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Sector update: Pharmaceuticals - Recovery ahead; rejuvenation not yet

2018 – Another bitter pill: The BSE Healthcare Index (BSETHC) underperformed the Sensex by ~10% in 2018 - the 3^rd successive year of underperformance after 6 years of outperformance in the preceding years. Limited new big-ticket launches in the US, combined with heightened price erosion in the base business led to the underperformance. Significant currency tailwinds in H2CY18, however, partially helped mitigate the earnings pain for export-intensive business models. 

US recovery key to 2019 growth: We expect progressive improvement in business outlook across most companies in 2019, primarily driven by normalization of price erosion in the US and expected pick-up in new product launches on a relatively depleted US sales base. Aggressive cost-cutting measures across R&D and SG&A will provide further impetus. For most companies, recovery in the US will continue to be the key growth driver, with the bounce-back largely contingent on successful launch of select big-ticket ANDAs. Any delay in launches of these key ANDAs and/or steeper price erosion could have meaningful impact on the earnings growth estimates. Notably, the pharma industry’s US growth/earnings dependence on specific ANDA launches has increased meaningfully over last couple of years, causing enhanced earnings volatility.

Structural challenges persist: The Indian pharma industry will continue to grapple with multiple near to medium to long-term structural challenges, despite expected pick-up in 2019 earnings. Some of these issues include 1) sustained high levels of competitive intensity across existing/new generic products, 2) sharp reduction in opportunities to make super-normal profits in US generics, driven by accelerated FDA approvals, 3) growing reimbursement challenges for new speciality launches, 4) continued uncertainty on price caps in the domestic formulation market and 5) profitability pressures, which could constrain the ability to step-up R&D investments. These will continue to cloud the medium-to-long term earnings visibility of most companies, especially the large caps, across the sector.

Cost control – growth mantra for 2019: The sector has seen significant earnings pressure over last 3 years and we believe companies (especially the large caps) will struggle to meaningfully surpass their FY14-15 peak profits in FY19E. Companies are therefore focusing on cost rationalization and we expect this trend to gain momentum over FY20-21E. A key element of this strategy is rationalizing R&D spends as against the historical trend of sharp annual increases. We gather from companies that bulk of these cuts have been effected on low value-adding generic programmes, while key R&D projects stay on track. As most companies are looking to move up the value curve (speciality, complex generics, etc.), necessitating higher R&D investments, the impact of R&D cost rationalization on medium-long term growth plans, needs to be seen.

Speciality strategies – inflexion point in 2019: Of late, most Indian large-cap pharma companies have begun to make aggressive investments in building their US speciality businesses. With upcoming approvals/launches of key products like Illumya/Cequa (Sun), Solosec (Lupin), DFN-02 (DRL) and Ryaltris (Glenmark), 2019 will be fairly crucial in determining the future trajectory of these companies’ strategies in speciality.

Consolidation – a structural imperative; but few takers: Business models of Indian companies significantly overlap, with most companies focussing on US generics along with domestic formulations. In the backdrop of a deteriorating macro environment, consolidation is the only recourse to reduce the number of players. (refer to our detailed note - ). While consolidation has played out among the US players, Indian generic players are yet to meaningfully participate in this process, ensuring high levels of competitive intensity in US generics.

Top picks: We have introduced FY21E earnings within our universe. Challenges around weak earnings visibility for the sector and reasonably rich valuations make us selectively positive on stocks. We prefer stocks with superior near-to-medium term growth visibility, driven by limited reliance on select ANDA launches in the US. Given this construct, Aurobindo, Ipca and Torrent Pharma are our top picks. We downgrade Cadila to Neutral given the near term earning challenges and limited upsides from current levels.