When we look at the universe of stocks, they are various ways to segregate the stocks, for example:

  • Market Capitalization: Micro Cap, Small Cap, Mid Cap, Large Cap
  • Sector wise: Capital Goods, Cement, IT, Banks etc
  • Business or Economic Cycle wise: Cyclical and non-cyclical (defensive)

The third one is of interest in this article, i.e. segregation of companies based on business (economic) cycles.

Cyclical Companies: Cyclical companies are those companies whose fortunes depends on the overall condition of the economy. If the economy is doing well these companies do well. If the economy turns for the worse, performance of these companies can go for a toss. Some examples of cyclical sectors is given below:

  • Auto companies: When the economy is going good, people tend to have surplus cash and the purse strings are let loose. Consumers look for new cars to replace their existing car. First time buyers stretch a little to buy the car of their dreams. However, when the tide turns, people re-allocate their resources towards necessary items and hence auto companies tend to fair badly in economic down-cycles.
  • Airline Companies: Thriving economy results in many frequent fliers. People plan vacations abroad. People in the south fly to places like Leh, Shimla, Manali. People in the north fly south to visit the backwaters of Kerala. However, when the economy is doing bad people tend to skip travel or use cheaper means to travel.
  • Commodities companies: Steel manufacturers do well when the economy is doing well. Vibrant economy triggers more construction there by resulting in more demand for steel. When the economy is in doldrums there is austerity all around resulting in fewer construction activities and hence subdued performance from steel companies.
  • The story repeats for other cyclical sectors like Capital Goods, Cements, Real estate etc.

Non-Cyclical companies: Non-cyclical companies are those companies whose performance is relatively immune to the overall condition of the economy. Some of the sectors that fall in this category are listed below:

  • Consumer Goods Sector: Consumer goods companies that manufactures items like soaps, detergents, food items fall in this category. People need these items irrespective of the state of the economy.
  • Information Technology (IT) Sector: This sounds an odd one out here. But IT companies are treated as non-cyclical companies. The reason being that IT companies in India are basically services companies that serve global companies. These global majors need to keep their IT systems running. You could be an insurance company or a Walmart or an Airline company or even a casino that runs slot machines, you need your software systems to be running and up to date. Hence you will set aside some of your expenditure towards software enhancements and maintenance. This is the money that predominantly drives the Indian software services industry. During global recession there is a possibility that the companies may cut down IT spending but they cannot cut down essential IT maintenance. However, if you are a company like HTC, Asus then you are a cyclical company as your mobile and PC refresh sales depend on the economic condition. If the economy is bad people stick to their own phones and PC.
  • Financial Sector: Banks are an essential part of the economy. Irrespective of the state of the economy Banks and other financial companies need to keep chugging along.
  • Pharmaceutical Sector: Medicines are essential to human wellbeing and survival. One may skip a meal but one cannot skip his daily dose of medicines.

On the face of it, it appears logical that one should invest in non-cyclical companies. Who doesn’t want to own a company that earns a revenue irrespective of economic condition?  However there is a catch here. Market pays top dollar for companies that surprise them. In the period of 2003-08 the economy was in full steam thanks to the overseas dollar flowing in. This was the period when the real estate industry picked up. People who owned the real estate companies (especially the two north India based companies) made humongous amount of money. During those periods it was a sin not to own real estate companies. So, the element of surprise is the reason why people take a liking for cyclical companies. On the other hand the performance of non-cyclical companies seem to be predictable. Their sales seem predicable, their net profit seem predictable. Their growth curve for the next couple of years seems predictable. Hence, the element of surprise is missing and when a company becomes boring, market participants tend to gravitate towards companies that have an element of surprise.

Now, let us look at Pharmaceutical companies. As we all know pharmaceutical companies manufacture drugs to keep diseases at bay. Diseases are not slaves to the economic conditions. Hence, irrespective of the economic situations, people fall sick, get operated and need medicines. Hence, the companies that manufacture these medicines can potentially survive economic downturns (caveat: see the risks section as well).  For the pharmaceutical companies to grow their revenue exponentially, more people have to fall sick. Hence, unless there is a major disease outbreak, the number of people falling sick does not increase exponentially. Hence pharma companies are non-cyclical companies. Based on historical growth and the statements from the management, one can fairly estimate the future growth of a pharmaceutical company. They are the tortoise in the Hare and tortoise race (Hare being the cyclical companies), except for the fact that the tortoise in question can run faster than the usual tortoise we know of.

Sector headwinds and sector tailwinds:

Headwind, in layman terms is the wind that blows on your face and reduces your speed whereas tailwind is the wind that carries you forward. In financial world if a company/sector is facing a headwind then it means the growth of the company is getting stifled because of various factors. On the other hand if a company/sector is facing tailwind then the company (or companies within the sector) will have better revenues and net profits compared to other sectors because of favorable circumstances.

An example for a sector that got a huge tailwind was the IT industry during the 2000s. Ample scope for growth, lack of software engineers in US, low-wage employee base led to multiple software companies earning huge revenues and expanding their net profit. This led to very happy shareholders during this period.

We noted above that the growth story of pharmaceutical companies seem to be fairly predictable. Pharmaceutical companies cannot increase their sales overnight. To increase their sales they need to setup new manufacturing plants and the companies disclose this information in their Management discussions. These new plants then take time to go through audits and approvals. By the time these plants contribute to the sales, their future sales would already have been factored in by the research analysts. So there does not seem to be an element of surprise about the future growth of the Pharmaceutical companies. However, there is an interest twist here. Since the year 2012 a lot of patents for critical medicines are going out of patents in the US. The graph below shows the potential market that has opened up because of the patent expiry [1].

0002_0001_patent_expiry_past

Source: Torrent Pharma Annual Report FY14

Now, how does this connect to the pharmaceutical sector headwind/tailwind? In India, most of the pharmaceutical companies are generics manufacturers. An expiring patent is an opportunity to grab the market share for these generic companies. Even assuming that each year about $15 billion dollar worth of medicines are coming out of patents, it generates a market opportunity of about Rs. 1,00,000 crores! It is a given that Indian companies are not the only ones to benefit from the patent expiry, there are companies from Israel, China, Europe who contend for the market opportunity. But then, the market opportunity is there for Indian companies to grab. Hence the patent expiry has become a huge sector tailwind for the pharmaceutical companies in India since 2012. Patent expiry is going to generate the tailwind necessary to propel the pharma companies for the foreseeable future. The US government is pushing generics on a large scale to counter the growing healthcare costs in the US. Hence this initiative will add to the existing sales of pharmaceutical companies.

In [2], Raamdeo Agrawal asks very pertinent questions that should be answered to decide if a sector has a tailwind. At a sector level the following questions matter:

Q: Is the Competitive landscape favorable for the pharma companies? Do the pharma companies have a bargaining power with Customers and suppliers?

 A: The competitive landscape seems to be favoring the pharma companies. The generics manufacturers have their own specialties and each company has its own space to grow. The entry barriers in the form of Regulatory approvals, Customer stickiness and “knowledge based niche”, ensure that the companies grow and thrive. Unlike ecommerce sector where it is dog eat dog situation, pharma is a fairly comfortable space.

The pharma companies do enjoy a bargaining power. The companies that have clean manufacturing facilities and do not attract any negative observation during the USFDA inspections tend to have a better bargaining power compared to low quality manufacturers from other countries.

Q: Does the pharma industry enjoy a large profit pool that can be tapped in an effective manner by the companies that have a unique value proposition or strategy?

A: Pharma enjoys a large profit pool. The large pharma companies that hold patents can answer this with aplomb. The generic companies may not have huge profit margins but they can offset this with volumes. Moreover, companies that are in the lucrative areas like oncology, central nervous system, ailments of the heart, obesity tend to make higher profits. Some companies like biocon, Dr. Reddy’s (and aurobindo pharma in the near future) that operate in the niche biosimilar manufacturing space have access to large profit pool. Other companies like Suven that are into drug discovery for Central Nervous System (CNS) tend to have a higher profit margin on their contract research business. If any of their products completes phase 3 and subsequently gets launched, it generates a windfall profit from the sale of intermediates for these new drugs.

Q: Is the pharma industry showing trends of value migration?

A: This question gets a big yes. The entire world is moving towards generic drugs. The value migration is happening from the existing patent holding companies to the generic manufacturing companies. This is similar to the value migration that happened in the banking space in the late 90s and early 2000s when private sector banks ate into the share of public sector banks. In the pharma space the large pharma companies that hold the patents for most of the drugs are losing their exclusive right and the value is migrating to the generic manufacturers.

Q: Is the pharma industry fairly stable? Is it vulnerable to business cyclicality, Regulatory hurdle?

A: This question has a Yes and a No as an answer. Pharma industry is fairly stable and it does not easily get impacted by the cyclical nature of economy. The business itself is not cyclical. However the regulatory impacts are immense. If the USFDA issues a form 483 with major observation, it causes a major setback to the company (More on this in the Risk section below).

Q: Is it a new industry or strategic opportunity with huge potential?

A: Pharma is not a new industry. However it does have the strategic advantage. The graph above answers this question. With the patent expiry and a 6 month exclusive period for the “first to enter” companies, a large bounty is in the waiting. Moreover, pharma companies have successfully demonstrated that the talent pool in India is immense. Which is another strategic advantage.

Pharmaceutical Market Snapshot:

  • Global Market for Pharma: Pharma is more of a global bet than a local bet. Hence it makes sense to see how pharma as an industry will grow globally. From [1] it can be observed that the global market size for pharmaceutical products has grown from $731 billion to $965 billion in a span of 5 years i.e. from 2007 to 2012. It is expected to grow by a similar amount to reach $1.2 trillion by 2017. Specifically the generics market is slated to grow from $ 242 billion in 2011 to $430 billion in 2016. Branded drugs are seen to be selling drugs worth $615-645 billion by 2016. Growth in developed markets will be in single digit where as in Pharmerging markets like China, India, Brazil, Russia etc, the growth is seen in double digits. Most of the new drugs that are being discovered are for the developed countries. In case of developing countries the bestselling top 20 drugs were discovered more than 10 years back. Blockbuster drugs in developed countries are related to diseases like heart disease, stroke, cancer, respiratory diseases, diabetes, and mental illness [1].
  • Indian Market for Pharma: Indian pharma market is a Rs. 75,000 crore market as of 2014. In India many essential drugs have been placed under price control thereby capping the maximum price that can be charged on such medicines. Nearly 80% of Indian market is dominated by generic medicines. Since 2013, there has been an increase in the cases related to chronic diseases in the area of cardiac, central nervous system, Anti-diabetic, dermatology. Hence the chronic therapies like Cardiology, Neuropsychiatry, Oncology and Diabetes are growing faster. As a country India is moving from acute disease to the above mentioned chronic and lifestyle diseases.

Pharma companies based on type on Industry:

In India there are three types of pharmaceutical companies. Generic drug manufacturers, Companies in the Contract Research and Manufacturing space (CRAMS), New Chemical Entity (NCE) developers (or Drug discovery companies).

  • Generic drug manufacturers: Many pharmaceutical companies in the 80s and 90s started to reverse engineer the widely sold expensive drugs and sell them in their respective countries at a much cheaper price. This was kind of genesis for the generic drug business. The drug manufacturing companies in India that cater to local market as well as global market, are predominantly generic drug manufacturers. Some of the prominent names in this space are: Sun Pharma, Dr. Reddy’s, Glenmark, Lupin, Aurobindo Pharma, Wockhardt, Cipla etc.

There are some companies that manufacture niche products called biosimilars. Biosimilars are structurally different from generic drugs. The generic drugs are manufactured by mixing chemical compounds and every dose of medicine is chemically same as the next dose from the same batch. However, biosimilars are generated in living cells by protein synthesis. Since the production is carried out in living cells, the output is different for each batch. It is like growing mangoes in different farms. Even if you sow the seeds of same variety, subject the trees to same nutrition, sunlight, water, the final crop from different farms would vary. Hence biosimilars are complex molecules to generate. Each biosiliar has to go through clinical trials before they are approved. Companies like Biocon, Dr. Reddy’s are active in the field of biosimilars.

  • Contract Research and Manufacturing (CRAMS): As the name suggests the companies involved in CRAMS business perform Research (Contract Research Service i.e. CRS) on behalf of global pharma companies or they Manufacture (Contract Manufacture Service i.e. CMS) on behalf of global pharma companies. In either case the output is directed to the global pharma companies. CMS amounts to 60% of total CRAMS output and CRS accounts for the rest 40% [5]. By 2016 it is expected that $92 billion worth of patents are going to expire [5]. This effectively means that the global pharma companies would need to invent new molecules. However, R&D expense is on the rise, and the large pharma companies in US will not be able to do all their research work in house. Moreover each new molecule has to go through Phase 1, Toxicology, Phase 2 and Phase 3, before it can apply for approval with USFDA. The chance of a molecule successfully moving from initial stage (patent filing) to market launch can be as low as 10,000 : 1 [3][4]. Therefore, the number of projects that the global companies can undertake gets drastically reduced. Hence, this work is expected to be outsourced to companies in India, China, Russia, Tiwan etc. Some of the companies that are active in CRAMS business are: Dishman Pharmaceuticals, Divi’s Laboratories Ltd, Jubilant Life Sciences Ltd, Biocon (via Syngine), Suven etc.
  • Drug Discovery (NCE): These are the companies that are involved in inventing new molecules on their own and coming up with the final product and launching the product. In India there is no company that is involved in pure drug discovery. The select few companies that are trying this, have a major revenue stream other than NCE. Some examples of such companies are: Suven, Natco pharma etc.

Pharma Companies based on type of Customers:

Indian pharmaceutical companies can also be segregated based on type of customer. Based on the type of customer, indian pharma companies can be thought of as B2C centric and B2B centric. Business to consumer (B2C) pharma companies manufacture their products and sell directly to consumer across various geographies. Some examples of B2C companies are Sun Pharma, Wockhardt, Dr. Reddy’s etc. However in case of Business to business (B2B) companies their products are sold to other Pharma companies who in-turn sell it to end users. There are very few companies that are predominantly B2B (ex: Suven). Most of the other companies do both B2B as well as B2C sales. Some companies like Granules have higher B2B revenues compared to B2C.

Pharma Companies based on geography of Sales:

As we saw in the market snapshot section, the largest market for pharmaceutical products is USA and Europe. Hence most of the pharmaceutical companies are export oriented companies. Their export is targeted towards developed countries. However some companies like Ajanta Pharma get most of their revenues from emerging markets like India, Africa. Even these companies are now eying for a market share from the developed countries. Many unlisted smaller companies are major players in the domestic pharma market.

My observation on the pharma sector:

Should one invest in pharma space? Some of my personal thoughts are listed below:

  1. For the pharma companies, the input cost of raw materials is cheap. For most of the generic medicines, the manufacturing cost is also cheap. Companies still make a lot of money from it because the value they provide to customer is high (These save lives of patients).
  2. Finished goods are small and hence can be sold in large quantities. Unlike infrastructure companies that need to sell flats and Auto companies that need to sell cars. Flats and cars are large products that have huge inventory cycle and each flat/vehicle locks up substantial part of capital which gets released only when the unit is sold. On the other hand, output of pharma companies have lesser per-unit cost hence it is possible to sell sizeable quantities of medicines to patients.
  3. These are recurring expenses. Till there are bacteria and virus, we will keep falling sick and we need medicines. In some cases like diabetes, blood pressure, heart ailments you need to take the medicines lifelong. Compare this with buying a house or a car.
  4. Medicines are NOT discretionary items. You NEED medicines. Allopathy (Treatment using pharmacologically active agents and/or physical interventions) is the predominant method to cure diseases throughout the world. So there is always a market for the output of pharmaceutical companies. So, pharma companies are inherently non-cyclical companies.

Major Risk Factors for pharma sector:

There are few risk factors that I feel one should always be aware of. Below are some that come to my mind.

  1. USFDA inspection: The pharmaceutical companies that export to USA are routinely inspected by the United States Food and Drug Administration (USFDA). These have become a source of panic for most of the investors in pharmaceutical companies. Any negative noting, observations by the USFDA invariably results in downward movement of the stock. The companies that are issued warnings need to respond back within a stipulated time. Non-compliance from the company could result in an import alert being issued for all medicines manufactured from the factory.
  2. Drug recall: Spurious drugs that fail the quality are inevitably recalled. Even if few samples are found to be spurious, generally the entire batch of drugs are recalled and destroyed. This is a major revenue loss for the pharmaceutical companies.
  3. Debt: Any manufacturing activity needs factories. To construct the factories the companies need capital. This capital can either be arranged from the shareholder capital or the company needs to borrow. If a company wrongly assesses the needs and over borrows leading to under-utilization, it could strain the balance sheet of the company. This risk is a generic risk for any manufacturing company (and not just limited to pharmaceutical company).
  4. Competition: There is no running away from competition. There are companies in China, Russia, Tiwan that can match the quality and talent of Indian pharmaceutical companies. These companies can take away the business from Indian companies.

100x growth companies:

In [6], Motilal oswal provides a compilation of companies that have grown 100x between 1994 and 2014. In all there are 47 companies and 8 out of these are pharma companies. These are: Lupin (1170x), Aurobindo Pharma(452x), Sun Pharma(347), Glenmark pharma(299), Cipla(222), Ipca Labs(150x), Ajanta Pharma(142) and Dr. Reddy’s Labs(140). Hence pharma as a sector has potential to churn out wealth creators.

Summary:

From my observation, pharma seems to have a sector tailwind with sufficient pricing power, customer stickiness (High switching cost) and sufficient entry barriers. Most of the pharmaceutical companies seem to have a consistent and predictable earnings visibility.

References:

[1] Annual report of Torrent Pharma FY 14.

[2] Motilal Oswal Wealth creation study 2013

[3] Annual report of Suven FY 14

[4] Annual report of Suven FY 15

[5] Care research 2013

[6] Motilal Oswal Wealth creation study 2014

Disclaimer:

I am not a SEBI registered research analyst. The information provided above is my subjective view based on what I have read on different websites, annual reports, and quarterly reports of various companies which I assume to be accurate. The above information should not be treated as an offer/advise to purchase a specific stock/investment instrument. Since these are my subjective opinions, I could be wrong in my understanding or presentation of information. I do not claim that the above information is complete or can be relied upon as such. We cannot be held responsible for any loss or damage caused due to any inadvertent error in the above information. We will not liable for investment decisions made by readers of this article based on the above information. I am not an investment advisor. Please consult your investment advisor for all your investment needs.

 

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