Pharma rally may lose steam as valuations factor in near term gains

Recovery in India business, traction in new launches in the US market are needed to sustain gains

The rally in the BSE Healthcare index may lose steam after gaining 76 per cent since March lows. Nearly a fifth of these gains came over the last month. The recent gains came on the back of June quarter numbers and expectations of steady earnings growth going ahead. 

While the outsized gains over the last five months look sharp, the same has come after a continuous streak of underperformance every year since CY16. Says Pankaj Murarka of Renaissance Investment Managers, “The rerating has happened on expectations that earnings growth will come back in FY21, the defensive nature of the sector and finally the ability to generate free cash flows while keeping leverage to a minimum.”

The near term trigger for the pharma space has been the June quarter results. Even as most sectors were struggling to cope with the lockdown and muted demand, the pharma sector fared much better. Led by Cipla and Divis, most pharma companies beat analyst estimates by a comfortable margin.

Motilal Oswal Research highlights that across sectors, healthcare and technology earnings stood out, both in absolute and relative terms. A common thread across most pharma companies has been the reduction in operating expenditure  and consequently higher operating leverage, which helped deliver higher profitability. The other factors that helped the sector were demand uptick in some markets and double digit growth in active pharmaceutical ingredients or API segment.

 

While some of the productivity-related gains are expected to sustain, there could be a spike in costs once the drug majors start their marketing efforts and the lockdown relaxations comeinto effect. However, for the rally to sustain, some of the structural factors which helped rerate the sector will need to kick in. 

Bansi Desai of HDFC Securities said, “While some of the triggers driving the pharma sector rally are captured in the price, further gains would depend on recovery in India and US businesses, continued growth momentum in APIs and ability to sustain operational gains achieved in the June quarter.”

The API segment is expected to do well given the policy thrust by the government, supply chain issues in China and rising export demand. Contract research and manufacturers such a Divis would be major beneficiaries given their capacities, execution and regulatory compliance.

One of the key factors for growth would be recovery in the domestic market which has been sluggish over the last four months. While analysts expect growth in FY21 to be in single digits (June quarter -6 per cent), a lot will depend on revival in the acute segment which accounts for two thirds of the market. Chronic segment and price increases have so far been able to offset the acute therapy weakness. 

For the US market, the traction from new launches, especially specialty products and regulatory compliance would be key drivers. While drug price erosion has now moderated to low single digits, any deterioration of the same from higher discounts could lead to margin pressures. The other worry is the impact of the four executive orders by Donald Trump, which are aimed at bringing down drug prices. 

Given the challenges, the rally could cool off as valuations are factoring in near term gains. Further, if there is an improvement in the Covid-19 situation, the sector could lose some of its defensive sector premium and cyclical stocks could see more demand.