Marketing Eye

Federal legislation is shaking up the pharmaceutical industry, leading to a frenzy of acquisitions, mergers and competitions as local and international producers scramble for market share.

Signs of a fierce contest for market share in Australia’s multibillion-dollar pharmaceutical industry had been gathering for months, but on July 1 the flag fell for the race to start. Legislation ushering in dramatic reforms to the $6.5 billion Pharmaceutical Benefits Scheme passed both houses of parliament.

The change has local companies desperately trying to lock up market share while engaging in a frenzy of merger-and-acquisition negotiations. And new entrants, both local and international, are clamouring to make the most of a quirk in the PBS reforms that will give them a toe-hold in the lucrative Australian market.

There is a huge opportunity for growth and profit. It is a battle between the imitators and the innovators, in its broadest sense. In the multibillion-dollar pharmaceutical industry – worth $U5634 billion, ($739 billion) according to consulting and services company IMS Health – the fastest growing companies are those that make and sell generic drugs: copies of drugs that have lapsed patents.

The brand pharmaceutical companies develop original therapies and spend billions of dollars on research and drug development, while their generic rivals, unencumbered with such costs and risks, target their market and make bigger profits. And there is more to come. The growth of the past several years will pale compared with the opportunities over the next 10, when more than 100 drugs, many of them blockbusters, will come off patent. Generic companies will scoop up a much bigger slice of the pharmaceutical pie. Australia’s drug market, despite its relatively small size – $8.5 billion in wholesale terms, according to IMS Health – offers an added opportunity for growth and profits.

Australia’s uptake of generic drugs is low compared with other parts of the world. Only 20 per cent of the PBS is spent on generics. Consumers have been resistant and suspicious of generics compared with branded drugs. Price differences do not matter to them because about 80 per cent are concession-card holders who pay just $4.70 of the cost of their PBS medicines. The remaining 20 per cent pay $29.50, and the difference between branded drugs and generic alternatives is usually nothing more than a few dollars. “There is absolutely no consumer pressure,” the chief executive of mid-size generic drug maker Genepharm Australasia, Dennis Bastas, says. “That is the key point.”

Bastas says generic substitution is growing at 15 per cent a year, according to his company’s research, and he expects that figure to jump over the next four years as the federal government launches a $20 million advertising campaign to encourage consumers to use generic drugs.

The profit margins in Australia’s drug market are looking more attractive in a world market facing intense global competition. In the United States and Europe, price competition for generic products is fierce, and will increase as new players are drawn into the market by the size of the opportunity.

Locally, profit margins have been among the best in the world. Rebates for pharmaceuticals are set by the PBS. Until the reform, the rebates for generics have ignored both the (lower) cost of making generic drugs and the wholesale price paid by pharmacies.

Instead, the rebate has been set as a discount to their branded rivals. This situation has delivered a fortune in profits to the generics companies, their shareholders, executives and founders. Father-and-son team David and Paul Duchen, who started the two biggest generics companies – Alphapharm and Arrow Pharmaceuticals (now a division of Sigma Pharmaceuticals) in 1982 and 1999 respectively – have made a personal fortune of $260 million.

Until the reforms, generic drug makers were free to share their profits with the nation’s 4500 pharmacies, which have, through the lobbying power of the Pharmacy Guild of Australia, kept rival retailers such as supermarkets out of the market. Until now, when generics companies gave pharmacies discounts on the wholesale price of drugs, there was nothing to stop pharmacists pocketing the difference between the price they paid and the government rebate.

At first glance, the federal government’s reforms spell disaster for the profits of both the generics sector and the pharmacies. Under the reforms, price falls of up to 25 per cent of some generic drugs are mandated. And prices could fall further.

Under the new system, the pharmacies must declare the discounts they receive, and these will translate into lower retail prices the following year. The price pharmacists pay for drugs will be transparent, and the cosy deals that existed between some pharmacies and generic drug makers is over.

It is worrying for big generic drug makers, but they are working quickly on new ways to protect their profit margins. To survive, they must buy rivals to increase market share, get costs down to keep margins up, and woo pharmacists into deals with sweeteners other than price.

Alphapharm is the biggest manufacturer and distributor of generics and chief executive John Montgomery is keeping his company’s plans secret. He spent a week in June huddled in strategy meeting with senior executives, unable to answer BRWs questions about the company’s plans, before boarding an aircraft, presumably to report to the company’s new owner, the US company Mylan Laboratories although its corporate affairs division will not confirm this. (Alphapharm was sold by Merck KGaA as a part of an $US8 billion global deal in May).

Alphapharm has a lot to lose. Once the market leader, the company has been steadily losing market share over the past eight years to its biggest rival the publicly listed Sigma. Alphapharm and Sigma are now estimated to own 40 per cent and 31 per cent respectively of the market by value. However, the sale to Mylan lowers Alphapharm’s costs, it will have an advantage in a market facing falling prices.

That could be a worry for Sigma, which need more scale to keep its costs down. Until the latter part of June, Sigma’s managing director Elmo de Alwis was locked in a fierce bidding war against publicly listed hospital company Healthscope to buy Symbion Health. Sigma wanted Symbion pharmacy and consumer businesses so badly that surpassed Healthscope’s offer by $19.9 million, offering to pay $ 1.105 billion for Symbion. (Symbion board accepted Healthscope’s offer instead – and the deal is still under review by the Australia Competition and Consumer Commission).

Ownership of Symbion’s pharmacy brands – Terry White Chemists and Chemmart – did not guarantee Sigma that these 300 pharmacies would buy from them. Chemists are independently owned. But Symbion claims to supply more than 3000 Australia’s 4500 pharmacies, and winning the bid would have helped Sigma.

Both Alphapharm and Sigma face another worry – growing interest from international companies in the Australian market, and the entry of hungry new players such as Generic Health, which was established in 2004 and is backed with $6 million by private investors who are convinced there is a market opportunity. Also India’s generics giant, Ranbaxy Laboratories, which had sales of $51.3 billion in 2006, opened an office in Sydney in July last year and has 16 representatives in the market.

The interest doesn’t stop there. Austrade’s senior export adviser (biotechnology), Stan Roche, has been fielding a flood of inquiries and visits from Chinese and Indian generic pharmaceutical companies. A partner at legal firm Deacons, Bernard O’Shea, has been busy informing overseas companies about the Australian PBS, government programs and the regulator, the Department of Health and Ageing’s Therapeutic Goods Administration (TGA). The events manager for the biotechnology industry organisation AusBiotech, Hayley Johnson, reported a 30 per cent increase in international delegates to its 2006 conference, in particular from 15 Chinese companies and five Indian companies.

Opportunity for new players comes in part from a quirk in the new PBS rules that gives the price cutters an advantage. The retail price of a new drug is set by a complex price-averaging system that is based on the difference between the price of the branded and generic products and the difference in market share.

So companies with a small market share, such as Ranbaxy, Genepharm and Generic Health, can offer big discounts without upsetting the retail prices, at least in the early stages, of a new drug coming onto the market. This is one way that new entrants, local and international as well as small new companies, can establish themselves in the market. Once they have a toe-hold, they can ratchet up their competitive advantage by wooing the pharmacies with the same elaborate sweeteners as their rivals.

So far, Ranbaxy and Generic Health have a limited range of generic products to offer pharmacies – each offers nine drugs. These companies must register each new drug with the TGA – a process that is costly, although not nearly as expensive as developing and registering a new drug in the market.

This is where Ranbaxy will have an advantage in the local market, the country manager for Australia and New-Zealand, Sundeep Khatri, says. Ranbaxy manufactures a big range of generic drugs in India, and its low manufacturing costs mean that it can use its profit margin to expand its range here rapidly – if it can gain market share. Khatri will not reveal how many pharmacies are Ranbaxy customers.

Generic Health’s managing director Gavin Upiter has the same idea, but points out that range is not as important as it once was for a new entrant. “A few years ago, half the range of generics represented about half the value of the market”, Upiter says. “Now you can have 10 products and represent 40 per cent of the value of the market.” This is because of the new generic blockbusters coming off patent.

And as the small players grow, they will become takeover targets.

Australian Pharmaceutical Industries is a wholesale distributor that does not make pharmaceuticals. Its chief executive, Stephen Roche, believes adding a manufacturing capability would be an advantage and says the company will make an announcement within months. “We are exploring our options. It is on our strategic radar to resolve our position shortly.” Which company would make an ideal suitor? Roche says: “We want to align with a leader, globally robust, with a low cost of production that has a presence in this country.” Ranbaxy? Possibly. But Roche does not rule out API courting a brand pharmaceutical company.