Ray of Hope

It is a question I ask myself everyday… but I have no clear answer. From a day-to-day perspective, I am not seeing the pressure reducing,” said Abhay Gandhi the CEO of Sun Pharma’s North America business, in a rather pensive mood at the company’s third quarter earnings call. Sun Pharma, India’s largest pharmaceutical firm has been fighting tooth and nail to hold its ground in an extremely competitive pricing environment in its biggest market, the US. Companies across the pharma industry, both main players as well as channel partners, are consolidating even as prices of drugs are falling like there’s no tomorrow. The carnage seems never-ending — at least for a few years.

And there are two solid reasons why the pricing pressure on the generic business will continue. First, there is rapid consolidation among customers of generic drug makers, which drastically reduces their bargaining power and second, the intense competition among generic drug-makers. “Earlier a pharmacy was acquiring another pharmacy; an insurance company was acquiring another insurance company. Now, the retail firm is acquiring the insurance firm and vice versa. While there was vertical consolidation earlier, now it’s horizontal, but consolidation itself is relentless. So, negotiating power of the generic companies is reducing vis-a-vis the big customers, who are buying the medicines from them,” explains Deepak Malik, pharma analyst at Edelweiss Securities.

The other stress point is the new regulatory climate whereby the emphasis is on increasing the rate of approvals, and the entry of new competition from China, Japan and new Indian companies. Average annual ANDA approval during FY05-15 was 571, whereas it is expected to be 924 for FY16-18. “The increased rate of approvals has given rise to high competition, which is unlikely to stabilise over the next 12-18 months,” says Abhishek Sharma, VP, IIFL Institutional Equities.

For Sun Pharma, the woes don’t end there. An extended hiatus on approvals for its Halol plant, since September 2014, has dealt a severe blow to its topline. Even in the latest inspection of the Halol plant in February 2018, the USFDA has made three observations, although the management reckons these are purely procedural in nature. 

Meanwhile, Sun’s revenue is likely to witness a 14.2% decline in FY18, the first double-digit decline for the company in the past two decades. 

For 9MFY18, the firm’s net sales have declined by 17% to Rs.19,355 crore, while its adjusted PAT declined by 60% to Rs.2,316 crore. The adjustment includes the one time change in taxation terms in the US (Rs.513 crore) and the Rs.951-crore settlement relating to anti-trust litigation, which have been written off in Q3FY18.

Over the past one year the Sun stock witnessed a sharp erosion in market cap, with the price witnessing a steep 24.45% correction, against the 10.2% increase in the benchmark BSE Sensex (see: Fizzle out). Now, it trades at 19x one-year forward earnings estimate (FY20), which is a historical low, at ~15% below the 10-year average P/E for the stock. Traditionally, Sun has commanded a 20-25% premium to peers in the Indian pharma sector, typically at 25-27x one-year forward price-earnings.

This is the worst ever. But could things get any worse? Analysts who have a Hold on the stock believe that Sun’s acquisition strategy has not been particularly successful and revenue from new specialty products will at best offset the loss of revenue from existing products, which are going generic, or facing stiff competition. On the contrary, Buy side says, the worst is over.

Getting better
While the erosion in the US base generic business continues at an unrelenting pace, some reason for cheer is that the firm’s foray into specialty segment in the US market is starting to pay off.

To the credit of the management, Sun Pharma had the foresight to make steep R&D investments since FY15, in building a strategic specialty pipeline, much before the pain in the US market started to emerge. As a fruit for its efforts, it recently received approval for Tildrakizumab, its first biological approval in the US market. The drug, intended to be used in the treatment of moderate to severe plaque psoriasis, has been in-licensed by Sun from Merck, for a sum of $80 million, and is expected to be launched by early FY19. The revenue from this product is expected to be about $100 million in FY20, with a peak revenue potential of $350 million. Yet, there is uncertainty over what will ultimately flow into Sun’s bottom-line. That’s because Tildrakizumab will face competition from similar products launched by Novartis, Eli Lilly and J&J. Sun Pharma’s success thus will depend on the safety and effectiveness of the drug, compared to its peers and its ability to get the pricing right. The firm is also expecting the approval of this drug in the European market by late CY18 or early CY19.

But there is more in the pipeline. Besides Tildrakizumab, the firm is also expecting approval for Seciera (OTX-101) — a drug used in the treatment of dry eye disease — by the first half of 2019. The firm is targeting annual sales of $60 million-$70 million for the same. Currently, the firm’s specialty portfolio consists of Odomzo ($40 million-$50 million), BromSite (~$132 million) and Absorica ($250 million). The management also announced the commercialisation of Odomzo in Germany in the earnings call, with Germany being the first point of entry for this product in the European market.

There are other strategic moves like its acquisitions and portfolio rationalisation that make good sense. In 2016, Sun acquired 14 brands from Novartis in Japan, marking its foray into the Japanese market, which is the world’s second largest drug market after the US. Then, it acquired 85% stake in Russia-based JSC Biosintez, which gave it access to local manufacturing capability across multiple dosage forms in Russia. Besides, to strengthen its specialty pipeline, Sun also bought rights to proprietary-niche molecules. The entire specialty portfolio is expected to contribute about 20% to the total revenue by FY20. The firm spent a total $528 million on acquisitions in FY17.

Sun’s current pipeline for the US market now includes 126 ANDAs and four NDAs, all awaiting approval with the USFDA. During Q3FY18, four ANDAs were filed and five approvals were received. The firm also rationalised its ANDA portfolio, withdrawing certain products which no longer seemed attractive enough to launch, or had a slim chance of recovering the subsequent investment required to get the approval for the product. “The decision to do away with relatively insignificant ANDA opportunities will enable the firm to sharpen its focus towards major upcoming launches,” says Praful Bohra, analyst, Equirus. The management has not revealed the extent of losses due to this withdrawal but re-assures that it’s not a ‘big’ number, as a percentage of the aggregate R&D cost.

Another key driver for the firm is the resolution of the Halol plant. Both management and analysts reckon that this is inevitable after the latest round of inspection. The Halol facility contributes ~10-13% of the US sales for the firm. Kumar Saurabh, analyst at Motilal Oswal Securities estimates incremental sales of ~$100 million-$150 million from this facility post the resolution. “Margins are bound to expand by FY20. While there will be some immediate margin expansion once the operating leverage kicks in after the resolution of Halol, the gradual ramp up in the specialty portfolio will also enhance profitability over the next couple of years,” says Bohra (see: Special dose). The management also reckons that most products will breakeven in about three years, from the day of the launch. “The story this time is more about margin expansion than revenue growth,” he adds.

While the firm’s US market witnessed a 41% decline in 9MFY18, its India business and EME business grew at 4% and 12%, respectively. The India business is expected to expand from an estimated Rs.8,600 crore in FY18 to Rs.11,300 crore in FY20. Indian formulation growth was unaffected despite inconsistent price-control measures by the government and channel disturbances due to trade margin issues with wholesalers/distributors.

Besides, the depreciation of currency in recent times is likely to benefit the firm further. But then, Sun is still not out of danger on two vitals. 

Waiting to stabilise
For Sun, Taro has not been an easy deal to digest from day one. Now, the biggest headache for Sun is the steep decline in Taro’s margins apart from the competitive pressure likely to be faced by its specialty product, Absorica. 

Taro is the centre for Sun’s generic dermatology portfolio, which by its very nature has a very long development cycle. These products have to undergo clinical trials, unlike other generic molecules, so it’s almost a five-year development cycle. “Taro had a great run from 2011-12 till last year. Derma is a very small market in terms of size, so a lot of players who were not making money moved out. Those who remained, started taking price hikes on the older molecules, to the tune of 5x and 6x. So, suddenly the market size expanded because of the price hike and presence of limited number of players. Taro started making 80-85% gross margins, which even some of the innovative companies do not make. Suddenly, when people realised that this market is huge, at 80-85% margin, 60% ROE, they wanted to come back,” says Bohra.

With the development cycle of almost five years, the firms that had decided to enter this lucrative market in 2011-12, were able to make significant in-roads since 2017. The good days for Taro are over, and incrementally, from here on, it will be difficult for it to sustain its dream-run with respect to margins. In Q3FY18, Taro’s gross margin declined 970 bps to 66%, unnerving investors. The question that remains now is, where will margins settle. Then again, Absorica, a product used in the treatment of severe acne, which brings in annual sales of $250 million for Sun, faces the prospect of losing a significant portion of revenue once the drug goes generic post 2020. It contributes a sizeable 55-60% of the total revenue from the US, excluding its Taro division. Although the prescriptions for this drug have reduced over the past few quarters, the management is trying to make it more profitable by rationalising costs. “We have made a significant correction in our corporate program. So, although you see a loss of prescription, it will go down to what you would have seen almost a year ago or slightly better and clearly that will mean a more profitable sale of Absorica,” said Gandhi during the earnings call. As part of cost reduction, Sun has been slashing co-pay support, whereby it provided financial assistance on purchase of this drug in order to promote their usage. Sharma concurs, “Absorica rebound is expected on account of reduction in co-pay. It will eventually face generic competition in two-and-a-half years, by when specialty launches would have started ramping up.”

It’s your call
Right from the beginning, Dilip Shanghvi, the visionary promoter of Sun Pharma built the firm concentrating on high-margin segments that offered growth potential. Today, the dilemma is, even if the track-record of the management reinforces faith in their ability to turn the tide, the external environment makes things really challenging (see: To buy or not to buy). But then, as the classic investing adage goes, only if you are willing to bear the uncertainty, do you have a bargain.

Malik is optimistic of Sun’s ability to surmount the crisis. He says, “For one, Indian players are generally the lowest cost players in the market. Besides, the fact that Sun continues to be run by a hands-on promoter is also a distinct advantage. Second, Sun is trying to move into speciality and complex products where comparatively, competition is not that severe and there are high entry barriers,” says Malik. Siddhant Khandekar, AVP (research), ICICI Securities concurs that Sun’s progress in the speciality portfolio is promising, which is the key differentiator compared with its peers.

While there may be some differences among analysts when things will turnaround, most of them reckon that Sun’s problems have been priced in. “The stock is currently trading at the lower end of the valuation band and is set to be re-rated,” says Bohra. From an earnings perspective, he forecasts an EPS of Rs.23-24 for FY20. If reversion to the mean is something you believe in, you can’t ignore Sun Pharma, especially, at this time and price.