Rethinking R&D

As more Indian pharma companies hive off their R&D units, Viveka Roychowdhury analyses the methods behind the moves 2008 may well be a watershed year for the Indian pharmaceutical industry. Five to six major Indian pharma companies, with a few more sitting on the fence, have announced plans to hive off their New Chemical Entity (NCE) research units into stand-alone companies.

This marks a major mindset move, marking the coming-of-age of an industry previously tagged as a 'copycat'. The early birds, Dr Reddy's Laboratories (DRL) and Sun Pharmaceuticals were trendsetters and after Sun Pharma's NCE research unit successful listing on the stock exchange, the trickle looks set to become a wave. The timing seems right - some industry analysts say that the Indian drug research pipeline has a total of 60 molecules at various stages of development in labs across the country.

Smart move

It is a no-brainer that this is one smart market move. Across sectors, hive-offs seem to have been the flavour of the year. As Hitesh Gajaria, Sector Head, Pharma, KPMG India puts it, "Unlocking of Value through Hive-Off has been the dominant theme in Capital markets during 2007 not only in the Pharma but also in many other sectors such as Telecom, Power etc." There are two key objectives of this move. One, to provide necessary financial resources to advance R&D initiatives and bring in sophisticated investors who understand the dynamics of this business and have a long term investment horizon. And second to increase the shareholder value by improving the overall profitability (ROCE / RONW) by hiving off the resources consuming R&D segment.

Hitesh Gajaria, Sector Head, Pharma, KPMG India

Looking back at his company's pioneering move, Dilip Shanghvi, Chairman and MD, Sun Pharmaceuticals says, "The idea was to bring in focus on the innovative projects that SPARC has in its pipeline. Innovative research produces results over the long term and hence it is a bit premature to talk of realization of objectives. But with this separation, we are beginning to see sharpening of focus."

A DRL spokesperson clarifies that the company has not done a demerger of its R&D arm as in the case of other Indian pharma companies. It is primarily a derisking strategy where DRL along with two private equity partners came together to form Perlecan Pharma. The formation of Perlecan Pharma was an innovative financial agreement which brought to table the strengths of the three companies. Perlecan Pharma provided DRL's Drug Discovery program, a model to rapidly advance its existing as well as future NCE assets through Phase II trials and seek out-licensing, co-development or joint commercialization opportunities thereby enhancing the value of the pipeline. Also this model was to enable DRL's Discovery Research division to work on multiple development programs.

Himanshu Varia, Institutional Sales, Asit C Mehta Investment Intermediates

In fact, expenditure on R&D has traditionally been seen as a 'cost' by Indian pharma companies, when it was actually an 'investment' in the future. The industry remained focused on generics and the domestic business segments, and reinvested a certain percentage of profits into R&D. Of late, margins in the generics business started dwindling, due to severe pricing pressures in major markets like the US. On the home front, price control also hit the companies' balance sheets. Thus sustainable R&D expenditure fluctuated as per the performance of pharma companies. Himanshu Varia, Institutional Sales, Asit C Mehta Investment Intermediates, points out that the research outfit would be able to raise capital either by long term debt funding or equity contribution from investors who are well informed about the risk-rewards involved in research projects.

Pharma companies going this way anticipate a savings from Day One. Nicholas Piramal India Limited (NPIL) expects to complete the approval process by February and to list the de-merged entity by May-June. While declaring the third quarter results, Ajay Piramal, Chairman, NPIL predicted that once the de-merger process was completed, the consolidated operating margin will go up by almost three percent. This is because Rs 73 crores will move off the NPIL balance sheet and be reflected in the new de-merged entity.

Analysying the trend from a global perspective, Gajaria lists three similar moves. In 2002, Aventis spun off its osteoporosis research arm, Proskelia, with a majority investment (60% stake) in it being taken by a key private equity firm, Warburg Pincus. The second was in June 2004, when SRI International, an independent R&D organization divested a division that develops cost-effective medicines, called Bridge Pharmaceuticals Corporation. Novartis' split of its nanotechnology research arm, Zeptosens AG, which was later acquired by Bayer, is the third example.

Valuation of R&D pipeline

Dr Swati Piramal Director-Strategic Alliances & Communications, Nicholas Piramal India

A key to the hive-off process is to first value the assets to be hived off. Gajaria says that valuation of standalone R&D units is a complex task and involves lot of assumptions. However, at the top of his list would be the number of research molecules and their development status.

Varia adds that the method adopted may either be an option valuation model or the frequently used discounted cash flow valuation which takes into consideration the series of cash flows that may accrue from the molecule (milestone and royalty payments from out licensing or sales revenues from commercial launch). Other things to be considered is the potential market size that these molecules are intended for, contemporary drugs and competing pipelines of other companies. According to Gajaria, Real Options Methodology implicitly accounts for economic abandonment and are therefore better suited to evaluate new drug development.

Dr Swati Piramal, Director - Strategic Alliances & Communications, NPIL points out that valuation of the R&D pipeline of Indian companies is somewhat hampered by the fact that there has not been a hit (successful drug molecule) so far. She says that previously there were no pharma specialist analysts based out of India but that is no longer the case today.

Dr Dilip Shanghvi, Chairman and MD, Sun Pharmaceuticals

Stock market response has been very good, according to Dr Piramal, as existing shareholders will get one share of the new company for every share of NPIL. With this, they get a present day profit-making company as well as a chance to cash in on the long term opportunity in the NCE entity. So they can hedge their bets. NPIL intends to divest not more than 10-20 percent of the NCE company's equity, to a strategic investor, who could be either a financial entity or an industry player.

Other companies are joining the bandwagon, albeit with minor modifications in their strategies. Like NPIL, Ranbaxy Laboratories and Wockhardt have also announced planes to de-merge their NCE R&D. Glenmark Pharmaceuticals recently did the reverse: kept R&D and spun off its generic arm. Sensing that the market may not be comfortable evaluating research, Biocon is planning to list its contract research arm, Syngene International, as it believes that outsourcing is an easier business to value.

Tax sops sweeten the deal?

Gajaria sounds a cautionary note, when he says, "Factors such as investor profile, investment structuring, tax implications and access to funds will be enablers. Ultimately the stand alone performance of these standalone R&D companies over a period of time will determine the lasting impact of such moves."

So is the R&D dream a bubble waiting to burst? The latest threat, at least at perception level, seems to be the Government's stand that the 150 percent weighted deduction allowed on R&D expenditure would not extend to standalone R&D units. Explaining the situation, Dr Piramal says, "We have asked the (Finance) Ministry to extend Section 81B to the pure R&D companies." Thanks to a sunset clause in this section, the tax sops expired last year, and there is intense pre-budget lobbying to extend this Section for another ten years, as well as cover the R&D hive -offs on the anvil. Even if the section is not extended to standalone R&D units, industry observers say that companies could claim tax breaks on both units by conducting some manufacturing activity at the standalone R&D unit as well, meeting the current criteria.

The provision seems open to misuse, but this is refuted by Dr Piramal. According to her, there are strict criteria to be met and site inspections by the Department of Science and Technology (DST) before a unit is certified as a DST-recognised R&D centre to quality for tax breaks.

When asked to respond on this matter, a Sun Pharma spokesperson said, "As we understand, the weighted deduction is available for manufacturing companies that do research. We wouldn't be able to comment on other companies' reasons for hiving off R&D. Companies seeking to de-merge for strategic reasons (as ours) would have a different set of priorities."

Results matter

Lost in the euphoria of stock market hype, is the reality of research-at the end of the day, laboratory results are all that matters and drug research is a tricky business. All the hype and positive sentiment could be wiped out with one major miss. There has been speculation that DRL's strategic investors in Perlecan, are pulling out. There are concerns that DRL's foremost molecule in clinical trials, in the same class as GSK's Avandia, will suffer the same fate and be associated with increased heart risks. A DRL spokesperson refused to comment on market speculation.

Drug research thus remains a gamble and the chips, the elusive and unpredictable molecules. Established players are investing for the future and preparing for a long wait, before they see results. Most are hedging their bets, to maintain positive cash flows. NPIL's deals with Merck and Lilly, Glenmark's with Merck and Ranbaxy's with GSK are examples of this strategy. When the chips are down, the stock markets bleed. But for now, industry is in a wait and watch mode as no one is willing to write off the Indian players.

viveka.r@expressindia.com