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Pharma: Do valuations justify optimism? - Views on News from Equitymaster
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  • Dec 8, 2004

    Pharma: Do valuations justify optimism?

    Since the beginning of FY05, stocks from the pharma sector have gained much attention, led by optimism regarding structural change in the industry. Also, stocks from the sector are considered to be defensive, as they seem to be insulated from the changes in the political environment, to some extent.

    Pharma stocks: Is the optimism justified?
      1-Apr 7-Dec Gains Forward P/E FY05E
    Sensex 5,741 6,323 10.1% 17.0*
    Dr Reddy's 980 830 -15.3% 32.2
    Glaxo 607 735 21.1% 19.5
    Wockhardt 270 330 22.0% 20.9
    Ranbaxy 990 1,207 22.0% 26.9
    Abbott 550 680 23.6% 17.3
    Cipla 235 293 24.9% 23.7
    Pfizer 478 609 27.4% 37.4
    Aventis 715 1,110 55.1% 24.2
    Nicholas Piramal 764 1,231 61.3% 20.3
    Novartis 396 658 66.1% 16.4
    *Trailing P/E for the Sensex

    As seen from the table above, pharma stocks across the board are trading at premium to the market (read Sensex). Now, while there are expectations of higher earning growth from these companies owing to the structural changes in the sector, one needs to look carefully at the valuations.

    Interestingly, stocks of domestic pharma companies are trading almost at par to their MNC peers. This is a divergence from the past, where MNC companies were always valued more by the investors, mainly based on their better business model and the consequent lower risk profile. However, currently, the shift in the trend is due to high growth prospects of the Indian companies, one major driver being their increasing participation in the international pharma markets. The penetration of generics in the world markets is increasing and countries like France, UK and Spain (with low generics penetration) provide a huge opportunity for Indian players. Leading domestic players like Ranbaxy and Wockhardt are likely to be the major gainers if the generics market in these countries grow as expected.

      Market size (US$ bn) Generics penetration
    US 219.5 12.0%
    Germany 27.6 21.1%
    France 25.4 2.9%
    Italy 17.4 0.5%
    UK 17.1 10.6%
    Spain 12.6 3.2%

    Source: Company presentations, internal estimates

    Apart from generics, companies like Cipla and Nicholas Piramal are high on their contract (custom) manufacturing business. While Cipla is working on more than 140 bulk drugs and formulations project. Nicholas Piramal is in the niche area of custom manufacturing where it will work with international companies on manufacturing certain drugs to be sold worldwide.

    The optimism regarding the run in MNC pharma stocks is due to the fact that the Indian market is going to see a sea change going forward. While the optimism is being built in too early, we believe that the long-term prospects for the MNC pharma companies are looking good once the new patent regime comes into force. However, while it is difficult to predict what exactly will be the case after a few years, we believe that companies, which have strong pipeline of products internationally, will be the biggest beneficiaries. One thing we have to bear in mind that there will be a great pressure on MNC pharma companies on pricing front. India has only about 5% population, which can afford costly medicines, but they too are not used to costly drugs.

    The P/E multiples of pharma companies seems to be high at the current juncture. We believe that the large companies, which have financial muscle, as well as market presence, will be the greatest beneficiary form the expansion in the market. Investors should take cautious view and realism should prevail while investing in pharma stocks at current valuation levels. While the growth prospects are high, the valuation of certain companies may be higher than what it should be.



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