OREANDA-NEWS. Fitch Ratings expects the consolidation in China's drug distribution sector to continue after the implementation of new standards to ensure quality and safety in the industry, with the next round of consolidation likely to be driven by the gradual exit of small, less-competitive players during a policy-driven downturn. Large, leading players will be able to expand their market share due to their advantages of greater geographical and product diversification, and increasing economies of scale.

Recent industry consolidation has been mainly driven by implementation of the new version of the Good Supply Practice (GSP) for Pharmaceutical Products that the Ministry of Health published in 2013. The new GSP, which will be fully implemented by the end of 2015, imposes higher transportation and storage standards for drug distribution. It has prompted small distributors that cannot afford to make the necessary upgrades to exit the industry.

The pharmaceutical distribution sector in China remains fragmented despite the wave of exits by smaller companies. The top 100 Chinese drug distributors held a combined 66% of the market, while the top three companies held 31% in 2014, according to the Ministry of Commerce. In contrast, about 90% of the U.S. drug distribution market is controlled by the top three distributors, according to the U.S. National Association of Wholesale Distributors.

Fitch believes further consolidation is inevitable, mainly driven by China's reform of the healthcare sector. One objective of the reform is to control drug retail prices, which can be as much as 4-6 times their ex-factory prices in China. Provincial health authorities have been cutting drug prices in each round of tender, resulting in margin erosion for both drug manufacturers and distributors.

We believe drug distributors' profit margins will deteriorate further during the healthcare reform as their bargaining power against manufacturers and hospitals is not strong. The thinner margins will push small, less-competitive distributors to exit the industry or merge with larger companies, although this process may be gradual.

The larger distributors will benefit from better economies of scale, enhanced brand awareness, and greater bargaining power with drug manufacturers. For example, Sinopharm Group Company has acquired more than 80 regional or county-level drug distributors since its IPO in 2009, significantly boosting its market share in nationwide drug distribution from about 10% in 2009 to 17% in 2013. The company's operating margin for its drug distribution segment increased steadily to 3.7% in 2014 from 3.3% in 2010, outperforming the decline in the industry's average profit margin.