Market-cap dynamics are in a state of flux in the Indian pharmaceutical sector, currently. Looking at the relative progress in the market cap of this sector, one sees a downwards correction since January 2005 as corroborated by the widening gap between the health-care index and the Bombay Stock Exchange Sensex. This is despite a fairly robust operational performance over the last many quarters in terms of sales and profits.
Most industry experts believed that the pharma market capitalization in the second half of 2004 was aggressively valued—especially in the light of fierce competition, low growth rates, declining margins and recent setbacks in the patent challenges in the US generic space. This would have been largely true if valuations were based only on performance.
But valuations are based on potential as well. While performance and valuations are inter-connected, a distinction must be drawn between the two. Because the speculative component of the market capitalization based on potential is significant in the valuations. It is this speculative component or rather lack of perceived potential that is now being discounted in the overall market- cap valuations even though performance has been robust.
Yet, all pharma companies are not exhibiting a similar pattern. Select players have performed brilliantly in the same time frame while most others have faltered.
The four major value creators for the industry are domestic sales, exports, CRAMS (contract research and manufacturing services) and innovative research. Until 1995, domestic sales remained the major value creator. And then, globalization-related opportunities dawned on Big Indian Pharma (BIP) players such as Ranbaxy, Cipla and Dr Reddy’s and they focused on export of generics to accelerate growth.
The three wise old men of the industry then, Dr Parvinder Singh of Ranbaxy, Dr Yusuf Hamied of Cipla and Dr Anji Reddy of DRL, looked at three different strategic options to position themselves for the generic sector that had then just entered the bull phase. Ranbaxy went in for the fully integrated front-end approach, Cipla, the back-end supply agreement route, and DRL focused more on the patent challenges.
Each achieved success mainly because of internal competence, but partly also because of the boom in generics then. Other Indian pharma companies that followed, aligned themselves to one of the three strategic options and flourished as well.
Exports alongside domestic sales became the two major value creators for the decade that followed 1995. Overall, the sector saw huge expansion in earnings and multiples, resulting in significant appreciation in market cap. The valuations of BIPs especially increased at a phenomenal pace. Post-2005, with India becoming fully TRIPS compliant with a product patent regime, CRAMS emerged as a major value driver.
The players who aggressively participated were not BIPs, but a new breed of players, including Dishman, Divis and Jubilant. So, while these companies had their market caps grow by leaps and bounds, BIPs found their valuations eroding.
The major reason was the perceived amount of business potential associated with CRAMS that gave birth to a significant speculative component of the valuations. Simultaneously, the perceived lack of business potential in export of generics in the midst of a downward cyclical trend of the global generics market has led to the undermining in the valuations of BIPs. Given the nature of their business models, no BIP ventured into the CRAMS space nor were perceived to be active participants by the market.
Innovative research is still in its nascent stage in India and will probably come of age by 2010. Again here, a different set of players such as Glenmark, Biocon and Sun Pharma are investing big bucks. BIPs have not been seen or projected as responsive to this latest value creator. They could have better leveraged the euphoric capital market to invest in it, especially since this is the only value creator that is truly sustainable in the medium to long term.
The industry would do well to shirk off its generic mindset when it comes to availing of these opportunities. A stark marker to the lukewarm approach is that only $125 million was spent in 2006 on innovative research (including capital expenditure) as against a global spend of $52 billion. And it costs around a billion dollars, if not more, to introduce a new molecule. The government, Indian pharma and the financial investors would do well to apply an integrated approach to this opportunity, which, if not leveraged will go to some other geography. Simply depending upon multinational corporations to create an innovative research hub here in India will not suffice or at best will be a short-term solution.
Collaborative research, out-licensing pre-clinical candidates and NDDS (new drug delivery systems) can be a good start and will help build value in the medium term, but for Indian pharma to maximize the value creation, it would need to go the entire distance of development. The players who do well in this space will ultimately be the real winners.
Sanjiv Kaul is managing director, ChrysCapital. Comment at email@example.com