China: Business as UNusual

Growth in the Chinese market for pharmaceuticals has been so robust and abundant in recent years that Western companies could score gains simply by being there. Today, the momentum has shifted: China is becoming a more complex market, with the potential for missteps if investors fail to accurately assess the dynamics of change and build a strategy that anticipates the new incentives that guide the actions of all key stakeholders in health. Many of these incentives are driven by the strong arm of government, while others reflect the impact of global trends on China as regards how medicines are developed, manufactured, marketed, and reimbursed. Key changes affecting the market include a drive toward generic commoditization, expansion of the OTC franchise, more pressure on hospital profit margins, consolidation in key adjacent businesses such as distribution and pharmacies, realignment toward a more competitive domestic manufacturer base, and fresh options for private health services.

(GETTY IMAGES / PHOTOSINDIA)

For the "C suite" audience of Pharm Exec, what matters most is helping your China-based team embrace change and avoid that "business as usual" mindset that tends to accompany a past record of success. What's the key message? The "altered state" of Chinese healthcare is moving from abstraction to reality—and 2011 is the deadline year for a strategic repositioning. Those who refuse to anticipate and prepare for change do so at their own risk.

Indeed, it would be a misinterpretation to assert that the massive reforms launched by the government in 2008 are simply a paper exercise. They have altered the structure of almost every facet of the medical product and service value chains—a fact often downplayed because in China there is a large gap between policy and implementation. Policies set at the national level are re-articulated at the provincial and local levels (a lengthy process), where they are enforced with varying degrees of fidelity to their original embodiments. Nevertheless, the overall direction of reform is clear—as is the fact that it, in conjunction with the central government's commitment to the 12th national economic plan which promotes increased domestic consumption, will irrevocably change the face of China's healthcare and pharmaceutical sector moving forward.

An End to Branded Generics?

Over the past decade, multinational pharmaceutical companies (MNCs) have proven able to compete on China's crowded generics playing field, and enjoy growth levels at or above the medicines sector as a whole. (Japanese pharmaceutical companies have been the notable exception for a number of reasons, including painfully slow decision-making in the boardroom.) Pharma MNC success in China has been built on the foundation of branded generic products, which have enjoyed higher prices and preferential treatment in the marketplace. Going forward, however, the branded generics space is one that will likely be increasingly unattractive for MNC players. Key factors clouding the horizon include systemic changes in China's health system in the areas of:

» Pricing: In their capacity as product originators, overseas drugmakers have been granted higher maximum pricing (referred to as "separate pricing") for their branded generics compared to their domestic generic brethren, which are limited to a lower maximum price ("general pricing") by the National Development and Reform Commission (NDRC). These separate prices, which may be significantly greater than general maximum prices, have played a major role in rendering MNC-branded generics attractive to hospitals. A new price list released on Nov. 29, 2010, focusing on essential drug list (EDL) products reduced separate pricing on 49 drugs (counted by molecule name) out of the approximately 200 Western drugs (including chemical and biological drugs) on the EDL. Moreover, the edict canceled separate pricing altogether for 13 products from 10 MNC pharmas. Going forward, reports coming from the NDRC indicate that the pricing body is now considering reducing or halting separate originator pricing across the board. Specifically, the NDRC will likely set a transition period of four years, during which the government will gradually reduce differences between separate and general drug pricing.

This news has been greeted with enthusiasm from some corners of the domestic drug industry, which chafes at what it perceives as preferential treatment of overseas pharma. In fact, a significant number of local pharmaceutical companies have achieved separate pricing for their products, often via non-innovative reformulations or combinations with vitamins or other products—a stratagem likely to be snuffed out by the new regulations.

» Hospital Incentives: With markups on drugs limited to an average of 15 percent by governmental regulation, hospitals have historically been keen to push higher-priced products, a position that favored the separately priced branded generics segment. The Ministry of Health (MOH) has made it clear that "profit-seeking" activities at hospitals will be curtailed, and profits on drugs (which have constituted a large portion of hospital profits) will be targeted directly. Measures being piloted by the government include prescription fee systems (in which hospitals are reimbursed a set amount for each drug, independent of price) as well as zero-markup policies in smaller community clinics.

» Physician Incentives: These are closely tied to the hospital incentives. Physicians typically receive a monthly bonus on top of their (meager) salary, which is based on revenues earned for their parent department or hospital. As profit motives are eliminated at the institutional level, this will translate into disappearance of physician rewards for prescribing more costly treatments.

» Hospital and Clinic Formularies: A key pillar of healthcare reform has been creation and implementation of the EDL system. Many smaller hospitals and clinics have found their formularies restricted to generic products on the EDL, which must be provided to these facilities and then sold at rock-bottom prices. Under most circumstances, supplying EDL products is an unattractive prospect for MNC pharmas.

» Central Procurement: A previous column in Pharm Exec (Nov. 2010, page 18) discussed the significant changes afoot in provincial and municipal drug sourcing, including the commencement of mandatory centralized online procurement and tendering. The establishment of such systems is serving to reduce drug wholesale prices via competitive bidding processes (and evaporation of incentive payments under the harsh glare of transparency). Much attention has focused on the creation of local "drug exchanges," the most notable example being the Chongqing Medicines Exchange. These entities seem poised to suck much of the value out of the drug distribution area and, moreover, speed generic drugs in China further down the road to commoditization.

How will MNC Pharma Respond?

The route to future success for multinational pharmaceutical companies in China may in fact be a forked one, with innovative/patented products on one side and consumer health product lines on the other. The middle path of branded generics, today a mainstay of many pharmas, will see comparatively less activity. Sanofi-Aventis's recent $520 million acquisition of BMP Sunstone, the largest cross-border consumer health M&A play in China to date, may be a blueprint for things to come.

With branded generics in danger of becoming commodity products, pharmaceutical manufacturers will need to look to their diversification strengths in forging a path forward. Sanofi, which has a major global consumer health presence, has added nationally recognized pediatric and women's health brands to its China portfolio and acquired a large sales network with the Sunstone transaction. While generic pharmaceuticals become a low-price/high-volume, government supplier game—one that only major Chinese domestic pharmas will win—the OTC and consumer health area will remain comparatively untouched, and perhaps even further invigorated, by the reforms. Pushing patients to self-funded OTC products sold at retail pharmacies instead of reimbursed/subsidized ethical drugs is one method of relieving the strain on government coffers in paying for the broader goal of universal health coverage.

For many of the reasons listed above, implementation of the new reforms will fuel consolidation in the domestic pharmaceutical industry. Many companies that have survived on aggressive physician incentives and local relationships and protectionism may be confronted with a less-hospitable business environment. Overseas drug manufacturers may encounter increasing numbers of potential M&A targets as well as larger, better-organized competition among the remaining domestic champions.

Getting the Balance Right

China's retail pharmacies are currently suffering a double identity crisis, at once both externally unsure of their place within the healthcare system and value chain, and internally struggling to find sustainable business models and successful product mixes. China Nepstar Chain Drugstore, the nation's largest retail chain pharmacy by sales revenue (and an industry bellwether), reported 2010 second-quarter revenues of RMB 565 million (US$83 million), an increase of 5.8 percent over the same period in 2009. This is a comparatively lackluster showing in a pharmaceutical market that has seen growth rates upwards of 20 percent. Like pharmaceutical manufacturers, pharmacy chains will also need to evolve and adapt to the changing face of China healthcare.

Drugstores are under pressure on several fronts. The pricing reductions being applied to prescription pharmaceuticals hits pharmacies as well as manufacturers, and it is likely that ethical products will continue to represent a decreasing portion of drugstore sales. Moreover, zero markup policies for medicines on the essential drug list mean that these will be loss leaders, or, more likely, simply pulled from pharmacy shelves. Also, even though hospitals have been told that drug profits are to be minimized in the future, they continue to steer patients to in-house pharmacies. In particular, the growing phenomenon of e-scrips, whereby physicians transmit prescriptions straight to hospital pharmacies at the end of a consultation and patients need only present their ID/insurance card, seems almost expressly designed to make sure patients do not stray beyond hospital walls to purchase medications.

Despite these pressures, retail pharmacies may have some key advantages moving forward. As mentioned above, governmental desires to offload drug costs to medical consumers, as well as reduced incentives for physicians to prescribe ethical drugs (if not needed), will likely increase OTC usage. Also important will be consumers' desire for choice. As the essential drug policy rolls out, there have been instances where Chinese medical consumers have demonstrated that they will shun facilities offering reduced formularies. Retail pharmacies will presumably be able to benefit from such activities if they are able to offer higher-end products that local hospitals cannot. Finally, the government itself may call upon drugstores to serve as surrogate in-house pharmacies for clinics. Early reports indicate that the "Development Plan of China's Medical Distribution Industry (2011 to 2015)," a policy currently in the drafting stages, suggests that community medical institutions need not establish their own in-house pharmacies if there are retail pharmacies nearby.

China's retail pharmacies are already responding to the shifting landscape with concerted efforts at diversification. Drugstores will tinker with product mixes and move away from ethical products to include nutraceuticals, personal care items and devices, household consumables, and convenience merchandise. Some smaller chains have already chosen to focus on more high-end/high-margin products, while larger operations will likely increasingly extend their footprint into the market space occupied by convenience stores. Promotions inspiring customer loyalty as well as reward card/points programs will also be on the rise.

Consolidation is Next

Like the domestic pharma industry, M&A activity is on the horizon too. To be sure, the retail pharmacy sector has already undergone several rounds of consolidation; however a recent uptick in M&A activity in the sector suggests that there is more to come. There are now a number of strong players in the retail pharma space, yet it remains the case that China still lacks a truly nationwide drugstore chain. But perhaps not for long: Much of the recent deal flow in the retail pharmacy space can be considered land-grabs by large retail pharmacy chains and/or large pharmaceutical distributors.

Retail drugstores are also being purchased by large conglomerates, with interests in other areas of the pharmaceutical commerce value chain, in particular by distributors such as Sinopharm and Shanghai Pharmaceutical. While conglomerate/SOE ownership of pharmacy chains is not new, it is likely that, rather than being isolated assets in a sea of healthcare holdings, attempts will be made to better synchronize gearing between distribution and retail assets (especially with central procurement now sucking profitability out of distribution in many cases).

China's drugstores will be profoundly affected by the rollout of China's new healthcare system, but, viewed as more commercial rather than medical-related businesses, they arguably have one of the weakest voices in determining the direction of medical reform. (The other laggard is China's beleaguered physicians.) The retail drug industry will need to be nimble in its navigation of the path forward. It must take pains to remain part of China's new health system to prevent being bypassed in delivering products to medical consumers, but at the same time avoiding, as much as possible, shouldering the burden for subsidizing the system.

Reform's Impact on Physicians

Physicians, facing the prospect of losing departmental and pharmaceutical company incentives and likely mandatory service requirements at community clinics, will also be looking for ways to supplement their paltry government incomes. The MOH continues to slowly follow through on its promise to allow doctors to practice at multiple locations, with an announcement from the Beijing Health Bureau that, effective March 1, licensed physicians will be permitted to work simultaneously at a maximum of three hospitals. Under these circumstances, practitioners, especially those with experience and reputation, will inevitably establish part-time practices in private settings charging market prices. (This has always occurred at a certain level, with surgeons operating "weekend clinics" for paying patients, but it has been actively discouraged by the MOH.)

Window for the Private Sector

Coupled with the release last November of a multi-ministerial opinion suggesting that private medical facilities be allowed to participate in public insurance schemes, enjoy tax benefits, and, at long last, carry 100 percent foreign ownership (versus the previous 70 percent maximum), it seems that private healthcare may have a chance at a new life. Growth of private pay has been hampered by the inability of top physicians to leave public practice as well as the privatization of hospitals by real estate developers and speculators, rather than by experienced hospital management teams. The government has suggested that it will actively encourage a new round of (well-supervised) creation of private healthcare facilities and is also beginning to push commercial health insurance. As is the case with OTC medicine, this is a clear attempt to ease the rapidly growing burden on public health systems by providing alternatives for those who can afford them. The government will move slowly in this area, with multiple safeguards to prevent a major siphoning of quality to any upper-tier private system. Widespread public discontent over healthcare disparities is, after all, the prime reason for the healthcare reforms in the first place.

Interest in the private option is just another illustration of how profound the transition is in China's healthcare sector. It's an appropriate conclusion to this story to cite again the magnitude of what is being attempted: basic, blanket, pay-as-you-go health coverage for 1.3 billion people, or more than a sixth of the world's population spread out over 3 million square miles of rural and urban territory, with an aging population subject to vast extremes of income. Other countries with a similar demographic—most notably India—have not even attempted to make a start in doing this. With a challenge like this, it is no wonder there are so many avenues being explored to cut costs and distribute the burden of funding such a system. Over time, the US and other industrialized countries may find that China is the real innovator in health system reform—for better or worse.