Near-term headwinds for pharma companies

March quarter results likely to be muted, further correction good opportunity to invest

The pharmaceutical space has corrected about five per cent last week, underperforming the Sensex, which was down 1.6 per cent after downgrades from some brokerages on slowing approvals, regulatory concerns and high valuations.

Further, there are near-term headwinds, such as adverse cross-currency movements, which would reflect in the March quarter results of most large companies. Beyond that, the longer-term story remains intact. Given multiple triggers (earnings growth driven by the US market, higher approvals and strong India revenues), analysts say any further correction is a good opportunity to enter stocks such as Sun Pharma, Dr Reddy’s and Cadila Healthcare.

Led by Sun Pharma and Lupin, which have logged gains of 40 per cent or more each, the sector has been a major outperformer since the start of the year. However, the sharp rise has also led to concerns on valuations. According to data from Bloomberg, the BSE Healthcare Index is trading at about 32 times, trailing 12 months earnings, the highest in the past five years. Given the valuation premium, broader indices such as the Sensex is over 60 per cent, analysts say PE multiples are unlikely to rise further. However, Aditya Khemka and Paresh Dave of Ambit Capital say while valuation multiples might not rise further, significant earning upgrades are likely.

Hitesh Mahida of Antique Stock Broking says larger generic pharma companies could see a 15-20 per cent annual earnings growth driven by the sales in the US. For the sector, valuation at 20-23 times FY17 earnings is reasonable, he adds. The top five pharma companies by market cap (Cipla, Cadila, Sun, Lupin, Dr Reddy's) trade at an average 21.8 times their FY17 earnings.

Analysts say in specific cases, such as Lupin, prior to the recent correction (stock down 15 per cent in 10 trading sessions), valuations had hit an expensive 27-28 times FY17 earnings though there are competitive pressures (approval for antibiotic Suprax to Aurobindo). Hemant Bakhru of UBS, however, says while valuations are substantially above historical average levels, there are near-term triggers such as the launch of the Nexium generic. Strong growth rates and improving returns on invested capital will help the company sustain valuations, he adds.

The key growth trigger for the sector, however, continues to be the US, which accounts for 40-60 per cent of sales for most companies. Sales and margins are expected to improve over the next few years, given the focus of pharma companies on limited competition products leading to a better product mix, resilient pricing, including increases in some cases and a strong pipeline. Further, with domestic growth (20-40 per cent of sales) also expected to come back on track, it will only add to the earnings of the entities.

The other overhang for the sector has been higher US Food and Drug Administration (FDA) scrutiny resulting in Form 483/warning letters/import alerts and longer waiting period for approvals, which has increased from 30 months earlier to 42 months now. FDA approvals are down from 100 in FY14 to about 57 in FY15. While these have shaken investor confidence in the US growth opportunity, Ambit analysts say despite FDA’s vigilance, most pharma companies (except IPCA) have not had major issues and the lengthening of the approval time is temporary and in line with FDA’s guidance. This is expected to improve.

For now, the sector will see earnings pressure in the March quarter. The higher base last year, which saw niche launches and lower product approvals, will mean that this will be the third consecutive quarter where year-on-year adjusted net profit growth is expected to be lower than sales growth. In addition to limited approvals in the US and absence of high margin products, Indian companies are also facing competition in key products. While Lupin has higher competition in Cymbalta (anti-depression) and Niaspan (cholesterol control), Dr Reddy’s is facing competition in anti-cancer drug Dacogen. This coupled with higher research and development expenses is expected to compress margins.

			Base 100
Date	S&P BSE-Healthcare	S&P BSE-Sensex	S&P BSE-Healthcare	S&P BSE-Sensex
31-12-14	14692.95	27499.42	100.00	100.00
01-01-15	14673.18	27507.54	99.87	100.03
02-01-15	14720.21	27887.90	100.19	101.41
05-01-15	14682.46	27842.32	99.93	101.25
06-01-15	14290.86	26987.46	97.26	98.14
07-01-15	14263.98	26908.82	97.08	97.85
08-01-15	14433.95	27274.71	98.24	99.18
09-01-15	14691.08	27458.38	99.99	99.85
12-01-15	14737.40	27585.27	100.30	100.31
13-01-15	14757.36	27425.73	100.44	99.73
14-01-15	14623.87	27346.82	99.53	99.45
15-01-15	14687.57	28075.55	99.96	102.10
16-01-15	14894.27	28121.89	101.37	102.26
19-01-15	15067.80	28262.01	102.55	102.77
20-01-15	15132.95	28784.67	102.99	104.67
21-01-15	15180.98	28888.86	103.32	105.05
22-01-15	15436.90	29006.02	105.06	105.48
23-01-15	15506.76	29278.84	105.54	106.47
27-01-15	15559.93	29571.04	105.90	107.53
28-01-15	15581.27	29559.18	106.05	107.49
29-01-15	15749.81	29681.77	107.19	107.94
30-01-15	15666.51	29182.95	106.63	106.12
02-02-15	15630.67	29122.27	106.38	105.90
03-02-15	15487.42	29000.14	105.41	105.46
04-02-15	15632.21	28883.11	106.39	105.03
05-02-15	15486.19	28850.97	105.40	104.91
06-02-15	15219.81	28717.91	103.59	104.43
09-02-15	15179.57	28227.39	103.31	102.65
10-02-15	15164.72	28355.62	103.21	103.11
11-02-15	15354.47	28533.97	104.50	103.76
12-02-15	15613.83	28805.10	106.27	104.75
13-02-15	15857.69	29094.93	107.93	105.80
16-02-15	15719.19	29135.88	106.98	105.95
18-02-15	15809.10	29320.26	107.60	106.62
19-02-15	15796.33	29462.27	107.51	107.14
20-02-15	15808.64	29231.41	107.59	106.30
23-02-15	15685.54	28975.11	106.76	105.37
24-02-15	15703.29	29004.66	106.88	105.47
25-02-15	15541.16	29007.99	105.77	105.49
26-02-15	15359.06	28746.65	104.53	104.54
27-02-15	15539.50	29220.12	105.76	106.26
28-02-15	15854.60	29361.50	107.91	106.77
02-03-15	16150.71	29459.14	109.92	107.13
03-03-15	16365.43	29593.73	111.38	107.62
04-03-15	16569.75	29380.73	112.77	106.84
05-03-15	16991.33	29448.95	115.64	107.09
09-03-15	17042.34	28844.78	115.99	104.89
10-03-15	17009.73	28709.87	115.77	104.40
11-03-15	16870.06	28659.17	114.82	104.22
12-03-15	17058.95	28930.41	116.10	105.20
13-03-15	16842.62	28503.30	114.63	103.65
16-03-15	16893.96	28437.71	114.98	103.41
17-03-15	17200.66	28736.38	117.07	104.50
18-03-15	17240.21	28622.12	117.34	104.08
19-03-15	17311.91	28469.67	117.82	103.53
20-03-15	17049.16	28261.08	116.04	102.77
23-03-15	17017.78	28192.02	115.82	102.52
24-03-15	17331.60	28161.72	117.96	102.41
25-03-15	17414.54	28111.83	118.52	102.23
26-03-15	17083.65	27457.58	116.27	99.85
27-03-15	16952.05	27458.64	115.38	99.85
30-03-15	17108.08	27975.86	116.44	101.73
31-03-15	17284.94	27957.49	117.64	101.67
01-04-15	17683.88	28260.14	120.36	102.77
06-04-15	18539.36	28504.46	126.18	103.65
07-04-15	18504.68	28516.59	125.94	103.70
08-04-15	18581.01	28707.75	126.46	104.39
09-04-15	18194.76	28885.21	123.83	105.04
10-04-15	18160.87	28879.38	123.60	105.02
13-04-15	18425.25	29044.44	125.40	105.62
15-04-15	18140.06	28799.69	123.46	104.73
16-04-15	17870.57	28666.04	121.63	104.24
17-04-15	17325.89	28442.10	117.92	103.43