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BW Businessworld

Sanguine Expectations

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In this fifth part of our series on possible Bear Stearns — the US banking powerhouse that collapsed overnight — lurking in Indian industry, we look at the country’s pharmaceutical sector. A slowdown might lead businesses to cut costs and individuals to think twice about buying homes, but it is unlikely to reduce the number of pills anyone pops. That, it appears, is the belief held by investors buying stocks of India’s pharma companies. In the first quarter of 2008, the BSE Healthcare (HC) Index outperformed the Sensex, in stark contrast to the way it had behaved through the bull run (see ‘Healthy Competition’ on page 57).

Between January and March this year, while the Sensex lost 20 per cent of its value, the BSE HC fell a relatively modest 13 per cent. Some stocks, in fact, gained in value. Compare this with the period between 2005 and 2007 — when the Sensex more than doubled, the BSE HC, which went up by a little over 40 per cent, was a relative underperformer.

In a recent report titled ‘Holding the Fort’, analysts at Mumbai brokerage Enam Securities attempt to explain this resurgence. “The pharmaceutical sector has outperformed the markets in the past three months, given its relative insulation from global concerns of a slowdown,” says the April report. They argue that the sector offers a good defence against “the precarious situation in the market”. “Pharma appears to be a safe bet,” says Ranjit Kapadia, pharma analyst at brokerage Prabhudas Lilladher.

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Climbing Down
Pharma stocks appear more reasonably priced today than they did a few years ago when they were stockmarket darlings. According to Enam’s research, in April 2004 the Sensex was trading at a one-year forward rolling price-to-earnings (PE) ratio of 13, while Enam’s universe of pharma stocks was trading at almost twice as much. The industry’s love affair with the stockmarket began cooling down sometime after mid-2004. Foreign brokerage CLSA de-rated the sector and downgraded estimates for blue-chip stocksm such as Ranbaxy Laboratories and Dr. Reddy’s, citing rapid commoditisation of the US generics market, the world’s largest. “The ability of generic companies to sustain growth momentum, in both revenues and profit, is at a rising risk,” the July 2004 report had said. In addition to stiff competition, it pointed to defensive tactics of innovator companies like authorised generic launches, and the imminent entry of several more Indian companies into the US market as reasons for its call. (See ‘Is the Pharma Dream Run Over’, BW, 1 November 2004.)

These concerns have been borne out. In addition, rising R&D spends have weighed down the bottom line further. This partly explains the subsequent underperformance of the sector when the Sensex took off. Kapadia provides an additional reason. During good times, he says, investors have more attractive sectors to put their money into. “Pharmaceuticals is probably the most heavily regulated industry and people may steer clear if there are options,” he says. Enam’s research also shows that, historically, the pharma sector underperforms the market in bullish times, remains neutral during uncertainty, and outperforms in downturns.

Still Expensive?
While pharma stocks have come off their earlier highs, it is pertinent to point out that some Indian pharma stocks still trade at a premium to some of the world’s largest pharmaceutical companies (see ‘Recipes For Value’). “Indian pharma stocks are pretty expensive when compared to large or mid-size companies whether in the US, Japan or Europe,” says Tarun Shah, India head of Wall-Street boutique research and advisory services firm Mehta Partners. One reason for this could be that generics is still a large market opportunity. The global generics market may add revenues of $50 billion between now and 2011 to touch $155 billion. With less than 10 per cent of that currently with Indian firms, the market opportunity is huge.

Also, says Mehta Partners’s pharma analyst Nimesh Mehta, “Indian companies are probably the only group of global generics players with a strong presence in the emerging markets of Brazil, Russia and, of course, India, which are growing strongly”. This has helped them partially make up for a dip in fortunes following structural changes in the US and other markets.

For instance, Israel’s Teva, the world’s largest generics drug maker, still does not has a marketing footprint in India, which has been growing at nearly 15 per cent every year for the past three years. Besides, at least three Indian companies — Ranbaxy, Sun Pharmaceuticals and Nicholas Piramal — have moved to separate their capital-intensive R&D business from the core generics company. Sun’s revenue growth and profitability have also held their own against the vagaries of the generics business far better than Ranbaxy or Dr. Reddy’s making it the largest drug maker by market cap.
A few pharmaceutical companies, such as Ahmedabad’s Dishman Pharmaceuticals, Hyderabad’s Divi’s Laboratories and Mumbai’s Piramal Healthcare, are also riding the wave of expectations about India’s pharma outsourcing story. They offer contract research and manufacturing services (CRAMs) to western drug companies, and optimism about the future potential of this sector is high.

The performance of individual stocks focused on the generics industry will continue to differ depending on the extent to which they meet growth and profitability expectations, as also their resilience in the face of risks inherent to the sector. Brokerage Enam identifies some of these risks — pricing pressure in generics, and uncertainty about product approvals and launches. CRAMs stocks, too, are trading at PE ratios varying ranging from 12 to 21, suggesting differing investor outlooks on their ability to make the most of the opportunity.

In the short term, what could dampen things for the sector? Regulation, says Kapadia. Media reports suggest that in a bid to control prices, the industry might be subjected to more stringent controls in a proposed pricing policy, reportedly to be decided by 30 April. “If that happens, then valuations will come down dramatically,” he says. Among large-cap companies, stocks of the Indian subsidiaries of multinational firms, such as GlaxoSmithKline and Pfizer, are more likely to be impacted than home-grown drug companies, such as Ranbaxy and Dr. Reddy’s. The overall sentiment regarding the pharma sector will be hit, nonetheless.

With inputs from Abhishek Chowdhury
[email protected]

(Businessworld issue 6-12 May 2008)

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