The announcement in April that US-based Charles River Laboratories (CRL.NYSE) would acquire WuXi Pharmatech (WX.NYSE) for US$1.6 billion showed that China’s contract research outsourcing (CRO) industry – the outsourcing of drug research and development – has come of age. China has long been the largest producer of chemical components that serve as active ingredients in pharmaceuticals, but despite the leap forward in research, it still isn’t ready to take the next step into developing its own blockbuster drugs.
Through the acquisition, Charles River – a major player in the laboratory animal industry – has tapped into WuXi’s expertise in the earlier, preclinical stage of the drug testing process. The US firm will take care of the final phase of clinical animal and human trials. The merged entity integrates the drug development process from compound creation to human testing, exploiting China’s improving R&D capabilities and its lower labor costs.
"This is just the beginning," said Dan Zhang, CEO of Chinese CRO provider Fountain Medical Development, "For most of the pharmaceutical firms, it’s not if China, but rather when or how."
The merger represents the largest cross-border transaction in China’s burgeoning CRO industry, which is expected to be worth US$430 million in 2010, up from US$260 million in 2008. Other foreign CRO players have been active on a smaller scale: Pharmaceutical Product Development (PPDI.NASDAQ) opened a new vaccine clinical research center in Taizhou and bought two Chinese CROs in November 2009, while Kendle (KNDL.NASDAQ) and Japan’s InCROM have been in China for years.
"The market in China from a labor standpoint is still very attractive for companies like Charles River to access well-trained resources," said David Windley, a healthcare analyst at Jefferies. But most of these firms don’t serve the local market.
While companies focused on domestic R&D outsourcing exist, they don’t do frontline research. Full-service CRO firm Venturepharm (8225.HK) employs more than 300 scientists in clinical trials and drug development for domestic manufacturers, but it primarily focuses on first-generation generics, produced to replace drugs that have just gone off-patent.
Despite the popularity of China as a destination for international CRO, the industry remains fragmented. WuXi was widely considered to be a market leader across the manufacturing, preclinical and laboratory services sectors. Other firms looking to acquire may need to settle for sector-specific targets like Sundia Meditech or Shanghai Medicilon, which focus on just one segment of R&D.
ShangPharma, the other highly diversified Chinese CRO and a likely second choice for acquirers after WuXi, remains a private corporation, but welcomed a US$30 million investment from US-based private equity group TPG in 2007. One potential buyer could be Covance (CVD.NYSE), one of Charles River’s American CRO competitors, which began building a preclinical facility in Shanghai after a planned joint venture with a WuXi preclinical lab fell through.
Purchasing a domestic CRO firm may also be an easy way for giants like Roche (ROG.SIX), Bayer (BAY.FWB, 4863.TYO), and GlaxoSmithKline (GSK.NYSE, GSK.LON) to expand their existing China research divisions and tap into a clinical trials market growing 20% per year. Acquisitions targeting this later stage of the drug development process may prove lucrative in the long term.
"China and India are the two most important nations in terms of clinical development. These two countries offer the largest patient pool in the world," said Zhang of Fountain Medical.
A growing China offers not only a testing ground for new drugs, but also a vast potential customer market for even top-of-the-line discoveries. According to Sinopharma Group, the country’s pharmaceuticals industry will be the second-largest in the world by 2020, worth an estimated US$120 billion.
The thousands of patients enrolled in Chinese drug trials may eventually become the millions of customers clamoring for the newest pharmaceutical technology – and improving research capabilities will in turn inspire research outsourcers to develop and manufacture their own products. The experience of traditional Chinese medicine (TCM) companies may suggest a way forward.
James Tong, CFO of Chinese TCM and pharmaceutical manufacturer Tianyin Pharmaceutical (TPI.AMEX), said that the average margin for drug manufacturing is about 10%, but higher margins are possible through a stronger product portfolio and economies of scale. Until then, developing first-generation generics may be a necessary stepping-stone.
Certain pharmaceutical manufacturing firms have already made moves toward domestic innovations, albeit in copying off-patent products like the HIV treatment drug introduced by Zhejiang Huahai Pharmaceutical (600521.SH) in 2003. The intended development of first-generation generics is also likely a factor in antitumor drug manufacturer Jiangsu Hengrui Medicine’s (600276.SH) decision to establish a state-of-the art research center in Shanghai.
With improved purchasing power, an aging populace and a medical prescription system beginning to treat more chronic illnesses, opportunities will only improve. There are also signs of progress on the regulatory side following a string of drug approval scandals that dogged the State Food and Drug Administration. Domestic testing doesn’t yet match Western rigor, but the advancement of CROs is raising the bar.
"The problems of the past occurred in the process of implementation," said George Liu, a healthcare economist at the University of North Carolina at Chapel Hill. "The government will make a more rigorous and serious enforcement of the [existing] regulations."
More good news for research can be found in a healthcare system that is increasingly oriented toward not only safety and efficacy, but value for money. High-end pharmaceuticals that offer an overall edge over cheaper but less effective generics create plenty of room for research, and Beijing is investing heavily in clinical development so that Chinese firms play a role in bringing these drugs to market.
The cost factor
However, there are already talent shortages in the country’s medical research industry, which could push researcher wages higher and erode China’s CRO advantage. Fountain Medical’s Zhang forecasts a national focus on educating and training the research workforce necessary to maintain China’s research competitiveness. But industry observers describe this as a natural progression. "What we see in the West is that regulatory requirements continue to get more onerous over time, and the resources get more expensive," said Jefferies’ Windley.
Consolidation across China’s pharmaceutical research industry will be key to long-term success. While companies currently lack the billions necessary to spend on original drug development, acquisitions could facilitate integration and deliver the necessary economies of scale.
Until then, a focus on developing first generation generics may be an unavoidable step for domestic research firms looking to break out from outsourcing. They will have to act quickly, though, as global firms move into the market.
"International companies are waking up to the reality that China eventually will become a very big market," said Du Jinsong, a healthcare analyst at Credit Suisse in Hong Kong.