 "Pharma packaging image via Shutterstock.")
The Indian pharmaceutical sector has some defining characteristics. Roughly 55 per cent of the turnover comes from export. There are a bunch of companies, with strong balance sheets. Pharma is considered a perennial sector, as demand might grow even in recessions. Most pharmaceutical companies have really high valuations - 50 times the price-to-earnings ratio (PE) is quite normal. One key reason for high PE valuations is strong foreign institutional investor interest in the sector. Foreign portfolio investors see Indian pharmaceutical as an area of steady growth. There have been quite a few mergers and acquisitions as well, which have driven up valuations.
Not all is rosy. The Indian pharmaceutical sector is often enmeshed in litigation abroad, especially in America, with complex cases involving nuances of intellectual property rights (IPRs). In the past couple of years, there have also been a sequence of adverse reports by the US Food and Drugs Administration, which inspects facilities that export drugs to America. The FDA has pointed to manufacturing deficiencies, issued warning letters and issued import alerts, meaning imports into the US from specific manufacturing units have been banned.
The FDA clearances are important, because roughly a quarter of Indian pharmaceutical export by value is to the US, the largest market in the world. At the same time, Indian pharmaceutical companies hold less than 10 per cent market share in the American generics drug market. So, there is scope for major expansion into that massive market. It is not that the FDA is inimical to Indian companies, despite its tough inspection schedules and advisories. Roughly a third of its new drug approvals in the calendar year have been for generic drugs marketed by Indian companies.
Of course, Indian companies are also interested in other markets. Europe is a highly regulated one. Africa has seen increasing interest from Indian drug makers, which have fought effective price wars in that continent. Indian companies can score as price warriors because the drugs are delivered extremely cheap. There are also good possibilities of growth in Latin America and in the former Soviet nations of central Asia and eastern Europe.
The National Stock Exchange's Pharma Index has a current PE of 58 and it returned a positive 2.5 per cent in the past year. This might not seem much but is a positive return during a period when the Nifty fell a little over seven per cent. Other things being equal, export profitability could rise in rupee terms if the dollar hardens, as it looks set to do. Of course, other things will never remain equal where so many variables are involved. For one thing, FDA action could be a cause of concern. There will also be inevitable litigation about IPRs. Also, the generics market is highly competitive with respect to price and that means thin margins. However, despite all these concerns, it is reasonable to hope that there will continue to be stable growth in revenue and in profits, for the industry as a whole.
It is worth noting that exports are often dollar-denominated, even when the importing nation uses another currency. Wherever exports are denominated in currencies other than rupees, there is currency risk. At this moment, it seems like the dollar should be strong for the medium term. But, the euro or the yen might depreciate against the rupee. Sometime or another, these currency relationships will change again and that will affect profitability parameters.
On the domestic front, there is a threat of more drugs being brought under price regulation. However, domestic drug consumption is very low in per capita terms and there are the usual arguments to suggest steady growth is also likely in the domestic markets.
The apparent safety and good track record is reflected in the high valuations all round. Many companies have also delivered very strong capital gains in the past couple of years. In reality, as mentioned above, there are significant risks. Companies are exposed to intellectual property cases, to stiff competition on the price front or both. The FDA's actions are hard to discount - share prices take a hammering whenever adverse FDA rulings are delivered.
On the other hand, the sector has consistently outperformed. The historical record suggests it could continue to generate double-digit annual revenue growth and profitability, at a time when most industries are struggling. A weaker rupee versus the dollar should be good. Pharma stocks might be worth buying. The investor could consider a shotgun approach, picking up holdings in several companies.
