Time to Look at Pharma Funds

We think it may be a good time to relook at Pharma funds after the pharma stocks have seen a large de-rating over the last almost two years. While we do not expect a sharp and immediate upmove from here for pharma stocks and hence pharma funds, SIP in pharma funds could generate decent returns over 1-3 years at a time when the other sectors/stocks seem to be close to topping out/have already have topped out. Aggressive investors could opt for large value small period SIP. Pharma is more of a long-term play and investors who can remain invested for long should only venture into this sector and deploy a buy-on-dips / SIP strategy to accumulate quality bets.

Reasons for underperformance of the Pharma sector during the past two years:
  • Headwinds in both supply side (spike in filings/ approvals by “increased” number of players) and demand side (channel consolidation leading to fewer buyers implying pricing pressure for manufacturers);
  • Potential pricing probe impact in the US and appreciating INR/USD;
  • Overhang from increased quality compliance issues raised by the US Food & Drug Administration (USFDA) (due to higher /more scrutiny) resulting in stoppage of profitable exports of APIs and formulations from these units;
  • Delay in getting drug approvals;
  • While the Indian pharma companies feel that there is an opportunity for them due to intended abolition/dilution of Obamacare, worries that the Trump administration might get tough on issues like intellectual property rights, or invoke the Trade Facilitation and Trade Enforcement Act of 2015 to curtail imports of medicines from India are impacting sentiments.
  • Increased competition in the US generics market and the resulting erosion in pricing power for domestic drug makers
  • Price control in the domestic market has weighed on the profitability of firms.
Two Key Risks that materialized in the past two-three years:

1) Pricing Pressures in the US/Europe:
Prices of drugs have fallen with rising competition and distributors buying jointly. As new companies enter US and existing ones seek to introduce more products, competition has increased, depressing prices and making it tough to maintain market share. While there is higher competition from more Indian companies in the US, Chinese firms are also increasing their presence. This increased competition has squeezed the revenues and margins of the companies. For eg, generic oral solid drugs, which fetched 40-60 per cent margins till about five years ago, now earn only 20-25 per cent. Also, the Drugs (Price Control) Order of 2013 in India which inducted a list of 348 drugs under the price control mechanism has been hurting the domestic profitability of the pharma companies as well.

2) Inspections:With India accounting for 40 per cent of US generic drug filings, FDA has over the last few years decided to ensure the drugs from India are of top quality. Inspections rose from 108 in 2009 to 290 in 2015. India has the highest number of US FDA-approved plants outside the US, with the total at 572 currently, compared with 433 in 2013. One-fifth of the FDA inspections happen in India and China currently, up from 11 per cent in 2012. FDA has also made other changes. It has cut prior intimation time for plant inspections to as little as 24 hours from 25-30 days and inspection frequency has increased to once or even twice a year from once in two-to-three years earlier. This has highly increased the uncertainty associated with this sector, further eroding investor confidence.

However, the performance of the midcap pharma players relative to the larger peers has been healthier. Revenue growth over the past five years for the mid-cap pharma firms has been higher and they have clocked faster operating profit growth of 17.18 per cent compared to large-cap firms' 14.76 per cent. Also, while operating margins for the latter have remained constant at around 22.5 per cent over the past five years, the smaller players have exhibited a 314 bps expansion.

Outlook for the sector:
  • Large companies remain under pressure as they await approval for complex/ niche products to take some pain off in the wake of intense competition. Small companies, which are yet to gain scale in the US, are yet to gain critical mass. Even on the domestic front, sales are expected to decline by midsingle digit for the Q1FY18 because of the disruption caused by destocking as a result of Goods and Services Tax or GST implementation. Growth in emerging markets (EMs) is expected to continue, but it is unlikely to move company revenues significantly. However, despite near term volume disruption due to GST implementation, there are structural positives on India business given the strong GDP growth, improving insurance coverage, healthcare infrastructure, etc
  • Improving outlook for accelerated new ANDA approvals and resolution of outstanding FDA queries while consolidation of distribution channel in the US is almost over.
  • The domestic players have now started to look at the specialty drugs business with increased focus and importance. Specialty margins are significantly higher and much more stable than the generic side. Typically, brand margins are 90 per cent plus, generic margins are 50 per cent or thereabout. Leading Indian drug makers such as Sun Pharma, Dr. Reddy’s Laboratories, Lupin Ltd, Cipla, Glenmark Pharmaceuticals, Cadila Healthcare Ltd, Aurobindo Pharma Ltd, and Biocon Ltd have been making investments to create such products, which is evident from the increase in their R & D spends. Nearly half of the medical spend in the US currently goes towards specialty therapies. Moreover, new product launches in specialty therapies have been higher than in traditional therapies, due to substantial unmet needs.
  • Firms are evolving their model to profitably serve other regulated markets like Europe and Japan, as well as in emerging markets.
  • Inorganic growth can help Indian pharma firms access new markets and enhance technological capabilities in developing new drugs. Collaborations in areas such as R & D, manufacturing and marketing, can also help enhance value by reducing cost and increasing efficiency.
  • US FDA inspections might prove to be a short term pain, long term gain scenario as companies will improve upon their quality standards which will in turn help them fare better competitively and obtain certain degree of pricing power. Vis-avis China, Indian units will be at an advantageous position if the Chinese units are not cooperative in FDA investigations.
  • Local pharma policy may come in for a change, going by the pronouncements of the PM recently to promote affordable drugs. Though this could be negative if implemented with full zeal, the impact of this on R & D efforts in India and Make-in-India initiative may prevent any drastic negative impact on the sector.

Pharma companies are solid franchisees with long term credibility. As the industry reduces its dependence on the US and creates emerging market/Rest of the world franchisees, they will become more attractive.

BSE Healthcare index rose at a CAGR of 35 per cent p.a. between Mar 2009 and Mar 2015. It has later fallen -18.39 per cent in absolute terms till now. Similarly NAV of SBI Pharma fund rose at a CAGR of 39 per cent over the same period and later fell -1.28 per cent till now.

The top holdings during the past one year of this scheme are: Sun Pharmaceuticals, Aurobindo Pharma Ltd, Strides Shasun Ltd, Lupin Ltd, Divis Laboratories Ltd, Cipla Ltd, Torrent Pharmaceuticals Ltd, Natco Pharma Ltd, Glenmark Pharmaceuticals and Alkem Laboratories Ltd.

These stocks indicate the top holdings during the entire previous year. Out of these, the scheme has considerable reduced its exposure to Sun Pharma from 15.93 per cent in March to just 1.60 per cent in July (and hence does not figure in top 10 stocks in July 2017). The other stocks hold more or less similar weightage as of July. As on July 2017, the scheme has replaced Sun Pharma, Lupin and Glenmark with Cadila Healthcare, Thyrocare Technologies and Sequent Scientific.