Q4FY16 was a mixed quarter for the Indian pharma sector. While revenue growth accelerated, margins moderated despite one-off gains. The key headwinds were 1) rising R&D, 2) pricing pressure and 3) USFDA actions. Management commentary for FY17 was largely muted as regulatory and pricing challenges are expected to continue. We remain cautious on large cap pharma and prefer mid/small cap players and Syngene.
Exclusivity drives growth: Q4 saw topline growth accelerating to c15% vs c7% in Q3. This was driven by exclusivity and price hikes in US, and strong domestic growth. Ex of exclusivities growth was 10%. India business growth accelerated to 15%. RoW business though continues to remain muted (3% y-o-y) led by forex and weakness in key markets.
Margins under pressure; guidance muted: Despite growth acceleration and large exclusivity, margins for the sector declined 80bps q-o-q. Base business margins saw moderation for most companies with Sun, DRRD and Cipla seeing the most weakness. The decline was led by 1) pricing pressure and 2) rising R&D. Additionally, guidance by managements for FY17 was largely cautious with few exceptions like Aurobindo.
R&D at c9% for the sector and rising: R&D cost has steadily increased over the past couple of years and was c8.5% for the sector (FY16). More importantly, most companies have guided for further increase in R&D. We expect the sector R&D to rise to c10% in FY17 with LPC, SUN and DRRD spending the most. Sun and Lupin plan to spend $c400 million each annually on R&D over FY17-18 as they build their specialty pipeline. This is similar to the spend by Mylan/Teva on generic R&D.
Pricing pressure to continue: Rising price erosion was a key issue in Q4FY16 and will remain even in FY17. In US: While some global majors like Teva, Mylan have talked about stable pricing most others like Perrigo, Endo, DRRD, Aurobindo, have talked about rising pricing pressure. On average all companies have indicated a mid to high single digit price erosion. The highest pressure is in pain and topical categories, which increases the risk for Sun (Taro). In India: FY17 will see impact of the new NELM pricing and the FDC ban and would have an impact of 2-3%. RoW markets are also seeing various levels of pricing headwinds driven by both regulatory mandated cuts and forex.
Active FDA calendar: The key headwind for the sector over the past couple of years has been regulatory and this continued in Q4FY16 with most companies seeing multiple inspections. While the past month has seen a spate of EIRs, the regulatory action overhang will likely continue even in FY17 in our view. Most companies have indicated that they expect 1 inspection every quarter now. Further, the key facilities for all the large players (SUNP, LPC, DRRD, CDH) will likely be re-inspected in next 6 months which will be the key event.
Prefer mid-cap and services over large cap players: We believe that headwinds for the sector 1) rising R&D, 2) pricing pressure and 3) regulatory issues will continue for another 12-18m especially for large cap pharma. While earnings estimates factor benefits of faster ANDA approvals, the resulting increased pricing pressure is under-estimated in earnings estimates, in our view, especially for Lupin.
On the regulatory front we believe that the overhang will continue for another 12-18m for the sector as companies undergo another round of inspection. Further, Indian pharma (especially large caps) need to transition towards specialty pharma over the next 2 years. This would imply a sharp increase in R&D spend.
While Sun/DRRD are best positioned for a transition to specialty pharma, in our view, the regulatory overhang and premium valuations leave limited room for upside. Given this we remain cautious on large cap pharma and prefer mid-cap players with strong product pipeline in US or significant ex-US business and healthcare service players like Syngene.