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Pharma: Back to the future...

Jul 10, 2006

Pharma stocks were at the receiving end in the recent meltdown witnessed in the Indian stockmarkets. We, however, continue to believe that FY07 will be the inflection point for pharma companies and will set the growth path for the future after the difficult past couple of years. With pharma companies slated to announce 1QFY07 results in July, we shall analyse major factors that are likely to influence the full year (FY07) performance. The growth drivers will be...

The domestic market: The domestic pharma market is expected to grow in higher single digits in FY07, largely led by growth in the existing products of pharma companies. Most of the pharma majors with their strong product portfolio are expected to grow above the industry growth rate. In terms of new product launches, in-licensing products will play a critical growth in driving the topline. Besides, MNC pharma majors have begun to launch products from their parents' folio (case in point Glaxo and Pfizer), which have started contributing to the topline, albeit in a small way. However, investors should note that it would be a while before these products start making a significant contribution.

Generics: As we have mentioned in earlier articles, the generics industry is expected to witness a revival with a large number of drugs going off patent in the US generics market. Besides Para III launches (drugs launched on Day 1 of patent expiry), there have been successes on the Para IV front as well (cases in point: Dr.Reddy's (for 'Simvastatin' and 'Proscar') and Ranbaxy (for 'Simvastatin 80 mg'). In addition, companies such as Cipla (which is partnering with global generic majors) will also stand to benefit immensely as the demand for bulk drugs starts picking pace on the back of a rise in ANDA approvals. These positive developments coupled with the contribution from the fast growing semi regulated markets of Russia, Africa, Asia and the Middle East are expected to significantly augment the revenue streams of pharma companies catering to the generics market.

Acquisitions: FY06 was the year in which Indian pharma companies embarked on the inorganic route to acquire companies and establish a presence in the global markets. The efforts on this front will be reflected in the FY07 results of these companies. Notable examples include Dr. Reddy's acquisition of Betapharm (Germany), Ranbaxy's acquisition of Terapia (Romania) and Nicholas Piramal's acquisition of Avecia and Morpeth (both in the UK). Since most of these acquisitions were made in the latter half of FY06, the full year impact of the same will start flowing in from FY07 onwards. Besides, this year could possibly see more such acquisitions taking place as Ranbaxy, Dr. Reddy's, Wockhardt and Nicholas Piramal have clearly outlined inorganic growth as part of their strategy in the future.

The margin story: While we expect margins as a whole to improve for companies under our coverage, the extent of improvement will depend upon the various business models adopted by these companies. For MNC pharma companies, the key will be improved product mix, reduced dependence on drugs under the DPCO control and cost efficiencies at the operating level. For domestic companies, the pricing pressure hampering margins will have to be offset by a continuous flow of products to the markets.

However, concerns still remain...

Pricing pressure: The pricing pressure in the US generics market has till now shown no real signs of abating. With the rise in patent expiries, the competition has also intensified, which is expected to pressurise the performance of generic companies. Even in FY07, with a rise in the number of patent expiries, prices could erode by as much as 90% on Day 1 itself (excluding the 180-day exclusivities). Therefore, besides a continuous flow of product launches, efforts made to diversify into other countries outside the US will be a positive move, which will enable companies to negate the impact of the highly competitive US market.

Regulatory issues: Regulatory issues remain an area of concern both in India and abroad. In India, the threat of the new drug pricing policy to bring 354 essential drugs under price control looms like a dark cloud over the sector. Since, the policy has yet to be announced, it will be difficult to guage the exact impact of the same. While MNC pharma companies will stand to lose out, domestic pharma companies will also likely feel the pinch if this policy gets introduced. Abroad, the attractiveness of the German generics market could get slightly blunted with the new drug policy in the country making 30% price cuts mandatory for generic drugs.

Investment in pharma stocks...
While growth is visible in most of the pharma companies under our coverage, valuations will be the key factor to watch out for. After the carnage witnessed on the Indian bourses during the last week of May, we believe that valuations of certain pharma stocks look reasonable at the current juncture. As such, we advise investors to adopt a stock-specific investment strategy while investing in the sector.


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