THE BIG STORY. Can Indian pharma fight back?

Stocks of Indian pharmaceutical companies have taken a knock over the last year and this is reflected in the poor run of the S&P BSE Healthcare Index. While its defensive cousins such as FMCG and information technology indices closed with flat one-year returns, the healthcare index moved in line with the broad-based Sensex and Nifty to close with losses of around 4 per cent.

This poor performance is in sharp contrast to the performance of these stocks between May 2014 and May 2015. While the Sensex gained 14 per cent, the Healthcare Index was one of the top gainers, returning 55 per cent then. Those were the heydays for pharma stocks when investors poured money into these counters, attracted by the strong growth in their earnings, especially from overseas markets.

Several factors continue to be in Indian pharma industry’s favour. India is the third-largest exporter of pharmaceutical products in volume terms. Its well-entrenched position in the US is a major positive. According to an IMS report, while the global pharmaceutical industry is expected to reach $1.3 trillion by 2018, the world’s largest market — the US — is expected to reach $450-480 billion. Indian companies supply almost 40 per cent of the generic and over-the-counter drugs sold in the US.

But select pharmaceutical companies are going through a tough phase due to regulatory issues. Many have also seen their revenue and earnings decline as a result of regulatory review, making investors view the entire sector with suspicion.

But all is not lost yet. Focus on compliance, tighter quality control and increasing spends on R&D can turn around their fortunes in the coming years.

The US Food and Drug Administration (US FDA) raised the red flag during its inspections on select Indian manufacturing facilities when it found issues with current good manufacturing practices (cGMP) and processes. This impacted exports to the US and product approvals. As a result, companies such as Sun Pharma, Dr Reddy’s Labs, Lupin, Cadila Healthcare and IPCA Labs felt the heat. Recently-listed Alkem Labs also reported adverse observations from the German and Netherlands regulators.

The Indian regulator has also been tightening its vigilance of late. In March 2016, the Health Ministry banned around 340 fixed dosage combination drugs (FDC). According to AIOCD-AWACS, the market research company of All India Chemists and Druggists Association, the FDC ban’s impact on the ₹98,042-crore Indian pharmaceutical market was estimated to be around ₹3,050 crore, or 3.1 per cent of the market.

The observations and warning letters issued by the US drug regulator have been taken quite seriously by Indian investors — and not without reason. Exports of many companies were impacted following these strictures.

In September 2014, when the US FDA inspected Sun Pharma’s Halol facility, it found violations of cGMP. Sun Pharma’s responses were not upheld and a warning letter was issued in December 2015.

While the company’s financials are not strictly comparable due to the Ranbaxy merger, the company reported a 4 per cent y-o-y drop in sales for the nine months ended December 2015. US formulations saw a higher 10 per cent drop. The company has guided consolidated revenues to decline or remain flat over the previous fiscal, with profits being adversely impacted due to remedial actions. During the last one year, the stock has lost around 15 per cent.

Three of Dr Reddy’s Labs facilities were inspected in November 2014, January and February 2015 and warning letter issued in November 2015. The stock lost a fourth of its value in the same month and in the last one year has shed 14 per cent. The company had submitted its response to the FDA in early December 2015. As per its results for FY 2015-16, consolidated revenues grew at 4 per cent y-o-y. Between FY-14 and FY-15, revenues grew at a stronger 12 per cent. While during FY-16 global generics business grew 7 per cent y-o-y, it reported stronger growth of 15 per cent in the previous fiscal. Its North American business continued to grow at 19 per cent in FY 2015-16 while it reported a growth of 17 per cent in FY 2014-15.

IPCA’s three facilities were inspected in July, October and December 2014. Although an import alert was announced earlier, the warning letter was issued in January 2016; the company had voluntarily stopped shipments soon after the inspections. Due to shortages in the US, a few APIs were subsequently allowed to be exported. In a recent setback, the Global Fund, citing this warning letter, decided not to source its requirement of anti-malarial drug. Over the last one year, the stock is down by a fourth.

Of late, the time taken for taking remedial action has been getting extended. While in the past, Sun Pharma was able to close out similar events at Cranbury, New Jersey, in about a year’s time, the company expects to call the FDA for re-inspection of its Halol facility only in Q1 of FY-17 almost 20 months after the initial inspections. IPCA too expects its remediation and re-inspection time line to stretch. This can further delay recovery in the company’s finances.

A warning letter, however, does not lead to an immediate stoppage of exports, nor does it lead to the dreaded import ban. The severity of the event matters as well as the company’s reputation. Also, it is facility-specific. Companies having multiple facilities can apply for site transfer for key products. While the lead time for such transfers is 12 to 18 months, it can help de-risk revenue.

Also, many companies have managed to take the needed remedial action to get back into groove. They are also continuing to receive approvals for new drugs.

For instance, in early April 2016, Sun Pharma announced that its subsidiary received USFDA approval for BromSite, used in the prevention of ocular pain in patients undergoing cataract surgery. The launch is likely in the second half of 2016.

Similarly, Dr Reddy’s Labs in early February announced that the regulator has provided tentative approval for Zenavod used in the treatment of inflammatory lesions.

Companies that paid stronger attention to their processes and product quality have managed to weather the current phase relatively better. Especially the Contract Research and Manufacturing (CRAMS) companies were able to pass audits with flying colours. A high reliance on export revenue, their inherent nature of business which calls for tighter internal controls and risk management and client inspections held them in good stead.

For instance, Divi’s Labs, which derives over 73 per cent of sales from the highly regulated markets in Europe and the US, had a smooth inspection of its Unit 2 at Visakhapatnam in February 2016. The US-FDA inspected the plant with no observations. The company is ramping up its Visakhapatnam SEZ and has proposed a new plant in Kakinada as well.

Within the past three years, Biocon’s subsidiary Syngene, which listed in August 2015, had five successful US FDA inspections with no adverse observations. The company sailed through with yet another inspection in Q3 of FY16.

Dishman Pharmaceuticals, too, had a successful completion of its overseas facility in the Netherlands in January 2015. The inspection confirmed that the site is compliant with the principles and guidelines of cGMP. It has been one of the better performing stocks, almost doubling over the year.

To build a robust product portfolio and maintain growth momentum, pharma companies find differentiation through R&D activities.

Take the case of Aurobindo Pharma. Between FY10 and FY11, net sales grew at 24 per cent. The company, which went through FDA regulatory issues in May 2011, reported lower topline growth of 6 per cent in FY 2012.

But it did not skimp on R&D spends during such difficult times. Between FY2011 and FY2012, spends increased by 13 per cent. Sustaining this momentum, between FY12 and FY15, R&D expenses jumped 81 per cent to ₹360 crore. Margins, which dipped to 12 per cent in FY 2012, have smartly recovered to 22 per cent in FY 2015 even as sales grew by 162 per cent during this period. In the last five years, R&D expenses as a percentage of sales were maintained at around 4 per cent.

Sun Pharma is another case in point. The company increased its R&D spends by 4.5 times in the four-year period. R&D expenses rose from ₹445 crore (5.6 per cent of sales) in 2011-12, to ₹1,960 crore (7.2 per cent of sales) in 2014-15. This has enabled the company to file almost 200 new abbreviated new drug applications (ANDAs) in the four-year period. The company, meanwhile, received approvals for 185 ANDAs.

But the manufacture of pharmaceutical products is just one aspect of the larger healthcare market. There are companies in the diagnostics and healthcare delivery segment which, too, offer good potential. In recent times, a slew of IPOs from the healthcare sector has hit the markets and investors have been ready to pay stiff valuations for them. (See box) Almost all of them have performed well on listing and continue to trade at a premium to their offer price.