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Sector UpdateWave 3: Vertical consolidationCompanies after forming vertical partnerships are now going for vertical integration byintegrating the different lines of healthcare business: Insurers acquiring PBMs: United Healthcare acquired Catamaran (PBM) for USD13bn tobulk up its pharmacy-benefit business. Catamaran, the fourth-largest pharmacy-benefitmanager in the US by volume of prescriptions processed, merged into UnitedHealthGroup’s OptumRx unit—the industry’s third-largest and part of the company’s Optumhealth-services arm. Insurers setting up PBMs: Anthem, the second largest health insurer, will launch its ownPBM IngenioRx in partnership with CVS, effective January 2020. The move comes asAnthem’s contract with Express Scripts expires at 2019 end following a high-profiledispute between the two. Rather than renew with Express Scripts or hand off themanagement of prescriptions entirely to another PBM, Anthem said it has formed apartnership that will give the health insurer "complete control" over its formulary, thepreferred list of drugs that is covered for its customers. Pharmacies and PBMs: CVS was the first to establish significant scale across 2 supplychain horizontals with the merger of CVS pharmacies and the Caremark PBM in 2007.Moreover, PBMs and pharmacies also align to form mail and specialty pharmacybusinesses. Walgreens and PBM Prime Therapeutics formed a mail and specialtycompany AllianceRx Walgreens Prime. Wholesalers and insurance companies: Now, distributors are looking to acquireinsurance companies to gain more negotiating power and protect their turf against aformidable player like Amazon.Probability of vertical consolidation in future is high Opportunities for further horizontal consolidation low: Top US health insurers havetried a variety of merger/consolidation options in the past few years. Both AetnaHumana (USD37bn) and Anthem-Cigna (USD48bn) deals were blocked by DOJ earlier thisyear. In absence of such consolidation opportunities, the interest in vertical alignment isexpected to grow for both health-plans and PBMs. Currently, just one integrated PBM-insurance player: UnitedHealth Group is the onlylarge-scale healthcare player which owns both health plan and PBM assets. Theintegrated model enables alignment of spends across medical and pharmacy, which isbecoming increasingly relevant and can result in membership gains. The Aetna-Humanadeal would have enabled Aetna to grow an OptumRx kind of PBM asset; instead, now itis 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 tointegrate:a.5CVS 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 itsassets portfolio will provide strategic advantage to CVS over UnitedHealth GroupOptumRx. With Aetna’s existing PBM relationship with CVS, the integration risk forthe acquisition is low. Risk of a challenging integration would have been different ifthe Aetna-Humana deal had materialised or if it had continued to drag for a muchlonger period. This will also pressurise other large health plans and PBMs to fill gapsin their portfolios.Edelweiss Securities Limited

Pharmaceuticalsb.Anthem issued an RFP earlier this year to replace Express Scripts as its PBM. Bothhave been working under a 10-year pricing contract since 2009, when ExpressScripts 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 itscontract, saying that Express Scripts overcharged it by USD3bn annually. Thecompany is losing its biggest client to CVS. Given the circumstances, Express Scriptsshould 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 dueto consolidation in the distribution channel in the US. Typically, when 2 drug purchasersenter into a joint sourcing agreement, existing purchasing agreements with generic drugmanufacturers are aligned in such a way that the lowest rate that was provided to eitherof the 2 purchasers is now applicable to both. Further, for new agreements, aggregationof demand increases the negotiating power of purchasers and negatively impacts drugmanufacturers.Over the past few years, as wholesalers, retailers and PBMs have entered into jointsourcing agreements and formed buying consortiums, pricing pressure on the genericpharma market has intensified. This is reflected in declining gross margins of key players.Chart 5: Gross margins for drug manufacturers have been 6675.4gross margin (%)46.5gross margin (%)gross margin (%)5156gross margin (%)56FY15Q2FY18Sun Pharma56FY15Q2FY18Dr Reddy'sSource: Company, Edelweiss researchNote: Generic business margin for Teva and Dr Reddy’s, company level margin for Mylan and Sun Pharma2.6Working 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 otherdiscounts paid to middlemen in the supply chain is much lower. Typically, while drugmanufacturers are required to pay rebates before they receive the gross price, i.e., thecash outflow in the form of rebates, needs to be made before they receive the cashinflow. Rising consolidation in the distribution channel has resulted in higher rebates anddiscounts. Total amount of drug rebates and discounts catapulted to USD127bn in 2016from USD39bn in 2008. This has increased the working capital requirements of drugmanufacturers.Edelweiss Securities Limited

Sector UpdateAmazon’s entry: Potential disruptorIn what could be a major disruption in the US pharma distribution system, media reportsindicate that Amazon is mulling entry in the US pharma distribution chain. Although Amazonhas not confirmed this, its possible entry has been a subject of speculation for months. As perearlier media reports, the company has hired a lead to devise a strategy in this regard and isin discussions with PBMs, while the most recent ones suggest that the company has beenapproved 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 ifit will. It could choose multiple routes. If it chooses to operate through a PBM, Amazon couldeither acquire/ partner with a large PBM or may even choose to learn the business model bypartnering with a smaller PBM. There are already reports that Amazon, with its 350,000employees, is trying to administer its own health plan internally as its own PBM. On the otherhand, it could also leverage its chain of whole food stores to establish in-store pharmaciesthat could also act as mail order fulfilment centers. Amazon’s strong distribution network andexisting customer base could give it an upper hand.If and when Amazon enters the pharma distribution business, generic drug manufacturersmay also be impacted. However, given that the prescription drug market is highly regulatedand requires approvals, threat due to Amazon’s entry could be some time away and it wouldbe premature to judge the impact at this juncture.Generic industry not yet ripe for consolidationConsolidation in the generic industry still looks difficult as the number of genericmanufacturers is increasing in the system. Even though cost of filing has increased andmargins in the US business have declined significantly, smaller players who have invested inthe 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 erodingthe negotiating power of generic players.Prefer companies with complex generics pipelineOverall, in addition to the price erosion due to customer consolidation, impact of fasterapprovals will also persist. The new USFDA commissioner, Scott Gottlieb, is focused on givingfaster approvals to reduce drug prices. While on one hand this will increase the competitiveintensity, on the other, companies with complex generics pipeline will benefit over the next2-3 years before that also gets flooded. Hence, we continue to prefer companies with strongcomplex generics pipelines.7Edelweiss Securities Limited

PharmaceuticalsAppendixUnderstanding the US drug distribution channelFig. 1: US pharmacy distribution and reimbursement systemSource: Drug Channels1.Distribution: Distributors/wholesalers purchase drug products from manufacturers and ship them to retailers, wherepatients access their prescription medications. The retail pharmacy market can be divided into 3 major categories: chainpharmacies & 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) orprivate sources (private health insurance and out-of-pocket payments). PBMs act as an intermediary and help payersmanage their drug benefits. They determine which pharmacies will be in the plan’s network, develop the formulary (list ofcovered medications) and negotiate price rebates with drug manufacturers. Manufacturers provide these rebates inexchange of having specific medications listed on the formulary. By aggregating purchasing and administration for planmembers, they are able to save significant costs through negotiating discounts on drugs with pharmaceuticalmanufacturers themselves.8Edelweiss Securities Limited

Sector UpdateEdelweiss Securities Limited, Edelweiss House, off C.S.T. Road, Kalina, Mumbai – 400 098.Board: (91-22) 4009 4400, Email: research@edelweissfin.comADITYANARAINAditya NarainHead of Researchaditya.narain@edelweissfin.comDigitally signed by ADITYA NARAINDN: c IN, o EDELWEISS SECURITIESLIMITED, ou HEAD RESEARCH,cn ADITYA NARAIN,serialNumber a1c30092792c20, postalCode 400005,2.5.4.20 f423fd58c07b02, st MaharashtraDate: 2017.11.21 12:15:16 05'30'Coverage group(s) of stocks by primary analyst(s): PharmaceuticalsAurobindo Pharma, Cadila Healthcare, Cipla, Divi's Laboratories, Dr.Reddys Laboratories, Glenmark Pharmaceuticals, Ipca Laboratories, Lupin, NatcoPharma, Sun Pharmaceuticals Industries, Torrent PharmaceuticalsRecent ResearchRecent ResearchDateCompanyTitlePrice (INR) RecosDateCompanyTitlePrice (INR) Recos02-Jan-14IPCAThe growth prescription;729Buy15-Nov-17 LaboratoriesIpcaChallenges526ReduceVisitNote persist;Laboratories Result Update23-Dec-13TorrentAggressive M&A valuations to480Hold14-Nov-17 PharmaSunPerformancein-linewith526BuystrainROCE; EventUpdatePharmamuted expectations;17-Dec-13RanbaxyReceivesapproval for generic418HoldResult UpdateLaboratories Felodipine ;14-Nov-17Cadila EdelFlashgLialda launch drives a strong448BuyHealthcare quarter; Result UpdateDistribution of Ratings / Market CapRating InterpretationEdelweiss Research Coverage UniverseRating Distribution** 1stocks under review 50bnHold16167ReduceRatingTotal11240Between 10bn and 50 bn 10bn1566211Expected toBuyappreciate more than 15% over a 12-month periodHoldappreciate up to 15% over a 12-month periodReducedepreciate more than 5% over a 12-month periodOne year price 161,500Nov-16(INR)Market Cap (INR)BuyDr Reddy Labs9Edelweiss Securities Limited

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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. Walgreens 15% CVS Retail 14% Express Scripts Mail Order Pharmacy 11% CVS Mai