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Moving money and drugs I

Regulations and capital injections are changing the face of

pharmaceutical distribution in China,

write Stephen Sunderland and Helen

Chen of L.E.K. Consulting

t seems that every other week another acquisi- tion or alliance is announced in China’s phar- maceutical distribution sector. Sinopharm,

the largest player in the industry, announced in June 2012 that it would issue up to RMB8 bil- lion (US$1.3 billion) of debt to fund expansion opportunities, just three years after its IPO raised US$1.13 billion. In the same month and in a simi- lar vein, Cardinal Health China acquired Zhejiang Dasheng Medic to deliver better coverage in the Ningbo area. International interest in the sector is also evi-

dent. Alliance Boots recently announced it would take a 12% stake in a major Chinese pharmaceu- tical distributor, Nanjing Pharmaceuticals, adding to its long-standing joint venture with Guangzhou Pharmaceuticals Group.

The big squeeze

Pharmaceutical distributors are a critical part of health care in China, ensuring that hospitals and pharmacies and thus patients have access to the drugs developed and manufactured by pharmaceu- tical companies. Te role of distributors extends well beyond logistics and inventory management to encompass areas as diverse as financing and sales support. As a result, pharmaceutical distribu- tors collectively generate more than US$139 bil- lion in revenue in China annually. However, the industry remains underdevel-

oped. It is highly fragmented with more than 13,000 registered pharmaceutical distributors now operating in the country. Te top 10 distributors now represent 54% of the market, substantially more diffuse than the US where the top three players control more than 95% of the market. Unsurprisingly, the industry is undergoing

massive and rapid consolidation. National and regional champions are emerging, mainly through mergers and acquisitions. For example, Sinopharm and Shanghai Phar-

Stephen Sunderland is a director and partner of global strategy firm L.E.K. Consulting based in Shanghai. Helen Chen is a director, partner and head of China life sciences


maceuticals, the two largest distributors, made acquisitions worth RMB7 billion in 2010, gob- bling up an additional 6% of combined market share. Companies are also increasingly expanding into related businesses, such as supply chain ser- vices, retail pharmacies and drug manufacturing. Chinese regulators are clearly pressuring the

industry to consolidate, in part due to concerns that the distribution channel is capturing much of the profit and passing on outsized health care costs to taxpayers and patients. Government agencies have issued a litany of

regulation to encourage the industry’s consolida- tion, including an explicit target for consolidation in the 12th Five-Year Plan. Te top 100 distribu- tors were to grow from 70% of the market in 2010

China Economic Review • November 2012

to 85% of the market by 2015, while up to three national giants and up to 20 regional leaders would be created. As part of the 2009 health care reforms, regulators also designated an Essential Drug List (EDL) to reduce the cost of key medicines for patients by capping hospital and pharmacy mark-ups and enhancing the level of competition between drug suppliers. Te number of drugs on the EDL has been expanded further in 2012. Te government also altered the tendering

process in 2010 so that provinces, rather than indi- vidual hospitals, take charge of bidding for phar- maceutical drugs, a change which favors larger distributors. Finally, it increased direct regulation and raised barriers to participation in the market by creating minimum standards with which mar- ket participants need to comply. Regulators have also proposed, but not yet

begun to widely enforce, a series of measures with the potential to drive radical restructuring of China’s prescription drug industry. Te govern- ment may directly limit the mark-ups allowable on manufacturer prices, implement a “two invoice” policy to improve industry transparency and coun- teract graft, or forcibly separate the dispensing of medicines and writing of prescriptions. Tere are no signs that the regulatory and

commercial pressures that are driving consolida- tion in the sector will let up anytime soon. Te dis- tribution market is far from consolidated by global standards, and health care costs remain a public and political concern.

The right target

What constitutes a good investment for these dis- tributors as they expand? First, the asset needs to be large enough to be worthwhile. Transactions and post-acquisition integration may distract management teams and exact a real cost, and it’s always possible that the distributor’s investment could be better used to grow organically. Investors also appear to do better in target-

ing depth rather than scattered breadth. Regional concentrations often give a company resilience and strategic options that they would not have using a scattergun approach which delivers national or multiregional reach. Finally, distributors must seek out good quality

relationships with major end-customers. Seeing the asset through the customers’ eyes is critical to understanding its future prospects and risks. It also reduces risk to the organization by ensuring that these most important relationships are reinforced at the corporate level, rather than devolved to indi- vidual salespeople. Tere are firms in the market still with these good characteristics, but acquiring reliable infor-

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