PHARMACEUTICALS Customer consolidation: Horizontal to vertical

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1 SECTOR UPDATE PHARMACEUTICALS Customer consolidation: Horizontal to vertical India Equity Research Pharmaceuticals In past 5 years, the US Healthcare has undergone frenzied round of consolidation, wherein negotiating power of retailers & payers has increased versus hospitals & pharmaceuticals manufacturers, leading to acute pricing pressure. The first wave of horizontal consolidation saw emergence of 2-3 large players. In the second wave, wholesalers, retailers and PBMs formed buying consortiums to align purchasing power, subsequently garnering 85% market share. However, anti-trust authorities have blocked the latest initiatives of further concentration leading to the third wave of vertical consolidation to gain mass. We believe vertical consolidation will improve efficiency - PBMs (middle men) will be eliminated, and create a behemoth with enormous negotiating power. CVS Health (CVS), the largest pharmacy chain in US, is looking to acquire Aetna, a healthcare insurance company. Entry of Amazon in healthcare distribution is a potential threat to incumbent pharmacies given its deep pockets and willingness to forego profits for years. These developments do not augur well for generic companies as pricing pressure will aggravate, and may pass on to pharmaceuticals suppliers. Vertical integration will add to woes CVS, which commands 23% of the US prescription drug sales market and owns the biggest PBM in US, is said to have made a bid to acquire Aetna a health insurance company. This is envisaged to bring greater pricing transparency, improve health outcomes and lower prices for customers. It will also clip market power of PBMs by eliminating middle men in the healthcare supply chain. If we extrapolate this trend, Wellcare, Centene and Humana (healthcare insurance firms) could be potential acquisition targets. The integration also seems to be a bid to reinforce the fort before entry of a formidable player like Amazon in drug distribution. However, it may not be good news for drug manufacturers as it will further tilt the balance against them. Generic industry not yet ripe for consolidation Consolidation in the generic industry still looks difficult as the number of generic manufacturers is increasing in the system. Even though cost of filing has jumped and margins in the US business have declined significantly, smaller players who have invested in the business set up for the US market find the market lucrative for its size and profitability. The number of filings and approvals will keep rising in the system, which will keep eroding the negotiating power of generic players. Prefer companies with complex generics pipeline FDA s focus on faster approvals to cut drugs prices is likely to increase competitive intensity. However, companies with complex generics pipeline, which face low competition, will benefit from faster approvals. We continue to prefer players with strong complex generics pipelines over the next 2-3years before that also gets flooded. Top Pick: Dr. Reddy s. Deepak Malik deepak.malik@edelweissfin.com Ankit Hatalkar ankit.hatalkar@edelweissfin.com Archana Menon archana.menon@edelweissfin.com November 21, 2017 Edelweiss Research is also available on 1 Edelweiss Securities Limited Bloomberg EDEL <GO>, Thomson First Call, Reuters and Factset.

2 Pharmaceuticals Fig. 1: Changing dynamics in the US drug distribution channel US drug distribution channel: Changing dynamics The dynamics among key stakeholders (retailers, wholesalers/distributors, PBMs and insurance companies) in the US drug distribution channel have evolved over the past few years: (1) horizontal consolidation: Consolidation among peers at each level has led to emergence of 2-3 large players with majority market share. Considering the already high concentration and the Department of Justice (DOJ) blocking latest initiatives, opportunities for further consolidation appear to be low; (2) vertical relationships: Wholesalers, large drug retailers and PBMs have formed alliances (buying consortiums) to align purchasing and enhance their negotiating power. Post the recent WBAD-Econdisc alliance, the top 3 sourcing groups will have ~85% market share and, therefore, impact of any further alliances will be low; and (3) vertical consolidation/integration: Players are looking to integrate across different lines of businesses, e.g., insurance players acquiring/setting up own PBMs. Vertical consolidation is still at nascent stage and probability of vertical consolidation going ahead is high. Wave 1 (past 5 years) Horizontal Consolidation Players at each stage of the distribution channel merge/acquire peers to increase market share Currently, top 2-3 players at each level have majority market share DoJ has blocked latest initiatives. Opportunities for further consolidation low. Wave 2 (gained momentum over past 2-3 years) Vertical relationships Wholesalers, retailers and PBMs form Buying consortiums to align purchasing and enhance negotiating power Top 3 sourcing groups have ~85% market share Recently, Econdisc (8% market share) joined WBAD alliance and now contributes 33% market share. Most of the major alliances have already been formed and impact of further alliances would be low Wave 3 Vertical consolidation Players integrate different lines of business (eginsurance players acquiring/setting up own PBM) CVS is looking to acquire Aetna, which will make it the first player with presence across all stages of the distribution channel. Vertical consolidation is still at early stages, yet to play out. Source: Company, Edelweiss research Wave 1: Horizontal consolidation Horizontal consolidation at each level has led to emergence of 2-3 large players with majority market share. Among retail pharmacies, the top 3 pharmacy chains i.e., CVS, Walgreens and Express scripts, already dispense ~50% scripts. Further, this is bound to increase as Walgreens completes acquisition of ~40% of Rite Aid stores. The wholesaler/distributor industry is more concentrated with the top 3 distributors cornering ~85% market share. Among PBMs, the top 3 players have ~65% share of claims. Concentration at the insurance level, with the top 10 players with ~50% market share, is relatively lower as the DOJ has not been approving recent mergers/consolidations (Aetna-Humana and Anthem-Cigna). Considering concentration is already high and DOJ has been blocking latest initiatives, probability of further pressure due to more horizontal consolidation seems low. Refer Appendix (page 8) to understand the US drug distribution channel 2 Edelweiss Securities Limited

3 Sector Update Chart 1: Top 3 pharmacies have ~50% share Walgreens 15% Others 46% CVS Retail 14% Chart 2: Top 3 distributors have ~85% share of pharma sales Others 15% McKesson 33% Cardinal Health 21% Walmart 5% CVS Mail Order 9% Express Scripts Mail Order Pharmacy 11% Amerisourc ebergen 31% Chart 3: Top 3 PBMs have ~65% share of claims Others 34% Optum Rx 13% Express Scripts 29% CVS Health 24% Chart 4: Top 10 insurance players have ~50% market share UnitedHeal th Group 11% Anthem 9% Others 52% Magellan 1% Molina 2% HealthNet 3% Wellcare 2% Aetna 4% Cigna 5% Humana 9% Centene 3% Source: USC Schaeffer, Edelweiss research Note: Based on 2015 data Wave 2: Vertical relationships among various stakeholders: Although the traditional distribution chain model creates channel conflict among different stakeholders as they negotiate for prices, rebates, discounts, getting listed on formularies etc., different stakeholders have started collaborating to develop vertical relationships. 1. Buying consortiums: Wholesalers, large drug retailers and PBMs have forged buying consortiums to align their drug purchasing. Aggregating volumes enhances negotiating power of the consortium and enables it to obtain favourable prices. Currently, the top 3 sourcing groups have ~70-85% market share. Among recent deals, while impact of the McKesson-Walmart deal (announced in May 2016) is visible, in the Econdisc-WBAD (announced in May 2017) deal, we understand, negotiations for new products have already begun and complete impact should be apparent by mid CY18. 3 Edelweiss Securities Limited

4 Pharmaceuticals Fig. 2: Buying consortiums have tilted the balance in favour of distribution channel Top 3 sourcing entities have ~85% market share Retailers Wholesalers PBMs Sourcing entity CVS Health 20% 5% Cardinal Health 25% 18% 7% 8% 33% 6% 10% 25% 8% Market share Source: Company, Edelweiss research 2. Pharmacies and wholesalers: Large pharmacy retailers are now shifting from selfwarehousing to establishing direct store deliveries from a wholesaler (Mckesson-Rite Aid agreement in February 2014 and AmerisourceBergen-Walgreens Boots Alliance in May 2013). In addition, wholesalers and retailers have also aligned their generics purchasing. Large pharmacies have historically purchased generics directly from manufacturers rather than via the wholesale channel. However, the reduced acquisition cost from these retail-wholesale purchasing relationships has encouraged pharmacies to forge generic purchasing agreements with wholesalers. 3. PBMs and pharmacies: The traditional PBM model creates 2 sources of channel conflict with retail pharmacies: (1) PBMs determination of pharmacy reimbursement rates & dispensing directly affects a pharmacy s revenue & profitability; (2) PBMs mail pharmacy absorbs dispensing profits that may otherwise be earned by a retail network pharmacy. However, these parties have formed alliances that benefit both parties and minimise conflicts. PBMs join buying consortiums to benefit from the combined purchasing power, resulting in lower drug costs. Pharmacies partner with PBMs to become their preferred pharmacy partner to bag incremental volumes, albeit at reduced margins. Moreover, PBMs and pharmacies also align to form mail and specialty pharmacy businesses (Walgreens and PBM Prime Therapeutics formed a mail and specialty company AllianceRx Walgreens Prime). 4 Edelweiss Securities Limited

5 Sector Update Wave 3: Vertical consolidation Companies after forming vertical partnerships are now going for vertical integration by integrating the different lines of healthcare business: Insurers acquiring PBMs: United Healthcare acquired Catamaran (PBM) for USD13bn to bulk up its pharmacy-benefit business. Catamaran, the fourth-largest pharmacy-benefit manager in the US by volume of prescriptions processed, merged into UnitedHealth Group s OptumRx unit the industry s third-largest and part of the company s Optum health-services arm. Insurers setting up PBMs: Anthem, the second largest health insurer, will launch its own PBM IngenioRx in partnership with CVS, effective January The move comes as Anthem s contract with Express Scripts expires at 2019 end following a high-profile dispute between the two. Rather than renew with Express Scripts or hand off the management of prescriptions entirely to another PBM, Anthem said it has formed a partnership that will give the health insurer "complete control" over its formulary, the preferred list of drugs that is covered for its customers. Pharmacies and PBMs: CVS was the first to establish significant scale across 2 supply chain horizontals with the merger of CVS pharmacies and the Caremark PBM in Moreover, PBMs and pharmacies also align to form mail and specialty pharmacy businesses. Walgreens and PBM Prime Therapeutics formed a mail and specialty company AllianceRx Walgreens Prime. Wholesalers and insurance companies: Now, distributors are looking to acquire insurance companies to gain more negotiating power and protect their turf against a formidable player like Amazon. Probability of vertical consolidation in future is high Opportunities for further horizontal consolidation low: Top US health insurers have tried a variety of merger/consolidation options in the past few years. Both Aetna- Humana (USD37bn) and Anthem-Cigna (USD48bn) deals were blocked by DOJ earlier this year. In absence of such consolidation opportunities, the interest in vertical alignment is expected to grow for both health-plans and PBMs. Currently, just one integrated PBM-insurance player: UnitedHealth Group is the only large-scale healthcare player which owns both health plan and PBM assets. The integrated model enables alignment of spends across medical and pharmacy, which is becoming increasingly relevant and can result in membership gains. The Aetna-Humana deal would have enabled Aetna to grow an OptumRx kind of PBM asset; instead, now it is looking to merge with CVS. Currently, it has agreement with CVS for PBM services. Anthem s new PBM and a possible CVS-Aetna deal could pressurise other players to integrate: a. CVS has an integrated platform across retail, PBM and a distributor joint venture (with Cardinal Health), providing CVS with an advantage. Adding a health plan to its assets portfolio will provide strategic advantage to CVS over UnitedHealth Group- OptumRx. With Aetna s existing PBM relationship with CVS, the integration risk for the acquisition is low. Risk of a challenging integration would have been different if the Aetna-Humana deal had materialised or if it had continued to drag for a much longer period. This will also pressurise other large health plans and PBMs to fill gaps in their portfolios. 5 Edelweiss Securities Limited

6 gross margin (%) gross margin (%) gross margin (%) gross margin (%) Pharmaceuticals b. Anthem issued an RFP earlier this year to replace Express Scripts as its PBM. Both have been working under a 10-year pricing contract since 2009, when Express Scripts had agreed to buy Anthem's struggling in-house PBM for USD4.7bn. In FY17, Anthem sued Express Scripts for USD15bn damages and the ability to end its contract, saying that Express Scripts overcharged it by USD3bn annually. The company is losing its biggest client to CVS. Given the circumstances, Express Scripts should be aggressively scouting for a health plan. How do these alliances impact drug manufacturers? 1. Price erosion: Generic pharma companies have been grappling with pricing pressure due to consolidation in the distribution channel in the US. Typically, when 2 drug purchasers enter into a joint sourcing agreement, existing purchasing agreements with generic drug manufacturers are aligned in such a way that the lowest rate that was provided to either of the 2 purchasers is now applicable to both. Further, for new agreements, aggregation of demand increases the negotiating power of purchasers and negatively impacts drug manufacturers. Over the past few years, as wholesalers, retailers and PBMs have entered into joint sourcing agreements and formed buying consortiums, pricing pressure on the generic pharma market has intensified. This is reflected in declining gross margins of key players. Chart 5: Gross margins for drug manufacturers have been declining CY15 Q3CY17 30 CY15 Q3CY17 71 FY15 Q2FY18 56 FY15 Q2FY18 Teva Mylan Sun Pharma Dr Reddy's Source: Company, Edelweiss research Note: Generic business margin for Teva and Dr Reddy s, company level margin for Mylan and Sun Pharma 2. Working capital: In the US market, while drugs are sold by manufacturers at list price (gross price), the actual price they receive (net price) after factoring in rebates and other discounts paid to middlemen in the supply chain is much lower. Typically, while drug manufacturers are required to pay rebates before they receive the gross price, i.e., the cash outflow in the form of rebates, needs to be made before they receive the cash inflow. Rising consolidation in the distribution channel has resulted in higher rebates and discounts. Total amount of drug rebates and discounts catapulted to USD127bn in 2016 from USD39bn in This has increased the working capital requirements of drug manufacturers. 6 Edelweiss Securities Limited

7 Amazon s entry: Potential disruptor Sector Update In what could be a major disruption in the US pharma distribution system, media reports indicate that Amazon is mulling entry in the US pharma distribution chain. Although Amazon has not confirmed this, its possible entry has been a subject of speculation for months. As per earlier media reports, the company has hired a lead to devise a strategy in this regard and is in discussions with PBMs, while the most recent ones suggest that the company has been approved for wholesale pharmacy licenses for at least 12 states. Amazon is a wild card. It's unclear when or how the company will enter the market, or even if it will. It could choose multiple routes. If it chooses to operate through a PBM, Amazon could either acquire/ partner with a large PBM or may even choose to learn the business model by partnering with a smaller PBM. There are already reports that Amazon, with its 350,000 employees, is trying to administer its own health plan internally as its own PBM. On the other hand, it could also leverage its chain of whole food stores to establish in-store pharmacies that could also act as mail order fulfilment centers. Amazon s strong distribution network and existing customer base could give it an upper hand. If and when Amazon enters the pharma distribution business, generic drug manufacturers may also be impacted. However, given that the prescription drug market is highly regulated and requires approvals, threat due to Amazon s entry could be some time away and it would be premature to judge the impact at this juncture. Generic industry not yet ripe for consolidation Consolidation in the generic industry still looks difficult as the number of generic manufacturers is increasing in the system. Even though cost of filing has increased and margins in the US business have declined significantly, smaller players who have invested in the business set up for the US market find the market attractive for its size and profitability. The number of filings and approvals will keep rising in the system, which will keep eroding the negotiating power of generic players. Prefer companies with complex generics pipeline Overall, in addition to the price erosion due to customer consolidation, impact of faster approvals will also persist. The new USFDA commissioner, Scott Gottlieb, is focused on giving faster approvals to reduce drug prices. While on one hand this will increase the competitive intensity, on the other, companies with complex generics pipeline will benefit over the next 2-3 years before that also gets flooded. Hence, we continue to prefer companies with strong complex generics pipelines. 7 Edelweiss Securities Limited

8 Pharmaceuticals Appendix Understanding the US drug distribution channel Fig. 1: US pharmacy distribution and reimbursement system Source: Drug Channels 1. Distribution: Distributors/wholesalers purchase drug products from manufacturers and ship them to retailers, where patients access their prescription medications. The retail pharmacy market can be divided into 3 major categories: chain pharmacies & mass merchants with pharmacies, independent pharmacies and mail-order pharmacies. 2. Financing: Payers, the financing source for drug benefits, can include public sources (generally Medicare or Medicaid) or private sources (private health insurance and out-of-pocket payments). PBMs act as an intermediary and help payers manage their drug benefits. They determine which pharmacies will be in the plan s network, develop the formulary (list of covered medications) and negotiate price rebates with drug manufacturers. Manufacturers provide these rebates in exchange of having specific medications listed on the formulary. By aggregating purchasing and administration for plan members, they are able to save significant costs through negotiating discounts on drugs with pharmaceutical manufacturers themselves. 8 Edelweiss Securities Limited

9 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 (INR) Sector Update Edelweiss Securities Limited, Edelweiss House, off C.S.T. Road, Kalina, Mumbai Board: (91-22) , Aditya Narain Head of Research Coverage group(s) of stocks by primary analyst(s): Pharmaceuticals Aurobindo Pharma, Cadila Healthcare, Cipla, Divi's Laboratories, Dr.Reddys Laboratories, Glenmark Pharmaceuticals, Ipca Laboratories, Lupin, Natco Pharma, Sun Pharmaceuticals Industries, Torrent Pharmaceuticals Recent Research Recent Research Date Company Title Price (INR) Recos Date Company Title Price (INR) Recos 02-Jan-14 IPCA The growth prescription; 729 Buy 15-Nov-17 Laboratories Ipca Visit Challenges Note persist; 526 Reduce Laboratories Result Update 23-Dec-13 Torrent Aggressive M&A valuations to 480 Hold 14-Nov-17 Pharma Sun strain Performance ROCE; Event in-line Update with 526 Buy Pharma muted expectations; 17-Dec Nov-17 Ranbaxy Laboratories Cadila Receives Result Update approval for generic Felodipine ; EdelFlash glialda launch drives a strong Hold Buy Healthcare quarter; Result Update Distribution of Ratings / Market Cap Edelweiss Research Coverage Universe Buy Hold Reduce Total Rating Interpretation Rating Expected to Rating Distribution* * 1stocks under review > 50bn Between 10bn and 50 bn < 10bn Market Cap (INR) Buy Hold Reduce appreciate more than 15% over a 12-month period appreciate up to 15% over a 12-month period depreciate more than 5% over a 12-month period One year price chart 3,500 3,100 2,700 2,300 1,900 1,500 Dr Reddy Labs 9 Edelweiss Securities Limited

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