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  • OCTOBER 11, 2003

Identifying an MNC pharma stock: Do's and don'ts

The case for an MNC pharma company for retail investors as far as equities are concerned stems from the fact that earnings visibility is relatively stronger compared to domestic pharma companies. Unlike Indian peers, risks regarding R&D is also absent. However, while MNCs, in general, bring in a culture of professionalism, there have also been instances of Indian shareholders getting an unfair deal when these very MNCs delist from the domestic stock exchange or when they are taken over by another company (like Digital-HP and Kodak to name a few). In this article, we shall understand the various factors that should be borne in mind while investing in an MNC pharma stock.

Consider various revenue streams for an MNC pharma company first. A global pharma company establishes an Indian subsidiary with an intention of taking advantage of the huge potential that the Indian market holds in view of its large population and growing health awareness. Hence, it derives a major portion of its revenues from the domestic market. The company's revenues from the domestic market are influenced by various factors that are briefly discussed in the following paragraphs.

The most important aspect that influences an MNC pharma company's revenues from the domestic market is its parent's outlook and strategy for India. The parent's view on the growth prospects of the domestic pharma industry which is influenced by factors such as rate of growth of population, per capita medical expenditure and health insurance infrastructure in the country. It is pertinent to understand that global pharma major, as the name itself suggests, have a worldwide presence. So, the parent will focus on those subsidiaries that could make a meaningful contribution in the long term. Though the contribution could be even less than 1%, consider the rate of growth of the Indian subsidiary with the parent company's growth in revenues.

One of the ways in which parent's commitment towards the Indian company can be evaluated is by calculating the contribution the Indian arm makes to the topline and the bottomline of the parent. This will help us know the relative importance the Indian subsidiary holds for the parent. Another aspect that needs to be looked into is the core segment-wise product profile of the parent. We must compare the Indian arms therapeutic break-up with that of the parent. Here, one should check whether the Indian arm has a similar therapeutic break-up as compared to its parent. The higher the resemblance, the better it is for the Indian subsidiary. This also suggests that the parent major is keen on the Indian market.

This apart, the parent's R&D pipeline should also be looked into. This will help us know the prospective launches in the future. The Indian arm could benefit immensely.

Further, an investor should also keep in mind that the global pharma industry is consolidating. If the existing parent is acquired by another global major (like Pfizer and Pharmacia), it will have a direct influence on the Indian arm. It could dilute the importance of the Indian arm or result in an unfair deal for the domestic shareholders. Given the fact that Indian subsidiaries market capitalisation is miniscule as compared to the parent's market cap, the parent may be tempted to buyback and delist it from the Indian stock markets. There have been numerous instance of this kind in the past and retail shareholders have no option but to participate in the buyback/delisting.

Finally, a very important aspect that needs to be looked into while evaluating the MNC's parent is the existence of parent's 100% subsidiary in India. In such an instance, what if the parent launches new products through the other 100% subsidiary and not through the listed entity? Shareholders will lose out significantly in the long term.

Once, we have made a detailed study on the parent, the next aspect that could affect the company's revenues is the therapeutic segment in which it operates. If the company generates a major portion of its revenues from the high margin lifestyle segments like diabetes, cancer and asthma as compared to low margin traditional therapeutic segments like anti-infectives and anti-biotics, obviously, the growth prospects and margins of the company will be higher.

Revenues in the domestic market are also influenced by the prices fixed by the regulatory bodies like the DPCO and NPPA. These organizations fix very low ceiling prices for bulk drugs and formulations, thereby limiting pricing power. Although, powers of these bodies is expected to reduce tremendously with the introduction of product patents, there is an apprehension that they might survive in some form even after product patents are implemented.

A company's product portfolio age is also a crucial factor that affects the company's growth prospects. As a drug matures, its volumes decline. Thus, a company with a relatively older product portfolio is likely to witness slower growth rates as compared to a company that makes aggressive new product launches. Moreover, aggressive new product launches also demonstrates parent's commitment towards the Indian arm.

Outsourcing is the second avenue of revenue available for an MNC pharma company. Here, the company can either manufacture its parent's patented drugs or act as an R&D base. An MNC pharma company can utilize the lowest cost manufacturing ability of the Indian subsidiary for drugs sold globally. However, to get such manufacturing contracts, the Indian arm will have to prove its cost effectiveness not only in comparison to its fellow subsidiaries but also Indian companies specializing in the same. This apart, the demand for the parent's product is another key factor that could influence the flow of revenues from this avenue. MNC pharma companies could also act as an R&D base for its parents. This is in view of the fact that highly skilled scientist and research personnel are available in India at a relatively lower cost as compared to other countries. Moreover, they could also act as a clinical research center for the parent given the availability of large number of patients with ethnic diversity at a much lower cost.

Key parameters to be kept in mind while investing in an MNC pharma stock:

  • Relative importance of Indian arm to the parent: As was mentioned earlier, Indian arm's topline and bottomline as a percentage of the global revenues and profits of the parent should be calculated. This will give us an idea about the relative importance of the Indian arm to the parent.

  • Parent's R&D expenditure as a percentage of sales: In a regulated market, new drug discovery research and product launches are key to a global pharma company's survival. Aggressive new product launches can only be made if the company is committed towards making R&D investments. This can be numerically measured by calculating the parent's R&D expenditure as a percentage of its sales. The higher this ratio, the more committed the company is towards its R&D initiatives.

  • Advertising and sales promotion expenses as a percentage of sales: In the domestic market, an MNC pharma company has to compete with generics manufacturers who sell drugs at a much lower price as compared to the MNC. Hence, to justify its premium price, an MNC pharma company has to undertake nation-wide product awareness programs and also conduct seminars and conferences. Although these initiatives eat into the company's margins, they are essential in the long term.

  • Market capitalization to sales: This is a very important ratio while analyzing an MNC pharma company, as it will give us an idea about the market's perception of the company's brand value. Higher the ratio, bigger the company's brand.

  • Other parameters: Apart from the above ratios, the usual ratios like operating profit margin, net profit margin and P/E ratio should also be considered before investing in an MNC pharma stock. As far as price to earnings is concerned for an MNC pharma major, better earnings visibility (provided the parent is committed) and access to the parent's global expertise could result in a premium valuation compared to domestic pharma majors.

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