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SUSTAINING COMPETITIVE ADVANTAGE IN CHINA

By RL Expert Leesa Soulodre

There is no question that while dividend returns are maintained, the pharmaceutical industry is no longer as lucrative as it once was for long-­‐term investors. McKinsey reports that R&D investment has doubled over the last decade while molecular entity approvals have decreased.

Pharmaceutical companies are now turning to China for its cheap access to capital and promising market growth rates. However, competitive market forces, country risks and increasingly challenging ethical and regulatory environments make navigating the industry more complex. Legal disputes and poor product quality control have also eroded stakeholder trust. Expiring patents (“patent cliff”), competition from generics, and government protectionism have impacted margins. Externalized investments for accelerated patent portfolio and M&A for market access and distribution are fast becoming the industry’s CEO toolkit – and bribery and corruption risks abound.

However, it seems that not a week goes by without another scandal in the pharmaceutical sector. Headlines abound on bribery and corruption, tax evasion, drug recalls, the mis-marketing of drugs, allegations of a lack of transparency in clinical trials and inequalities in providing sustainable access to medicines to those communities that need it most.

So just how can Big Pharma achieve a competitive advantage in China?

China Opportunity

Health care spending in China is on the rise. As a key pillar of China's 12th 5 year plan, the
country’s annual expenditure is projected to grow at an average rate of 11.8 percent a year in 2014-2018, reaching $892 billion by 2018 (Deloitte). Spending is being driven predominantly by the government’s public health care reforms and the booming middle class. 

China’s shifting disease profile is embedded in the social, economic and environmental changes that swept the country over the last 30 years. As an example the Ministry of Health Report (WHO, p2) declared over 100 million+ Chinese live with diabetes. The number of diabetic cases among Chinese aged 40+ is forecasted to triple over the next 20 years if prevention and control strategies aren’t implemented (WHO, p14). Health care reforms implemented in the new 5 Year plan support this agenda.

With growing national obesity, the Chinese diabetes drug market was forecasted to increase to more than $USD2.8 billion by 2015 (IMARCG, 2009). Today 47% of Chinese healthcare spending is in the public sector. Three public health insurance schemes merged in 2010, covering more than 90% of the Chinese population (AT Kearney, p2) making them integral to success in the pharmaceutical value chain.

China accounted for just over 25% of Asia Pacific total pharmaceuticals market value (DataMonitor). Japan accounts for more than half of this market and is the second largest consumer of pharmaceuticals globally. With rural middleclass healthcare reforms and construction of thousands of healthcare centers, AT Kearney forecast that it could overtake Japan in the coming decade based on its aging population, the rising middle class and the expected increase in Non-­‐Communicable Diseases (AT Kearney, p2).

Competitive Landscape

China’s pharmaceutical market has strong buyer power, with market access affected by its fuzzy legal and regulatory frameworks and prioritization of State Owned enterprises. Rivalry is strong and cost control/reduction is a challenge. Governments dictate pricing. If the patent cliff drags down volumes sold, price control reduces drug prices. It is frequently the only strategy used by market players. Developing new drugs and acquiring new patents via M&A and JV’s are common strategies to accelerate patent pipelines, achieve vertical integration for economies of scale and optimize supply chains – but these strategies are not only opportunistic, they are fraught with risks.

Risks in China M&A

Due diligence on potential partners for successful JV and M&A’s is difficult, with limited availability and dubious quality of financial and commercial data. Sanofi and Merck only chose to partner with companies they’d worked with extensively in the past (KPMG), however they’re still exposed to local practices and ethical standards. Corporate values may also conflict and company vision may differ. More than 2,470 Company related risk issues have been published since 2006 by international news agencies on China’s pharmaceutical sector (RepRisk AG, 2013). These violations of international environmental, social and governance standards (UNGC) impact access to capital, lead to $USDM fines, impose drug recalls and damage the reputation of global brands.

Risk of Distribution

Drug distribution remains complex, limiting foreign companies’ growth in China’s pharmaceutical industry (AT Kearney, 2013). China’s pharmaceutical distribution is highly fragmented. There are over 13,000 distributors providing access to a local market or 2-­‐3 hospitals (Figure 1, AT Kearney, p3).

The three largest distributors, Sinopharm, Shanghai Pharmaceuticals and China Resources, have 20 percent of the market (Figure 1, AT Kearney, p3). Given this fragmentation, drugs are passed from multiple distribution layers before reaching healthcare providers. Hospitals are the primary route (70%) and retail pharmacies make up the balance (Figure 2, AT Kearney, p30).

Figure 2

The new risk for Big Pharma is that the Central Government’s 12th 5 year plan (2011-­2015) has mandated industry consolidation to 1-‐3 national distributors and 20 regional distributors (AT Kearney, p6. 2013). Sinopharm alone made 30 acquisitions in 2010-­‐ 2011. Local regulators are also restricting drug distribution license issuance and renewals, forcing smaller players to exit, bringing greater competition to distributors.

Complexity in this fragmented distribution chain results in higher distribution costs for any Pharmaceutical firm due to disintermediation between supplier and buyer, and lack of information and transparency impacts supply and demand data.

MNC Pharmaceutical companies seeking organic growth may attempt to sell directly to health care providers. This requires local knowledge, cultural skills and access to key decision makers. This maneuver is risky. With 70M of the Chinese Communist party in power positions of every facet of Chinese life, this strategy may prove politically and culturally challenging (MarketLine, China Report 2013) and could result in Government or industry retaliation.

Boots tried to overcome these barriers to gain entry through a JV with Guangzhou Pharmaceuticals and partnership with Nanjing Pharmaceuticals Group. Both are State owned entities (AT Kearney, p6) with regional distribution channels.

Risk of Innovation and Market Access

Many pharma companies have focused their strategy on innovation and the launch of blockbuster drugs. To achieve this, McKinsey Quarterly report that industry players are now externalizing more R&D to increase the number of drug projects and increase their chances of delivering the blockbusters. McKinsey reported in 2010 that over half of late-stage pipeline compounds were externally sourced in 2007. The challenge they now face is how to increase its access to more drug programs at a lower cost with less risk. Industry players are adopting a variety of strategies at different stages of the product development lifecycle. The strategy selected typically depends on their appetite for risk and access to capital (Figure 4, McKinsey, 2010).

Figure 4.

Deutsche Bank forecasts European drug makers have potential to deliver new drugs from 2013 to 2015 with peak annual sales of $64 billion (or $27 billion after adjusting for risk of failure), while fresh patent losses will be only $12 billion (Reuters, 2013). However, this forecast assumes a diversified market position. NovoNordisc for example dominates a niche and derives almost 3/4 of its revenue from Diabetes today.

With a niche strategy and only 20 years to capitalize on a patent (A drug typically in trials for the first 12 years), regulatory setbacks can impact 3-5 years. In May 2013, NN's long-term profit targets wereimpacted in the U.S. market when U.S. Food and Drug Administration (FDA) failed toapprove new Diabetes drug Tresiba. The impact of this regulatory decision is significant, particularly when a CEO claims it represents 50% of the product’s growth potential (Reuters, 2013).

Attempting to counteract this, some Companies have taken the approach of applying identical mousetraps to new markets in Asia i.e. NN’s Drug liraglutida will now be used as a weight-loss treatment forthe severely obese (WSJ, 2013). This indicates the “volatility” of a dependency on both market access and efficacy of their Blockbusters.

More innovative approaches can be adopted by pharma companies to R&D as outlined in this simplified framework published by McKinsey (2010). This model uses two variables for financing and partnership modeling (Figure 5, McKinsey 2010).

Product licensing, company acquisitions and program partnerships based on majority control are also favored by MNC competition. Structures have evolved to share the risks and rewards over the course of pharmaceutical-product development, but the split is generally proportional to the degree of resources invested and overall operating control.

Value Creation

Sanofi and NN have both developed Research Centers to accelerate global and local clinical trials in China. Access to a larger pool of patients reduces development cycles and costs for recruitment and investigators are lower. Local trial numbers count towards European and US regulator quotas rapidly reducing time to market and providing the ability to launch simultaneously in two markets e.g. Bristol Myer Squibb is reported to have launched in China with only a six month delay (McKinsey, 2010). Local clinical trials also enable them to tailor drugs to specific local demands and forge relationships with governments and regulators early in the “approval” process. These are all value creating initiatives.

NN’s dividend and capital history shows the company created shareholder value through dominating its niche. From 1997 to 2012 its dividend/share increased from $0.58 to $18.0 (Appendix B–3: NN Dividend Analysis). When we consider the EV/EBITDA, NN A/S had an EV/EBITDA ratio of 13.05 forecasted for the next 12 months. This was significantly higher than the median of its peer group: 9.62. Nordisk A/S's valuation is also above its peer groups. Based on peer analysis, this ratio is higher than the average of its sector: 11.06.

However, industry insider’s argue that any Big Pharma who positions to tackle the market alone, serves to destroy long-term shareholder value in an industry where the patent pipeline, pricing and distribution are critical to success. If license issuance in the distribution of pharmaceuticals become scarce, IP enforcement is difficult, and acquiring and retaining talent becomes challenging, it will become increasingly difficult to compete in a market hostile to foreign players not sharing the spoils of success.

Risk of IP Protection in R&D

There is no question of access to biotech talent and IP in China. China has over 5,500 of its own state-owned R&D facilities, 119 national engineering laboratories and 30 national engineering research centers. It partners today with 152 countries for scientific R&D (A.T Kearney 2013). It also produces the second largest outputs of science and engineering graduates after India and is marked by the Government as the foundation of the country’s technological future. With the Government’s focus on biotechnology as a strategic sector in its 12th 5-year plan, MNC’s argue (Merck, 2012; Sanofi, 2012) that these assets serve to underwrite the country’s further development and reinforce potential for Government protectionism.

However, China is renown for weak enforcement of intellectual property rights (IPR) and challenges with expiring patents. From 2012 China remains on the US Trade Representative's Priority Watch List and is subject to monitoring. This indicates that the country must do more to reduce IPR violations and to demonstrate prompt and effective legal procedures. Retaining staff is key for all companies and corporate espionage commonplace, making protecting a company’s trade secrets in the R&D lifecycle a significant risk, unlikely to be mitigated by simple contractual terms.

Risk of Protectionism

Revenue growth, forecasted publicly at 20% on an ongoing basis, has made multinationals a target for retaliation on foreign competition in China (AT Kearney, p2). With NN, Eli Lilly & Co and Sanofi owning more than 90% market share in a high growth Chinese Diabetes market, where State owned operators are now seeking to compete, risks from Government “protectionism” are expected to increase.

This occurred already in the technology industry. In 2010 AMCHAM claimed that Beijing wanted to squeeze foreign technology companies out of the multi-billion dollar market for selling computers and office equipment to government departments. New rules were implemented, stipulating high-tech goods must contain "indigenous innovation" (Chinese IP). This became a pre-requisite for them to be included in any government procurement (BBC News, 2010). Allegedly, more than half of all drugmakers in China are being investigated for potential violations of anti-corruption laws. Companies who have been or are being questioned include Novartis, AstraZeneca, Sanofi, Eli Lilly & Co, Bayer, and Chinese subsidiaries of Merck & Co Inc (Reuters, 19.05.2014). Former Chinese employees have accused their leadership of bribing Doctors to promote sales in China. This activity is expected to heat up as both Chinese firms and Multinationals start to compete in each other’s territories as markets mature (KPMG, p2), as was the case with Rio Tinto in March 2010 when China's powerful state-owned mills lost millions of dollars in potential profits over a deal and Rio’s Executive team were charged and jailed for bribery (Washington Post, 2010).

Others argue that this is not aligned only to foreign companies, given the effort to curb allegations of corruption in the government, Authorities in China have now broadened their investigations to include executives at state-owned corporations. The chairman of Sanjing Pharmaceutical Shareholding, a subsidiary of state-controlled Harbin Pharmaceutical, allegedly jumped to his death amid an ongoing corruption investigation (WSJ, 19.05.2014).

The challenge is that China’s health care industry traditionally operated within an environment of systemic and institutionalized corruption. Lack of governance offers a foundation for retaliation. With significant market growth forecasted and a company operating with a traded stock, country risks related to Bribery and Corruption may result in market losses and dire personal consequences for leaders.

Reputation Risk Management

Reputation risks are the misalignment between our projected identity “who we say we are as a company and how we operate” and our perceived identity “who our stakeholders perceive we are and how we operate”. Achieving alignment and building and maintaining trust with our stakeholders remains a challenge for every company.

There are 4 key steps that Big Pharma companies can take to managing risks to reputation in China.

  1. Understand your key reputation drivers in China. Build and maintain an ongoing dialogue to achieve alignment on core strategic issues with key stakeholders. Risk management is the continuous application throughout the lifecycle. Sustaining alignment with stakeholders is core to maintaining trust and protecting a company’s reputation. Point in time survey style audits leave Big Pharma open to risks and missing opportunities.
  2. Establish real-time early warning and monitoring systems into all functional areas of the company that are directly aligned to key stakeholder groups and the key risks of the organization. This should include an analysis of ‘inside out” – what people inside are saying about the company and “outside in” – what your stakeholder’s perceive about the company.
  3. Factor outrage into the company's risk analysis and scorecard. Risk Managers typically score for hazard and probability. However, we know that the risks that kill people e.g. lack of exercise are not the same as the risks that upset people e.g. GMO (Sandman, 1987). Therefore, understanding your stakeholder’s expectations of your company’s legal obligations to operating and also social and ethical expectations, is critical to ensuring relevant risks are identified, weighted appropriately and resourced for effective engagement and risk mitigation.
  4. Build a multidisciplinary risk council to review, assess and benchmark the organizations’ performance. Establish clear KPI’s and integrate them into the organization across people, process and technology. KPI’s provide an opportunity to quantitatively and qualitatively measure progress for performance and assess, adapt and reallocate essential resources where necessary to ensure an unrestricted license to operate.
Conclusion

Sun Tzu once said “Know your enemy and know yourself, if you do so, then you will win a hundred out of a hundred battles".

There is no question that Big Pharma’s who decide that their competitive strategy is to dominate the niche of one disease area and grow organically, has paid off handsomely for shareholders. However, there are a number of qualitative factors potentially affecting profitability for those that do in the long term.

  • An ability to sustainably increase both distribution and margins,
  • Applying the same “mousetraps” to new market segment,
  • An ability to augment one’s patent pipeline faster than the competition,
  • An ability to retain and attract talent,
  • An ability to protect its trade secrets and IP, and
  • An ability to mitigate risks to reputation including governance, ethical and product related risks. 

Limiting one’s strategy to organic growth in a market dynamic that has accelerated growth via distribution, enabled by JV’s and M&A’s puts Big Pharma’s future value at risk. Whilst there is certainly value in looking at new ways to invest in R&D through traditional externalization models, in a market where rule of the law is often vague, IP and its enforcement is lax and talent churn is an issue, also puts the core of their “innovation” strategy at risk.

If Big Pharma wants to capitalize on the potential of the Asian market growth, local M&A and/or JV activities and innovative R&D models must be considered. For it appears to be the most effective way to tackle directly risks related to product lifecycle acceleration, IP protection, talent management, increased political protectionism, competition and distribution.

Underwriting this with an effective reputation risk management program serves to support Big Pharma to then proactively allocate resource to mitigate related risks and to take advantage of market opportunities. This should include an effective multi-stakeholder engagement plan that includes a continuous dialogue with stakeholders around key risks and issues for the company in order to build the necessary trust to acquire or retain market access; the implementation of a real-time reputation risk monitoring system that continuously monitors the internal and external landscape for risks; factoring probability of outrage, not just hazard into the risk register and having a multidisciplinary risk council that evaluates core KPI’s and related risks in order to achieve organizational strategy.

Big Pharma can achieve a competitive advantage in China, however, they cannot do it alone.

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