Indian pharma leaders – for example Sun and Lupin- have witnessed a 25% price erosion from their highs.  Are there structural challenges to growth or just a one off? What are implications for investors?

Context

The US is the largest markets for Pharma in the world and typically the largest market for large Indian companies.  Indian Pharma supplies over 40% of generics, in volume, to the US market.  As a nation, we have a strong competitive edge in this industry with the largest number of US FDA approved plants outside the US. 

While the “generics pharma” opportunity is secular and structural, the industry profitability of supplies to the US could be lower than the last few years due to enhanced competitive intensity and FDA actions.  The industry will need to make a transition to “Branded generics” or specialized products to retain/enhance profitability over the medium term.  

While the leaders should make this transition, the immediate future should see pressure on growth rates and margins – which is reflecting in recent share price weakness for some players.

Volume growth

• Companies are unable to translate ANDA pipeline to revenue as more time is being taken by FDA to clear new ANDAs. Even though the FDA has initiated a program to fast track ANDA clearances, the back log is so huge and it may take a few years to reach the normal period of 10-12 months for approval after filing.
• Incrementally, harder to come up with new molecules
• Increasing competition as more Indian companies have learned the game – resulting in more competition per product.  The only consolation is that fewer new companies are entering the race as the FDA is raising the bar for compliances.

Margin pressure

• There are over 15 Indian companies filing for ANDAs with a focus on the US market as preferred strategy.  Similar business models mean there are now many suppliers for the same generic molecules. 
• Consolidation among Insurance companies, and whole sale distributors is resulting in margin squeeze as they negotiate prices more aggressively
• Increased product development spends to make the leap to more specialized products
• Higher cost of FDA compliances

Concerns on capital allocation on acquisitions

In order to make the leap quicker, or worse avoid being relegated, there is a risk that companies could make aggressive Capital Allocation decisions, specifically

• Over paying for acquisitions or
• Underestimating integration challenges; over estimating synergies 

The chances of overpaying are high as number of candidates are limited and debt funding is cheap (10 year money can be raised in USD Terms @ 3.0- 3.5%). 

This is a catch 22 situation.  For strategic reasons, companies need to acquire to build capabilities, but the suitors have multiple options and will not sell cheap.  An acquisition strengthens long term competencies but over paying threatens return metrics and creates concern on leverage and equity dilution.

Some examples

• Lupin believes in acquiring companies which can give 7-8 year paybacks.  This is not cheap.  Lupin recently concluded the acquisition of Gavis where it paid 10X sales, for access to controlled substances and a specialized derma portfolio.  Despite guiding for strong expected growth in next few years (35%+), 10 X Sales is not cheap because the future is always uncertain. 
• Sun has signalled synergies realization being delayed from its Ranbaxy acquisition due to integration challenges.

What are implications for large Indian Companies?

• There is no dispute on the strategy being followed by our leading companies.  The market opportunity is large, scale is increasing important for a Generics player and one needs to build capabilities by acquisition to widen portfolio/geographic coverage and to preserve leadership status. 
• However, there is a risk that given short term growth and margin pressures, and risk of wrong Capital Allocation decisions, multiple could be re rated downwards, especially if growth falters.
• This could lead to significant pressure on the stock price or time correction in prices.
• However, they should remain secular bets in a long term portfolio. 

Implications for mid-cap pharma companies

• Unless a large part of the portfolio comprises unique products with limited competition, growth and margins will be challenged as buyers look to consolidate vendors to drive further volume discounts
• FDA scrutiny will lead to weaker players being eliminated.
• Those without differentiated models could become acquisition targets for others who see value in a complementary portfolio
• Strength of the Indian franchise, differentiated products/delivery systems, and presence in OTC space becomes very important to support growth and PE multiples.

How should one respond as an investor?

• We would encourage investors to examine “right to win” of product portfolio, and the compliance culture of companies they are invested in.   These are the two stand out variables that will separate winners and also rans.
• We believe that the long term investment thesis for many players is intact.  While the US market may provide challenges, India OTC, bio generics and entry into other markets provide new avenues for growth…
• … However, one could witness both price and time corrections (note, significant price correction has already taken place from 52 week highs) 
• Specific actions should be a function of one’s investing style, time horizon and weightage of stocks and sectors in a portfolio. 
• As always, consult an investment advisor for advise suitable to your situation

Disclosure:

• This is not a recommendation to buy or sell Lupin/Sun Pharma or any other pharma sector stocks.   Readers should assume that we may have advised our clients to buy/sell/trim positions in these stocks in the recent past.
• We are very grateful to Mr Satish Khanna, Chairman of Fullife Healthcare Pvt Ltd, and a veteran of the Pharma industry for his input