Pharmaceuticals - The Going Gets Tough; Sector Update :: Edelweiss

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Sector’s earnings panned out exactly as we had highlighted in our Q3FY15 preview note and were impacted by: (a) approvals slowdown; and (b) emerging markets (EM) headwinds. Earnings downgrades (Chart 8) too put in an appearance after long. We believe these issues will continue to pose challenges in the near term (more for mid caps) and if they do not subside, the sector’s premium valuations could be at risk. As companies are eyeing growth, FY16 will be characterised by M&A. Our long-term view on the sector remains positive and have ‘BUY’ on 70% of our coverage companies. We continue to prefer large caps over mid caps as we believe latter’s valuations and growth estimates do not factor in emerging risks. We prefer players with potential to spring positive earnings surprise-Cipla and Sun Pharma (SUNP) among large caps, and Cadila (CDH) among mid caps.

ANDA approvals: Fingers crossed, but no light at end of tunnel

Slowdown in ANDA approvals is a reality, but companies remain “hopeful” of USFDA faring better on this front in the future. As highlighted recently (research), we believe review cycle for approvals will not improve soon (Chart 11) and could significantly hurt the sector’s growth. Given most companies have Form 483s, further USFDA action is unpredictable and may/may not delay approvals. Mid caps are more dependent on approvals for growth and their less mature / less niche filings lend more uncertainty.

EM currency headwinds: Vital dent; mid caps to hurt more

We had anticipated EM currency headwinds, but the impact has far exceeded our estimates. In Q3FY15, gross margins remained stable, but EBITDA margins plummeted; mid caps bore the brunt more than large caps. EM currencies continue to slip and high combined exposure to non-US / India (Table 3) are bound to take a toll.    

Inorganic moves: Potent imperative

Most pharma companies are looking to raise funds given the buoyancy in the economy and easy availability of funds. Large caps may resort to acquisitions in their tryst to gain “specialty company” badge, whereas mid caps may need to plug geographical gaps and sub scale portfolios. Though the overall sector’s balance sheet is healthy, mid caps are laden with debt (>INR90bn net debt; net D/E~0.3-1.0x in FY15E) and any large / unrelated acquisitions / fund raising will act as an overhang. 

LINK
https://www.edelweiss.in/research/Pharmaceuticals--The-Going-Gets-Tough;-Sector-Update/28486.html