The U.S. Food and Drug Administration’s (USFDA) record warning letters to Indian pharma majors in the recent years, Katherine Eban’s hard-hitting book on Indian pharma (ignoring the controversial aspects), and our research on the sector raise concerns around the risk-adjusted rewards of investing in the standard Indian Big Pharma model. Moreover, in an industry where non-compliance costs years of research and development (R&D) investments and loss of contracts, it is important for investors to give the regulatory track record of the investee companies the same level of importance that they give to its recent financial performance.

“At the behest of managers, the company’s scientists substituted lower-purity ingredients for higher ones to reduce costs. They altered test parameters so that formulations with higher impurities could be approved. They faked dissolution studies. To generate optimal results, they crushed up brand-name drugs into capsules so that they could be tested in lieu of the company’s own drugs. They superimposed brand-name test results onto their own in applications…The company even forged its own standard operating procedures, which FDA investigators rely on to assess whether a company is following its own policies…Essentially, Ranbaxy’s manufacturing standards boiled down to whatever the company could get away with.” —Katherine Eban, Bottle of Lies

Indian pharma’s unending regulatory woes

In her controversial bestselling book, Bottle of Lies: Ranbaxy and the Dark Side of Indian Pharma (2019), American investigative journalist Katherine Eban gives several examples of sub-standard generic drug manufacturing and intentional data falsification by big pharmaceutical manufacturing companies in India, China, and other countries.

With the scandal that destroyed Ranbaxy as the centrepiece (the firm seems to have cooked up the test results which gave it the right to exclusively manufacture Lipitor for 180 days once Pfizer’s patent expired), Eban highlights how several major pharma companies based in India sacrificed the interests of patients and grew their business on the back of a corporate culture which treated the efficacy of medicines and the data integrity of the drug development and production process as subservient to the goal of maximising profits.

As one would expect, given the unflattering picture the book paints of the Indian pharma industry, the wrath of Indian authorities could potentially be unleashed upon Eban, who is presumably watching the cash register ring non-stop as the controversy further enhances the sales of this New York Times bestseller.

One would assume that given the examples cited in the book are a decade old, things would have improved since then and the level of compliance with good manufacturing practices and adequate data integrity measures would have become part of the standard operating procedure for the generic pharma companies in India. However, the results of the inspections carried out by global regulatory bodies (primarily the USFDA) point to a different reality.

In 2019, the USFDA issued a record 20 warning letters to Indian pharma majors which includes Lupin, Glenmark, Cadila, Torrent, Aurobindo, and Mylan (Unit 8). Just to explain, the USFDA issues warning letters when drug manufacturers fail to remedy lapses bought to their attention after the FDA inspections. The issues leading to stringent action by the USFDA against Indian pharma companies range from lax documentation of the drug manufacturing process (example: records of all batches, including defective ones, have to be kept) to open toilet drains to rusty and malfunctioning equipment at the drug manufacturing facilities to hidden chromatography equipment (which allows the manufacturer to check the chemical composition of the drug without having to record the results if the results turned out to be deviating from the required norm).

For those who believe that the USFDA’s efforts are a part of a sinister foreign conspiracy to handicap Indian pharma companies, apart from the red flags raised by western regulators, Indian pharma companies were also flagged by Indian regulators but were saved by weak law enforcement. To grasp the extent of compliance violation in India, consider the data published in an article in The Hindu BusinessLine: Between 2015 and 2019, there were 16,675 inspections of pharma manufacturing sites by Indian regulators in Telangana, and they identified 3,853 cases of non-compliance, a violation rate approaching 25%.

Why is the $30-billion Indian pharma industry, which accounts for 20% of global generic drug manufacturing, repeatedly being caught by global regulators for violating compliance norms?

To some extent, it is an outcome of the export-oriented business model of the Indian pharma industry, which is to reverse engineer patent-protected molecules and launch the generic version of those molecules in Western countries after patent expiry. This simple and clear business strategy has one big shortcoming: generic drugs often see up to 90-95% price erosion within one year of launch and this substantially reduces the chances of making profits from generic product development.

To overcome this problem in the U.S. market, pharma companies from across the world try to be one of the early players (called “first to file”) to introduce the generic drug and thus enjoy an exclusivity period in which they can sell the generic drug at prices only slightly lower than the branded product and thus make windfall gains. Since it takes a lot of time and money to develop generic drugs and obtain approval from Western regulators, most of the big Indian pharma companies work on several products at once to increase the chances of getting approval for any one product. This ambition sometimes leads to a dilution of management focus on quality control and results in deviations from prescribed manufacturing norms in order to expedite the development and delivery of new generic products to the all-important American market.

Another factor which contributes to the challenged regulatory status of the Indian pharma industry is the use of different manufacturing standards for different geographies in order to reduce costs. Use of multiple standards implies that companies need to adhere to good manufacturing norms only if prescribed by the relevant regulator. For example, since the Nigerian regulator might have less stringent requirements than the USFDA, this creates the mindset that one can take as many shortcuts as possible with the aim to just manage the local compliance requirements for Nigeria.

The above-listed issues appear to be symptomatic of management’s inability to judiciously allocate time to oversee compliance with regulations which, if addressed properly, can become a critical moat for an Indian pharma company, which is seeking to build an enduring franchise in the highly regulated Western markets. Arguably, the only Indian pharma to have done this successfully is Cipla, with the remarkable Yusuf Hamied at the vanguard.

At Marcellus, whilst we do not have access to the Indian pharma companies’ labs, we have been reading their annual reports for several years before the Ranbaxy scandal broke. The annual reports of several of the frontline listed Indian pharma companies betray the corporate culture prevalent at some of these firms: Boards are stuffed with friends and family, the profits shown on the profit and loss account don’t stack up with the operating cashflows of these firms, implying (at best) that the working capital cycles are relentlessly expanding or implying (at worst) that the profits flatter to deceive.

In short, the annual reports appear to be a microcosm of what drug regulators—India’s included—are finding in the lab: Big pharma in India prioritises short-term profits in favour of building sustainable long-term competitive advantages.

Investment implications

In an industry where non-compliance costs years of R&D investments and loss of contracts, it is important for investors to give the regulatory track record of the investee companies the same level of importance that they give to its recent financial performance.

A company like Divi’s Laboratories has benefitted enormously from a relatively clean compliance track record and management’s focus on quality control, which has resulted in Divi’s becoming the outsourced manufacturer of choice for Western Big Pharma companies.

These relationships with Western pharma have been nurtured by Divis’ senior management over nearly 30 years and, ironically, has given the firm a higher profit margin and higher RoCE (return on capital employed) business than any of the Indian pharma companies who are trying to sell their own drugs in the U.S. market. In effect, Western Big Pharma is willing to pay a premium for Divis’ contract manufacturing services.

Distinct from the business model followed by Divi’s, over the years while researching the companies in Marcellus’ portfolios, we have observed that the difference between industry-leading firms and the rest is the unrelenting focus of the leading company’s management on brand creation, production and supply chain processes, and product innovation. This focus, in turn, seems to be a by-product of disciplined allocation of management’s time. Several of these attributes are reflected in the brand-building efforts of the Indian subsidiaries of global pharma companies like Abbott, Sanofi, Pfizer, and GSK, which helps them earn substantially higher margins than their Indian peers manufacturing unbranded drugs.

The higher margins result in a very high level of free cash flows for the Indian subsidiaries of the global pharma companies. This, in turn, creates a more predictable and more sustainable business model (centred around the manufacturing of proven drugs) rather than more cash consumptive, less predictable, more regulatory-risk prone business model followed by the large Indian pharma companies.

Views are personal.

Disclosure: Divi’s Laboratories Ltd. and Abbott India Ltd. are part of most Marcellus’ clients’ portfolios

SudhanshuNahta is a portfolio counsellor at Marcellus Investment Managers and Saurabh Mukherjea is the founder of Marcellus Investment Managers (http://marcellus.in)

Bottle of Lies

Learnings from the unravelling of the Indian pharma industry