The pharmaceuticals sector enjoyed a golden decade in the 1990s when a slew of innovative drugs came to the market, leading to companies generating tens of billions of dollars in profits.
However, the following 10 years have been dominated by concerns over patent expirations and increased competition from generic pharmaceuticals companies. The situation has been exacerbated by diminishing returns on research and development (R&D) investment coupled with a tougher regulatory environment.
During these challenging times, many of the major pharmaceuticals companies have increasingly turned to merger and acquisition as a coping mechanism, hoping economies of scale would lead to efficiencies in both sales and R&D productivity.
This has led to companies developing leaner sales and marketing infrastructure, but success in increasing R&D productivity has proved to be elusive. The current economic downturn has seen a new pressure point, with both national governments and healthcare providers calling for a reduction in drug prices.
Crossroads
Global sales growth in branded pharmaceuticals has halved over the last decade, in part due to a slowing down of so called “blockbuster” drugs (sales of over $1bn) coming to the market. In addition, increased competition from generic companies has cannibalised tens of billions of dollars in sales of branded pharmaceuticals.
Although Western markets including Japan currently make up nearly 80% of global sales, emerging markets are forecast to contribute 70% of sales growth over the next five years. The new markets include China, Brazil, India, Turkey, Mexico, Russia and South Korea – so called “pharmerging” countries.
Along with greater emphasis on developing a sustainable business model in emerging markets, the passing of long overdue healthcare legislation in the US augurs well for companies operating in the biggest pharmaceuticals market in the world.
The US House of Representatives passed a landmark healthcare Bill in March of this year which brought an additional 32 million non-insured Americans into the healthcare system. Although pharmaceuticals companies have been forced to take some pain on pricing in the short term, the uplift in patient volumes should more than offset that hurt over the longer term. The US spends the equivalent of 16% of its GDP on healthcare, nearly twice as much as other OECD countries. In contrast the average expenditure for Bric countries is less than 6%.
In 2001, nearly 80% of sales growth came from mature Western markets, but by the end of the decade this had dwindled to 16%. The decline has been due to a surge in demand for pharmaceuticals and healthcare services in emerging markets. The Bric countries along with Turkey, Mexico, Venezuela, Argentina, South Africa and Egypt account for 85% of emerging markets pharmaceuticals sales. The key drivers include economic development, demographics and the onset of Western lifestyle diseases.
Economic development
Economic development is perhaps the key determinant to how significant a role emerging economies will play in the long term development of the global pharmaceuticals market. There is a strong positive correlation between increased GDP and pharmaceuticals spending. Emerging economies such as the Bric countries are currently enjoying a surge in GDP and this will be accompanied by an increase in healthcare expenditure.
The case that margins will be much lower in the developing world is not necessarily true. The emerging economies tend to have much higher out-of-pocket healthcare costs than in developed countries, which often have larger welfare provisions in their healthcare systems.
Out-of-pocket costs include paying for visiting the doctor for a diagnosis and also for any prescribed treatment. For example, in Brazil and India, out-of-pocket costs run as high as 80% and more, but in the UK the number is closer to 25%. The larger economies of India and China now have a burgeoning middle class, running into hundreds of millions, who have more than enough disposable income to pay for their growing healthcare needs.
The emerging markets currently represent 85% of the world population. This large base is becoming not only highly urbanised, but also increasingly aged. It is estimated that by 2030, 80% of the population in the developing world will be residing in towns and cities.
Over the next two decades, the population aged over 60 in the developing world will grow at over 3%, with numbers forecast to rise from 475 million in 2009 to 1.6 billion in 2050. This will result in an increase in the healthcare industry customer base and the amount of the national income spent on healthcare.
Western lifestyle diseases
The increase in economic prosperity has led to a change in diet and consumption patterns that has resulted in increased incidences of chronic illness including diabetes, cardiac and respiratory diseases. Chronic diseases represent the biggest opportunity for pharmaceuticals companies in the developing world.
The World Health Organisation estimates deaths due to chronic diseases will rise from 20% in 2005 to 30% by 2030. For example, India is expected to have 74 million diabetics in 2025, compared to 40 million in 2007.
China is set to dominate; currently capturing over 25% of sales in emerging markets, it is set to become the third-largest market by 2012, after the US and Europe. The Government has implemented a programme of heavy investment – $124bn – into developing a national healthcare system over the next three years. The aim is to have 90% of the population covered by basic health insurance by 2011, and universal access to essential healthcare for 1.3 billion people by 2020.
The population is not only aging, forecast to have more than 200 million people over the age of 60 by 2015, but is also fast developing Western lifestyle disorders such as diabetes, cardiovascular and metabolic diseases.
The continued improvement in reimbursement from healthcare insurance providers and an increase in affordability should lead to sustained double-digit sales growth in both branded and generic pharmaceuticals
Attractive valuation
The pharmaceuticals sector is currently attractive in terms of yield, growth and valuation, with many leading companies having little debt or net cash on their balance sheets. The balance sheet strength is augmented by a dividend yield close to 5%, which is amply covered through highly visible earnings growth.
The sector has become more popular with income seekers following the malaise in the banking and oil sectors, which used to provide the lion’s share of dividend income in the UK. The pharmaceuticals sector, which hit highs of 30 times price earnings multiples at the end of the 1990s ,has seen a steady decline to reach single digit multiples in 2009.
Slowing growth in the traditionally lucrative Western pharmaceuticals markets has been the key driver for the pharmaceuticals sector’s new focus on gathering market share in emerging markets. So, with Western growth potential now limited and challenges from patent expiration, generic competition and reduced national healthcare spend in the near term, emerging markets look significantly more attractive in the long term.
Ketan Patel is senior investment analyst at Ecclesiastical Investment Management
