Prescription for recovery in FY23 for underperforming pharma sector

Easing pricing pressures, complex generics uptick in the US, steady India/emerging-market growth potential booster shots

The Nifty Pharma Index was the second-worst performer among Nifty sectoral indices over the past year, shedding over 13 per cent in trade. Over a two-year period, its underperformance has grown starker. It is the only index to generate a mid single-digit return (6 per cent), with its closest competitor enriching investors by over 35 per cent.

Pricing pressures in the US market, rising raw material costs, regulatory headwinds, uneven growth in multiple segments in the India market - both in the formulations and active pharmaceutical (pharma) ingredient segments - were some of the reasons investors kept their distance from drugmakers.

The results in the April-June quarter of 2022-23 have probably reinforced the growth worries for the sector. The US business, which accounts for 30-40 per cent of revenues for larger players, declined 4 per cent year-on-year (YoY). This, according to Axis Capital, was on account of price erosion and higher competition as was the case for Lupin and Cipla for their generic version of Brovana. The bronchodilator is used in treating chronic obstructive pulmonary disease. The India business growth, down by 2 per cent YoY, was impacted by a Covid-heavy base.

The bigger impact in the quarter for the sector was on the margin front. The operating profit margins in the quarter were down over 400-basis points YoY because of raw material pressures that weighed on gross margins, as well as higher operating costs.

Says research analyst Alka Katiyar of Centrum Research, “The quarter’s performance was largely weak for our coverage universe, resulting in a sharp margin contraction and an earnings degrowth. The performance was impacted by increased cost pressure on account of inflated raw material costs, freight costs, and increased operating expenses, leading to margin contraction.”  

What will compound the problems of generics majors, such as Sun Pharmaceutical Industries (Sun Pharma), Dr Reddy’s Laboratories (Dr Reddy’s), Zydus Healthcare, Lupin, Torrent Pharmaceuticals (Torrent Pharma), and Cipla, is the regulatory risk.

Say analysts, led by Tushar Manudhane, of Motilal Oswal Research, “The increasing number of official action initiated, or OAI (higher regulatory risk), citations during the pre-Covid phase, delay in inspections by the US drug regulator after implementation of remediation measures, and evolving requirements of compliance have raised the regulatory risks for Indian pharma companies. The prolonged period with OAI citations has delayed product approval from the respective sites.”

While some companies have chosen to file from an alternative site to derisk potential regulatory action, this results in lower utilisation and return ratios on such assets.

Given these worries and ongoing price erosion in the base portfolio, Motilal Oswal Research prefers companies in contract development and manufacturing segment such as Gland Pharma (niche portfolio, superior return ratios) and Laurus Labs (superior execution, contract development and manufacturing organisation capital expenditure) which have better compliance than their generics peers.

Other brokerages, however, believe there are multiple triggers going ahead turning the risk-reward for the underperforming pharma sector more favourable.

Analysts Vishal Manchanda and Bezad Deboo of Systematix Institutional Equities identify four triggers that underpin their positive outlook on the sector. These are easing inflationary pressures, lower price erosion in the US market, monetisation opportunities in complex generics, and secular growth potential in branded formulations.

The brokerage has a ‘buy’ on Sun Pharma, Cipla, Dr Reddy’s, Ajanta Pharma, and Indoco Remedies. The brokerage argues that companies with large US exposure are trading at a discount due to growing pressure on prices and uncertainty around execution and as a consequence could surprise on the upside as things turn around.

In addition to the US market, the Street is also bullish on prospects in the Indian market which posted its third consecutive month (in August) of healthy growth, led by price hikes. After Covid disruption, a majority of therapies have picked up pace with footfall in dermatology, ophthalmology, neurology, and gynaecology starting to pick up.

Anand Rathi Research has maintained its positive view on chronics-focused companies such as Ajanta Pharma, JB Chemicals & Pharmaceuticals, Eris Lifesciences, and Torrent Pharma.