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Nath Balakrishnan

INVESTORS in the pharmaceutical industry may see in year-end results of frontline companies a bitter pill. Value-added tax (VAT) issues at home and pressure on pricing in key markets abroad had left the bottomline anaemic. So what is going to be the prognosis for the big four — Ranbaxy, Cipla, Sun Pharma and Dr Reddy's?

Till a few years ago, it appeared that leading Indian companies could do nothing wrong in the lucrative pharma market in the US. Dr Reddy's had emerged triumphant in a legal battle against giant Eli Lilly and enjoyed a six-month exclusivity on Prozac, an antidepressant, which led to windfall gains.

Ranbaxy, too, enjoyed an extended run with Ceftin (a version of GlaxoSmithKline's Augmentin), which pulled in revenues in excess of $100 million (about Rs 450 crore at the then exchange rate).

Cut to today, the US landscape has palpably altered. Admittedly, the market continues to hold out immense potential and several Indian players have set their sights on it, for a slice of the action.

But a closer look reveals a business environment that is becoming progressively tougher for Indian outfits. Multiple generics being launched on the same day leading to a dramatic fall in prices, the practice of the launch of `authorised generics' by the innovator company (the original patent holder) and the negative court verdicts are but a few challenge Indian pharma companies are faced with.

Does it mean the Indian pharma industry is flagging, requiring a quick dose of Viagra? Not yet.

Unlike in the past, when stocks of every possible hue in the pharma business were being touted as the next biggest thing, it is now the time for discretion and careful stock selection. What are the dynamics of the US market and their implications for Indian players? What are the prospects in the domestic and export markets and how to play the large-cap stocks in this sector?

The threat of authorised generics...

This is clearly the biggest risk for Indian companies. An authorised generic is launched by the innovator company, either through its subsidiary or by tying up with another outfit.

The drug continues to be manufactured by the innovator company. The impact of such a launch may be muted if several generics players are already lined up for launch; however, should such a launch happen during the 180-day exclusivity period that the challengers enjoy for overturning patents, in one stroke it would diminish the upside possibilities for the generic player.

Innovator companies adopt such a strategy to hurtgeneric players by making the opportunity unattractive. Companies such as Dr Reddy's and Ranbaxy, which have a strong pipeline of Para IV challenges (on existing patents; a successful challenge entails the generic player to a 180-day exclusivity), face a higher degree of risk to their growth plans from authorised generics.

... and multiple generics, too

Another trend has been the launch of multiple generics on the same day, leading prices to plummet as much as 90 per cent in certain instances. This strategy may be here to stay.

However, in the case of drugs to be administered through, for example, the inhalation process (an area of Cipla's strength), the extent of the price drop may not be as substantial, as the complexity involved in the manufacture could limit the number of generic entrants. Companies that target such niche spaces are likely to see better realisations, as prices may tend to be stable.

In this context, it is important to keep an eye on Indian companies that target relatively small generic opportunities (say, under $50 million a year; Ranbaxy has pursued this tack with Ganciclovir). Such molecules are, more often than not, unlikely to figure prominently on the radar screens of larger generic companies and, therefore, offer a more profitable niche.

In the backdrop of the current pricing environment for generics in the US, the importance of such an opportunity cannot be underestimated.

Ballooning legal costs

The upshot of challenging innovator patents also manifests in the legal costs for the challenger companies. Taking on pharma behemoths such as Pfizer and Eli Lilly can turn out to be a protracted affair and would call for deep pockets.

The verdict of the lower court is almost always subject to appeal and innovator companies are bringing to bear their considerable financial clout on this process.Dr Reddy's has suffered reverses since its successful litigation against Eli Lilly, underscoring the unpredictability of such legal battles.

Its recent deal with ICICI Ventures for legal and ANDA (abbreviated new drug application) expenses is the first step to defray such costs. It would be of interest to see if such deals can also be extended to the drug development effort.

Given the inclination of Dr Reddy's and Ranbaxy to challenge innovator patents, the legal costs are set to become permanent entries on their expenses statements.

In this context, a strategy that relies more on an amalgam of patent and non-patent challenges — Ranbaxy has adopted such an approach — may offer a cushion against risk, and serve as a more prudent course of action from an investment standpoint.

European pastures

Understandably, with the focus squarely on addressing opportunities in the US, other export markets such as those in Europe and South America have not enjoyed the same kind of visibility. If the pricing of generics in the US market trends lower, the importance of a presence in such markets would get magnified. The relatively low penetration of generics in these markets may well hold out substantial opportunities for Indian players. The dependence on the US market, too, will be de-risked.

However, the European market brings to the table its own set of intricacies; it lacks the homogeneity of the US market and there are language and cultural barriers to be overcome.

In this context, acquiring and/or partnering with companies in this geography may be a batter option that starting operations from scratch. This is precisely what outfits such as Wockhardt and Ranbaxy have done by acquiring companies in the UK and France respectively.

Further, valuations in Europe for acquisitions are more competitive than in the US, which enhances the attractiveness of this market.

Cushion in the Indian market...

With exports taking an increasing share of the revenue pie, the importance of domestic operations has been crumbling. But this is not to suggest that the domestic market is not a lucrative opportunity. Take the case of Sun Pharma, which derives close to 60 per cent of its revenues from this market, and has healthy operating margins upwards 35 per cent, courtesy its focus on chronic therapy segments.

The passage of the amended Patents Bill a couple of months ago marks a milestone in recognising intellectual property rights. Though thought to be in favour of multinationals, the Bill, in its current form, has adequate safeguards built-in to protect the interests of domestic players. Benefits for MNCs will start accruing only in 2007-08, should they launch their patented molecules here.

Our picks

WE prefer to play the large-cap space through Sun Pharma and Cipla. Sun's strength in the domestic market and its geographically diverse revenue base underpin our confidence on the stock; Cipla might follow the least risky route among all players in the large-cap space, but we believe its clutch of alliances with leading global generic players will serve as a key driver of earnings and guard against volatility.

Having a strong presence in the generics market domestically is a negative from an MRP-based excise duty standpoint, but commissioning of a new facility at a tax-free location should help Cipla offset the drawback.

Ranbaxy and Dr Reddy's have a strong pipeline of products addressing the US market; however, the dynamics of that market can stifle earnings growth. In the case of Dr Reddy's we expect the revenue-cost misalignment to continue for some more time and see no near-term triggers for the stock.

Cutting exposures may be appropriate now. In Ranbaxy's case, though valuations are rich, news flow on the Lipitor patent challenge might provide support on the downside. Retain holdings of the stock.

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