The Hindu Business Line : Pharmaceuticals: Demerger of R&D units

Creating a separate company is an innovative way for pharma players to mitigate the risks involved in the drug discovery business where, despite years of expensive research, the success ratio is still small.

Kumar Shankar Roy

For the listed drug companies, 2007 has been forgettable as their corporate performance and stock prices have languished, amidst euphoric market conditions. From a business perspective, the most lucrative market for pharma exporters — the US — has seen immense competition, pricing pressures and the emergence of additional regulatory complexities.

In this backdrop, when a pharmaceutical major such as Nicholas Piramal announces that it will spin off its new drug discovery unit as part of a restructuring exercise, conventional wisdom indicates that this is a move intended to boost investor sentiment.

Carve out the expenditure related to new drug R&D and the balance sheet looks much better.

But is that really the motive behind such a move? Maybe not.

Costs escalate as new drug candidates mature (read advance to stages of clinical trials) and hence, funding becomes an important issue.

New drug research activity does not form part of the core operations of pharma companies, which is why it becomes difficult to solely focus available resources and energy on it.

And last, creation of a separate company is an innovative way to mitigate the risks involved in the drug discovery business where, despite years of expensive research, the success ratio is still small.

Need for new drug discovery

When India enforced only process patents, pharma companies took advantage through efficient use of reverse engineering and introduced generic drugs within months of a product being launched globally.

Following the recognition of product patents from 2005, the tight controls on the domestic prices of drugs compelled Indian pharma companies to shift their focus to the US markets.

Now, with several global pharma companies entering the generics fray, and over 8-10 ANDAs (Abbreviated New Drug Application) being filed for every product expected to go off patent, there have been severe pricing pressures in the US market. An ANDA contains data which, when submitted to US FDA, provides for the review and ultimate approval of a generic drug product. Once approved, an applicant manufactures and markets the generic drug product.

Indian companies such as Dr Reddy’s Labs and Nicholas Piramal, who took a long- term view, started off their own new drug discovery programmes. While every business foray entails some risks, new drug developments undertaken by pharmaceutical companies carry particularly high investments with uncertain payoffs.

To uncover a new drug, funding requirements can typically range between $500 million and $1 billion (depending on the drug’s use and area of therapy).

The time to market for new drugs can range between 12 and 15 years from the lab to the end-user, that is, the patients.

There is the lure of huge potential gains from discovery but there are significant downsides too, with an undefined timeframe, drug failure and other unpredictable outcomes.

Funding challenges

Seventy per cent of a drug’s development cost goes into clinical trials and companies cannot sustain the funding required for these molecules on their own. The expenditure budget of drug discovery companies can vary according to the phase up to which the development is undertaken. Clinical trials are commonly classified into four phases that run over many years.

If the drug successfully passes through the Phases I, II and III, it will usually be approved for use in the general population. Phase IV is ‘post-approval’ studies. Phase III trials are the most expensive, time-consuming and difficult trials to design and if a drug moves to Phase III, clinical-trial costs can shoot up, except when the company gets a licensing partner. For instance, in the case of a cancer drug, it takes, on average, about 8-10 years from the time it enters clinical trials and until it receives approval from regulatory authorities for sale to the public.

Companies that out-license drugs in the final stages can save costs as they will be transferring costly clinical trials to another entity while retaining the patent and sharing future revenues (in the form of milestone payments) on the development.

For example, Glenmark signed an out-licensing contract with New York’s Forest Laboratories. The American company agreed to pay $190 million to Glenmark for the marketing rights, in the US, of its asthma and anti-lung inflammation drug under development.

Indian drug makers cannot match the financial muscle and experience of global drug firms such as Pfizer, AstraZeneca, Wyeth, Eli Lilly and GSK that have substantial R&D budgets. Pfizer, the top spender in the drug industry, put around $7 billion in 2006 for R&D alone with a large portion going into innovative research. In comparison, India’s largest drug maker by sales, Dr Reddy’s, recorded annual revenues of $1.5 billion in 2006.

India’s top pharma companies spend close to 6-7 per cent of their sales on research and development compared to around 20 per cent spent by big pharma players such as Amgen and Merck & Co.

From discovery to market

As soon as companies find that they might have an NCE (New Chemical Entity) in the making, they make sure that this potential drug contains no active functional group or specific atoms/molecules that is responsible for the pharmacological action of a drug that has been approved by FDA in any other application.

The innovator company will develop this NCE, a chemical molecule, in the early drug discovery stage. Post-synthesis, the second step of development of the drug begins with clinical trials. This is a crucial point, as many companies may not have the financial backing to undertake the high costs involved in such trials on their own.

Such companies can license the NCE to another company, which has significant financial muscle to carry the drug through trials and into the market. Where NCEs are licensed to a third party, companies can avoid the expensive and lengthy process of clinical trials.

Companies adopting this model of business would be able to generate high margins as they get a one-time payment for the NCE apart from entering into a revenue-sharing agreement with the licensee company on subsequent sales.

Having a separate company, which does not rely on the parent’s balance sheet but incubates the NCEs and associated R&D expenditure, makes sense in this light.

Dr Reddy’s has promoted India’s first integrated drug development company, Perlecan Pharma, together with ICICI Ventures Capital Fund Management Company and Citigroup Venture Capital International Growth Partnership Mauritius. Perlecan Pharma is engaged in the clinical development and out-licensing of NCE assets. Its early priorities are to advance the clinical development of NCE assets received from Dr Reddy’s through Phase II and thereafter seek out-licensing, co-development or joint commercialisation opportunities.

The current picture

In recent times, several companies, including Nicholas Piramal, Ranbaxy and Sun Pharma, and smaller players such as Shasun Chemicals have debated a demerger of their NCE business. Ranbaxy this week announced its decision to hive off New Drug Discovery Research (NDDR) into a separate company.

While Dr Reddy’s did not list Perlecan Pharma on the stock exchanges, the listing of Sun Pharma Advanced Research Company (SPARC) earlier this year was followed with keen interest. Like Nicholas Piramal — which has 13 NCEs — SPARC has an impressive mix of two NCEs (New Chemical Entities), two pro-drug NCEs, and eight products under development using four distinct novel drug discovery system (NDDS) platform technologies. It has one antihistamine molecule, which is in phase II trials in the US and is few years away from being commercialised.

One aspect to be noted here is that the current spate of de-mergers relates only to new drugs (NCEs, NDDS) and not to the entire research and development unit.

Listing of NCE units with an impressive pipeline could command good valuation in the market. For the parent company and its shareholders, there is the potential for unlocking value by offloading stakes in these companies to PE (private equity) firms and venture capital companies.

Also, through the current demerger initiatives, pharma companies can reduce the R&D costs and improve the margins of their standalone business. For instance, Nicholas Piramal’s operating margin is projected to increase by as much as 3 percentage points to 18 per cent post de-merger of its NCE division, according to the company’s guidance.Demerged companies such as SPARC and NPRC mirror the shareholding patterns of their parents.

The advantage is that the promoters of these firms can sell either part or whole of their stakes in the demerged entities to raise funds for new R&D ventures or simply to even recover their capital. Listing on the stock exchanges also gives them better visibility and helps to command better valuations. Of the demergers that have happened so far, Dr Reddy’s has kept Perlecan Pharma unlisted and has licensed out four products to a company for clinical development. SPARC is a full-fledged research company that discovers and develops new drugs/delivery systems.

More Stories on : Pharmaceuticals | Insight | Restructuring | Research & Development

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