Strong pill in medium doses

While large-cap pharma has been a star performer, select few mid-caps could outperform

Large-cap pharma companies have been major outperformers in the past few years, trumping the broader markets and smaller peers. Year-to-date, large-cap pharma stocks have outperformed. The valuation discount between the two categories existed earlier, too, given robust product pipelines, high earnings visibility, strong balance sheets and healthy return ratios. However, given the growth prospects and the yawning valuation gap, analysts say select mid-caps (market cap between Rs 5,000 crore and Rs 15,000 crore) could give better returns, even as some have run up recently. Says Kapil Bhatia, assistant vice-president, Systematix Capital: "While large-caps have grown at a faster pace, as mid-caps expand global reach and improve their therapeutic mix, they are likely to catch up or exceed the growth of larger peers."

Large-caps trade at 20-25 times their FY15 estimates while mid-caps are between eight and 14 times, a discount of between 44 per cent and 60 per cent. The discount is likely to reduce. Says Ranjit Kapadia at Centrum Broking: "Improving margins and profits on higher sales volumes and market share gains in the domestic market should help mid-caps to bridge the valuation gap."

Given the performance of some mid-caps in the fortnight, the Street is discounting some positives. Unichem Lab, Aurobindo, Biocon and Torrent Pharma have touched 52-week highs. However, given the increased risk with mid-caps, Hitesh Mahida of Fortune Research says investors who wish to take exposure to mid-caps should opt for ones with robust business models and attractive valuations.

Aurobindo Pharma
Despite making 52-week highs recently, Aurobindo remains one of the cheapest. Trading at 8.1 times its FY15 earnings estimates, it is still at a discount to the mid-cap average P/E (price-earning) of 14.2 times and large-cap average of 17.8 times, according to the Bank of America Merrill Lynch Research (BofAML).

  Having resolved Food and Drug Administration (FDA) related issues, the company is on a strong wicket in the US after the re-launch of cephalosporin class of drugs from Unit-VI (one of the affected facilities) and market share gains by products launched in 12 months. The increase in injectibles at Unit IV and at least three injectibles launches in 30 days (all in the shortage list of FDA, with a market size of $68-80 million) bolsters its prospects. Analysts at Edelweiss say sustainable operational performance will restore confidence over execution, resulting in valuation re-rating. Notably, Aurobindo has the largest pipeline in the US.

Sarabjit Kour Nangra at Angel Broking estimates net sales to clock a compounded annual growth rate (CAGR) of 17.4 per cent over FY13–15, while BofaML estimates a 21 per cent growth with 580 basis points margin increase on improving product mix and higher share of formulation. BofAML analysts add with the investment cycle behind it and increased capacity utilisation along with strong free cash flows, balance sheet would improve considerably, resulting in a re-rating.

Bloomberg consensus by analysts polled in November shows a target of Rs 355.

Biocon
Biocon has been touching 52-week highs in a week following a drug approval and improving growth prospects of its biosimilar portfolio. The company got a nod from India's drug controller to market the breast cancer drug, Trastuzumab. The drug has been developed with Mylan and is estimated to have a market size of $21 million in India. Given the innovator product sales for its biosimilar portfolio (co-developed with Mylan) are pegged at $34 billion globally, there is a huge potential. The company, with sales of $414 million in FY13, is looking at doubling the same to $1 billion by FY18. While the domestic pharma (14 per cent of revenues) is growing at 30 per cent annually and listing of its Syngene could unlock value, the bigger trigger is the opening of the regulated markets to its biosimilars after the expiry of patents of key drugs in CY15. The stock, which trades at 13 times its FY15 estimates (35 per cent discount to larger peers) has not priced in any upside from biosimilar products, according to India Infoline Limited (IIFL). The firm estimates earnings will grow at annual rate of 24 per cent over FY13-FY16. Given the longer time frames for approvals, investors with two to three years should consider investing in the stock.

Torrent Pharma
Analysts at IIFL believe the company has a strong business portfolio with the highest growth potential. More than 60 per cent revenue comes from emerging markets and 70 per cent of domestic revenue comes from higher margin specialty business. The company remains unaffected by the domestic traders’ stir and according to the All Indian Origin Chemists & Distributors (AIOCD) data, it grew 13.3 per cent in October 2013. For the US markets, Torrent is focusing on accelerating its filings to 10-15 ANDAs each year.

It has 23 pending approvals and 31 under development. It is likely to launch one product on exclusivity in the US this month. This strong pipeline is likely to drive Torrent's US and European growth, observes Perin Ali at Edelweiss. A low base and high number of product launches will keep growth in the US above 30 per cent for the next three years, say IIFL analysts. They predict that given the high contribution from growth markets, growing revenue base and strong free cash flows, the stock which is trading at 20-50 per cent discount to larger peers, could re-rate over the medium term.