Re-rating likely of pharma stocks

With return of domestic growth and higher FDA approvals; easing of US regulatory concerns a big positive

The BSE Healthcare index has been one of the biggest gainers over the past few days, on easing of regulatory concerns, improving visibility over product launches and a return of growth in the domestic market.

Ranjit Kapadia of Centrum Broking believes there are encouraging signs which could lead to a re-rating of pharmaceutical stocks, on the back of re-stocking in India and some recovery in the American market. 

Earlier, most analysts had thought there would be no revenue growth in the US market for large generic players for at least a year. The expected recovery there, led by niche product launches and regulatory clearances for affected plants, could now start in the March quarter of FY18, instead of FY19.  Barring Cipla, the top five Indian pharma companies by market capitalisation get upwards of 40 per cent of their revenue from the US market. 

The key trigger for the segment has been the recent regulatory clearances for factories here, earlier pulled up for not meeting the US Food and Drug Administration’s (FDA) regulations on good manufacturing practices (GMPs). Analysts at JM Financial say significant opportunity loss in terms of earnings, with a delay in launches and incremental remediation costs, led to an increased focus on being compliant with GMPs. This led to clearances for Lupin’s Goa facility and Cadila’s Moraiya (MP) one. Dr Reddy’s was the only company with a major regulatory hurdle to clear but two of its three key units got the FDA's go-ahead last week. Dr Reddy’s stock got re-rated on both this account and its portfolio of limited competition drugs. 

The bigger surprise for the Street was the resolution of the FDA's import alert on Divi’s Laboratories. In what is a first, the inspection of Unit-2 of the company’s Vizag facility was done within six months of the alert being issued, as against the historical trend of 12-18 months, say analysts at Motilal Oswal Securities. The quick re-inspection has led to stocks of companies with import alerts such as Ipca Laboratories also gaining last week, on the hope of similar quick resolution. 

The other re-rating trigger is the slew of approvals in recent weeks which will help offset the price erosion worries to an extent. Glenmark, for example, received three approvals in 10 days for drugs with sales of $200 million. Given the rise in the number of competitors, Indian pharma companies, in addition to volume growth, will look at high-entry barrier drugs to improve profitability. 

The near-term trigger continues to be the gradual recovery in domestic drug sales. Pharma market growth had dropped to single digit in the March and June quarters. It is expected to return to double-digit within the next two-quarters. 

Given the 25 per cent contraction in valuation multiples of the pharma sector, analysts believe the risks have been adequately factored in. Analysts at PhillipCapital expect net profit growth to pick up and grow 10 per cent, while return on capital employed is expected to see 170 basis point improvement over FY17-20. While margin growth is expected from the ramp-up in complex generic and speciality products, brand-driven volume growth would come from the domestic market, as well as from emerging markets. 

In the near term, among larger companies, analysts prefer those with higher revenue exposure from domestic formulations such as Cadila, Torrent, Cipla and Alembic. Sun Pharmaceutical and Dr Reddy’s have the most significant complex drug pipeline among Indian entities but monetising this is expected only in FY19 and FY20.