Pharma Sector Update

Pharma Sector Update
August 22, 2013
US - Key growth driver for 1QFY2014

1QFY2014 Results snapshot: 1QFY2014 results of Pharma companies under our coverage had a mix start to the year with US boosting growth on one side while ambiguity on domestic pricing policy, pricing pressure in emerging markets and volatile currency resulted in headwinds. While top-line growth at 12.6% yoy (we estimated 16%) came in lower than our expectation, OPM at 22.6% (we estimated 22.4%) and APAT growth at 11.9% (as against our estimate of 8.9% yoy) highlighted focus on improved operating performance. Despite high base, improved product mix led to 70bp expansion in gross margins (63.9% in 1QFY2014 v/s. 63.4% in 4QFY2013 and 64% in 1QFY2013). Growth in profitability was aided by lower tax rates and improved operating performance of Aurobindo, Lupin and Ranbaxy. Guidance: Management commentary remained positive but with a hint of cautiousness. Most companies have guided for double digit sales growth with steady margin improvement. However, pain is expected to continue in domestic formulations for another quarter. Exports primarily led by US formulations remains key growth driver and is expected to be aided by currency. Nonetheless, companies remain skeptical about the pace of approvals and intensifying competition in US. Emerging markets performance is dependent upon cross currency behavior and regulatory conditions (Japan, Russia, Brazil) and will be key monitorable. High debt companies like Ranbaxy, Aurobindo, Dishman are likely to face pressure due to depreciating rupee. Outlook: We expect valuation premium for Indian Pharma v/s. the broader market to expand, given better earnings momentum and defensive appeal. We highlight three potential surprises for FY2014E (1) earnings quality in EM; (2) favorable currency; and (3) expansion of R&D landscape. We reckon that earnings are more important than P/E expansion and stay positive on the US story for Indian Pharma. Despite concerns of patent cliff, there are significant opportunities within the already genericised US market. Indian firms are moving towards higher margins complex generics as Sun, Dr Reddys, Glenmark, Lupin have all increased R&D budgets for complex products in FY2014E. Top picks: 1. 2. 3. Glenmark (hefty R&D pipeline, strong dermatology franchise in US) Ipca Labs (smart recovery anticipated post re-inspection of Indore SEZ) Aurobindo (strong growth on low base in US)
US remains spearhead: Exports continued to steal the limelight with 67% contribution of the total sales, where 41% of the total export contribution is from US, partially led by currency. Dr Reddys (up 37% yoy), Sun (up 32% yoy), Lupin (up 27% yoy) and Glenmark (up 14% yoy) remained key contributors from US. On a sequential basis, Ranbaxy delivered an impressive performance (up 24% qoq). Aurobindo also delivered robust US growth post the resolution of USFDA issues. Indian formulations (up 12% yoy) outperformed industry growth of 7.5% despite ambiguity around the new drug pricing policy and challenges pertaining to inventory de-stocking at trader levels. Robust growth was witnessed in Cipla (up 17% yoy), Glenmark (up 17% yoy), Sun Pharma (up 11% yoy), Torrent Pharma (up 11% yoy), IPCA (up 12% yoy), while Lupin and Dr Reddys disappointed.
Earnings upgrade: Factoring in the improved growth visibility, we have upgraded our earnings estimate for Cipla and Ipca labs. Also, we are of the view that currency benefits will drive Sun Pharmas export earnings.
Analyst: Sapna Jhavar sapna.jhavar@rcap.co.in
Currency depreciation supporting the sector: INR depreciated sharply against the US$ in 1QFY2014 resulting in gains for most companies under our coverage. We continue to believe that the sector remains net beneficiary of depreciating rupee (relying on natural hedges) except for Ranbaxy (has a complex set of derivatives) and Aurobindo (debt of US$600mn). We summarize the hedging policy and forex impact of our pharma universe as below.: Exhibit 1: Hedging policy and forex impact on the Indian Pharma companies in 1Q
Company Aurobindo Pharma Cadila Healthcare Cipla Dishman Pharma Divi's Labs Dr Reddys Glenmark Ipca Labs JB Chemicals Lupin Opto Circuits Ranbaxy Strides Arcolab Sun Pharma Torrent Pharma Unichem Labs Vivimed Labs
Source: RSec Research
Forex gain/(loss) (Rs cr) (172.4) 26.7 12.0 (5.9) 42.5 (13.1) 2.5 (48.0) (5.5) 30.0 (540.0) (12.4) (13.0) 5.2 -
Hedging policy No hedging policy, keeps receivables position open No forward cover Outstanding hedges at US$230mn No hedging policy Outstanding cash flow hedges worth US$480mn hedged between Rs56-59 for a period of 18 months and balance sheet hedges worth US$350mn hedged at market rate Hedged 26% of exports at Rs57.1/US$ and ECB worth US$67mn Hedged 35% of receivables for 18-20 months Outstanding hedges at US$860mn with US$36mn of hedges maturing every month Outstanding hedges stand at US$27mn at Rs55.5/US$ No hedging policy Hedged US$200-250mn at Rs58-59 per US$ Hedges 20-30% of the exports
Exhibit 2: Strong operational performance and lower tax liabilities reflect in bottom-line
Adjusted PAT (Rs cr) Aurobindo Pharma Cadila Healthcare Cipla Dishman Pharma Divi's Labs Dr Reddys Labs Glenmark Ipca Labs JB Chemicals Lupin Ranbaxy Sun Pharma Torrent Pharma Unichem Labs Vivimed Labs Total
Exhibit 3: Operating leverage improves PAT
Apr-Jun 13 191 169 333 35 132 323 128 120 26 371 135 1,241 120 31 20 3,367
Apr-Jun 12 78 206 350 43 137 327 135 102 23 264 381 796 113 28 27 3,010
% yoy growth 146.5

(18.2) (4.8) (18.6) (3.8) (1.3) (5.4) 17.6 (12.7) 40.3 (64.5) 56.0 6.4 12.1 (26.6)
Jan-Mar 13 110 280 222 34 192 446 215 68 19 482 111 1,012 96 32 17 3,335
% qoq growth 73.9

(39.7) 49.9 2.6 (31.0) (27.7) (40.4) 77.0 37.7 (23.0) (21.5) 22.7 25.0 (2.3) 17.5
11.9
1.0
Exhibit 4: Top-line growth impacted by slowdown in India
Exhibit 5: Lower contribution from India reflects in muted Top-line

Net Sales (Rs cr) Aurobindo Pharma Cadila Healthcare Cipla Dishman Pharma Divi's Labs Dr Reddys Labs Glenmark Ipca Labs Apr-Jun 13 1,700 1,607 2,308 306 516 2,845 1,238 806 229 2,421 2,633 3,482 903 262 341 21,574 Apr-Jun 12 1,197 1,516 1,932 315 468 2,541 1,040 634 185 2,219 3,174 2,658 736 263 273 19,152
% yoy growth
41.9 6.0 19.4 (2.9) 10.1 12.0 19.0 27.0 24.0 9.1 (17.0) 31.0 22.8 (0.4) 25.1
Jan-Mar 13 1,553 1,566 1,917 345 650 3,340 1,335 672 198 2,537 2,440 3,071 803 241 298 20,966
% qoq growth
9.5 2.7 20.4 (11.4) (20.6) (14.8) (7.3) 19.9 15.9 (4.6) 7.9 13.4 12.5 8.7 14.3
JB Chemicals Lupin Ranbaxy
India performs better than expectation: Sun (up 11% yoy), Glenmark (up
17% yoy), Cipla (up 16% yoy) and IPCA (up 12% yoy) remained key performers during the quarter, ahead of industry growth of 7.5%. The growth is commendable in our view, given the uncertainty surrounding the pricing policy and trade challenges related to inventory de-stocking. However, we feel that 1Q has not fully registered the impact of these challenges indicating near term pain in subsequent quarters.
Sun Pharma Torrent Pharma Unichem Labs Vivimed Labs Total

12.6
2.9
Exhibit 6: Domestic markets led by Cipla and Glenmark
Exhibit 7: Exports grew 18% yoy led by Aurobindo, Lupin, Sun,and Cipla
Exhibit 8: Higher expenses are steadily being built in the system
Exhibit 9: Improved product mix results in higher gross margins
Exhibit 10: Robust operational performance sequentially led by Sun, Aurobindo and Ranbaxy
OPM (%) Aurobindo Pharma Cadila Healthcare Cipla Dishman Pharma Divi's Labs Dr Reddys Labs Glenmark Ipca Labs JB Chemicals Lupin Ranbaxy Sun Pharma Torrent Pharma Unichem Labs Vivimed Labs Total
Exhibit 11: Margin improvement led by robust growth in Glenmark, Lupin, Torrent and Aurobindo
Apr-Jun 13 17.2 14.4 22.2 25.8 38.0 19.0 20.0 21.2 15.0 24.8 8.1 44.0 16.8 18.1 13.4 22.6
Apr-Jun 12 10.3 20.4 26.3 27.9 40.7 19.7 21.1 22.3 13.0 19.1 8.1 45.8 20.3 17.6 22.4 23.3
% yoy growth
691.7 (601.2) (409.4) (211.7) (268.1) (65.2) (114.2) (111.9) 198.8 572.4 0.0 (182.2) (347.0) 54.7 (905.2)
Jan-Mar 13 14.3 16.0 19.0 26.2 40.1 21.5 22.4 21.2 9.6 24.0 6.6 41.0 16.1 18.1 15.8 22.0
% qoq growth
284.8 (156.9) 320.6 (44.3) (211.9) (249.2) (243.0) (0.2) 538.4 73.7 148.7 293.8 76.8 0.0 (243.9)
Improved gross margins boost operating performance: Aurobindo, Lupin

and Ranbaxy were notable outperformers given the low base and quick ramp up in base business. Absence of high margin and FTF products led to decline in margins for Sun Pharma, Cipla, Glenmark. However, the sequential performance of these companies indicated improved product mix and higher realizations due to currency benefits. We expect companies under our coverage to report improved margin performance benefitting from currency and strong pipeline monetization in regulated markets.
(65.8)
61.0
Interest cost up yoy: Most companies under our coverage showed spike in interest charges, as foreign currency loans were impacted by depreciating rupee. The interest cost grew by 10.3% yoy and 32% qoq in 1QFY2014 for our universe. Exhibit 12: Foreign currency borrowings spikes interest charges
Exhibit 13: Sun, Lupin, Dr Reddys drive growth in US
We note that companies like Aurobindo (283 filings, 191 approvals), Ipca (37 filings, 14 approvals and 8 commercialized) and Torrent (27 pending approvals) had been filing aggressively to build strong product pipelines in
US. Despite being late entrants, Torrent (limited competition products), IPCA (branded formulations), Aurobindo (injectables, controlled substances) have been executing well on gaining market share in niche product profile in the US market. We estimate US growth in these companies to grow at a CAGR of 50% (on a low base) over the next 3 years.
Midcaps start aggressively in US: Sun (benefitted from recent acquisitions

and price hike in key products), Lupin ( growth driven by generic formulations and branded portfolio was impacted by slowdown) and Dr Reddys (driven by limited competition products) remained key performers during the quarter. Further, Ranbaxy impressed with its robust sequential performance in US (up 24% yoy), while Aurobindo also reported double digit growth (USFDA issues have been resolved).
Exhibit 14: 1QFY2014 Earnings Review

Company Aurobindo Pharma Guidance Top-line guided at 20-25% yoy growth with margin improvement of 200-300bp in FY2014E. US guided to grow at 30% yoy in US$ terms. Management focused to bring down debt from 1.3x in FY2012 to 0.7x in FY2014E Cadila Healthcare Management to assess revenue guidance of Poor operating performance, subdued JV performance. Lower interest rates and tax charges aided PAT Ramp up in US and India expected in FY2015E US$3bn by FY2016E. Deferred guidance of 20% growth in US. Margins to continue under pressure Cipla Guided for 14-15% sales growth in FY2014E (excl. Medpro) and indicated that margins would remain under pressure as R&D and staff costs are expected to escalate Dishman Pharma Top-line guided at 10-12% yoy growth; EBITDA at 23% and slight improvement in profitability in FY2014E Divi's Labs Maintained top-line guidance as that of previous year and continues to remain cautious on margins, as fixed costs increase Dr Reddys No guidance provided for FY2014E due to uncertainty in ANDA approval timeline in US, however, healthy growth expected in other markets Glenmark Guided for 20% growth led by US and India, expects EBITDA margins to remain flat at 21%, as R&D costs expected to increase Ipca Labs Top-line guided at 17%, margins at 22%. Indore to start commercialization by 4QFY2014E Resolution of power related issues will ease margins. However, growth is unlikely to pick up in the next 2 quarters until DSN SEZ unit receives approval Muted growth barring US and ROW, as Russia continues to underperform. High R&D costs in compex injectables, biosimilars in US compressed margins US growth was lower than expected witnessing pricing pressure in base business. Working capital position deteriorated further to 115 days from 105 earlier Strong traction in exports led by institutional tender business led to higher than expected results Ramp up in US, once Indore SEZ starts commercialization, pick up in institutional tender business
Continued
The quarter gone by Better than expected 1Q, APAT was aided by lower interest cost and improved operating performance. Strong traction witnessed in US and ramp up in existing products
Key monitorables ahead Benefit from business, launches spin off of injectables key US debt reduction,
Strong performance across geographies but margin expansion remains key concern as it focuses on establishing its front end business in US Results in line. Netherlands facility to go on stream from 2HFY2014E
Inhaler launches in regulated markets, lower capex cycle
Traction in Carbogen Amcis, SEZ land sale to drive growth Ramp up in export volumes once DSN SEZ receives approval. Growth up in FY2015E Approvals in US, as it has one of the best in class product pipeline to pick
Monetization
of
R&D
pipeline,
out-
licensing deals to drive growth
1QFY2014 Earnings Review

Company JB Chemicals Guidance Strong margin growth aided by currency The quarter gone by Like to like healthy growth (ex. Russia OTC business) and focused products in domestic market, margins at 15% surprise positively Lupin India guided to grow at 15% , R&D to remain high at 8% for FY2014E Ranbaxy Believe in monetizing Diovan and Valacyte exclusivity, to improve base business through impending launches like Ximino, Nexium Strides Arcolab No guidance until AGILA sale process is completed Sun Pharma Sustained growth momentum, integration of DUSA and URL to pep US growth. But remained cautious of growth led by price hikes Torrent Pharma Growth in US and emerging markets to drive growth Quarter led by volume gains in Doxycycline and URL and DUSA, as Taro reported weak numbers, OPM strong at 44% on a sequential basis. Penalty payout of Rs2,517cr towards Protonix impacted reported profitability Healthy growth in US, ROW and EU led to in-line quarter, growth in Brazil continues to remain under pressure, core operating margins improved qoq led by favorable currency Unichem Labs Targets Rs1,500cr of revenue over the next 2-3 years, implying 12% growth CAGR Muted top-line growth due to slowdown in domestic market and high base. However, favorable rupee aided margins and bottom-line
Key monitorables ahead Growth in base business and rebuilding OTC business in other emerging markets makes it a long term bet Improvement in Irom margins, currency pressure in Japan, headwinds in ROW markets and growth in US branded portfolio Monetization of key FTFs/Para IV in US, growth in emerging markets, reduction in huge derivative position Receivables of sale proceeds and investor retun form. Improvement in residual pharma business Ramp up in newer business of URL and DUSA, inorganic growth will act as re-rating factor
Slowdown in India and Japan led to dismal quarter with single digit top-line growth (lowest in past 5 years). Genericisation in US branded portfolio also poses a risk Base business grew 10%+ yoy, sequential improvement in margins is a respite, USFDA ban continues to remain a overhang Incomparable results as AGILA sale is under transition
Ramp up in product launches in Brazil and US along-with capex completion for facility expansion to boost growth Product approvals from US, EM and Brazil in FY2014E will boost export growth
Our View
We expect valuation premium for Indian Pharma v/s. the broader market to expand, given better earnings momentum and defensive appeal. We highlight three potential surprises for FY2014E (1) Earnings quality in EM; (2) favorable currency and (3) expansion of R&D landscape. We reckon that earnings are more important than P/E expansion and stay positive on the US story for Indian Pharma. Despite concerns of patent cliff, there are significant opportunities within the already genericised US market. Indian firms are moving towards higher margins complex generics as Sun, Dr Reddys, Glenmark, Lupin have all increased R&D budgets for complex products in FY2014E
Exhibit 15: Valuation table

Company CMP (Rs) Reco* Target (Rs)** Net Sales (Rs cr) FY14E Aurobindo Pharma Cadila Healthcare Cipla Divi's Labs Dishman Pharma Dr Reddys Labs Glenmark Ipca Labs JB Chemicals Lupin Opto Circuits Ranbaxy Strides Arcolab Sun Pharma Torrent Pharma Unichem Labs Vivimed Labs 172 660 393 945 45 2,047 516 625 80 768 24 331 794 482 395 149 160 Buy Buy Accumulate Buy Buy Buy Buy Buy Buy Neutral Neutral Neutral Neutral Buy Neutral Buy Buy 240 860 450 1,226 128 2,390 670 715 105 770 65 400 883 570 462 232 474 6,748 7,011 9,255 2,483 1,413 13,191 6,066 3,307 860 10,923 2,536 11,284 1,445 13,829 3,634 1,189 1,265 FY15E 7,619 7,995 10,587 2,891 1,548 14,731 6,929 3,829 998 12,537 2,900 13,248 1,026 15,662 4,136 1,323 1,435 EPS (Rs) FY14E 20.6 39.8 18.9 52.4 12.9 106.9 30.5 37.4 12.5 34.0 18.1 23.3 40.6 8.4 29.9 14.6 66.7 FY15E 25.2 47.8 22.5 61.3 15.5 119.5 37.6 44.7 14.8 40.5 20.1 24.7 29.6 22.8 33.6 16.7 78.8 P/E (x) FY14E 8.4 16.6 20.8 18.0 3.5 19.1 16.9 16.7 6.4 22.6 1.3 14.2 19.6 57.4 13.2 10.2 2.4 FY15E 6.8 13.8 17.5 15.4 2.9 17.1 13.7 14.0 5.4 19.0 1.2 13.4 26.8 21.2 11.8 8.9 2.0 EV/EBITDA (x) FY14E 7.1 14.3 15.1 13.0 3.2 13.6 12.4 11.8 4.5 14.4 2.5 10.1 15.3 18.1 10.5 7.8 3.5 FY15E 5.9 11.8 12.5 11.1 2.6 12.0 10.2 9.7 3.4 11.9 2.0 8.8 21.5 15.5 8.5 6.7 2.8
Source: RSec Research; *CMP as on August 21, 2013; **In case of our Neutral Reco. our Target Price = Fair Value
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Pharma Sector Update

August 22, 2013

US - Key growth driver for 1QFY2014

Analyst: Sapna Jhavar sapna.jhavar@rcap.co.in