Rating Criteria for

the Pharmaceutical Industry

The pharmaceutical industry encompasses aspects of healthcare such as
medicines and diagnostic kits. The industry also includes manufacturers of
both bulk drugs and formulations, and is highly fragmented. While the
multinational companies dominated the domestic pharmaceutical industry till
the early 80s, the late 80s and early 90s saw the emergence of Indian companies.

The pharmaceutical industry is relatively immune to economic cycles. Unlike

other industries where macro-economic fundamentals play an important role
in determining the overall demand levels, the demand for pharmaceutical
products is relatively independent of such parameters. This has translated into
fairly steady growth rates for the industry in the past.

CRISIL's analysis of pharmaceutical companies involves assessing

government policies and regulatory issues, market position and operating
efficiency.

BUSINESS RISK ANALYSIS

Government policies and regulatory issues
Impact of changes in government policy and regulations
The pharmaceutical industry has been a highly regulated industry worldwide
by virtue of its direct bearing on public health. In India too, government
policies have played a key role in the performance of companies. A main
feature of governmental regulation affecting the industry has been the explicit
control on drug prices in the form of the drug price control order (DPCO).
While DPCO fulfills the socialistic objective of ensuring availability of drugs at
reasonable prices, it restricts the pricing flexibility of companies, thereby
adversely affecting profitability.

The government is in the process of setting up the National Pharmaceutical

Policy 2006, which is expected to address the issue of pricing controls. The
government proposes to bring all 354 essential drugs under its control;
however, in order to encourage the usage of generic drugs; it proposes to keep
such drugs out of price control. It also proposes to reduce the prices of drugs by
CRITERIA - Corporate Sector

fixing caps on manufacturing, wholesale and retail margins. It also proposes

that the maximum retail price (MRP) of all drugs should be inclusive of taxes.

In analysing the impact of pricing controls on the profitability of companies,

CRISIL looks at the percentage of the company's sales that come under the
purview of pricing controls. However, considering the large number of players
in the industry, competitive pressures rather than regulation are likely to be the
key determinant of prices in many of the segments in future.

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The impact of post product patent regime
Product patents in pharmaceuticals were
introduced in the country with effect from January
1, 2005 with an amendment of the Patents Act,
1970, in conformity with the TRIPS Agreement.
Following the introduction of product patents,
Indian companies are no longer allowed to
introduce the latest patented drugs without
licensing agreements with the patent owner. This,
CRISIL believes, will lead to structural changes in
the industry; it will encourage innovation and
greater investment in research and development
(R&D). It may not impact the industry over the
short term; over the long term, however, there
could be a slowdown in the introduction of new
products in the domestic market. CRISIL in its
assessment of the impact considers the strategies
being adopted by companies to ensure that the
pipeline of new products is maintained.
Indian companies have been refocusing their
business strategies on either the generics (patent
expired products) market, entering into co-
marketing/licensing arrangements for patented
products, or on manufacturing and R&D tie-ups
with international majors. CRISIL in its
assessment of the impact of the patent regime on a
company's performance, considers its
implications on the financial structure and future
business prospects.
Given the total worth of drugs going off patents in
the global market and the growing population of
the aged in the developed markets, there exists a
huge opportunity for Indian pharmaceutical
companies to export bulk drugs and generics.
CRISIL, therefore, also assesses the strategies
adopted by the company to tap the export
opportunities.
Other issues
In addition to the above, CRISIL's analysis also
focuses on issues such as tariffs, taxes and non-
tariff barriers such as reduction in customs duty,
excise duty exemptions, and ban on the import of
bulk drugs. The analysis also covers the impact of
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changes in excise and income tax rules on the
competitiveness of companies. CRISIL also takes
into account how sensitive the company's
performance is to these changes.
Market position
Product mix
A pharmaceutical company's market position is
largely determined by the product mix and the
competitive position of the products. CRISIL
examines the company's overall sales mix in terms
of bulk drugs and formulations as well as in terms
of domestic and export sales.
Factors affecting market position for bulk drug
manufacturers:
Pricing ability: In the bulk drugs business, which is
characterised by a high degree of competition,
market position is largely determined by pricing
ability, which in turn is linked to the company's
operating efficiencies and economies of scale.
Product quality: Quality of products and reliability
of services are also differentiating factors in the
industry.
Product range: Given the high level of competition
in the pharmaceutical industry, CRISIL believes
that the diversity of the company's product range
and the presence of molecules involving
complexity in manufacture significantly mitigate
the impact of competitive pressures and support
the company's performance in terms of sales
growth and profitability.
Geographical diversity: Another factor that
enhances the company's risk profile in the bulk
drugs business is exports to the regulated markets
in the US and European countries, characterised
by high entry barriers and offering a substantial
premium over realisations in other markets. Also,
exports to many countries minimises event risks
associated with adverse market conditions in a
specific country.
Access to developed markets: Given the intense
competition in the domestic bulk drug market,
access to developed markets provides significant
business diversity to a pharmaceutical company.
However, in order to tap the developed
international markets, Indian pharmaceutical
companies first need to obtain necessary
approvals for their manufacturing facilities from
regulatory agencies such as US Food and Drug
Administration (FDA) and its counterparts in
other markets. This will enable pharmaceutical
companies to file for Drug Master Filings (DMF),
which in turn are necessary to tie-up as suppliers
to established drug manufacturers in developed
countries. CRISIL evaluates a company's strategy
and progress on these fronts to determine future
benefits.
Factors affecting market position for formulators
In sharp contrast to the profile of the bulk drugs
business, the formulations business is driven
largely by brand image and the marketing and
distribution strengths of a company. The
formulations business is therefore characterised
by steady growth rates and fewer price variations
vis-a-vis the bulk drugs business. Hence, some of
the key determinants of performance, according
to CRISIL are:
Distribution set up: CRISIL assesses the company's
marketing and distribution setup in terms of
geographical reach and the medical
representative sales force's reach with the doctors.
CRISIL also looks at the productivity of the sales
force, benchmarked against industry norms.
Therapeutic segment coverage of the company: One of
the unique features of the formulations business is
the large number of therapeutic segments. A
product in one segment cannot be used as a
substitute for products in another segment. As a
consequence, each segment assumes
characteristics of a separate industry. Therapeutic
segments have varying growth rates, loyalties of
usage, rates of new drug discovery and
competitive pressures. CRISIL assesses the
company's strategy to increase its presence in the
fast-growing segments.
Market share: CRISIL examines the company's
position in therapeutic segments in terms of
relative market shares and growth rates and the
presence of strong brands in the segments.
Brand loyalty: Another key feature of the
formulations business is the premium and loyalty
of the medical fraternity associated with brands.
Large brands that are fairly well entrenched in
their respective therapeutic segments
considerably strengthen the company's business
position and render a degree of stability to the
sales. In analysing the relative position of
companies on this aspect, CRISIL looks at the
number of strong brands in the company's
portfolio and contribution of these brands to the
overall sales.
New product launch: In an industry driven by the
discovery of new therapies which either replace
older therapies or fulfill unmet therapeutic needs,
the presence of new therapies / molecules in the
company's product basket is another key
determinant of overall competitive position.
Newer therapies/molecules typically command
a premium over the older therapies and witness
fairly high growth rates often at the expense of
older therapies. This has implications on the
company's growth and profitability prospects. To
assess the company's capabilities in this respect,
CRISIL looks at its track record at introducing
new products, and their contribution to the
overall turnover. In the case of Indian subsidiaries
of international pharmaceutical majors, the level
of new product introductions is guided by the
research strengths of the parent company and the
parent company's policy of differential pricing for
developing countries such as India. CRISIL also
examines the various strategies adopted by the
company: these include co-marketing and
licensing arrangements with patent holders of
new generation drugs.
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Strategies in Regulated markets: Indian
pharmaceutical companies have begun to focus
increasingly on the large generics market in the
regulated markets. Companies entering the
market through Para III filings have been
subjected to increased pressure on prices and
margins. Para IV filings, which provide
profitability, have been aggressively and
successfully challenged by patent holders,
resulting in large R&D and ligitation losses for
Indian companies. A large opportunity has also
opened up for contract research and
manufacturing services (CRAMS), leveraging the
cost and skill advantages that India offers. CRISIL,
in its assessment, evaluates the level of risk-
mitigation followed by companies in their growth
strategies in the regulated markets. CRISIL
considers the level of diversity in revenue streams
from different generic strategies and geographies
Operating efficiency
Technological capability
Manufacturing in the pharmaceutical industry
involves two stages: the manufacture of bulk
drugs and the formulation of these bulk drugs into
various dosage forms such as tablets, capsules and
syrups. The manufacture of bulk drugs is
technology and capital intensive in nature;
however, the manufacture of formulations
involves mere physical processes such as mixing,
adding binders and packaging with relatively low
capital requirements.
In analysing the operating efficiencies of a bulk
drugs manufacturer, CRISIL considers the
chemical synthesis capabilities and process
complexities involved in manufacture. A product
with a high degree of complexity in manufacture,
such as those involving fermentation technology,
is typically characterised by high entry barriers
and thereby, the presence of fewer players.
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Extent of backward integration
CRISIL also looks at the level of backward
integration and flexibility offered by the
company's facilities to manufacture a wide range
of bulk drugs. There are benefits to be derived
from a high level of backward integration in the
form of higher operating margins, greater pricing
flexibility and greater control on quality
standards, vis-a-vis the smaller players.
However, backward integration at times also
constrains the company's ability to capitalise on
cheaper intermediate and raw material sources.
Cost of production
Given the commodity nature of some bulk drugs,
no analysis of the company's operating
efficiencies is complete without a comparative
assessment of the company's costs of production
vis-a-vis the landed costs of imports.
Quality standards
While assessing the operating efficiencies of a
formulator, CRISIL considers the level of
automation and the certification of the company's
facilities by regulatory authorities in the US and
European countries. CRISIL believes this is
critical, given the increasing thrust of Indian
companies towards exports.
R&D
Internationally, product life cycles of
pharmaceutical products necessitate that
pharmaceutical companies to keep up a steady
stream of new product launches. This in turn is
critically linked to the company's R&D
capabilities. Consequently, most leading
companies devote a large proportion of their
resources in terms of people, funding and time to
the discovery of new molecules. The resource
commitment to R&D activity is justified by the
high returns on investments on account of pricing
flexibility and patent protection for the new
products.
Until recently, R&D activities by most Indian
companies were restricted to process
reengineering for new drugs introduced
worldwide and development of new dosage
forms and better drug delivery mechanisms.
However, with the changes in patent regime from
process to product patents in 2005, the importance
of basic R&D efforts in the Indian context has
increased. Some large Indian pharma companies
have made concerted efforts to step up R&D
activity. Apart from getting regulatory clearance
for generic introductions, companies have been
looking increasingly towards new drug delivery
systems (NDDS) and new chemical entity (NCE)
research. Some of these activities involve
extremely high expenditures with uncertain
outcomes. Companies have been managing this
risk through various strategies including
partnering and out-licensing. International
pharmaceutical companies have also begun to
focus on collaborative research and outsourcing of
research activities in their efforts to reduce overall
R&D costs. This offers ample opportunities for
Indian companies given their process strengths
and relatively cheap skilled manpower costs. In
assessing a company's ability to capitalise on these
opportunities, CRISIL examines the quality of the
scientific and technical manpower, the annual
spend on R&D, and the adequacy of the R&D
facilities. CRISIL also examines the risk-
mitigation strategies followed in undertaking
large R&D expenditures with long gestations.
FINANCIAL RISK ANALYSIS
For the analysis of the financial risk of a
pharmaceutical company, CRISIL follows the
standard criteria used for all manufacturing
companies. This criterion is presented in detail in
our publications ' Rating Criteria for
Manufacturing Companies' and 'CRISIL's
Approach to Financial Ratios'.
CONCLUSION
Thus, in CRISIL's opinion, the key success factors
for the pharmaceutical sector include the presence
of:
! Strong research and development capabilities
! Diversity in product mix and presence of
molecules involving complex manufacturing
! Geographical diversity and brand equity