Pharma: Searching for the recovery room
The saying ‘Health is Wealth’ may seem like a cruel joke to investors in pharmaceutical stocks. Since October 2015, the S&P BSE Healthcare Index is down by one-fourth in value. The 10-year return still looks respectable at 253%, compared with the Sensex’s 114% gain, but that may offer little consolation, especially for more recent investors.
The seeming invincibility of the pharmaceutical business model meant a steady flow of money into these stocks.
Even now, the sector is trading at a premium of 27.5 times its trailing 12-month earnings, which is higher than the broader market’s 22 times. Still, the ratio is below historical levels; it was trading at 43 times in October 2015.
The business model of most large pharmaceutical industries is under stress. Consider their India business. The list of drugs under price controls keeps increasing every year. Once they are in the list, annual price increases are pegged to wholesale price inflation.
The Reserve Bank of India’s (RBI’s) inflation-targeting may mean price increases may remain relatively low for a long period. Also, the government has cracked down on irrational fixed-dose combinations, hitting at a lucrative business.
The case is in the courts but the net result of these is slower growth.
This March, domestic industry growth was 9.6%, compared with 19.6% in March 2015, according to market research firm AIOCD Awacs. A new uncertainty here is how far the government will go in its bid to push unbranded generics, in its effort to make drugs more affordable.
Indian firms were supposed to reap a windfall in the US market. That was important for several reasons. Earnings growth to justify valuations and return the faith posed by investors was one. More crucially, the money earned from this market had several uses. Companies are spending on research to launch complex generic drugs. These require more investments but have better pay-offs. They are also investing in drug discovery programmes. Lastly, they can make acquisitions using these cash flows, to secure future growth. Firms have been doing this in the past few years.
Their revenues from the US generic market have seen slower growth and, in some cases, the March quarter saw them decline as well. Plant compliance issues are delaying approvals filed from these locations. Companies are losing precious revenue, either because the plants are banned or because they are not getting new approvals.
Lost revenue affects profits and cash flows, ultimately affecting the company’s future prospects. The US market has additional problems, partly due to more competition among existing generic companies but also due to consolidation in the distribution channel. Acquisitions among them have increased their bargaining power, forcing sellers (generic companies) to lower prices.
The cuts have been more severe than expected. Add to this the US president’s stated intention to lower drug prices and more trouble is expected. The net impact of the reversals suffered in India and US are a squeeze on earnings, which is the reason why valuations have plummeted.
Investing in pharmaceutical stocks has become risky for sure, but has turned into a stock-specific activity. Cadila Healthcare Ltd, for instance, got a green signal for a few plants that were under scrutiny. That paved the way for a number of approvals that has seen the share jump. Aurobindo Pharma Ltd is another company that has played the generic game well. Or consider Biocon Ltd, a share that investors were once sceptical about as it was playing a really long-term game. It has done well, as its plans have cleared critical milestones. Its share is up 38% from over a year ago. These are some bright markers in an otherwise weak prognosis. The days when you could throw a dart at the pharma stock screen and pick a winner are behind us.