Drug makers may outperform again in 2013: U.S. sales, domestic business, and currency depreciation have driven pharma sales. Lupin and Dr Reddy’s are likely to benefit most from low competition opportunities in the U.S. The rupee may fall to 60 against the dollar in second half of 2013, helping drug makers. The domestic business may, however, slowdown, accentuated by the impact of proposed price control.
Valuation gap between Indian and US generic firms may persist: Large-cap Indian firms trade at 18-22-times FY14 forward price earnings, whereas the US counterparts are at 7-11-times. On a relatively smaller base, the growth prospects of Indian companies beyond their explicit forecast period remain strong. Also, profitability as measured by Return on Equity (ROE) has consistently remained higher for Indian companies.
Price control policy negative: The price control policy creates long-term uncertainty and could lead to structural de-rating of the India business. That's because almost 20 per cent of the market will be under price control and the National List of Essential Medicines (NLEM) list and pricing policy will be revisited after five years.
Midcaps offer greater value: Valuations are more compelling in midcaps. The return in midcaps will be delivered on back of sustained growth in earnings and P/E re-rating. Some of the midcaps generating interest include Glenmark, Zydus Cadila, Ipca Labs, Torrent Pharma and Jubilant Lifesciences.
Acquisitions may be the way forward: Strong balance sheets can lead to acquisitions. Larger generic players such as Teva, Mylan, Watson and Sandoz suggest that they became most acquisitive after attaining a sales base of $2-3 billion. Sun Pharma has been the most acquisitive, pursuing three simultaneous acquisitions Taro, Dusa and URL generics. Cipla’s proposal to acquire majority stake in Cipla Medpro and Dr Reddy’s acquisition of Octoplus are other acquisitions announced in the recent past.
Acquisitions may not necessarily be value accretive?: Generally, acquisitions have added value to pharma companies (e.g. Sun - Taro and Lupin - Kyowa). However, Dr Reddy’s acquisition of Betapharm was a standout disappointment. With net yield on cash at 4-5 per cent, an acquisition at less than 20-times P/E is earnings accretive.
Lupin and Sun Pharma best long-term bet: Sun has a stronger domestic business and can add value through acquisition. High margins due to Taro and certain product-specific opportunities present downside risks. Lupin’s margin are lower currently and can witness substantial expansion on the back of product launches in the U.S.. Ex Taro, Lupin scores higher than Sun Pharma. On valuations, Lupin trades at a marginal discount to Sun Pharma.
Dr Reddy’s may deliver sustained growth: The company has seen sustained de-rating as investors are suspect on long-term growth prospects. It is perceived largely as a US-centric growth story. However, earnings can present upside. Dr Reddy's has the highest operating leverage among peers, it has sustained growth in India, Russia and RoW (Rest of World) markets and a more conservative approach towards acquisitions and R&D investments - making it an attractive bet.
What’s in the price for Glenmark? Over the past month, Glenmark stock is up 13 per cent versus a broader market return of 4 per cent. The improvement in the balance sheet is now largely in the price. There is marginal expectation of the possible upside from the research pipeline. The outcome of R&D (Research and Development) projects remains uncertain, and sustainability of growth across markets will remain key from here on.
Are valuations of Apollo justified? Apollo presents a pure long-term play. Valuations may appear to be rich, particularly when ROE is suppressed. Apollo currently trades at 26-times FY14F P/E. However, when compared to regional peers like Bangkok Dusit and IHH, valuations are reasonable.
(Based on Nomura Research titled India pharmaceuticals - Road show feedback)