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Sanjiv Shankaran

FOR equity investors there is much potential in pharmaceutical companies over the next couple of years. Over the last ten months, the share prices of most pharmaceutical companies have already provided sizeable returns against the backdrop of impressive financial performances. In fiscal 2002, a Business Line study of 1,500 listed companies showed that pharmaceutical companies' earnings grew 59 per cent against the overall earnings growth of 3.9 per cent. Unfolding events in the pharmaceutical industry suggest that the good tidings will last. The following factors will determine a pharmaceutical company's valuation over the next couple of years.

Overseas sales: The key

The best place for India's pharma exports is the US, the world's largest and most lucrative pharmaceutical market. The US is also the toughest market to penetrate because it has the most stringent regulatory requirements and an entrenched distribution system that may appear daunting for outsiders. Companies that do penetrate the US market report impressive returns.

In 2001-02, about half of Dr Reddy's operating profits came from the sale of a single drug — Fluoxetine — in the US. The statistic is put in context when one considers that Dr Reddy's sells dozens of drugs in many countries. The profitability is not indicative because Dr Reddy's was able to make an uncommon breakthrough. But the data indicate the potential that the US market for generic medicines (drugs that have lost patent protection and are open to competitors) holds.

Top-end companies such as Dr Reddy's and Ranbaxy have succeeded in gaining a firm foothold in the highly lucrative formulations (drugs in finished form such as tablets) market. Other companies have attempted the same, though with less success. Few may succeed in the US formulations market because of the high entry barriers, but the ones that succeed are likely to show higher profitability — sustainable too — than companies in most other industries.

Selling bulk drugs (ingredients to manufacture formulations) in the US is relatively less difficult. Indian companies such as Orchid Chemicals have invested heavily to sell bulk drugs there because returns are higher than what overseas markets provide. Morepen Laboratories, for instance, intends to sell an anti-allergy bulk drug, Loratidine, in the US as soon as the patent on it expires. Even a single bulk drug can make a significant difference to Morepen's profitability and equity valuation, and also provide the resources to strengthen its competitive position.

The market for US generics represents an unprecedented opportunity for Indian companies. The returns for companies will vary according to the segment they target. In the event of a successful entry into the US, such companies as Orchid Chemicals can easily deal with the pressure on profit they experience in other markets. US generics hold the key to equity valuation in the next couple of years. Pharmaceutical exports to relatively less lucrative markets, such as Africa and Russia, are also of significance.

Exports have gone a long way in boosting profits of a number of relatively low profile companies such as Ipca and Lupin Laboratories because realisations are higher overseas. An increasing number of companies have begun to work on boosting exports. For instance, even Cipla, which is highly competitive in the domestic market, has worked on steadily increasing the proportion of overseas sales. Over the last four years, Cipla's exports have increased from 14 per cent to 35 per cent of the total revenue.

Therefore, overseas revenue will have an overwhelming impact on a company's valuation. Among the companies with a large proportion of overseas revenue, exports to developed markets such as Europe and North America will be valued more highly. Another differentiator is between the end product — formulations — and the lower value bulk drugs.

R&D: Hidden ace?

The impending tightening of India's patent regulation to fulfil the country's World Trade Organisation (WTO) obligations has pushed the pharmaceutical industry to spend more on research and development. Existing skills in reverse engineering drugs discovered in regulated markets have been important in making Indian companies competitive in overseas markets.

Companies that have displayed strength in reverse engineering the latest drugs are likely to command a higher equity valuation because the R&D skill infuses a higher level of competitiveness. Cipla is arguably the best example of a company that has achieved a very high level of reverse engineering skill that has helped make an impact in the domestic and overseas markets.

Typically, the higher the level of R&D skills, the better placed a company is to spread to other markets and make products that present high entry barriers. Consequently, the company's revenues and profits are cushioned from a slowdown in the domestic pharmaceutical market or newer generation of drugs overwhelming older ones.

For instance, Wockhardt has strengthened its position by being one of the early entrants into biotechnology. The company has successfully penetrated the market for genetically-engineered vaccines and is expected to launch genetically-engineered insulin next year. If Wockhardt is successful, it would open up a huge market and cushion the company from a bad showing in other segments. Additionally, success in R&D also attracts people and partners, thereby strengthening a company further.

The R&D strengths of established players such as Dr Reddy's and Ranbaxy are well documented. Investors may perhaps benefit more when the market increases the valuation of lower profile companies that quietly enhance their R&D strength. Glenmark's share price shot up last year when the market learned that the company had synthesised a promising compound. Regardless of the fate of the compound synthesised — few compounds finally hit shop shelves — the development added to the Glenmark shareholders' fortune.

New drug discovery is a long shot for Indian companies. A few companies have invested resources in this area, but thus far, only Dr Reddy's and Ranbaxy have had some commercial success. But this area holds the potential for an unexpected return, and thereby a sudden sharp increase in a company's share price.

Overseas sales and R&D are the two most important factors in equity valuation. Generally, companies that show the most promise are the ones that will produce the best returns for shareholders. In addition, a few other factors may have a bearing on the valuation of pharmaceutical companies.

Drug price policy: India maintains a tight control on drug prices through the National Pharmaceutical Pricing Authority (NPPA) that fixes a ceiling on the prices of select drugs. Often, companies have complained that the price controls are too stringent. Recently, the Government unveiled guidelines for a new price control policy. The guidelines aim to prune the list of drugs under control and impart transparency to the process involved in price control. The new list of drugs to be placed under price control is under preparation.

The impending developments on this front are critical for multinational companies such as Pfizer and GlaxoSmithKline. Traditionally, these companies have operated against the backdrop of a portfolio comprising strong brands, but with a large number of them falling under the price control regime.

The new list will have significant implications for MNCs because select companies stand to gain in the event key brands are brought out of the price control regime. The strength of MNC brands provides more flexibility to effect price hikes. Therefore, the new price control list may act as a trigger for select MNC stocks.

Changing pattern of demand: The recent years have seen a concerted move by the industry to launch drugs that combat lifestyle-related ailments such as cardiovascular problems, stress and metabolic problems. Growing urbanisation, and modern healthcare infrastructure's limited presence in the rural areas have resulted in lifestyle-related drugs growing faster than categories such as antibiotics.

Companies such as Sun Pharma, which has always had an overwhelming focus on lifestyle-related drugs, are likely to grow faster than their peers. But the recent emphasis by companies such as Ranbaxy, Zydus Cadila and Glenmark, among others, on lifestyle-related segments could throw up a set of companies that have restructured their product portfolio to grow faster than the rest of the market.

OTC: Over-the-counter (OTC) drugs can be sold without a prescription. This is likely to be a high growth area. Recurring ailments such as common colds and nutritional supplements in the form of vitamins lend themselves to a marketing strategy that mirrors the consumer goods industry. Therefore, over the last two years, OTCs have attracted a few important entrants. For example, Novartis renewed emphasis on OTC recently, and raised the profile of its long-standing brand, Calcium Sandoz. Around the same time, Morepen, traditionally strong in bulk drugs, set up a subsidiary to capitalise on the OTC market's potential.

It is early days yet for new entrants in OTC. For instance, Novartis' OTC segment had a profitability of a mere 6 per cent in fiscal 2002 against 19 per cent for its prescription pharmaceutical business. The OTC segment, however, holds potential and a strong presence can prove be an ideal foil for a company with a strong prescription business such as Novartis'.

The overseas generics market is likely to be the single most important determinant of profitability and equity valuation in the near future. Companies that look strong in this segment are likely to be the best investment opportunities.

The other important factor in determining valuation is likely to be tangible progress in R&D. At the moment, top-end companies such as Dr Reddy's, Ranbaxy, Cipla and Wockhardt seem to be best. But for an investor the best return could come from a lower profile company that displays progress in R&D. Other triggers for a rise in equity valuation are likely to the new price control list and successful product introductions.

For investors, the pharmaceutical sector appears an attractive destination. Few other industries have the opportunity to eliminate risks associated with geographical and product concentration and discover the high growth possibilities simultaneously. The future appears bright, and investment, attractive.

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