poor corporate governance attitude of the parent.
5. Strong cash flows due to minimal R&D and very low assets in the business as most of the manufacturing is sub-contracted.
6. Low growth in domestic market, marked by constant price controls (DPCO and new pharma policy) by the government on various essential drugs. This has resulted in poor topline and bottomline growth for several companies solely dependent on the domestic market.

The International market focussed model

1. This model is followed by the indian pharma companies such as ranbaxy, dr reddy’s, nicholas pharma etc
2. These companies are in the process of globalizing. Their approach to it has been through the drugs which are coming off patent (generics strategy). These companies have built a strong R&D infrastructure in india to develop these drugs coming off patents. They also have a marketing and legal infrastructure in foreign markets to file ANDA and other applications for these drugs as soon as they come off patents. If these companies win these cases, then they get a 180 day exclusive marketing period for these drugs. Post the exclusive period too, these companies are able to maintain good market shares. Thus these companies have created a value chain of R&D labs in india, and a distribution, marketing and legal infrastructure abroad to funnel these new drugs coming off patents.
3. These companies are following riskier strategy as these legal challenges are costly and if the company loses one, the entire money is down the drain.
4. The market was pricing earlier as if each of these ‘bets’ would pay off. However due to some high profile failures in the past, the market has started pricing the risk of the strategy now.
5. Some companies are also acting as outsourcers for the global pharma companies. This is the contract or custom manufacturing business. There a large no. of FDA approved facilities in india ( second largest in the world). Several indian companies now provide advanced manufacturing facitility to global pharma companies and are now doing accquisitions in this space to accquire complementary assets abroad.
6. The third segment of this model is the R&D segment where some of the top companies are now investing heavily in R&D to develop NCE and NDDS. Some of the molecules are now in the stage I and Stage II trials. Some companies such as DRL have licensed these molecules to other companies and they get royalties based on milestones. This is a high risk, high return startegy. However it is likely the larger pharma companies in india could go down this path and emulate their global counterparts.

It is easier to predict the cash flow and valuation of the domestic model as the overall business risk is lower in that model. The international business model has a higher upside, however the valuation seems to reflect that upside in several instances. All these international market focussed model has ‘real options’ embedded in it. However I do not have the skill to do the valuation of these options. It is often difficult to predict which Patent challenges would be successful and which ones will fail

For additional detail on the pharma industry see
here. The article is dated, but useful to understand the various terms such as ANDA, Para I,II etc.

There are several good stocks in the pharma industry available at reasonable valuations. I have discussed about merck earlier. In addition I am looking at novartis and alembic too.

Caution : Stocks which i look at generally perform poorly in the short term as they are undervalued. Please do your own research before investing in them.

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