Japan: The Final Frontier

Most western drug firms have shunned the Japanese market, regarded as highly problematic. But short on new products and with diminishing returns on investment at home, many are now taking a fresh look at the world's second largest health care market.

Most Western drug firms have for years regarded Japan—protected from foreign competition by cultural and regulatory barriers—as an important but highly problematic market. And as a result, most companies haven't paid it the kind of serious attention they've paid to the other major regions. But short on new products and with diminishing returns on investment at home, many are now taking a fresh look at the world's second largest health care market, according to Michael Devlin, a partner in McKinsey & Co.'s Tokyo office, who spoke at Windhover's 2001 Pharmaceutical Strategic Alliancesconference in September.

Although the $50 billion Japanese pharmaceutical market is bigger than that of the UK, Germany and France combined, it is highly fragmented—the top ten players account for just 36% of the market—and extremely competitive at the sales representative level. There are over 40 reps per 100 physicians in Japan, four times as many as in the US and eight times as many as in Germany, according to McKinsey. "You often have to provide inordinate amounts of detailing behind your products to make any headway against entrenched drugs," explains Devlin. Players like GlaxoSmithKline PLC and Pfizer Inc. are doing just that: both now have more reps than many of the largest Japanese companies.

But even though foreign companies are likely to have the more innovative products, their productivity as measured by sales per medical representative remains substantially lower than that of the locals: roughly ¥130 million per rep, as against ¥200 million per rep for the Japanese, due to the smaller average size of foreign companies' field forces, and their continued difficulties in attracting strong local talent.

These and other factors contributing to Japan's isolation mean that the majority of Western companies are still significantly under-represented (although some like Pfizer and Merck & Co. Inc. —through its 1983 acquisition of a controlling stake in Banyu Pharmaceutical Co. Ltd. —have broken into the top ranks). McKinsey estimates, for example, that some companies' market shares in the Japanese market are less than a fifth of their global levels (see Exhibit 1). Many players are "leaving several billion dollars on the table in missed sales opportunities by not fully pulling the Japan lever in their global strategies," Devlin concludes. Particularly since drug prices in Japan are on average only slightly lower than in the US, and as a result higher than in many European countries.

Things are changing in Japan, though, which will likely make it easier for Western firms to tap the market's full potential. The regulatory and clinical environment is coming into line with global standards. Traditionally slow in seeing Western drugs through to approval, Japan's Ministry of Health, Labor and Welfare (MHLW) has recently committed to a streamlined 12-month drug approval process (excluding questioning periods). In addition, Japanese authorities no longer automatically require Western firms to perform expensive and often redundant phase III clinical trials locally as a pre-condition for gaining approval in Japan—probably the biggest single disincentive historically for Western companies trying to launch new drugs there. Pfizer was one of the first to take advantage of a new "bridging" approach to compensate for ethnic variations across populations, gaining approval for sildenafil (Viagra) in March 1999 after only six months of review by the regulator.

These cracks in the floodgates to foreign competition aren't making life any easier for local players, however, who are already feeling the pinch of a slowing economy and price reductions as the MHLW attempts to keep a lid on the country's mounting health care expenditures. The government also plans to de-list drugs without proven efficacy, signaling an end to premium-priced "me too" products and forcing local companies to invest more in R&D, where spend has been low by international standards (although Devlin points out that the quality and efficiency of Japanese R&D is unfairly underrated outside Japan). At the same time cheaper generics—until now largely absent in Japan—are looking increasingly likely to feature more prominently in future MHLW plans for a cost-conscious health care system.

To date, however, only one Japanese player—Takeda Chemical Industries Ltd. —has managed to spread its risk through a significant overseas presence. Indeed, as Devlin points out, only two other Japanese players—Yamanouchi Pharmaceutical Co. Ltd. and Sankyo Co. Ltd. —are close to global scale. Although Japan's domestic firms still have the advantage over foreigners in Japan, they have in fact been growing more slowly there over the last two years than Western companies' affiliates, reflecting the negative compound annual growth rate of the Japanese drug market between 1995 and 2000 (-5% compared with +12% in the US when measured in dollar terms).

With little or no shareholder pressure and a business culture which views mergers with suspicion, most Japanese players have thus far resisted consolidation. So while M&A activity elsewhere in the industry has significantly changed the global pecking order among top Western drug firms, the rankings in Japan have remained much the same since 1996, according to McKinsey. Those deals that have taken place have tended to be between very large and very small players.

Falling barriers to entry coupled with difficult conditions in Japan have prompted a rise in M&A activity there over the last two years—both domestic and foreign. The five deals which have occurred since the beginning of last year (as many as the four years previous) included the largest deal to date—the merger of domestic players Tanabe Seiyaku Co. Ltd. and Taisho Pharmaceutical Co. Ltd. [See Deal]—and the first unsolicited deal, Germany's Boehringer Ingelheim GMBH 's 50.2% stake in SSP Co. Ltd. , achieved in several steps [See Deal].

The Taisho-Tanabe deal, along with the merger of Mitsubishi Chemical Corp. and Welfide Corp. six months earlier (now called Mitsubishi Pharma Corp. ) [See Deal], may well mark the beginning of a trend towards domestic consolidation in the drug industry, just as the country's banking industry has gone through since 1997. And although rapid change is less likely in the drug industry than it was in banking or indeed automobiles (since drug companies, although squeezed, are still profitable), "there's a feeling in the [drug] industry that changes are a-foot, and deals are starting to happen," according to Devlin. But, he warns, "M&A is a new area for most Japanese companies. Most are still becoming familiar with the concept and how they can benefit strategically from it."

Merging with their compatriots won't necessarily secure Japanese companies access to overseas markets though—few in the audience at PSA felt Japanese firms could establish an overseas presence alone—so many may seek foreign partners.

Which leaves plenty of opportunities for those Western players seeking to increase their clout in Japan. Historically, many have been content to out-license their drugs to local players in Japan, surrendering a fair amount of value but benefiting from local expertise and lower costs. Few want to continue down this route today (many are re-negotiating such deals), yet cultural and cost barriers remain to even the largest players seeking to build their own businesses in Japan.

Strategic alliances with Japanese firms may offer the best solution. Not only do they minimize cultural barriers, but Japan's own pressures mean terms are more likely to be favorable to both parties. GSK's recent deal with Shionogi & Co. Ltd. , for example, gives it a chunk of Shionogi's pipeline relatively cheaply, and although it only gets ex-Japanese co-promotion rights to potential products, the deal is, according to one analyst, the nearest GSK could come to a full merger [See Deal]. Shionogi, on the other hand, keen to internationalize, wins a leg-up onto the global scene, and has the option to buy GSK out in ten years' time should it want to establish a fully-functioning drug company outside Japan. The deal shows that Shionogi is no longer likely to make the mistake of out-licensing worldwide product rights to Western partners, as it did in giving away (rosuvastatin) (Crestor)to AstraZeneca PLC .

Outright acquisitions by mid-sized European players UCB Group (which bought Fujirebio Inc. 's pharmaceuticals business [See Deal]) and Schering AG (which bought Mitsui Group 's Mitsui Pharmaceuticals Inc. in January 2000 [See Deal] show that even this route is no longer completely cut off. Yet Devlin points out that acquiring a Japanese company quickly is still not a viable option unless it is "very small, or very distressed." And he warns that the Japanese government has hinted that it may prefer to see domestic consolidation rather than cross-border acquisitions (just as it did in banking), encouraging the creation of domestic giants that can be globally competitive, and thereby limiting foreign ownership.

Devlin's conclusion is that first movers, Western or Japanese, will have the advantage of securing the best partners, whatever course of action they take: broad cross-licensing agreements, strategic alliances, or full-blown M&A. If that's the case, deal making in Japan is likely to continue and this final frontier for Western companies might be crossed more quickly than expected.