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Sector update: Pharmaceuticals - Time to explore value unlocking in domestic formulations?

India’s pharmaceutical industry has significantly underperformed the broader market over last 3 years by ~41%. While rest of world (RoW) markets have grown in salience, India’s pharma industry remains broadly governed by the US and Indian market dynamics, with both markets having seen divergent trends. The US market has been turbulent, struck by challenges like accelerated price erosion, lack of meaningful new approvals and negative newsflow on the regulatory front, resulting in lower profitability and diminished growth outlook. While the Indian market too has had its share of challenges from price controls and GST implementation, it has been reasonably steady. Despite strong India franchises, Indian pharma companies have been unsuccessful at leveraging the positive investor sentiment towards strong domestic consumption business models due to negative newsflow from the US market. These companies have been trading at sharp discounts to healthcare B2C business models like diagnostic chains and pharma MNCs. We believe investors are unlikely to realize the full valuation potential of the strong domestic formulation franchises, as structural challenges in the US market may not wither soon and continue to dominate the investment narrative. Indian pharma companies with hybrid business models should evaluate options to unlock value in their domestic businesses. Our analysis of 8 large domestic pharma companies shows fair value of their domestic formulation businesses to be 38% - 137% of their current market cap – indicative of significant potential upsides in any value unlocking process.

Domestic pharma businesses – suppressed valuations: Negative newsflow from the US market has effectively subsumed the strength of consumer-oriented domestic market franchises of most Indian pharma companies, while domestic consumption-focussed business models have re-rated significantly. Notably, consumer-oriented healthcare businesses like Dr Lal Pathlabs/Metropolis trade at 37x/28x FY21E earnings, while FMCG/consumer durable businesses trade at 36-37x FY21E earnings (Bloomberg). Indian pharma companies have not benefited from this trend, despite strong quasi domestic consumption-oriented business franchises and continue to trade at 15-16x FY21E earnings – at a sharp discount to various B2C franchises. As structural challenges in the US market are unlikely to fade soon, with the US market newsflow continuing to dominate the narrative for Indian pharma companies, we believe investors are unlikely to realize the full valuation potential of the strong domestic formulation franchises for long in the current corporate structures.

Domestic pharma business value unlocking – an idea worth exploring..: While hybrid structures (India branded formulations+exports) are a norm in the industry, we increasingly see limited synergies between the two business segments, barring potential leveraging of domestic formulation cashflow to grow the export business. Along with distinct portfolio strategies, most companies typically have separate manufacturing facilities as well as reasonably different supply chains for their domestic and export businesses (particularly US generics). Apart from cost synergies in shared services, we see increasingly limited overlap between the domestic and export business segments of most Indian pharma companies. We recommend that Indian pharma companies should begin to evaluate options to unlock value in their domestic businesses, as it could generate significant value for all stakeholders without impacting exports. Managements could either transfer domestic formulation business in a subsidiary and IPO it or demerge and subsequently list the domestic formulation business. Biocon has already successfully leveraged this model to unlock value in its contract research business (Syngene) and is contemplating unlocking value in its biologics business too.

..Fair value estimation suggests significant upside potential: Our analysis of 8 large domestic companies shows that fair value of the domestic formulation business for Indian pharma companies ranges from 38% - 137% of their current market cap. While DRL’s domestic business has a relatively lower fair value at 38% of its current market cap, we estimate Glenmark’s domestic business is potentially more valuable than the value assigned by the market to the whole company. The domestic business value of most other companies itself is ~80% of their market cap. We have conservatively assumed 25% EBITDA margin (for most companies) and 30x FY21E PER for estimating the fair value of domestic pharma businesses across companies. Arguably, the profitability and fair value of these leading domestic franchises could be significantly higher than our estimates, given that the Rs1,200bn domestic pharma market is estimated to register 10%+ CAGR over next several years and these listed entities are likely to continue to dominate this market. Lack of options to participate in this long term and fairly steady growth story will further embellish valuations of any pure-play domestic business.

India’s pharmaceutical industry has significantly underperformed the broader market over last 3 years by ~41%. While rest of world (RoW) markets have grown in salience, India’s pharma industry remains broadly governed by the US and Indian market dynamics, with both markets having seen divergent trends. The US market has been turbulent, struck by challenges like accelerated price erosion, lack of meaningful new approvals and negative newsflow on the regulatory front, resulting in lower profitability and diminished growth outlook. While the Indian market too has had its share of challenges from price controls and GST implementation, it has been reasonably steady. Despite strong India franchises, Indian pharma companies have been unsuccessful at leveraging the positive investor sentiment towards strong domestic consumption business models due to negative newsflow from the US market. These companies have been trading at sharp discounts to healthcare B2C business models like diagnostic chains and pharma MNCs. We believe investors are unlikely to realize the full valuation potential of the strong domestic formulation franchises, as structural challenges in the US market may not wither soon and continue to dominate the investment narrative. Indian pharma companies with hybrid business models should evaluate options to unlock value in their domestic businesses. Our analysis of 8 large domestic pharma companies shows fair value of their domestic formulation businesses to be 38% - 137% of their current market cap – indicative of significant potential upsides in any value unlocking process.

Domestic pharma businesses – suppressed valuations: Negative newsflow from the US market has effectively subsumed the strength of consumer-oriented domestic market franchises of most Indian pharma companies, while domestic consumption-focussed business models have re-rated significantly. Notably, consumer-oriented healthcare businesses like Dr Lal Pathlabs/Metropolis trade at 37x/28x FY21E earnings, while FMCG/consumer durable businesses trade at 36-37x FY21E earnings (Bloomberg). Indian pharma companies have not benefited from this trend, despite strong quasi domestic consumption-oriented business franchises and continue to trade at 15-16x FY21E earnings – at a sharp discount to various B2C franchises. As structural challenges in the US market are unlikely to fade soon, with the US market newsflow continuing to dominate the narrative for Indian pharma companies, we believe investors are unlikely to realize the full valuation potential of the strong domestic formulation franchises for long in the current corporate structures.

Domestic pharma business value unlocking – an idea worth exploring..: While hybrid structures (India branded formulations+exports) are a norm in the industry, we increasingly see limited synergies between the two business segments, barring potential leveraging of domestic formulation cashflow to grow the export business. Along with distinct portfolio strategies, most companies typically have separate manufacturing facilities as well as reasonably different supply chains for their domestic and export businesses (particularly US generics). Apart from cost synergies in shared services, we see increasingly limited overlap between the domestic and export business segments of most Indian pharma companies. We recommend that Indian pharma companies should begin to evaluate options to unlock value in their domestic businesses, as it could generate significant value for all stakeholders without impacting exports. Managements could either transfer domestic formulation business in a subsidiary and IPO it or demerge and subsequently list the domestic formulation business. Biocon has already successfully leveraged this model to unlock value in its contract research business (Syngene) and is contemplating unlocking value in its biologics business too.

..Fair value estimation suggests significant upside potential: Our analysis of 8 large domestic companies shows that fair value of the domestic formulation business for Indian pharma companies ranges from 38% - 137% of their current market cap. While DRL’s domestic business has a relatively lower fair value at 38% of its current market cap, we estimate Glenmark’s domestic business is potentially more valuable than the value assigned by the market to the whole company. The domestic business value of most other companies itself is ~80% of their market cap. We have conservatively assumed 25% EBITDA margin (for most companies) and 30x FY21E PER for estimating the fair value of domestic pharma businesses across companies. Arguably, the profitability and fair value of these leading domestic franchises could be significantly higher than our estimates, given that the Rs1,200bn domestic pharma market is estimated to register 10%+ CAGR over next several years and these listed entities are likely to continue to dominate this market. Lack of options to participate in this long term and fairly steady growth story will further embellish valuations of any pure-play domestic business.