Weathering the storm

PENNY WISE

The mounting pricing pressure in the US generics space is taking its toll on India pharma biggies. But Sun Pharma seems an exception.

There is no such thing as panacea. Even when it comes to pharma companies. For several years now, the Indian biggies were hoping to tap the US generic opportunity to make their billions.

But the acceleration of pricing pressures clearly visible in the last quarter results of large generic players may call for some introspection. Can Indian generic players combat the tougher operating environment overseas and march ahead on the path to riches?

The answer is not all can. For share market investors, it is better to go with safer players whose strategy seems relatively less vulnerable to the vagaries of overseas markets.

For instance, take Sun Pharma where the domestic market accounted for about two thirds of net sales and exports the remainder in the last quarter. A revival of domestic sales in the June quarter following the uncertainties created earlier by VAT, coupled with the company's strategy to expand overseas sales beyond America, helped earnings before tax grow 48.2 per cent to Rs 144.5 crore.

Net sales of the company grew 34.5 per cent to Rs 421.7 crore, thanks to the improved demand for its formulations for oncology and diabetes segments. M J Pharmaceuticals' merger with Sun Pharma at the end of Q4 FY05 also provided earnings momentum.

In contrast, the performance at other generic players has been mixed - for instance, Ranbaxy reported a 52.5 per cent drop in its consolidated profit before extraordinary items to Rs 126.3 crore in the last quarter.

For Ranbaxy, exports as a percentage of net sales amounted to about 65.5 per cent in the quarter, with the US market alone accounting for about 26.5 per cent of net sales. And the well-documented pricing pressure in America led to Ranbaxy's consolidated profit before extraordinary items dropping 52.5 per cent to Rs 126.3 crore.

Other Indian players like Cipla have relied on a partnership-based model in overseas markets to combat pricing pressures. The company had a tie-up for over 120 products with overseas players at the end of the last quarter.

No doubt this strategy limits aggressive profit expansion as Cipla has to share profits with its overseas partner, but it is viewed as a low-risk model, as it avoids large marketing and allied costs in overseas markets.

Nevertheless, the strategy helped the company's exports as a percentage of total sales rise 540 basis points to 41.9 per cent and profit before tax grow by 37.5 per cent to Rs 143.4 crore in the last quarter.

Meanwhile, diversification of the export base in Russia and other Eastern countries, coupled with its recent deal with ICICI Ventures for funding its R&D expenditure, has helped Dr Reddy's Laboratories (DRL) to grow its net profit by 106 per cent to Rs 63.34 crore in the quarter.

But then, the stiff competition in the generic space and the uncertainties regarding patent applications, which is central to DRL's growth strategy, make its business model risky, say analysts.

In comparison, Sun's strategy seems to be working well. Sun is focusing on diversifying its export base in Europe and Latin America apart from deriving synergies from its American subsidiary Caraco.

And as a part of that strategy, the company has recently acquired a raw-material and dosage-form manufacturing facility in Hungary from Valeant Pharmaceuticals International, USA. And its diversification into new markets like Mexico has helped overseas sales of the merged entity grow around 21 per cent on a y-o-y basis to Rs 138.7 crore in the last quarter.

The company, including the American subsidiary, has 26 ANDAs pending approval, including four patent challenges where suits have been initiated, at the end of the June quarter.

Even for Sun, the picture is not all rosy. Like other pharma companies, Sun has also witnessed a sharp surge in R&D and staff costs over the last few quarters. For instance, in the last quarter, R&D expenditure has grown 26.31 per cent y-o-y to Rs 26.45 crore and staff cost has grown 40.6 per cent.

Given the new patent environment in the country, this growth in expenditure is viewed as inevitable. Of course, a rise in these key operating costs for pharma companies, coupled with pricing pressures in the US, has put a strain on operating profit margins of most generic players.

In the case of Sun Pharma, the combined entity's operating profit grew 33.1 per cent to Rs 135.2 crore in the last quarter, but operating profit margin shrank marginally by 33 basis points to 32.06 per cent. In contrast, Ranbaxy's EBIDA margins almost halved to 11.12 per cent.

Earnings momentum for Sun Pharma in the medium term is expected to be provided by its recently commissioned injectables manufacturing facility at its Halol unit, which is probably the largest such facility in Asia.

In addition, the company has also set up new sterile and non-sterile blocks at its recently-acquired Phlox facility for cephalosporins. This expansion appears well-timed given the sharp recovery observed in cephalosporin prices.

What's the Street expecting? The different strategies to combat pricing pressures in America resulted in these stocks showing varied performance on the street. Sun Pharma has outperformed the Sensex over the past year - the stock has gained 65.08 per cent compared to a 50.92 per cent growth in the broader market. 
 

HOW THEY COMPARE
Sun Pharma
Rs crore	FY05	FY04	% change	Q1FY06	Q1 FY05	% change
Sales/income from operations	1301.00	1066.30	22.00	421.70	313.60	34.5
Operating profit	450.70	401.69	12.20	135.25	101.59	33.6
Net profit	419.70	350.50	19.80	136.30	88.40	54.2
Ranbaxy
	CY 04	CY03	% change	Q1CY05	Q1CY04	% change
Sales/income from operations	5441.00	4805.00	13.23	1364.20	1299.20	5
EBIDA	1096.00	1221.60	10.23	151.80	286.20	47.2
Net profit	744.50	760.90	-2.20	101.60	196.10	48.5

In contrast, Ranbaxy's stock underperformed the broader market and grown merely 11.40 per cent in the last year. However, Cipla's strategy appears to have earned the confidence of the street and the stock gained 46.40 per cent during the period.

Apart from Sun's improved performance in the last quarter, investor sentiment for its stock has been strong, thanks to the company's cash pile of over $440 million or around Rs 1,915 crore (including $350 million from its recent FCCB issue) at the end of the June quarter. And it has fueled investors' expectations that the company would aggressively pursue more overseas acquisitions.

Despite the recent run up, the Sun Pharma stock trades at a mere 23.5 times estimated FY06 earnings compared to a discounting of 45 times estimated CY05 earnings for Ranbaxy.