The sale of Ranbaxy to Daiichi Sankyo has surprised many. Why would the promoters of the leading drug company sell out when there are significant growth opportunities in the near future? Here is why. By Vivek Sharma

Here is the scenario. By 2012, more than three dozen drugs will lose patent protection – many of them blockbusters like Lipitor, the cholesterol lowering drug which is the biggest selling drug ever. Combined annual revenues of large drug companies from these drugs are a staggering $70 billion. This large number of patent expiries will open up unprecedented opportunities for generic drug companies, who profit by selling cheaper versions of patented drugs in unregulated markets and in regulated markets when the drugs go off-patent. Many of these generic companies have been preparing for this wave of patent expiries for a long time now.

Imagine that you are the promoter of a large generic company, with a one-third stake valued at a few billion dollars. Your company is one of the leading global generic companies, the seventh largest to be precise, with annual revenues of close to $1.7 billion. You are a leader in your domestic market, have manufacturing facilities in other parts of the world and sell your products in more than 60 countries. Your company has been aggressively challenging attempts by large drug manufacturers to get patent extensions on blockbuster drugs, including Lipitor. You also enjoy 'first-to-file' status for generic versions of select blockbuster drugs and will get a six-month period of exclusive market access when those drugs go off-patent.

In short, your company is one of the most prepared among generic manufacturers to exploit the coming opportunity – which is truly 'once in a lifetime' in many ways. You are also emotionally attached to the company, built by your father. Will you sell this company when it appears to be all set for the best years in its history, even if the offer is good enough? Not many would, but a few may.

That is what the promoters of Ranbaxy, India's largest drug company, did yesterday when they sold their 35 per cent stake to Japanese company Daiichi Sankyo. This is undoubtedly a transformational deal for the entire Indian pharmaceuticals sector with wide reaching implications, it is not everyday that an industry leader is sold to a foreign buyer.

But the more immediate question is, why did the Ranbaxy promoters decide to sell out now?

The generic honey pot

The coming wave of patent expiries is widely seen as a honey pot for the generic drug industry. Worth over $70 billion, honey pots don't get bigger than this one either. After decades of being looked down upon as copy cats and patent violators, for generic companies this was an opportunity to get even with big pharma companies. Some industry analysts have even predicted a future dominated by generic companies.

But the problem with honey pots is that they attract too much attention. And it is no different in this case either. The big opportunity has every generic manufacturer in all corners of the world salivating for a long time now. This means there will be a rush of generic products flooding the market, the moment the six-month market exclusivity period ends after the patent expiry. And that can shrink the honey pot to a great extent.

Patented drugs often sell for as much as 10 times their cost of manufacture, even more in the case of exclusive drugs. The size of the potential market for generic companies being talked about is based on these prices. As soon as a number of generics are introduced, prices will fall dramatically to come closer to manufacturing costs within no time. Instead of the 90-95 per cent margins enjoyed by big drug firms for patented products, generic players will struggle to maintain even wafer thin margins. Yes, volumes will increase when prices drop but overall profits will still be much lower.

The steep climb up the value chain

The sharp fall in generic drug prices is nothing new; companies have been struggling with this for the last few years. Some of them, including Ranbaxy, have tried to build their primary research and drug discovery capabilities. A lower cost base and availability of research talent in India work to the advantage of these companies. There have been successes too, though most Indian companies prefer to sell promising discoveries before they reach the marketable stage to global drug firms.

But, drug discovery is like playing the lottery. It is highly unpredictable with very low success rates. Unlike the lottery where the initial investment is low, new drug research demands huge upfront investment over a long period. Pfizer, for instance, spent over $7 billion last year on new drug research, while the research budget of all generic companies combined would only be a fraction of that. Even with such astronomical funding, research success of large drug companies have steadily declined in recent years.

If discovering a molecule is tough, taking it past multiple levels of regulatory approvals to ensure its safety for human use is even tougher. Drug approval processes are being continuously tightened as governments have become much more sensitive to harmful side effects in future. Earlier if a drug had to be tested on 1,000 patients during trials, it now has to undergo testing on at least five times as many. This adds to the costs and, more significantly, to the uncertainty as the probability of rejection increases. There have been some high profile recent cases where potential blockbuster drugs failed at the very last stage of clinical testing, like Pfizer's cholesterol drug torcetrapib (See: Pfizer aborts cholesterol drug tests). In many other cases, the approval process is delayed which cuts into the typical 20-year patent window available for inventors to sell the product without competition.

Generic companies are slowly realising that it is quite a steep climb up the value chain. If their margins dip in future because of increased competition, they will struggle to find enough resources to sustain their research efforts.

Then why is Sankyo taking the plunge?

If the outlook for generic manufacturers is not quite rosy as widely believed, why is Daiichi Sankyo buying Ranbaxy – that too at a premium? What does the Japanese company hope to gain from it's nearly $5 billion investment? Why would Daiichi pay over 30 times Ranbaxy's trailing earnings, if it doesn't see significant growth potential? Not even technology stocks command that kind of valuations these days.

For Sankyo, the justification for this deal is very straightforward. The company is primarily a research driven entity, with most of its revenues coming from Japan and Europe. Ranbaxy adds generic capabilities and access to markets across the globe. In other words, Sankyo is hedging its bets through Ranbaxy and broadbasing its business – both geographically and in terms of product range. The combined entity, with a market value of close to $30 billion, will be among the top-20 drug companies globally.

There is an even bigger prize which Sankyo may be eyeing – the huge potential of the domestic Indian market. Though our population is only modestly smaller than China's, their pharma industry is four times as large as India's. Rising income levels and increasing spread of health insurance coverage are certain to push up healthcare spending in India. The pharma industry in India is projected to grow to nearly $30 billion in annual revenues by 2015. Exports will continue to dominate, but the growth rate in the domestic market is likely to be faster.

Together, Sankyo and Ranbaxy are better placed to build on their existing competencies and expand their reach. There is hardly any overlap between the two businesses, which are almost perfectly complementary. From a long term perspective, Ranbaxy is worth the premium Sankyo is paying.

For the Singh brothers of Ranbaxy, both still in their '30s, it is time to build new empires with the money they will land from the deal.