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Pharma: Angst ridden year?

Nov 27, 2007

As has been the case in CY05 and CY06, the stocks in the pharma sector continued to lag the Sensex in CY07 as well. This has been amply demonstrated by the graph below, which shows the BSE Healthcare index under performing the BSE-Sensex by a wide margin. While concerns over pricing pressure spilled over to CY07 as well, the year was also plagued by other issues. At the same time, there were some strategies adopted by the pharma companies, which received the thumbs up from the investing community. In this article, we shall take a look at factors that have dampened investor sentiments and those that have been received well by investors at large. What has dampened sentiments?
Rupee appreciation: In the last few years, domestic pharma companies have been increasingly focusing on the exports markets of the US and the Europe to capitalise on the generics potential and also to mitigate the long-term impact of the likely slowdown of product launches in the domestic market in the future. As a result, the sharp appreciation of the rupee against the dollar has seemingly dampened investors' sentiments towards pharma stocks. The rupee has appreciated from US$ 45 levels to US$ 39.3 levels in the past one year and has dented topline performance of most of the domestic pharma companies for whom exports contribute around 50% to 80% to total revenues.

Rise in raw material costs: Of late, pharma companies have been witness to increasing raw material prices. Many of them import intermediates (used for making APIs) from China, which is very strong in the manufacture of the same. However, China has curbed the export incentives for pharma exports amongst others (to control its trade surplus) and as a result, the import of intermediates has become expensive thereby leading to higher raw material costs. That said, had it not been for the rupee appreciation, the raw material expenses would have risen further.

Concerns over pricing pressure persist: Concerns over pricing pressure in the global generics market continued to persist in the last one year. While increasing number of molecules going off patent coupled with rising competition exerted downward pressure on prices in the US, the European markets especially Germany were not spared either. In Germany, which was initially a branded generics market, regulatory changes forced companies to slash prices by a considerable amount leading to uncertainty prevailing in the overall pricing scenario in that country as well.

Events that have generated interest...
CY07 so far has witnessed some strategies being adopted by a host of domestic pharma companies, which have been enumerated below:

Out-licensing deals: There was a flurry of out-licensing deals concluded this year, the majority of them being bagged by Glenmark and Nicholas Piramal. While Glenmark was successful in out-licensing its molecules GRC 8200 and GRC 6211 to Merck KgaA and Eli Lilly respectively, Nicholas Piramal clinched deals with Eli Lilly and Merck. Out-licensing is beneficial in the same that it helps in generating revenues at a relatively earlier stage of the entire R&D process, besides leveraging on the skill and expertise of the innovator company.

Settling patent suits: This strategy has gained further momentum in the past one year with Ranbaxy and Dr.Reddy's being at the forefront given that both these companies have been more active than their peers in challenging patents of global innovator companies. The biggest positive that accrues by settling the patent suit outside the court is the certainty with respect to the exclusivity period. Both Ranbaxy (for 'Valtrex' and 'Fosamox') and Dr.Reddy's (for 'Imitrex') will get the opportunity to launch its generic version a few months before the scheduled patent expiry with no other generic company present. This will enable them to generate substantial revenues and profits with an element of certainty attached to it.

Hiving off R&D: Hiving off the R&D division into a separate company has been another strategy being followed by domestic companies to mitigate risks from R&D, improve margins, de-risk the overall business model and secure funding for the newly R&D company. This model was initially adopted by Dr.Reddy's (read Perlecan) and since then Sun Pharma, Nicholas Piramal and Ranbaxy have followed suit.

Looking ahead...
Overall we reiterate our positive view on the pharma sector as a whole despite the various challenges that this sector continues to face. We expect partnerships in generics, CRAMS, R&D and in-licensing to be the key growth drivers going forward. Having said that, investors need to adopt a stock specific approach while investing in this sector.


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