Those with their ears to the ground knew it some time ago. Pharma stocks are hot. Not just any pharma stock, but small- and mid-cap ones.
Consider the numbers: While the market capitalisation of large-cap pharma stocks has increased by 58.40 per cent since April this year, small-caps appreciated by 61.68 per cent. But mid-caps have been in a mad-cap rush, surging by 81.50 per cent.
Even in a bull run such as the one now underway, pharma scrips have stood out. While the BSE Sensex has gained 42.59 per cent since the start of April, the BSE Health Care Index has outperformed that by a mile, posting 69.39 per cent gains during the same period.
Among sectoral funds, pharma funds have done better than their peers. And if analysts are to be believed, the northward journey isn't going to end anytime soon.
Big pharma companies like Dr Reddy's, Ranbaxy and Cipla are already highly priced. That leaves mid-cap pharma as the only ones within reach for most investors.
What is driving these scrips upwards? According to analysts, opportunities in the lucrative global generic markets, domestic growth prospects and the hope of big orders in contact manufacturing and research and development from global majors post-2005 are the main sentiment drivers.
"Post-2005, once the regime change comes into effect, mid-cap pharma companies would have found it difficult to survive. Once they became aware of the threat, they started looking at alternative ways to sustain themselves and grow. They have been filing applications for drug approvals and have been successful to an extent in getting USFDA approvals. Once this started happening people became interested in these stocks. Their pipeline, though relatively lean as compared to the big players, looks very interesting," says Tejas Doshi, head of research at Mumbai-based research firm Sushil Finance.
"Valuations are their biggest strength. Mid- and small-cap companies are positioning themselves more towards contract manufacturing and research where there is a big opportunity post-2005," adds Doshi.
For the uninitiated, 2005 marks the year when the patent regime changes from the current process patent protection to product patents under the Trade-Related Intellectual Property Rights agreement.
In the past, Indian pharma companies were able to exploit the domestic markets by taking advantage of the Indian Patent Act that protected only processes, not products.
This enabled them to reverse-engineer newly discovered drugs by MNCs and produce them cheaper.
This approach made valuable drugs accessible to Indians within a few months of their being introduced abroad, at much lower prices.
With the introduction of product patents, Indian pharma companies will not be allowed to re-engineer patented products as they do now. They will, however, be allowed to reverse-engineer all molecules registered until December 1994.
This, too, will be stopped after 2010. This is why more and more Indian companies will look at generics, which are beyond patents, to drive growth.
The same applies to the outsourcing segment, too. The expanding market for generics and the low costs may prompt the global majors to shift their manufacturing bases to countries like India.
This will provide an opportunity for Indian companies to undertake contract manufacturing even for patented products.
The government's decision to allow 100 per cent foreign direct investment in the pharma sector is also expected to boost outsourcing work to the country.
However, there are doubters. "Most of the outsourcing opportunity is hyped. While there is definitely a chance for good companies with good infrastructure to make money, most of the companies will find it difficult to win clients," says Prashant Nair, assistant vice-president (equities) of Mumbai-based Pranav Securities.
Is the thrill of the ride based more on future expectations than current performance?
"Yes," says Vijay Bhambwani, chief executive of personal finance advisory firm BSPLIndia.com.
"The entire market is going up, so pharma scrips have also gone up. Pharma counters are also seen as defensive counters, where it is safe to park your money in a volatile market. However, I feel that most of these scrips are operator-driven with low free-float."
Nair also agrees that low liquidity is a concern in these counters. "These scrips will find it difficult to maintain the current pace," he warns.
What about valuations? "Though I wouldn't say that all of them are overvalued, some scrips like JB Chemicals, Cipla and Orchid Chemicals do look stretched for the time being. The valuations of these companies might get capped at 10-12x," says Nair.
"If you are planning to invest in these stocks, the margin of safety has to be fairly high. Disappointments are commonplace in the pharma industry, with molecule developments getting stuck with litigation and process delays. Scalability is also very important in this business and I don't think most of these mid-caps have that capability," cautions Nair.
"Product approvals and plant approvals take time to materialise and there is a lot of litigation involved in these matters," agrees Doshi.
"If the next quarter results are not good, even though the potential remains intact, these scrips could face short-term disappointments."
That hasn't stopped investors from playing the odds. The market capitalisation of mid-cap pharma companies has been increasing not just since April, but from almost a year ago.
Their market-cap has increased by 56.75 per cent over the last year compared to a mere 10.83 per cent in topline growth and a 19.90 per cent gain in net profits.
But past numbers may not tell the whole story.
"Mid-cap pharma companies have been making investments in infrastructure for some time and they are partly reaping the rewards now. They are actively looking at contract research and manufacturing which has caught the market fancy. These investments have contributed to a drop in financial performances. However, overall profitability has improved," notes Nair.
Despite contrarian views on valuations and earnings potential, analysts did pick out some scrips that could post growth stories, based on their proven track record, cost advantages, opportunities in generics and the contract research and manufacturing space.
They also picked some companies whose prospects look suspect. Here's the low-down:
The prospects
Matrix Laboratories: Matrix Labs has been an obvious winner, registering a 301 per cent rise in net sales to Rs 416.93 crore (Rs 4.169 billion) and a mind-boggling 1,575 per cent jump in net profits to Rs 75.05 crore (Rs 750.5 million) in FY03, resulting in a near 700 per cent jump in share price to Rs 881.80 over the previous year.
June quarter performance has been a little shaky though with the net profit declining by 8.93 per cent to Rs 30.71 crore (Rs 307.1 million) despite total sales going up by 52.46 per cent to Rs 127.03 crore (Rs 1.270 billion) on a sequential basis.
Matrix is a leading supplier of Citalopram to several generics companies in Europe. This product has catapulted the company to new success, which is expected to continue. The stock currently trades at a P/E of 11x.
Aurobindo Pharma: According to Prashant Nair, Aurobindo Pharma is among the top mid-cap pharma scrips which is poised for growth. The company reported a 171.93 per cent jump in price over the last year to Rs 598.25.
It saw a 14.71 per cent rise in sales to Rs 1,190.38 crore (Rs 11.903 billion) and a 50.55 per cent increase in net profits to Rs 103.14 crore (Rs 1.031 billion) in FY03 over FY02 even though, sequentially, the June quarter performance was disappointing.
The company recently upgraded its facilities and is commissioning new capacities, which are expected to contribute to revenues and profits from the second half of the current fiscal onwards. With a current P/E of 13x, the stock is still worth holding, say analysts.
Nicholas Piramal: The company posted a 20 per cent rise in sales (Rs 1,136.13 crore -- Rs 11.361 billion) and a 145 per cent jump in net profits (Rs 118.11 crore -- Rs 1.181 billion) in FY03 as compared to the previous fiscal.
The June quarter performances were not as impressive, though the scrip did scale more than 80 per cent over the last year at Rs 413.90.
The company has been on a acquisition spree in the past three years, taking over Rhone Poulenc (India), ICI's pharma division and Global Bulk Drugs.
While the first two acquisitions strengthened its position in the domestic formulations market, the third one is used mainly as a exports hub.
Having established a strong domestic base, the company is focusing on exports to drive growth. It aims to become a partner to MNC pharma companies. The scrip is presently trading at a P/E of 13x.
Ipca Laboratories: The company has been marked out by analysts as another growth story in the mid-cap sector. Ipca reported a 15.21 per cent jump in sales (Rs 524.97 crore -- Rs 5.249 billion) for FY03, compared to FY02, while net profit improved by 76.49 per cent (Rs 61.86 crore -- Rs 618.6 million).
The market was quick to pounce on the scrip, driving it up by 332 per cent to the current level of Rs 533.90. Ipca is changing its business mix in favour of exports. With analysts expecting steady earnings growth, valuations at 6x are thought to be cheap.
Elder Pharma: Elder Pharma has seen its scrip appreciate by 314 per cent during the last year (Rs 132.55). Financial performance has supported that with net profits for the June quarter jumping 310.81 per cent (Rs 3.04 crore -- Rs 30.4 million) over the previous quarter.
Sales and net profits for FY03 improved by 15.39 per cent and 61.24 per cent respectively to Rs 232.78 crore (Rs 2.327 billion) and Rs 8.32 crore (Rs 83.2 million).
The company's strong brands like Shelcal and the new bulk drug plant at Patalganga are expected to lead the way to robust growth. The scrip trades at a P/E of 11x.
FDC: FDC, which reported an 18.05 per cent rise in total sales (Rs 237.64 crore -- Rs 2.376 billion) and a 6.47 per cent rise in net profits (Rs 39.80 crore -- Rs 398 million) this fiscal compared to the previous fiscal, has seen its price zoom 119 per cent to Rs 64.65 during the year.
The reason: Good June quarter performances which triggered off the current price run. FDC reported a 187.57 per cent jump in net profits (Rs 21.28 crore -- Rs 212.8 million) as compared to the March quarter, while total sales improved by 52.80 per cent (Rs 83.95 crore -- Rs 839.5 billion).
The suspects
Morepen Labs: The worst of the pharma sector lot, the scrip was hammered 68.72 per cent to Rs 12.45 during the last year. Sinking sales and net profits did no good to the image of the company with analysts unanimous in condemnation.
Even a recent effort by the company to repay Rs 162 crore (Rs 1.62 billion) to its fixed deposit investors has found no takers among analysts.
JB Chemicals and Pharmaceuticals: Despite a 67.90 per cent rise in stock price (Rs 300.45) analysts are not too enthusiastic about the company. The company's valuations seem to be stretched at the current levels, say market watchers.
A mere 5 per cent rise in sales (Rs 291.77 crore -- Rs 2.917 billion) and a 15 per cent rise in net profits (Rs 48.54 crore -- Rs 485.4 million) for FY03 reinforces the arguments.
The stock is trading at a P/E of 9x.
Orchid Chemicals: Orchid Chemicals was among the top gainers, moving up 197 per cent over the past year to Rs 195.95.
The company's total sales and net profits in the June 2003 showed a decline on a sequential basis of 11.30 per cent (Rs 172.92 crore -- Rs 1.729 billion) and 24.45 per cent (Rs 7.57 crore (Rs 75.7 million) respectively. At a P/E of 26x, analysts say the scrip is already overvalued
Mid-cap pharma stocks offer opportunities...
. . .but there are some threats