Pharmaceutical Sector Analysis: Opportunities & Traps

Indian pharmaceutical industry contributes to 20% of overall generic medicines manufactured globally. It has 22% of US FDA approved plants in the world. Over last decade it has consistently grown in size and offerings. As per industry reports, in generic medicines, one in every three in US and one in every fourth in UK is manufactured in India. Generic medicines contributes to over 70% of revenue for Indian pharma companies. Truly, Indian companies are the global factories when it comes to generic medicines owing to the availability of cheaper resources in India. However, over last three years pharma stocks have been struggling because buyers gaining more bargaining power and many countries joining this model. With Covid-19 pandemic, pharma stocks are back in focus. However this segment if not easy to crack because of complicated science, supply side disruptions, export dynamics, US FDA bans etc. There exists value traps as well as growth options. Due to corona induced pharma rally, investors are making the mistake of blindly buying anything. We have done a sector roundup analysis to come up with certain recommendations in our portfolios (both small cap & multi cap portfolios). This time we have also consulted medical professionals as part of our research. They have far more medical insights than we can have as an equity analyst into how corona virus may transform the pharma industry both in long & short terms. We are sharing part of our analysis for the benefit of ace readers via AI post.

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Indian Pharma Industry: Overview

European Commission - Competition
Drug Life-cycle, Source: European Commission

Indian pharma industry is poised to grow at 10-14% annual rate till 2025 and they should continue outperforming global pharma industry which is expected to grow by 5%. Pharma is one of the sectors where we have been able to maintain growth ahead of China as it continues to grow at 11% in the past. However, things have changed since Covid-19 and there will be sizable market share migrating from China to India. With a pessimistic assumptions, the industry can grow at 15-18% over next few years. This comes very timely as Indian pharma is at inflection point. A point where there is going to be a change in the pecking order. In the past, current market leaders like Sun Pharma & Lupin enjoyed success by bulk selling generic medicines. The world’s biggest market is US and they mapped it. Further increase from here is unlikely as envied by success, many companies from other emerging countries have joined the party. The cost pressure is huge and there is a significant margin erosion for these companies. Sensing this other Indian pharma players have stopped dreaming to make it big via generics but rather investing their time & money into other sections of pharma industry. Even bigger companies like Sun & Lupin are also moving into complex generic and new formulations. The problem is they were generating so much money that by merely shifting their focus to somewhere else can’t make up with expected shortfall in bottom line numbers. This glaring difference has kept them under check for past three years. Simply too big to quickly turnaround.

On the other hand, many mid & small sized pharma companies have seen this happening to their big brothers & taken course corrections. They are the one which can make big splashes in time to come owing to their agility and ability to grow at a higher pace than larger players.

Now we go into a level deeper by slicing pharma companies on the basis of their business focus. Typically, there are four to five buckets under which we can place most of the pharma companies. We have created a mapping of companies from listed space across these buckets as below.

As you can see Indian pharma companies have presence in the initial & final phases of a drug lifecycle and not present across the value chain. The cream of entire lifecycle, which is exclusive manufacturing rights, is dominated by US based pharmaceutical companies. Usually, with each new drug patent filing, company gets an exclusive right to sell that medicine for a period of 10 years (varies). During this period, companies make a killing as they are the only manufacturer of such medicine with no competition. This is where bulk of the revenue comes and compensates for the spend done during drug discovery phase. This is a specialized area where none of the Indian or Asian companies have much presence. Once exclusive license expires (let’s say 10 years), regulators allow other companies to sell same product as a generic medicine. In order to do so, generic manufacturer has to file ANDA (abbreviated new drug application). Based on ANDA filing, US FDA may approve & authorize them to sell generic medicines in US. In a way, generic manufacturer gets the leftover portion of the drug lifecycle and there is a massive pricing competition since there is no moat. Still, this is a volume game. Companies like our Indian pharma, they setup large manufacturing setups in cheaper locations to bulk produce these generic medicines & export to US or other markets.

There is another area which is slowly evolving but relatively unknown, IT enabled pharma compliance & clinical research data management. These are pure service sectors and our IT biggies like TCS, Wipro etc are actively involved in this. With advent of artificial intelligence, there is significant boost to pre-trials and companies like IBM via Watson platform are trying to munch on it.

This was the overview of pharma sector. Now, let’s go another level deeper to understand each sub-segments. For sake of simplicity, we will be skipping the sections where Indian companies do not operate.

1. Drug Research

Credit: bp-3.com

These are companies involved in the first stage of overall drug life-cycle. It takes around 12 years for any medicine to be commercially launched. The process starts with thousands of molecules as potential candidates. It goes through a series of pre-clinical trials to filter out 99% of those candidates. Typically out of a thousand only 10 will make it to the next phase which is clinical trials. Based on the results of clinical trials only 1 molecule will get selected for stage 3 human trials. Once past human trials, if satisfactory, it gets regulatory nod for commercial production. This is very costly procedure since it involves paying highly skilled scientists & labs to conduct such projects over many years.

To reduce this cost, some companies offshore bulk of trial activities to cheaper locations like India. It is called CRAMS (Contract research & manufacturing services) and such companies are called as CDMO (Contract development & manufacturing organization). CRAMS is there since many years but not many players can crack this. There are reason for it. One, not all companies are not comfortable to share drug discovery process offshore. Second, the pool of skilled scientist in cheaper location is limited. As per estimates India had just one tenth of scientists as compared to US. One of the reason is talent migration as well. Talking in Indian context by far the most established players in this segment are Syngene & Divi’s Labs. Both of them have spend decades in close collaboration with major MNCs to develop a level of trust & a pool of skilled scientists. This segment typically takes time to grow but it has client stickiness and can ensure years of solid cash generation because once client takes a plunge with a service provider they are not likely to change them mid-way in the project.

2. US Focused Manufacturers

As you have realized, most successful Indian business are into generic medicines and US being their biggest market. These are companies having majority of their revenues coming from US. Such companies are currently market leader like Sun Pharma who were early adopters of this model. They had a dream run till 2014 after which the pricing pressure & intense competition led to price erosion and a sharp dip in profitability. Within this segment also we have two type of business models, one where Indian company sells generic medicine in US directly. Another, where they do a marketing & distribution tie-up with an American company. Firm like Natco Pharma has such models. While most firms like Sun or Cadila or Dr. Reddy have first business model. Irrespective, both models are under pressure. For both types of model, companies can choose to manufacture either simple generic medicine or the complex one. That is where smaller firms like Natco has an edge as they cater to only highly complex generic medicine which are difficult to produce. Hence, some kind of a moat in otherwise no moat business. Since generic market is pretty saturated, such firms can’t over grow multiple times like they had in the past with same profile. So choices they are making is to diversify into under penetrated markets like Japan , China or South America. This is what firms like Lupin are doing. Another choice they have, is to increase their market share within US by snatching more share from competitors. This is what companies like Sandoz, Mylan or Teva are doing. Having said that there are many patents going to expire in next five years. These can give fresh lease of life to such companies but competition is going to remain intense.

Worldwide Patent Expiry

Generic segment slowed down but there are opportunities in future as many patents are getting expired over next 5 years (Worth $170 billions). Data source: EvaluatePharma

3. India Focused Manufacturers

Thanks to a large population, India’s own pharmaceutical market is 10th largest in the world. There are companies that mainly earn revenue by focusing on domestic market instead of exports. This is not a bad option since Indian market is expanding at a higher rate than global average. India’s own pharma grew at 14% over last 5 years while estimates were to grow at 9%. So surprise is on the higher side. With rising income patterns in India and lifestyle related ailments, there is going to be a robust demand in future as well. Unlike developed countries, India’s pharma is dominated by something called branded generic. Branded generic is nothing but a generic medicine with a brand name. For example, we remember popular medicines like Digene or cough syrups like Corex or Benadryl etc. These are not the name of chemical compound but the brand name given to a particular medicine so public can remember & have a brand loyalty. On the other hand unbranded or simply generic medicine will not have any simplified brand name attached to it. It will be sold as per actual chemical name only. For example, some of you may have seen paracetamol tablets simply names as paracetamol tablets without any brand name like Crocin etc.

Indian Pharma: Revenue-wise breakup, Source: AIOCD

Branded generic covers 70% market share in India and company making most revenue from here is Alkem Labs, followed by Indoco & Torrent. Above table can give you a good idea about which company generates most revenue from the region. In terms of diversification, it seems Cipla & IPCA are very well diversified with revenue splitting across the regions.

Within Indian pharma manufacturers the largest market share by disease is from Anti Infective, followed by Cardiac & Gastro. Some of them have seasonality patterns like respiratory & anti infective. While the most stable one are cardiac & diabetics. Vitamins has been gaining traction on back of rising health awareness. In pain management, we have huge presence of OTC drugs (over the counter) and companies like Amrutanjan have good market share.

Top 5 Drugs Sold in India in 2019

While Indian pharma companies have a good presence in Indian market, the top medicines being sold in India are still dominated by Multinational Pharma companies. In top 10, seven are owned by MNCs. Only prominent Indian firms to feature in top 10 are USV Pharma (Unlisted) & Himalaya Drug Company (Unlisted). Over last year, Indian medicine sales grew by 9% which was also the fastest in last few years. It was largely led by anti diabetes & cardio drugs. India is world’s diabetes capital with over 70 million people impacted by it. It is followed by cardio which is one of the major causes of death in India. The spread of these diseases is amplified by increasingly sedate lifestyle of white collar working population.

4. Focused on APIs

API (Active Pharma Ingredients) are used as input material for manufacturing medicines. India imports 60% of API material from China which is a huge dependence. This has come to the forefront with corona virus situation as supply chains are disturbed. However, there are many Indian pharma players who focus only on API manufacturing. Some of them have made a big name for themselves like Divi’s Lab. It may be a smart move as they don’t have to focus on ANDA filings etc. They just need to maintain API quality as per requirements. Indian leaders in this sector are Divi’s Labs, Dr. Reddy’s, Cipla etc. Many of them manufacture APIs for their captive consumption. This sector is yet to saturate because of changes in formulations & many blockbuster drugs going off-patent in few years.

Within India, production of APIs is worth around $11 billions and is expected to grow at 10% annual rate. India sources 32% of API requirement from abroad. Out of this China alone has 60%, followed by Germany, Italy, Malaysia. At global level Indian API industry has 8% market share.

Indian API industry needs some massive boost to gain market share from China. Katoch committee recommended to create Pharma SEZ zone like IT SEZ. Provide incentives for industries to setup API plants in India catering to the world. While Government push remains to be seen, private companies are trying to tap into this opportunity by expanding their manufacturing capacities.

Summary

In the beginning, we thought to cover hospitals & medical diagnostics as well in this article but later we curtailed the scope as it is becoming too much under one post. The aim of AI post is to share knowledge in a simplistic ways and not to confuse investors. Let’s save it for the next time.

Pharma industry will see a renewed interest from investors & authorities alike in the wake of Covid-19. Also, there is a seismic shift as companies will look to de-risk themselves from China. This has changed the equation in India’s favor and hence investors are buying these stocks. Talking about opportunities & traps, by now you may have understood that companies selling generic medicines in US are value traps which can be avoided. Company focusing on APIs, Domestic branded generic are good places to invest. CRAMS is another area worth exploring but it has a long gestation period and investor need to be highly selective. Based on our analysis and consultation with medical experts, we have added few pharma & diagnostics stocks in our long term portfolios. Some of them are very niche and have potential to grow multiX in next few years. One of them has already doubled and looks to double once again, making it 4x jump from 52 weeks lows. If you are interested to join us, reach out to us on whatsapp @ 9958092336.

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