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Sector update: Pharmaceuticals - Cashflow analysis suggests limited downsides

Our cash flow analysis of 7 large pharmaceutical companies (Sun Pharma, Aurobindo, Cadila, Cipla, Dr. Reddy’s, Lupin and Torrent) over last three years (FY16-19) shows that most Indian generic companies (barring Sun) delivered relatively steady operating cash flows (OCF; notwithstanding deteriorating working capital) despite significantly weak earnings profile during this period. In FY19, these companies recorded 5% yoy growth in OCF. Most companies (barring Sun Pharma) in the group generated healthy 4-6% OCF yield (OCF/current market capitalisation) in FY19. Dr. Reddy’s and Torrent stand out with the highest EBITDA-to-OCF conversion as well as OCF yields. Given big-ticket M&A activities by Aurobindo, Cadila and Torrent, group free cash flow (FCF) metrics / record are relatively muted. We hold the view that Indian generic companies have superior financial strength versus their global peers such as Teva, Mylan, Amneal, etc, with significantly higher leverage on their books.

Expected improvement in US and domestic revenues, along with continued focus on cost optimisation should help leading pharma companies to report better OCF going forward. We estimate FY20E/FY21E OCF yields at CMP to improve to 6.6%/7.3%, respectively, from ~5% in FY19 for the group. Even FCF yields (adjusted for inorganic growth investment) should improve meaningfully, given the industry’s focus on capex optimisation. While the earnings growth trajectory across pharma companies does pose an element of uncertainty, improving cash flow generation/attractive cash flow yields should help limit the downside from current levels, in our view. Upside would be a factor of how earnings crystallise across each company. Aurobindo, Ipca, Natco and Ipca are our top picks.

Healthy OCF generation..: While Indian generic companies have struggled to grow revenues and have faced adverse working capital movement, most of them have done a remarkable job in generating improved operating cash flows (OCF). Given the revenue growth challenges, cost optimisation (primarily across SG&A and R&D costs) has majorly driven OCF generation across companies. Average R&D as percentage of sales has reduced from 8.2% in FY18 to 7.4% in FY19 for top 7 companies, with other expenses too having slipped from 29.2% in FY18 to 28.9% of sales in FY19.

..despite working capital challenges: Companies generated improved OCF despite the increase in their working capital requirements. Net working capital days increased from 123 days to 130 days on average, as companies began stocking inventories anticipating industry-wide supply shortages. Receivable days too deteriorated with surging competition in generics and higher bargaining power of distributors. Most firms saw their OCF/EBITDA ratio improve, with DRL and Torrent outperforming the group and Sun and Aurobindo being relative laggards.

Capex moderation aids FCF: Capex-to-sales ratio of companies in the group (excluding acquisition costs) fell from 0.14x in FY17 and 0.08x in FY18 to 0.07x in FY19, causing overall FCF (excluding acquisition costs) in FY19 to improve for most companies (barring Sun and Aurobindo). We expect FCFs in the group to improve meaningfully to post implied FCF yield of 4.4% in FY21E, supported by superior OCFs and continued capex optimisation.

Comfortable leverage: Over last couple of years, most companies (apart from those engaged in acquisitions) have meaningfully pared debt, thereby strengthening their balance sheets. Even companies which have recently completed big-ticket acquisitions, such as Torrent and Cadila, have kept net debt/EBITDA comfortably in check at 2.4x and 2.2x, respectively, compared to their global counterparts, Teva and Mylan (5.2x and 3.8x, respectively, as of Dec 2018). Average net debt/EBITDA of the 7 companies slipped from 1.2x in FY18 to 1.1x in FY19.

Improving FCF a bright spot in the sector; Attractive OCF/FCF yields may limit downsides: While the Indian pharma sector has been buffeted by multiple headwinds and has underperformed the broader market over last 3-4 years, we believe improving FCFs across leading companies (broadly representative of the sector) is an emerging positive, which should also enhance their fiscal capacity to pursue aggressive growth investments. At CMP, we estimate average OCF yield of ~5% on FY19 earnings for the group, likely scaling to 6-7% over FY20-21E on expected revenue and profit pickup. These should translate into improved FCF generation across companies, which continue to control incremental capex. The strong FCF generation trend could provide downside support to stocks, with upsides continued to be governed by realisation of earnings growth triggers across respective stocks.