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Emerging Technology Report #21: September 2, 2002

The Restructuring of the Japanese Pharmaceutical Industry: Regulatory Reform Should Support Innovation and Growth

- Summary -

Louis Ross (Global Emerging Technology Institute, New York)

The life science sector in Japan is going through a significant amount of change. The same pressures that are affecting the rest of the world, such as rising R&D costs and pressure on profit margins due to regulatory changes, are magnified in Japan. This is a result of the slow progress being made on reforming business practices and freeing the industry from government regulation. These issues are keeping Japanese pharmaceutical firms from maintaining and enhancing profitability and growing sales. In response, Japanese firms have been more vocal about supporting change, as competitive pressures and the difficulties and costs associated with developing new innovative drugs at home and abroad are expected to increase. Global consolidation of the sector, marked by recent announcements of mega-mergers, is forcing Japanese firms to live up to analyst's hopes and expectations that the number of companies in Japan will be significantly reduced. On the regulatory side, a number of changes regarding the drug approval process and how drugs are priced guarantees that industry restructuring and consolidation will continue to take place. The potential for the increased competitiveness of these firms also rests on the success of utilizing IT and emerging technologies to develop new drugs faster and in a more economically efficient way.

Through the 1990's costs for drug development, as has been the case in the rest of the world, has increased drastically in Japan. In the U.S., the cost of drug discovery and development has increased fourfold over the past decade yet the number of compounds emerging from labs has remained roughly the same. The R&D budget expenditure per company surpassed the Y40b mark several years ago and continues to rise. In 1990, it was a little over Y25b. The trend reflects the fact that the burden of R&D spending required to bring new products to market has become enormous, as developing an effective medicine costs tens of billions of yen. Progress in new technologies, including the creation of medicines using genomic data, has only driven R&D costs higher but these investments must be made as the potential pay-off for companies is to large to ignore. Though net profit margins experienced small increases on average up until the end of the decade for many firms in Japan, the mandatory reduction in prices keeps squeezing companies in the world's second largest pharmaceuticals market, a market that is larger than all of the major European countries combined. Pharma firms in Japan need to desperately cut production costs in order to free up funding for R&D.

The market for pharmaceuticals and healthcare services in Japan will grow as Japan's population continues to age. The desire to service the needs of growing legions of elderly has attracted other types of companies into the life sciences area, which can serve to help the industry to evolve. The role of IT in the life sciences will continue to grow and be the key toward the creation of drugs and the way they are administered in the future. Japanese chemical, electronics and even trading companies are raising their exposure to the sector through a variety of means, including entering new businesses and earmarking more investment capital to develop bio-IT products. The number of alliances between these firms will increase significantly over the next several years and will help the sector to restructure and reduce costs.

The expected changes in the market will provide unprecedented opportunities for foreign companies. Mergers, alliances and eventually acquisitions will increase as pharma in Japan restructures and firms increasingly specialize and divest unprofitable business lines and outsource production. Concerns about falling drug prices should be tempered with the fact that there is a strong likelihood that future regulatory practices may be reformed in order to permit a more robust pricing system more in line the world's largest market, the U.S. The lack of a vibrant biotechnology venture company base in Japan has induced the creation of an increasing number of tie-ups with Japanese and foreign companies both to conduct business in Japan and abroad. Along with the tie-ups, foreign competition continues to intensify, with many of the successful firms setting up their own operation as opposed to simply licensing out drugs to Japanese companies.

Though the Japanese pharmaceutical industry on one hand appeared to represent a highly protected inefficient domestic industry, many are more global than meets the eye. The percentage of foreign ownership in many of these firms has risen considerably since 1995, with a number of the largest companies including Takeda, Sankyo, Yamanouchi, Daiichi, Fujisawa and Eisai all with at least a quarter of their shares held by foreigners. These firms also have a large percentage of their sales outside Japan, with Takeda maintaining 70% of its sales overseas. Also, since 1996, Japanese firms have maintained a "positive surplus" of licensing royalty revenues (royalty revenues exceeding royalty payments). As in other sectors, a large number of foreign shareholders will help bring these companies closer to meeting the requirements of global competition and will put more pressure on them to specialize. These firms will be required to divest themselves of unprofitable businesses, inevitably. For other companies, a dry product pipeline which fails to support internal growth will lead them to consider other options, including M&A. The promise of these firms appears to be great considering that even in a highly regulated environment they were still able to innovate. However, it is clear that more specialization is required and size does matter. The size and sales figures of Japanese pharma firms are arguably too small to compete in the future on a global scale.

The benefits to increased competition in Japan would be very large indeed. Under Japan's national health-insurance system, drug prices are not decided according to value. Prices of innovative drugs are determined based on those with similar effects. If the situation does not change, there will be no incentive to invest in developing new drugs. Many industry executives agree that Japan must adopt a "money-for-value" principle in setting drug prices. Government-imposed price controls in Japan drive down the prices of new drugs, making it difficult for companies to generate adequate returns on their investments in order to fund research on new products and to grow sales. Their task has gotten a bit easier recently as regulations overseeing drug development have been harmonized between Japan and other western countries. Major drugmakers are aiming to outsource production of pharmaceuticals in anticipation of the enactment of a revised Pharmaceutical Affairs Law. Prior to these regulatory changes, firms were required to sell drugs from their facilities. Last month, the lower house approved revisions to the Pharmaceutical Affairs Law. Since the revisions have already passed in the upper house, the changes became law. Since it will take time for the Health, Labor and Welfare Ministry to revise its ordinances, drug companies will be able to begin actually taking advantage of the revisions in around fiscal 2005. In the meantime, expect a good deal of M&A activity. Large firms will spin off their production divisions and focus more on R&D and new drug development while smaller ones will help take up the slack. Foreign pharma and biotech firms will be tapped to help these companies fill product pipelines. Japanese pharma will become more aggressive in their overseas business and will increase the percentage of their foreign sales. The must become more globally competitive if, for anything, they are to be able to compete in their own home market.

The application of IT and breakthroughs in key emerging technology areas such as advanced micro-electronics (bio-MEMS) and nanotechnology will significantly improve the chances of developing new novel drugs and devices for which there will be significant markets. Though the Japanese government strongly supports projects in regard to the above, Japan must also continue to nurture its fledgling, under-developed biotech industry. It will be crucial in terms of helping Japanese pharma firms to compete and deal with the increasing complexity and costs of new drug development. Public support for advanced medical research, bio-MEMS and nanotechnology is necessary, but too much government regulations are counter-productive in regard to innovations in the biotechnology field. As previously mentioned, the appropriate government policies are necessary in order to help support industry growth, not inhibit it.

Provided the proper policy mix and support, Japanese firms do appear to have the ability to innovate and be globally competitive in the life sciences area. In 2000, the number of biotechnology patents was actually greater in Japan than in the U.S. even though the U.S. arguably had a much better infrastructure for nurturing biotechnology start-up companies. It also had more private equity available to fund these companies at the early stages of their development, which led to the U.S. having more listed biotechnology companies by a ratio of more than five to one, and far more private companies. Foreign firms have taken note of the potential in Japan. For example, La Roche was attracted to Chugai research capabilities. La Roche's decision to acquire a controlling interest in Chugai reflected its desire to tap the Japanese firm's advanced R&D capability, especially in the field of biotech drugs. Novartis AG continues to speak with firms, including start-ups, to obtain rights to chemical compounds likely to become new pharmaceuticals. Hopefully, efforts at boosting the biotech industry by supporting partnerships, through alliances with more than 1,000 biotech firms, small drugmakers and universities will be beneficial to the industry. Japan needs platforms for medical research bridging academic, public and private sectors. Also, in terms of potential M&A and alliance activity by Japanese firms, the timing is arguably much better. For example, U.S. biotech firms were able to raise nearly ten times more cash only a few years ago than they can today and many private firms are severely cutting back their operations, reducing staff and canceling planned clinical trials. These firms are actively seeking patient investment capital and potentially lucrative agreements and alliances with foreign companies. It is estimated that about one in seven public biotech companies in the U.S. has a year's worth of cash or less and private companies may be in worse shape. Alliances with these firms could be mutually beneficial, and could help Japan become a global contender in the research and development of new drugs while providing stimulus to develop its own biotechnology sector. The competition will increase, as a number of other countries are building their own biotech sectors in Asia, including Singapore, Korea, and Australia. Growth in Japan and Asia looks extremely promising considering the growing importance of IT and expectations for it to lead to a majority of business and scientific advances in the biotech industry. Many analysts believe that IT will provide tools that will be used to manipulate the vast amounts of genomic, proteomic, chemical and clinical data in the life sciences and be the key to developing new drugs in the future. The identification of a drug target to generation of optimized candidate drugs in 3-4 months rather than the 3-5 years could be the end game.

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