Indian Pharmaceuticals:Key themes and our top picks heading into 2HFY17
After a very tough 1HFY17, we look at some key themes and address investorconcerns that could potentially impact the Indian pharma companies over the nextfew quarters. Regulatory setbacks, competition in large products and earningsdowngrades have led to the sector underperforming the broader market YTD. Webelieve news flow on the re-inspection of impacted facilities over the next fewquarters could be an inflection point for the sector, providing comfort on newANDA approvals/launches and improved earnings visibility. The weakness in thesector has created buying opportunities in select names with medium-term growthdrivers, company-specific catalysts and attractive valuations.
Regulatory headwinds likely to abate and removing overhang on FY18approvals: We had expected 2016to be a transition year for the sector ascompanies address outstanding issues in the impacted facilities and globalmanufacturing network. Most of the impacted facilities have completed/ arelikely to complete remediation with re-inspection likely over the next fewquarters. While companies have guided to higher ANDA approvals into2HFY17(mostly de-risked), an all-clear from the USFDA will increaseconfidence in FY18approval and earnings.
Generic pricing likely to remain at mid to high single digits into next year:Generic pricing over the last year was high single digit to low double-digit withhigh product concentration in large-cap companies worsening the impact.Despite the continued challenging pricing environment, price erosion isexpected to stabilize in the mid to high single digits. Further, improvement inapprovals/launches should help offset this impact going forward.
R&D execution key for higher-than-average returns: Elevated R&D is aconstant theme across companies with increased spending on complex generics,specialty (including bio-similar) and novel opportunities. These investments areexpected to drive higher margins/returns over the medium term. But there areinvestor concerns given greater technical hurdles and increasing overlap amongcompanies (in areas such as injectables, derma, respiratory) limiting margins.Therefore, companies that show the ability to monetize this risky R&D spendingahead of peers will see a re-rating, in our view.
M&A – Building out portfolio rather than buying sales: There have beensmaller bolt-on acquisition by companies over the last year. However, given thebalance sheet flexibility, we expect to see companies pursuing larger deals(~$500Mn-1+bn) over the next year. This is in line with their strategy to acceleratemarket forays into complex generics, strengthening presence in ex-US markets(EM/Europe) and targeting specialty brands. However, we do not see the largecompanies pursuing multi-billion dollar deals to buy sales despite valuationarbitrage given organic growth drivers and a conservative approach to M&A.
Dr Reddy is our top pick: September quarter results (reported end October) arelikely to be weak with continued pressure on US revenue. However, we wouldsee any weakness as a buying opportunity to play the recovery in the US fromrecent launches, approvals expected in 2HFY17and re-inspection of facilitiesincreasing visibility on FY18. In addition, we also highlight our views on ourother top picks – Aurobindo and Sun Pharma.