Our bullish stance on mid-cap pharmaceutical stocks has played out exceedingly well since our sector update in September. The three mid-cap pharmaceutical stocks—Torrent Pharmaceuticals Ltd, Ipca Laboratories Ltd and Cadila Healthcare Ltd—recommended in the update have given cumulative returns of about 44% as against 11-12% appreciation in the benchmark indices.
We maintain a positive view on pharmaceutical stocks due to their improving financial performance and under-ownership by institutions. Also, many positive themes are likely to play out in 2010 in different segments of the sector and spur the stocks ahead.
In terms of picks, Sun Pharmaceutical Industries Ltd (complex generics, controlled release substance) and Lupin Ltd (complex generics, branded formulations) are safe investment bets. Cadila (strong domestic formulations, niche investigational new drug filings), Ipca Labs (focused on domestic and emerging markets, API advantage) and Torrent Pharma are our top picks in the mid-cap segment. Among front line companies, Biocon Ltd and Cipla are interesting investment avenues for the short to medium term.
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The two key concerns are exchange rate volatility (which impacts export-driven models) and the strict US Food and Drug Administration (USFDA) stance. The appreciating rupee is negative for export-oriented pharmaceutical companies at the margin level.
However, after burning their fingers due to the mark-to-market (MTM) losses on their outstanding hedges in FY09, the companies are more cautious and have cushioned themselves with appropriate hedges to cap their MTM losses. Most of these companies have a meaningful level of foreign exchange debt via external commercial borrowings/foreign currency convertible bonds, which should offset the negatives of an appreciating home currency.
Also, USFDA’s vigilance has boiled to the brim for the generic pharmaceutical companies as the same continues to bog down their revenues.
While we shift valuations and price targets for the sector higher (as the earnings growth remains intact), we argue for a lower premium to the market, given lower risk aversion and sector-specific issues.
We expect the growth momentum seen in the recent quarterly results to sustain. We estimate the revenues of the Sharekhan pharmaceutical universe to grow at a compounded annual growth rate of 16% with a 12% compounded annual growth in the earnings over FY09-11.
The earnings before interest, tax, depreciation and amortization margins would also expand by 200 basis points over this period on an aggregate basis. Generic exports will continue to be the key driver of growth in the near term.
The momentum of investing in emerging markets is stepping up as companies begin to exploit the lesser mature markets. Companies such as Torrent, Lupin, Ipca Labs, Glenmark Pharmaceuticals Ltd have established themselves stronger in emerging markets such as Brazil, Commonwealth of Independent States (CIS), Russia and Asia-Pacific.
Further, leading companies such as Dr Reddy’s Laboratories Ltd, Sun Pharma, Lupin, and Ranbaxy Laboratories Ltd (gradually recovering from USFDA and currency issues) have significantly derisked their generic export business model by increasing focus on niche product opportunities as well as by gradually reducing their reliance on the highly competitive regulated markets. Also, despite being late entrants, mid-cap companies such as Ipca Labs and Cadila have marked their presence.
We believe, these Indian firms are well placed to emerge as leaders in the global generic business.
We look for companies that can increase their market share and continue to surprise us on the upside. We also focus on companies that are making optimum use of their capital, a feat that should allow them to not only grow organically but also exploit inorganic growth options. We remain positive on the sector.
Graphics by Yogesh Kumar / Mint