Bucking the trend- The reverse expansive outsourcing

It’s a paradox facing India’s outsourcing industry. Its low cost location is its raison d’etre. But to stay in the game, it also has to be where the customer is, often an expensive site in western Europe or the US. First, India’s IT services industry began to buy western companies. Now, India’s drug makers are following suit.

In the past year, three Indian companies — Nicholas Piramal, Dishman Pharmaceuticals and Chemicals, and Shasun — have acquired European contract research and manufacturing (CRAM) outfits. They conduct early stage research and development (R&D) of experimental drugs for large and emerging drugmakers, produce them in small amounts for clinical trials, and do contract manufacturing. The reasons for this are sound: Indian companies have found that Big Pharma is either wary of offshoring some key, patent-sensitive activities to India or lacks adequate incentive to do so. India accounts for barely 1-1.5 per cent of the global CRAM industry. “[Acquisitions] will give the Indian companies access to customers who may not have otherwise considered doing business with them,” says Edward Vawter, president, QD Information Services, a US-based consultancy firm.
The path is not without risk. Though the companies have not been bought at fantastic valuations, the acquisitions come with high labour and manufacturing costs. Managers and scientists are free to leave once their contracts expire. But this is just the beginning. “More Indian companies will be purchasing European companies,” predicts Harry Rathore, US-based vice-president (sales and business development) at leading European contract manufacturer Lonza. The players also say they are open to more deals. So, what is behind this appetite?

Big Pharma is outsourcing like never before. According to Frost & Sullivan, the global pharma outsourcing market is worth $37 billion and growing at almost 11 per cent. Cost and time pressures are forcing customers to turn to China and India. By one estimate, India’s annual labour costs are at $3,000 a head compared to over $50,000 in western Europe. This has no doubt put western incumbents on the backfoot. But even today, most of the outsourcing activity happens there. Fifty per cent of the contract manufacturing market is in North America and just 10 per cent is in Asia, with the balance in Europe. This will not change in a hurry. “While we are an important cog in the wheel, it is never going to be all India and China,” says Ajit Mahadevan, president (custom manufacturing) of the Rs 1,582-crore Nicholas Piramal. This is why Nicholas and its peers have decided to take the battle for market share to the West.

No doubt, India is very much on the radar of the bluest of blue chips. Big Pharma such as Pfizer, AstraZeneca and Eli Lilly have outsourced to India. But business is only trickling in. Take the case of early-stage R&D. “There are some things that will not happen in India for two decades,” claims Janmejay Vyas, managing director, Dishman. Vyas claims that innovators are not comfortable offshoring early stage R&D — developing and scaling up new chemical entities — to India. The country has an untested patent protection law and no data protection. This is partly why the Rs 277- crore Dishman stumped up $74.5 million (Rs 343 crore) to buy Carbogen and Amcis, two sought-after names in the western outsourcing space.

Carbogen synthesises bulk drugs —the key ingredients that lend a drug its potency — for innovators. This includes finding the best possible process to make a bulk drug with the least amount of impurities. It also produces these bulk drugs for human trials. This isn’t rocket science. Indian companies have the skills to do it. But Vyas claims that Big Pharma will very rarely, if ever, offshore this to India. At the bulk drug synthesis stage, a company’s research may not yet be protected with watertight patents. India and China, with their history of copying innovator drugs (legal until recently), are therefore suspect.

Vyas says Dishman’s experience proves this. In spite of landing its first customer in 2002, Dishman only gets contracts to work on intermediates, the building blocks of a bulk drug. This is safer from a customer’s point of view since without knowing what the intermediate goes into, there is little you can do with it. Vyas thinks Carbogen, which works on about 400 products a year, will help Dishman move up the value chain. The other reason is proximity to the innovator. Early-stage R&D requires continuous interaction between scientists. Also, at this stage the drug goes back and forth between the innovator and the outsourcing company several times. “A scientist on the west coast of the US is going to struggle to communicate with someone sitting in Chennai or Mumbai,” says Mahadevan. Last December, Nicholas acquired UK-based Avecia from some private equity investors. Avecia owns 100 per cent in Canada-based Torcan, which is also into early R&D, like Carbogen.

Companies are not just reacting to what they perceive as problems. They are also proactively cementing ties with the biggest outsourcers. Nicholas already had a contract for process development and scale-up of world No.1 Pfizer’s animal healthcare products. But by acquiring Pfizer’s factory in Morpeth, Scotland, Nicholas emerged as its largest supplier in dollar terms. (Pfizer has agreed to source from this factory for the next five years or so). This means Nicholas now sits in on key supplier discussions. “When there is talk of ways to use a new supplier strategically, we are in the process,” Mahadevan says. It was Chennai-based Rs 377-crore Shasun’s existing customers who recommended Rhodia Pharma Solutions, says its CEO and managing director N. Govindarajan. Shasun can now offer a broader range of services to them.

Customers aside, specific skills and technology are also attractions. The low-cost Chinese juggernaut is providing tough competition to Indian companies in the high-volume, low-value business. They need to quickly enter higher barrier-to-entry markets. Technology can make the difference where cost won’t. Amcis, the contract manufacturer that Dishman bought along with Carbogen, is a case in point. Its facilities are small but handle potent and highly toxic material used to make cancer and eyecare drugs, requiring high levels of safety and containment. Although their potency means they are administered in small quantities, their dollar value is far higher — anywhere from $10,000 to $100,000 per kg. Being highly-priced, these are profitable for innovators. Minor cost differences cannot motivate them to change suppliers. “The contribution of manpower cost in a $5,000 product is nothing. What logic says that if I save $10 on a $5,000 product, the customer will be interested?” asks Vyas. Similarly, with Rhodia, Sha sun got access to technologies that it had licensed from Harvard University and MIT to counter low-cost competition from India and China. Nicholas’ Avecia is abile to make toxic products and other high-value drugs such as hormones, and owns fermentation equipment to make drugs more efficiently.

These deals are also about building scale. With Avecia and the Morpeth aquisition, Nicholas’ revenues from custom manufacturing jumped to Rs 920 crore from Rs 220 crore. Nicholas has laid claim to being among the top 10 contract manufacturing companies in the world. With Amcis, Dishman has added $100 million (Rs 460 crore) to its topline. Shasun has got business worth $72 million (Rs 331 crore) from Rhodia. The upshot of all this is that companies are converting fast to the view that to leapfrog a business is to buy it. Says Nimish Mehta, pharma analyst, Edelweiss Capital: “Companies have realised they have to run some part of their businesses outside India.”

But there are concerns. One is that of customers deserting. Often they have another source supplying the same product and could increase offtake from them. This concern has led the Indian acquirers to meet all key customers before they sign on the dotted line. Also, in some cases they have got an assurance from the seller that the customers will honour their contracts.

But losing customers is a business risk. It is not unique to acquisitions. It can happen to any CRAM company. The more pertinent question is: where does all this leave their famed cost advantage? How long can they offer viable solutions to customers with expensive manufacturing sites and high-cost labour? “In the short run, this works out very well but I doubt whether you can sustain it,” says Venkat Jasti, vice-chairman and CEO of Hyderabad-based Suven Life Sciences.

Jasti should know. In 2003, when India didn’t have a product patents law, Suven was the first Indian company in the outsourcing space to purchase a small US laboratory called Synthon Chiragenics that did research for innovators. Synthon did have some technology, but Jasti believed that its value lay in its location — in the innovators’ backyard and far from India. “It was about giving comfort to the customer,” he says. But by 2005, things changed. The same customers came back to Jasti asking for cost benefits from its Indian site. By December 2005, Jasti had closed the lab and moved the equipment to India. He admits it wasn’t difficult — the lab employed 18 people, was located in a hire-and-fire market, and did not have any manufacturing attached to it.

That is not the case with the latest acquisitions. They come with hundreds of workers employed in factories. Redundancies are tough and expensive. This is likely part of the reason why no acquirer is willing to discuss the migration of jobs to India. At least, not yet. “We did not buy these companies to shut them down, scoop up the insides and bring them home,” says Mahadevan. There is another good reason for this. Factories are continuously churning out drugs for their customers and a disruption in supply would prove fatal. Changing a manufacturing site requires regulatory clearance that takes at least a year.

The acquirers are, thus, going for the low-hanging fruit. Sweat the existing assets better and squeeze efficiencies out of the supply chain. The first thing that Dishman, Nicholas and Shasun have done is switch raw materials that the Europeans were buying from Europe and the US with Indian and Chinese supplies. Dishman’s Vyas points out that Amcis, for instance, couldn’t be bothered with tapping Asia for incremental savings for its high-value drugs. “But now, if I can save them this money, then why not?” he asks. The second thing is to increase capacity utilisation. Nicholas has done this by moving customers from one-year contracts to 3-5 year ones. Earlier, according to Mahadevan, customers were unwilling to do this since Avecia was seen to be struggling. But the sale to Nicholas has brought stability. This, and new contracts, have improved its capacity utilisation from 60 per cent to close to 90 per cent. Shasun expects to increase Rhodia’s ultilisation by 10 percentage points to 50 per cent for similar reasons.

More importantly, by fitting the large-scale Indian manufacturing back-end into the existing operations, the Indian outsourcers think they offer a proposition that’s hard for customers to ignore. Again, look at Carbogen and Amcis. An innovator works with Carbogen through the early stages of bulk drug synthesis until phase 2 of human trials (Carbogen makes the drug for the trials). By phase 3, the quantities required are much larger since these trials are conducted on large numbers. This is where Amcis — Carbogen’s sister company — a pure-play contract manufacturer, comes in. Since the project manager remains the same, the customer does not feel he is dealing with a different company.

But Vyas found that, thanks to its cost structure, Amcis would turn down any business below a particular value. The innovator had to look for another contractor. Enter Dishman. It can offer to make both phase 3 and launch quantitities of a drug synthesised at Carbogen in its facilities in Bavla, Gujarat. By then, patent protection around a product is sound and the economics makes sense. Importantly, it saves a precious two years of transferring technology from Carbogen to the innovator and from him to his contract manufacturer. Vyas says this one-stop solution lowers the total cost of bringing a drug to market for the innovator and increases Dishman’s revenues. He claims a bluechip customer who found Carbogen too expensive has now signed up, thanks to the India connection. Dishman also sees Amcis able to take on business that requires a far larger capacity — in terms of fermentors, for instance — than what Amcis can currently provide.

Companies would also like to move the production of mature drugs that have reached the end of their patent life into India while retaining the manufacturing of new patented drugs in the UK. Both Nicholas and Shasun want this. Shasun also wants to use the patented process-development technologies that it has aquired, back home. “You have to employ 20-30 chemists to keep trying these technologies. We can do that cost-effectively in India, and that would increase their viability,” Govindrajan says.

In the meantime, all three are marketing their Indian facilities to customers through the acquired companies. They claim that, through this marketing, existing customers are giving them more business and new ones are coming on board. “If you can fill up the plant there and you get a lot of value, including business, coming into India, then why would you want to shift?” asks Mahadevan. Nicholas’ near-term margins have been under pressure due to Avecia’s losses. But a turnaround is expected by the end of this fiscal. Shasun’s Govindarajan also expects Rhodia to post a profit this year.

Industry watchers warn that western Europe is losing the cost battle to India and China. The true test for the Indian acquirers, then, will come a few years down the line when customers start squeezing more out of them. Then these assets and people may harm, rather than help, their business. Getting custom, they may discover, was the simple part.

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