Apart from the centenary of Benjamin Britten's birth, and the likely humiliation of the Australian cricket team in the Ashes, there isn't much to make 2013 a particularly memorable year in popular folk memory. However, investors will probably remember it as the year that the market finally started to dispassionately evaluate the prospects for companies in emerging markets free of the rather hubristic notion that the so-called BRIC countries (Brazil, Russia, India and China) would inevitably inherit the earth. However, any investor with the least notion of how history is written will understand that potential opportunities are not the same as generating a measurable return. And, as recent events prove, big pharmaceutical companies are finding it as difficult as anyone to build a presence in emerging markets without getting burnt.
Guard your intellectual property
GlaxoSmithKline (GSK) is the latest company to be hit by a scandal in one of its overseas subsidiaries. Revelations of bribery and corruption in China, with local representatives routinely 'topping up' the country's low-paid doctors to prescribe certain medicines - along with much more lurid allegations - is a deep embarrassment to the company, particularly after its own internal investigation apparently cleared anyone of wrongdoing earlier this year. There are obvious lessons about how difficult it is for people at headquarters to know what the foot soldiers are up to. Corruption on the ground can have serious repercussions, particularly if regulators in the US and Europe start to use anti-bribery legislation aggressively. However, the more pressing problem for pharma companies is the ability to defend their intellectual property effectively in new markets. And so far there is no sign that the patent-protection situation is any more stable.
For example, a survey for the US Chamber of Commerce last year found that emerging economies are consistently the worst for patent theft and copyright infringement when it comes to pharmaceutical products. The worst was India, with a score of six out of a possible 25, followed by China on 9.13, Brazil 9.57, and Russia 11.17. That fundamental problem cuts against the prevailing orthodoxy when it comes to selling products in these markets, which is that companies must invest heavily in home-grown manufacturing and distribution networks in order to gain a meaningful foothold. In a perfect world that is exactly how businesses would approach expansion abroad, but with no guarantee that their rights will be protected, such an approach by pharma companies exposes their entire development and manufacturing process to potential pirates.
The dilemma over patents facing swiss company Novartis (NOVN) illustrates the problem perfectly. The company lost a key patent case in India earlier this year that prevented it from 'evergreening' the patents in the country for its best-selling cancer drug Glivec. Evergreening means extending the life of the patents to protect property beyond the expiry of the original patent. It's a controversial practice even in the developed world, but the significance of the ruling is the legitimacy it gives to India's home-grown generics industry, which is a huge hurdle to overcome if foreign companies want to break the market. As Novartis is already a major generics producer, it may want to invest money in this sector, rather than run the gauntlet of India's lax patent laws with its expensively developed block-buster drugs.
The other point to consider is that the healthcare infrastructure in these countries is very underdeveloped. This works against pharma companies in two ways. Firstly, efficient distribution of medicines becomes difficult when there isn't the network of district hospitals, pharmacies and primary health clinics to act as conduits for medicines. That afflicts the likes of Brazil, India and Russia in particular. This can be remedied in the long term but it needs governments to give sustained leadership and funding.
Where are the profits?
Novartis has had notable success in building up its business in BRIC countries and its chief executive, Joseph Jimenez, has publicly wedded the company to continuing the policy, telling the China Daily recently: "Novartis is shifting its center of gravity toward these fast-growing markets, particularly China, in order to drive growth, gain access to broad distribution networks, tap into local market expertise and move a higher volume of medicines to those in need." The company generated about 25 per cent of its sales outside of the main developed markets, although this includes relatively wealthy areas such as the Gulf States and South Africa. Tellingly, it doesn't break out the proportion of profits that this level of emerging markets revenue generates.
Judging by the experience of other pharma companies, profits from these markets do not match their share of sales proportionately. GSK's recent results showed emerging markets sales were barely half as profitable as those generated in the US. That is to be expected as the US is the world's richest economy, but it also implies that many, many decades of GDP growth is needed before pharma companies can charge the sort of prices in China and India that generates operating margins of 70 per cent. GSK has said it will consider tiered pricing of products to make them more affordable. It is unlikely to be the only company looking seriously at this.
IC VIEW:
Investors need to remember that relentless overseas expansion is a legitimate goal for pharmaceutical companies, but it is not a one-way bet and much riskier than the hordes of consultants and commentators are likely to admit. What we take issue with is the automatic assumption that cost and reimbursement controls somehow stop once you leave US customs. For example, the likes of China and Turkey have started to introduce measures in the past year to control the upward cost of medicines, in what looks like the beginnings of a much more tightly controlled system. Perhaps the industry just needs to accept the logic of the world's ageing population. A: There are lots of pensioners in Arizona and West Sussex; and B: they can all afford to buy your drugs thanks to the unprecedented wealth of the baby boomers. Surely, there has to be a substantive debate at the highest levels of pharma management about whether piling resources based on increasingly outdated growth forecasts is the wisest course of action. Just as a general illustrative point, it is fair to say that the emerging markets bubble in stock prices has well and truly popped over the past few months. According to MSCI data, investors who bought into these markets are now sitting on year-to-date losses of more than 11 per cent, while just sticking with a basket of boring developed market indices would have yielded a 15 per cent return.
