Pharmaceuticals – Positive : Daiwa

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Sector thesis: positive bias toward companies focusing on the
domestic business
We have a Positive rating on the India Pharmaceuticals Sector, due mainly to our
forecast for sales for the India formulation market to expand by 12-14% annually
over the next three years. We prefer the companies that derive a high proportion of
sales from India and other EMs, and believe that the rich valuations enjoyed by
companies focused on the US and Europe markets are unsustainable. We favour
companies with business models that deliver stable revenue growth and do not
pursue high sales growth at the expense of EBITDA margins. We are also positive
on the contract research and manufacturing (CRAMS) market, due to increasing
demand for outsourcing by innovators. Innovators prefer to spread their contracts,
thereby managing the risks of failure by any one CRAMS company. Hence, we
believe that investing in a number of CRAMS stocks would be more rewarding
than investing in just one. A long-term approach to investing is desirable for
CRAMS stocks, in our view, as it should allow investors to benefit from PER
re-ratings during the companies’ high earnings-growth phases.


Over the past six years, revenue-growth rates for the industry in the India market
have been far higher than those for the US market, as have operating-profit margins.
Increasing competition in the US market has led to the generics market shrinking in
value terms, whereas we forecast sales for the India market to increase by 12-14%
annually over the next three years. We prefer businesses that have a strong focus
on profitability, coupled with sales-driven models that can boost profitability and
increase leverage. Stable sales and profitability are vital for a strong defensive
stock. However, sales driven by the probability of ‘at-risk launches’, and/or nonrecurring
and uncertain revenue can improve the short-term outlook, but also
increase the volatility for EBITDA margins. An increasing reliance on such
uncertain profit may have a negative effect on the defensive nature of the stocks.
While PBRs and ROEs effectively reflect the premium for profitability, PER
valuations in the generics space reflect the quality of the business, in our view. We
believe that PER bands will continue to be the best valuation method for a long
time to come.
Over the past few years, fewer new molecular entities (NME) have been approved,
reducing the R&D productivity of innovator companies. Hence, the pressure on
innovators to cut costs is greater now than it was five years ago. With their strong
process-chemistry skills, high regulatory standards and low manufacturing costs,
we believe India’s CRAMS companies should continue to receive substantial
outsourcing contracts. Before the global financial crisis, most innovators had about
12 months of inventory, but this stands at around less than six months currently.
This has affected the sales of the Indian CRAMS companies. We see this as an
opportunity to invest in the India CRAMS stocks, as we expect sales to normalise
over the next one-to-two quarters. Innovators prefer to spread their contracts,
thereby managing the risks of failure by any one CRAMS company.
Structural outlook: three-year view
We are positive on the companies that derive a high proportion of sales from India
and other EMs, and believe the rich valuations enjoyed by companies focused on
the US and Europe markets are unsustainable. As an increasing number of patents
are set to expire over the next three years, this is likely to lead to generics securing
a larger share of the prescription market. However, we believe that competition
after that in the generics market will increase, and lead to further price erosion.



Best-positioned: GlaxoSmithKline Pharmaceuticals
GlaxoSmithKline Pharmaceuticals (Glaxo) is the market leader in most of the
therapeutic categories in which it operates, and is ranked among the top Indian
pharmaceutical companies in terms of market share. Vaccine sales comprised about
10-11% of its total sales for 2009, up from 6% for 2007. We expect vaccine sales
to accelerate due to the under-penetrated nature of the market. Anti-infectives and
dermatology sales contributed about 33% and 12%, respectively, of Glaxo’s 2009
pharmaceutical sales. We expect Glaxo’s leadership position in the Indian
dermatology segment to be strengthened by the acquisition of Stiefel Laboratories
(Not listed). Glaxo’s coverage spans therapeutic areas, such as anti-infectives,
dermatology, gynaecology, diabetes, and oncology.
Over the next three years, we forecast Glaxo’s sales to increase in line with the
sales-growth rate we expect for the overall India pharmaceutical market. We
believe the company’s EBITDA margin should remain around 35% over the next
few years, as it plans to launch newer patented products and vaccines in India.

Worst-positioned: Piramal Healthcare
After selling its healthcare-solutions business (domestic formulations) to Abbott
(ABT US, US$52.81, 2) on 21 May 2010 and the pathlabs business to Super
Religare Laboratories (SRL) (Not listed) on 14 July 2010, we believe the company
is in a strong cash position, but believe its remaining business are weak. Piramal
said it will decide how to utilise the cash received from the sales of the domesticpharma
and pathlabs businesses at the end of the September quarter. The company
guides for its FY11 pharma-solutions sales to be flat on a year-on-year basis. We
expect the performance of the pharma-solutions business to improve in 2H FY11.