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Pharma: Will ghosts of 2005 return? - Views on News from Equitymaster

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Pharma: Will ghosts of 2005 return?

Dec 27, 2005

Introduction
The Sensex in the past one year scaled new peaks and touched the coveted 9,000 mark. The BSE Healthcare index, in the meanwhile, 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 44% gains, the healthcare index has significantly under performed the benchmark managing to garner a mere 2% gains!

The year that was...
The year 2005 was 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 all the companies in the January to March quarter. As if that was not enough, the government passed a resolution to charge excise duty on the maximum retail price (MRP) as against the ex-factory price further squeezing margins of the sector. This saw the pharma industry growing at a marginal 4.2% in FY05.

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 on the back of fewer product patent expiries. Having said that, exports outpaced domestic sales in the year. This was because while the US played a 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 expenditure exerted considerable pressure on margins.

Our 2005 assumptions Vs reality
While putting through our outlook for 2005 at the end of 2004, we had indicated that the introduction of the patent act might not see a sudden jump in revenues and profits of MNC companies as they may approach new product launches with caution. As indicated, the top MNC companies such as Pfizer, Glaxo and Novartis did not make significant product launches during the year. In fact they are planning to launch patented products from 2007 onwards. However, despite this, in 2005, these companies posted healthy topline growth, barring the VAT issue, which severely affected the first quarter revenues of these companies (including domestic) and was unforeseen.

We had indicated significant growth on the exports front for domestic companies. As expected, while there were no significant product launches in the regulated markets (US and Europe) on the back of a reduction in patent expiries, exports to the semi regulated markets such as Russia and the CIS nonetheless witnessed a significant traction. Companies with focus on contract manufacturing saw exports outpacing domestic sales despite pricing pressure in the regulated markets.

The sector outperformer: Pfizer
MNC pharma companies were the biggest gainers during 2004 with Pfizer emerging as the leader and GSK Pharma not far behind. The introduction of the product patent regime has focused the limelight on these companies, which can now launch products from its parent's product folio. Despite a poor performance in the first half of the year, Pfizer bounced back in the third quarter posting a healthy topline growth. The company's restructuring exercise also started to reap benefits and aided the margin expansion. Besides this, Pfizer indicated the launch of new products in the coming years from its product stable such as 'Caduet' (a blockbuster cardiovascular drug), which led to a rise in its stock price. GSK Pharma has also been focusing on the launch of lifestyle drugs mostly through in-licensing arrangements, while the parent company is looking to conduct clinical trials in the country.

Key gainers in 2005
23-Dec-04 23-Dec-05 % Change
Pfizer 671 981 46.2%
Glaxo 763 1,080 41.7%
Cipla 304 430 41.5%
Aventis 1,305 1,622 24.3%
Wockhardt 368 431 17.3%
Dr. Reddy's 854 968 13.4%

In the domestic pharma space, Dr. Reddy's was one of the companies in the limelight in 2005. The company bounced back in the first half of FY06 after a forgettable FY05. However, the icing on the cake for Dr. Reddy's was the formation of Perlecan Pharma Pvt Ltd by roping in ICICI Venture and Citigroup Venture Capital. The formation of this company will be beneficial to Dr. Reddy's in the long term in the sense that it will mitigate the risks and costs associated with clinical development of the molecules. The company's partnership deal with ICICI Venture for the purpose of funding the ANDAs filed in FY06 also started to reap benefits in terms of reduced R&D expenditure as a percentage of sales.

The laggard: Ranbaxy

The laggards in 2005
23-Dec-04 23-Dec-05 % Change
Ranbaxy 620 359 -42.0%
Novartis 677 575 -15.1%
Biocon 503 500 -0.4%
Nicholas Piramal 273 277 1.4%

Ranbaxy took a beating during 2005, which saw the stock plummet by 43%! The year began on a bad note for the company, which saw the US court slapping an injunction prohibiting it from marketing the generic version of Pfizer's blood pressure drug 'Accupril'. More importantly, the severe price erosion in the US generics market (contributing around 30% to the topline), weighed heavily on the company's performance during the entire year with prices in the US markets eroding by as much as 20%. This led to the company posting losses at the operating level in the third quarter. Also, the stock had been in the news on the back of its challenge to Pfizer's and the world's largest selling blockbuster drug 'Lipitor'. However, adverse rulings on the same for Ranbaxy in the key markets of the UK and the US also took its toll on the stock. The problem was further compounded by a considerable rise in R&D and litigation costs depressing the operating margins.

What to expect in 2006?
The generic landscape: After a forgettable 2005, which saw product launches in the generic markets drying up, generic companies are now gearing up for 2006, which will see a considerable rise in patent expiries of drugs. Drugs estimated at US$ 55 bn are expected to go off patent 2006 onwards. However, it must be noted that the extent of competition witnessed in 2005 is likely to be the same in 2006. This means that while pricing pressure will most likely continue in 2006 as well, it will not be as severe as 2005 on account of a rise in product launches. Despite the hiccups, the fundamental factors driving the generics industry remain strong and domestic companies will capitalize on this opportunity going forward to compensate for the slowdown in product launches in the domestic markets. Activities on the contract manufacturing and contract research side may also intensify with the introduction of the patent law.

New product launches in domestic markets: In light of the patent regime, the number of new product launches will be the key to stay ahead in the domestic markets. 2006 is likely to see an increase in new product launches from MNC pharma companies from their parent's stable providing stiff competition to domestic players. Also as far as therapeutic class is concerned, the chronic therapy segment has been growing and will grow at a faster rate than the acute segment.

R&D focus: 2006 is most likely to see domestic companies stepping up their R&D expenditure. This expenditure will be towards generics as well as new chemical entities. In fact most of the domestic companies such as Ranbaxy, Dr. Reddy's, Biocon, Wockhardt, Nicholas Piramal and Glenmark have already initiated R&D for discovery of new molecules and this activity will continue in 2006 as well. Leaving the demons of 2005 behind, 2006 is thus likely to be a much healthier year for the beleaguered Indian pharmaceutical industry.

To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.


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