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Pharma: How justified is the premium valuation?

Aug 31, 2004

The BSE pharma index is one the key indicators of the performance of the stocks in the pharma sector and based on trailing twelve months earnings, the P/E of this index is about 21.5x. However, not all companies in the sector have valuation at these levels. While some are trading at premium there are others, which are at a discount to the index P/E. The pharma index itself is at a premium to market P/E of about 13. Let us try to analyse why the pharma index is valued at premium by the market and the further why some companies are valued at such a high premium while other are trailing on valuation front.

Company P/E
Abott 9.1
Novartis 12.3
Nicholas Piramal 14.7
Aventis 14.8
Wockhardt 18.0
Cipla 22.2
Glaxo 24.4
Ranbaxy 24.5
Dr Reddy 30.9
Pfizer 42.1
Sector 21.5
Nifty 13.0
In the table given beside we can see that while Abbott is amongst the lowest on valuation front. There are several reasons for the same. Firstly, the company has a very high share of traded goods (lack of manufacturing facilities in the country) in the topline, which gives an indication of the company's lack of involvement in the Indian markets. However, this type of business model can be highly effective once the new product patent regime is enforced in India. Post 2005, the company can aggressively launch new products in the Indian markets. The same is the case with Novartis, which again should be seen as a trading company. However, in case of Novartis we can see new products launches in the market in near future.

The second valuation range is for Indian companies such as Nicholas Piramal and Wockhardt. While Nicholas is trading at about 15x, Wockhardt is trading at about 18x trailing twelve months price to earnings ratio. Wockhardt seems to have a higher valuation as its international business (Europe) has done pretty well in last three quarters. The company has presence in the generics business in the UK and recently, shifted its manufacturing operations from UK to India. This move will reduce the costs for the company improving margins further. However, sustainability of the growth that it has shown in the past is the key concern. In case of Nicholas Piramal, the company's strong presence in the domestic market can be advantageous for the company in the future when the patent regime will be enforced. It can use its to launch in-licensed products of international pharma majors, who do not have presence in the Indian market. However, company's contract manufacturing foray can give a boost to company's bottomline and topline and we may see an improvement in valuations of the company going forward.

In the third range we have top Indian pharma companies, like Cipla, Ranbaxy and Dr Reddy's. All these companies are valued at about 2 times the Index valuation. These companies have been the face of the Indian pharmaceutical sector in the international arena. Although, the International market has been focus area for the Indian companies, Cipla's performance in the domestic market has been commendable. It is now the largest pharma company in the Indian market.

Apart from the Indian market, Cipla has managed growth by its contract for bulk drug supply to leading generics companies such as Ivax and Watson. This is highly profitable for Cipla as it is one of the lowest cost producers of bulk drugs. While Cipla chose to focus on bulk drugs, Ranbaxy and Dr Reddy's has gone all alone in the tough generics market in the US and Europe. Offlate we saw some hiccups in the performance of Dr Reddy's, and the company is currently investing heavily in R&D and distribution network in the target markets in order to launch new products aggressively going forward. While Dr Reddy's is going through investment phase, Ranbaxy is reaping benefits from the investments it has made in the last few years. While growth for Ranbaxy has slowed down in US market, on back of higher base last year, the European market has come as a succor for it.

The highest valuation among pharma companies is given to Glaxo and Pfizer. This can be attributed to their long presence in the Indian market, strong brands, market reach, and a very strong franchise amongst doctors. But the most important cause for their higher valuation is the fact that they are the largest pharma companies in the world with many proprietary products. With the patent regime coming into force from the year 2005, these companies are likely to benefit the most. However, this effect may not be visible in a year or two, in the longer run it seems, that they are likely to reap the benefits of a growing Indian pharma market.

The growth of the pharma sector is generally better than the growth of the general economy, which. With, very low penetration levels of medicines in the country and changing life style we can be sure that in coming years the growth of the pharma sector may change its trajectory and go on a higher growth path. Apart from that, the cost competitiveness of the Indian producers can be a great advantage for them in the international market. Thus, it can be said that the premium valuation of the pharma industry is to some extent justified.

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