Managing Director & Senior Partner
The rules of the game are being rewritten in the pharmaceutical market in China. Some basic truths about the Chinese pharmaceutical market will remain unaltered, including the fact that it is a large, vitally important market that boasts robust growth prospects—but little else will remain static. In fact, the Chinese pharmaceutical market is in the midst of a fundamental shift that will dramatically alter the winning strategies of both multinational corporations (MNCs) and local companies.
Certainly, industry growth will remain healthy, driven by the aging population, urbanization, increasing wealth, and the government’s commitment to spending more on health care. At the same time, however, two significant market-oriented factors are at play. The first is health care reform, which is both expanding coverage for the Chinese population and creating stronger budgetary controls and price pressure. The second is the emergence of local players as more formidable competitors, a development that has major implications for MNCs operating in China.
The result: companies need to develop new strategies and skills. MNCs will find that they can no longer rely on their off-patent-product portfolios, a segment that has generated tremendous growth over the past decade thanks in part to the Chinese government’s policies. And local companies, meanwhile, have a tremendous opportunity to take share from MNCs. But capitalizing on that opening will require new approaches, including in some cases a shift from their focus on simple, nondifferentiated generics—which are off-patent, commodity drugs—to a more differentiated product portfolio and the development of more-effective go-to-market strategies.
The pharmaceutical market in China will continue to grow at a rapid pace thanks primarily to two potent trends.
The first is the ongoing demographic shift, which is driving demand. The Chinese population is aging: in 2020, 33 percent of the total population will be 50 years of age or older, up from 24 percent in 2010. In addition, chronic illnesses are becoming more prevalent: in 2020, about one-third of adults will have hypertension, for example, and about one-tenth will suffer from type 2 diabetes. Importantly, the number of people in the middle-class and affluent populations is growing significantly, and the number of small to midsize cities is exploding, expanding access to modern health care.
At the same time, the Chinese government has committed to picking up a greater portion of the nation’s health-care bill. In particular, government-funded health insurance has been made available to virtually all Chinese citizens. And although the depth of coverage varies significantly across the three public insurance funds within China and across the various provinces (some provinces have larger funds because of their greater wealth levels), it is generally being deepened to cover more types of treatments for individuals.
These factors will drive overall health-care spending at a 14 percent compound annual growth rate through 2020, with health care accounting for about 7 percent of Chinese nominal GDP in that year, up from 5.1 percent in 2011. These same trends will power compound annual growth in the pharmaceutical sector of 13 to 15 percent from 2011 through 2020, a robust expansion by any measure, albeit slower than the 20 percent annual pace from 2008 through 2011.
Underlying the double-digit growth, however, is significant change wrought by ongoing health-care reform. The Chinese government has the twin objectives of reducing inefficiencies in the health-care-delivery system and paring the relative cost of major elements of health care; drugs are the most prominent. (See Exhibit 1.)
As the impact of the government’s health-care reform becomes evident, the competitive dynamics in various segments of the pharmaceutical market will shift. This means more intense competition along with price deterioration in some areas of the market and improved prospects in others.
A Shift in Drug Segment Fundamentals. Consider the impact of reform on individual drug segments. (See Exhibit 2.) The patented-drug segment, for example, will see strong sales growth as several new, potentially high-selling products—including biological drugs—launch. At the same time, the government will continue to support innovation through steps such as the development of diversified insurance schemes that will improve access to more innovative and more expensive medicines. Even without enhanced reimbursement, rising incomes will mean that patented drugs will be more affordable.
Meanwhile, off-patent originator drugs that are not on the EDL will enjoy volume growth thanks to improved insurance coverage, better affordability due to rising incomes, and reduced price premiums over local generics as the government presses to lower prices on those products.
The group of differentiated generics that are not on the EDL will continue to post robust growth, partly driven by looming patent expirations. But although first-to-market generic drugs will initially enjoy a premium relative to competing generics that are likely to come to market later, over time that broader set of follow-on generics will trigger fairly rapid price erosion.
The segment of nondifferentiated generics not on the EDL will likely contract. Either these drugs will migrate to the EDL, or their production will become concentrated among a smaller number of companies that can use scale to produce high-quality generics at a low price.
Finally, the EDL segment will experience strong growth owing to the addition of more drugs to the list and the increased use of those drugs across all city and county hospitals, as well as throughout the basic health-care system.
A Change in Customer Dynamics. It is critical for pharmaceutical companies to understand how health care reform in China is changing the way that three key customer groups (city hospitals, county hospitals, and the basic health-care system) operate—and therefore changing the composition of the market. (See Exhibit 3.)
City hospitals will account for about 50 percent of growth from 2011 through 2020. These hospitals provide better economics, relative to county hospitals and community and township health-care centers, for pharmaceutical companies thanks to their strong demand for pharmaceuticals and the reasonable costs that pharmaceutical companies incur in selling to these organizations. As a result, city hospitals will continue to be a hotly contested market among MNCs and local companies.
County hospitals, however, will become an increasingly important market. The government is increasing its investment in new infrastructure and physician training to improve county hospitals’ capabilities and is adopting reimbursement policies that encourage people to go to the county facilities instead of the big-city hospitals. That’s why county hospitals are expected to grow faster than city hospitals—at a 16 percent compound annual growth rate from 2011 through 2020 versus a 13 percent rate for city hospitals over the same time period. But competing in this category comes with real challenges: lower profitability caused by dispersed distribution across locations and lower sales per hospital.
The broader basic health-care system is made up of community health-care centers in cities and township health-care centers in rural areas. This primary-care system will be the key area of competition for EDL drugs.
A Need to Understand the Factors That Drive Success. Adapting to new market forces requires a keen understanding of both the competitive dynamics in key drug segments and the challenges facing customers. Four sectors are of particular importance for pharmaceutical companies in the Chinese market—and what it takes to win in each sector is changing. (See Exhibit 4.)
MNCs need to address two basic questions in setting their strategies for selling pharmaceuticals in China. The first is where to compete. The second is how to compete.
Determining where to compete rests on a company’s current and future position in each of the four sectors listed previously and encompasses expected changes in the overall competitive environment. So, a key factor will be the health of the company’s drug pipeline. For a company whose pipeline contains a plethora of new, innovative, patent-protected products that are ready to launch, it may be reasonable to put lesser resources into the highly competitive off-patent segments. Most companies, however, will need to achieve a balance between the patented and off-patent segments.
Over time, though, MNCs will likely find the greatest rewards in the patented-drug segment. It seems clear that Chinese companies will continue to dominate in the generic-drug segment, in part because of local companies’ low-cost position and willingness to live with lower returns (as is typical of EDL products). That position is likely to be strengthened as government policy promotes consolidation among local players with the aim of creating several larger, more powerful Chinese companies. This won’t happen immediately, but we believe that by 2020 there will be many Chinese companies of considerable scale able to compete successfully in all segments but particularly in the EDL and off-patent- drug segments.
On the issue of how to compete, the answers for patented and off-patent drugs will be quite different. And while any individual company’s strategy will depend on its product mix and competitive advantage, five key levers can be used:
Enhancing the Patented-Drug Business. The goal for any company competing in this segment is to maximize the sales of products during the period of patent protection. MNCs should be aware, though, that the traditional sales-force model will become more challenging; the restricted access to doctors that is already commonplace in more-developed countries is likely to become the norm in China as well. Companies must ensure the rapid and effective launches of new patented drugs. They must also strengthen their ability to gain market access by striking new reimbursement agreements with provincial governments, for instance, particularly for expensive innovative drugs.
Transforming the Business for Off-Patent Originator Drugs. MNCs will have to determine what new business models they should adopt and what new capabilities they need to build in light of the fact that a large sales force doing single-line detailing will no longer work in this segment. The changes required to adapt will encompass all aspects of the commercial model: sales, marketing, and market access. As premiums on off-patent products disappear, sales efforts may have to evolve; rather than focusing on specific drugs, companies may need to focus on broad disease categories. At the same time, marketing must be made more cost-effective through the use of tools for reaching out to physicians, such as digital communication channels. And market access will need to evolve as well, moving beyond a simple focus on gaining reimbursement to developing a broad effort that includes a team with the ability to manage the tendering processes run by the provincial governments.
Entering the Generics Business. Some MNCs have looked to the generics segment—including both differentiated and nondifferentiated generics—to build new “legs” for their businesses. We believe it is unlikely that MNCs, as standalone businesses, will be able to compete successfully in pure generics. Should they wish to enter this segment, they will need to forge alliances or joint ventures with local companies. Hisun and Pfizer have formed a joint venture called Hisun-Pfizer Pharmaceuticals, for example. The reasons why MNCs will need to make such moves to compete in this segment are straightforward. We believe that the Chinese government intends for local companies to supply the bulk of generic drugs in China; therefore, local companies will likely be favored in the tendering process and in gaining market access. In addition, the economics of the generics business are better suited to the lower costs of Chinese organizations and their willingness to tolerate lower returns.
Leveraging Manufacturing and R&D. MNCs need to think strategically about where they locate manufacturing and the extent to which pharmaceutical R&D is integrated into operations in China. Having local manufacturing sites, for example, can be a positive factor in government negotiations for reimbursement. And the launches of new products can be accelerated in some cases if multicenter clinical trials include sites in China. The importance of speeding up launches can’t be overstated given that companies must maximize revenues during the period of patent protection.
Building an Organization with the Right Skills and Expertise. The right strategy is meaningless if it cannot be effectively executed. MNCs must take a hard look at their organization and identify where gaps exist. Functions such as market access, for example, will become more critical, and companies must invest either to improve existing capabilities or to develop them where they are lacking.
Local companies, although they typically operate from a position that is diametrically opposed to that of the MNCs, will nonetheless need to address the same core questions about their strategy going forward.
The locals are mostly present in the less-differentiated end of the market. Thus, for local companies, determining where to compete means examining how robust their patented- and differentiated-drug portfolios are in terms of breadth as well as how competitive their off-patent-drug operation is in terms of cost.
When it comes to assessing how to compete, the specific capabilities that local players will need to enhance or develop will depend on the segment or segments in which they intend to participate. But regardless of their chosen market focus, it is clear that many companies have critical gaps when it comes to the skills and abilities required to compete.
If local companies continue to play in the off-patent, nondifferentiated drug segments, they will clearly need to continue to improve their manufacturing and commercial operations to be able to compete on cost and efficiency. They will also need to achieve improvements in overall product quality and market access. Stronger local players that are able to achieve scale (as noted, we expect several such companies to develop by 2020) will be successful competitors in the off-patent drug segments. Moreover, quite a few leading local companies that are focusing on the nondifferentiated end of the market are state-owned enterprises and have not fully integrated recent acquisitions. Improving areas such as corporate governance is critical for business integration that will improve efficiency and avoid a duplication of efforts.
In the patented-drug and differentiated-generic-drug market segments, on the other hand, local companies will need to consider how to enhance R&D capabilities to speed up drug development, or they can explore external sourcing opportunities. We already see several leading Chinese players investing in R&D to better compete in the differentiated-generic-drug and patented-drug segments. These local companies are unlikely to have the breadth and depth of products in the patented-drug segment that MNCs enjoy, but they will still gain some presence. In addition, local companies in the patented-drug and differentiated-generic-drug segment will find it critical to develop effective brand-building skills and improve their product-marketing and product-sales capabilities.
The changes being wrought by demographic, regulatory, and competitive forces in the Chinese market are far reaching. And the changes required to compete will be just as significant.
For MNCs, this will require nothing short of a fundamental rethinking of strategies in the Chinese market. Most have built significant businesses mainly on the strength of off-patent originator drugs. That business will essentially disappear over the next five to ten years, making it critical for MNCs to focus on bringing truly innovative products to the market. At the same time, however, many of the most innovative MNC drugs are very expensive, so securing reimbursement is an uphill battle. Certainly, the enhanced and diversified reimbursement schemes that the government is putting in place will cover some of the expense, but the majority of the costs for these drugs will still be paid out of pocket by patients.
Compounding those difficulties is the likelihood that MNCs will not be able to launch new patented drugs in China rapidly enough to fully offset the declines in the off-patent portfolio, in part because of their weak new-product pipelines. And some of their most innovative drugs, which are biologics, will be challenged by local companies offering less-expensive similar versions that manufacturers claim are equivalent to the original patented product.
All of this means that MNCs will be trying to maximize the sales of their off-patent products even as many of those medicines move onto the EDL. In some cases, this will mean focusing on cities where the pricing is a bit higher for those drugs or refraining from bidding to be on the EDL altogether, a step that will result in lost market share over time.
For some MNCs, these shifts are prompting a move into the generic-drug business—both differentiated and nondifferentiated—through joint ventures or possibly as standalone competitors. It will be difficult, however, for MNCs to compete as standalone entities in this space in part because of the explicit intention of the Chinese government to promote the development of local pharmaceutical champions in both the innovative and the generics markets. Even without that factor, MNCs will find that their business models—particularly their current sales forces—are not suited to the economics of the generics business.
For the local players, the evolution of the market presents more opportunity than challenge. That’s because the expansion of the generics segment is likely to drive significant growth, albeit growth that favors stronger players as the government seeks to consolidate the sector to reduce the number but increase the strength of local companies.
There will also be more opportunities for innovation as local companies enhance their scale and invest more in R&D, even if much of this investment will be along the lines of the “me too” development focus that we see today. And while “me too” biologics present clear opportunities for local companies, generic small-molecule products will continue to account for the bulk of the market. As a result, local companies that have large-scale, high-quality operations will have a true competitive advantage.
Whether the changes create new openings or new hurdles, the ability to adapt will be paramount. Those that do not adjust will be left behind.