We tested the pharmaceutical sector’s vulnerability to macro headwinds after it outperformed the broader market by a sharp 7% in the past one year and have arrived at the conclusion that the current premium of 50% relative to the Sensex is unlikely to sustain because of two reasons.
One, the pressure on domestic earnings has not yet been fully discounted by the market and also as research and development (R&D)/marketing costs rise in the wake of intense competition, there is pressure likely on the price-earnings multiple (P-E) . Two, with growing multinational companies (MNC) presence, concerns regarding a hike in drug prices have resurfaced and may trigger policy change by the government (such as stricter scrutiny of foreign investments in brownfield projects and increase in the number of drugs under the new list of essential medicines), a move that will significantly erode the sector’s premium valuation. We see the growth in domestic formulations business moderating to 12-14% in FY12 from 16% compounded annual growth rate in the past two years as intense competition and pricing pressure in acute therapies dent volume growth. Marketing and R&D expenses, which have so far remain stable, are also likely to increase as companies struggle to maintain their market share. Following the recent spate of takeovers of Indian companies by MNCs, concerns regarding a hike in drug prices have resurfaced. Recently, a high-level inter-ministerial-group headed by Prime Minister Manmohan Singh decided to bring all foreign investments in brownfield projects— currently cleared through the automatic route—under the purview of the Competition Commission of India, rendering it to stricter scrutiny. Further, the talk of a revised new list of essential medicines (NLEM), which will bring an additional 311 drugs under price control (nearly half of the industry’s output, as per rough estimates), has started gathering steam and would cap any near-term expansion in the sector’s PE multiple.
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We believe the international growth drivers led by the US generics market (which is in a multi-year cyclical upturn given the impending patent cliff), and emerging markets (owing to favourable demographics and similarity with the domestic market) still hold and would partially cushion any erosion in PE multiple.
Torrent Pharmaceuticals Ltd (TPL) and Glenmark Pharmaceuticals Ltd (GPL), owing to their discounted valuations and strong earnings trajectory are our top buys whileSun Pharmaceutical Industries Ltd’s near-term growth looks fully priced in and therefore gets our hold rating. We assign a sell rating to Cipla Ltd because of muted growth profile and declining return ratios. We also have a sell rating on Cadila Healthcare Ltd owing to lack of clarity on growth drivers for its $3 billion revenue target by 2015. Barring TPL and GPL, FY13 profit after tax estimates for other companies in our coverage universe are 4-10% below consensus estimates, given our expectations of a slowdown in domestic market growth and pressure on margins.
Edited excerpts from a report by Nirmal Bang. Send your comments at firstname.lastname@example.org.
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