The pharma sector has been on a roll, with peak revenues in FY24. The Nifty Pharma breached 20,000 levels for the first time in July 2024, gaining 20 per cent YTD compared to Nifty-50’s 12 per cent gain.

Pharma valuations, which have been on the rise in the last five years, continued to expand in 2024, too. At 29.5 times one-year forward EPS, the index is valued at its highest in the last decade. While several positive have underlined the momentum, investors can ill-afford to dismiss valuations, which leave no room for error, especially given the headwinds.

Positive drivers

First, the US generics pricing cycle has turned favourable. Indian companies, with sizeable US revenue contribution, faced high price erosion starting from FY16-17. Now, as many players or products have been discontinued, the generics market faces severe shortages. The industry can now expect a normalised 5-6 per cent erosion per year.

Second, the industry has pivoted to complex formulations, which are margin accretive, in response to the pricing pressure. Towards this end, investments in the form of R&D, in licensing and partnerships is taking shape. The R&D expenditure, focussed on biosimilars, line extensions and complex filings, is expected to rise 100-200 bps from hereon from 5-6 per cent previously.

Finally, the sector is flush with cash as a result of the high margin portfolio. This gives companies the ammunition to spend on acquiring complimentary assets. Sun’s acquisition of Concerta Pharma and Dr Reddy’s acquisition of nicotine replacement portfolio from Haleon are recent examples. More can be expected.

Headwinds expected

However, the leading revenue and profit generator for the companies can face a cliff in the next two years led by Revlimid. Revlimid has had a unique impact on Indian pharma. It boosted US revenues beginning FY21-22 for a few companies, and its positive impact is expected to last up to FY25-26 for 4-6 companies. Revenues from the premium margin product can taper off starting FY26 as the low competition contract ends. Ilumya for Sun, Asacol for Zydus, respiratory products for Cipla and Lupin, are in the midst of a strong momentum, but may face headwinds soon. While exclusivity cycles are part of pharma operations, the double impact from the winding down of Revlimid as well as the other drugs mentioned above may dampen revenues.

The blue-sky valuations also don’t seem to consider the regulatory overhang, especially after the intense post-Covid surge in US FDA observations. Sun Pharma (Dadra Warning Letter), observations on Cipla’s Goa unit, or Aurobindo Eugia in the last three months serve as a reminder. The impact of any slowdown in revenue on observations will be stronger on the stocks, as lofty valuations will also be impacted.

Thirdly, with many players upping their India presence in response to the pricing pressures in the US, intensified competition may knock down growth rates a notch for all involved. The rise of trade generics can also intensify in the Tier-1 markets, further pressuring growth rates. Due to these reasons, Indian markets’ double-digit growth may no longer be the base case.

Thus, pharma valuations, while factoring in the positives, have leapt over the headwinds. Investors need to factor for safety in valuations in their pharma holdings.

Published on July 13, 2024