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Pharma stocks: Running ahead of times

Dec 24, 2004

The markets have risen to their all time highs, and pharma is one of the sectors that have outperformed this broad rally, although marginally. In light of the structural changes taking place within the sector, both on the international and domestic fronts, increasing investor interest has been witnessed over the past few months.

The global pharma market is becoming increasingly competitive. Although, there is a lot of differentiation that companies can undertake in the pharma sector through launch of new products through R&D, we have witnessed the R&D cost increasing at a rapid pace in recent times. Currently, it costs 4 times more to come up with drug than what it used to cost 20 years back. This rapid rise on the cost front has led the global pharma companies to look at low cost countries for manufacturing as well as R&D services. Also, generic drugs have become order of the day in western countries. This segment of the pharma market is extremely competitive as there is room for many players in the segment. This has led to generic companies moving towards India, which provides them with the cost competitiveness advantage and also adequate technical capabilities to produce drugs at half the cost it is done in the western countries.

In the Indian context, we are moving into an era of product patent, where patents will be granted on the products itself rather than the processes to make those products, that was the case earlier. This necessarily means that companies that have new patented products will be able to launch new drugs in the market and those that do not have patented products will have to either go along with their old products or spend towards R&D activities to introduce new products.

In the tables below, we take a look at eleven pharma companies that form part of our research coverage and try to figure out where these companies stand based on financial certain parameters. Let us look at the MNCs first:

MNC Companies Price P/E NPM OPM ROA ROE
Abbott 735 18.7 15.9% 19.0% 18.0% 21.7%
Aventis 1,303 28.0 16.0% 24.1% 20.2% 26.9%
Glaxo 764 20.2 18.0% 25.1% 20.3% 28.8%
Novartis 677 16.9 20.0% 25.0% 26.5% 37.1%
Pfizer 669 41.3 16.0% 20.0% 16.0% 23.3%

As seen from the table above, MNC companies are trading at premium to the overall market as well as the average valuation of the pharma sector. However, if we compare these companies on financial parameters we find that Glaxo and Aventis come out to be the best picks in the sector, while others like Abbott and Pfizer are the laggards. The premium valuations accorded to these companies are owing to the fact that the new patent regime that will come into force from 2005 will be significant for these MNC pharma companies. Most of the foreign companies have restructured themselves, be it Glaxo, Pfizer or Novartis, to take advantage of the new patent regime. In the long run, these MNC companies will certainly gain market share in high value patented products, which means a growth path that may justify their current valuations.

Let us now look at some domestic pharma companies.

Domestic Companies Price P/E NPM OPM ROA ROE
Biocon 502 26.2 23.1% 30.2% 26.7% 30.0%
Cipla 305 24.5 17.1% 21.5% 15.2% 24.8%
Dr Reddy's 854 33.1 14.5% 19.0% 13.6% 17.4%
Nicholas 1,362 22.5 15.9% 21.5% 22.5% 30.4%
Ranbaxy 1,239 27.6 16.6% 23.5% 22.5% 36.5%
Wockhardt 366 23.3 15.0% 22.4% 16.5% 27.5%

Amongst domestic companies, we see that Ranbaxy outperforms the rest on different financial parameters while Biocon comes a close second. However, one must keep in mind the fact that Biocon is at the peak of capacity utilization of its existing business and the return ratios are likely to come down once it enters into the investment phase. The opportunity that Indian companies have is of outsourcing, and Cipla and Nicholas Piramal can be said to be the biggest beneficiaries of the same. While Cipla will help generic companies in the US with its low cost manufacturing and R&D facilities, Nicholas Piramal has adopted custom manufacturing as its major growth driver.

Considering the fact that most of the pharma stocks are trading at the higher end of their respective valuations, investors need to practice utmost caution. Although, while there is no denying the fact that the growth opportunity for Indian companies is huge, paying more than the value is not reasonable both for short as well as the long run.


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