Pharma Sector index at around 8,800 level, is just a shade above its multi year lows.

Pharma companies with exposure to USA generics market have witnessed a collapse in their profits in recent years. Annual Profit for Sun Pharma has come down from the peak levels of 7,500 Cr to less than Rs 3,000 Cr, Lupin from Rs 2,500 Cr to 1,400 Cr, Dr Reddy from Rs 2,150 Cr to Rs 1,200 Cr. The profit collapse has been due to multiple reasons:

• Significant price erosion in the base generics business of 10-12% Year on Year, due to (1) Channel consolidation (2) Higher competition encouraged by USA FDA (3) Limited First to file opportunity with fewer drugs going off patent

• Additional Margin pressure arising out of increased R&D spends on Complex generics & Specialty initiatives, which have not yet paid off

• Increased regulatory scrutiny with almost everyone being issued 483 Observations, warning letters and import alerts, constraining them from launching new drugs

What is our take on the Sector going forward?

Even though the Pharma sector has performed abysmally since last three years, we feel it is a good time to build exposure to the sector now for reasons outlined below;

a) India business continues to perform well

The Indian pharma companies have two distinct businesses, India business on one hand and International (mainly USA) on the other. While the USA business has struggled in recent times, the India segment being of branded generics nature, has not only seen healthy EBIDTA levels (30%), but also robust growth of over 10%. As such the growth & profitability of the India segment, sets a floor to the valuation of Pharma sector.

For instance, Lupin’s India business with domestic sales of over Rs 4,000 Cr, and Annual Profit in range of Rs 700 Cr can be easily valued at Rs 20,000 Cr. As it’s total market capitalization is Rs. 35,000 Cr, the market is valuing its international business at merely Rs 15,000 Cr, which is a steal!

b) Negatives have played out in the USA segment

Further, we feel that most of the negatives for the USA business has already played out and expect quarterly profits to sequentially (QOQ) recover. As profits stabilize and start recovering, the earning multiples will rerate to 25 to 30 times (FY 19 projected earnings) from the existing 15 to 20 times, resulting in 20 to 25% rebound in prices.

c) Indian Rupees in the past month has weakened against US Dollars by 4 to 5%.

This will be a big tailwind for international business and add 4 to 5% points to the shrinking profit pool in the coming quarters.

d) Technically too, the Pharma Sector Index appears to have formed a bottom.

Why do we think negatives have played out in USA?

• The resolution of key facilities like Halol for Sun, Srikakulam & Duvvada for Dr. Reddy, Goa & Indore for Lupin will significantly boost sentiment, as this will enable them to launch many drugs that are held up due to import alerts & warning letters.

• Further, many Indian companies are expected to get traction from their investments in Complex Generics, Specialty & Biosimilar areas:

1. Sun Pharma: Tildrakizumab for plaque psoriasis; Seciera for Dry Eye; BromSite for pain in cataract; Odomzo is Sun’s first branded oncology product
2. Dr. Reddy: G Nuvaring, Copaxone, Subaxone & Aloxi expected launch in FY 19
3. Glenmark: GSP 301 for allergic Rhinitis undergoing phase 3 trial, GBR 310 for Asthma, GBR 830 for Atopic Dermatitis

• While base business will suffer some more price erosion, this will be more than compensated for by the new launches enabled by the resolution of warning letters & also the expected traction in the Specialty business.

• Further, we expect the acute pricing pressure to abate going forward as the higher cost structure of global generics players (MYLAN, TEVA, SANOFI etc,) leaves them with little ability to further reduce prices.