Pharma Sector sell off is a buying opportunity last week

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Pharma Sector has witnessed a dramatic sell off in the last one week, with fourth quarter earnings of most companies coming below par. The Sectoral Index fell like mid cap stocks.
As an outcome of earning disappointments, companies such as Sun Pharma, Lupin, Aurobindo, Glenmark, Divis Lab etc., now trade at a multiple between 15 to 20 times earnings (based on FY-17 numbers).
For most of these companies, USA constitutes around 40% of their total business and this segment witnessed sharp pricing pressures, leading to analysts revising downwards their future earnings forecasts.

What is happening to the Generics business in USA?

Generics business in the USA, has been the main staple of the Indian Pharma companies till late. However, it has seen serious erosion in profits in recent times, for a number of reasons:

  • The entire sector has faced the ire of the US Drug regulator in the last few years. The rising expectation of compliance to good manufacturing practices has meant adverse observations, warning letters and even the import alerts. This has led to loss of market value, stymied fresh approvals as well as additional cost of remediation.
  • Significant consolidation of buyers has given them a better ability to negotiate, putting serious pressures on prices.
  • US Patented drugs going off patent, in the small molecule space, peaked in the period 2010 to 2015 and is expected to come down by at-least 40% in the years ahead. This used to be the low hanging fruit for the Generics companies as they not only made money during the 6 month exclusivity period but also in the subsequent 2-3 years, till such time competition built up.
  • Further, the windfall profits from the “First to File” opportunity too is drying up fast.  While in the past, the six months exclusivity was typically given to a single company, in future this exclusivity will mostly be shared by multiple entities.
  • Biologics offer significant off patent opportunity in the coming years. However, Indian companies will need to up their game to make a dent in the Biosimilar space.

Our take on the USA business

  • We have learnt the hard way the serious downsides of non-compliance to good manufacturing practices. We believe that the companies are taking this very seriously and we expect this issue to be addressed/resolved over the course of next year.
  • As the simple generics space has become crowded, the Indian companies have responded by trying to move up the value chain into complex generics, specialty medicines. Increased R&D spends are a strong indicator.
  • Indian Pharma sector brings significant competitive advantage in terms of manpower/compliance costs, with respect to their global counterparts. As the Indian companies still constitute a small fraction of the total generics market in the US (USD 15 Billion out of USD 75 Billion), they are likely to gain market share from their global counterparts.
  • We expect pricing pressures to subside over the next six to twelve months, as for most global generics players, Profit after Tax/Sales ratio has dropped to less than 10% and they have limited ability to bring prices further down.

Time to build Pharma Sector exposure

While, FY-18 earnings may be flat for the sector, we expect the US business to continue to grow at over 10% (in USD terms) over the longer term.With India business growing at 8 to 10% & also the USA/Rest of the World segments growing at 10% range (volume terms), the Earnings Multiple deserves to be re-rated to over 25 as compared to 16-20 range, currently.

We expect the stock prices/Sectoral index to recover at least 20% on average by the year-end.

Our recommendation is to use every dip to build pharma sector exposure upto 15% of your equity portfolio, through a basket of stocks or through Pharma Sector funds.

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