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Side effects of regulation

Tanmaya Desai, Fund Manager, SBI Pharma Fund believes that the Indian pharma story remains promising despite being hit by regulatory concerns in the US and currency volatility in emerging markets

In this interview with Vibhu Vats, Tanmaya Desai, Fund Manager, SBI Pharma Fund explains why, in spite of hitting a speed breaker lately, the Indian pharma story is still promising and why pharma funds are likely to remain in the forefront in the future, too.

Side effects of regulation

In the quarter ended March 2016, pharma funds, as a category, lost over 9 per cent, while many other categories gave positive returns. What has led to this decline?
The US business accounts for close to 50 per cent of the revenues for the sector as a whole. Over the last one year or so, many Indian pharma companies have faced regulatory issues from the US Food and Drug Administration (USFDA). This has impacted the pace of approvals in the US and hence growth has been lower in this geography. This, coupled with the fact that companies will take some time to resolve the issues, has impacted sector valuations and that has primarily led to the decline in sector returns. Also, growth for companies in rest of the world (ROW) markets has been impacted mostly due to currency volatility in key emerging economies - Brazil, Mexico, South Africa as well as in developed markets like the European Union and Australia.

How serious are those concerns?
Interestingly, not so long ago, a number of pharma companies of the US origin also faced regulatory hurdles from the USFDA and they emerged out stronger. We believe, for Indian companies too, these issues aren't structural in nature and companies should emerge stronger from this heightened scrutiny as they strengthen their processes and systems, and learn from the current set of inspections. Also, outside the US, Indian companies have the maximum number of plants catering to the US market and they have the maximum number of product filings too for this market. Outside the US, per cent share of the generics business in the US is the highest for Indian companies and hence they are important in the overall scheme of things. This implies increased scrutiny by the USFDA going forward, too.

How promising is the domestic market for Indian pharma firms?
The prospects of growth in the domestic market continue to remain quite good. India is still an under-penetrated market and with increased access to medicine, investments in healthcare infrastructure and higher incidence of chronic diseases, growth continues to be quite promising for Indian pharma companies in the domestic market. At 25 per cent of sales (at the sector level), the domestic market remains the second-highest contributor to the revenues of Indian pharma firms.

What has led to the outperformance of Indian pharma funds for many years?
Broadly speaking, pharmaceuticals is a structural-growth sector, the demand being inelastic in nature. Over the last five years, growth has been quite robust in all three broad areas - India, US and ROW. The largest component of growth and outperformance for Indian companies has come from the US, where growth has been quite exponential and that has come along with strong profit growth, too, in this geography.

Haven't valuations of the pharma sector run up a lot? Can pharma stocks and funds see a sharp correction in the future?
Valuations are richer for this sector than what they were five years ago. However, comparing today's valuations five years ago isn't the right benchmark because inarguably the sector too has done well in this period. The sector has evolved and the growth has been good across geographies. Companies are constantly increasing their spend on research and infrastructure. So from a three- to five-year time horizon, on a structural basis, the earnings visibility continues to remain good and hence the valuations have justifiably moved up over the last five years or so.

However, there will certainly be challenges in the near term; firstly, there are the regulatory issues. It will probably take some time for growth to come back to the US market for some of the companies. Second is the volatility witnessed on currency front in the ROW markets. So even if the constant-currency growth is good, the reported growth gets impacted due to currency volatility.

How much can price controls dent the margins of pharma companies?
The positive stance on the domestic market emanates primarily because a large part of growth in the domestic market is driven by volumes as well as new product launches. To that extent, price controls do not dent the optimism we have on this market. Also, India comprises close to 25 per cent of revenues for the sector as a whole and hence any control impacts only a portion of the revenue stream. India continues to be a market with strong growth potential, though time and again you should expect government-induced controls or barriers to this growth story.

Won't intense competition in the domestic market be a problem?
The good part of the Indian pharma market is that in spite of intense competition, growth has been good and in double digits over the years. It is a highly fragmented market and the top ten players account for 40-45 per cent of the total market. Every company has certain strengths that it tries to play on. There is enough room for volume growth in the Indian market going forward, too.

Where do mid and small pharma companies get their revenues?
The companies that are large in size today were also small at some point in time. With India as their cash cow, the money being made here was ploughed back in foreign markets, particularly the US. Today the profits from the US are being invested in the ROW markets and in increasing R&D capabilities further. Today's mid and small pharma companies are following a similar philosophy. They started their businesses in India and are now spreading their wings in US and other lucrative ROW markets. Since they are small, their potential for earnings growth will be higher. But their growth could also be more volatile as compared to that of their large-cap peers. Valuations of mid- and small-cap peers too have moved up and one needs to be selective even here in terms of stock picking.

What role does research play in the success of pharma firms?
Research is an extremely important aspect for pharma companies. It can be divided into two broad buckets. One is the generic research (be it pure vanilla generic or complex/specialty generic), where the company files for a product, gets product approval and launches that product in the respective market. That's the traditional business model that Indian pharma companies have been following. Here, the R&D spend has gone up from 5-6 per cent of sales to 8-10 per cent of sales. The second bucket is research on developing new delivery systems/new chemical entities (NCEs) and licensing those NCEs to the big pharma companies in the western market so that they can take the research further. They do so because the cost of developing an NCE is prohibitively high and resources available in India are limited. The first model is the primary reason for the success of Indian pharma companies in the US market.

Won't patents affect the growth of Indian pharma companies in the US market?
Largely speaking, patents are not a problem. Majority of competition enters post patent expiration. In those cases where companies intend to enter before the patent expiry, they enter into a litigation with the patent-holder to invalidate the patent or prove non-infringement. In such cases, the opportunity is lucrative and companies get exclusivity for a certain time period where only they, along with the innovator, are in the market selling the product. Patents are not a roadblock for doing business in the US market.

Where does growth lie in the various pharma sub-sectors?
Within the formulations business, the branded-formulations business (in India, part of Latin America, South Africa, etc.) is doing well and is largely stable. The growth in the vanilla generic business in the US market can see ups and downs. Growth can be good if companies keep launching newer products in the market and constantly keep investing in creating a robust pipeline. The nature of the generics business in the US market is such that competitors can affect the sales of the existing products (impacting price as well as the market share of existing players), which makes new product launches important for growth in this geography. The active-pharmaceutical-ingredient (API) business is volatile and could be quite lumpy from one year to the other. On the contract-manufacturing side, focused companies have done quite well and going forward, there is tremendous growth potential in this space, too.

How do you select stocks for your fund? Since it's a sectoral fund, how do you ensure diversification?
Our stock-selection focuses on the following criteria: management integrity; the ability to scale the business and grow better than the industry average; R&D pipeline, particularly for the US market; focus of the company on return ratios; and the capital allocation of the company. On the subjective side of analysis, we meet with the key management and people across business verticals. We also conduct plant visits to understand how the company has been investing in R&D and infrastructure.

Diversification is achieved by the fund across categories. One level of diversification is to invest in a basket of stock across market-cap categories (large, mid and small cap). Another way to look at diversification is to manage the risks emanating from regulatory concerns and currency volatility across geographies. To achieve this, the fund has invested in the generics space as well as the contract-manufacturing space. Further, over the last one year, we have also been investing in the healthcare-services space - hospitals and diagnostics services.

What can investors expect from your fund in the future?
We continue to like the generics story as well as the contract-manufacturing space. For US, we are also focusing on companies that are moving up the value chain from being pure vanilla generics to becoming specialty generics. Barring the near-term risks of slower growth in the US and currency volatility in ROW markets, growth continues to look good for the sector on an overall basis.

This interview appeared in the May 2016 Issue of Mutual Fund Insight.