Lupin to Cipla, pharma firms on course to shed 'underperformer' tag in FY19

Easing of pricing pressures, launch of limited competition drugs in the US, weak rupee are key triggers

After underperforming the broader indices for each of the last three fiscal years, the Nifty Pharma — with returns of over 20 per cent — has been one of the best performing indices this fiscal. And the trend is likely to continue.

One of the reasons for the rally has been the 15 per cent depreciation of the rupee compared to the greenback. While Divi’s is the biggest beneficiary (90 per cent of revenue exposure to the dollar), Dr Reddy’s, Aurobindo and Cadila Healthcare, too, will benefit as over half their revenues are denominated in dollars. 

Further, what has helped is the Street’s preference for defensives with Indian pharma companies experiencing a gradual turnaround in the US. Most experts believe the sector is poised to improve its financials and returns trajectory. 

Analysts led by Deepak Malik of Edelweiss Securities expect a revival in revenue and earnings growth, to be led by normalising regulatory and concentration risks, entry into complex and specialty drugs, and currency tailwinds. 

A key indicator of the turnaround has been the improvement in pricing environment in the US. Price erosion—which had been hovering at low to mid teens last year—has come down to single digits with the trend likely to continue over the next two quarters. 

While the September quarter (Q2) results point to a mixed bag, Kunal Dhamesha of SBICAP Securities expects pricing pressures in the US—which accounts for 20-50 per cent of revenues for larger pharma firms—to abate on two counts. First, companies continue to rationalise portfolios. With returns on some of the molecules turning negative, companies are pulling out even approved molecules, with withdrawals increasing to 548 over the last one year. This is double the number recorded over the previous two years. Teva and Sun Pharma have the highest withdrawals of drug applications. 

The reason is the shift in focus to complex generics and molecules that are difficult to make and more profitable. While the base business will continue to face pricing pressure as has been the case in Q2, incremental specialty launches should help reduce overall impact.

What should also aid generic players is the resolution of regulatory issues at various plants, especially with respect to launch of limited competition drugs in the US. 

Following updates from the management after Q2, analysts expect resolution and clearance by the US FDA for Lupin’s Unit II (Pithampur, Indore) and Goa Unit by mid-2019. Both had received a warning letter in November 2017. 

While Dr Reddy’s regulatory resolution may take time, any resolution—especially of its Duvvada oncology formulation unit at Visakhapatnam where inspection began last month—is expected to be positive for the stock. 

Second, consolidation among generic manufacturers increases their bargaining power. While there has been consolidation among distributors, which has increased their bargaining power (top three distributors account for 90 per cent of sourcing), generic manufacturers are fragmented, with the top ten accounting just over 55 per cent of the generic spends in the market. This is expected to drive consolidation of generic players at attractive valuations, as evident when Aurobindo acquired some generic assets of Sandoz for $900 million at less than one-time sales. 

The low leverage of large Indian generic players (most are sitting on cash) — less than half their international peers — should help them acquire assets in the US and other geographies at reasonable valuations. This will lead to lower competition in the sector on the manufacturing side and thus improve pricing, say analysts. 

With various positives are likely to play out over the second half of the current fiscal, analysts believe earnings growth for larger generic players should be upwards of 15 per cent, over FY18-20. This should reverse the cycle of poor performance resulting in decade-low operating profit margins in FY18 due to pricing/regulatory pressure in the US. 

Brokerages prefer Aurobindo, Sun Pharma and Dr Reddy’s—given the diversified portfolio, a differentiated pipeline, R&D and execution capability. Sun will release its Q2 results this week.