Dr Reddy's Labs, Cadila Healthcare, Alkem Labs, Cipla to IPCA Labs, all you need to know about Pharma Sector

Improving U.S. outlook should lead to better operating leverage and return ratio expansion in the pharma industry, CGSCIMB says they believe the domestic business’s strong recovery in growth should ensure healthy cash flows and better RocE. They initiate coverage on the Pharma sector with Overweight rating; add rating on Dr Reddy’s Labs, Cadila Healthcare, Alkem Labs, Cipla, IPCA Labs, Natco Pharma, Ajanta Pharma, Indoco Remedies and Hold rating on Alembic Pharma, Torrent Pharma.

Improving U.S. outlook with price erosion abating:

The pricing pressure that spoiled net profit growth in the U.S. over FY17-19 is easing, led by increasing oral drug shortages since 2018. The unprecedented demand due to large numbers of critically ill Covid-19 patients aggravated the drug shortages. They expect mid-single digit price erosion in the U.S. going forward.

India Pharma market, a pit stop before a smooth run:

Indian pharmaceutical market (IPM) sales were impacted by the Covid-19 lockdown in Apr-May 2020 but have rebounded since Jun 2020. They believe post Unlock 5.0, a gradual rise in prescription demand and recovery in elective surgeries in hospitals in the second half FY21F should result in gradual traction in overall value growth.

Initiate Coverage on the Pharma Sector with Overweight rating:

The improving U.S. outlook and negative operating leverage, which compressed return ratios in the past, should improve. U.S.FDA compliance issues at manufacturing facilities are being resolved more quickly by pharma companies given increasing oral drug shortages. Also, a recovery in domestic pharma market revenue growth could generate better cash flows and healthy ROCE and lead to a sector re-rating going forward.

Top picks:

Dr Reddy’s Labs, Cipla, Alkem Labs, Natco Pharma and Indoco Remedies are the top picks in the Pharma sector. They like Dr Reddy’s Labs for its lean business model and healthy balance sheet; Cipla for its strong expertise in the respiratory pipeline; Alkem’s Labs India business potential; Natco Pharma’s strong chemistry skills and capability to identify niche molecules and Indoco Remedies’ business spread across India, the U.S. and other regions.

Sector valuation and Key risks:

Sector valuation P/E retraced to 27.5x in Nov 2020 from its low of 16.1x in Apr 2020 due to a recovery in India's Pharma industry and improved U.S. outlook. As the sector is emerging from the bottom of its earnings cycle, the P/E will appear higher. As P/E is coming off a trough, earnings (net profit) and cash flows will be strong, especially with capacities largely in place.

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Key Catalysts:

1)      Higher prices of generics in the U.S.
2)      Rupee Depreciation.

Key Risks:

Adverse currency movement and supply chain disruption due to Covid-19