For Japan, made in India

LUPIN, INDIA'S THIRD-LARGEST pharmaceuticals company, acquired Kyowa Pharmaceutical Industry Company, Japan’s seventh-largest branded generics company, on Oct. 10, 2007, after months of deliberation. A few months later, the Indians invited Kyowa’s president, Tadashi Sugiura, and a few others, for a meeting in Mumbai and a tour of Lupin’s showpiece factory in Goa. Commissioned in 2004, the plant was certified by regulators from around the world, and exported 90% of its production to the U.S. and the remainder to Australia and South Africa.

Touring the factory, Sugiura made the usual polite noises. Lupin was, after all, his new employer. But over dinner, after much prodding, he said he was not entirely happy with the Goa unit. He pulled out a small tin filled with pills from one pocket and a magnifying glass from the other. And then proceeded to demonstrate how the surface of the tablet was not as smooth as he expected, and it could not be sold in Japan. “For the life of me, I could not understand what he was looking at and saying, because we had been exporting the same tablets to the U.S. and elsewhere without any issues,” says Kamal K. Sharma, recently reappointed as Lupin’s managing director for three years.

But Sugiura’s dinner table exposition squarely illustrated the challenges Lupin (ranked 135 on the Fortune India 500, up eight positions from last year) would face in the world’s largest pharma market after the U.S. “The Japanese have far more exacting standards for physical appearances such as surface finish, particle size, even the colour of the active pharmaceutical ingredients [APIs]. They like to add a lot of cosmetic appeal to their medicines,” says Sharma. Foreigners complain that Japanese regulators insist on generics matching the branded drugs exactly; for example, if the API of a generic has even a trace of brown when the branded drug’s API is pristine white, it is rejected.

Inside Japanese factories, visitors are rubbed all over with a sticky roller to remove traces of fibre, says Nilesh Gupta, executive director, and son of founder Desh Bandhu Gupta. After a tablet is compressed to its required size, it is photographed by half-a-dozen cameras from every angle, and scrutinised to ensure that it is perfect in every way.

Regulations governing pharma in Japan are equally baffling. In other countries, a patented drug can be challenged in court and its generic version introduced just before the patent expires. That can’t be done in Japan, where it is considered inappropriate for companies to clash in court. If a company wants to launch a generic version of a patented drug, it will have to get a clearance from the patent holder. Otherwise, it will have to wait for the patent to expire. Once that hurdle is crossed, generic drugs can be approved only twice a year, and new drug approvals only four times a year; elsewhere in the world, approvals can be allowed any time of the year.

But in the last five years, Lupin has battled all this and more to build a successful business in Japan, and has emerged as the only Indian firm to have cracked that market. (Though Sugiura quit within a year of the visit, one of the first things Lupin did was to re-configure the manufacturing process in the Goa factory.) Enthusiastic analysts are busy recommending its shares. Manoj Garg, pharma analyst at brokerage firm Edelweiss, wrote in his October report that Lupin’s increased focus on the chronic illness segment will result in above-market growth; the management’s guidance has been 18% to 20% growth on a sustainable basis. Brokerage house ICICI Securities too has a ‘buy’ rating on Lupin. According to its report, a “strong balance sheet, good working capital management, and management focus remain the differentiator for Lupin”.

Lupin’s strategy hinges around outsourcing production. As Japan genericises, and demands cheaper drugs, Lupin will make them in India (formulations in Goa and APIs in Tarapur, Maharashtra) and sell them in Japan through Kyowa and I’rom Pharmaceuticals (a company it picked up through Kyowa in November 2011). Already there are plans to increase the Goa factory’s 7 billion pills a year to 9 billion. More important, Nilesh Gupta says it is on the prowl for “another acquisition in the $50 million [Rs 277.95 crore] to $100 million category”, though he doesn’t divulge details.

SOME DEMOGRAPHIC, ECONOMIC, regulatory, and market conditions have come together to create a perfect opportunity for Lupin. Nearly all Japanese are covered by health insurance schemes—provided by employers or under the government’s National Health Insurance (NHI) scheme. Such subsidies have led to an underdeveloped generics industry where doctors aren’t willing to prescribe generics, and pharmacists unwilling to stock them. Compared to the U.S., where 75% of all drugs sold by volume are generics, in Japan it’s 24%. The “Japanese mindset or cultural ethos” also believes that generics “are inferior to patented drugs”, says Gupta.

Generics in Japan are priced at 60% to 70% of innovator drugs—this is mandated by the state and is higher than in most countries—and their price decline is not as steep as, say, in the U.S., because of fewer launches after the patent expiry. Tokyo-based Hidemaru Yamaguchi, managing director, pharmaceutical and healthcare, Citi Research, says even after patents expire, companies find it difficult to introduce generics because patent holders block them using associated patents.

But its continuing economic woes, combined with higher per capita consumption of medicines because of a rapidly ageing population, has forced Japan to push the pedal on genericisation. In FY10, it spent ¥36 trillion (Rs 24.12 lakh crore) on health care, or roughly ¥280,000 per person. “With the Japanese economy in a state of stagnation, insurers are finding it difficult to even collect premiums, and in some cases, loss-making health insurance associations have been dissolved,” says Yamaguchi. Equally, people are shifting to government schemes, resulting in increased usage of public funds. “This has made rightsizing of health care costs a key issue for the Japanese government,” he says.

In 2002, Japan’s Ministry of Health, Labour and Welfare (MHLW), notified that hospitals should use generics wherever possible. Hospitals operate on a reimbursement programme that pays them a fixed fee, inclusive of drug costs, instead of fees for each service provided. Since savings automatically fatten a hospital’s income, many hospitals have already started prescribing more generics. In 2011, there were 1,449 hospitals that prescribed more generics than patented drugs, up from 82 in 2003. Doctors too are incentivised to prescribe generics and paid ¥170 or nearly $2 each time they do; those who don’t, have to specify why.

In 2007, the MHLW announced an ‘Action Programme for the Safe use of Generics’ setting a target of achieving a 30% market share by volume for generic drugs by 2012, up from 18.7% that year. The government at that time predicted that it would lead to a saving of $500 billion over these five years.

The state has resorted to even stronger arm tactics. In 2010, it mandated price cuts of 16%, and in 2012 between 12% and 13%, to push generic drugs further. Essentially, Japanese authorities force retailers to pass as much of the discount they get from wholesellers to the customer.

The results have begun to show. The Japanese pharma market is worth around $125 billion in 2012 and is likely to touch $145 billion by 2015, growing at a compounded annual rate of around 3% between 2010 and 2015. Of the three broad segments of drugs—generics, non-generics (all patent protected and non-patent protected drugs excluding generics), and other products such as over-the-counter drugs (those that can be sold without prescriptions)—the generics segment is expected to see the fastest growth: 14% between 2010 and 2015.

“Just imagine the potential when the present 24% touches 60% of the nearly $130 billion pharma market. There’s tremendous scope for growth,” says Sharma. Indeed, Lupin is hoping to double its current turnover to $3 billion by 2015, with much of the growth coming from Japan—$500 million in the next three years. Japan currently accounts for 14% of sales. The U.S. accounts for 38%, and India 31%.

“It makes sense for Lupin to focus on the Japanese market rather than on the other big regulated market, the European Union (valued at around $100 billion), because you are dealing with just one country rather than 18 different countries with different rules and regulations,” says Ranjit Kapadia, pharma analyst and senior vice president at Centrum Broking.

He adds that beyond the government’s push, nearly $9 billion worth of innovator drugs will be going off-patent in Japan in the next five years, creating more opportunities for generics manufacturers. Lupin focusses on anti-cancer drugs not just because the disease is growing at 19% to 20% every year but also because innovator drugs such as Plavix (Bristol-Myers Squibb), Zometa (Novartis), and Xeloda (Genentech/Roche) will go off patent in the next few years. At current prices, the anti-cancer market is worth $12 billion. Lupin will either in-licence or jointly develop seven to eight drugs with European firms and market them in Japan through I’rom. The company is also setting up a dedicated oncology facility in Sanda, Japan, around 400 km from Tokyo, where Kyowa has a manufacturing unit.

JAPAN HAS BEEN a graveyard for Indian pharma so far. Ranbaxy (now wholly owned by Daiichi Sankyo) was one of the first to enter the country in 2002 by acquiring a 50% stake in Nihon Pharmaceutical Industry (a subsidiary of Nippon Chemifar). But it was unable to make much headway, and after its acquisition by Daiichi, it ended the tieup in 2009. Ahmedabad-based Torrent Pharmaceuticals opened a fully-owned subsidiary in Yokohama in April 2006, only to exit two years later. Dr. Reddy’s too announced its entry into Japan in 2011 by signing a joint venture with Tokyo-based Fujifilm to deliver APIs and formulations. Similarly, Ahmedabad-based Zydus Cadila has been in Japan since 2007 after it acquired Nippon Universal Pharma. But Japan barely accounts for 1% of the total business of Zydus Cadila and Dr. Reddy’s.

Those who track international pharma describe Japan as a fortress, where the top 10 firms, including Takeda, Astellas, Daiichi Sankyo, Eisai (all Japanese), Pfizer, Roche, Merck, and Novartis (foreign), account for 44.7% of the total market. Most foreign firms partner a local player because the Japanese prefer buying drugs made by Japanese companies; the big Japanese firms also control the trade.

For Lupin, the buyouts were opportunistic. Kyowa’s owners wanted to retire and because of the debt on its books, nobody in Japan was interested. For three years prior to the buyout, Lupin had been selling APIs to Kyowa and knew it well. It snapped up Kyowa for around $60 million (the company never put out an official cost of acquisition). Later, when I’rom Holdings, the promoter of I’rom Pharmaceuticals, wanted to focus only on clinical trials, Lupin picked up its pharma business.

After buying Kyowa, Lupin’s managers went on a charm offensive. Sharma went on NHK, a national TV channel, to explain the buyout and tell the Japanese more about Lupin. It retained Kyowa’s top management (except Sugiura) and added two Indian managers. And, says Sharma, “you won’t even find the Lupin name on Kyowa’s factories”.

Parallelly, it began incremental changes—tweaking the system for greater efficiency, ensuring better economies of scale, and renegotiating prices with large independent wholesalers (oroshi) and regional (hansha) players. For instance, at Kyowa’s factories, instead of producing the full quota of drugs for a month (200-odd), it decided to produce less per month but for three months continuously. This brought down operational costs significantly because it reduced the time taken for cleaning between changeover for drugs. “Without creating any dissonance in the company, we were able to raise margins from 33% to 42% in the first year,” says Sharma.

Kyowa’s sales have grown from ¥7,815 million in 2007-08 to ¥14,194 million in 2011-12, making it one of the fastest growing pharma companies in Japan. (I’rom’s sales were nearly ¥5,360 million at the time of acquisition.) In 2010-11, it added 11 new products to its range of 272. Then, without much capital infusion, it expanded manufacturing capacity from 900 million units to 1,400 million units at Sanda.

Timing also helped. The year Lupin picked up Kyowa, Norvasc, an anti-hypertensive drug from Pfizer with sales of ¥184 billion went off patent. By the following year, the first generic formulations (amlodopine) had been approved, and Kyowa’s version was among the first to launch. To get a larger market share, it even outsourced manufacturing to two local Japanese companies.
Unlike in the U.S., where drugs are sold through major retail chains such as Walgreens and Kroger, Japan has a complex and multilayered distribution system where drugs are sold through oroshi and hansha, which in turn provide drugs to the hospitals. And generic drug makers also target doctors to increase sales. Here, Lupin unleashed the sales forces of I’rom and Kyowa (125-strong) to cross-sell, says a Mumbai-based analyst. Kyowa manufactures a range of psychiatric, neurological, cardiac, respiratory, and anti-allergy drugs sold as tablets, targeting clinics and pharmacies. I’rom sells injectibles to hospitals.

Lupin’s top management is fully aware that the big bucks will start flowing once it shifts its API manufacturing to Tarapur and formulation to Goa, which has already been certified by Japanese authorities. That should bring down costs by 20% to 30% and improve margins. A strong yen versus the rupee should lift margins even further. “The fact that Lupin is one of the most vertically integrated players in the country—producing everything from APIs, intermediate products to formulations—and selling them in the U.S. market, means that it should have little problem in making the transition [to India],” says Kapadia.

But the company is in no hurry. Business, says Gupta, is not just about reducing costs and maximising profits, but about building an organisation. “For us, it is extremely important to establish a sense of belonging, a sense of connectedness—finding acceptance with the locals so they do not feel exploited in the hands of the new owners.”

There are other issues as well. “You will only shift the manufacturing of those drugs or APIs to India which have large requirements and high margins. The change should make economic sense,” says Sharma. So Lupin has selected four APIs to be manufactured in Goa and made three drug master file (DMF) submissions in Japan while a fourth is under way. DMFs are confidential information about facilities, processes, and articles used in manufacturing, processing, and storing drugs to allow Indian factories to start production for other countries.

“Even after they find the right API, test it, put it in the product, and look for stability, they will still have to wait for 18 months before they are given the go-ahead by the Japanese regulator,” says Kapadia. But with the Kyowa plants already working at full capacity, the shift to India should happen earlier than expected.

However, it is only a matter of time before competition intensifies in Japan. Gupta is also clear that over time, the Western style of litigations for challenging patents will become the order of the day. And when that happens, he will be looking at his 60-member specialised intellectual property management group—a team of researchers that not only looks at the viability of challenging existing global patents but also ensures that the company’s own products do not infringe any valid patents—to come to the company’s support as it has done for so many years. In fact, from 2000 to 2009, Lupin has had the best record in Indian pharmaceutical companies—75% success rate in challenging patents compared to Sun Pharma’s 67% and Dr. Reddy’s 61%.

Unlike some other Indian pharma outfits, Lupin didn’t spot the U.S. or European opportunity early enough, something Lupin’s top brass still regret. Neither did it spot the Japanese opportunity first. But by sheer doggedness, it has made up for its delay in being a first mover.