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The American factor

Over the years, pharma stocks have seen a dream run before they started limping recently. In this interview with Vibhu Vats, Tanmaya Desai of SBI Pharma Fund tells us the inside story of the sector

Over the years, pharma stocks have seen a dream run before they started limping recently. In this interview with Vibhu Vats, Tanmaya Desai of SBI Pharma Fund tells us the inside story of the sector.

The American factor

Pharma stocks have corrected in recent times. What has led to this?
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.

So, are Indian processes and systems not as good as US ones?
We cannot generalise that processes and systems of Indian companies are not as good as their US counterparts. I think the level of scrutiny by the USFDA has evolved over the years and they keep updating their standards of plant inspection. With the breadth and intensity of questions being raised increasingly, the USFDA has constantly been raising the bar of doing business in the US. The cost of doing business in the US has surely gone up and it is all about understanding the requirements of doing business in the US.

Can one say that US policies are also protectionist in nature?
No, one can't say that. Indian pharma companies occupy the second largest share in the US market. Our share has increased from single digits five years ago to now double digits of the generic US pie. It is only natural for the US authorities to come and inspect our plants. Earlier the USFDA didn't have any offices in India. Today they have a number of offices in India and there are even instances of walk-in inspections. As mentioned earlier, with our share in the US increasing, it would also mean increased scrutiny (both in terms of quality and frequency) by the USFDA.

So, this means the US market has a significant role to play in the bottom lines of Indian pharma companies.
Absolutely true. Over the last five years the share of revenues of Indian pharma companies from the US market has moved up from 25-30 per cent to about 50 per cent. However, since the cost of doing business in the US has also gone up, this suits larger players more than smaller players in the Indian pharma space. Given their sizes and experience, larger companies have rightfully been investing both in infrastructure as well as in R&D for the US market. These factors tilt the game in favour of companies serious about doing business in the US.

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.

Are Indian pharma companies facing competition in the US market from other Asian or European countries?
Competition from Europe has always been there. As to the competition from Asian countries, China has traditionally been in the active-pharmaceutical-ingredient (API) business but not in the formulations business. They are currently looking to enter it. We need to see how they progress with their initiatives for this market. Chinese scale-up, in our opinion, will take a few more years as their US compliance issues are much deeper than those of India.

For Indian pharma companies, why haven't other developed countries become as important as the US?
There are few reasons for this. First is the sheer size of the US market. The second reason is that the US is a homogeneous market, whereas, say, in Europe, there are different rules and regulations of doing business in different countries. Lastly, the US pricing environment is far better than that in other developed countries.

Should we see China as a competitor or as a prospective market for Indian pharma companies?
More than China, Japan could be an interesting opportunity for pharma companies. The Japanese government is also taking initiative to increase the generic penetration in its market. Companies like Lupin and Sun Pharma have a meaningful presence in this market. We do not see competition from China on the formulations side in the near term but China has always been a competitor on the API side.

Haven't valuations of the pharma sector run up a lot? Can pharma stocks and funds see a sharp correction?
Valuations are richer for this sector than what they were five years ago. However, comparing today's valuations with those 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.

This Interview appeared in the May 2016 Issue of Wealth Insight.