The Indian pharmaceutical sector has been going through a rough patch over the last few years. While the Nifty 50 index has gained over 15 per cent in absolute terms since 2015, the Nifty pharma index has fallen nearly 33 per cent in the same period.
Regulatory issues in the US — a major market — and drug pricing concerns in other key markets have continued to weigh on the revenue and earnings of Indian pharma companies. This, in turn, has kept investor sentiment in pharma stocks muted, resulting in a significant fall in their share prices.
Most pharma players that focus on the US market have been hit hard during this period and are now trading at multi-year lows. The share prices of pharma majors such as Lupin Ltd, Sun Pharmaceutical Industries and Dr Reddy’s Laboratories have tumbled more than 45 per cent over the last two years. Though concerns persist, the sharp fall in stock prices provides a good buying opportunity.
Subdued Q1 results
June quarter (Q1 FY18) earnings for most players have been weak, and companies expect growth to remain subdued for the next couple of quarters. The sector’s performance was largely impacted by the drop in US sales and Goods and Services Tax-related de-stocking in the domestic market.
Muted US growth
The drop in US sales during the first quarter of 2017-18 was primarily attributed to the expiration of exclusivity of generic products such as Gleevec (Sun Pharma), Glumetza (Lupin) and Abilify (Torrent Pharma Limited). In the absence of large products to replace them and due to a lack of meaningful high-value launches, the sales growth in the US market was lower than usual.
Second, continued price erosion as a result of competitors opting for distribution channel consolidation hit Indian companies’ generics business in the US. Consolidation of buying groups (the top three players control 85-90 per cent of the market in the US) has applied continuous pressure on drug pricing for Indian companies. Increase in competition in the key drug segments due to a higher pace of approvals also put pressure on Indian players.
For instance, revenue from the US for Lupin, which accounts for about half the total revenue, has been shrinking over the last few quarters. The company has reported a sharp sequential decline of 16 per cent year-on-year (y-o-y) to ₹1,602 crore in Q1 FY18. Increased competitive intensity for Taro Pharmaceutical Industries, a subsidiary of Sun Pharma, pushed down its US revenue by 31 per cent y-o-y. Dr Reddy’s Labs — hit heavily by regulatory issues — reported a 4 per cent (y-o-y) decline in its US business to ₹1,495 crore.
However, some pharma companies braced themselves by diversifying their portfolios and foraying into high-margin, limited-competition complex generics. For instance, Aurobindo Pharma, which is gaining market share with new launches, especially in the injectables, oncology and other complex segments, reported a marginal decline of 0.5 per cent in its US business during the June quarter. Cipla, whose US business accounts for 18 per cent of its total revenues, registered a 2 per cent y-o-y growth, showing gradual improvement.
Regulatory hurdles
Increased scrutiny by the US drug regulator — Food and Drug Administration (USFDA) — remains a key challenge for Indian pharma companies. Dr Reddy’s Labs, Divi’s Laboratories and Wockhardt, to name a few, have been beaten down by Form 483 observations and warning letters issued by the USFDA for deviations from the Current Good Manufacturing Practice. Exports are not allowed until these issues are cleared, which is a major blow for these companies.
For instance, Dr Reddy’s plant in Duvvada, Srikakulam, in Andhra Pradesh; Sun Pharma’s Halol facility; and Wockhardt’s Ankleshwar plant are facing issues with the US regulators. Regulatory clearance will lead to a significant pick-up in business through new product approvals.
New launches
Though earnings are expected to be muted in the near term, most companies remain optimistic over the medium term and are expecting a strong recovery on the back of new launches. Around 30-35 new launches have been planned in the US over the next 12-18 months.
Lupin plans three to four first-to-file launches including Ranexa (treats chest pain), Moviprep (stimulates bowel movements), Moxeza (treats bacterial conjunctivitis) and Minocycline ER. Aurobindo Pharma has received USFDA approval for higher-margin Sevelamer Carbonate tablets, which is expected to contribute to over 7 per cent of the US sales of the company during FY18. Along with the launch of Lialda, with first-to-file opportunity in late FY18, Cadila Pharmaceuticals plans to launch six limited-competition products. A higher number of product approvals and launches will lead to a stronger business base in the US.
Improving domestic business
Domestic business witnessed a decline in the June quarter for most companies due to channel de-stocking ahead of GST implementation. The implementation of GST has impacted primary sales and profitability in the domestic market.
For instance, with a relatively domestic-heavy portfolio (around 36 per cent of its total sales), Cipla reported a 13 per cent decline (y-o-y) in its domestic business during the June quarter. Dr Reddy’s Lab registered a 10 per cent decline while Sun Pharma posted a 5 per cent decline in domestic business. Given its domestic portfolio, which is skewed towards the high-margin chronic segment and less impacted by GST, Lupin registered a flat growth in its India business. Lupin’s revenue from India stood at ₹932 crore during the June quarter.
Contracting operating margins
The operating profit of most companies in the June quarter contracted year-on-year due to lower gross margins, forex losses and base business erosion. Lupin’s operating margin narrowed down to 21 per cent during this quarter, slipping from 32 per cent seen in the same quarter last year. Operating profit of Dr Reddy’s Labs came in at ₹336 crore for the quarter, down by 16 per cent due to increasing employee costs and lower contribution from the domestic business. The EBITDA (earnings before interest, tax, depreciation and amortisation) margin for the quarter stood at 10 per cent, 12.3 per cent less than in the same quarter last year.
The EBITDA margin of Sun Pharma declined sharply to 11 per cent in the June quarter from 34 per cent in the same quarter last year, owing to lower gross margin, higher operation expenditure and negative operating leverage. However, Cipla’s operating margin came in at 18.3 per cent, 159 basis points higher than last year, because of a better gross margin during the quarter.
R&D spend
Given the fact that the longer-term opportunities are outcomes of research and development investments, the top pharma companies have increased their R&D spends significantly. A gradual shift in the composition of R&D costs is clearly visible, as companies such as Lupin and Cipla are focusing more on speciality generics in developed markets rather than their earlier strategy of geographical expansion.
In a recent earnings call, Lupin guided for lower R&D in view of cost control while rationalising its pipeline and getting a financial partner for its bio-similar development. R&D spend is conservative for Aurobindo Pharma and Cipla — around 5-6 per cent — while it accounted for 15.3 per cent of the sales for Dr Reddy’s Labs in FY18.