The BSE Healthcare Index has rallied 28.3% in the last month versus the BSE Sensex at +9.4%. The rally was led by the market rotation into defensive sectors like pharma as well as by recent FDA actions to ensure availability of critical medicines during the COVID-19 pandemic (e.g., FDA’s expedited approval for Cipla’s albuterol inhaler and allowing Ipca Lab to supply hydroxychloroquine sulfate).

Further re-rating to be driven by earnings upgrades
The rolling 12-month forward PE valuation for the sector has moved up by 40% from recent lows in March 2020 and it currently trades at c1 standard deviation above the 5-year mean. With stock prices having run up by 15-55% in the last one month for most coverage names, we believe benefits from COVID-19-related supplies are largely priced in. Further sector re-rating and upside for stocks from now on will be driven by an improved outlook for earnings growth, in our view.

Meanwhile, challenges such as slower-than-expected monetisation of specialty brands and differentiated generics, high competition, FDA overhangs at plants, etc. remain for the US market. We think benefits of expedited FDA approvals and regulatory leniency at plants would not extend to non-COVID-19 products. In addition, benefits of INR depreciation will be largely nullified by weaker emerging market currencies. In the long term, we believe there is a risk of higher costs if the US mandates generic companies to shift manufacturing to the US.

We remain selective amid a broader volatility
We prefer names with clear earnings growth drivers such as scope for significant scale-up in focused segments (e.g. Biocon), and cost competitiveness (e.g., Aurobindo), both rated Buy. We revise estimates for all the names in our coverage in line with the current outlook and update the INR/USD rate to 76.66 (current sport rate, earlier 70). We revise our TPs for all names. While we like the structurally strong and cash-generating business model of Torrent Pharma, we believe the c24% rally in the last month factors in its earnings growth visibility. Hence, we downgrade it to Hold from Buy.

Q4FY20 earnings preview
We expect an improvement in US base sales to continue for most names in 4Q, except ones with pending FDA issues. Q4 is seasonally a weak quarter for India formulations business; however, a few companies can maintain the growth momentum. We expect a good quarter for Biocon, Dr Reddy’s, Lupin and Sun; India-heavy names like Alkem will likely see a soft quarter.