• FEBRUARY 13, 2007

Pharma: Acquisitions to intensify?

India Inc. has been witnessing increased activity on the M&A front across sectors of late. First it was Tata Steel's acquisition of Corus, then Vodafone's acquisition of 67% stake in Hutchison Essar and finally, Hindalco's bid to acquire Novelis for US$ 6 bn. These acquisitions highlight the fact that the deal size is getting bigger and bigger. Similarly, acquisitions have been gathering pace in the Indian pharma industry as well. Two big acquisitions by the behemoths, Dr.Reddy's (Betapharm) and Ranbaxy (Terapia) prove testimonial to the fact. In fact, with the European company Merck KgaA looking to put up its generics business Merck Generics on the block, the scramble amongst both global generic companies and Indian generic companies to acquire scale seems to have intensified. Here, we look at some of the pros and challenges that Indian pharma companies are expected to face on the consolidation front going forward.

The pros...
Scale: It is a well documented fact that the US generics market has been facing intense price erosion, which has been due to increasing competition from both Indian and global generic players. It must be noted that the pharma distribution chain in the US market is highly consolidated with around 3 companies dominating around 70% of the distribution network for pharma products. This means that having the required scale is important in increasing the distribution reach and attaining significant market share in a particular product in this highly competitive market. Acquiring scale holds true in other markets as well in cornering a larger chunk of the market. It must be noted that the gap between Teva and Sandoz (the top two players at present) and the rest of the pack has widened and thus there is ample scope to reduce the same, thereby intensifying the need for consolidation.

Access to new geographies: Given the fact that the US market is highly competitive, Indian companies are increasingly looking to establish a presence in other geographies to de-risk the revenue profile. However, as per our interaction with a leading pharma company, it is not easy to set up operations in any country right from scratch and hence an acquisition provides a ready platform to strengthen presence in a particular market. Given the fact that different countries have a different regulatory environment and different market conditions, acquiring a company in a particular market enables the acquiring company to strengthen its foothold in the market at a faster pace. For instance, Dr.Reddy's had a marginal presence in Germany initially and the acquisition of Betapharm has provided the former a vehicle to strengthen its reach in the German market, which is the largest generics market in Europe.

Strengthening product portfolio: The rising competition in the generics space has led to a commoditisation of plain vanilla generics and thus there has been increased focus on niche and technology intensive products where the level of competition is relatively lesser. For instance, in FY05, as a part of its strategy to cater to the specialty segment, Dr. Reddy's acquired Trigenesis, a US based dermatology products company for a consideration of US$ 11 m in order to establish a footprint in the fast growing and niche dermatology market.

The challenges...
Market and regulatory risks: This is one of the major challenges that Indian pharma companies have to contend with while acquiring a company, as it is difficult to take a call on the likely regulatory changes that may take place in any country. To put things into perspective, a host of healthcare reforms in Germany and France have taken its toll on the fortunes of Indian companies having operations in these regions. For instance, in the lucrative German market, the government has made some regulatory changes, which has prompted the top companies including Betapharm to undertake price cuts on their products to comply with these changes. This has put pressure on the margins of Betapharm and could consequently increase the payback period for Dr.Reddy's. Similarly, regulatory changes in Brazil has resulted in Ranbaxy having to re-file applications for its generic products impacting sales from this region in CY06.

Expensive valuations: In the scramble to acquire scale, the number of companies looking to acquire potential targets has gone up, but the number of companies up for sale have not been that many leading to a rise in valuations. In all the large acquisitions made in the global generics space in the last couple of years, the price to sales multiple has not been less than 2 times, which is a tad expensive. Besides this, many Indian companies have raised resources through the FCCB route for funding potential acquisitions. This means that in the event that the rupee depreciates, the value of the FCCBs will increase, leading to a rise in interest obligations, thereby affecting profitability. In the case of zero-coupon FCCBs (which have also gained popularity), while companies do not have to pay interest, payment pressures (magnified further by the rupee depreciation) could arise during the time of redemption.

To sum up...
Domestic pharma majors such as Ranbaxy and Cipla have evinced an interest in bidding for Merck Generics, which is currently the fifth largest player in the global generics market. With the latter having reported revenues of around US$ 2.5 bn in CY05, the deal size is not likely to be less than US$ 5 bn, which is not a small amount by any yardstick. Thus, while a large ticket acquisition will provide Indian generic companies the much needed scale to survive the tough conditions in the generics market and contribute to the overall performance in the long term, integration issues and funding for the same could put a strain on profitability in the medium term.

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