Pharma: In the pink of health? - Views on News from Equitymaster

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Pharma: In the pink of health?

Dec 9, 2005

The BSE-Sensex in the past year has scaled new peaks and touched the coveted 9,000 mark. The BSE Healthcare index, in the meanwhile, has failed to set the pulse racing. Nothing highlights this fact more clearly than the following statistic: in the past one year, while the Sensex zoomed and notched up 42% gains, the healthcare index has significantly under-performed the benchmark, managing to garner a mere 11% gains!

Why the poor show?
2005 has been a year full of upheavals for the domestic pharma industry. While the year began with the introduction of the product patent law in the country, things took a turn for the worse, as VAT-related concerns plagued almost all the companies in the January-to-March quarter. As if that was not enough, excise duty was slapped on the maximum retail price (MRP) as against the ex-factory price, further squeezing margins of the sector. This saw companies ending the fiscal year (i.e. FY05) or beginning the calendar year (i.e. CY05) on a poor note.

On a global scale, intense competition and price erosion, especially in the US, weighed heavily on domestic pharma behemoths such as Ranbaxy and Dr. Reddy's. Having said that, exports outpaced domestic sales in the year so far. This is because, while the US played spoilsport, exports to semi-regulated markets showed healthy growth. As far as margins are concerned, Ranbaxy, Dr. Reddy's and Biocon continued to step up their R&D expenditure in line with their vision of being discovery-led companies despite the declining revenues. Though beneficial in the long term, the R&D spends exerted considerable pressure on margins.

In a way, CY05 could be regarded as a transition year for the pharma sector. Players like Ranbaxy, Dr. Reddy's and Wockhardt are looking to increase their geographical reach in a bid to de-risk their business profile through the organic as well as the inorganic route. These companies are also looking to capitalise on the generics potential in the next two years. Nicholas Piramal has identified contract manufacturing as the means to propel its growth engine and is in the process of building relationships with innovator companies, a requisite for this business. Biocon has been scaling up its capacities to cater to the statins opportunity next year. It is also looking to strengthen its contract research business.

The scenario looking ahead...
The continuous pricing pressure in the global generics market will continue to remain a cause for concern. When this pressure will ease is anybody's guess. Having said that, while the competition most probably will show no signs of abating, a considerable rise in the patent expiries of blockbuster drugs in the coming years is likely to provide a breather to generics companies and boost revenues. The ability to manufacture drugs at the cheapest cost and leverage one's marketing and distribution network to increase reach will be the key to survival.

As far as the domestic markets are concerned, the real test for domestic pharma majors will be when the number of new product launches slow down with the introduction of the product patent law. One strategy to arrest this decline would be to enter into in-licensing arrangements with global innovator companies to launch the latter's products. Companies like Glaxo, Ranbaxy and Nicholas Piramal have already initiated steps in this regard. The product patent law also provides an opportunity to MNC pharma companies to leverage on their parents' portfolio and move ahead of their domestic peers.

Since the pharmaceutical industry stresses on R&D initiatives, intellectual property (protecting or challenging patents as the case may be) and the cyclical nature of the generics business, benefits from the same will accordingly take a longer time to accrue. We therefore believe one must maintain a long-term investment horizon for investing in pharmaceutical stocks.

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