Big Pharma’s Tenuous Grip on the Emerging Markets

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Richard Evans

203.901.1631

richard@sector-sovereign.com

July 8, 2010

Big Pharma’s Tenuous Grip on the Emerging Markets

  • The argument that health spending grows with wealth is correct but over-simplified – health spending generally and pharmaceutical spending particularly are very late-cycle developments. Sorting the world’s economies into four GNI per-capita tiers, 2/3rds of absolute GNI growth (’03 – ’08) came from the first two (poorest) tiers, but 3/4ths of pharmaceutical growth came from the fourth (wealthiest) tier
  • We sort the world’s importers of pharmaceuticals into faster- and slower-growing economies, and categorize the world’s exporters as traditional large-cap pharma companies, or their emerging global challengers. 85% of pharmaceuticals flowing into slower-growing economies come from the traditional large-cap’s home countries (and manufacturing bases), as compared to just 71% of imports into faster-growing economies. Large-cap exports grow at half the rate of their emerging challengers’
  • Big pharma’s value proposition to emerging markets (EM’s) might be any of: innovation, efficiency, or aspiration. Selling innovation (patented brands) is hindered by low per-capita incomes, nascent health systems, weak patent law, and the fact that most essential medicines are available as generics. Selling on the basis of efficiency – being the low cost / high quality exporter of a broad range of essential medicines – is hindered by the large-cap’s high operating costs and narrow product lines, the presence of lower-cost global challengers, and the ambitions of larger EM’s to manufacture on their own
  • This leaves aspiration as big pharma’s primary EM value proposition – selling branded versions of generically available medicines to EM consumers with disposable income. The premise is one of EM consumers preferring the large-cap’s brands for classic reasons of brand aspiration, and the related assertion is made that as a result, EM product life-cycles will be long-lasting, rather than ending abruptly with patent loss as is the case in the developed world. We’re convinced this is wrong. Rather, we expect that wealthier consumers in under-formed pharma markets buy the large-cap’s branded generics simply to be assured of quality, and that this motive fades as EM pharma markets develop, and as the rapidly growing non-traditional exporters produce greater quality
  • We accept that the EM’s are an important and growing source of pharmaceutical demand, but believe the EM bull-case is considerably over-played. Selling branded generics to moneyed EM consumers strike us a remarkably narrow and short-lived approach. Rather, we believe a more sound EM strategy can be built on a foundation of in-region and in-country manufacturing and distribution networks owned in partnership with locals; but, the large-caps have a late start, and face structural dis-advantages v. both existing and emerging generic producers

Persistently low large-cap pharma valuations are drawing considerable attention, but the uncertainty of longer-term (post-major patent) cash flows remains an ominous sticking point. We sense well-placed skepticism regarding manufacturers’ ability to replace patent losses with new products, particularly as returns on R&D spending in all likelihood have fallen below cost of capital. This leaves export growth as the leading candidate to support longer-term earnings, and the companies’ prospects in emerging markets (EM) have become a focal point of the large-cap pharma investment case. In this call we focus on the EM bull case and find it to be weak; we see growth in these markets, but we’re not convinced that the EM’s can be large enough soon enough to offset losses in the developed world. More importantly, we expect that EM’s demand for pharmaceuticals ultimately will be met by emerging challengers to the established large-cap multinationals.

How big and how fast — wealth and health

Health spending clearly grows with wealth; Exhibit 1 compares per-capita GNI (x-axis) with per-capita health spending (y-axis). The relationship is exponential; as economies become wealthier, a higher proportion of marginal wealth is spent on healthcare. Thus simplistically, if mid-tier economies are growing faster than wealthier economies, the rate of health spending growth likely will be faster in these economies as well, and health-oriented exporters might logically focus on these markets to find growth. This is basically correct, but thinking along these lines it’s easy to lose track of the relative contributions of emerging and developed economies to global pharmaceutical demand.

It’s critical to keep track of the difference between the rate of health spending growth, and the amount of health spending growth – smaller economies with faster rates of spending growth have much smaller health-spending bases, so their absolute dollar contribution to growth is smaller than the new dollars found each year in more mature economies – despite a slower rate of both GDP and health spending growth in the more mature economies.

Exhibit 2 organizes countries along a per-capita GNI continuum on the x-axis, and tracks the cumulative percent of world population, world health spending, and worldwide pharmaceutical imports as per-capita GNI grows[1]. The vast majority of the world’s population accounts for a very small amount of global health spending; and, conversely, the minority of the world’s population, living in wealthier countries, accounts for a great majority of health spending. Viewed optimistically this suggests tremendous growth potential; viewed pragmatically, this shows that health spending growth generally, and pharmaceutical imports particularly, are very late-cycle developments – which raises questions of timing. Note that while we rely on pharmaceutical imports in Exhibit 2 (and throughout this call) for a number of technical reasons[2], the import data don’t account for pharmaceutical consumption within a country when the goods are produced in that same country. As such, the use of pharmaceutical imports significantly under-estimates consumption in countries with manufacturing capabilities — which are the higher per-capita GNI economies. Thus the ‘true’ pharmaceutical spending curve is even more right-shifted than it appears in Exhibit 2.

To our minds Exhibit 2 suggests that the relationship between per-capita GNI and health spending (and pharmaceutical imports) consists of roughly four tiers, from lowest per-capita GNI to highest. Exhibit 3 summarizes these four wealth and health-spending tiers, and again shows that the great majority of spending and absolute dollar growth for healthcare (and pharmaceutical imports) falls in the fourth, and wealthiest, tier – even though only 14% of the world’s population lives in these economies. Note the contrast with Exhibit 4, which shows that tier 2 economies are responsible for half of absolute ’03 – ’08 global GDP growth, and have the highest rate of health spending growth. Thus while it’s true that less wealthy economies are producing most of the world’s GDP growth, and have the fastest rate of health spending growth (Exhibit 4), absolute dollar growth in health spending (and pharmaceutical imports) is very much focused in the wealthier economies (Exhibit 3). N.B. most of the countries that are considered emerging pharmaceutical markets are in the lower tiers, for example India is tier 1, China and Brazil are tier 2, and Russia is tier 3. (Please see the appendices for complete lists of countries by tier.)

Emerging challengers in the emerging markets – whose products are the fast-growing economies buying?

To believe that growing EM demand works to the benefit of the traditional large-cap manufacturers, we have to believe that the pharmaceuticals consumed in the EM’s will be produced and sold by these same large-caps. For a variety of basic politico-economic reasons we have our doubts this will happen in the medium to longer-term; but before we get to those more subjective arguments, it’s useful to take an objective look at where the emerging markets are buying their pharmaceuticals today.

For our immediate purposes we arbitrarily define ‘faster-growing’ economies as those having GDP growth rates that were at least 1.1x the global GDP growth CAGR over the period 2003 – 2008. These faster-growing economies are listed in Exhibit 5, along with their GNI per-capita tier. For the rest of this call, we’ll use ‘faster-growing economies’ and ‘emerging markets (EM)’ interchangeably. We recognize that there are many definitions of emerging markets in use, but believe that a GDP-growth based definition is the best basis for analyzing whether the traditional large-caps are likely to capture pharmaceutical demand growth in these markets. The figures shown in Exhibit 5 are each faster-growing country’s share of 2008 global pharmaceutical imports; in total these countries are responsible for roughly a quarter of the 2008 global total, and for about 28% of growth in global pharmaceutical imports (Exhibit 6).

We analyzed countries of origin for the pharmaceutical imports flowing into the faster-growing economies; we assume that pharmaceuticals originating in countries ‘tied to’ the major multinationals (“MNC Home Countries”, Exhibit 7) generally are sold by the traditional large-cap manufacturers that are either domiciled in these countries, or use these countries (e.g. Singapore, Ireland) as major manufacturing hubs. Outside of the MNC Home Countries, we looked for countries having large and growing pharmaceutical export totals, and arbitrarily defined these as “Up & Coming Pharmaceutical Exporters”, Exhibit 8).

MNC Home Countries – our proxy for large-cap multi-national pharmaceutical manufacturers – supply 85% of the imports going into slower-growing economies (Exhibit 9), but only 71% of imports flowing into the faster-growing economies (Exhibit 10). Interestingly, the Up & Coming exporters have comparable shares of the faster-growing (6%) and slower-growing (5%) markets, because the faster-growing economies are satisfying much of their import demand from a very broad list of smaller exporters. Shifting perspective slightly to look at the destination of goods originating in either MNC Home Countries or Up & Comers’ home countries, we see that around 22% of the established large-cap’s export dollar value is going to faster-growing economies (Exhibit 11), and that around 28% of Up & Comers’ exports are heading into the faster-growing economies (Exhibit 12). In terms of overall rate of growth, Up and Coming exports are growing at twice the rate of MNC Home Countries’ exports (Exhibit 13).

Thus even before considering whether faster-growing economies will source their pharmaceuticals from the traditional large-caps over time, we already see evidence that these economies are much more likely than the developed markets to source their prescription drugs from other suppliers. As demand grows in the EM’s, so do alternative sources of pharmaceuticals, which plainly threatens the ability of the traditional large-caps to capture EM growth in the mid- to longer-term.

What value proposition do traditional large-caps offer the EM’s?

At least in theory, we see three possible value propositions: innovation, aspiration, and efficiency – though we see considerable challenges to each.

Innovation … ?

In developed economies, traditional large-caps have been almost wholly reliant on innovation; i.e. on sales of patent-protected brands. Bear in mind that patents tend to run concurrently on a global basis, i.e. EM patents tend to expire before patents in the developed world[3]. Thus many of the patents that protect the large-caps’ brands in the developed world also are being lost – or already have been lost – in the EM’s. It follows that the EM’s cannot offset developed world patent losses on a brand-by-brand basis – e.g. if Lipitor’s patent is lost in the developed world, it’s almost certainly lost in the EM’s as well. This is very nearly equivalent to saying, more broadly, that the EM’s demand for innovative products cannot offset weak pipelines in the near-term or inadequate R&D productivity in the mid- to longer-term. The only possible exception would be for marginal EM demand (for patent-protected innovations specifically) to be at least equal to the amount by which global patent losses exceed new innovative revenues in the short term, or by the gap between returns on R&D spending and cost of capital in the longer-term. The short-term hurdle plainly is insurmountable, and we expect it will take decades for the EM’s to add sufficient marginal demand to innovative products to contribute meaningfully to bringing R&D returns back above cost of capital. In the short-term the EM’s simply aren’t major users of patent-protected products – e.g. well less than 10% (in dollar terms) of the Chinese pharmaceutical market consists of patent-protected brands. In the longer-term relatively weak intellectual property (IP) environments, weak pricing, and relatively large local distribution costs also are significant challenges to earning returns on innovation in the EM’s.

We analyzed medical staffing and infrastructure by GNP / capita tier (Exhibit 14); staffing and care infrastructure are comparatively sparse in tiers 1 and 2, though there are few differences between tiers 3 and 4. Recognizing that the great majority of the world’s important pharmaceutical innovations already are available as generics, we think it’s unreasonable to expect the tier 1 and tier 2 EM’s to routinely opt for the level of sophistication represented by patented or to-be-patented innovations, at least until their medical staffing, health care infrastructure, and associated professional standards evolve to or toward developed world levels. As the less-developed EM’s medical systems evolve, logically these economies will preferentially ‘install’ the basic, essential (and largely off-patent) pharmaceutical technologies – better to treat 100 hypertensive patients with diuretics than just one with a branded angiotensin-receptor blocker (ARB).

With respect to the intellectual property environment, we spoke with global IP counsel who serve the traditional large-caps, the take-away being that despite recent gains in global IP law (e.g. TRIPS), protection remains substantially weaker in these economies than in the developed world. More objectively, we analyzed data on issued and active patents by country. We simply divided active patents per country by that country’s total GNI, to normalize the number of active patents by the size of each country’s economy, and expressed the result as the number of active patents in effect per million dollars of GNI (Exhibit 15). Plainly the tier 4 economies have the most active IP systems; and, interestingly, the tier 3 economies IP systems, though clearly more developed than tier 1 and 2 systems, seem very weak as compared to tier 4, at least on this crude measure. This is consistent with our sense of how medical systems evolve; it appears that the staffing and infrastructure required to make use of more innovative technologies are in place before well before the requisite IP protections for patented-product profits.

Aspiration?

To be fair, the traditional large-caps typically haven’t claimed broad use of patent-protected brands as the foundation of their EM strategies. Rather, the common denominator largely has been a strategy of selling what are effectively branded generics – branded versions of products that are off-patent. Plainly this relies on buyers having and exercising a preference for the brand, irrespective of the availability of cheaper generics. Such buyers would have to be literate consumers with disposable income – in effect a global middle class. In tier 1 economies low adult literacy rates are a fairly substantial headwind to selling brands (presuming the consumer is making the brand selection, rather than the physician or distributor), but literacy rates almost certainly are not a significant issue

for branded selling outside of tier 1. The more important rate-limit by far is income.

We analyzed income distributions by country for each of the GNI per-capita tiers – the aggregated results are shown in Exhibit 16; bubble sizes in the chart represent the percentage of total global dollars of income that fall into each income quintile in each of the four tiers. So for example, if we arbitrarily think of middle class in tier 4 terms, then only the wealthiest (fifth) quintile of tier 3 economies – which holds 4.9% of total global income — have sufficient per-capita income to meet this standard. Perhaps more meaningfully, if we think in terms of a ‘global middle class,’ and set (again somewhat arbitrarily) the per-capita income cut-off for this class at the tier 3 average per-capita income of roughly $15,000, then global middle class would consist of all quintiles of tier 4, the fourth and fifth quintiles of tier 3, and only the fifth quintile of tier 2. All in, these three tiers add 20% of global income dollars to the 52% of global income dollars that already reside in tier 4.

That’s frankly an enormous number, and we can appreciate why companies choose to focus on selling branded generics to higher income consumers in the EM’s – but ultimately the more important question is why these higher income consumers purchase the branded generics. Normally we think of consumers buying brands for any of three reasons: the brand is the only version available (i.e. there are no generic alternatives), the brand is the best version available (the generics are inferior) and/or, purchasing the brand is a symbol of status. We’ve largely minimized the first reason – having established that brands being lost to generics in developed economies also are lost in emerging economies; and, that the emerging economies’ use of more advanced on-patent technologies remains limited. This leaves the second reason (the brand is the best quality), and the third (the brand as status-symbol).

At least some of the traditional large-caps are claiming that product lifecycles in the EM’s will be longer than in the more developed economies, because of these consumers’ demonstrated appetite for branded generics. In effect, these companies assert that wealthier EM consumers choose brands over generics for reasons of aspiration, much like these consumers might choose branded cosmetics and cigarettes over generic alternatives. We struggle to accept this[4] – pharmaceutical brands are hardly as prominent as traditional consumer brands, and we simply can’t picture wealthy EM consumers trading details of their (ethical, prescription) drug use. Even if consumption of pharmaceutical brands does offer some satisfaction of wealthy EM citizen’s lifestyle aspirations, we’ve got to think the drug brands rank well down the list of items these consumers aspire to – and $15,000 per year doesn’t take the average consumer terribly far down this list. Rather, we suspect that wealthier EM consumers buy branded generic pharmaceuticals simply because they want to be assured of having the best available quality – and it follows that as the quality of non-branded medicines flowing into the EM’s improves, that this reason for preferring brands (from the traditional large-caps) over generics (from elsewhere) goes away. Presumably the quality of unbranded EM generic pharmaceuticals will improve either because the traditional western generic companies target the EM’s; or, because the Up & Coming exporters recognize, and capitalize on, consumers’ willingness to pay for quality.

Basing an EM strategy on consumer aspirations also assumes that consumers remain largely free to act on their aspirations. As pharmaceutical markets in the EM’s grow, two other developments work against these freedoms – 1) distribution systems become more formalized, and these distributors exercise considerable power over what products are or are not carried (typically with a bias toward cheapest-available generics); and, 2) maturing health systems develop some type of insurance scheme – typically government based (Exhibit 17) – which does much to cover costs and raise total consumption, but also tends to place restrictions on what will (low cost generics) or will not (branded generics) be subsidized, and at what price. As recent examples, Hungary (tier 3) went to reference pricing in 2007, the Czech Republic (tier 3) has added substantial restrictions to re-imbursement, and Romania (tier 2) has moved to effectively import lowest global pricing, by requiring companies to sell in Romania at the lowest price the same products are sold in other global markets.

Wealthier consumers of course retain the freedom to purchase branded generics with their own money — provided they’re available in the distribution system – though experience tells us that even wealthy consumers will choose the on-formulary (generic) product in order to gain the benefit of any available insurance subsidy.

Summarizing, we see wealthy EM consumers’ preference for branded generics as a temporary phenomenon that ends with any combination of higher quality generic supply, establishment and use of power by distributors in the supply chain, and/or formalized health insurance schemes.

… or Efficiency?

The remaining theoretical value proposition that the traditional large-caps might offer the EM’s is efficiency –i.e. lower cost and higher quality than can be achieved from other suppliers. If efficiency were the basis on which the EM’s were buying, then we’d place our bets on established generic manufacturers well before we’d bet on the traditional, brand-oriented large-caps. The generic manufacturers offer broader product lines, and we believe operate far more efficiently — and, the established Western generic manufacturers already manufacturer to the same quality standards as the traditional brand-focused large-cap manufacturers. Taking the argument a step further, ultimately we’d bet on generic manufacturers in the Up & Coming Pharmaceutical Export countries. Small molecule production is not terribly demanding in terms of energy and transportation infrastructure – locating in or near ports arguably is sufficient, even in economies with poor internal infrastructure. This suggests wage and tax rates would be major determinants of relative production costs, and here the Up & Coming Pharmaceutical Exporters plainly have an advantage (Exhibits 18, 19). All of this suggests that if the EM’s choose their pharmaceutical suppliers on the basis of cost and quality, that in the near term they would choose established Western generic suppliers, moving on to the Up & Comers as these emerging exporters attain competitive standards of quality – which we have every reason to believe they will. Thus it follows that operating efficiency (cost and quality) almost certainly is not a feasible value proposition that the traditional large-caps can use as a foundation of their EM strategy – even in the very short term.

And finally — why import at all?

As health systems evolve they consume a growing portion of GDP, and as we’ve seen the drag of health spending on GDP very much ranks as one of the developed world’s priority economic problems. Many of the dollars spent by the developed world on pharmaceuticals are spent on patent-protected brands, meaning these economies have little choice but to source these products from the traditional large-cap manufacturers at premia that reflect the seller’s IP protection. In the emerging markets the picture is quite different; most of the dollars spent on pharmaceuticals are spent on generics, and these markets ultimately can source these generics from whoever can supply acceptable levels of quality at the best price. We showed at the outset of the call that fast-growing Up and Coming Pharmaceutical Exporters are relatively more focused on the EM’s than the traditional large-caps, and while we can accept that quality standards in the Up & Coming product lines may not be at traditional Western levels, we have no reason to believe that quality will stand still – if the EM’s show demand preference for quality, there is every reason to believe the Up & Comers will provide quality.

Conversely we see no reason to believe that the EM’s will import generics from the traditional large-caps in significant volume over significant time spans – if the EM’s are going to import generics at all, they will have learned the lesson of developed world health cost burdens, and will source from more cost-efficient suppliers. And there’s a very strong argument to be made that the larger EM’s ultimately don’t import substantial dollar volumes of generic small molecules, but instead choose to produce them at home. Small molecule manufacturing is well within the technical means and

infrastructure capacities of the larger EM’s; and, keeping with the established traditions of international trade, we expect particularly the lower GNI per-capita EM’s (e.g. India, China) to erect trade barriers in defense of their own domestic manufacturing bases (Exhibit 20). Such protections still occur fairly far up the development scale, for example as recently as 2006 Poland (tier 3) imposed pharmaceutical price cuts on foreign manufacturers only, but spared domestic Polish firms.

Summary and Conclusions

We readily accept that the EM’s are an important and growing source of global pharmaceutical demand, but see the traditional large-cap’s present approach to these markets as both overly narrow (largely reliant on the narrow subset of EM consumers with disposable incomes) and short-sighted (few steps are being taken to deal with threats from emerging global exporters, or to find mutually beneficial ways of satisfying the larger EM’s own pharmaceutical manufacturing ambitions).

In contrast, we believe the large-caps could enjoy greater EM success over longer timeframes by building in-region and in-country manufacturing and distribution infrastructure that is co-owned alongside local interests. As the health systems in the EM’s mature, growing availability of health coverage leads to growing pharmaceutical consumption, but these products will consist of a very broad list of essential medicines that have to be produced at very low cost, rather than a short-list of branded generics imported from elsewhere. And, as the EM’s mature even further, ultimately the adoption of innovative on-patent medicines by their government-based payors will unfold along familiar lines – which is to say that bringing jobs to these economies will go a long way toward opening these markets to patented brands.

The large-caps have a late start; exporters from the emerging economies are more focused on the EM’s and are growing faster overall. And, the large-caps face considerable structural challenges – they produce comparatively narrow product lines at comparatively high-cost, but need to produce very diverse product lines at very low cost – and here they are at a dis-advantage not only to their emerging global export competitors, but to the established global generic manufacturers as well.

Appendices: Lists of Countries by GNI per-capita tiers

  1. Two things are worth noting – the countries analyzed amount to just less than 90 percent of world population (we limited the analysis to countries having credible health spending and Rx import data — the missing countries tend to be lower GNI per-capita countries); and, the gaps between observations on the x-axis are not uniform.
  2. More consistent apples-to-apples data across a broader range of countries than is available with commercial (IMS) data (more standardized basis of collection across countries); and the fact that most figures benefit from having two reporters – the importer and the exporter.
  3. Patent claims are generally made on a global basis, all at once. Patent applications become public before they are granted (or denied), which makes serial patenting across groups of countries effectively impossible – anyone in a country where an application has not been filed could in theory jump in front of the innovator using information from patent applications made public in countries where the innovator had filed. Emerging market exclusivity tends to run out before developed markets, as the latter tend to have more complex intellectual property systems that give innovators the chance to maintain exclusivity through comparatively small increments of innovation – extended release dosage forms, for example. Generally speaking this is far more difficult to accomplish in the emerging markets, thus the expiration of the first patent filed tends to mark the effective end of exclusivity.
  4. Valium is an interesting natural experiment of the brand-loyalty thesis. Before the Valium patent expired, Valium production was modified so that all tablets had a “V” cut out of the middle – and this cut-out was trademarked. Valium users grew accustomed to seeing the “V” cut-out in their tablets, and the hope was once the Valium patent expired, that Valium consumers would refuse generic versions that lacked the “V” cut-out. It worked briefly in a small corner of the market, but this was in a time period of questionable generic quality and little to no difference between generic and brand co-pays. Subsequent attempts of the same strategy with later Roche brands (Klonopin “K”) – in a time characterized by trust in generic quality and escalating brand v. generic co-pay differentials — failed outright. If American consumers won’t pay premiums for brands, who will?
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