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Indian Pharma: Flight to Safety
Relative stability, reasonable valuations
Our positive stance on Indian pharma is premised on sector’s relative resilience to Covid disruption, favorable currency tailwinds and stable outlook for India and US business. India growth has picked up (~10% growth for IPM as of MAT Mar’20) and we forecast 11% growth for covered companies over the next two years. US pricing environment continues to remain benign and the regulatory challenges are well understood. The pharma sector is up ~1% YTD and has outperformed the Nifty Index by 28%. We prefer stocks with high India exposure as it offers greater earnings visibility, supported by reasonable valuations. Reiterate Buy on Cipla. Downgrade Dr. Reddy’s to Reduce.
India business accounts for ~ 70 %+ of EV for Cipla and Lupin
In order to assess the proportion of India business embedded in the current valuation, we thought it’s prudent to breakdown the enterprise value of each company and ascertain the contribution of each business to the overall EV. We calculate the business/geography wise EV and group them into - India, other businesses (aggregated) and the US (residual). Based on the current market cap and our analysis, India accounts for almost ~70% of the current valuation for Cipla (72%), Lupin (77%) and Torrent (66%). At the same time, the implied one year forward EV/EBIDTA multiple for the US business is sub-4x for Cipla and Lupin and 10x+ for Sun, Dr. Reddy’s and Torrent.
Sector margins are expected to be resilient
The efforts to rationalise fixed overheads and calibrate R&D spends are likely to continue. Most companies have guided for tighter cost control. Dr. Reddy’s and Cipla have already demonstrated this (+5-6% CAGR in fixed overheads over FY17-20). Lupin has guided for an improvement in cost structure which will aid margins in the next two years. These initiatives, along with INR depreciation are likely to cushion the margins for the sector in the near to medium term. We factor sector EBIDTA margins to improve by ~170ps from 20.7% in FY20 to 22.4% in FY22.
Covid-19 impact and earnings sensitivity
We factor the Covid led disruption (raw material supply issues, plant shutdown, logistic issues) in our Q4FY20 and Q1FY21 estimates. This, along with sharp EM currency depreciation offsets the upside from INR depreciation. We build USD/INR rate of Rs 73-74 (from 71) in our model for the next two years. We factor above and tweak our earnings by 0-5% for FY21/22. In the event of extended lockdown (1.5 months), our earnings sensitivity suggests 7-11% impact on FY21 EPS estimates.
Key takeaways from Management interaction on Covid-19 update
a) Resumption of raw material supplies from China; b) Regulated markets are currently not impacted; c) India business is impacted due to lower manufacturing (mobility constraints) and logistics issues.
Valuation and Risks
The sector trades at ~23x one year forward, 10% below its 5 year historical average. The sector premium to Nifty is at 35% vs. (5 year avg of 38%). Key risks: a) extended lockdown can impact demand and manufacturing; b) Delay in US FDA plant resolution due to travel advisory; c) EM markets currency risks and subdued demand; d) delay in key approvals.
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