Pharma's 4Q Debacle

4QFY17 was a disastrous quarter for many Pharma majors, with most of them missing guidance by a wide margin. Although there are arguments that this pain is structural (hence more permanent) in nature, with high pricing erosion in generics products, we believe otherwise. While there can be no denying the shift in the mechanics of the US business (which we have highlighted in our note: Truth vs Hype), in our opinion, these issues are transitory in nature and were in the spotlight owing to the absence of crucial capacities for many of these companies. We believe that once the Indian Pharma companies come up the curve in terms of regulatory compliance, their progress in more lucrative spaces such as complex generics and specialty will be unencumbered, and the sector multiple is likely to re-rate. Quality of pipeline remains crucial.

Price erosion has been everpresent in the generics business model. However, it has historically always been offset by new product launches. Companies like SUNP, DRRD and CDH faced US FDA bans on the very facilities that were meant to be their key growth drivers. Others such as ARBP and TRP faced capacity constraints. FY17 ended up being a confluence of negatives, especially for SUNP, DRRD and CDH. These companies did not receive significant product approvals, and hence had limited power to deal with the base business erosion. This resulted in a decline in the US business and erosion of margins. Going ahead, once the companies have their facilities cleared and capacities available, new product launches will quickly follow and the US business will bounce back.
We also believe that post the warning letters, companies have significantly de-risked their business by spreading their filings across various facilities. A case in point is CDH, which has already received 10 approvals YTD in CY17 vs 9 in the whole of CY16. The first approval from its Moraiya facility has also been received in Jun-17.
While CDH's Moraiya facility was cleared in the re- inspection, SUNP and DRRD received serious observations which will need more time to be resolved. We do not expect these clearances to happen in the near-term, and hence the outlook for FY18 is soft for SUNP and DRRD. However, both companies have strong R & D capabilities, and we believe that there are enough opportunities in their respective pipelines to revitalise the businesses post FY18E.
We prefer companies with a strong growth outlook in the US business in FY18E and no current regulatory overhang CDH, LPC, (Ex-gGlumetza and gFortamet) and GNP.
Companies focussed on the domestic market like ALKEM, TRP and CIPLA will experience some difficulties in 1HFY18, owing to the impending GST implementation and resultant channel disruption. Hence, we believe that 2HFY18 will provide a good entry point for these stocks. Prefer ALKEM

4QFY17:Company-Wise Snapshot