Does Cardinal Health's Acquisition Of Zuellig Pharma Signal China's Intent To Allow More Foreign Investment?

U.S. wholesaler's entry could signal the Chinese government is willing to approve foreign ownership in health care industries, such as drug distribution, that historically have been reserved for domestic players.

SHANGHAI - In what some are calling a transformational event for the China pharma industry, Cardinal Health announced Nov. 29 that it has closed a deal to acquire local private distributor Zuellig Pharma China (Yong Yu in Chinese) for $470 million.

The acquisition by the U.S. wholesaler could be a signal that the Chinese government is willing to approve foreign ownership in some health care industries like drug distribution that historically have been reserved for domestic players in an effort to drive innovation and consolidation.

"The acquisition of Yong Yu creates a new platform for growth and does so in the right market with the right company and the right management team at the right time," Cardinal's CEO George Barrett, told investors and analysts during a Nov. 29 call.

Zuellig Pharma China started its China operation in 1993 as Zuellig Yong Yu XinXing, a JV between Zuellig Pharma and local distributor XinXing; Zuellig Pharma owned 85 percent of the company. Yong Yu was also China's first approved foreign investment in China drug distribution in 2003.

Yong Yu currently has roughly 700 employees and runs seven distribution centers in Shanghai, Beijing, Shenyang, Wuhan, Chongqing and Guangzhou. Headquartered in Shanghai, it supplies pharma products to 49,000 hospitals and clinics and 123,000 pharmacies for multinational companies as well as local pharma companies.

According to the company's management, about two-thirds of Zuellig's business is generics, in which primarily Chinese firms participate, and one-third of the business is branded or off-patent originator products, which are mostly multinational company products.

"Our portfolio of business is heavily oriented towards the branded part of the business," Eric Zwisler, Zuellig Pharma China president, said during the call.

"Zuellig is an interesting player - its international customer set and business practices are less of a worry for [a company] like Cardinal in what can be a very gray area of the value chain," Helen Chen, L.E.K. China Healthcare director, told PharmAsia News. "It immediately adds a substantial commercial footprint, and also there's less of an integration issue given that Cardinal has no distribution presence in China."

Welcome Foreign Investment In Health Care Industries?

"Importantly, we view the completion of the regulatory approval as a transformational event, demonstrating the Chinese government's willingness to allow foreign players to tap into some previously domestic-only market segments," Oppenheimer analysts Katherine Lu and Carolyn Qiu, wrote in a Nov. 29 note.

Lu pointed out that there are several health care market segments where China has not allowed broad foreign entry, such as distribution, hospitals and medical insurance.

"We think today's event indicates the Chinese government's willingness to strategically open up the domestic market to bring in innovation and technology to streamline and upgrade the domestic industry," the analysts wrote.

"It's typical of the Chinese government to allow one very strong foreign player in to compete with the local companies," Cardinal's Barrett noted.

A Different World And A Different Competitor

Unlike the U.S. pharma distribution market, which is dominated by AmerisourceBergen, Cardinal and McKesson, China's pharma distribution industry is quite fragmented with the top three companies only accounting for 20 percent of the market and the top 10 companies accounting for 35 percent of the market in 2008.

The No. 1 distributor in China, Sinopharm covers almost 90 percent of the territory with sales of RMB 65 billion ($9.7 billion) in 2009. Shanghai Pharmaceutical Group, the leader of regional distributors, held the No. 2 spot with RMB 34.8 billion in sales.

Jointown, as the largest private company and the only other company with a nationwide distribution network, was in third place with RMB 22 billion.

According to Cardinal's CFO Jeff Henderson, Zuellig, as the first foreign player in China's drug distribution industry, is about at number nine in market share with $1 billion in annual sales.

"The possibility of acquiring the only foreign wholly owned pharmaceutical distribution company in China provided us with a unique opportunity," said the CFO.

In China, 70-80 percent of pharma sales are generated from hospital channels, and distributors are reimbursed primarily through the social welfare system, so reimbursement risk is low with no reimbursement risk from the patients themselves, Jeffries said during the call.

He told analysts that Yong Yu reaches the higher income portion of the Chinese market, with most of its products sold through Class III hospitals, and the rest sold through a collection of Class II hospitals.

"In some cases there's a bidding process that goes on with the hospitals within a particular region, and actually the distributors provide a fair amount of value in this process because they're actually representing the pharmaceutical companies to a large extent in that bidding process, so it gets us very much involved," said Barrett.

M&As Are Inevitable

To facilitate consolidation in the highly fragmented market, China is releasing a series of new policies that favor large distributors, according to Niu Zhenqian, Jointown's vice general manager (Also see "China's New Drug Price Policies Will Favor Big Distributors, Restrict Smaller Ones" - Scrip, 20 Jul, 2010.).

Reliant on mostly organic growth over the past 17 years, Zuellig saw the consolidation of local companies as a good time to take the company to the next step and expand its distribution network, Barrett told analysts.

L.E.K.' s Chen suggested that as many MNCs push out to lower tier cities and to supplying community health centers, Zuellig may no longer fully serve their needs and could create a disruption that might lead MNCs to "reconsider their distribution options."

"Consolidation of this industry is already beginning to take place and is an inevitable byproduct of the push for efficiency ... we bring some experience of leading this process in the U.S.," said CEO Barrett.

Earlier this month, Cardinal closed a $1.3 billion acquisition of regional drug wholesaler Kinray in New York ('Cardinal Health Boosts Generics Wholesale Business With $1.3 Billion Kinray Acquisition,' 'The Pink Sheet' Nov. 19, 2010).

Citi analysts Richard Yeh and Garen Sarafian said in their Nov. 29 research note that they expect all competitors will continue to look for consolidation opportunities and that more MNCs will enter the Chinese market by establishing businesses or acquisitions. They also pointed out that acquisition costs will inevitably increase.

Big Distributors Look To IPOs To Expand Networks

Citi analysts predicted that the next battleground for the Chinese drug distribution industry will be the battle for distribution network and market access. To that end, large distributors in China are investing their money raised from IPOs to expand their networks to gain a larger market share in the future.

For example, Sinopharm was 30 times oversubscribed in a public offering last year in Hong Kong and Shanghai (Also see "The Year Of The Tiger Looking Strong For IPOs In China Following Sinopharm Success" - Scrip, 4 Dec, 2009.).

Jointown hoped to raise RMB 899.8 million through its IPO in Shanghai (Also see "China's Largest Private Drug Distributor, Jointown, Seeks Initial Public Offering In Shanghai" - Scrip, 20 Oct, 2010.).

And, Shanghai Pharmaceutical plans a new share offering in Hong Kong to raise $150 million. (Also see "Drug Distributor Shanghai Pharmaceuticals Plans New Share Offering In Hong Kong" - Scrip, 9 Sep, 2010.).

"Sinopharm's aggressive network expansion in the last two years should position the company well for the next phase of growth. We believe that Cardinal's entry is still early and may take years to make potential impact," the Citi analysts added.

- Dai Jialing ([email protected])

[Editor's note: This article appears courtesy of PharmAsiaNews.com, Elsevier Business Intelligence's source for Asian biotech and pharmaceutical news. Register for a 30-day risk free trial.]