China's Outsourcing Future: Rising Costs Are Not Necessarily a Bad Thing

Includes: NVS, WX
by: Derek Lowe

Some recent conversations about China and chemistry outsourcing prompt this morning's observations. Every major drug company is working with Chinese contractors and/or setting up their own operation there. This is partly (in some cases, almost entirely) driven by the low cost of scientific labor there compared to North America and Europe.

But that cost is going up. Everyone keeps mentioning that "China isn't as cheap as it used to be". And that's going to continue, I think - I'm not expecting them to reach US/EU cost levels any time soon, but the bottom-line advantages of doing contract work there, which a few years ago were immediately apparent, are starting to become more of a matter for thought. There are problems with doing things that way, you know - the time difference, the at-a-distance decision-making problems that any far-flung effort suffers from, the worries (sometimes founded, sometimes not) about intellectual property leakage. When the cost was so dramatically lower, these factors weren't enough to slow things down, but as time goes on, they could be.

As an aside, I'm happy to see costs going up in China (and in India, too). As a free-trade sort of guy, I think that's exactly what's supposed to happen. The high-cost country gets goods and services at a better price, and the low-cost country improves its economy and its standards of living. But then some other low-cost country has an opportunity to get into the game - and who's that going to be? Someone's going to give it a try within the next few years.

This also makes a person wonder about the big operations that Novartis (NYSE:NVS) and others have been setting up in China. Are these things going to really hit their stride just as the costs of doing business there come within range of the parent company's? One answer is that these branches aren't completely about cutting costs. They're an entry into the Chinese market. Everyone looks at the Chinese economy, and has the same thought that foreign businesses have always had: "If we could just sell one of our widgets to every tenth household here. . .every hundredth, every thousandth, then holy cow. . ." And there's a lot to that.

But the feeling is that the best way to get entry to that gigantic market is to show that you're a big, friendly business partner. China (the government and the population, who are not always completely on the same page of the sheet music) is worth taking seriously, and they most definitely want to be taken seriously as a world power. It's safe to assume that the regulatory authorities there will look more kindly on drugs developed with a lot of local participation, and that doesn't mean just shipping them in at the last minute for the last step or two. (A lot of that gets done in reverse in the US and Europe, by the way, if you didn't know that). The best treatment, I think, will be given those drugs that had the highest amount of value-added work done in China.

The logical extension of that is a local all-Chinese drug discovery company, which we haven't quite seen yet. A lot of people had WuXi (NYSE:WX) picked as a good candidate for that, until the recent Charles River deal (NYSE:CRL) - I have to think that this announcement was probably a disappointment to many people inside China itself. But as a colleague of mine was pointing out to me recently, the people who founded WuXi are still around, and after a year or two helping to run the new company, they just might use their unmatched connections and local business sense to start up what they'll hope turns into the Chinese equivalent of Novartis, Merck (NYSE:MRK), Pfizer (NYSE:PFE), or GSK. Worth watching for.