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Posted on 7/11/2017 6:30:00 PM

The burgeoning domestic market is likely to see a leg up as the income per capita and the standard of living improves with the expansion of the economy

Markets often tend to be volatile and so, when we see widespread pessimism towards a certain theme sector, understanding the underlying components will help shine light on why that pocket could be a contrarian investment to consider. Of late, the Indian pharmaceutical space has been facing numerous headwinds in the form of US Food and Drug Administration (USFDA) concerns translating into considerable price erosion. Consequently , the institutional ownership in this space too has fallen sharply, as the popularity of this sector is currently at a multi-year low. However, on closer inspection, it is visible that many of the pharma players have indigenous positives that are likely to play out with time. 


While we recently saw broader market indices touching all-times highs, the pharma sector saw a sharp drop in its market share. Nearly two years back, the sector's market capitalisation as a percentage of the overall market capitalisation in India was at 8%, which now stands at 5.9%. The sector is no longer expensive in terms of absolute market capitalisation, which is one of the hallmarks of a contrarian pick. In fact, the valuation of the sector has corrected by nearly 25% (on priceto-earnings) in the last one year and is currently trading at a discount to its long-term average. Historically , this was one sector which was always trading at a premium to the market. Despite the pessimism surrounding the sector, we believe there are ample growth opportunities in the local and global markets as the USFDA issues start getting resolved. 


On closer inspection of the challenges faced by Indian pharma companies, it can be gauged that the observations mainly are on the manufacturing units operated by the companies. Over the last few years the numbers of inspections have risen. However, this should be seen in the light of the increased volume share of India in the US generic drug market, which has risen to nearly 35% as of 2016, when compared to 28% market share in 2014.

In fact, this increased scrutiny is an inevitable outcome of the success of Indian pharma. Today more than 13 of the generic drugs (by volume) consumed in the US are produced in India. When Indian pharma is such an important component of the US pharma sector, it is no surprise that its standards will be scrutinised. Going forward, the number of these inspections is only bound to increase.

Even otherwise, the US FDA has stepped up the level of quality compliance across the globe, and India is no exception. With the increased automation of many of the manufacturing plants in India, it is likely that going forward, the number of issues may be resolved at a faster pace, thereby benefitting the sector as a whole. So, amidst this short term pain, lies the opportunity to tap into sizeable gains which is likely over the long term.

Other than this, the US is also focused on lowering the drug prices and the easiest way to get this through is by increased approvals to the generic players. As of date, more than 25% of these pending approvals in the USFDA are solely from Indian players who are the relatively cheap manufacturers and sellers of drugs in the US. As the approval for these generics start coming by , Indian pharma is likely to benefit disproportionally. 


It is not only the international markets that can aid pharma's growth.The burgeoning domestic market is likely to see a leg up as the income per capita and the standard of living improves with the expansion of the economy. India is in the early stages where healthcare as a sector is slowly taking the center stage.

Currently, healthcare spends in India as a percentage of GDP is low at 4.7%. It has been observed that as the economy expands, the per capita spend on health care too increases steadily . Also, the growing incidences of lifestyle related diseases too suggest that India could sustain a double-digit growth for the next five years. When it comes to the listed space, there has been quite some selloffs from the private equity space, especially in the newly listed names, particularly post the expiry of lock-in periods. As a result, the supply of stock increased rapidly in the market not because of sector issues
but because of private equity exits.


Robust balance sheets coupled with good cash flow generation has ensured that the fundamentals of pharma companies remain fairly robust, unlike the stock price, as seen in some cases. It is likely that going forward, the healthy cash flows could be deployed for research spends or for inorganic growth through mergers and acquisitions. Currently, Indian pharma companies are upping the ante when it comes to investments in research and development in generic and specialty business, with investments at an all-time high. Such increased investment in research and development usually takes about 3-5 years to bear fruit.  


Thus, far the fall in pharma prices have been majorly on account of the lack of earnings growth and as such the sector has not been de-rated. However, going forward, we believe, revival in earnings is likely, as the operating leverage begins to play out. While the stress has largely been on international businesses, the India business of pharma companies continue to remain profitable and cash generating. In the quarters ahead the cloud surrounding the international business is likely to clear out, thereby the earnings reemerging profitably .

In light of the above listed positives, pharma presents an interesting case for contrarian investing. Looking at parameters like market cap, margins, positioning and leverage, pharma sector in India fits the bill for a contrarian bet.

This article was published on July 11, 2017 in Economic Times

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