Nithya Balasubramanian on why Cipla will outperform its peers and market post FY23

“Look beyond FY23, FY24, FY25 and FY26 and you will see a return to 11-12% kind of growth and there are already green shoots. Several of the large pharma companies are now investing in India in terms of adding manpower on the ground and people are now going to try and expand the market and chase volume growth,” says Nithya Balasubramanian, Director - Healthcare, Sanford Bernstein

When Covid hit us all of us thought that India’s IT and pharma moment had arrived. We had everything going our way; we had the bulk drugs, we had the vaccines, we had the capacity and we had the goodwill. But suddenly everything is now tumbling down for pharma like Humpty Dumpty falling from a hill!
I think there are some three or four reasons why the sector is seeing the correction that it has; one is of course we had a very high base in FY22. A lot of companies including Cipla, Alkem, Dr Reddy’s in my coverage universe benefitted quite a bit from selling Covid therapeutics as well as other parts of the portfolio which benefited because of Covid. Therefore, on that high base, we are now looking at FY23. Optically the growth is going to look subdued. It is very difficult for the market as a whole and specific companies to post meaningful growth on that base. The Indian market has always been the bedrock of these companies and the growth is going to look subdued because of the high base.

The second is of course the raw material and logistic cost increase. If you go back and look at the commentary last quarter, pretty much everybody guided to anywhere between 50-170 bps impact on the gross margins, which is quite significant. If one looks at the consensus numbers, after the last result season, there were earnings downgrades across the board. So that is another reason why the stocks are performing the way they are.

The last one is that FDA inspectors are on the ground. They have been on the ground since March, April this year. We do keep hearing news flow in terms of different facilities being inspected, 483s, companies not being able to lift the OAI or the warning letter status and obviously the market is anticipating more news flow because of FDA inspections continuing throughout the year. There is a huge backlog and they really need to catch up. These are broadly all the reasons why the sector is not performing well in the recent past but a lot of this will be short lived.

Let us differentiate the wheat from the chaff or men from the boys. As you look into the future, which are the companies and businesses you think will normalise and which are the companies on the cusp of recovery?
Looking narrowly at FY23 numbers obviously is not the right thing to do because the fundamentals remain quite healthy when it comes to the India domestic pharma market. I believe that if you are willing to look beyond FY23, FY24, FY25 and FY26, you will see a return back to 11-12% kind of growth and there are already green shoots.

Several of these large companies are now investing in India in terms of adding manpower on the ground and people are now going to try and expand the market itself and chase volume growth. Sun Pharma announced that they are going to add another 10% and they had already added 600 a couple of years ago. Alkem is adding people. The number of Indian domestic pharma companies adding people on the ground or investing in India has definitely gone up in the last year and therefore I see FY24-25-26 as healthy growth years.

I have not focussed too much on what the growth numbers are going to look like in FY23. Of course, it is going to look subdued. Mostly, it is in the numbers and so amongst companies that I cover, Sun Pharma, given the investments that they are doing and the market leadership that they have, are going to do well in India. Cipla, as well, because they now have a much better diabetes cardio portfolio, respiratory of course always continues to support.

Beyond that, the trade generics division and consumer health portfolio as well we believe will drive a lot of growth.

Some of the other factors I had mentioned like raw material costs will soften towards the second half of the year. We have been tracking the export data from China and we will actually be interested to know that prices are actually coming off the peak and going back to pre Covid levels.

So companies typically hold about six months worth of inventory which means that once they exhaust this high priced inventory, in the second half of the year, the gross margins will actually look much better which I do not think is in the numbers today. The US is a tough market and it will remain a tough market.

We do not see secular growth and we have always maintained that a handful of companies probably have some interesting complex generics in the portfolio which will do well. Otherwise, we do not see companies outperforming in the US, not in the near term and not in the long term.

Do you have coverage on Natco?
No, I do not.

Let us understand Cipla. What is so unique about Cipla? Do you like the domestic business or the export business? The US market for Cipla is not very large and it has been trying to create a niche there but frankly it is not even a billion dollar market.
I think it is actually a fabulous thing in the US market and fortunately the US market is one where scale is not really a good thing. The larger you are, the more your base erodes and the more the price erosion you need to worry about, the more launches you need to cover up the base erosion and grow on top of that.

Cipla compared to peers has a much smaller base in the US and therefore growth will be relatively easier. Beyond the fact that they have a smaller base, they do have some very interesting material products both in respiratory generics as well as some complex injectables which are likely to come through in FY23 and 24. These really augur well for double digit growth for them in the US and also significant margin improvement for them in the US.

In the second half of FY23, they are anticipating a generic respiratory product and one injectable both of which can realise about $50-60 million minimum annualised sales. These are also very high gross margin products and that is one reason we like Cipla. We think they have several material assets in the next three-four years which will come through one after the other supporting growth. But in addition, the respiratory inhaler pipeline is a bit more special than even other complex generics.

We think these actually have a very long tail which is unique about respiratory products and therefore this part of the business should actually be given a premium multiple over even other complex generic portfolios.

Second, when it comes to the domestic portfolio, I think FY21 and FY22 numbers were masked by a lot of Covid sales. But even four or five quarters pre-Covid, they had already started outperforming the market and now when I look at the next three or four years, I think three factors are likely to drive growth.

One is that compared to pre-Covid period, they now have a much fuller and comprehensive diabetes portfolio which always also has a second order impact on cardio. They are one of the few companies which have both the oral portfolio as well as insulin for diabetes. That will drive growth.

The second is trade generics, they have traditionally been a market leader and I believe that in the next three-four years, trade generics will continue to grow faster than the market and given that they are market leaders with established equity in the system and distribution muscle, I expect Cipla to grow faster.

The last one is they have now started increasingly allocating capital to the consumer OTC/wellness portfolio. They now have enough brands which are mature, enough brands which are Rs 100 crore or more and given that they are increasing investments, we see this part of the business as increasing in relevance over a period of time and this is a B2C business and therefore branded business with more resilient revenue stream and incremental profitability will be higher. These are all the reasons why we believe both in the US as well as India, excluding FY23, Cipla will be able to outperform their peers as well as the market.

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