By Michael Waterhouse | 04-08-11 - Taken from MorningStar
Consolidation to Continue in the Generics Industry
The generics industry remains in the midst of a consolidation phase. Operating in a highly fragmented and relatively commodity-based segment of the health-care industry with low barriers to entry, generic manufacturers gain advantages from acquisitions, which can quickly boost economies of scale as consolidated fixed costs become allocated over a larger manufacturing volume base. Therefore, generic manufacturers have an incentive to get big and drive down relative operating costs. Additionally, moving from a fragmented industry toward an oligopoly generally raises barriers to entry and eases pricing pressure.
The generics industry remains in the midst of a consolidation phase. Operating in a highly fragmented and relatively commodity-based segment of the health-care industry with low barriers to entry, generic manufacturers gain advantages from acquisitions, which can quickly boost economies of scale as consolidated fixed costs become allocated over a larger manufacturing volume base. Therefore, generic manufacturers have an incentive to get big and drive down relative operating costs. Additionally, moving from a fragmented industry toward an oligopoly generally raises barriers to entry and eases pricing pressure.
The largest generics industry players, Teva (TEVA), Sandoz (subsidiary of Novartis (NVS)), Mylan(MYL), and Watson (WPI) continue to drive industry consolidation. As Table 1 shows, there has been at least one large acquisition every year since 2004. Teva has demonstrated the largest appetite for acquisitions, quickly rising into its position as the world's top generics manufacturer with an acquisition every other year. Through acquisitions, we estimate these four generic manufacturers now possess nearly 50% of the generic drug market, and we anticipate unannounced deals could put combined market share near 60% by 2015.
With plenty of cash flow through 2013 from the patent cliff, we expect consolidation to continue. Table 2 includes our list of industry acquisitors, Teva, Sandoz, Mylan, Watson, and Hospira (HSP). We include Hospira, the world's leading generic injectables manufacturer, on our list. It is important to note, however, that smaller players, especially emerging market players in India, will likely participate in smaller acquisitions as well. With Teva and Hospira each digesting recent acquisitions and Mylan handicapped somewhat by higher financial leverage, we think Watson and Sandoz stand out as the two likeliest acquisitors, at least in the near term. We think Watson has the most to gain from an acquisition since it lacks a broad international presence and vertically integrated operations comparable to its larger competitors. A European acquisition could help boost Watson's scale, while an acquisition in India could enhance the company's vertical integration by gaining active pharmaceutical ingredient (API) manufacturing facilities. Although Watson has some vertically integrated operations, owning API facilities enables generic manufacturers to further cut costs out of their operating structure. Watson also stands out as a potential takeover target for Sandoz or Teva, but we think Watson's current market capitalization makes this less likely. Teva would also likely face antitrust scrutiny if it pursued Watson.
Emerging Market Drug Markets Offer Compelling Opportunity
We expect emerging market drug manufacturers will be the focal point of future industry consolidation going forward. Until now, most of the generic industry's major consolidation has occurred in the large and developed drug markets of North America and Western Europe where similar market characteristics helped drive economies of scale. The different characteristics of emerging generic drug markets, including higher growth and unconsolidated customer bases, offer attractive new opportunities. Besides countries like India and China where GDP and disposable income growth could be substantial, emerging markets generally lack the streamlined drug distribution structure seen in the U.S. and much of Western Europe. While the majority of generic drug sales in the U.S. funnel through large pharmacies such as Wal-Mart (WMT) or Walgreens (WAG), or pharmacy benefit managers such as Express Scripts (ESRX) or Medco (MHS), generic manufacturers sell primarily to a fragmented market of independent pharmacies in emerging markets. Although a generic drug will not have patent protection in these markets, sales and marketing efforts utilize brand strategies to appeal to this fragmented customer base. Often called "branded generics," sales of generic drugs in emerging markets resemble slightly cheaper versions of their branded innovative counterparts. This branding strategy, which meshes well with innovative drug marketing efforts, has drawn the attention of big pharma firms such as Abbott (ABT), Pfizer (PFE), and GlaxoSmithKline (GSK) in addition to the large generic manufacturers. Lower barriers to entry in emerging markets, thanks to less stringent intellectual property and safety regulation, keep emerging markets relatively fragmented, but brand recognition makes it slow for new entrants to gain market share. Although the branding strategies in smaller emerging markets require relatively higher operating costs, these drugs usually see less aggressive pricing pressure and, therefore, produce overall higher profit margins.
With plenty of cash flow through 2013 from the patent cliff, we expect consolidation to continue. Table 2 includes our list of industry acquisitors, Teva, Sandoz, Mylan, Watson, and Hospira (HSP). We include Hospira, the world's leading generic injectables manufacturer, on our list. It is important to note, however, that smaller players, especially emerging market players in India, will likely participate in smaller acquisitions as well. With Teva and Hospira each digesting recent acquisitions and Mylan handicapped somewhat by higher financial leverage, we think Watson and Sandoz stand out as the two likeliest acquisitors, at least in the near term. We think Watson has the most to gain from an acquisition since it lacks a broad international presence and vertically integrated operations comparable to its larger competitors. A European acquisition could help boost Watson's scale, while an acquisition in India could enhance the company's vertical integration by gaining active pharmaceutical ingredient (API) manufacturing facilities. Although Watson has some vertically integrated operations, owning API facilities enables generic manufacturers to further cut costs out of their operating structure. Watson also stands out as a potential takeover target for Sandoz or Teva, but we think Watson's current market capitalization makes this less likely. Teva would also likely face antitrust scrutiny if it pursued Watson.
Emerging Market Drug Markets Offer Compelling Opportunity
We expect emerging market drug manufacturers will be the focal point of future industry consolidation going forward. Until now, most of the generic industry's major consolidation has occurred in the large and developed drug markets of North America and Western Europe where similar market characteristics helped drive economies of scale. The different characteristics of emerging generic drug markets, including higher growth and unconsolidated customer bases, offer attractive new opportunities. Besides countries like India and China where GDP and disposable income growth could be substantial, emerging markets generally lack the streamlined drug distribution structure seen in the U.S. and much of Western Europe. While the majority of generic drug sales in the U.S. funnel through large pharmacies such as Wal-Mart (WMT) or Walgreens (WAG), or pharmacy benefit managers such as Express Scripts (ESRX) or Medco (MHS), generic manufacturers sell primarily to a fragmented market of independent pharmacies in emerging markets. Although a generic drug will not have patent protection in these markets, sales and marketing efforts utilize brand strategies to appeal to this fragmented customer base. Often called "branded generics," sales of generic drugs in emerging markets resemble slightly cheaper versions of their branded innovative counterparts. This branding strategy, which meshes well with innovative drug marketing efforts, has drawn the attention of big pharma firms such as Abbott (ABT), Pfizer (PFE), and GlaxoSmithKline (GSK) in addition to the large generic manufacturers. Lower barriers to entry in emerging markets, thanks to less stringent intellectual property and safety regulation, keep emerging markets relatively fragmented, but brand recognition makes it slow for new entrants to gain market share. Although the branding strategies in smaller emerging markets require relatively higher operating costs, these drugs usually see less aggressive pricing pressure and, therefore, produce overall higher profit margins.
India Takes Center Stage
We think India will be the focal point of industry consolidation, but valuation concerns may limit takeovers. India, in particular, possesses some of the largest generic manufacturers with access to many of the world's emerging markets. Ranbaxy, Dr. Reddy (RDY), Cipla, Sun, Lupin, and Aurobindo comprise a significant portion of the global generics market with operations in emerging markets like Russia, Eastern Europe, and India, in addition to developed markets. As seen in Table 3a, we view India-based firms as appealing takeover candidates thanks to their emerging market exposure and low-cost vertically integrated operations. It should be noted that we include only the largest India manufacturers; numerous smaller companies exist. The Indian generic drug manufacturers, however, trade at high price/sales multiples when compared to historical deals, which could prevent potential acquisitions. Deals typically occur in the 2-3 times sales range, much lower than where many of the Indian pharma companies currently trade. Abbott, for example, paid about 7 times sales for its recent Piramal deal. But it is still uncertain whether pharmaceutical companies are willing to pay any premium over already lofty price multiples for these Indian manufacturers. As large players attempt to avoid rising acquisition multiples and Indian firms desire greater access to global generics markets, joint ventures, similar to Dr. Reddy's agreement with Glaxo or Aurobindo's agreement with Pfizer, may play an increasing role in this industry. We rate Orchid as a less likely takeover candidate since Hospira acquired the attractive injectables segment in 2010 and has signed long-term supply agreements for a large part of Orchid's API capabilities. We also rate Wockhardt as low interest since the company's majority shareholder, Khorakiwala, appears unwilling to liquidate assets despite the firm's financial duress.
We think India will be the focal point of industry consolidation, but valuation concerns may limit takeovers. India, in particular, possesses some of the largest generic manufacturers with access to many of the world's emerging markets. Ranbaxy, Dr. Reddy (RDY), Cipla, Sun, Lupin, and Aurobindo comprise a significant portion of the global generics market with operations in emerging markets like Russia, Eastern Europe, and India, in addition to developed markets. As seen in Table 3a, we view India-based firms as appealing takeover candidates thanks to their emerging market exposure and low-cost vertically integrated operations. It should be noted that we include only the largest India manufacturers; numerous smaller companies exist. The Indian generic drug manufacturers, however, trade at high price/sales multiples when compared to historical deals, which could prevent potential acquisitions. Deals typically occur in the 2-3 times sales range, much lower than where many of the Indian pharma companies currently trade. Abbott, for example, paid about 7 times sales for its recent Piramal deal. But it is still uncertain whether pharmaceutical companies are willing to pay any premium over already lofty price multiples for these Indian manufacturers. As large players attempt to avoid rising acquisition multiples and Indian firms desire greater access to global generics markets, joint ventures, similar to Dr. Reddy's agreement with Glaxo or Aurobindo's agreement with Pfizer, may play an increasing role in this industry. We rate Orchid as a less likely takeover candidate since Hospira acquired the attractive injectables segment in 2010 and has signed long-term supply agreements for a large part of Orchid's API capabilities. We also rate Wockhardt as low interest since the company's majority shareholder, Khorakiwala, appears unwilling to liquidate assets despite the firm's financial duress.
Fewer Options Exist in North American and European Markets
Many of India's larger pharmaceutical companies, such as Dr. Reddy, Cipla, Sun, and Lupin, will also likely broaden their geographic exposure through acquisitions. A large portion of Indian drug manufacturer growth has come from entry into the much larger generic markets of the U.S. and Europe. Dr. Reddy acquired the German generic manufacturer Betapharm in 2006 and acquired GlaxoSmithKline's Tennessee based penicillin manufacturing operations in 2011. Sun owns a majority stake in Israel-based Taro and U.S.-based Caraco, while Ranbaxy has made acquisitions in Italy and Romania. Hikma (HIK) has an agreement to purchase Baxter's generic injectables drug business. Although the highest-quality U.S. and European generic manufacturers have already been acquired, one of India's large generic manufacturers, such as Ranbaxy, Dr. Reddy, Cipla, or Sun, hoping to gain greater exposure in the world's larger pharmaceutical markets, could vie for the smaller remaining North American or European companies. Table 3b lists some of these remaining manufacturers. With nearly $2 billion in revenue, Stada remains one of the last big generic manufacturers in Europe with some takeover rumors circling. It has also been rumored that potential acquisitors recently passed on Actavis due to valuation concerns. Amneal, Impax, Par, and Apotex remain as the few midtier North American-based generic drug manufacturers. We view Hi-Tech, Lannet, and KV as possible but unlikely acquisition candidates due to their low sales figures.
Many of India's larger pharmaceutical companies, such as Dr. Reddy, Cipla, Sun, and Lupin, will also likely broaden their geographic exposure through acquisitions. A large portion of Indian drug manufacturer growth has come from entry into the much larger generic markets of the U.S. and Europe. Dr. Reddy acquired the German generic manufacturer Betapharm in 2006 and acquired GlaxoSmithKline's Tennessee based penicillin manufacturing operations in 2011. Sun owns a majority stake in Israel-based Taro and U.S.-based Caraco, while Ranbaxy has made acquisitions in Italy and Romania. Hikma (HIK) has an agreement to purchase Baxter's generic injectables drug business. Although the highest-quality U.S. and European generic manufacturers have already been acquired, one of India's large generic manufacturers, such as Ranbaxy, Dr. Reddy, Cipla, or Sun, hoping to gain greater exposure in the world's larger pharmaceutical markets, could vie for the smaller remaining North American or European companies. Table 3b lists some of these remaining manufacturers. With nearly $2 billion in revenue, Stada remains one of the last big generic manufacturers in Europe with some takeover rumors circling. It has also been rumored that potential acquisitors recently passed on Actavis due to valuation concerns. Amneal, Impax, Par, and Apotex remain as the few midtier North American-based generic drug manufacturers. We view Hi-Tech, Lannet, and KV as possible but unlikely acquisition candidates due to their low sales figures.
ReplyDeleteVery interesting blog. I really liked it.