The Hindu Business Line : What's in store for pharma MNCs?

Talk about the pharmaceutical industry in India and you will find that the conversation invariably veers around to discussing the prospects of such players as Dr Reddy's, Ranbaxy, Cipla and others of their tribe. Indeed, if their accomplishments are anything to go by, they are, without doubt shining examples of India's intellectual capital being second to none globally. In a sense, these outfits have acted as torchbearers, and serve as an inspiration to other like-minded companies, all of which are striving to make a mark across the world.

Even as domestic pharma companies have been strengthening their Research and Development arms to take on markets abroad, their multinational counterparts have been quietly making steady progress here, with growing stock valuations reflecting the market's fancy for them.

The boost in their stock prices can be attributed to a combination of factors: Restructuring to weed out tail-end brands; focussing on products that address chronic therapeutic categories; de-emphasising products coming under price control, and bringing in molecules from their parent's pipeline. As a consequence, the Aventis stock has risen almost four-fold over a three-year period; Glaxo has almost trebled in the same time.

Behind the re-rating

A significant part of the re-rating may be explained by India's transition to a product patent regime since last January. But that would be ignoring the improvement in operational efficiencies and the sharper focus these companies have acquired.

Now, the industry's prospects are delicately poised, with the new pharma policy likely to be put up for Cabinet approval early next month. And going by the initial announcements from the Ministry concerned, the pharma MNC gravy-train might go off-track. Admittedly, even home-grown pharma outfits with significant exposure to the domestic market are likely to take a hit, though not to the extent of their MNC counterparts, as the former do have an export hedge.

Here is an attempt to analyse the key near- and mid-term factors that are likely to impact the valuation of pharma MNC stocks.

Threat of price control

Price control is, without doubt, the biggest near-term risk that threatens to undermine the industry as a whole and pharma MNCs, in particular. A draft of the new Drug Policy suggests that the number of drugs to be brought under price control includes 354 formulations, in addition to the 74 already so controlled.If implemented, this will deal a body blow to companies that depend on the domestic market, and MNC pharma outfits will bear the brunt of this legislation. It would, however, be interesting to see how the cap on price is implemented. The Dr Pronab Sen Committee suggested averaging the prices of the top three brands in a therapy area; the current view appears to be one of capping prices on the basis of cost, after providing for a 150 per cent MAPE (maximum allowable post-manufacturing expense) for the new drugs to be brought under control.

The former is a simpler mechanism and should be easier to implement. The latter raises important questions in terms of how costs will be calculated and what components would be included under the MAPE provision. The exact extent of hit that players would take will become clear after the finalising of the list of formulations whose prices are to be controlled and the method of imposing the price-cap.

Our preferred view is that the current recommendations will go through some modifications before they are implemented, given the far-reaching impact they would have on the industry. However, should the draft proposals be implemented in their current form, there would be downside risks to the earnings of pharma MNCs. In that event, we foresee a significant contraction of the valuation multiple assigned to the sector, given the perception of higher regulatory intervention.

The revenues that the pharma MNCs analysed in this study generate from the current set of drugs under price control are more or less the same (almost 30 per cent). Hence, we expect the new drug price control to have a uniform impact on all of them. Aventis, though, may have an edge, as it serves as an outsourcing base for its parent and derives close to 30 per cent of sales from exports.

Product patent regime

Before the introduction of product patents last January, there were fears that this regime would lead to MNCs swamping the industry at the expense of domestic outfits. A year and half later, that has certainly not happened and it is business as usual. We expect the issue of awarding patents to innovator companies to remain a contentious one and believe there will be as many battles in the courtrooms as in the marketplace.

A reasonable timeline for the first patent-protected molecule to hit the domestic market will be the next couple of years. Subsequent to launch, it would take another two-three years before the product scales up substantially enough to make a meaningful contribution to the bottomline. Plus, pricing issues would need to be addressed. Hence, it would take five to seven years before such products turn out to be key earnings drivers. The possibility of a few patent-protected molecules making their way into the Indian market is live. However, it would be inappropriate to price in upsides related to such launches at this juncture.

An ability to tap into the parent's portfolio for products is a key growth driver. On this parameter, our preferred picks would be Aventis and Glaxo. Through new product launches, their parent companies have shown an inclination to grow their Indian franchise. Though Pfizer, too, brought in Viagra recently, this was several years after the product's global launch and it is priced steeply compared to generic versions available in the domestic market.

Risk of wholly owned subsidiaries

When Wyeth decided to launch a key molecule through its unlisted subsidiary, the market reaction was swift and telling. The stock shed close to 25 per cent and recovered ground only after the parent decided to route the product through the listed entity. Pfizer, too, operates one such subsidiary and the market appears to be pricing in the risk of the launch of a patent-protected molecule through this entity.

On this score, we would prefer to be cautious vis-a-vis these two outfits. Glaxo would be our top pick on this parameter followed by Aventis. Though the latter has a wholly-owned subsidiary, we are inclined to take a positive view given the parent's consistent willingness to launch products from its pipeline through the listed entity.

The final call

Glaxo and Aventis continue to be our preferred picks. We have buy calls outstanding on both these stocks and reiterate that they are the best MNC plays. We would recommend that investors accumulate these stocks on price weakness.

The quarterly earnings for these stocks may not be flattering on account of the unfavourable year-on-year comparisons, but that, in our view, is largely in the price.

On Pfizer and Wyeth, we maintain our view on retaining holdings. However, investors need to monitor announcements on product launches for entry/exit triggers.

Another reason behind our view on Pfizer is that we await greater clarity on the domestic impact of the sell-off of the consumer healthcare business by its parent to J&J at the global level.

Though Abbott does not carry the risks attached to a wholly-owned subsidiary and has a few established brands in its portfolio, we continue to ascribe a hold rating to the stock.

It may be argued that it quotes at a significantly lower valuation than some of the other stocks, but we believe that the lower multiple well captures the high contribution of a single product — insulin — to its revenues (the company has an arrangement with Novo Nordisk for the product).

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