Pharmaceuticals- On a feverish pitch; ; Edelweiss PDF link

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Post a strong outperformance to broader market over the past three years (Jan 2009-Dec 2011), valuations in pharma stocks have now peaked and we believe that the risk-reward is turning unfavorable as beyond FY13, companies will face growth challenges for ~60%-65% of the business. While revenue growth may remain numb, earnings are likely to see a higher deceleration from margin pressures due to various operational and regulatory challenges in the US and India.

Large generic players are likely to face growth pressures from shrinking pipeline of patent expiries beyond CY12. Over 2012-20, drugs worth USD100bn are facing patent expiries in the US even though most of these opportunities are front-ended (45% will face generic competition during CY12-13). Thus, Indian companies could see a slowdown in US growth as contribution from new products decline and base business sees higher price erosion from intense competition. We also see higher pressure on margins due to a decline in blockbuster opportunities and deepening price erosion from higher competition in base business.  Further, with the implementation of generic drug user fees, far more stringent regulatory norms and higher focus on differentiated products which could result in upfront investments in R&D and capex, the industry’s fixed costs are likely to shoot up. Companies like Dr. Reddy’s and Ranbaxy who have attained higher scale could see strain on organic growth while companies with lower base and strong pipeline such as Lupin, Cadila and Glenmark will continue to exhibit double digit growth.

India geography is another key growth driver for companies because of higher profitability and superior return profile. Despite favorable macro trends, industry is facing multiple operational and regulatory headwinds which have started to impact profitability. We are also witnessing a decline in growth contribution from new launches. Thus, companies have started to look at Tier II/II markets for volume which along with rising competition from MNCs/regional players and higher customer acquisition cost will impact margins. Also, regulatory risks such as drug price control and free medicine distribution in government hospital have the potential to de-rate the sector as a whole as was the case in China where healthcare index has underperformed the broader market by 28% over the last 12 months.

On the back of these emerging trends, we expect a slower earnings growth of 13% CAGR during FY13-15E from 25-21% CAGR during FY06-11/FY11-13E, respectively. This along with higher asset base, owing to higher capital investments, will result in decline in ROEs.

Although we are cautious on the sector, select companies with robust pipeline, strong domestic franchise and earnings visibility could outperform the universe. Lupin and Glenmark emerge as our preferred bets. We are positive on Sun Pharma, however, current valuations do not leave much upside hence downgrade it from ‘BUY’ to ‘HOLD’. We are also downgrading Dr Reddy’s from ‘BUY’ to ‘HOLD’, owing to slower earnings traction beyond FY13. We maintain ‘HOLD’ rating on Cipla and Cadila and ‘REDUCE’ rating on Ranbaxy.   

Pharmaceuticals- On a feverish pitch; sector update

Regards,