In the developed world, rising health care costs remain a major concern. In the US, health care spending has outpaced income growth for almost two decades. Small wonder that this sector remains a major political issue in this year’s US presidential election.

Health care spending in the US is forecast to grow by 57 percent over the next decade, while US gross domestic product (GDP) is expected to grow by only 38 percent. However, this trend doesn’t just bedevil developed societies.

In emerging countries, as incomes have grown and standards of living improve, demand for health care has skyrocketed. Heart disease, diabetes, obesity and a host of ailments related to growing affluence are becoming more prevalent. Dietary changes such as increased consumption of protein, sugars and processed foods have radically boosted caloric intake.

At the same time, emerging market populations are becoming increasingly sedentary—and fatter—as a result of urbanization and industrialization. The same people who are spending more money on cars, refrigerators and high-tech gadgets are now spending more on medical attention.

As Indians enjoy the fruits of rapid economic development, type II diabetes has become a raging epidemic, currently afflicting more than 50 million or roughly 7 percent of the population. That bestows India with the dubious honor of being home to more diabetics than any other nation on earth. The disease is expected to kill about 1 million Indians annually for at least the next decade.

In China, while the absolute number of diabetics is smaller, the situation is even grimmer. A recent study by researchers from the University of North Carolina found that Chinese teenagers develop diabetes at a rate nearly four times that of American teenagers. If that trend continues, China’s diabetes epidemic will be the world’s worst in about 20 years. As a result of the young ages at which the disease is being diagnosed, it would cost the country exponentially more than India’s battle and potentially put a sharp dent in productivity.

Diabetes isn’t the only disease that’s becoming increasingly common in the developing world. Income growth has driven increased consumption of tobacco products and alcohol, boosting the incidence of lung cancer, cardiovascular illness and liver disease. As life expectancies lengthen, age-related ailments such as dementia are on the rise as well.

Chinese health care spending is forecast to shoot up by 167 percent over the next decade, compared to 115 percent GDP growth over the same period. In India, while GDP is expected to double, health care spending should rise by 140 percent.

Pharmaceuticals are poised to account for the lion’s share of that increased spending, with emerging market drug sales expected to reach USD550 billion annually by 2020. That equates to about 70 percent of anticipated global drug sales, with China becoming the fastest-growing pharmaceutical market in the world.

However, you won’t find brand-name drugs such as impotency treatment Viagra, insulin product Apidra or the sleep aid Ambien topping prescription sales. Because health insurance products are still in their infancy across most of the emerging world, generic drugs will dominate the space.

Most patients pay for drugs out of their own pockets and typically opt for the least expensive treatments. As countries such as China continue developing rudimentary government-sponsored health care systems, cost control will be a major imperative, creating an even greater bias towards generic drugs.

A Generic Play

Portfolio holding Dr. Reddy’s Laboratories (NYSE: RDY) is one of the best-positioned players in the emerging market generics business.

The second-largest pharmaceutical company in India, Dr. Reddy’s is a second-tier player worldwide, with revenue that trails major outfits such as Novartis’ (NYSE: NVS) Sandoz generics division and Teva (NSDQ: TEVA). That said, it is one of the fastest growing, with revenue achieving an average compound annual growth rate of about 15 percent. Despite strong competition, the company ranks at or near the top of market share with its target products in emerging market countries.

Meanwhile, the company is making strong inroads into the generics market in North America, where its generic versions of drugs such as Plavix and Lipitor are defying price pressure and attracting more customers.

For its first quarter of fiscal 2013 ending in June 2012, Dr. Reddy’s reported total revenue growth of 28 percent, with strong overall generic revenue growth of 32 percent and double-digit growth in generic sales in all of its geographic markets. About 75 percent of the company’s revenues derive from generic drugs. (For full-year figures, see chart below.)



A major driver of the company’s stellar sales growth has been the bargain retail price of Dr. Reddy’s products, thanks to the company’s low-cost operations and efficient use of capital. Over the past five years, the company’s gross margin has run in excess of 50 percent, with net margin in the mid-teens over the past two years. Return on assets and equity are running at 13.3 percent and 27.6 percent respectively, among the best in the pharmaceutical business.

Dr. Reddy’s is also a major presence in both the active pharma ingredients (API) and custom pharma services (CPS) markets, both of which account for 25 percent of revenue.

Every drug is based on an active ingredient that’s often synthesized by expensive and complicated processes. Many smaller drug companies simply don’t have the expertise or capacity to manufacture those active ingredients on a commercial scale, forcing them to rely on companies such as Dr. Reddy’s to handle that process for them. Under its CPS operations, Dr. Reddy’s can even provide other companies with finished pharmaceutical products.

To produce active ingredients, a pharmaceutical company must have a drug master file (DMF) on record with regulators in the market where the product is to be sold. In the first quarter of fiscal 2013, Dr. Reddy’s filed 7 new DMFs, bringing its global cumulative total to 550 DMFs with 188 in the US. That’s the broadest portfolio of DMFs of any generic manufacturer, giving Dr. Reddy’s a clear competitive advantage in the space.

Dr. Reddy’s can be expected to continue making gains in its share of the global generics market. It will also benefit from a growing portfolio of strategic partnerships to manufacturer and market drugs worldwide.

The company recently inked a deal with Merck (NYSE: MRK) for the two companies to cooperate in developing and manufacturing a variety of new and existing drugs. The partnership will provide Dr. Reddy’s with exclusive rights to several promising drugs in emerging markets, as well as a steady stream of revenue from sales in the developed world.

Dr. Reddy’s has also sealed a deal with GlaxoSmithKline (NYSE: GSK) that allows Dr. Reddy’s to market a variety of products in the emerging world. Both deals are clear recognition of Dr. Reddy’s ability to operate in less-developed regions. Continue buying Dr. Reddy’s up to 37.

Promising Devices

Another attractive emerging market health care play is Mindray International (NYSE: MR).
A Chinese medical device manufacturer, Mindray specializes in patient monitoring equipment, blood chemistry analyzers and imaging systems such as ultrasounds.

Chinese hospitals, especially those in rural areas, tend to be under-equipped. More than half of their equipment is at least 30 years old, with insufficient monitoring devices to cover their entire patient caseloads. Mindray addresses those deficiencies by offering mid-priced products with multiple capabilities that are easy to use and reliable.

That strategy has paid off in spades. In the second quarter of 2012, Mindray reported that its Chinese revenues grew by 27 percent on a year-over-year basis, reaching USD115.3 million. Sales in other emerging markets grew by 21.1 percent. Second-quarter revenue hit USD267.8 million, an increase of more than 23 percent compared to the same year-ago quarter.

Also in the second quarter, products in the company’s patient monitoring segment racked up sales growth of 23 percent, diagnostic products  jumped by 31 percent and imaging systems rose by more than 15 percent.

Mindray’s revenues tied to warranties and services reached USD15.1 million, a year-over-year increase of 24.4 percent, largely thanks to its rapid sales growth in previous quarters. Sales of reagents used in its diagnostic products also experienced a sharp increase, stemming from a growing in-service equipment count.

Gross margin improved in the second quarter to 57.4 percent, helped by an almost 1 percent decline in operating expenses because of improvements in manufacturing processes. Mindray’s growth rate last quarter was in line with previous periods, leading management to forecast net revenue growth of at least 18 percent for 2012. That should result in full-year earnings per share of about USD1.52.

Mindray should be able to sustain its rapid growth rate over the coming years, because of its cost and price advantages. A typical Mindray device costs about a third less than one from its competitors. China’s ambitious hospital construction program also should provide a long-term boost (see chart, below).



Mindray will also continue to benefit from its 2008 acquisition of US-based Datascope, which gained the company access to the US market and raised the likelihood of future acquisitions.

The lack of health care infrastructure in emerging markets gives a competitive edge to companies such as Mindray that meet patient care challenges with fresh ways of thinking. At Mindray, innovation will remain a key driver of growth. The company’s research and development spending in the second quarter increased to 8.9 percent of revenue, from 8.5 percent in the same period last year.

Mindray annually launches an average of 10 new products; in recent years many of those have been premium-priced and geared towards higher-income markets.

The newest addition to our Long-Term Holdings Portfolio, buy Mindray up to 40 to capture a slice of China’s exploding health care market.