Identifying a domestic pharma stock: Do's and don'ts - Views on News from Equitymaster

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  • Jul 26, 2003 - Identifying a domestic pharma stock: Do's and don'ts

Identifying a domestic pharma stock: Do's and don'ts

Jul 26, 2003

There is a famous saying that 'while investing in equities, investors are actually buying the business of the company and not the scrip per se'. If this is the case, there are lots of complexities involved when it comes to picking a pharma company for investment. Here is an attempt by us to enable a retail investor to identify a domestic pharma company for investment.

As can be seen from the chart above, Indian pharma companies derive revenues from the domestic and international market.

Domestic market:

The domestic market can be broadly divided into two categories i.e. bulk drugs and formulations. Two key factors that have to be borne in mind are that the Indian pharma market is highly fragmented due to the lack of a patent regime. Therefore, pricing power is very less and any player can duplicate a product in a very short span of time.

Coming to bulk drugs, they primarily represent the basic raw materials used in the manufacture of a formulation. If the company is engaged in the bulk drugs business, what the investor must look into is the extent of the Drug Price Control Order (DPCO) cover on the company's products. DPCO is a government regulation that fixes the ceiling prices for the bulk drugs. Thus, a company manufacturing drugs covered by the DPCO loses its pricing power, resulting in lower margins. Therefore, lower the exposure to products covered by DPCO, the better.

Another important thing to be looked at is whether the bulk drug company carries out any contract manufacturing activity. In this case, the company acquires a contract from another company for manufacturing its products, which will subsequently be sold by that other company. But why contract manufacturing? Low labour costs and US-FDA approved plants are advantages on which the Indian pharma companies can capitalize and increase revenues.

On the other hand, if a company is dependent on formulations, the investor must ascertain the extent to which its products fall under the National Pharmaceutical Pricing Authority (NPPA) cover. NPPA fixes the ceiling price for formulations. Thus, as in the case of bulk drugs, lower the exposure to products covered by NPPA, the better for a formulations company. Here again the company could enter into a manufacturing contract with an MNC.

Even in formulations, there are two broad categories i.e. lifestyle segment and traditional segment. Lifestyle segment comprises of drugs that are used to cure diseases that are linked to stress, urbanization and changing diet pattern and lifestyle of high-income level population. Major drugs in this segment are anti-diabetes drugs, cardiovascular system drugs, gentio-urinary and sex hormones drugs, CNS drugs, anti-depressants and psychiatry. These segments are not price sensitive and are less fragmented.

The traditional segment, on the other hand, comprises of anti-infectives, pain management and anti-biotics. This segment is highly fragmented. Thus, if a company has higher exposure in the lifestyle segment, the growth prospects and margins of the company will be higher.

International market:

As far as international markets are concerned, as apparent from the graph above, is broadly divided into three categories viz. generics, Novel Drug Delivery System (NDDS) and developing a New Chemical Entity (NCE).

Genericsare a bio-equivalent of a patented drug. Simply, if 'erythromycin' is coming out of patent, a company can launch the same erythromycin, but with a different composition (end effect however, is the same). Every year, a number of drugs come out of the patent regime. So, a company in India who does not have the R&D capabilities or funds to invest in R&D launches the generic version of the drug that is coming off patent. The advantage here is that the Indian company need not invest large sums in R&D. However, legalities are very complex (like Para I to IV) and time consuming. When the company's research is at a very nascent stage, it concentrates on the sale of off-patent drugs.

Read in detail about Pharma R&D and its structure.

Starting from Para I to III, there is no restriction on the number of players that can enter the market (competition is global in nature). Margins therefore, are not very high. It is basically a volume driven strategy.

Gradually, as the company grows, it shifts its focus onto developing a new drug delivery system for an existing drug and also challenges existing patented drugs by introducing their bio-equivalents. A company files an ANDA for NDDS when it has developed a new method or dosage of delivering a patented drug to the patient. When a generics company challenges an existing patent, it is required to prove that the patent is not infringed or that the patent is invalid. He is thus required to prove that his drug is bio-equivalent to patented drug. If successful, the company gets a 180-day exclusivity period during which it has the sole right to sell the drug in the market. Consequently, the company enjoys very high margins during this period of exclusivity. However, the litigation expenses are very high in such a case.

An investor has to put more emphasis on the total number of Para 4 ANDA filings rather than the aggregate number of ANDAs filed. Further, the investor should look into the long-term prospects of the company and not base his decision on the outcome of a single legal suit, or a single blockbuster generic success.

Read in detail about New Chemical Entity: What is it all about?

Major aspects that need to be observed:
Government policies have a major influence on the domestic pharma sector. As can be seen from the table below, due to the absence of a good health insurance policy, India has one of the lowest public health expenditure as a percentage of GDP. Moreover, even on the health infrastructure front, India has a long way to go as compared to other developing nations.

A long way to go
Country Public health expenditure
as a % of GDP
Per capita health
expenditure ($)
No of hospital
beds per 1000 people
India 0.8% 94 0.8
Brazil 2.9% 453 3.1
China 2.0% 143 2.9
Malaysia 1.4% 189 2.0
USA 5.8% 3950 3.7
Source: World Bank website

Management is the most crucial aspect for any company's success. While this is true for every industry, it attains even more significance in the pharma sector. Being an extremely specialized sector, it is very important that the management has the requisite expertise and skills to handle the complexities involved it this business. Thus having 'the right person at the right place' is key to the success of a company. Watch out for this in the annual reports.

R&D expenditure as a percentage of revenues is a very useful tool for evaluating the company's R&D thrust. As product patents come into effect, only companies with high R&D investment will survive. Thus, higher the ratio, higher will be the R&D focus of the company and the better placed will it be to face the uncertainties of the future. Of course, R&D has its inherent risks as well.

Last but not the least, keeping aside growth prospects, the sector has significantly high-risk profile due to the dynamism. Even erstwhile big names in the global pharma industry like Upjohn, Burroughs, Knoll, SmithKline Pharma, Pharmacia and Hoechst, found the going tough alone. Ultimately, they had to join hands with bigger players in a bid to survive. Indian companies are still relatively small. If this is the case, a retail investor has to exercise caution. So 'pick and choose'.

Click here to identify stocks from other sectors.

Related Links for Pharmaceuticals Sector: Quarterly Results NEW | Sector Analysis Report | Sector Quote | Over The Years

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