Is pharma sector worth the bet?

Historically, it has been a huge outperformer over two decades

The pharma sector has been depressed for several years. One key reason for this is more stringent inspections by the US Food & Drug Administration (FDA) that has led to many Indian export facilities being debarred from exporting to the US. The FDA has a huge team doing Indian inspections and almost every pharma exporter has had problems passing the test.

Another reason has been patent disputes. For example, Dr Reddy's recently lost a key patent ruling when it was prohibited from selling gSuboxone in the US.  This is a permanent issue with pharma companies everywhere and it will continue. Figuring out when a drug comes off patent, and then making a cheaper generic format, has been a standard Indian tactic. 

A third issue has been the insistence of the Indian government on bringing a large number of drugs under price controls.  Changes in the Drug Price Control Orders (DPCO) will bring more and more drugs under pricing control. Domestic margins could be squeezed even further, if Amazon is entering the Indian retail market in a big way.

As a result of these trends, exports have been under pressure and domestic price realisation has been muted. In addition to these challenges, there have also been scandals. For example, there was the Ranbaxy affair where the courts ordered the former owners to pay huge sums to Daiichi Sankyo, for concealing key information.  Last month, the Enforcement Directorate attached the assets of Sterling Biotech for an alleged money-laundering and fraud. Surya Pharmaceuticals is another company under investigation for bank fraud.

On the positive side of the ledger, all the FDA inspections should have eventually resulted in better compliance with hygiene and quality standards. For example, Sun Pharma's Halol facility was cleared for US exports last month. Pharma companies are learning to cope better with FDA inspections.

Importantly, the industry earns forex, which means a boost to rupee-denominated balance sheets, given the current trends in forex movements.  Approximately half of the sector's earnings come in forex. The industry's export revenue potential has improved since China has recently decided to slash tariffs and open its vast domestic market to Indian generics. 

The stock market returns from pharma have been poor for several years. The Nifty Pharma Index has underperformed the Nifty substantially over the past five years. Taking the period since January 2013, the pharma index has a compounded annual growth rate (CAGR) of 7.6 per cent, while the Nifty has a CAGR of 11.5 per cent.

Taking the period of the past 36 months since August 2015, the returns have gone in opposite directions. Since August 2015, the pharma Index has lost 33 per cent (absolute) while the Nifty has gained 38 per cent (absolute).  In the past year, the pharma index has lost 11 per cent and it's lost 4.7 per cent in the past month.  The Nifty has gained 10.5 per cent and gained 1.6 per cent respectively. The correlation of returns is low, and it's been negative during several periods.

This lack of correlation could actually have advantages if the major market trend turns negative. A negative correlation suggests defensive values in a broad bear market.  In terms of absolute returns, the pharma index is still looking unattractive.

Valuations are interesting.  While the stock returns are negative due to price erosion, the price-to-earnings (PE) ratios have actually gone up, from around PE 47 in January to PE 51 in July. That indicates earnings have fallen even faster than the prices. This is very unusual in a non-cyclical industry.  PEs in this range are uncomfortable unless earnings are doubling every two or three years. 

The results this quarter will not reflect the China factor. However, the opening up of China could, in the long run, be a major booster shot. The US market may not be easily accessible anymore, but the worst may be over in the US, and China could help replace the lost US revenues to some extent.

Is the pharma sector worth a bet? The negatives are marked and the valuations are from outer space. But the sector is seen as a ‘perennial’ since it is largely immune to business cycles. Historically, it has been a big outperformer over two decades.  If the rupee falls more, investors are going to look for any businesses with overseas earnings visibility. That could lead to a re-rating for the industry, and for specific companies.