Classroom | Key parameters to look at when investing in pharma companies (Equity: Part 22)

Part 22 of the Moneycontrol Classroom deals with key parameters to look at when considering analysing investments in the pharmaceutical sector.

Business structure: It is important to understand the basic business model. Is the company selling finished drugs or the APIs (active pharmaceutical ingredients, the main ingredient that goes into it)? Does it sell in regulated markets or markets with low regulation (the former is more lucrative)? How much does it spend on research in relation to peers? Is it dependent on a few products either for sales or profitability, posing a potential risk?

Therapeutic area focus: Each company has certain therapeutic areas (that is the illness sought to be treated) that offer differing opportunities for growth. This can vary across countries too. How rich this mix plays a big role in determining growth and margin prospects in India and abroad. For instance, in recent years, dermatology, oncology, ophthalmology and respiratory products have been drawing attention of Indian generic companies in the US market.

Research focus: Pharmaceutical companies have been increasing their R&D spends, which drives future growth. Which product areas are being focused upon, how much increase in spending is taking place and the likelihood of success are factors to watch for. Research pipelines with products in an advanced stage of development or with promising candidates are good opportunities for licensing opportunities.

US generic filings: The US market is a key market for both revenue and profit. A healthy pipeline of filings, with launches that come with a six-month exclusivity period (when no other generic competitor can sell) is welcome news. Conversely, litigation or delayed approvals are risks to watch out for.

US FDA inspections: The frequency of plant inspections by the US Food and Drug Administration has increased. At times, these result in adverse observations and can result in penalties such as holding back of new approvals or even stopping all sales to the US from that plant. Conversely, an event-free inspection is a good sign of the company's compliance standards.

Gross margin: In India, we take this as the difference between sales and material costs. A steady or increasing trend in gross margins is desirable and higher the gross margin compared to peers, the better.

Usage of surplus cash: Pharmaceutical companies accumulate strong cash balances as cash flows are healthy in relation to capital investments. These monies can be reinvested in the business, in R&D, capex, used to buy out a portfolio of products under development, or an entire company itself. These can help a company leap up the growth ladder. Conversely, an acquisition gone wrong can pull its performance and balance sheet down.