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Pharma stocks including the likes of Lupin, Sun Pharma, Dr Reddy's saw a bit of a sell-off last week due to profit-booking and on concerns of premium valuations for the sector. While the sector’s price-to-earnings (PE) ratio has traded at a premium to the broader markets in the past, the premium has expanded further in this fiscal. From 41% in 2012, the premium to the Sensex, which had risen to 53% in September last year, has now crossed the 60% mark. While the sector benefited from the growth in the high-margin Indian formulation business and from strong presence in the US generics space during FY13 and FY14, the rupee depreciation of 11-14% added to the gains.
While the performance in the US has been one of the key mainstays of the sector’s strong show over the last several quarters, the laggard had been the domestic pharma space which contributes between 20-40% of revenues to top players. The domestic pharma space, which was impacted by new drug pricing norms and channel stocking issues, had been growing in single digits. This was the key monitorable that investors were looking at which would justify the premium valuations for the sector.
Aided by jump in volumes, the domestic pharma segment has been recording double digit growth rates off late. In February, the sector recorded a growth of 19% year-on-year, the highest in three years. Over 70% of the growth was led by volume gains aided by new product launches while the rest was due to price hikes. Given the strong volumes show, Surajit Pal of Prabhudas Lilladher expects the growth in the Rs 85,000 crore Indian pharmaceutical market to sustain in FY16.
Analysts expect growth in the US to also remain resilient going ahead. What will contribute to the same, according to analysts, is the higher realisations from new product launches and rising share of the limited-competition drugs leading to improved product-mix and margins. While adverse FDA outcome (for a few companies) could lead to stock correction, the risk to longer term valuations, according to J P Morgan analysts are limited given India’s position as a low-cost supplier of generic drugs to the US, which remains the key driver for growth and investment for Indian companies.
Despite the growing valuation premium to the Sensex, analysts at Axis Capital say given the 24% annual earnings growth over the next two years on the back of structural growth drivers such as higher entry barrier segments in the US and increasing healthcare spends in India and emerging markets, the valuations are reasonable.
Most brokerages are positive on the prospects of large Indian generic makers but prefer names such as Lupin, Dr Reddy’s Laboratories and Cadila Healthcare.
Lupin
Given the staggered entry of generic competition in the US for Nexium (an antacid) and increased product launches in the coming fiscal, most brokerages have revised their earnings estimates upwards and expect Lupin's earnings to grow by 22% over FY15-17 as against 19% earlier. The stock now commands a higher one-year forward multiple of 23-25 times as against 21-22 times earlier. While the company has so far done better than peers on the execution and cost leadership fronts, analysts at Axis Capital expect growth going ahead to be powered by a strong visibility on abbreviated new drug application (ANDA) pipeline in US market (45% of overall revenues in FY15), growing India business, potential value accretive M&A and partnerships to build its speciality portfolio of dermatological, inhalation, injectables and biosimilar products.
Dr Reddy’s
While the stock is trading at a discount to larger peers due to near-term earnings worries and regulatory challenges, analysts are positive on the company's prospects given its ANDA pipeline (43% of revenues), market share gains for products (both in the US) and R&D strength. Of the 68 pending ANDAs, 60% is complex generics, with injectables forming a third of pipeline and 20% of sales which should boost realisations and margins. Analysts say margin concerns given the large investments in R&D (the company has been one of the largest spenders) could come down as it brings some of the products on to the market. Increased traction in its niche portfolio should also aid profitability.
Cadila Healthcare
The company has seen strong earnings growth for 9MFY15 on the back of a 61% year-on-year growth from the US business as well as margin expansion. Analysts expect margins to increase by 400 basis points from 16.6% in FY14 to 21% by FY17 due to higher incremental filings in niche segments like dermatology, respiratory and complex injectables. Given the strong performance expected from the US market due to the product pipeline and approvals, analysts expect earnings growth in the FY15-17 period to be between 25-40%.
