ICRA RESEARCH SERVICES. INDIAN PHARMACEUTICAL INDUSTRY New Pricing Policy: An Update

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1 ICRA RESEARCH SERVICES Corporate Ratings Subrata Ray com Shamsher Dewan com INDIAN PHARMACEUTICAL INDUSTRY New Pricing Policy: An Update Kinjal Shah com Khushboo Shahani khushboo. india. com

2 INDIAN PHARMACEUTICAL SECTOR New Pricing Policy: An Update An Update October 2012 ICRA RESEARCH SERVICES New Pricing Policy: An initial step towards transforming India into a pure generics market After the Supreme Court s intervention into the finalization of the new drug pricing policy following a prolonged delay, the Group of Ministers (GoM) have recently concluded the policy and are expected to submit the proposal to the cabinet for approval. The new guidelines propose to control the prices of essential drugs using a weighted average price (WAP) of all brands with a market share in excess of 1%. This is in contrast to the earlier proposal that suggested using the WAP for only the top three brands in the respective segment. While the averaging out the prices over a wider spectrum of brands will result in higher than expected price cuts, the most important takeaways from the recent developments is however the fact that the new pricing policy will only cover the list of 348 essential drugs (or 654 derived formulations) as against the earlier proposal that aimed at even bringing the combination therapies along with formulations with non-specified strengths/dosages under price control. Industry estimates point out that the earlier proposal would have impacted nearly 3/4 th of the Rs. 610 billion domestic formulations industry, while the new proposal would limit the impact to ~30% of the industry. A proposal in favour of the market-based pricing compared to the archaic cost-based mechanism is the second-most important development that will be positive for the industry in the long-run. Our analysis of 17 companies indicate that MNC companies are likely to be impacted the most on account of a) significant dependence on domestic formulations and b) relatively superior pricing strategy (resulting in higher impact of reduced prices). In addition, given the distribution of essential drugs being higher in favour of Anti-Infective, Pain Management/Analgesics and Cardiovascular therapies, companies with higher exposure on these segments may also have to resort to higher price cuts. In our view, with the uncertainties related to the pricing policy getting clearer, companies are likely to review their business strategies for the domestic market. To begin with, companies may start with rationalizing promotional and marketing related initiatives while increasing focus on field force productivity. Over the long-run, an increased thrust on combination drugs (as those are out of the span of pricing policy), in-licensing initiatives, co-marketing/alliances with MNCs and other measures like enhanced focus on OTCs, vaccines, institutional segment and even biosimilars would start gaining importance in overall business strategies. In our view, the new policy framework also marks an initial step that may lead to the transformation of the Indian market to a pure generics-led model over the long-run. Exhibit 1: Difference between Drug Policy (1994), NPPP 2011 and the recent proposal Parameters Drug Policy (1994) Earlier Proposal (NPPP 2011) New Policy Comments Based on essentiality of drugs Based on essentiality of drugs Based on market share Coverage Proposed to cover all the 348 drugs Proposed to cover only 348 principle (in NLEM) along with combinations drugs without combinations Market-Based Pricing Market-Based Pricing Pricing Mechanism Based on WAP of all brands Cost-Based Pricing Based on WAP of Top-3 Brands with market share >1% Price Revisions Based on change in WPI Based on change in WPI Impact on Industry Scope Covered ~12% of the industry Covers both Bulk Drugs & Formulations Almost 75% of the Rs. 60,000 crore market Covers only Formulations Span of control likely to be limited to 30% of the market Covers on Formulations In our view, the new pricing policy is likely to result in 10-15% price cuts, thereby impacting the industry to the extent of 3-5% The impact is likely to be higher on companies with premium pricing strategy, especially MNCs and companies with relatively higher product/therapeutic concentration

3 Likely to shave-off 3-5% of the industry size; impact on MNCs and companies with high therapeutic/product concentration to be higher The domestic branded formulations industry remains one of the most profitable business segments for the industry, exceeded only by one-off exclusivity-led launches in the U.S. generics space. The dominance of branded generics, high proportion of expenditure on healthcare being out-of-pocket and prescription-driven model are some of the key characteristics that make it more profitable than some other markets. In addition, the not so stringent regulatory process for product approvals and manufacturing facilities also support the relatively low capital investment requirements in the sector. Led by a combination of high operating margins (25-35%), higher efficiencies (arising from scale and lesser regulatory challenges) and lower capital intensity, Indian companies generate high RoCEs from India business. Furthermore, the growth prospects remain strong aided by rising penetration of healthcare services, increasing prevalence of lifestyle related disorders and more importantly favorable demographics continues to offer strong growth prospects for pharmaceutical companies. Given these considerations, it continues to be of significant importance for most Indian pharmaceutical companies as well as multinationals having presence in India. The implementation of the proposed pricing policy is therefore expected to have a material impact on the profitability margins in domestic business. However, the impact on an individual company would depend on multiple variables including the extent of dependence on the domestic market, the degree of diversification both at product and therapy level. MNCs are likely to be impacted the most, given their pure-domestic market driven business model and premium pricing strategy. Among large Indian companies, Cipla, Cadila Healthcare and Torrent that generate substantial share of earnings from India operations may see relatively higher impact. Alternatively, players like Strides Arcolab, Dr. Reddy s, Ranbaxy and Glenmark may not see significant impact as their earnings remain more dependent on international markets. Exhibit 2: Impact Analysis on the Industry Impact Analysis NPPP 2011 Covers all the 348 Essential Drugs listed in NLEM 2011 Domestic Formulations Market Size Rs. 610 billion Expected Market Coverage^ ~30% Market Under Coverage Rs. 183 billion Scenarios Optimistic Likely Conservative Impact of Price 5% 10% 15% 20% On Industry Size Rs billion Rs billion Rs billion Rs billion Reduction in Gross Margins of Domestic Price Cuts of 5% 10% 15% 20% Assuming Gross 75% (base level) 1.32% 2.78% 4.41% 6.25% Source: ICRA Estimates; ^ Industry Estimates While the exact impact of the new pricing policy will depend on multiple factors including a company s exposure on the domestic formulations market, therapeutic mix and pricing strategy, we believe that the impact of new pricing mechanism is likely to result in 10-15% reduction prices, thereby implying an erosion of 3-5% in market size of the domestic formulations market. Assuming gross margins of 75% (at base level), the profitability of the domestic business may shrink by % on an aggregate basis. We believe that MNC pharma companies operating in India are likely to be impacted the most given their significant dependence on the domestic formulations segment and relatively premium pricing strategy that may force sharp price cuts post the implementation of the pricing policy. In addition, some of the mid-size domestic companies with relatively higher reliance on domestic market for earnings would also see a meaningful impact on earnings as their investments in regulated markets are yet to start contributing considerably to overall earnings.

4 Companies likely to revisit their strategies for the Indian market; rationalization of marketing/promotional initiatives may begin soon Exhibit 3: Share of India Formulations Business for various companies 120% 100% 80% 40% 20% 0% 3% Strides Arcolab* Impact is likely to be minimal Impact likely to be moderate MNCs + Companies with strong India focus would be impacted the most 17% 21% 25% Dr. Reddy's Ranbaxy* Glenmark 28% 32% 34% 35% 36% 37% Lupin IPCA Labs. Torrent Natco Sun Cadila Healthcare 47% Cipla Indoco Remedies 67% Unichem Labs. 81% 82% Pfizer India Aventis * 98% 99% GSK India Abbott India Formulations Business - % of Total Source: Company Data, ICRA Estimates In addition to extent of exposure on the domestic market, the degree of diversification at therapy and product level will also influence the earnings of companies post the pricecuts. As most of the molecules forming part of the list of essential drugs belong to either acute segments like anti-infective and analgesics/pain management or chronic segments like CVS, the impact could be higher on companies that have greater reliance on these segments. Exhibit 4: Company-wise contribution from Top 3 Segments 75% 70% 65% 55% 50% 45% 40% 48% IPCA Labs. 50% 52% 52% Cadila Lupin Natco 53% Indoco Rem.^ Source: Company Data, Industry & ICRA Estimates 56% 56% 58% Ranbaxy* Cipla Dr. Reddy's 67% 72% Sun Glenmark Torrent In this context, we expect companies with high exposure on few therapy segments like Torrent with high concentration on CVS segment, Ranbaxy and Cipla with significant dependence on acute segments in their portfolio to be a little more vulnerable than others despite their well diversified geographic presence. In our view, with the uncertainties related to the pricing policy getting clearer, companies are likely to review their business strategies for the domestic market. In the near term, we expect companies to start rationalizing expenditure on promotional and marketing initiatives while increasing focus on field force productivity. Over the long-run, an increased focus on combination drugs (as those are out of the span of pricing policy), in-licensing initiatives, comarketing/alliances with MNCs and several other measures like focus on OTCs, vaccines, institutional segment and even biosimilars would start gaining importance in the overall business strategies. We believe that overall, the new pricing policy intends to strike a balance between interest of the consumers and the industry through a limited impact on the earnings at an aggregate level.

5 A brief about National ceutical Pricing Policy (NPPP) 2011 In November 2011, the Department of ceuticals released a draft note on National ceutical Pricing Policy (NPPP) 2011 with the objective to replace the existing pricing policy and bring a wider gamut of drugs under the pricing control. The proposed policy was structured around three key principles a) covering all the essential drugs under the span of price control, b) moving away from a cost-based pricing to a market-based pricing mechanism and c) controlling prices of only formulations as compared to bulk drugs earlier. The policy aimed at widening the ambit of medicines under price control by including all the 348 essential drugs (forming part of the National List of Essential Medicines (NLEM) in comparison to only 74 bulk drugs that form part of the present policy regime. In addition, it marked an important shift by computing price ceilings using market-driven pricing compared to the archaic cost-based approach. Exhibit 5: Snapshot of the proposed policy Parameters Drug Policy (1994) Proposed Policy (2011) Comments Coverage On Market share Principle On essentiality of drugs Policy aimed including drugs under pricing control based on their essentiality rather than market share principle implemented earlier; The coverage is drawn from NLEM finalized in 2011 Pricing Mechanism Cost-based pricing Market-based pricing Impact: Expected to bring transparency and would be beneficial for the industry in the long-term The new policy aims to replace the cost-based pricing mechanism with market-based pricing approach wherein a ceiling price would be formulated based on the weighted average price (WAP) of the top-3 brands in a segment. However, new proposal would be based on WAP of all the brands with market share > 1% Scope Covers both Formulations & Bulk Drugs Source: Draft Policy Document, ICRA Proposes to cover only Formulations Impact: Would result in marginally higher price cuts in comparison to the earlier proposal The new policy proposes to regulate the price of formulations only. This is different from the earlier principle of regulated price of specified bulk drugs and their formulations Impact: Would encourage investments into development and manufacturing of APIs/Bulk Drugs Besides ensuring affordability of medicines through effective price control mechanism, the proposed policy also aims strengthen the drug distribution and availability mechanism through various measures. Some of the prominent initiatives proposed by the policy included: Streamlining the drugs procurement mechanism by the Government through a strong and transparent drug purchase policy Improving direct healthcare access by expanding healthcare cover through State healthcare systems Promoting usage of generic drugs through various channels including the Jan Aushadhi programme Supporting the industry by introducing policies to encourage investments into Research & Development (R&D); improve access to capital for start-ups, set up of pharma development parks, rationalize tax structure as well the pharmaceutical retail trade and Improving the access to drugs used for specialized treatments particularly anti-cancer, HIV etc. The pricing policy also proposed that non-essential drugs should not be under a controlled regime and the prices should be decided by market dynamics. However, the policy does aim to keep the overall drug prices under check and monitor the prices on regular basis. It further suggests that the price hike should not be more than 15% p.a. or the increase in WPI, whichever is higher. For imported drugs, it doesn t propose a differential ceiling mechanism, while it remains unclear on the patented drugs. The prices of bulk drugs and their formulations under the scope of the DPCO are proposed to be held constant for two years. Thereafter, the price revision will be linked to the changes in WPI.

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