Large Opportunity For Big Pharma

(By Damien Conover) Emerging markets carry significant barriers to entry and should broaden geographic footprints and strengthen moats for most Big Pharma firms. However, we believe the investment community is discounting the strategic upside of these markets due to 1) recent economic slowdowns that have increased volatility in emerging markets, 2) a historical focus on the dominant U.S. market, and 3) the mistaken investor perception that margins in emerging markets are too low to matter. We expect this discount will dissipate as emerging markets' economies stabilize and their sales contribution increases. In short, emerging markets still offer strong competitive advantages for Big Pharma firms.

We estimate sales from emerging markets will represent 26% of Big Pharma's total sales by 2015, up from 19% in 2011, largely due to patent losses in developed markets along with rapid wealth creation in emerging markets. As the sales contribution increases, we expect the investment community to recognize the importance of these markets.

Recent economic slowdowns in key BRIC (Brazil, Russia, India, and China) nations likely will increase the volatility of sales growth in these nations. However, long-term secular trends in income growth (80% correlated with drug spending), brand importance (less sensitivity to patents in some markets), and increases in Western diseases (strong product offerings) should help propel growth from emerging markets over developed markets.

GDP Growth Drives Pharmaceutical Spending
Growth in gross domestic product is directly correlated with drug spending. Based on a sample of 63 emerging and developed countries, World Markets Monitor calculated an 80% correlation between GDP per capita and pharmaceutical spending. Most countries fall close to the average regression, with the notable exceptions of the U.S. (significantly above) and Russia (significantly below). Further, the rapid growth in emerging-market incomes during the last five years has led to dramatically higher drug purchases. From 2004 to 2009, the BRIC nations' populations with household income above $5,000 grew by 27% annually. While this growth is expected to slow through 2014, low-teens annual growth is still expected. This massive expansion in wealth should directly increase the market opportunity for drug companies.

What's in a (Brand) Name?
Due to the perception of a high degree of variation in quality of generics, these drugs are seen as generally inferior to branded drugs. In addition, counterfeit drugs have plagued emerging markets for decades, and we believe this has instilled a sense of distrust toward non-branded drugs. The strong reputations of large multinational drug companies for manufacturing and safety also have supported branded drug sales, and such firms are able to provide a much higher degree of service to physicians and patients in the form of educational marketing relative to generics. Lastly, out-of-pocket pay comprises the majority of revenue in emerging markets, but patients still are willing to pay more for a trusted manufacturer. The importance of the branded drugs not only allows companies to launch into emerging markets with less fear of counterfeits, but also gives the branded drug a much longer life cycle in emerging markets relative to developed markets.

Margins Lower, but Still Attractive
While pricing power is not as strong relative to developed countries, emerging-market drug prices remain high enough to confer 20%-plus operating margins (excluding research and development and central administrative costs, as these require minimal incremental investment beyond base levels). During the last few years,  Sanofi-Aventis(SNY),  GlaxoSmithKline(GSK), and  AstraZeneca(AZN) have reported operating margins in emerging markets (after incorporating any drug discounts) of 23%, 28%, and 41%, respectively, relative to developed markets and excluding R&D and central administrative costs.

While pricing power varies depending on the therapeutic class and specific market, branded drugs in emerging markets are typically priced at a 50% discount relative to developed markets. However, operating costs are much lower in emerging markets. According to AstraZeneca, a sales representative is more than 50% cheaper in emerging markets; Brazil is 50% cheaper; Turkey and Russia are 60% cheaper; and Mexico and China are 80% cheaper. Therefore, lower marketing costs help offset lower pricing power in emerging markets.

Firms at the Forefront
 Bayer(BAYN) is one of the best positioned firms in emerging markets. It earned 32% of its health-care revenue from the emerging markets in 2011, and recently restructured to facilitate significantly increased investment in the regions. The restructuring program resulted in a net loss of 300 jobs worldwide in the company's HealthCare segment--the firm eliminated 1,800 jobs in the U.S. and other established markets, while creating 1,500 new positions in emerging markets. In 2011, the firm made two notable investments in the emerging markets. It established a joint venture with Zydus Cadila to strengthen its position in the rapidly growing pharma market in India and it purchased exclusive rights to Trius Therapeutic's antibiotic torezolid in Asia, Africa, the Middle East, and Latin America. Bayer also launched its blockbuster MS drug, Betaferon, in China in 2010. We expect the sales contribution from emerging markets to grow to 43% by 2015.

Sanofi also holds a leading position in the emerging markets, which contributed 30% of the firm's sales in 2011. We expect the company's strong historical entrenchment will enable it to maintain this position for several years. The company was among the first to enter Russia (1970) and China (1982) as well as several other markets. In emerging markets, brand awareness is critical, and Sanofi's long history in these territories has helped instill a strong brand name, creating a significant competitive advantage that should help support future growth. The firm's diverse operations include over-the-counter drugs (cheaper drugs that introduce patients to the company's brand), vaccines (high interest from emerging-market governments), branded drugs, generic drugs, and diabetes treatments (one the fastest growing diseases in emerging markets), which should address key areas in emerging markets. Further, we expect Sanofi will maintain its acquisition strategy in emerging markets and continue to build out its presence.

 Abbott(ABT) has shot up the ranks in emerging markets through acquisitions. Its $7 billion acquisition of Knoll in 2001 not only brought in blockbuster Humira, but also gave the company a strong branded generic presence globally. Abbott's recent acquisition of Solvay's drug unit further expanded the company's distribution in emerging markets. Finally, Abbott's acquisition of Piramal in 2010 opened up a door to the fast-growing Indian market. However, India's recent decision to offer free generic drugs could weigh on the potential of this particular emerging market that is critical for Abbott.

Firms on the Fringe
 Johnson & Johnson(JNJ) has one of the lowest exposures to the emerging markets out of the entire Big Pharma group, but is slowly embracing the idea. On the consumer health side, Johnson and Johnson recently expanded its presence with the purchase of a line of Russian OTC cough and cold brands from J.B Chemicals and Pharmaceuticals for $245 million in cash. In addition to new acquisitions, the firm is working to introduce well-known, established brands into emerging markets. For instance, the company launched Listerine Essencial in Brazil in 2010, which benefits from Listerine's well-known brand, but is adjusted to serve a slightly lower price point to make it affordable in the Brazilian market. The firm also has made significant investments to expand its presence in the medical device and diagnostics industries in the emerging markets. The acquisition of Synthes will increase its exposure, but the firm also opened two new large innovation facilities: the DePuy Institute for Advanced Education and Research in India and an Asia-Pacific innovation center in Suzhou, China. The centers will develop new products and educate professionals on the firm's products. We estimate Johnson & Johnson's emerging-market sales contribution to hit 13% in 2015 from 10% currently.

Bristol-Myers Squibb(BMY) is largely embracing a strategy to align its innovation-driven developed-market strategy with emerging markets, but we believe the emerging-markets emphasis is considerably secondary (only 8% of sales in 2011). Currently, Bristol is targeting BRIC nations and Turkey with innovative new drugs rather than the branded generics strategy utilized by its peers. As a result, Bristol generates the lowest sales contribution from emerging markets. While Bristol's long-term goal is to achieve 15% of sales from emerging markets, we believe this target will be hard to achieve and estimate the company will reach an 11% contribution from emerging markets by 2015.