Ample catalysts to sustain luster
We see several growth catalysts across key markets and product categories (inhalers, biosimilars, complex injectables) playing out over the next 2-3 years for Indian pharma companies. The investments made over the last few years leave them well placed to capitalise on these opportunities. With cost bases pruned and operating leverage benefits, the sector is poised to grow at ~21% earnings CAGR and witness ROCE improvement of 430bps to 15% over FY20- 23e. This, coupled with strong balance sheets (near debt-free), should support valuations, in our view. BSE HC Index has outperformed Nifty by ~47% in the past one year and trades at ~29x 1-yr forward, ~30% above its historical average and ~22% premium to Nifty (vs. 10-yr average of 31%).
* India biz remains attractive; chronic leads, vitamins strength could sustain: While chronic therapies continue to lead (Torrent, Lupin, Cipla to benefit), we see Vitamins as a promising therapy that could sustain higher growth, led by Covid induced changes in nutrition awareness and habits (Exhibit 17). The recovery in acute therapies will further consolidate market share gains for companies with strong therapeutic presence and leading brands (Alkem).
* Progress on complex pipeline in US augurs well for growth and profitability: The share of injectables, specialty, biosimilars, and complex products in US revenues is expected to increase from ~22% in FY20 to ~33% in FY23e, for our covered universe. Improving quality of pipeline in the US will not only ensure that the growth rates hold up better but will also drive higher profitability.
* API business sees the turn of fortunes, PLI benefits a few years away: The strong performance in 1HFY21 (21% YoY for the covered universe) was driven by factors such as customer stocking, pricing/currency benefits, which have largely normalised. However, the broader demand environment remains strong, driven by structural tailwinds (supply chain de-risk, PLI scheme), and is likely to drive healthy growth over the next few years. PLI scheme benefits are a few years away and will majorly benefit MSME players. Sun, Aurobindo, Lupin are likely to have participated, among covered companies (Exhibit 35).
* Covid vaccine monetisation offers upside potential, not factored in estimates: Vaccine monetisation can add material cash flows, although upsides will be for limited period and contingent on several variables (pricing, competition, capacity). We see three possible ways of monetising with varying degree of lucrativeness: a) develop/ manufacture own vaccine; b) undertake third party manufacturing; c) distribute vaccines. Among covered companies, Aurobindo, Cadila and Dr. Reddy's are in the race to monetize this opportunity (Exhibit 36).
* Cost savings, moderating investments to drive return ratios higher: Investments in R&D/capex have peaked and are likely to be more targeted towards complex filings/capabilities going forward. With cost bases rationalised, operating leverage benefits will drive margin expansion of ~350bps over FY20- 23e. We expect sector RoCE to improve by 430bps to ~15% in the same period.
* Top picks are Alkem, Aurobindo, Cipla and Lupin: We like Alkem (the best play on acute recovery), Aurobindo (building complex pipeline, Covid upsides), Cipla (strong India franchise, inhalers monetisation) and Lupin (chronic focused portfolio, inhalers, operating leverage).
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