We remain positive on Indian pharma and expect it to outperform in the current uncertain market environment. Multiple growth drivers exist over the next three to four years and we believe potential operating leverage benefits are still not fully appreciated. There are risks as well, but the industry appears much better placed to absorb these, with more sources of growth and limited capex. In sum, earnings surprises are more likely to be on the upside than on the downside for most companies.
We are very positive on the US market, as the patent expiry cycle (peaking over 2010-14) plays out. Most companies have infrastructure in place, have expanded their filings basket and moved from plain vanilla generics to niche/complex areas: P-IVs, injectables, oncology, OCs, derma, XRs, etc. Key risks: longer ANDA approval timelines, rising FDA scrutiny.
While the Indian market would remain a key growth driver, growth would also come from other interesting markets such as Latin America (especially Brazil, Venezuela, Mexico), Russia/CIS, West Asia and South Africa. However there are some key risk such as stiffer competition from Big Pharma, regulatory pressure on pricing, potential transition from branded to pure generics.
Sluggish demand has persisted far beyond what we had originally expected and high fixed costs have hurt profitability. There are signs of recovery in contract manufacturing in the Q4 results of most companies, but we would like to see these trends sustain for a few more quarters to signal a turnaround.
Demand remains strong, and companies continue to see higher occupancy, better case mix and pricing power. Both companies have aggressive expansion plans (Apollo: 2,400 beds, 28% of current base; Fortis: 1,400 beds, 37% of current base) and balance sheets are comfortable.
Valuations are not cheap but have come off the frothy highs seen in December 2010. We expect companies focused on generics to outperform Contract Research and Manufacturing Services (CRAMS) while healthcare delivery (hospitals) remains a good long-term story. Dr Reddy?s and Lupin are our top large-cap picks while we prefer Aurobindo and Apollo Hospitals among mid-caps. Cipla is our top ?sell?.
There are risks ? largely execution and regulation-related ? associated with most of these growth drivers, but the industry appears much better placed to absorb these given that there are more sources of growth and investment in capex is largely done. In sum, earnings surprises are more likely to be on the upside than on the downside for most companies.
In this report, we revisit the opportunities and risks associated with the key medium and long-term growth drivers for the industry. We also outline the key investment thesis and catalysts for all stocks in our coverage universe.
We expect strong traction in revenues over the next three to four years, primarily from patent expires in the US and EU ($50 billion over 2011-15). Most Indian firms are much better placed (in terms of size, visibility, readiness of plants and filings) to target this wave of patent expires than in the past. At the same time, diversification into niche, complex segments (injectables, controlled subs, oral contraceptives, asthma, ophthalmics, sustained release forms, etc) and efforts to tap the Indian and other emerging markets would also buoy revenues. Larger companies such as Ranbaxy, Dr Reddy?s, Sun Pharma and Lupin also stand to benefit from certain unique opportunities (FTF/P-IV/settlement upsides) in the US market.
Over the longer term, we expect Japanese generics and biosimilars would emerge as key drivers ? though fewer Indian companies are likely to succeed in tapping these opportunities. Earnings momentum should also remain robust. Besides healthy top-line growth, the tapering off of capex and lower leverage on balance sheets would drive profitability. We believe that while the momentum in revenues appears well known, the Street could be underestimating the impact of operating leverage on earnings growth. There are risks in the form of longer approval timelines, a more stringent US regulator, rising competition in emerging markets, etc, but most of these are largely timing-related and, unless severe (a la Ranbaxy?s issues with the USFDA), unlikely to have a material impact on long-term growth prospects.
We expect strong growth to continue in Indian hospitals, as favourable demographics continue to drive strong demand growth. We expect occupancy rates to pick up and case mix to improve for good quality hospitals, which along with some price hikes would improve profitability. At the same time, growing scale has gradually improved the hospital companies? ability to invest in future growth (organic and inorganic) initiatives. The recent policy thrust (offsetting capex on new hospitals against profits for tax purposes) and greater granularity provided by companies on financials have helped the Street appreciate the true potential of this industry much better. The key risks for this industry relate to execution (delays in setting up new hospitals could constrain growth) as well as the impact of rising cost of capital on IRRs.
At this point, both companies under our coverage appear reasonably comfortable on the balance sheet front though we believe that both of them will have to lever up, and even potentially raise fresh equity, in order to execute their longer-term expansion plans.
Citigroup Global Markets