FY24 should see improvement in margins for pharma sector: Aditya Khemka

"The raw material cost had gone up more than the price increase therefore their margins are slightly muted in FY23 but FY24 should help see reduction in raw material cost and therefore improvement in overall margins," says Aditya Khemka, InCred Healthcare PMS.

Just to sum up what have been some of your key observations for the pharmaceutical sector in particular, do you believe that we will see high raw material prices continuing to play spoil sport?
The raw material prices in the pharma sector had actually begun to cool off in the last six month which has primarily been linked to oil prices, reduction in logistic cost etc. However, because of fresh COVID outbreak in China what we are hearing is raw material cost for COVID related products still continues to go up or remain slightly inflated. But that is a select bunch of products which are used during treatment of COVID. Barring those products or a majority of the other products what we understand from the industry is that raw material cost are coming off and that should help the margins of primarily those players who sell products in India because they have taken price increases in FY23. But the raw material cost had gone up more than the price increase therefore their margins are slightly muted in FY23 but FY24 should help see reduction in raw material cost and therefore improvement in overall margins.

Do you believe domestic pharma business is going to be the key area for growth, what is driving that optimism?
The domestic pharma has been over the past decade one of the best performing segments for Indian pharma companies. Just to give you a perspective the domestic pharmaceutical industry has grown by 12% CAGR over the past 10 years whereas the export market has been significantly subdued especially due to the pricing pressure that we have seen over the last five to seven years.

However, in FY24 what we believe is that the government will again allow pharma companies to take price increases anywhere in the range of 12% to 13% on the NLEM drugs and the non-NLEM drugs again about up to 10% which will help the price realisation in terms of growth. The volume growth in the industry has been around 5% to 6% including new product introductions. So overall the market can grow in mid to high teens and therefore the companies which will do better should grow better than the market.

We will see some of these smaller companies which are more focussed on the Indian pharma industry growing top line in more than mid teen in the India market and that definitely will result in higher operating leverage and the bottom line will grow faster. So we believe some of the stocks are extremely cheap in the current operating environment just because they are small and midcaps they are not being recognised by shareholders or investors as credible companies but we do recognise them as companies which have brands, high amount of cash flow, very efficient balance sheets and very efficient working capital. So we really like some of these companies that are smaller in size, focussed on the India business and we feel that the growth in the India business will make them do extremely well.

Why is the export data which came yesterday for Divi’s and for Gland Pharma not encouraging, we are talking about turnaround, pricing power coming back, CRAM business doing well but rather than growth there is contraction?
You have to understand that Divi’s and Gland Pharma are both different companies and are different businesses. I think more than 90% of Gland’s revenue in my understanding is purely generic-generic, it is not branded generic. Because it is unbranded generic the pricing power in unbranded generic just does not appear because the supply is more than the demand. So even if there is raw material inflation which there is for unbranded generic as well instead of increasing prices they are actually still decreasing prices because the competition keeps going up and if that happens then you have a double whammy on the company where the selling prices is coming down and the purchase price of raw material is going up.

So you get squeezed on margins and obviously your revenues also get squeezed because your price realisation is coming off. Same goes for Divi’s but only a portion of their business is unbranded generic but the trouble that they are witnessing is in that portion of that unbranded generic.

Also, Divi’s last year had significant sales of COVID related products which have not recurred in this year. So Divi’s is a slightly different matter. But Gland I think is a prime example of where the unbranded generic business is just going down the road. It is in a structural decline and we do not see a near term recovery to that business which is why we are not very optimistic about companies like Gland or many other large cap pharma companies which have significant exposure to US and western European businesses.

Sector has a headwind whether it is pricing power, commodity prices or large companies not doing well historically. We have seen barring one or two small and midcap stocks the sector does not do well. PE expansion will not happen, pricing issues will always be there so why should one go against the grain when you have more headwinds than tailwinds why buy pharma at all?
Yes, that is fantastic question and I would like to elaborate here if you divide the BSE healthcare Index and take the last 10 years data. Then if you had invested Rs 100 in Nifty, you would have around about Rs 300. Similarily 10 years ago, had you invested let us say Rs 100 in BSE healthcare today you would have around about Rs 310. So you would have outperformed Nifty by Rs 10 by just investing in the healthcare index. But this is the fun part. If you breakup the healthcare index into two halves the first half of market cap which is largely those companies which are invested in US market and the second half is everything else so companies which are invested in the India business, hospitals, diagnostics, API, chemical companies those are the other half. So have you invested only in the US centric companies over the last decade if you had invested Rs 100 you would have about Rs 200 and if had you invested Rs 100 in the second half which is API, diagnostic, hospitals and India centric pharma companies then you would have Rs 600.
So you have to understand when you say the sector has not worked you are actually focussing on the index which is 100 to 310. But if you focus on the second half of the index that is from 100 to 600 and that has outperformed Nifty by 300% over the last 10 years. So the sector has actually done extremely well. It is the largest pocket of the sector which is the US centric pharma companies that have not done well and I am saying that they will not do well because that business is in a structural issue situation and therefore you need to avoid those companies.

When you look at the sector you look at companies like Sun Pharma and Cipla and you come at a conclusion as to how the sector is doing, I do not think that is fair there are some 300 listed pharma companies so why do you look at two companies and arrive at a conclusion as to how the sector is doing.

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