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India’s pharma market is expected to continue to grow at about 10% a year for the next several years

Inside the bull run in the pharma shop

9 min read . 08:38 AM ISTClifford Alvares

• Pharma stocks have been on a dream run in the markets. What’s driving the surge and will it last?
• The one-year forward price-earnings multiple of the Nifty pharma index has already shot up to its highest in recent times: 27 times the earnings, against 14.7 times in March 2020

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long-reads

MUMBAI : When the pharmaceuticals sector began to catch investor attention earlier this year, it was right in the middle of a massive turnaround. After being roiled by slow growth and US Food and Drug Administration (FDA) woes for more than half a decade, it suddenly found light at the end of the tunnel.

Pharma stocks had been massively undervalued, and under-owned, which is street parlance for ownership levels at institutions and mutual funds. In April 2015, the Nifty pharma index market capitalisation was nearly ₹6.5 trillion. By March 2020, that halved to ₹3.25 trillion, which was wealth erosion on a massive scale.

Come 2020, the winds of change are hard to miss. In 2020, the Nifty pharma index is the best performing, vaulting 42%. Since March, the index has added back almost 84% of its lost market value.

“In January 2020, the pharma sector was at a 10% discount to the broader market compared to an average 40% premium over the last 10 years. With this rally, the sector has returned to the 40% mark, showing resilience against others during covid-19. So, fund managers have increased capital allocation to this sector," said Aditya Khemka, assistant vice president, equities, DSP Mutual Fund.

The pandemic and a sudden rethink about which segments of the economy truly hold value has helped. So has the spike in demand for critical medicines. However, the most key factor at play may be international. Stung by supply chain disruptions in China, many countries turned to Indian pharma giants. The US government even lifted import bans that had earlier been placed on a few Indian plants because of regulatory concerns.

Whether these shifts will remain in place for the long-term is uncertain. However, for now, fund managers, both domestic and foreign, can’t get enough of Indian pharma. In fact, domestic and foreign institutions have increased their allocations to the sector by 200% and 120% year-on-year, respectively.

Roaring returns

Click on the image to enlarge

Among small-cap pharma stocks, a bigger frenzy has been cooking. In fact, beyond the Nifty pharma index, smaller companies such as Aarti Drugs Ltd, IOL Chemicals & Pharmaceuticals, Neuland Laboratories, and Solara Active Pharma Sciences have all seen their share prices skyrocket, gaining 125-404% this year.

The US FDA saga

Pharma’s long-time appeal to investors in the early part of the previous decade stemmed from the high margin business in the US. Between 2008 and 2015, some of the companies in the sector enjoyed a good run in the US as many products were going off patent and the prices of generic drugs were quite high. After 2015, however, the US FDA started more stringent evaluation of the manufacturing processes and plants in India.

That led to a large number of warning letters, leading to a slump in the sector. Competition in key products in the US increased, causing a price erosion in generics, which wiped out the high margins. Market observers told Mint that the chief issue was that while Indian production quality was generally good, most Indian manufacturers did not follow the strict manufacturing and process protocols that the US FDA required.

“The US FDA’s issues have been hanging over the industry for the last five years. The focus on processes meant that Indian pharma had to see a cultural transformation," said Saumen Chakraborty, president and chief financial officer (CFO), Dr Reddy’s Laboratories. “The industry came together and, after much training and understanding of processes, companies started getting out of warning letters. The US FDA is now more satisfied. Still, we shouldn’t feel complacent as there is a long way to go," he said.

It’s not as if compliance issues have suddenly disappeared. However, earlier this year, several companies obtained Establishment Inspection Reports, or EIRs, which brought Indian plants under fewer observations. Further, the pandemic-triggered travel restrictions have largely curbed the US FDA’s physical plant inspections. Market observers say that US FDA compliance-related issues are in abeyance for now. However, when the US FDA begins to revisit compliance post the lifting of travel restrictions, some of the observations could get flagged again and sour the pharma party.

In the last half a decade, the sector has also been trying to grapple with generic pricing headwinds. The prices of generic drugs in the US have been falling, sometimes even to the extent of 20% a year, shrinking the US profits of Indian companies. In the past two quarters, such US pricing pressures have eased. In some categories, the price erosion of the past continues, but in the low single-digits.

First-quarter US growth of several India pharma companies is still lumpy, but most firms say that generic drug prices in the US are now not falling as steeply.

To counter the problem, pharma firms have started to invest in products and technologies that require complex capabilities. Others have branched out. “US generic price factor has been there. To an extent, companies have diversified their geographic footprint to other parts of the world," says Kedar Upadhye, global CFO, Cipla Ltd.

Domestic growth

So, what does the domestic market look like for Indian pharma companies? Over the last few years, pharma sales in the home market have been growing at 8-12%. Part of that stems from volume increases and the rest from new launches and price hikes. In fact, India’s pharma market is expected to continue to grow at about 10% a year for the next several years and some sections of the market are drawing parallels with the fast-moving consumer goods sector.

Most large Indian companies generate 30-35% of revenues in the home market, some even 50% or more. Hence, domestic pharma growth is nothing to scoff at. After all, for several companies, earnings from the home market is significantly higher than those from the US and the increasing consumption of medicines in India is here to stay.

“Given low per capita spending on medicines, volume-led growth should remain a central theme and help sustain the current growth rate of the industry," said a recent note by CLSA India. “Annual per capita spending in class II-IV towns is just 48% of that per person in metro cities with the disparity even larger when it comes to rural areas," notes the report.

In the coming years, on the back of a rise in lifestyle diseases, the chronic segment is expected to account for a larger slice of the Indian pharma pie, say analysts.

The other factor that’s driven interest over the last few months is an increase in the sales of active pharma products. With anti-China sentiment strengthening, active pharma ingredient (API) supplies have been severely disrupted. The market expects some of the active pharma ingredient manufacturing to move to India as global pharma companies seek to diversify their sourcing.

The Indian government, on its part, recently announced production-linked incentives (PLI) to promote the manufacture of active pharma ingredients within the country. But some sections of the market note that the scheme may not have enthused pharma manufacturers. “We believe such flexibility from the government is because of muted response to the PLI scheme from the industry. Most listed pharma companies have not been eager to participate in the scheme. Fermentation-based APIs, where incentives are good, require significant investment," said Kunal Dhamesha, a pharma analyst with Systematix Securities.

Despite all this, the prices of many active ingredient pharma stocks have skyrocketed. However, that’s just because of the first-quarter results and partly thanks to the improved sentiment that the sector could see. The real test for the active pharma sector’s growth lies in the months ahead.

Market observers say that China is still a force to reckon with due to its huge, and under-utilised capacities. India has a smaller manufacturing base and may find it difficult to compete, particularly in some bulk drugs and intermediates. Further, issues such as quality and logistics remain barriers to growth.

“The API ecosystem requires a coordinated effort for it to be successful in the long run," said Dr Reddy’s Chakraborty. “The environment, logistics, and quality and safety are paramount. The government and the industry have to take care of several issues, and it needs to be backed by the right kind of tax incentives. This would make the API segment a long-term growth story. Otherwise, growth is there for the short-to-medium term for sure," he said.

Future of stock surge

While first-quarter sales have been muted, growth for many companies in the active pharma ingredient segment has been decent. However, this segment could see growth taper off in the coming quarters. “Sales could taper off in coming quarters if companies have over-stocked these products, which seems to be the case," said Dhamesha.

The moot question now is: Will the pharma sector continue to reprise some defensive characteristics? Will the sector repeat the outperformance it marked over a seven-year spell that began in 2008?

That may not come easy in this round of re-rating. The industry expects slower sales growth in FY21 with covid-19 curtailing the movement of goods and the consumption of medicines. This year’s growth in earnings, which is critical to sustaining valuations, is also because of huge costs savings. Companies have saved on travel and sales promotion.

Besides, the recent run-up in the sector has made it look quite expensive. The one-year forward price-earnings multiple of the Nifty pharma index has already shot up to its highest in recent times: 27 times the earnings, against 14.7 times in March. In that sense, the sector’s re-rating seems more or less complete.

Besides, market observers point out that if a vaccine launch is successful in the coming months, the wider market may shift focus to some other beaten-down, but-still-promising sectors. That would leave pharma in the lurch.

Optimists though counter that some chemicals companies trade at even higher valuations and the pharma sector, with its better brand profile and non-discretionary nature of the business, is on a firmer footing.

However, as the sector has seen a sharp lift, further gains hinge heavily on improvement in earnings. Certainly, the sector is not going to re-rate any more than this. While earnings may vary across companies, those with a better product profile and good pipelines for drugs have an edge.

Pharma’s journey of market expansion over the last six months has been somewhat of a dream run and a little burst of energy may perhaps still be left. However, it remains to be seen whether or not the high-margin, stupendous growth years that the sector witnessed between 2008 and 2015 is seen again soon.