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The best medicine

Investing in select pharma stocks might be the shot in the arm that your portfolio needs in times of a slowdown. The general environment for the pharma industry, particularly for domestic companies, seems positive.

R. Sree Ram | Print Edition: February 5, 2009

The new year is already a few weeks old, but it doesn't seem to have done your investments much good. The bears look like they have camped out in the markets. This is the time when some investors go looking for stocks of companies that provide goods and services which are scarce. Others look for companies that can withstand recession. It is for such investors that we direct our public service message: do drugs. No, seriously. Pharma companies seem well placed to weather out these markets, though you wouldn't think so judging by their performance during the previous bull run. But that poor showing was largely due to regulatory and company-specific issues. However, these companies are now steadily gaining ground as margin pressures ease due to lower commodity prices.

The general environment for the pharma industry, particularly for domestic companies, seems positive. Tight healthcare budgets have led to a bigger push for cheaper drugs by government and insurance companies in emerging markets. This offers significant opportunities for the Indian companies. Apart from the rising scope for producing cheaper drugs, Indian pharma companies are becoming popular among global innovator firms. These outsource their research and production activities to cheaper locations, and India is a favoured destination.

The Right Dose
Why pharma stocks can outperform Sensex in 2009
Robust domestic demand: The Indian pharma market is expected to grow by 14-15% a year over the next two years.
Focus on cheaper drugs: Stretched healthcare budgets are forcing emerging economies to look at cheaper generic options.
Outsourcing opportunities: Indian pharma companies are increasingly offering clinical trials and R&D services for MNCs; API and CRAMS is set to grow by 20% per annum.
Off patenting: Global generic drug manufacturers target an estimated $70 billion worth of drugs to go off-patent over the next five years.

"The estimates for outsourcing opportunities vary from a modest $5 billion to $50 billion till 2016, when most of the current blockbuster drugs will become off-patent. India has an edge over other emerging economies in this space and this presents a huge advantage. More and more innovator and generic companies are either setting up their own operations in India or are resorting to heightened outsourcing," says Ajit Kamath, Chairman and Managing Director, Arch Pharmalabs. More such Indian companies are increasing their foothold in non-US markets like Latin America, Russia, Africa and Asian countries such as Japan. These markets are not only growing at a faster pace than the developed ones, but also offer high potential for generics drugs.

So, how do you select a pharma stock? There are three broad types of pharma companies in the country: generic manufacturers, contract research players, and multinationals. Generic drugs are produced by companies like Lupin, Cipla, Sun Pharma and Ranbaxy. These companies offer long-term value due to their strong foothold in developed markets. The contract research and manufacturing services (CRAMS) players offer outsourced production and research services to MNCs. The companies in this segment include Piramal Healthcare, Divi's Labs and Jubilant Organosys. Finally, there are MNCs like GSK Pharma and Pfizer, which leverage the strengths and expertise of their global parents in the domestic market.

Which of these will help your portfolio? "The robust earnings of India pharma companies are likely to come from patent challenges, which leads to a 180-day marketing exclusivity in the US. The companies in the CRAMS segment are likely to report good growth as the margins are higher than in generic drugs," says Ranjit Kapadia, head of research, Prabhudas Lilladher.

Best Pharma Picks
StockSales CAGR 2007-2011E (%)Net profit CAGR 2007-2011E (%)
P/E (x)
Free cash flows (Rs Cr)Net Debt/Equity (%)
   2008-9E2009-10E2007-82008-9E2007-82008-9E
Cipla23.629.817.311.7-3972291113
Dishman Pharma26.930.18.16.0-273-319997
Divi's Labs27.131.616.012.21372772-18
Lupin26.323.29.17.6-522-122828
Piramal Healthcare14.826.512.18.1327-826066
Sun Pharma23.924.510.69.7558752-35-43
Data source: Nomura, Enam Securities
Sun Pharma, Cipla, Lupin and Piramal Healthcare are the preferred stocks. Sun Pharma has the strongest balance sheet in the sector, allowing it to generate multiple new growth engines in the future.

Apart from the intrinsic strength of these companies, there is also the fact that pharma has traditionally fared better than the other sectors during a downturn largely due to an inelastic demand. During the previous bear phase (February 2001 to July 2003), the BSE Healthcare Index gained 21%, while the Sensex lost 11%. In 2008, when the Sensex lost 53%, the Healthcare Index outperformed it by containing its losses to 33% (see chart). "Over the next couple of years, major pharma stocks are likely to outperform the Sensex due to a strong growth in the domestic market and a sharp rise in formulation exports. The stocks will attract long-term investors like insurance companies and pension funds which have a three to five year investment horizon. Pharma stocks are likely to give steady returns," says Kapadia.

Prescription For Profit
Low debt-equity ratio: Will help the company in avoiding high interest costs.
Free cash flows: Ensures that the company is liquid and is making money from operations.
Low P/E ratio: Don't overpay; look for stocks that have a P/E of less than 10.
No foreign debt: Avoid firms that have FCCBs coming up for conversion in the near future.

Pharma stocks might help your portfolio weather the recession, but only if you select wisely. However, not all pharma stocks are recession-proof. This is due to the weak or highly leveraged balance sheets of some of these companies. Until last year, when credit markets were flush with liquidity, almost all pharma companies raised money through foreign currency convertible bonds (FCCBs) either to fund acquisitions or capacity expansions. These bonds, issued to overseas investors, carry a stipulated interest rate and have an option of conversion to equity shares on expiry. Investors opt for conversion if the market price is higher than the conversion price on expiry. If the market price is lower, they are likely to opt for cash payment.

Hence, the pharma companies whose FCCBs are due in the near future and whose market prices are lower than the conversion price will be financially strained as they need to borrow or sell assets to meet the debt obligations. This can result in an increased debt burden and their overall profitability can come under pressure.

So, stay away from stocks whose prices are much lower than the conversion price and are facing a FCCB conversion in the near term. Wockhardt and Aurobindo Pharma are the most vulnerable, with the former expecting FCCBs for conversion this year, and the latter in 2010. Wockhardt's FCCBs are due on 25 September at a conversion price of Rs 486 per share against the current market price of Rs 95.

Aurobindo's conversion price stands at Rs 522 in 2010 against the market price of Rs 109 per share. Companies like Orchid, Jubilant, Ranbaxy and Glenmark have two-three years before their FCCB conversion comes into force. But experts are positive about these companies as they enjoy strong cash flows, which would eventually help them repay the FCCB amount even if the bonds aren't converted.

Based on analyst reports, we have shortlisted the best picks in the sector (see table). Sun Pharma, Cipla, Lupin and Piramal Healthcare are the preferred stocks. "Sun Pharma has the strongest balance sheet in the business, which equips it to generate multiple new growth engines going forward," says analyst Nitin Agarwal, setting a target price of Rs 1,398 per share for the stock.

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