Wealth creators: Long term investors could buy these 3 pharma stocks

Nifty Pharma index has been quoting higher for eight straight trading days on the National Stock Exchange (NSE). During this period, the index rallied 15 percent as compared to a 2 percent rise in the Nifty. Dr Reddy’s Laboratories, Lupin, Cadila Healthcare, Sun Pharmaceutical Industries, Aurobindo Pharma and Cipla from the Nifty Pharma index were up in the range of 8 percent to 14 percent last week. Alembic Pharmaceuticals, Granules India, Marksans Pharma, Ajanta Pharma and Suven Lifesciences, the non-index pharma constituents gained between 9 percent and 20 percent last week.

Dr Reddy’s was up 4 percent at Rs 2,365 on Friday after the US Food and Drug Administration (USFDA) approved the first generic versions of Indivior’s Suboxone sublingual film used in the treatment of opioid dependence. The stock rallied 14 percent last week.

Lupin gained 3 percent on Friday and rallied 14 percent in the past five trading sessions. The company on Thursday received approval from the US health regulator to market Drospirenone, Ethinyl Estradiol and Levomefolate Calcium tablets used to prevent pregnancy in the American market.

Last week, Sun Pharma announced resolution of regulatory compliance issues at Halol plant and Aurobindo Pharma gained on the back of USFDA approval for Omeprazole (used to treat certain stomach and esophagus problems). Both stocks gained 8 percent each last week.

On the domestically front, India's trade deficit widened to a four-month high of $14.62 billion in May as imports surged nearly 15 percent. Commerce Minister Suresh Prabhu said exports in May rose 28.18 percent to $28.86 billion while imports were up 14.85 percent to $43.48 billion.

A rise in receipts of petroleum, engineering and pharmaceutical products boosted May’s export growth figures to a six-month high of 20.18 percent, up from 5.71 percent in April. Even then, the trade deficit widened to a four-month high of $14.62 billion, compared to $13.7 billion deficit in April, as imports rose 14.85 percent during the month as against a 4.6 percent rise in April. This could pressurise current account deficit in the first quarter of the current financial year after it stood at 1.9 percent of GDP in the fourth quarter of FY18 compared to 2.1 percent in the third quarter.

Within exports, major labour-intensive sectors such as gems and jewellery and ready-made garments continued to see declines. Export growth rate had peaked at over 30 percent in November last year. Since then, the rate has fallen continuously until March. However, growth in outbound trade strengthened in May, with India exporting goods worth $28.86 billion.

After major refining units remained shut for over two months, India finally managed to take advantage of rising global crude oil prices in May when petroleum exports rose by over 104 percent to $5.23 billion. It had declined 4.48 percent in April. Rising oil prices led to a much higher import bill of $43.48 billion in May. A major part of this was due to the $11.5 billion crude oil import bill, which jumped nearly 50 percent, up from the 41 percent rise in April.

US President Donald Trump has decided to impose 'pretty significant' tariffs and announced a list targeting $50 billion of Chinese goods on Friday. A second wave of products worth $100 billion has been cued up. China retaliated against planned US tariffs on Chinese goods by targeting high-value American exports, including farm products, cars, and crude oil,  bringing the world's two biggest economies closer to an all-out trade war.

Shortly after the Trump administration unveiled plans on Friday to impose 25 percent tariffs on $50 billion Chinese products, China's State Council announced it would levy penalties of the same rate on US goods of the same value. In striking back at the US action, China expanded the list of US products that would be subject to tariffs on 659 types of goods from some 106 types it originally disclosed in April. Most of the added goods on China's retaliatory list are agricultural, seafood and energy products. President Donald Trump said earlier Friday that the US would respond with more tariffs if China retaliated.

India also has submitted a revised list of 30 items - including motorcycle, certain iron and steel goods, boric acid and lentils -to the World Trade Organisation on which it proposes to raise customs duty up to 50 percent. As duties hiked by the US on certain steel and aluminium products would have implications of about $241 million on India, the raise in tariffs proposed by New Delhi too would have an equal implication on America. Earlier in May, India proposed to raise duties by up to 100 percent on 20 products such as almonds, apple and specific motorcycles imported from the US. The additional duty proposed to be hiked on these items ranges from 10 percent to 100 percent.

The US Federal Reserve on Thursday had raised interest rates and took a more hawkish tone in forecasting a slightly faster pace of tightening for the rest of the year.

Globally, the Asia Pacific MSCI index, excluding Japan, edged down 0.3 percent and was set for a weekly loss of more than a percent.

European shares set their best week in more than three months as investors pushed back expectations for an interest rate increase after Thursday's European Central Bank meeting. The pan-European STOXX 600 index fell 0.2 percent, up 2.2 percent on the week, as a recovering euro to the dollar weighed. The euro posted its worst weekly loss in 19 months after the ECB signalled interest rates would be left at record lows at least till mid-2019.

The common currency shed 1.9 percent to the dollar, its biggest daily decline since Britain voted to quit the EU in 2016. The drop in the euro gave a lift to the dollar, which hit its highest against a basket of currencies since November 2017. While the Federal Open Market Committee and ECB provided much of the week's central bank fireworks, the Bank of Japan produced no surprises at the end of its two-day policy meeting on Friday and looked set to continue its asset purchases for some time.

Chinese stocks led the losses, with the benchmark Shanghai Composite plummeting to a 20-month low, as investors worried about the economic damage from trade tensions with the US. Japan's Nikkei average closed up 0.5 percent.

Oil prices were little changed as investors eyed a key meeting of the Organisation of Petroleum Exporting Countries in Vienna. Saudi Arabia and Russia, architects of a producer deal to cut output, have indicated they want production to rise.

At Ajcon Global, we believe most quality names are available in the largecap space. Midcaps have been witnessing consistent hammering after Union Budget 2018-19 and Securities and Exchange Board of India's re-allocation dictum for the mutual fund industry. No doubt, midcaps and smallcaps have delivered excellent set of returns before this downfall. However, investors need to be careful while selecting stocks in the midcap space as any unfavourable result in state elections would result in a drastic fall in midcaps and smallcaps.

At present, stocks from the state-run banking space and defensives like pharma can do well as we feel these sectors have bottomed out. One can accumulate companies in pharma with a 2-3 year horizon as it will get re-rated when earnings become visible. Shares of pharmaceutical companies were on a roll last week with the Nifty Pharma index posting its biggest weekly gain in 15 years following the positive newsflow with regard to US regulatory issues.

Here is the list of three pharma stocks that one can bet on for wealth creation:

Sun Pharma

We believe Sun Pharma is the best play in pharma space and investors can add this stock in their long term portfolio. At the current market price of Rs 571 per share (face value: Re 1 per share), the stock trades at a price to earnings of 52 times FY18 EPS which seems expensive in the near term after the recent rally. However, considering the long term prospects of the company and expected approvals of its products pipeline after the USFDA's clearance of its Halol plant (after nearly 3 years of non-compliance), we believe investors will be rewarded in the longer term.

Please note that a warning letter is issued to a manufacturing site if the manufacturer fails to address the violations of good manufacturing practices raised by the US drug regulator to its satisfaction. Though the warning letter doesn't restrict the company from selling products already approved, but it blocks new approvals.

Halol plant was engaged in manufacturing every formulation including tablets, capsules, liquids, sterile dry powder injectable, small volume injectable, ointments, soft gelatine caps and andaerosols. It has approvals from key regulators such as USFDA, MHRA (UK), MCC (SA). In FY15, the site accounted for about $400 million of sales, or nearly 15 percent of total sales before the warning letter was issued. Since then, sales from the plant have fallen to 8-10 percent of total sales. In fact, its entire injectable portfolio was filed from Halol site and that held key for Sun Pharma’s future growth.

The company is transforming itself from being a generic player to a speciality one and has 3 major drugs in its pipeline: tildrakizumab, OTX101 and a newly approved oncology drug Yonsa. Ideally, it would take 2-3 years for these products to ramp up and contribute significant to sales. Remember, Sun Pharma is one of the pioneers among Indian pharmaceutical companies to see tremendous value in investing in research and development (R&D).

The company’s early investments in R&D, beginning three decades ago, enabled it to make technology its key differentiator and develop a basket of robust products for diverse markets across the world. The company has around 2,000 research scientists working at multiple R&D centres, equipped with cutting-edge enabling technologies. The scientists have expertise in developing generics, difficult to make technology intensive products, active pharmaceutical ingredients (APIs), novel drug delivery systems (NDDS) and new chemical entities (NCEs). The company has 422 approvals and 139 pending abbreviated new drug applications (ANDAs).

The company has over 40 (API and finished dose) state-of-the-art manufacturing sites spanning 6 continents. These manufacturing units are located in India, the US, Brazil, Canada, Egypt, Hungary, Israel, Bangladesh, Mexico, Romania, Ireland, Morocco, Nigeria, South Africa and Malaysia. The units ensure that we are able to provide best-in-class products to patients across 150 countries worldwide.

The manufacturing operations are focused on producing generics, branded generics, speciality, over-the-counter (OTC) products, anti-retrovirals (ARVs), APIs and intermediates in the full range of dosage forms, including tablets, capsules, injectables, ointments, creams and liquids. The company also manufacture speciality APIs, including controlled substances, steroids, peptides and anti-cancers. It has a diversified revenue mix with US formulations accounting for 45 percent, India branded formulations at 26 percent, emerging markets 15 percent, Western Europe and other markets 9 percent and API and others 5 percent.

The US business was under pressure since the USFDA warning letter for its Halol facility as it has not received any product approval from Halol facility in the last three-and-a-half years. The facility contributes 8-10 percent of US sales, down from over 15 percent at the time of the warning letter. The facility’s contribution later declined to about $250 million.

On June 12, the company said it had received an establishment inspection report (EIR) from the USFDA for its crucial Halol facility in Gujarat indicating closure of inspection.

The EIR will allow Sun Pharma to restart supplies from the Halol facility to the US. The latter alone contributes around 40 percent of its overall sales in FY18. US revenue degrew 34 percent year-on-year as the company was struggling with pricing pressure in that market.

Current resolution of the Halol issue would augur well for the company. We can expect visibility on key approvals including Xelpros, Elepsia, Vagifem, etc. Going forward, the management's focus will shift to its specialty pipeline (Llumya, Yonsa and Seciera to launch in FY19). Going forward, it is looking to launch 3 speciality generic product like Yonsa (Q1 FY19), Tildrakizumab (IL-23) (in Q2) and OTX-101 (possibly H2). The company has also received approval for gGlumetza and will be commercialising it in the US soon. In addition, we believe improvement in Taro’s US business along with a ramp-up in non US markets such Europe, emerging markets and India will help to sustain margins.

Dr Reddy's Labs

Dr Reddy’s is an integrated pharmaceutical company, committed to providing affordable and innovative medicines for healthier lives. Through its three businesses - pharmaceutical services and active ingredients, global generics and proprietary products - it offers a portfolio of products and services including APls, custom pharmaceutical services, generics, biosimilars and differentiated formulations.

The company’s major therapeutic areas of focus are gastrointestinal, cardiovascular, diabetology, oncology, pain management and dermatology. Dr Reddy's operates in markets across the globe. Its major markets include - the US, India, Russia and CIS countries, and Europe. At the CMP of Rs 2,351 per share (face value: Rs 5 per share), the company is valued at a P/E of 40 times FY18 EPS. Investors can consider this company with a 3 year horizon. Its earnings performance is dependent upon timely approvals of products in its pipeline.

The company recently announced that it has received an approval from the USFDA and is launching Buprenorphine and Naloxone Sublingual Film, a therapeutic equivalent generic version of Suboxone. Buprenorphine and naloxone are used to treat adults with opioid addiction. “Buprenorphine helps suppress withdrawal symptoms caused by discontinuation of opioid drugs, and naloxone reverses and blocks the effect of opioids. This combination of medications is used as part of a complete treatment programme including prescription monitoring, counselling and psychosocial support.

The Suboxone brand had US sales of about $1.86 billion for the 12 months ending April, according to IMS Health.

Dr Reddy's said it is launching generic Suboxone at risk, implying that it is launching the product even as the patent granted to the innovator is valid until 2023.

Indivior has sued Dr Reddy's for infringement of its patents and litigation is still on. The company is confident that after the recent court verdict going against Indivior for delayed assertion of new patents and two of the three patents being just an extension of old patents. It also faces the risk of Indivior getting an injunction.

In the worst case scenario, if Dr Reddy's loses the patent litigation, it may have to forfeit sales made on the drug. The company bought Suboxone Film’s ANDA from Teva Pharmaceuticals for $70 million in June 2016 with seven generic filers. Mylan too received an approval from USFDA to launch generic Suboxone. It's not immediately known whether Mylan will launch it immediately or wait till 2023. Mylan had reached an out of court settlement with Indivior on Suboxone.

Alvogen, Endo, Par Pharmaceuticals and Actavis are also in the race for USFDA approval, some of them have settled patent infringement cases with Indivior to launch an authorised generic.

Natco Pharma

Incorporated in 1981 and headquartered in Hyderabad with over 4,825 employees across all locations, the company is a niche player with an R&D focus, vertically integrated with an experienced management team and presence across multiple speciality therapeutic segments. Focus on complex generics for the US markets with niche Para IV and Para III filings and an integrated platform makes Natco a low cost manufacturer. Its strong global presence establishes it as a prospective player.

Natco enjoys an API portfolio of over 37 US DMFs (submission of details to FDA) with more than 10 products under development. The company has 43 niche ANDA filings, including 20 Para IV filings in the US and 22 approved ANDAs. Natco through its partner Mylan is expecting to generate significant sales from gCopaxone 40mg in FY19. Note gCopaxone is used for the treatment of people with relapsing forms of multiple sclerosis (MS). Through their another partner Alvogen which launched gTamiflu suspension for the first time last year is expected to boost revenue growth during flu season (typically November-March).

The management in its recent concall in Q4FY18 said it benefited from the strong flu season in the US market. gTamiflu (suspension and tablet) revenue in Q4 was high and some profit will also get recognised in Q1 FY19e. gCopaxone is a slow ramping but a sticky product and will drive profitability in FY19e. Current market share stands at 15-16 percent. The management expects less competition. The 20mg gCopaxone is manufactured in India, while 40mg gCopaxone is manufactured at a contracted site.

gVidaza market share is 7-8 percent but it is not a large product. In gFosrenol (lanthanum carbonate - used to lower phosphate levels in patients with end stage kidney disease), Natco is the only generic player. In gRevlimid, it has replied to USFDA queries and expects to submit the drug for approval. The latter is likely by end FY19e or early FY20e.

In Q4 FY18, formulation revenue, excluding US, stood at Rs 158.5 crore (oncology: Rs 82.8 crore, non-oncology: Rs 62.4 crore), API revenue: Rs 60 crore and export formulation (including profit sharing): Rs 492 crore). In domestic oncology, Natco has launched some first-to-launch drugs. Its Hep-C franchisee is stabilising and will grow further when it bags approvals in Indonesia and Philippines.

The management believes that only niche products will make money in the US market. Over the next few years, the company said it has few one-off large opportunities in the US. It expects approval momentum to tick in from Brazil from FY19e onwards. Going forward, India, Brazil and Canada will remain focus areas and the management said it will keep focussing on niche areas. Canada business has a topline of Canadian $15 million and is profitable.

The company is executing well and is one of the best niche players in the pharma industry. It boasts of a strong brand position in domestic oncology and Hepatitis C (Hep-C) segments. It launched the generic version of Gilead’s Sovaldi (Sofosbuvir) and its combinations for treatment of Hep-C in India.

Over the last couple of years, it has proved its R&D capabilities and successfully launched multiple complex generics. The company has witnessed a stellar run in its profitability at the PAT level from Rs 157 crore in FY16 to Rs 695 crore in FY18. It has a strong balance sheet and a robust base to make relatively aggressive investments (versus the past) to move into the next growth orbit.

We expect strong earnings growth owing to anticipated launches of gNexavar, gRevlimid and gCopaxone. The company is intensifying regulatory filings rate in rest of the world (RoW) markets led by the Hep-C portfolio. The management is focused on a select few high potential filings  through either NDDS or complex chemistries.

With the scale-up in India and RoW markets, the company is bound to witness a healthy run in the next 3-5 years. For FY18, RoE and return on capital employed stood at 22.6 percent and 28.9 percent, respectively.

At the CMP of Rs 830 per share (face value: Rs 2 per share), the company is valued at 21 times FY18 EPS which we believe is cheap as compared to its peers. Long term investors can add this company to their portfolio and wait for at least 5 years to reap the rewards of wealth creation.

Disclaimer: The author is Vice President – Equity Research, Ajcon Global. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.