Sunday, November 20, 2011


A number of pure play Active pharmaceutical ingredient (API) manufacturing companies in India are on the block and are seeking strategic investors. These companies are reeling under the pressure of debt as they have invested heavily in capacities and R&D, in anticipation of lucrative CRAMS business from the global innovators. Unfortunately, the kind of business anticipated has not really flown to India for a variety of reasons.  The state of affairs is reflected in the valuations, as we see the pure play API companies are languishing at low single digit P/E valuations and below book value, while on the other hand the branded generics business's in India is trading at high teen P/E multiple and 3-4 times book value.

It is always debatable whether or not the valuations are indicative of the fundamentals.   But for sure, the valuations are suggestive of two things
1) Pure play API business model may not be sustainable and is value destructive. The median P/E multiple of the sector is 7.8, implying a negative growth of 2% for the Industry.
2) Branded generic business will continue to grow at at the same pace as today - So no pricing controls and there is no threat of government intervening to promote the non-branded generics as it has happened in Europe

The API business at any point in time will only be a fraction of the total branded generic business. In the current scenario, the API business is  about 20% of the formulation business.  The future growth of API business depends how much formulation companies grow and how much  they choose to outsource. 

The outsourcing decision would obviously be driven by how well API companies can incentivize (low cost API) the brand/innovator companies for their outsourcing decision by providing low cost API's. While pharma market like India being still in its nascent stage, growth should not be a a concern atall.  The growth of the formulation business is expected to be double digit and this is also reflected in the valuation multiples. Hence API business being a function of the formulation business, it as well should grow at the same rate assuming  there are no major competitive pressures that leads to undercutting.  Undercutting is a phenomenon that has impacted the API busines margins in the recent past. The huge fixed cost burden that API companies are carrying because of the compliant manufacturing and R&D set up, has forced these companies to undercut.

Going forward, in the next fiver years,  the demand for API should strongly accelerate, as products worth upto $140b in sales would lose patent.   Prior to patent expiries, the API sales of such products are generally captive with the innovator, while on expiry, multiple generic companies, who intend to launch their generic version in the market look for pure play API companies as partners which can supply them with low cost API's.  Earlier such business was generallly outsourced to the EU companies, but with credibility of Indian companies growing because of the largest number of USFDA approved plants outside the US, the business is shifting to the Indian counterparts. Infact the pure play API companies in India already have such tie ups with global generic players in place.  These expiries should translate into major business for pure play API companies as the global generic players generally prefer pure play API companies as their partners.

I feel as far as business from innovators is conerned, it is more of a time lag between expectation and the real.  The large pharmas are taking more time, as it is not easy for them as well to do away with their manufacturing assets because of labour laws. The next few years would be the transition time and those pure play companies which can manage the gap would be the ones to reap the rewards.  It is not that, business from large innovator companies has not entirely come in, but we can see the trend setting in. A number of companies in India have successfully gained orders for API's of patented drugs from innovators (Brilinta -  Dishman, Telaprevir - Shasun, Rivaroxaban - Shasun), which earlier was the privilege of the european API companies. 
Competition from Chinese companies has been perceived to be as a key threat for Indian pure play API  companies and that is as well impactig the investor sentiments. But so far we have not seen Indian companies losing out and closing down shops for the reason (Chines pricing).  Indian companies infat have found a way to leverage the chinese pricing as they source cheap intermediates, whiile with their regulatory capabilities are able to cater the global markets. A case in point is  IOL chemicals and pharmaceuticals - a lesser know API company is focused on single product and has cost leadership  in the ibuprofen market. As we know Chinese companies have significant stake in the ibuprofen API, but despite IOL chemicals and pharmaceuticals is effectively competing and as growing strongly, while the larger players like piramal  had to withdraw themselves from the ibuprofen business as they lacked the foucs to exist in such a competitive market. .  

The R&D and regulatory skills is likely to drive the leadership of  Indian companies business in the API segment of the pharmaceutical industry.  Over the last 5 years, the topline of the the major pure play API companies in India have growth @25% and is likely to get stronger as teh macro enviorment is getting favorable.

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