Stealth bull run in formulation players continues, API players continue to struggle
The stock price performance of the pharma players should drill home the importance of diversification at all point of time. No noise, no big buzz, just steady price performance for many quarters now. While themes like ship building, defense, PSU, power, Infra, Capital Goods, Data centers and EV have hogged the limelight, the dull and boring pharma theme has silently delivered good performance.
Sun Pharma up 60%+ YoY, Cipla up 29%, Lupin up 100%, Alkem Labs up 74%, Divis labs up 39%. Most of them, if not all, have beaten the NIFTY 50 return with no noise. We have a good exposure to pharma in the portfolio through Divis Labs, Alkem labs, Aarti Pharma (part pharma API, part FMCG), Gufic Bio and now Windlas Biotech.
Q1 investor calls have multiple references to the positive effects expected from the US Bio Secure act over the medium term, as a decent chunk of the supply is set to come to India on the back of the negative China sentiment. That however does not seem to be stopping the price erosion in the US, the very economics of the US healthcare market (in the face of rising deficits) will keep a lid on drug pricing for years to come. We have been hearing for almost 3 years now that pricing erosion in the US is bottoming out, only for something new to crop up and keep pricing muted.
On the other hand, India Pharmaceutical market (IPM) continues to be a good fishing spot for many of these diversified players. The moving average has now crossed INR 2 lakh Cr annum, a combination of hygienic volume growth and product mix changes should be growth rates healthy for many years here. The large players here have painstakingly built distribution channels over decades that act as a defensible moat in combination with their MR coverage of doctors. There is clear push by the Govt in favor of generics in India too but it is still early days in this trend. The average well run IPM based formulation player today trades at 45+ PE (Abbott India, Pfizer, Eris Life, Mankind Pharma). These businesses can be viewed as similar to many FMCG players, hence the valuation multiples aren’t far off too from what FMCG players trade at.
The Contract manufacturing segment is another interesting pocket we have added exposure to recently through Windlas Biotech. With a medium term growth visibility of 18%+ p.a., all three listed players – Windlas, Innova Captab & Akums are trading at 3-3.5x TTM sales. While this is slightly elevated that it ideally should be, each one of these is only skimming the surface in terms of product portfolio and scalability. We would expect them to take the inorganic route to quickly ramp up scale when good opportunities present themselves. Given that their baseline EBITDA margin serving IPM customers is 13-14%, a higher proportion from new products (injectables, dual chamber bags, ampoules), newer segment (generics & institutional) and newer markets (exports) can improve the margin profile over the medium term. This is one space to be tracked closely so long as valuation is still reasonable. These players do have to address regulatory requirements but the pressure is nowhere close to what the large players deal with in developed markets like the US and EU.
API makers on the other hand look set for another average year. Like chemicals, many of them announced large capex in FY22 and FY23 only for the operating environment to turn sour. Raw material pricing volatility will keep things challenging for them as China becomes more active in a bid to sweat the large asset base it is sitting on. Aarti Drugs, Laurus Labs and the like have only been disappointing investors since FY22, even if things will eventually turn around cyclically. Pure play API makers that do not have a differentiated CSM business or scale like Divis Labs should ideally be bought in the 18-20 PE range on a normalized basis. Many things need to fall into place for a couple of years even after demand trends become better than they are, the core ROCE profile of API making ensures that a 200 bps fall in EBITDA margin can depress terminal value by 30% or more. There are some interesting plays here like RPG Life and Glenmark Life that are turning in good numbers, but valuation already prices good times in.
There is a good possibility that stock prices of large formulation players will start overextending in FY25, it will be a good time to prune exposure here if it happens. While pharma is a good defensive bet, beyond a price multiple it becomes as risky as another sector from an allocation point of view. One should ideally build exposure at lower than average multiples and prune exposure as the sector comes back into vogue.
