Why pharma companies are no longer a defensive play

The USFDA newfound aggression has put Indian pharma companies, and their stock, on the back foot

Consumer goods and pharmaceuticals are generally considered to be the two defensive sectors where an investor can earn steady returns and park their money during volatile period. Not anymore, and especially not in the pharmaceutical space.
Some of the most volatile stocks in the market these days are in the pharmaceutical space, especially in the big pharma space where firms are competing with global players for a pie of the biggest market in the world, the United States. Over the years, the risk emerging from the American markets has increased as Indian players are now impacting earnings of so-called ‘Big Pharma’.

Earlier, Indian companies would rush with their ANDA filings to take advantage of the small window of opportunity when a product goes off patent and the first company to file the their documents gets an exclusive period of 180 days to market the generic product along with the patent holder. Many Indian companies posted sharp growth based on this strategy.

But as the number of drugs going off patent has fallen and competition increased, both within India and outside, this opportunity has shrunk.

On the other hand, the US Food and Drug Administration (FDA) has become stricter on products that are entering US borders. As a result, surprise inspections have increased and companies are being issued warning letters, which is the main reason for added volatility in the stocks.

One a day like today, when the market has crashed following BJP’s loss in Bihar, pharmaceutical stocks should have been idle hedge as their growth is not too dependent on overall growth of the economy, which many feel will be impacted as the government  goes into socialist mode. But the top two losers today in the BSE Sensex are Sun Pharma and Dr. Reddy’s laboratories.

Sun Pharma has fallen because of a poor performance in the US market which accounts for 48% of its revenue. Sales to the US dropped by 28% to $510 million on account of disruption of sales from its unit in Halol which has not met USFDA standards. Dr. Reddy has suffered a major setback as US FDA issued warning letters to three of its main manufacturing units.

Other big Indian pharmaceutical companies have been at the wrong end of the USFDA stick. Cipla was served nine observations for their Indore unit while Lupin received a letter for their Goa facility.

While Indian companies have complained that the sudden change in attitude of the USFDA is on behalf of the big pharma players in the US who want preferential treatment in India, the fact remains that FDA has been vindicated in all their complaints. Indian companies have been found violating the norms.

The USFDA is well within its rights to control what enters the country, and if a product does not meets its quality standards, it can reject it. In fact, Indian authorities should also have a similar norm so that sub-standard products do not reach Indian consumers.

As for investors, analysts have been forthcoming in downgrading companies which have been on the receiving end of USFDA sudden alertness. Analysts cannot be blamed for acting with hindsight and after the stock has reacted sharply. The reason the USFDA is raising a warning flag is because of procedural issues or plant design issues which an analyst cannot be expected to comprehend. One assumes that the pharmaceutical companies, especially those that cater to the US markets will be following the best practices. But repeated warning letters have lowered the confidence of the investing community in these companies.

As has been seen in the case of Sun Pharma, a single unit which supplies to the US market can have a big impact on the overall performance of the company. In such a situation the defensive premium that these stocks were getting is clearly not justified.

With the fear of negative surprise cropping up anytime, pharmaceutical sector is in a defensive mode but surely are not a
defensive play for investors.