Sriraam Rathi & Vinay Bafna (Analysts, ICICI Securities)
Pharma companies have witnessed 15-20 per cent increase in stock prices in the recent past. This was driven by bottoming of the earnings downgrade cycle, positive commentary by companies regarding stabilisation of pricing environment in the US, cost control initiatives of companies, favourable currency environment and reasonable valuations. We remain structurally positive on long-term outlook for the Indian pharma sector considering abundant growth opportunities, strong balance sheets, improving return ratios and free cash flow generation. But the recent rally in valuations has limited upside potential in several stocks. We believe companies with strong India presence, specialty/complex generics pipeline in the US and vertical integration would trade at premium valuations. We expect healthcare companies under our coverage to report revenue and earnings CAGRs of 12.9 per cent and 21.7 per cent, respectively, over FY18-21.
The consensus earnings of largecap pharma stocks witnessed downgrade of over 38.9 per cent over last two years. The downgrade was primarily due to higher competition and pricing pressure in the US, increase in R&D spends and USFDA issues at various plants. The downgrade cycle has bottomed out considering stabilisation in pricing environment in the US (5-7 per cent erosion now vs double-digit earlier), cost control initiatives across companies and relatively lesser FDA issues on improving compliance.
The valuation of pharma stocks has re-rated 10-20 per cent on improving US business environment and expectation of strong 21.3 per cent earnings CAGR over FY18-21. We expect improving growth visibility, better compliance and strong earnings growth with improving return ratios to help the re-rating sustain.
The India business would provide growth and margin sustainability. In the US, companies with clean FDA record and pipeline of specialty/niche and complex generics are better placed to grow faster with profitability improvement. We expect steady mid-teen revenue growth for healthcare (hospitals and diagnostics) mainly driven by higher volumes, which would drive operating leverage.
Our top picks are Aurobindo and Alkem in pharma space, Apollo Hospitals and Dr Lal Pathlabs in healthcare.
We believe earnings cut for the sector is largely over and expect strong 21.3 per cent earnings CAGR for the companies under our coverage over FY18-21.
We believe that recent rally in pharma stocks was an outcome of the above and expect the key drivers for these factors to play out.
*Stabilisation of pricing environment in the US generics with price erosion of single digit vs double-digit earlier as per management commentary of most generic companies and impact of buyers’ consolidation being already in base.
*Ramp up in specialty business in regulated markets of companies like Sun Pharma and Lupin, which already have the pipeline in place.
*Steady double-digit growth in India business with sustainable higher margins, though, Q2FY19 would have high base effect.
*Cost control initiatives implemented by companies to aid margin expansion. But increasing raw material costs would negate the benefit to some extent.
*Favourable currency movement with the dollar appreciation to benefit with higher profitability. We have increased our assumption of the rupee/dollar to 70 from 68 earlier.