Pharmaceutical Sector: Bitter Pill Turns Sweet

Pharmaceutical Sector: Bitter Pill Turns Sweet

The panic created by the virus pandemic has taken a heavy toll on most sectors but pharmaceutical companies seem to have withstood the carnage with some stocks even delivering healthy returns during this period. Join the DSIJ Team to know how the sector has been affected and what lies in store.

The Indian pharmaceutical industry is the world’s third-largest drug producer by volume and the country’s market manufactures 60 per cent of vaccines globally. This constitutes 40-70 per cent of supply to satisfy the World Health Organization’s (WHO) demand for Diphtheria, Tetanus and Pertussis (DPT) and Bacillus Calmette Guerin (BCG) vaccines and 90 per cent of the global demand for measles. Along with supplying affordable and low-cost generic drugs to millions of people around the globe, India operates more than 250 US Food and Drug Administration (FDA) and UK Medicine and Healthcare Products Regulatory Agency (MHRA)-approved plants.

Drugs produced in India are exported to more than 200 countries in the world, with the US being the key market. Generic drugs account for 20 per cent of global exports in terms of volume, making the country the largest provider of generic medicines globally and expected to expand even further in the coming years. Pharmaceutical exports from India, which include bulk drugs, intermediates, drug formulations, biologicals, ayush (ayurvedic, yoga and naturopathy, unani, siddha and homeopathy), herbal products and surgical items, reached USD 19.14 billion in FY19 and USD 13.69 billion in FY20, up to January 2020.

This sector is expected to grow to USD 100 billion and the medical device market is expected to grow to USD 25 billion by 2025. Furthermore, the active pharmaceutical ingredients (APIs) market is forecasted to attain revenue of USD 6 billion by the end of 2020.

The Indian pharmaceutical sector is defined by several unique characteristics. Primarily, branded generics dominate, making up for 70-80 per cent of the retail market. Secondly, local players have enjoyed a dominant position driven by formulation development capabilities and early investments. Finally, the price levels are low, driven by intense competition. These aspects present their own opportunities and challenges. 

Despite the nationwide lockdown which has disrupted the distribution of drugs and fresh prescription generation, there has been a sizeable 8.9 per cent growth for pharmaceutical sales in March 2020.

An Overview 

There are five aspects to be taken into consideration when it comes to the Indian pharmaceutical sector:

1. Threat of New Entrants:

The threat of new entrants is low to moderate based on the following factors: It has become very important for the pharmaceutical companies to focus on research and development to sustain their position in market. The cost associated with research and development is in itself one of the biggest hindrances for new firms to enter the market. Along with this, there are also the stringent government regulations with regards to quality and price of various drugs which leads to impediments when it comes to approvals of new drugs. Besides this, various other challenges such as drawing up appropriate distribution strategies, selecting the right products, anticipating competition, among others, are raising the barriers for new entrants.

However, many pharmaceutical companies are progressing in the market by shifting from traditional business approaches and resorting to emerging new business approaches such as new contract research (drug discovery and clinical trials), contract manufacturing and co-marketing alliance. Thus, new companies are able to enter the market without burden of costly tasks such as research and development, clinical trials and manufacturing of drugs. Furthermore, patent expiry is one reason that offers opportunities for lower cost generic manufacturer in terms of greater market access.

2. Threat of Substitutes: The demand for generic drugs compared to branded drugs has increased because of cost. Generic manufacturers do not incur the high cost involved in research and development and regulatory activities such as FDA approval and clinical trials. Thus, they can offer their products at cheaper prices. This increases the threat of substitutes. Hence, the threat of substitute ranges from moderate to high.

3. Bargaining Power of Buyers: The buyers’ bargaining power is high. There are many companies in the market providing similar products. As a result, big buyers such as hospitals and other healthcare organisations have the power to select and often pressurize pharmaceutical companies to keep prices of the drugs low. However, when it comes to retail consumers, the bargaining power is very low as the consumer, in this case, is the patient who has to buy the drugs as prescribed by the physician.

4. Bargaining Power of Suppliers: The bargaining power of suppliers in the market is low. Pharmaceutical products require various types of organic chemicals and there are a number of chemical suppliers present in the market. Thus pharmaceutical companies have the option of switching from one company to another based on cost.

5. Intensity of Competitive Rivalry: Due to the increasing demand for high-quality drugs, the low-to-moderate entry barrier for the new entrant and the presence of a number of large and small firms, this market is highly competitive.

Performance of Pharmaceutical Stocks
Pharmaceuticals, as a sector, has emerged a strong contender to drive the next leg of the rally. In anticipation, pharma stocks have seen a huge run-up in the last few days. The S&P BSE Healthcare index has been the best performing sectoral index since March 25, 2020, when the first lockdown began. It has gained over 34.14 per cent as of end April 2020, far higher than the next best performing sectoral index, namely, S&P BSE Metal, which expanded by 21.13 per cent. The BSE Sensex in comparison has gained 18.16 per cent during this period.

Shares of IOL Chemicals and Pharmaceuticals, Abbott India, Aurobindo Pharmaceuticals have surged up to 69.45 per cent, 43.39 per cent and 34.02 per cent respectively. IPCA Laboratories and Cadila Healthcare were among the gainers too, being the largest producers of hydroxychloroquine in India. The anti-malarial drug is being touted as a ‘game-changer’ in the fight against the corona virus and is being aggressively sought by US President Donald Trump. At the other end of the scale, Aster DM Healthcare, Piramal Enterprises and Bliss GVS Pharmaceuticals have cracked up to 40 per cent during this period. 

Response to Corona Pandemic
Despite the nationwide lockdown which has disrupted the distribution of drugs and fresh prescription generation, there has been a sizeable 8.9 per cent growth for pharmaceutical sales in March 2020. This was primarily on account of panic buying of medicines in various categories. Cardiac therapy drugs, for example, saw a 19.8 per cent growth compared to 11 per cent in February. Anti-diabetic therapy, too, saw a strong growth of 18.2 per cent in March compared to 11 per cent the previous month. With the virus outbreak, sales of respiratory medicines too saw a sharp spike at around 23 per cent.

The pharmaceutical industry in India has been pulling out all stops to ensure that the production of medicines, essential in fighting the corona virus pandemic, is not severely impacted. In an unprecedented move, all major companies have come together to help one another with knowledge and sharing of resources. Capacity utilisation at an all-India level, relating to both small and big manufacturers, is 60-70 per cent, which is higher than in most other industries. The Indian Pharmaceutical Alliance (IPA), the lobby group that represents India’s top 25 giants, has said that the biggest companies are able to operate normally despite the crisis. Almost all the major drug firms have their units in Sikkim, where plants are operating at full capacity. 

“The crisis has brought us together. Moreover, the firms are also helping one another to pool resources. For example, in manufacturing clusters like Indore and Goa, companies are pooling resources like trucks and even helping one another to approach the regulators, etc.,” said Sudarshan Jain, Secretary General, IPA. However, despite the efforts of the industry to ensure the supply of essential medicines, the pandemic has ultimately caused some problems. Highlighted below are some of the issues faced by companies in the Indian pharmaceutical sector amidst the pandemic.

1. Inter-State Transport Challenges: There is a lot of medicine stock that comes from Goa, Baddi and Sikkim. Due to the lockdown, it has become difficult to reach retailers. The distributers are also facing transportation issues for supplying medicines in other states. The government has exempted private laboratories from the lockdown to ensure that movement of lab technicians and transportation of samples, along with the opening of temporary collection centres, should not face any hurdles. However, despite being an essential service, the lack of transport options has led to a shortage of labour.

As with some other essential services, this industry too has faced a shortage of supply of ancillary materials including packaging material such as bottles and caps since these are not categorised as essential services. Disruption in the movement of trucks has also led to finished goods not being moved. All of these have led to a drop in production as well as an increase in the cost of production.

2. Supply Chain Breakdown: According to a report on the Indian pharmaceutical industry, the source of APIs is a crucial part of the pharmaceutical industry’s strategic plan to combat the pandemic. A majority of APIs for generic drug manufacturing across the globe are sourced from India, which also supplies approximately 30 per cent of the generic APIs used in the US. However, Indian manufacturers rely heavily on APIs from China as well for the production of their medicine formulations with procurement of up to 70 per cent – China being the top global producer and exporter of APIs by volume. The primary driver is the low cost of production.

The impact of the various pandemics over the years has exposed the dependency of the Indian pharmaceutical sector on China for its API procurement. Supply chain disruptions and product export restrictions from India have resulted in further shortages. In China, manufacturing has been impacted on account of the quarantine policies adapted and adopted by different provincial governments in response to the virus. Supplies were further impacted by the disruption of logistics and transportation systems, restricting access and movement of products to and from ports.

The current dependency of Indian pharmaceutical companies on Chinese APIs is identified as a serious concern for national health security, prompting the Indian government to set up a taskforce to review the internal API sector. Several key representatives from the pharmaceutical industry and NITI Aayog, an Indian government policy think tank, have suggested that fostering the approvals of pharmaceutical infrastructure developments, clearance from the environment ministry and providing tax exemptions and subsidies for the development and promotion of the pharmaceutical industry hubs could benefit the market.

While the API supply chains have gradually been crawling back with Chinese manufacturers restarting production, one of the important fallouts is that in order to reduce dependency on Chinese API manufacturers, India has identified and prioritized production of 53 raw materials and APIs as part of its ‘China- Plus-One’ policy to fill in supply gaps of affordable medicines. The plan includes investing USD 1.3 billion in domestic pharmaceutical producers and potentially reviving state-run companies to ramp up cheap generic production.

Outlook

Pharmaceuticals and healthcare services being at the top layer of essential services remain exempted everywhere and hence barring few supply-related disturbances, there hasn’t been as significant of an impact on the pharmaceutical industry as compared to other industries in India. Now that Chinese supply lines for key starting materials (KSM) and APIs are returning to normal, the supply side issues are slowly waning too.

The outbreak has also presented Indian pharmaceutical companies an opportunity to become a preferred alternate hub for manufacturing APIs and intermediates. Having recognised this opportunity and declaring Indian pharmaceutical sector’s dependence on Chinese APIs as a threat to national security, the central government has approved a slew of measures to promote the manufacturing of APIs and KSMs within the country which is expected to reduce the manufacturing cost of bulk drugs and dependency on other countries for bulk drugs. With these incentives the central government aims to reduce the dependence of the domestic pharmaceutical companies on a single supplier like China and, more importantly, change the global footprint of Indian pharmaceutical companies.

Stocks in Favour 

In our view, the following stocks may outperform markets in the coming quarters:

Aarti Drugs CMP (Rs ) : 721.35

BSE Code : 524348 I Face Value (Rs ) : 10 I Mcap FF (Cr.) : 638.68 I 52 Week High / Low : Rs 812.65 / 419.30

Aarti Drugs Limited is a pharmaceutical company which manufactures bulk drugs and speciality chemicals. The company’s products include vitamins and sedatives, as well as anti-inflammatory, anti-asthma, anti-arthritis, antifungal, anti-diabetic, anti-osteoporosis, anti-cholinergic and anti-depressant drugs. Its products under APIs include Aceclofenac, Diclofenac Potassium, Diclofenac Diethylamine, Clopidogrel Bisulphate and Telmisartan. On a consolidated quarterly front, its net sales expanded by 24.57 per cent to Rs 473.51 crore in Q3FY20 from Rs 380.11 in Q3FY19. The company reported an operating profit of Rs 67.74 crore in Q3FY20, up by 30.24 per cent from Rs 52.01 crore reported in the same period for the previous fiscal year. Similarly, its net profit saw growth of 33.11 per cent to Rs 27.78 crore in Q3FY20 from Rs 20.87 crore in Q3FY19.

On an annual front, net sales came in at Rs 1,560.94 in FY19, increasing by 23.63 per cent from Rs 1,262.57 crore recorded in the previous fiscal year. In FY19, the company reported an operating profit of Rs 213.54 crore, up by 7.03 per cent from Rs 199.52 crore reported in FY18. Net profit reported in FY19 was Rs 89.75 crore, up by 9.05 per cent from Rs 82.30 crore in FY18. The company has reduced its debt recently, which has resulted in D/E of 0.7x by the end of December 2019 as against 0.9x in March 2019. It has been paying regular dividend to its shareholders since the past several years.

The company’s anti-diabetic facility has been expanded, which will double the capacity and make the company one of the largest metformin players in the world. This segment is expected to generate good double-digit growth in revenue in the upcoming years. It is also a leading manufacturer of fluoroquinolones led through a backward integration process. Ciprofloxacin, which is one of its top 10 products, has 40-50 per cent global market share. In anti-protozoal, it has further increased its capacity to curtail the imports.

Civil construction is in progress for its multipurpose facility of vitamins and anti-inflammatory segment to target highly regulated markets, where the proposed installed capacity is likely to contribute Rs 35-50 crore per annum. The company’s strong API portfolio will continue to be its revenue driver led by volume growth. The steady contribution by its subsidiary in API and formulations segments would further strengthen its position in domestic and international markets. Also, its focus on high-margin export business, coupled with backward integration and expansion, would be beneficial for the company over the upcoming years. Considering all these factors, we recommend a BUY.

Pfizer CMP (Rs ) : 4768.90

BSE Code : 500680 I Face Value (Rs ) : 10 I Mcap FF (Cr.) :7,853.99 I 52 Week High / Low : Rs 5,172.95 / 2,797.50

Pfizer Inc. is a research-based global biopharmaceutical company engaged in the discovery, development and manufacture of healthcare products. Its global portfolio includes medicines and vaccines. The company manages its commercial operations through two business segments, namely, Pfizer Innovative Health (IH) and Pfizer Essential Health (EH). IH focuses on developing and commercialising medicines and vaccines. IH therapeutic areas include internal medicine, vaccines, oncology, inflammation and immunology, rare diseases and consumer healthcare. EH includes legacy brands, branded generics, generic sterile injectable products, biosimilars and infusion systems.

On a standalone quarterly front, its net sales were reported at Rs 538.18 crore in Q3FY20, up by 4.75 per cent from Rs 513.79 crore in the same quarter for the previous fiscal year. The company reported an operating profit of Rs 191.66 crore in Q3FY20, declining by 12.36 per cent from Rs 218.68 crore recorded in the corresponding period for the previous fiscal year. This was due to higher than expected raw material cost, employee cost and other expenses. However, despite these costs, net profit saw growth of 5.4 per cent to Rs 139.06 crore in Q3FY20 from Rs 131.94 crore in Q3FY19 because of the impact of deferred tax. 

Looking at the annual trends, its net sales saw growth of 5.12 per cent and were recorded at Rs 2,081.50 crore in FY19 as compared to Rs 1,980.19 crore in the previous fiscal year. The company reported an operating profit of Rs 732.59 crore in the fiscal year ended March 2019, increasing by 19.2 per cent from Rs 614.58 crore recorded in the fiscal year ended March 2018. Similarly, net profit expanded by 19.16 per cent to Rs 429.05 crore in FY19 as compared to Rs 360.07 crore in the previous fiscal year.

Pfizer has a strong focus on legacy power brands as well as an introduction from the global parent’s stable and consistent free cash flow generation. Moreover, its debt-free balance-sheet and strong core RoEs, along with a healthy dividend payout track record, make it a strong bet to deliver healthy returns during this troubled period. Going forward, the company’s revenue drivers will continue to be its flagship brands such as Becosules, Corex and Prevnar. The revenue trajectory can accelerate if Pfizer is able to source new launches from its parent portfolio and leverage its cash position for acquisitions. Among the recent new launches, Eliquis and Xeljanz have the potential to scale up and become power brands over time and thus the long-term growth potential for this scrip is encouraging. As a result, we recommend a BUY.

(Closing price as of May 06, 2020)

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