Pharma: Go with the globe-trotters

After an eight-month hiatus, pharma stocks are back in action. The BSE Healthcare Index has been the top sector performer since the Narendra Modi Government took over, gaining over 35 per cent since May.

Stock prices were propelled by robust financials in the June quarter — aggregate revenue and profit of the 17 companies in the BSE Healthcare Index grew 28 and 31 per cent, respectively. The index has, in fact, jumped three-fold in the last five years, even as the Sensex gained 70 per cent in this period. The aggregate profits of companies constituting the BSE Healthcare Index have risen at 23 per cent annually since 2008-09, faster than the 14 per cent profit growth for Sensex companies.

Given the stellar rally in the last five years, is there more steam left in pharma stocks? Certainly. But given the challenges on the regulatory, pricing and business fronts, here’s how you should go about selecting the stocks for your portfolio.

If you’re looking for pharma companies with good growth prospects, select the ones with some exposure to the overseas market. Yes, the home market used to be the best bet a couple of years ago, but that has changed now, with the Indian drug pricing regulator, the National Pharma Pricing Authority (NPPA), cracking the whip on drug makers.

India being a branded generics market, pharma companies were earlier given a free hand to fix the prices of drugs not covered under the National List of Essential Medicines (NLEM).

Taking advantage of this, drug makers were charging fancy prices for these drug formulations. In many cases, the price differential between the cheapest and the expensive brand was as high as 14-15 times.

A key reason for this was that multinationals continued to charge stiff premiums for their new drugs even after these molecules lost patent protection.

Sample this. AstraZeneca’s Crestor brand (rosuvastatin), used to manage cholesterol, costs six times more than the cheapest brand. Amaryl, which is Sanofi’s glimepiride brand used to treat diabetes, retails at a price that is almost eight times higher than its cheapest alternative. Likewise, Boehringer Ingelheim’s hypertension drug brand Micardis (Telmisartan) is priced 14 times higher than the cheapest brand. Multinationals were thus pocketing huge profits on their innovative drug brands.

To address this anomaly and make these drugs affordable, the NPPA has imposed price curbs on 108 drug formulations used to treat diabetes and cardio-vascular disorders. The maximum price that can be charged on these drug formulations has now been capped at 125 per cent of the simple average price of all brands in the respective molecule category. The key molecules that have now been brought under the price scanner include anti-diabetic drugs such as glimepiride, gliclazide, sitagliptin and pioglitazone and blood pressure lowering drugs such as atenolol, amlodipine, telmisartan and olmesartan. And this is just the beginning.

The NPPA aims to eventually make drugs used to treat diseases such as cancer, malaria, asthma and tuberculosis, as well as vaccines, more affordable. It can now restrict the selling price for any drug, if it finds prices to be unreasonable and irrational.

Though the regulatory direction may be negative for pharma companies, it may not hurt all drug makers alike. For instance, companies such as Sun Pharma, Cadila Pharma, Lupin and Dr Reddy’s Labs, which have reduced their dependence on the domestic market by expanding into other geographies, may see little impact from these moves. The revenue loss for these companies is expected to be a meagre 1-2 per cent.

Take Sun Pharma, for example. A strong product portfolio in the US and healthy growth in other emerging markets enabled the company grow its export sales by almost 35 per cent annually over the last five years. Even as new launches and market share gains in existing products aided growth, key acquisitions such as the Israel-based Taro Pharma and US based-URL Pharma also provided a leg-up to Sun’s export revenues. As a result, domestic revenues, which made up nearly half of Sun’s consolidated revenues five years back, now account for just a fourth. Its operating profit margin vaulted by almost 11 percentage points in the last five years to 44.7 per cent in 2013-14.

From 35 per cent in 2008-09, the India business now contributes to just 22 per cent of Lupin’s consolidated revenues. Strong growth in the US generics segment led by new launches and good show in South Africa have helped the company reduce dependence on India. Despite the fall in contribution from India, the company’s operating profit margin has improved from 17.2 per cent in 2008-09 to 26.6 per cent in 2013-14.

Likewise, higher sales from exclusive product opportunities in the US, coupled with healthy growth in other export markets such as Europe, South Africa and other emerging markets, have helped Cipla reduce dependence on its Indian operations. The company’s domestic sales as a proportion of consolidated revenues have fallen from 48 per cent in 2007-08 to 39 per cent currently. Cipla’s operating margin has increased by over 5 percentage points in the last five years to 21.1 per cent in 2013-14.

Similarly, Dr Reddy’s Indian operations account for less than a sixth of its total revenues now. This is unlike, say, five years back when domestic revenues accounted for over a fifth of its revenues. Sales ramp-up in key export markets such as the US, Russia and CIS led to a decline in contribution from the domestic market.

Dr Reddy’s operating margins have improved from 13.8 per cent in 2009-10 to 24.3 per cent in 2013-14.

Despite a fall in contribution from the India business, these companies have managed to improve their operating profit margin in the last five years. Though they aren’t completely immune to domestic price controls, the above companies are better placed to weather them for two reasons. First, they adopt a relatively benign pricing strategy, many of their brands are in the mid-range of the pricing band compared with their multinational peers. Second, these companies are improving their product portfolio in regulated markets such as the US by shifting focus towards niche products, which yield better margins. As a result, even at the profit level, the dependence on India will gradually decline. Also, the rupee’s weakness against the dollar can further perk up the profitability of these companies.

In contrast, the listed Indian arms of multinationals such as Sanofi, AstraZeneca, Pfizer and GSK Pharma, which derive a major chunk of their revenues from the local market, are most impacted by adverse pricing policy changes.

For instance, GSK Pharma, with domestic sales exceeding 99 per cent of the company’s total revenues, may see significant revenue and earnings impact should the Government expand the span of price control. In 2013, GSK reported 30 per cent decline in adjusted profit, post implementation of the new drug pricing policy. Its operating margin has shrunk from over 34 per cent in 2009 to about 20 per cent in 2013.

AstraZeneca’s Indian subsidiary is no exception. The British drug major’s listed Indian subsidiary, AstraZeneca India, derives over 90 per cent revenues from the local market. The company reported a loss of about ₹51 lakh last fiscal.

In addition to high dependence on the domestic market and changing regulatory environment, the premium pricing strategy pursued by most multinationals makes their profits far more vulnerable to any adverse pricing policy action, compared with their Indian counterparts.

The higher regulatory activism has also meant that companies with a more diversified product basket and a larger brand portfolio are better placed to succeed. Until recently, GlaxoSmithKline Pharmaceuticals derived over 10 per cent of its revenues from its top-selling brand Augmentin. Following the implementation of the new drug pricing policy in May 2013, the company had to cut Augmentin’s retail price by almost 30 per cent, leading to a steep fall in profits. Similarly, Sanofi India suffered sharp losses after the NPPA decided to curb prices of 108 non-NLEM formulations. Sanofi’s top brands such as Amaryl, Cetapin V and Clexane, which constitute almost 30 per cent of the company’s revenues, have now come under price control. This may likely impact the company’s profits by over 10 per cent. Likewise, AstraZeneca’s Indian subsidiary may likely see a 20 per cent revenue impact on account of the recent NPPA regulation.

Expanding out of India to developed markets has hardly been a cakewalk. As Indian companies expanded into highly regulated markets such as the US, ensuring regulatory compliance has proved a key challenge. For instance, companies supplying drugs to the US have to ensure that they meet the stringent quality requisites laid down by the drug regulator — the Food and Drug Administration (FDA).

While many Indian drug companies have received warning letters, some have also been temporarily banned from exporting to the US in the past.

But a few large companies have been successful in addressing regulatory issues. Consider Lupin; the company was able to resolve quality issues at its Mandideep facility (Madhya Pradesh) in just seven months from the receipt of the warning letter in May 2009.

Likewise, Sun Pharma was able to fix the regulatory issues at its manufacturing facility in New Jersey (Cranbury), US, in about a year. Cadila Healthcare was successful in achieving regulatory compliance at its facility located in Moraiyya, Gujarat, in about a year’s time. In contrast, Aurobindo Pharma, which was barred by the FDA in February 2011 after its laboratory staff destroyed contaminated microbial plate during a US FDA inspection, is not out of the woods completely yet. While the non-sterile products from this facility were allowed to be exported to the US after two years, in March 2013, the ban on sterile products from this facility is yet to be lifted.

Given that regulatory issues are not very easy to avert, resolving them at the earliest and bringing these plants back on track may be critical to sustain healthy growth. While it may be difficult to foresee such issues, companies which have had a track record of resolving regulatory issues in a timely manner may be preferred over the ones that have proved tardy on this score.

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