Sanjay Dongre is the fund manager of UTI Pharma & Healthcare. Here he shares his views on the sector and the reasons he believe, investors are now moving into pharma.
There are around 24,000 players in the Indian pharma sector, but only a few are in the organised sector. Is that so?
Out of the total number of companies in this sector, around 2,000 are in formulations, while the rest are in the bulk drug business. The companies in formulations source their bulk drugs from a lot of manufacturers. Since bulk drug manufacturing is not a capital intensive business this space is more crowded, in terms of number of companies. For example, Crocin® is manufactured by GlaxoSmithKline. But its main ingredient Paracetamol, is no longer a patent protected and is thus manufactured by several other companies. Thus, this ingredient, which is a chemical, is sourced by various companies in the formulations space. They add a stability factor, coat it, make it palatable for a patient, brand it and sell it in the market in the form of tablets. Thus there are several brands of the generic Paracetamol.
Due to this ease of entry and existence, the industry is very fragmented. For instance, the top player will not have more than a 5 per cent market share, while those at the bottom of the pyramid too will have a very low market share, of barely more than a few basis points. No single player has any dominance in this industry.
Within this entire pharma space, each company will have its own strategy. A few big players have more than 50 per cent of their turnover coming from outside the country. Some pharma companies may focus only on a region, like the CIS (Commonwealth of Independent States) countries; or focus on emerging markets; still others may look at the American or European market. Then a few pharma companies have global aspiration and hence would be focussing on every region. These companies do not want to be dependent on a single market. On the one hand, a number of companies have ventured outside the country and bought companies abroad. On the other hand, there are many companies that see tremendous potential in India itself so they are solely focussed on the domestic space.
Challenging environment in the global pharma market has led to the companies adopting several other strategies. Some pharma companies have a good blend of plain vanilla ANDA filing, niche generics and products with ‘First To File’ status (FTF). On other hand, others have demerged their drug discovery research into a separate company given its high risk high return nature.
Do you have any preference in terms of domestic or export focus?
From a diversification point of view, we would prefer the export-oriented companies. After all a source of revenue from various regions does mitigate risk to some extent. So if one region does not do well, there is another to balance it and this will give some stability to the top line of the company. We like companies with a business model which is a combination of vertical integration, access to low cost manufacturing, exposure to more geography and good mix of plain ANDA and FTF.
From a short-term view, one may focus on a company which draws high revenue from a region experiencing a high rate of growth.
But do you not think that some companies have gone overboard with their global expansion plans?
Yes. Some companies have bought others in the emerging markets, in the U.S. and Europe. After three to four years, the benefits of the integration are still not reflected in the earnings to a large extent. There was rupee appreciation, regulatory issues abroad and other such factors which proved to be a hindrance, thus the acquisitions to date have not borne much fruit.
What sort of growth are you looking at?
In India, we can always expect a secular growth of 8-12 per cent per annum, since the pharma and healthcare industry is rather immune to economic cycles. In the last two years, the domestic pharma market has been doing well, driven mainly by volume growth.
Any observations from the last quarterly results?
If you look at the past few years, though Indian companies have been targeting the U.S. generics drug market, which is the biggest generics market in the world, there has been a high degree of price erosion in most of the products. For instance, if a company was going off patent, there would be a number of companies launching that product. Once the patent expired, at least 8 to 10 other generic companies would launch a similar product resulting in a lot of competition. There have been instances where price erosion on the first day of the launch of generics, would be as much as 99 percent. As a result, the companies were not in a position to reap supernormal profits. Also there were regulatory issues abroad. Therefore the companies were not able to show good growth in the top and bottom line. In addition to all this, there was rupee appreciation which was eating away at the profits booked in foreign currency.
But in the last two quarters we have seen a change. Pricing pressure has ebbed and margins have stabilised in the overseas markets, which is getting reflected in the numbers. Thus the companies are doing well domestically as well as overseas even, while the rupee has begun to depreciate again.
Do you have any preference in terms of companies in bulk drugs or formulations?
No. We do not focus on any single segment since each strategy has its own pros and cons. One must be diversified across these strategies so even if one fails, another will prove to be a buffer. In our UTI Pharma Fund, we have a mix of companies that have an exposure to the global pharma market as well as those which are purely focussed on the domestic market. We also have those in the Contract Research and Manufacturing Services (CRAMS) space as well as those into R&D. As R&D was eating into the profits, some companies have demerged their research units into separate companies. Now these companies can continue with their research, which is a higher risk activity, and raise funds separately from investors with the appetite for such risk.
In keeping with our philosophy of following a top-down approach, we look for companies within the pharma space that are likely to exhibit a stable growth.
Where do you see more growth happening?
We are quite excited about the CRAMS space. Globally, companies are reducing their R&D spends and outsourcing it. These big players are entering into collaborative drug discovery research and manufacturing arrangements with Indian companies. Manufacturing costs in India being lower than overseas, this space may exhibit slightly higher growth. Overall strong micro environment is expected to translate into high revenue and earnings growth for CRAM companies. But the listed opportunities here are very limited. We also like companies with a strong pipeline of exclusivity products or niche products.
Has pharma emerged as a defensive sector?
Earlier, growth exhibited by pharma companies was less than that by companies from other sectors for reasons discussed earlier. As a result, investors were significantly underweight on pharma sector. Today it is a different situation. Expectations of a slowdown in GDP to less than 8 per cent coupled with the dismal situation in the U.S. have thrown up a different scenario. Continuing concern about inflation, interest rates, weakening rupee is weighing heavily on the performance of most sectors of the economy. With expectations down, the relative growth exhibited by pharma companies looks attractive again. That is why investors are shifting a part of their assets into pharma sector.
What sort of returns can one expect from the sector?
The returns from pharma sector will be relative to the market. The market is expected to remain range bound in the short term on the back of higher inflation, higher interest rates and weaker rupee. Pharma sector being a defensive and under-owned sector is likely to outperform the broad market.
Currently, investors are still significantly underweight in this sector. It is a secular growth story and the domestic market will grow at 10-12 per cent. Exports are looking up. If the rupee continues to depreciate, it will add to the earnings growth trajectory. In such a situation the growth exhibited by pharma companies could be more than that of companies in other sectors, relatively speaking.
What could hinder the pharma industry’s growth?
Being a export oriented business model, significant rupee appreciation is likely to impact the earnings of generics and CRAM phrama companies.
Regulatory issues within the country and globally. There are difference between Govt. and Pharma industry on the New Pharmaceutical Policy. The government wants more drugs to come under price control. This will naturally hit the profitability of the companies. Given the strong opposition from the pharma industry, the government has appointed a Group of Minsters (GOM) to give final recommendation on the New Pharmaceutical Policy. We shall have to wait and see the outcome of this process.