Generic pharma sector; differentiating the best from the rest

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Generic pharma sector; differentiating the best from the rest

  1. 1. Emkay Research Generic Pharma Sector BALDifferentiatingG L lO c a l from the rest the obest Geographically Dominance in a niche well diversified business segment Global Generics US$135bn Healthy Para IV pipeline Lean cost structure n Generic markets to become a US$135bn market by 2013 n Varied growth triggers for different geographies n Our generic scorecard ranks companies on their ability to become global generic players n Lupin, DRL and Cadila are our top picks Reco Company CMP (Rs) TP (Rs) BUY Cadila Healthcare Ltd. 787 962 ACCUMULATE Cipla Ltd. 314 366 BUY Dr Reddys Laboratories Ltd. 1168 1478 BUY Lupin Ltd. 1585 2111 SELL Ranbaxy Laboratories Ltd. 453 329 HOLD Sun Pharma Industries Ltd. 1655 1644 March 2010 Manoj Garg Research Analyst-Pharma manoj.garg@emkayglobal.com +91 22 6612 1257 Akshat Vyas Research Associate akshat.vyas@emkayglobal.com +91 22 6612 1491
  2. 2. Generic Pharma Sector ContentSynopsis 3Valuation Matrix 6Investment Argument 8 Generic industry: greener pastures 8 US$135bn opportunity awaits generic drugs by 2013 8 Key growth drivers for generics 9 Key geographies: macro environment and growth drivers 11 Global Generics - Overview 13 Indian generics: Well placed to capture the growing generic opportunities 15 Scorecard of Indian pharma companies 17 Expect earning CAGR of 28% over FY09-12E 17Valuations 18 Premium valuations to sustain 18 Top picks 18Sector Risks 21 CompaniesCadila Healthcare Ltd. 23Cipla Ltd. 27Dr Reddys Laboratories Ltd. 37Lupin Ltd. 41Ranbaxy Laboratories Ltd. 45Sun Pharma Industries Ltd. 57Emkay Research 10 March, 2010 2
  3. 3. Generic Pharma Sector Synopsis Synopsis The generic pharma industry has evolved and grown over the years to become a US$87bn market, with the potential of touching US$135bn by 2013. However, with time, the growth opportunities have shifted from being solely US centric to a global one as economies around the globe are increasingly favoring generics. Too much of focus and dependence on any single market is turning out to be a risky proposition. We believe that generic players have to be dynamic in their approach if they want to fully capitalize on the growth opportunities that the sector offers. We have identified four parameters, which will enable them to tackle the diverse issues across geographies and emerge as strong players in the generic space. They are - a) Geographically well diversified business, b) Dominance in a niche segment, c) Healthy Para IV pipeline and d) Lean cost structure. We believe that these parameters will ensure that a generic player is able to capitalize on the opportunities available across regions and also grow profitably in the highly competitive generic space. We have assessed the companies in our universe on each of these parameters and assigned scores accordingly. Sun Pharma and DRL emerge as the highest generic scorers with a score of 17 each, while Cadila and Cipla rank lowest with a generic score of 12 each. We have rated the companies on the basis of their generic score, earnings growth and valuations. As a result, we have rated Sun Pharma and Ranbaxy as a Hold and Sell respectively, despite them scoring high on our generic scorecard owing to expensive valuations. Similarly, Lupin and Cadila are our top picks despite lower generic scores on account of the immense upside potential (34% and 22%) that they offer from current levels. Lupin, DRL and Cadila are our top picks. We initiate coverage on Cipla with an Accumulate rating, Sun Pharma with a Hold rating and Ranbaxy with a Sell rating. We have a positive bias on all these stocks and will upgrade our ratings on Cipla, Sun Pharma and Ranbaxy, subject to materialization of the positive triggers that we have anticipated for each of them. Generic markets to become a US$135bn market by 2013 We believe the growth drivers for generics are clear and sustainable. We expect the generic industry to grow at a faster pace (9% CAGR over CY08-13E) compared to the overall pharmaceutical market (2-3% CAGR over CY08-13E). The global generic market, which stands at US$87bn, is likely to grow at 9% CAGR over CY08-13E to US$135bn on the back of a) drugs worth US$235bn going off patent over FY10-15E, b) tripling of elderly population (60+ population-700mn in 2005 to 1900mn by 2050), c) spiraling healthcare expenses across the globe and d) favorable government policies. Varied growth triggers for different geographies We are of the view that while we expect generics to grow across geographies, the factors driving growth for generics are varied. To elaborate further - In the US - the largest generic market - generic usage is being driven by a) pro-generic environment, b) huge patent expiry, c) rising healthcare cost. In the EU territory, we are of the view that the generic industry has yet to reach its full potential. Pro generic policies will drive growth in the more developed Western EU markets while Central and East European (CEE) markets offer higher growth prospects because of low generic penetration and lower per capita spending on drugs. Similarly, Japan is going to be the most exciting market for generic companies on account of a) It being the second largest pharmaceutical market in the world, b) low generic penetration and c) government initiative to promote generic usage. Though developed markets continue to remain critical markets because of their sheer size, developing markets are emerging as a compelling opportunity because of higher growth prospects. We expect the generic opportunity outside the US, western EU and Japan toEmkay Research 10 March, 2010 3
  4. 4. Generic Pharma Sector reach US$92bn by 2013 (CAGR of 11.5% over CY08-13E). Emerging geographies offer higher growth potential on the back of a) rising prevalence of life-style related diseases, b) aging population, c) increasing per capita spend, d) lower penetration of modern medicine and e) increasing insurance penetration. We have identified four parameters essential for becoming generic majors While there exists huge opportunity in the generic space, we believe that to become a major generic player calls for certain requirements. We have identified four parameters, which will enable companies to become strong contenders for generic opportunities. Geographically well diversified business - Too much of focus and dependence on any single market is turning out to be a risky proposition. In order to capitalize on the growth opportunities that different regions offer, a well diversified geographical presence is a must. Dominance in a niche segment - In order to remain profitable in the highly price sensitive generic market, it is advantageous to have dominance in a niche segment, which will provide the much required hedge against price erosion in the competitive generic segments. Healthy Para IV pipeline - will boost profitability and also ensure a competitive edge post the exclusivity period Lean cost structure - to ensure profitable growth We believe that companies that can differentiate from competition by building niche product portfolios, novel drug delivery systems, chart a geographically diversified presence and sustain and nurture vertically integrated operations will benefit the most. We believe that companies, which fare well on these parameters, are well placed to cash in on generic opportunities. Our generic scorecard ranks companies on their ability to become global generic players We believe that companies which fare well on the above mentioned parameters, are well placed to cash in on generic opportunities. We have rated and assigned scores to the companies in our universe on each of these parameters and have arrived at an overall generic scorecard. As per our scorecard, Sun Pharma and DRL emerge as most preferred companies with the highest score of 17 each. Cipla and Cadila feature last with a score of 12 each. Cipla scores low because of absence of Para IV pipeline as it has adopted partnership model. We have valued companies in our universe using valuation tools that best capture their value. Based on their generic score, we have valued them at premium, par or discount.Generic score card Company Parameters Total Score Valuation Criteria Geographical Dominance in Para IV Cost presence niche segment pipeline structureSun Pharma 3 5 4 5 17 10% premium to sector multipleDr Reddy 4 5 5 3 17 15% premium to its 5 year mean multipleRanbaxy 5 5 5 1 16 5% premium to sector multipleLupin 4 5 3 3 15 In-line with the sector multipleCipla 4 5 0 3 12 In-line with sector multiple because of low risk business modelCadila 4 5 0 3 12 10% discount to sector multipleSource: Emkay ResearchEmkay Research 10 March, 2010 4
  5. 5. Generic Pharma Sector Initiate coverage on Sun Pharma with Hold rating, Ranbaxy with Sell rating and Cipla with Accumulate rating We initiate coverage on Sun Pharma with a Hold rating and Ranbaxy with a Sell rating. Given their high generic scores, we have ascribed 10% and 5% premium to Sun Pharma and Ranbaxy, arriving at a price targets of Rs1644 and Rs329 respectively. Despite this premium, we believe that current valuations are expensive. We believe that the growth prospects for Sun Pharma and Ranbaxy in the generic space are extremely promising. They are however, marred by US FDA ban on certain facilities (Caraco for Sun and Paonta Sahib and Dewas for Ranbaxy). While we are confident that the worst is behind and that these issues will be resolved in the near future, we have not factored the potential upsides from a positive outcome on these issues. We shall be keenly watching the developments and will revise our rating on the stocks when clarity emerges. We initiate coverage on Cipla with an Accumulate rating as our current estimates have not factored in the upsides from launch of combination inhalers in EU. Despite a low generic score (12) due to the absence of Para IV filing, we value Cipla in line with the sector average because we believe that its dominance in the lucrative inhaler space and established business model makes it a low risk bet on the generic opportunity. Lupin, DRL and Cadila are our top picks We re-iterate our Buy rating on Lupin, DRL and Cadila with price targets of Rs2111, Rs1478 and Rs962 respectively. Lupin, third in our generic scorecard (score of 15), with its well diversified geographical reach, foray into high growth oral contraceptive segment along with attractive Para IV pipeline is an attractive investment proposition because of valuations discount to its large cap peers (20%). Lupin provides the highest upside (34%) in our universe with a price target of Rs2111 (20xSep11 EPS; NPV of Rs22/share for Para IV pipeline). DRL, with the highest score of 17 on our generic scorecard, is among the best bets to buy into the generic growth story. We have ascribed a 15% premium to its 5 year average multiple and valued the company in line with the sector multiple of 20x Sep11 EPS and arrived at a target price of Rs1478 (20xSep11 EPS; NPV of Rs77/share for Para IV pipeline), an upside potential of 26%. Cadila, despite featuring last in our generic scorecard, is one of our top picks. Even after ascribing a 10% discount to sector multiple, our fair value of Rs962 (18xSep11E) provides an upside potential of 22%. We believe that strong earnings growth and visibility in Cadila and Lupin compensate for its lower generic scores and provide huge upsides from the current levels. We have valued the companies on the average of FY11E and FY12E earnings reflected as on September’11 EPS.Emkay Research 10 March, 2010 5
  6. 6. Valuation Matrix CADILA CIPLA DR REDDY 2009 2010 2011 2012 2009 2010 2011 2012 2009 2010 2011 2012 Financials (Rs mn) Sales 29275 37734 45673 54626 52343 58299 65990 75313 68830 72727 86682 100626Emkay Research Sales (base) 63566 70338 79985 90141 EBIDTA 6058 8164 9797 11706 12218 15135 17312 19854 14749 15594 21170 26205 EBIDTA (base) 9718 11910 14565 16916 PAT 3272 5077 6391 8182 9719 11305 13610 15745 7571 9481 13680 18066 PAT (base) 4301 8087 10458 13134 Growth (%) Sales 26 29 21 20 24 11 13 14 38 6 19 16 Sales (base) 30 11 14 13 EBIDTA 32 35 20 19 47 24 14 15 93 6 36 24 EBIDTA (base) 31 23 22 16 PAT 24 55 26 28 51 16 20 16 127 25 44 32 PAT (base) 124 88 29 26 Profitability (%) 10 March, 2010 EBIDTAM 21 22 22 22 23 26 26 26 22 22 25 27 EBIDTAM base 16 17 19 19 PATM 11 14 14 15 19 19 21 21 11 13 16 18 PATM base 7 12 13 15 RoE 29 35 33 31 19 22 22 22 19 24 28 28 RoCE 22 26 29 32 20 21 22 22 16 20 28 31 Per Share Data (Rs) EPS 24.0 37.2 46.9 60 12.1 14.1 17.0 20 45 56 81 107 EPS Base 26 48 62 78 CEPS 32.2 46.4 56.9 71 11.5 16.0 19.7 23 75 81 108 137 BVPS 89 123 165 218 55.9 72.2 84.2 98 209 257 329 425 DVPS 4.5 5.0 5.0 7 2.0 3.4 4.2 5 6 7 8 10 Valuation (x) P/E 29.1 18.8 14.9 11.6 26.1 22.4 18.6 16.1 26 21 14 11 CPER 21.7 15.0 12.3 9.9 27.5 19.8 16.1 14.0 16 14 11 9 P/BV 7.8 5.7 4.2 3.2 5.6 4.4 3.8 3.2 5.6 4.5 3.5 2.7 EV/Sales 3.7 3.1 2.5 2.0 5.1 4.6 4.0 3.4 3.1 2.9 2.3 1.9 EV/EBIDTA 17.4 12.7 10.4 8.3 26.8 20.7 17.7 15.1 14.3 13.1 9.3 7.0 Dividend Yield (%) 0.6 0.7 0.7 0.9 1 1 1 2 0.5 0.6 0.7 0.9 Turnover (Days) Debtors Turnover 61 56 55 55 134.5 133.2 133.2 133.2 77 72 70 70 Inventory Turnover 76 75 75 75 101.5 100.8 100.4 100.4 71 72 71 70 Gearing Ratio (x) Net Debt/Equity 0.84 0.51 0.28 0.1 0.2 -0.01 -0.04 -0.1 0.4 0.2 0.0 -0.2 Generic Pharma Sector Source: Emkay Research, Company 6
  7. 7. Valuation Matrix LUPIN RANBAXY SUN PHARMA 2009 2010 2011 2012 2008 2009 2010 2011 2009 2010 2011 2012 Financials (Rs mn) Sales 38523 47346 56526 64749 74214 75970 84753 91777 41870 40515 45218 49765Emkay Research Sales (base) 71854 70157 71780 78453 34448 33861 41389 50269 EBIDTA 7284 9565 12241 14163 5732 7124 13052 15014 18676 13465 16116 16978 EBIDTA (base) 5242 3055 4666 8630 11702 8973 12830 16589 PAT 5058 6559 8438 10109 2597 4338 8212 8910 18178 13622 15297 16596 PAT (base) 2254 1693 2549 4639 12947 10288 12818 16315 Growth (%) Sales 41 23 19 15 9 2 12 8.3 27.1 -3.2 11.6 10.1 Sales (base) 8 -2 2 9 28.8 -1.7 22.2 21.5 EBIDTA 61 31 28 16 -37 24 83 15 20.2 -27.9 19.7 5.4 EBIDTA (base) 25.2 -23.3 43.0 29.3 PAT 51 30 29 20 -53 67 89 9 22.3 -25.1 12.3 8.5 PAT (base) -57 -25 51 82 26.5 -20.5 24.6 27.3 Profitability (%) 10 March, 2010 EBIDTAM 19 20 22 22 7.7 9.4 15.4 16.4 44.6 33.2 35.6 34.1 EBIDTAM base 7.3 4.4 6.5 11.0 34.0 26.5 31.0 33.0 PATM 13 14 15 16 3 6 10 10 43.4 33.6 33.8 33.3 PATM base 3 2 4 6 37.6 30.4 31.0 32.5 RoE 37 36 33 32 7.3 9.9 17.4 17.2 31.2 18.5 17.9 17.0 RoCE 25 28 30 32 -0.6 7.5 12.3 15.5 27.4 14.9 15.8 14.5 Per Share Data (Rs) EPS 57 74 95 114 0.0 0.0 0.1 0.1 87.8 61.3 73.9 80.1 EPS Base 0.0 0.0 0.0 0.0 62.5 49.7 61.9 78.8 CEPS 67 88 115 135 6.2 10.3 19.5 21.2 68.5 57.2 70.0 87.5 BVPS 172 251 318 399 5.4 4.0 6.1 11.0 340.1 394.0 454.5 520.1 DVPS 13 18 24 28 88.4 22.7 15.6 13.6 27.5 20.3 22.8 24.8 Valuation (x) P/E 28 21 17 14 73.3 43.9 23.2 21.4 18.9 27.0 22.4 20.7 CPER 23 18 14 12 35.1 27.1 17.2 16.0 24.2 28.9 23.6 18.9 P/BV 9 6 5 4 4.4 4.3 3.8 3.6 4.9 4.2 3.6 3.2 EV/Sales 4 3 3 2 2.9 2.8 2.5 2.3 7.8 7.9 6.9 6.0 EV/EBIDTA 19 16 14 11 88.4 22.7 15.6 13.6 17.6 23.7 19.2 17.6 Dividend Yield (%) 1 1 2 2 0.0 0.7 1.1 1.2 1.7 1.2 1.4 1.5 Turnover (Days) Debtors Turnover 99 98 98 98 66.2 65.8 62.3 62.3 75.8 108.0 108.0 108.0 Inventory Turnover 91 91 91 91 97.7 96.5 91.8 88.2 84.0 86.4 86.4 86.4 Gearing Ratio (x) Net Debt/Equity 0.8 0.3 0.1 0.0 0.4 0.3 0.3 0.3 -0.2 -0.3 -0.4 -0.4 Generic Pharma Sector Source: Emkay Research, Company 7
  8. 8. Generic Pharma SectorInvestment Argument Investment Argument Generic industry: greener pasturesBy 2050, world population of the 60+ The growth outlook for generics remains robust. An aging population, rising healthcareage group is expected to jump 2.7x to spending and increasing acceptance, coupled with favorable government policies are1.9bn. key growth drivers for generics. By 2050, the world population of the 60+ age group is expected to jump 2.7x to 1.9bn. As elderly people consume 66% more medicine than the younger group, this jump is likely to further pressurize healthcare costs of developed countries. The healthcare costs of developed countries have already been growing faster than their GDP. As more brand-name drugs come off patent and payers push for cost cuts in health care, the demand for generics are likely to scale new highs.Global generic market to grow at a Overall, we expect the global generic market to grow at a CAGR of 9% to US$135bn byCAGR of 9% to US$135bn by 2013 2013, which will be higher than the growth of the branded pharmaceutical market. We are of the view that non-US markets will be the key growth drivers and will grow faster than the developed markets. The share of the US generic market is likely to come down from 20% to 16% by 2013. US$135bn opportunity awaits generic drugs by 2013Generic opportunity outside the US, The global generic market, which stands at US$87bn as on CY2008 (IMS Health) is likelyWestern EU and Japan to reach US$ to grow to US$135bn by 2013 (CAGR of 9%). Though US would continue to remain the92 bn by 2013 largest generic market (currently 20% of total generic market), emerging markets are likely to grow at a faster pace and narrow the gap going further. We expect the generic opportunity outside the US, Western EU and Japan to reach US$92 bn by 2013 from the current level of US$53bn (CAGR of 11.5% over CY08-13E). Generic industry growth estimates 160 140 $135b 120 100 $87b $50b US$ bn 80 60 40 20 0 2008 2013 North America Europe International Source: Emkay Research, Teva Generic penetration in key markets 70% 64% 65% 60% 54% 50% 50% 40% 30% 17% 17% 20% 12% 7% 10% 0% France US UK Germany Japan Netherlands Spain Italy Source: Emkay Research, StadaEmkay Research 10 March, 2010 8
  9. 9. Generic Pharma Sector Key growth drivers for generics Patent expiries, rising healthcare costs coupled with aging population and favorable government policies are the key drivers of increased generic penetration the world over. Drugs worth US$235bn are likely to go off-patent over 2010-2015Patent expiry likely to open a plethora Drugs worth US$235bn are likely to go off-patent over 2010-2015. With high profile drugsof opportunities for generics like Lipitor (US$13.5bn) and Plavix (US$8.7bn) going off-patent in 2011, the global pharma market is likely to see a further slowdown in sales. Other key products going off-patent in the next five years are Takepron (Lansoprazole; US$4.2bn revenue; 2009), Seretide (Salmetrol + Fluticasone; US$7.7bn; 2010), Effexor (Venlafexine, US$4bn, 2010), Seroquel (Quitapine, US$5.4bn, 2012) and Nexium (Esomeprazole, US$7.9bn, 2014), etc. These patent expirations are likely to open a plethora of opportunities for generics and ensure that their growth momentum is maintained. Generic growth driven by patent expiries ($bn) 121 235 114 2010 - 2012 2013 - 2015 Total Source: Emkay Research, Teva 2010-2014 - Key patent expiries 2010 2011 2012 2013 2014 Arimidex US Plavix Symbicort Oxycontin Nexium Cozaar/ Hyzaar Advair Seroquel Cymbalta Copaxone Aricept Zyprexa Avapro Zometa Actonel Taxotere Femara Avandia Yasmin Micardis Lipitor Singulair Xalatan Diovan Viagra Detrol Geodon Lovenox Avapro Source: Emkay Research, Industry Spiraling healthcare expenses indicate greater acceptance of genericsHealthcare expenditures of OECD With spiraling healthcare expenses across the globe, the acceptance of generics iscountries (ex-US) are likely to rise to steadily increasing. In a bid to cut healthcare costs, countries hitherto using only branded16% of their GDP by 2020 drugs are gradually resorting to use of generics. As a result, branded markets like Germany are resorting to use of generic drugs. Similarly, we have also seen a steady increase in the generic penetration of developed markets like US, UK. The healthcare expenditures of OECD countries (ex-US) are likely to rise to 16% of their GDP by 2020 (currently, it is 10% of GDP). By 2020, the US is likely to spend around 21% of GDP on healthcare from the current level of 16%. In all, the US will spend approximately US$10tn by 2020. Curtailment of this uptrend is a very significant factor driving generic growth.Emkay Research 10 March, 2010 9
  10. 10. Generic Pharma Sector Healthcare spending as % of GDP in the US 17% 15% 12% 9% 7% 1970 1980 1990 2003 2008 Source: Emkay Research, Teva Graying planetElderly people consume 66% more Growing proportion of elderly population is expected to add to the already burgeoningmedicine than the younger group healthcare costs in both developed as well as developing countries. As per WHO estimates, global elderly population (65+) is expected to almost double from 480mn in 2000 to 800mn by 2025. As per industry estimates, there are currently 30 pension eligible elders in the developed world for every 100 working age adults. By the year 2040, there will be 70 elders for every 100 working adults. Elderly people consume 66% more medicine than the younger group, further adding to healthcare costs. World population by age (in bn) 9.1 1.9 6.5 60 above 0.7 2.3 40 to 59 1.4 2 2.5 20 to 39 2.4 2.4 0 to 19 2005 2050 Source: Emkay Research, Teva Biosimilars: the futureBetween 2010 and 2015, biotec drugs Generic biologics or Biosimilars have the potential to be the next growth driver for theworth US$101bn are set to loose generic industry. Biosimilars promise remarkable cost-savings for spiraling healthcarepatent protection budgets. Yet, the full potential can only be harvested when a number of significant markets, regulatory and clinical hurdles have been overcome globally. There is still lack of clarity for product launches in the US market. However, Europe has already begun to approve generic biologics and till date has approved 13 biosimilars for launch. Biosimilar legislation is evolving rapidly in other countries as well. Other national authorities have already successfully addressed the biosimilar regulatory and legal framework, prominent among them being Australia, Canada, Malaysia and Japan. On October 5, 2009, the Japanese government has approved the first biosimilar. However, progress in the US, the most lucrative biopharmaceuticals market with two thirds of global biological sales, is still painfully slow. Legislation has been introduced in Congress to provide a similar pathway for approval and regulation of generic biologics in the US. Now that this legislation has the backing of the Obama administration, we expect the first biosimilar approval in 2011. Between 2010 and 2015, biotec drugs worth US$101bn are set to loose patent protection.Emkay Research 10 March, 2010 10
  11. 11. Generic Pharma Sector Biologics patent expiry ($ bn) 20 9 59 8 2 1 1 1 Number of 1 3 4 2 3 9 7 16 45 molecules Source: Emkay Research, Industry The impending expiry of several patented blockbuster biopharmaceuticals and the increasing demand from patients, insurers, and government agencies to reduce drug costs have created numerous opportunities in the global biosimilar markets. This is new territory for most generic players with the commercial rewards of their foray paying off in the long run. Key geographies: macro environment and growth driversUS generic market to grow at a CAGR Our analysis of macro and micro environments of key geographies clearly reveals thatof 5% to US$22 bn over 2008-13 each of the markets present ample opportunities and challenges in terms of generic usage. To put things in perspective, despite multiple challenges, US continues to remain the largest and most exciting market in the generic space. The generic penetration in the US is as high as 65%. The new healthcare bill under discussion, proposes to discount prices of certain drugs by 50% from their current levels and provide coverage for people currently not eligible for coverage (15% of US population). Though the new bill is expected to act as a disincentive to research and innovation, it is expected to provide a big impetus to generic drug manufacturers globally. Pro-generic environment, huge patent expiry (drugs worth US$94 bn are likely to go off-patent in next 5 years) and rising health care costs are some of the key growth drivers for increased generic usage, going forward. We expect this market to grow at a CAGR of 5% to US$22 bn over 2008-13.CEE generic markets offer significant Similarly, we are of the view that the EU generic industry has yet to reach its full potential.growth opportunity (12-13%) The EU generic industry is highly fragmented and on the basis of usage, can be classified as mature generic markets (generic penetration of more than 40%) and developing generic markets. Countries having pro-generic policies such as Germany (generic penetration 59%), UK, Denmark, Netherland and Poland are the mature generic markets, while countries like France, Italy and Spain, where the current generic penetration is very low are developing generic markets. These developing generic markets offer significant growth opportunity (12-13%), going forward.Japan is aiming to raise its generic Similarly, Central and East European (CEE) markets offer higher growth prospects becauseexposure to 30% of volume by 2012 of low generic penetration and lower per capita spending on drugs (10-30% of Western Europe). On the other hand, Japan, the worlds second largest pharmaceutical market, is expected to be the most exciting market for generic companies, going forward. While the Japanese pharma market constituted 9.9% of global sales in 2008, it had one of the worlds lowest consumption rates for generic drugs. Japan, which currently has 19% generic penetration in volume and 4% in value (US$2.7bn), is aiming to raise its generic exposure to 30% of volume by 2012.Emkay Research 10 March, 2010 11
  12. 12. Generic Pharma SectorEmerging geographies offer higher Though developed markets continue to remain critical markets because of their sheergrowth potential size, developing markets are emerging as a compelling opportunity because of higher growth prospects. Although, the generic market value of these countries are not as impressive as mature markets, most are experiencing tremendous growth rates compared to the modest 2-5% growth seen in the US and Europe. We are of the view that emerging geographies like India, Brazil, China, Russia, Mexico, Turkey and South Africa offer higher growth potential on the back of a) rising prevalence of life-style related diseases, b) aging population, c) increasing per capita spend, d) lower penetration of modern medicine and e) increasing insurance penetration. Being branded generic in nature, these markets not only offer higher margins but also have strong entry barriers because of doctor relationship and brand equity. We expect these pharemerging markets to grow at a sustainable rate of 12-13% over the next decade to become a US$400bn market by 2020. Ongoing economic growth in these countries will not only improve socio-economic profile and healthcare infrastructure but also result in increased spending on chronic diseases. The table overleaf is a snapshot of various regions in terms of size, growth potential, regulatory environment, key growth drivers and challenges for each of the key geographies. Genericisation of the global pharma market: n Governments across the globe, and particularly those in major pharma markets such as UK, US, Germany and Japan, have come under increasing cost contain- ment pressure, leading to creation of regulations that encourage the use of lower priced generics. n The era of blockbusters has passed. As recently as 2006, there were nearly 90 drugs that had achieved the blockbuster status, generating 30% of total global pharma sales at US$200bn. By 2009, eight of these block buster drug ($18 bn) were facing patent expiry. n Failure of newly launched drugs due to safety concerns and dwindling pipeline of small molecule drugs n Increasing acceptance of generic drugs in large, highly regulated pharma markets. n Emergence of biotechnology as an alternative to traditional small molecule phar- maceutical n A spate of M&As, driven primarily by pharma majors like Pfizer, Merck and Roche to gain wider R&D pipeline n Pharma majors are increasingly turning towards emerging markets as these mar- kets offer higher growth potential n Pharma majors are eying the generics and biosimilars markets as an alternate revenue source.Emkay Research 10 March, 2010 12
  13. 13. Global Generics - Overview Europe US Germany UK France CEE Spain Italy Nature of market Mature Mature Mature Developing Developing Developing Developing Generic penetration 64% 54% 65% 17% 20-25% 12% 7%Emkay Research Market size as of 2007 (US$ bn) 17 6.7 4.5 5.4 14 2.7 3 Expected market size by 2013 (US$bn) 22 7.8 4.8 7.3 26 3.4 3.5 CAGR 5% 3% 1.3% 6% 13% 4.7% 3.1% Drugs going off patent (US$bn) 94 50 Regulatory Environment Pro generic Pro generic Pro generic Encouraging generic usage Key growth drivers • Largest generic market • Various healthcare reforms introduced by the German government have resulted in • Drugs worth $94bn are going off patent progeneric structural and regulatory changes • Regulatory & political environment is pro-generic • Government in other European markets such as France, Hungary, Spain and Italy have also initiated various reforms to combat the healthcare cost • Rising healthcare cost is leading to legislative changes that are likely to see an increasing penetration of generics in Europe • 0.5bn people- aging population • Low generic penetration 10 March, 2010 Key challenges • Price Erosion • No long term generic medicine policies • Competition • Limited transparency on prices and availability • Stringent FDA regualtions • Continued price linkage to originator products • Market entry delays due to post-market authorization procedures for establishing pricing and re-imbursement status • Economic disincentives for pharmacists to dispense generic medicines • Lack of economic incentives for physicians to prescribe the generic medicines • Limited incentives for patients to request generic medicines • Evergreening of medicines Indian companys presence • US has always remained an important destination • Indian companies have expanded their presence in the EU market through M&A for Indian generic companies • Increased penetration of generic drugs in EU countries is long term positive for Indian • Indian companies have scaled up their presence in companies the US market • DRL was the second highest contract winner of AOK tender. • Indian companies are ranked one among the top 5 companies in terms of ANDA and FTF filings • Built up strong Para IV pipeline • Companies like DRL and Lupin stand one among the top 10 generic companies in the US • Despite 90-95% price erosion, realizations are still higher in the US Key opportunities • Large market share • Generics have yet to reach its full potential • Para IV monetization • Increased pace of generic penetration • Focus in the niche segment • Some of the Western European markets still have low level of penetration • Biosimilars can be a key opportunity • Central and Eastern European markets offer higher growth prospects • Bio-similars can be a key opportunity Source: Emkay Research Generic Pharma Sector 13
  14. 14. Global Generics - Overview Emerging markets Japan Brazil Russia India South Africa Nature of market Developing Branded Generic Branded Generic Branded Generic Branded Generic Generic penetration 17% 20% 30% 70% 40%Emkay Research Market size as of 2007 (US$ bn) 2.7 1.5 2.5 6.6 1 Expected market size by 2013 (US$bn) 4.9 4.6 5.2 9.3 1.5 CAGR 15% 25% 16% 14-15% 15% Drugs going off patent (US$bn) Regulatory Environment Encouraging generic usage Pro-generic Pro-generic Pro-generic Pro-generic Key growth drivers • Large number of patent expiries • Improving economic condition • Largely under penetrated nature of market • Aging population • Governments initiative to encourage generic usage • Low per capita drug consumption • Higher purchasing power • Rapid growth in insurance sector • Increased prevalance of chronic diseases • Low penetration of modern medicine 10 March, 2010 Key challenges • People’s perception and cultural difference towards • Upfront investment to establish front end marketing and distribution network generic • Opportunities spread over 100 markets • Prescribers attitudes • Government and regulatory interference • Japanese patients perceive generics as inferior to • Acceptance of patent regime branded products • Currency fluctuations • Competition Indian companys presence • The Indian pharma industry is diversifying its • Indian companies have fairly large presence in some of the key emerging markets geographical presence to reduce dependency on • Indian pharma companies have higher familiarity with emerging market dynamics US • Most of the Indian companies have built-up front end marketing and distribution network in • Japanese generic market offers huge opportunity these countries except Cipla, who mainly rely on partnership model • Ranbaxy plans to capitalize Daiichi’s presence in • With large product baskets, regulatory expertise, low costs and successful experience in Japanese market operating profitably in semi-regulated branded generic markets, India pharmas are targeting • Lupin and Cadila have built presence the market large opportunities in emerging markets Key opportunities • Government provides traction for higher generic • Emerging markets are likely to grow 5-6x faster than developed markets (expect this utilization market to be US$400bn by 2020) • Under patented market • Offers higher margins because of branded generics • High entry barriers because of doctor relationship and brand equity • Renewed interest of MNCs towards emerging markets Source: Emkay Research Generic Pharma Sector 14
  15. 15. Generic Pharma Sector Indian generics: Well placed to capture the growing generic opportunitiesGeographical diversification, Indian pharma companies, by virtue of their strong presence in the domestic pharmadominance in a niche segment, Para market, highest number of US FDA approved plants outside the US and considerableIV pipeline and cost structure are the exposure to developed generic markets are in the forefront for capitalizing opportunities inqualifying parameters for a formidable the generic space. Global presence, a wide and diversified product pipeline spreadgeneric player across multiple segments, presence in niche segments, strong FTF pipeline and integration across the product value chain coupled with lean cost structure are the key fundamental drivers for Indian generic companies. We have identified four parameters for a company to qualify as a formidable generic player. They are geographical well diversified business, dominance in a niche segment, Healthy Para IV pipeline and Lean cost structure. We believe that companies, which fare well on these parameters are well placed to cash in on generic opportunities. We have explained each of these parameters in detail below and have also rated the companies in our universe on each of these parameters. Geographically well diversified businessWidespread geographic footprint Indian pharma companies operate in multiple geographies with a majority of their revenuesreduces earnings volatility and coming from the sale of branded formulations in India and other semi-regulated markets.enables them to capture oppurtunities A widespread geographic footprint reduces earnings volatility, especially as traditionally lucrative markets such as US, Germany and UK have turned extremely competitive. Moreover, a well diversified geographical mix will enable them to cash in on the growth opportunities that different markets provide. Most Indian pharma companies are well diversified geographically, but Ranbaxy clearly has the widest global footprint, with products available in 125 countries, operations in 49 countries and manufacturing base in 8 of them. Cipla would be the second with exports to 175 countries mainly through a partnership model. DRL has built a significant presence in CIS/Russia as well as in Germany and US and the partnership with GSK will further strengthen its presence in the emerging markets. Sun Pharma has a strong presence in the US and exports formulations to 26 countries- mainly in the emerging markets. It is now diversifying into European territories. After building strong franchises in US, Japan, India and 22 countries in AAMLA region, Lupin is gearing to enhance its presence in other key markets such as EU territories and Latin American countries. Geographical presence 120% 100% (Revenue %) 80% 60% 40% 20% 0% Ranbaxy Cipla Sun pharma Dr Reddy Cadila Lupin US EU Emerging market Japan Source: Emkay Research, Company Dominance in a niche segmentDominance in a niche segment Apart from having presence across various product categories, we believe that dominanceenables them to have pricing power in a niche segment is a pre-requisite for becoming a major generic player. Dominance inand better margins a niche segment enables them to have pricing power and better margins, which will largely insulate them from the tough competition in the generic space. A more specializedEmkay Research 10 March, 2010 15
  16. 16. Generic Pharma Sector focus on products that are difficult to manufacture or have limited generic competition, even though the target market may be small, differentiate them from me too generic companies and reduce the sensitivity of earnings to price erosion. Most Indian generic players have already identified and are establishing themselves in a particular niche segment, which will afford them insulation against the vagaries of the highly competitive generics market. Cipla, with its dominance in inhalers, DRL in bio-similars, Sun Pharma in controlled substances and Lupin in oral contraceptives are working towards these directions. Building a niche in complex generics Ranbaxy Cipla Sun pharma Dr Reddy Cadila Lupin ANDAs 241 107 159 92 90 DMFs 271 133 148 76 85 Complex Penems Inhalers Controlled Biosimilars Transdermal Oral generics Substances patches; Contraceptives vaccines Source: Emkay Research Healthy Para IV pipeline The 180-day period of exclusivity for the first generic company is a very strong incentive for generic companies to stay ahead of the competition. Strong Para IV pipeline with potential FTFs not only provide 6-months exclusivity (one time profit) but also help to maintain leadership position in that molecule. Indian pharma majors are likely to derive significant benefit from some non-recurring Para IV earnings and their first mover advantage will also help them retain market share, even post exclusivity. Among Indian companies, we believe that DRL with 38 potential FTFs, Ranbaxy with 26 potential FTFs, Sun Pharma with 24 potential FTFs and Lupin with 15 potential FTFs will benefit the most from this development. Cipla, on account of adopting the partnership model, has no Para IV pipeline. Para IV - product differentiation Dr Reddys 38 Ranbaxy 26 Sun 24 Lupin 15 0 5 10 15 20 25 30 35 40 Source: Emkay Research Lean cost structureCompanies with lean cost structure Being cost competitive is one of the key ingredients of a successful global generic company.and front end presence across region While integration across the value chain from intermediate to formulation yields costwill be better positioned to capitalize advantages, forward integration by way of having front end distribution network lowers theon generic opportunities risk of increasing competition and allows a company to capture large share of profit from a product. As it is difficult to predict the future revenue, the only thing which a company can do is to control cost. Our view is that companies with lean cost structure and front end presence in key geographies will be better positioned to capitalize on generic opportunities. Sun Pharma has the leanest cost structure with low fixed costs, while Ranbaxy and DRL (high manpower cost and other expenditures) are aggressively cutting cost by closing down their non-profitable operations.Emkay Research 10 March, 2010 16
  17. 17. Generic Pharma Sector Cost structure of Indian companies Ranbaxy Cipla Sun pharma Dr Reddy Cadila Lupin Raw material cost 42% 47% 20% 34% 33% 42% GPM 46% 53% 80% 66% 67% 58% Employee cost 13% 5% 8% 15% 11% 13% R&D cost 6% 5% 7% 6% 5% 6% Other exp 33% 23% 19% 25% 31% 21% OPM 7% 19% 45% 20% 21% 19% Source: Emkay Research Scorecard of Indian pharma companies We believe that companies that can differentiate from competition by building niche product portfolios, novel drug delivery systems, chart a geographical diversified presence and sustain and nurture vertically integrated operations will benefit the most. We have ranked the companies on the basis of above parameters. As per our scorecard, Sun Pharma and DRL emerge as most preferred companies with the highest score of 17 each. Cipla and Cadila feature last with a score of 12 each.Generic score cardCompany Parameters Total Score Geographical Dominance in Para IV Cost presence niche segment pipeline structureSun Pharma 3 5 4 5 17Dr Reddy 4 5 5 3 17Ranbaxy 5 5 5 1 16Lupin 4 5 3 3 15Cipla 4 5 0 3 12Cadila 4 5 0 3 12Source: Emkay Research Expect earning CAGR of 28% over FY09-12E We expect our generic universe revenues to grow at a CAGR of 15% over FY09-12E, driven by 23% and 19% growth in Cadila Healthcare and Lupin pharma respectively. $235bn patent expiry, double digit growth in the emerging markets and sustainable momentum in the domestic markets would be the key growth drivers going forward. We expect operating margins to expand by 215 bps to 21.7% over FY09-12E. We expect Ranbaxy’s margin to expand by 660bps and Cipla’s margin to expand by 310bps during the same period. We expect 15% revenue CAGR and strong operating performance to drive a 28% earning CAGR over FY09-12E.Emkay Research 10 March, 2010 17
  18. 18. Generic Pharma Sector Valuations Valuations Premium valuations to sustainPremium valuations to sustain Our universe currently trades at 20x (ex-Ranbaxy) FY11E EPS and 16x (ex-Ranbaxy) FY12Ebecause of 28% earning CAGR, EPS. Current sector valuations are at a 20% premium to its 5 year average historical PE.strong return ratios, low leverage Historically, generics have traded at a 10-15% premium to the broader markets on account(0.2x) and free cash flow of consistent earnings growth, healthy balance sheet and non-cyclical nature. Going forward, we expect premium valuations to sustain because of 28% earning CAGR, strong return ratios, low leverage (0.2x ) and free cash flow. Moreover, we are of the view that because of emergence of innovator-generic partnership model, premium valuations for Indian pharma are likely to sustain. We expect our large cap universe to continue to trade at 20x one year forward PE (in-line with its 5 year mean multiple; 20% premium to sensex). However, in case of companies like Lupin and Cadila, who have historically traded at 5 year mean multiples of 13-14x (mid cap valuations), the gap to large cap multiple is narrowing down as these companies have gradually moved into the league of big pharma companies and we expect this gap (trading at 20% discount to comparable peers) to further narrow down. We initiate coverage on Cipla, Sun Pharma and Ranbaxy with an Accumulate, Hold & Sell rating respectively. Lupin, DRL and Cadila are our top picks in the sector. Historically, the pharma sector has outperformed in times of uncertainty as well as downturn and has underperformed when the market is bullish. As the broader market is likely to remain zigzag, we are of the view that investors will continue to hold pharma stocks to balance their high beta exposure. Apart from appreciating currency coupled with company specific issues, the sector is largely insulated from the concerns that prevail in a slowdown. Lupin, DRL and Cadila are our top picks Cadila Healthcare Cadila Healthcare emerges as our top pick given its strong growth prospects, wide geographical reach, foray into difficult to manufacture generics and attractive valuations. We expect Cadilas earnings to grow at 27% CAGR over FY10-12E on the back of strong growth in its international business, steady growth from domestic operations & meaningful contribution from Hospira JV. We believe that over time, Cadilas Hospira JV will not only make up for losses on its Nycomed JV but also add to Cadilas overall profitability. Despite ascribing 10% discount to sector multiple because of low generic score (12, last in the universe), its discounted valuations are sufficient to provide huge upsides. Our fair value for Cadila is Rs962 (18xSep11E), an upside potential of 22%. The fact that Cadila has surpassed all our estimates since we initiated coverage on the stock, increases our confidence in its ability to meet our future estimates. We re-iterate our Buy rating on the stock with a target price of Rs962. Cipla Ltd We initiate coverage on Cipla with an Accumulate rating and a price target of Rs366. Apart from being the largest Indian pharma company by market size, it is one of the most diversified companies with presence in more than 175 countries. Its strategy for export is built around supply chain model and tie-ups with global players, without investing in building up front-end presence. We are of the view that huge capacity expansion made over last four years will start delivering now, improving its RoCE, going forward. Moreover, despite significant capex, Ciplas balance sheet continues to remain healthy with a D/E of 0.2x and expect company to generate net free cash flow from FY11E onwards. We expect earnings CAGR of 18% over FY10-12E driven by a) 11.8% CAGR in domestic market,Emkay Research 10 March, 2010 18
  19. 19. Generic Pharma Sector b) 12.6% CAGR in export formulation. Since Cipla has adopted the tie-up route in the generic space, it has no Para IV pipeline, resulting in it being one of the lowest scorers (generic score of 12). However, its dominance in the lucrative inhaler space and established business model makes it a low risk bet on the generic opportunity. As a result, we have valued Cipla in line with the sector average (20x Sep11 EPS of Rs18.3) and arrived at a target price of Rs366 (upside of 16%). Signing of MNC contracts and launch of inhalers in EU could be potential upside triggers. Dr Reddy’s Laboratories (DRL) DRL, with the highest score of 17 on our generic scorecard, is among the best bets to buy into the generic growth story. Its well diversified geographic reach, strong presence in the high growth potential biosimilars space, healthy Para IV pipeline and strong earnings growth are likely to ensure upside potential from the current level. Strong growth in base business (barring Betapharm), revenue upsides from its Omeprazole OTC launch and its GSK alliance are likely to result in a 38% earnings CAGR over FY10-12E. Despite 38% out-performance to broader market over the last six months, we continue to remain positive on the stock and reiterate our buy rating with a target price of Rs1478, an upside potential of 26%. Lupin Laboratories Lupins outperformance across segments along with its well charted growth strategy makes it our best bet in the Indian generic pharma space. We expect Lupins earnings to grow at 24% CAGR over FY10-12E driven by a) strong growth across the key geographies, b) launch of oral contraceptives in the US market, c) increasing generic penetration in the Japanese market and d) 200 bps operating margin expansion in next 3 years. Lupin, third in our generic scorecard (score of 15), with its well diversified geographical reach, foray into high growth oral contraceptive segment along with attractive Para IV pipeline is an attractive investment proposition because of its valuation discount to large cap peers (20%). Despite 57% absolute return and 47% outperformance to broader market over the last six months, strong execution across the markets and increasing visibility in revenue and earnings (17% and 24% CAGR over FY10-12E), makes Lupin our preferred pick in the large cap pharma space. With the Mandideep issue getting resolved in favor of Lupin, we are of the view that Lupin should now trade in-line with its large cap peers. We re- iterate our Buy rating on the stock with a target price of Rs2111 (20x Sep11 EPS of Rs104.5; NPV of Rs22/share for Para IV). Ranbaxy Labs We initiate coverage on Ranbaxy with a Sell rating and a price target of Rs329. With dominance in niche segments such as penems, strong para IV pipeline coupled with well diversified geographical reach, Ranbaxy features second in our generic scorecard (score of 16). Our base business earnings of Rs6 and Rs11 for CY10E and CY11E factors a gradual improvement in the base business as we believe that most of the initiatives will start contributing from CY11E onwards. We have valued its FTF pipeline on NPV basis unlike the practise of treating FTF as recurring earnings.This itself has brought a valuation difference of Rs95 per share. We have arrived at a price target of Rs 329, assigning Rs220 for its base business (20xCY11E) and Rs 109per share as NPV of FTF pipeline. Though we are positive on the long term prospects of the company, we believe that current valuations are way ahead of actual improvement in the business and hence, recommend a sell on the stock. Earlier than expected resolution of FDA issue at Dewas or strong earning visibility from CY11E onwards are positive catalysts to the stock price.Emkay Research 10 March, 2010 19
  20. 20. Generic Pharma Sector Sun Pharma We initiate coverage on Sun Pharma with a Hold rating and a price target of Rs1644. Sun Pharmas strong foothold in the domestic formulation business, robust pipeline for regulated markets and healthy balance sheet are the positives, which will enable it to maintain its leadership position. While Sun Pharma ranks high on parameters like dominance in niche segments such as controlled substances and attractive para IV pipeline, it is its lean cost structure that gives it a distinct advantage over its peers. We have ascribed 10% premium to sector multiple because of its high generic score (17). Our fair value for Sun Pharma works out to Rs1644 (22x Sep11E base business EPS; NPV of Rs66/share for Para IV pipeline; Taro Investment- Rs30/share). Despite ascribing 10% premium because of high generic score, our target price of Rs1644 does not offer much upside from the current levels. Earlier than expected clearance of Caraco, visibility of high end product launches or successful acquisition of Taro are potential positive catalysts to the stock price. Delay in clearance of Caraco could impact our numbers adversely.Emkay Research 10 March, 2010 20

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