Drugged up in CEE

By bne IntelliNews November 27, 2006

Nicholas Watson in Prague -

Romania's government announced last week it would put 53% of the country's state-run drug maker Antibiotice up for auction next summer. International companies were falling over each other to register for the bidding in a sign of how keen they are to break into this potentially huge market. But recent actions by other CEE governments show how unpredictable the operating environment can be for these drug firms.

Antibiotice is just one of number of Central and Eastern Europe (CEE) makers of generic drugs - those not covered by patents - that has attracted the attention of multinationals this year. So far eight deals have been announced, with the latest being Barr Pharmaceutical's $2.5bn acquisition of Croatia's Pliva, which was completed on October 25.

The driving force behind this march eastwards is that big foreign drug makers are stuck between a rock and hard place: while prices for their drugs fall in their traditional markets of North America, Western Europe and Japan, competition from low-cost makers in India and China intensifies as these firm shift from supplying the raw materials of drugs to actually making the drugs themselves.

Growth of the pharmaceutical markets in developing nations such as those in CEE will, therefore, clearly surpass that in the established markets. The countries of the region represent a total market of 309m people with a combined GDP of about $1.9 trillion in 2006. Most of these places have strongly growing economies and a flourishing middle class, factors that will enable the government to spend more on their healthcare sectors at the same time as their citizens are demanding better ones. These improvements will drive the sales of branded drugs, generic drugs, as well as the so-called "branded generics" - a peculiarity of the CEE region.

A look at Romania's drug market with the state-run Antibiotice is a case in point. As the country heads towards EU membership next year, the value of its pharmaceutical market is forecast to rise by 19% in 2006 to almost $400m, according to market research company Cegedim Romania.

Twenty-two non-binding offers were submitted by the November deadline to Romania's State Assets Realisation Authority (AVAS) for the government's remaining 53% stake in Antibiotice. The AVAS didn't name the interested parties, though reports said letters of intent were submitted by seven pharmaceutical companies, three drug-distribution firms and 12 investment funds.

"It is likely that some of Central and Eastern Europe's leading generic players have shown interest in Antibiotice; for instance, Czech drug maker Zentiva is believed to have submitted an offer," says Sacha Baggili, an analyst with the consultancy Global Insight.

A look at the company's business shows why. At the end of October, Antibiotice said it hopes to double its profits by 2010, with a projected 24% rise in net profits for this year. According to reports, the drug maker aims to accelerate profit growth by deepening sales penetration in the US market and by securing financing from "a new investor."

That makes Antibiotice the most valuable asset belonging to AVAS currently on the slate to be sold, the first round of binding offers for which will have to be filed by February or March, Teodor Atanasiu, head of the AVAS, told Reuters in an interview on Thursday.

"We will probably sign the privatisation contract for Antibiotice in the summer," Atanasiu said.

So far so good. But for the shareholders in these CEE drug makers, and the multinationals that buy them, the ride will almost certainly be bumpier than the rosy long-term forecasts would suggest.

Challenging markets

Although sales look impressive on paper, the markets in CEE present considerable challenges in reality. "For example, drug manufacturers often take years to recoup payments from the government for subsidised drugs through the state healthcare system," says Baggili.

The recent share performance of another prime takeover target, Hungary's Gedeon Richter, also shows how reality often intrudes on the sunny long-term outlook.

Richter, founded in 1901, is Hungary's largest drug manufacturer and one of the last major CEE pharmaceutical firms yet to be acquired by a multinational. Around two thirds of revenues are still generated in CEE, with sales in 2005 amounting to €547m, a rise of 15.9% over 2004. Richter is expected to post annual sales growth in excess of 15% through 2010, estimates ABN Amro.

During the Communist era, Richter was one of the leading suppliers of pharmaceuticals within the Soviet bloc, and is the largest seller of generic drugs in Russia. This has multinationals salivating because Russia has the potential to become one of the world's largest pharmaceutical markets due to its population of around 143m. Demand for generic drugs, which account for 90% of the market by volume, is growing between 30-40% a year, compared with just 7% in the US. Admittedly, demand at the moment is very low, due to small levels of household disposable income and insufficient public healthcare funding, though that is changing alongside the spectacular growth of the Russian economy.

Nevertheless, Richter's share price has been hurt recently by uncertainty in its business both at home and abroad.

The Russian government said last month it will boost its 2007 budget for the Russian state subsidized drug system, or DLO, to $1.5bn-1.6bn from this year's expected $1.2bn, but changes to the DLO list of drugs from November 1 meant a number of Richter's products were removed from the list.

"We expect minimal or nearly no sales under the Russian DLO system in the fourth quarter," CEO Erik Bogsch told reporters earlier in November.

"The recent changes to the DLO drug subsidy list reminded investors that the Russian market is not only one of the fastest growing, but also one of the least predictable," says Vladimira Urbankova, an analyst with Erste Bank.

At the same time, Richter's business is under pressure at home. The government, struggling to plug a huge hole in its budget, announced in October that its drug makers would have to pay between 10-20% more of their sales of subsidised drugs into the annual budget. Richter said the proposed legislation would erode $14.1m-$18.8m off its bottom line in 2007.

Analysts believe the news may not end up being as bad as first thought. The original draft version of the new drug subsidy law was prepared without any consultation with the pharmaceutical industry, indicating that some softening of measures might be on the agenda and the final version of the law won't be so harsh.

Richter has also asked the Hungarian president to refer the new drug law to the constitutional court. "The last time the pharmas went to the constitutional court was over the unilateral 15% price cuts in April 2004 and the court decided in favour of producers," notes Bram Buring, an analyst with Wood & Co.

"Richter has not lost its appeal, particularly for long-term oriented investors," says Erste Bank's Urbankova. "Nevertheless, as long as the home market outlook remains cloudy, do not expect the stock price to recover significantly."

Branded generics

Another big attraction of the CEE market is the dominance of so-called branded generics. These are copies of prescription drugs no longer protected by patents and are marketed under brand names, which sell for more than commodity generics.

However, John Jacques, a Prague-based consultant to the industry, says this works both ways: sales teams in the CEE region have to be much larger than equivalent teams in, say Latin America, in order to push these branded generics.

A big question, therefore, hangs over whether generics will remain as a branded market or move towards international non-proprietary name, or INN, prescribing, whereby the doctor uses the INN name or the name of the molecule in the medicine he or she wishes to be dispensed, leaving it up to the pharmacist to choose the product that meets the specifications.

"To change, this will take a mini-cultural revolution," says Jacques.

Finally, as acquisitions gradually reduce the number of independent firms, the price of the remaining few will inevitably rise.

As well as Richter, Slovenia's Krka offers an attractive way to buy into Russia, which will account for about 85% of its estimated $850m in sales this year. But Krka will come at a steep price: the company has a market capitalisation of over $2bn and the stock is trading at a price-to-earnings ratio of 22 times its estimated 2006 earnings.

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