Why mid-cap pharma is looking better

With the Big Three domestic pharma companies losing steam, market interest shifted to mid-cap pharma stocks this year. But, as always, there is a gap between promise and reality.

The news is apparently not too good for big Indian pharma companies. With the recent spate of negative news - the failure of R&D molecules that were in advanced stages of development (Ranbaxy, Dr Reddy's Laboratories), increasing competition, price erosion in generic drugs in international markets and comparatively rich stock market valuations - equity analysts are not gung-ho about the big three in domestic pharma, which includes Cipla apart from Ranbaxy and Dr Reddy's.

Is it, therefore, time to shift focus to mid-caps such as Cadila Healthcare, Divi's Laboratories, Shasun Chemicals and Vimta Laboratories?

With many players in the mid-cap segment gearing themselves up for the expected gold rush in the outsourcing and contract-research and manufacturing services (CRAMS) space, analysts are betting on them for future growth in the pharma sector.

Add the prospects of bigger business in the international generic markets after the change in the patent regime come 2005, and mid-cap pharma stocks focused on CRAMS look set to generate decent returns in the long run, say analysts.

"The long-term fundamentals of these (mid-cap) companies are good. If you hold these stocks for the longer term they could provide you with decent returns. Having said that, I do not expect much price appreciation in the short-term," notes Tejas Doshi, head of research at Sushil Finance Consultants.

The markets are already reflecting this shift in preferences. Mid-cap pharma stocks have been running ahead of their large-cap peers. While Ranbaxy's shares have risen only 8.40 per cent from November 3, 2003, (Rs 1,124.30 as on November 30) on the BSE, Dr Reddy's has seen a decline of 39.40 per cent to Rs 793.95. 
 

Outsourcing plays are set to gain from industry growth
Large-cap	Price as on Nov 30, 04 (Rs)	Price as on Dec 1, 03 (Rs)	% Change	EPS FY05E (Rs)	P/E FY05E
Ranbaxy	1124.30	1037.15	8.40	43.60	25.30
Dr Reddy's Laboratories	793.95	1310.20	-39.40	30.10	25.50
Cipla	277.45	247.76	11.98	12.70	23.60
Sun Pharmaceuticals	495.50	307.12	61.34	19.50	22.30
Wockhardt	326.25	215.23	51.58	16.10	21.40
Mid-cap
Cadila Healthcare	511.70	382.80	33.67	27.80	19.40
Divi's Laboratories	1160.10	1093.45	6.10	19.90	19.90
Shasun Chemicals	394.70	394.60	0.03	33.50	14.00
Vimta Laboratories	593.60	184.05	222.52	42.80	14.00
Dishman Pharmaceuticals	567.25	542.00	4.66*	33.20	15.80
* Since listing on April 22, 2004

Compare this to the rise in the stock prices of Cadila Healthcare (33.67 per cent at Rs 511.70) and Vimta Laboratories (222.52 per cent at Rs 593.60). Barring for a correction in mid-November, the stock prices of Divi's Laboratories and Shasun Chemicals also would have put the big stocks to shade. Starting from November 3, 2003, Divi's Labs stock has appreciated by 31.26 per cent to Rs 1,160.09, whereas Shasun Chemicals has risen by 25.10 per cent to Rs 394.70.

The underlying theme running through these stocks is outsourcing and CRAMS. All of them do contract jobs on behalf of international companies. The reason is simple. With international competition heightening, pharma companies worldwide are seeking to reduce production and research costs. Indian companies, with their strong chemical engineering capabilities and low costs, offer these advantages. But they are not there yet.

According to Doshi, while the long-term prospects of outsourcing and contract manufacturing are very good, one cannot expect miracles in the short term. A lot will depend on how mid-cap companies adopt to the change in the patent regime from next year, when India will start protecting global product patents rather than just process patents as earlier.

"A big factor will be the comfort levels enjoyed by MNCs with the Indian firms who are into contract manufacturing and research. If we provide the right environment and legal systems for redressal (of patent infringements), MNCs will look at India more favourably."

So are the Indian firms ready to hit big time come 2005? Doshi doesn't think so. "Growth is not expected to happen very fast," says he. "My estimate is that it will take one to three years for Indian companies to start benefiting from the outsourcing and CRAMS segment."

The CRAMS opportunity
But nobody's denying the potential. "The opportunity in CRAMS is huge," says Prashant Nair, analyst at Motilal Oswal Securities. The global R&D spend of MNCs is estimated to be around $50 billion annually. With Indian companies offering research services at less than one-fifth the cost, the economic logic for moving a part of the R&D work now done in the West is unassailable.

But what MNCs will be watching for is how national governments help them protect their intellectual property rights (IPR). If the legal and political environment for IPR protection is seen as acceptable post-2005, MNCs will definitely move research jobs offshore to India due to cost advantages.

According to one estimate, the global outsourcing opportunity in pharmaceuticals, including CRAMS, is expected to cross $65 billion by 2005 from under $40 billion in 2000. The pressures on global pharma companies to outsource are growing for three reasons.

One, an ageing population in the West is straining healthcare budgets almost everywhere. Most US and European governments are thus looking for cheaper generics and lower cost drugs. Two, with new drugs becoming more difficult to develop, pharma companies cannot sustain large R&D spending unless new blockbusters are developed cheaper.

And three, a large number of blockbuster drugs - currently accounting for an estimated annual sales of around $80 billion - is set to go off-patent over the next five years. Unless new blockbusters are quickly developed to replace them, most pharma companies will start seeing slimmer margins and toplines after 2010.

This is where Indian outsourcing and CRAMS fit into the global picture. The size of the opportunity can be gauged from the fact that in the clinical research space, India's share is only 0.6 per cent of the overall global pie, which is above $10 billion.

"India has barely scratched the surface of the outsourcing opportunity. A conservative 8-10 per cent share of global contract manufacturing will more than double India's pharmaceutical exports," says Shahina Mukadam, senior research analyst at HDFC Securities.

According to Mukadam, India is already on the map of innovator MNCs as a preferred source for contract manufacturing.

"But on account of the extensive time necessary for audits and crystallisation of orders, only a few contracts have been signed to date."

According to estimates, the total size of these contracts is less than $150 million, which is a fraction of the existing opportunity.

While CRAMS is yet to take off in a big way in India, analysts expect this segment to emerge as a key future growth driver. "Overall, the CRAMS segment is expected to grow at 41 per cent during FY05-06," notes Sarabjit Kour Nangra, analyst with domestic brokerage Angel Broking in a recent report.

While mid-caps focusing on this segment are expected to ride the boom, their growth will also be decided by further product launches in the US, apart from strong alliances with international partners and their ability to scale up research capabilities.

"Since the theme is relatively new - there are very few companies with a long track record, and most others have no track record at all - it is an open question who will succeed in the long run and who will not," notes Nair.

As per Nangra's estimates, the mid-cap segment currently trades at 11.8 times FY06's estimated earnings as opposed to the average FY06 price-earnings multiple of 17.6 for the bigger players. As for the FY05, the average P/E for the outsourcing and CRAMS segment is estimated at 16.3 as compared to 21.3 for large-cap companies.

Even so, analysts have doubts about the future. "I don't agree with the view that valuations in this segment are more attractive than the large-cap segment. In most cases, prices have already run up high and seem to have factored in the opportunities to an extent. While these firms are smaller in size, and therefore have the potential to post higher sales and profits growth compared to large-caps, the same cannot be said for stock price returns. It has to be kept in mind that these firms carry a much higher risk," says Nair.

"The potential to generate returns is definitely there for mid-cap pharma companies, considering the opportunities in the outsourcing and CRAMS segment. The fact they are entering into long-term contracts should ensure a steady flow of revenues. So in that sense, their growth is more predictable," says Mukadam.

The Smart Investor spoke to analysts about the prospects of some mid-cap pharma stocks. Here's a summary of what they had to say.

Divi's Laboratories
Divi's Laboratories is one of the foremost players in the contract-research space. It is working with the top five global pharmaceutical firms. The current pipeline of the company consists of 60 molecules, which are under various stages of research. Overall, the segment currently contributes around 27 per cent of the overall sales of the company and is expected to grow further.

Analysts estimate a 26 per cent growth in this segment during FY04-06. Going forward, commercialisation of molecules would be a key growth driver for the company. Nangra pegs the company's FY05 and FY06 valuations at 19x and 14x respectively with a long-term price target of Rs 1,785.

Shasun Chemicals & Drugs
Shasun Chemicals was one of the early entrants into the contract-manufacturing space and is gearing to move up the value chain. Currently it has tie-ups with innovative companies like GSK Pharma, Eli Lilly, Boots and Reliant Pharma for contract manufacturing, with almost 85 per cent of its sales coming from direct sales to these companies.

The CRAMS segment contributed around 8 per cent of its overall sales in FY04. According to analysts' estimates, this percentage is expected to move up to 25 per cent of overall sales by FY06E. Analysts peg a P/E of 14x for FY05E and 9.8x for FY06 earnings estimates. The strong growth in the CRAMS segment and new product launches in the US markets are expected to improve the stock price going forward.

Dishman Pharmaceuticals
Dishman is a pure contract-manufacturing player. The company bagged its first contract for developing bulk drug Eprosartan Meslyate and its key intermediates for Solvay's anti-hypertensive drug Teveten. This is expected to be a key growth driver for the company in the near term.

According to analysts, the contribution from Solvay in the company's overall sales mix is expected to increase from 34 per cent in FY04 to 47 per cent in FY06. To reduce its dependence on a single client, the company is in talks with other MNCs for future tie-ups.

Besides, it enjoys a leadership position in India in the QUATS (quaternary ammonium salts) segment and is also among the top players in this segment globally.

The company's sales and net profit are estimated to grow at compounded annual growth rates (CAGRs) of 32 per cent and 80 per cent respectively during FY04-06. Nangra has put a 12-month price target of Rs 620 on the stock which currently rules at Rs 570 levels.

Vimta Laboratories
Vimta Labs is the only player in the niche area of contract research (CR). The company conducts bio-equivalence/bio-availability (BA/BE) studies for global generic majors and Indian pharma companies and has the expertise for phase I, II, III and IV clinical trials. CR is a Rs 430-crore market in the country and is estimated to be growing at 30 per cent per annum.

The company, whose clients include six Fortune 500 companies and three of the world's top generic development firms, is expected to post a topline growth of 80 per cent in FY05, compared to Rs 35.11 crore in FY04. The fact that the company has no competitors in the listed category and no domestic firm has a similar business model gives it an easy entry into analysts' good books.

The stock has been on a no-holds-barred rise in the past year (320 per cent) and quotes at a P/E of 16.9x. The downsides are any adverse news flow on its human trials during CR, apart from the possibility of key clients getting into CR themselves instead of outsourcing.

Cadila Healthcare
According to analysts, Cadia Healthcare's joint venture with Altana Pharmaceuticals for contract manufacturing (manufacturing intermediaries for Panatprazole) is currently the most profitable one among Indian companies.

The venture contributes around 26 per cent of the overall exports of the company and has operating margins of around 81 per cent. Though this tie-up is the only one for the company right now, the patent expiry of Panatprazole by 2009 and 2010 in Europe and US respectively is expected to augur well for the future. Apart from contract manufacturing, exports to regulated markets are also a key growth driver.

The company's French subsidiary (acquired from Altana Pharma) is expected to contribute significantly to the overall profitability from FY07 onwards. The stock trades at a P/E of 25.6. Going forward, Nangra expects the scrip to trade at 19.4x FY05E and 14.5 FY06E and pegs a price target of Rs 750 by March 2006.

CRAMS - The key segments

Generics
Contract manufacturing comprises manufacturing intermediates and active pharmaceutical ingredients (API) for NCEs (new chemical entities) and the generic segment (drugs sold without patent protection).

Estimated to be a $15-billion industry in 2001, the market is expected to touch $27 billion by 2010, led by increased outsourcing and a large number of drugs going off-patent.

The international generic market is estimated to have grown by 20 per cent (compared to the 12 per cent growth in the branded segment) in 2003 and currently is worth around $35 billion. This market is estimated to reach $80 billion in 2008.

India, with its cost advantages, large number of US Food & Drugs Administration (USFDA)-approved manufacturing facilities and chemical skills, is likely to hugely benefit from the growth in this segment.

Patent drugs
Though growth in the patent drugs segment is slow, it is expected to pick up after the change in the Indian patent regime. During the initial phase, analysts expect contract manufacturing activities to remain restricted to the later stages of patent drugs development or segments with high dosage requirements and competitive pressures.

Intermediates for NCEs
The rise of generics and declining R&D productivity are forcing drug manufacturing companies to outsource a part (intermediates) of their manufacturing activities. This will allow them to concentrate on drug discovery, development and marketing and distribution.

The opportunity for Indian companies lies in working with innovator companies in the custom synthesis segment (for manufacturing intermediates and bulk drugs that are at various stages of research).

The long lead time in this segment and high exit barriers for innovator companies (it is difficult to change suppliers quickly in view of the high costs and lengthy FDA approval processes) work in favour of Indian companies.

Contract research outsourcing
Contract research outsourcing can be broadly classified as clinical research outsourcing and drug discovery research outsourcing. The high costs of R&D abroad coupled with the fact that many drugs are going off patent are forcing MNCs to increase their product pipelines and reduce the overall 'time to market'. The R&D outsourcing segment has been on the rise in the past decade.

According to one estimate, the segment has been growing at a CAGR of 16 per cent vis-à-vis a 10 per cent in overall R&D expenditure during the last seven years. Of the overall contract research outsourcing segment, the clinical research outsourcing segment (CRO) is expected to reach $14.40 billion by 2007, while the drug discovery segment is expected to touch $6 billion.

A host of MNCs and CROs is expected to set up base in India or look out for collaborative partnerships with Indian companies in this space going forward. Their case is simple. The overall cost of basic research in India is estimated to be lower by 40-50 per cent in comparison to the global trends.

"As of now, the opportunity for CRO from India is still to evolve. India becoming IPR compliant in January 2005, could act as a catalyst," says Mukadam.