Consumption-Driven Sectors: Domestic Demand to Support Stable Outlook; Focus on Product Innovation to Rise

Robust domestic demand is likely to compensate for slowing exports and support stable outlook for large consumption-driven sectors (auto and pharmaceutical) in FY19, says India Ratings and Research (Ind-Ra). Ind-Ra has continued to maintain a stable outlook for the auto and pharmaceutical sectors for FY19.

Ind-Ra expects favourable demographics and inflation mix to boost private final consumption expenditure and drive a broad-based, healthy recovery in domestic demand in FY19 (FY19: A Year of Upside). In view of this, the agency expects steady volume growth in the passenger vehicle and two-wheeler segments. The light commercial vehicle segment, the majority of demand for which is from last-mile connectivity, is likely to benefit from increased demand in e-retail, FMCG and other consumer segments. Growing health awareness and the government's focus to expand access to formal healthcare is likely to sustain brisk growth in the domestic pharmaceutical market.

Focus on Product Innovation to Increase: Intensifying competition, shifting customer preferences and tightening regulatory expectations continue to drive companies in the auto and pharmaceutical sectors towards product innovation. The transition from Bharat Stage-IV to Bharat Stage-VI is likely to keep many auto manufacturers focused on the development of new cost-effective technologies. The eventual launch of electric vehicles will lead to a paradigm shift in product development for auto manufacturers in the medium to long term.

Stiff competition in commoditised oral solid drugs, especially in the US generic drug market, has led to an increased focus on the development more complex difficult-to-manufacture generic or specialty drugs by several large Indian pharmaceutical firms.

Auto and pharmaceutical companies are the leading spenders on R&D. Ind-Ra expects R&D expenditure in the auto and pharmaceutical sectors to remain high and put pressure on margins in the near term. However, it augurs well for the medium-term prospects of these sectors.

Free Cash Flows to Remain Stretched: The need to continuously augment product development capabilities is likely to lead to active inorganic growth initiatives. Unlike pharmaceutical firms that have demonstrated strategic preference to the inorganic growth route, auto companies have mostly relied on organic growth strategies. Ind-Ra expects M&As to pick up in the auto space in the medium term, as a large portion of product development breakthroughs in the electric vehicle space is currently being made by small or non-auto companies. Pharmaceutical firms are likely to continue targeted acquisition to acquire product capabilities or enter new markets. Free cash flow generation of auto and pharmaceutical companies is likely to come under pressure.

Stable Rating Outlook: The majority of large issuers from the auto and pharmaceutical sectors have low leveraged balance sheets. Hence, such issuers are capable of absorbing moderate free cash flow shocks. In FY17, net leverage levels of large issuers marginally increased owing to large debt-funded investments and subdued profitability. Ind-Ra expects the rating headroom for its rated entities from the auto and pharmaceutical sectors to remain mostly stable in FY19 on account of strong operating cash flow generation and comfortable credit metrics.

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