Prefer domestic healthcare consumption plays: IIFL Capital Services

4 Jan 2023 , 11:25 AM

Most of the mid-cap pharma companies continue to outperform domestic pharma market growth by 300-500bps p.a. thereby driving improvement in business mix and profitability levels. With export-focused players primarily dependent on one-off large product opportunities for growth, analysts at IIFL Capital Services believe domestic-focused formulation companies will continue to outperform export-focused peers. Their top-picks in the pharma sector are Sun Pharma, JB Pharma and Torrent Pharma. They have a cautious view on Divi’s/Biocon/Lupin and Divi’s is their top Sell idea for 2023.

The India healthcare delivery market is also expected to sustain its 13-14% CAGR over the next 4-5 years driven by increasing prevalence of chronic diseases, rising affordability levels, medical tourism and government’s push on primary healthcare in rural markets. With most hospital players focused on consolidating bed capacities over the past 5 years, the hospital sector’s EBITDA margins/RoIC (pre-tax) expanded ~800/1500bps to ~23/22% respectively over FY17-H1FY23, thereby driving a rerating for the sector. 

Analysts at IIFL Capital Services believe the hospital sector’s margins/return ratios will broadly sustain, which will be aided by further improvement in occupancies of existing hospitals and ARPOB growth, driven by rationalization of institutional business and increase in international patient volumes. Their top picks in the hospital sector are KIMS, Rainbow and Apollo.

Domestic Branded Pharma – Limited risk of earnings downgrades for JB Pharma and Torrent 

The domestic India Pharma Market (IPM) continues to clock secular 10-11% growth for the industry (ex-COVID portfolio) led by price hikes of 6-7%, volume growth of 2% and new introductions of 2%. Most of the mid-cap pharma companies (JB, Ipca, Alkem, Ajanta, Torrent), deriving 60-80% of their overall EBITDA from branded generic markets of India/RoW, continue to outperform domestic pharma market growth by 300-500bps p.a., thereby driving an improvement in their business mix and profitability levels. Analysts at IIFL Capital Services expect these midcap players to sustain India business outperformance, driven by their stronger volume growth of 6-8% p.a., market leadership in certain large brands and scale-up in new therapies.

For the domestic formulation companies (Torrent, JB, Alkem, Ipca and Eris), IIFL Capital Services expects median ~13/22% overall revenue/EBITDA CAGR over FY23-25. Analysts at IIFL Capital Services see limited risk of earnings downgrades for JB and Torrent. However, with export business challenges and raw-material cost pressures for Alkem/Ipca and underperformance for Eris in the domestic market, they see earnings downgrade risks for Alkem, Ipca and Eris.

Export Pharma – Sun is IIFL Capital Services’ top-pick; Earnings downgrade risks for Divi’s, Gland, Biocon and Lupin

After a brief period of moderate price erosion in the US generic market during the COVID pandemic in FY21, US generic price erosion has again reverted to mid-to-high single-digits (and low-double-digits for certain players). The elevated levels of price erosion have impacted US business/margins/earnings of large-cap export-focused pharma players. Analysts at IIFL Capital Services believe the narrative for the US-focused generic companies would continue to remain weak in 2023, especially given the lack of meaningful complex product opportunities in near-term and impact from the recent warning letters/import alerts handed by the USFDA to Indian players. Export-focused generic players are primarily dependent on one-off large product opportunities (Lupin on Spiriva, Dr. Reddy’s on Revlimid, Cipla on Advair & Abraxane) for growth in the US market and hence they will likely witness high volatility in their earnings performance.

For the export-focused pharma companies (Sun, Lupin, Dr Reddy’s, Aurobindo, Cipla, Zydus, Gland, Divi’s), analysts at IIFL Capital Services expect median ~10/15% overall revenue/ex-Revlimid EBITDA CAGR over FY23-25. They see limited risk of earnings downgrades for Sun Pharma, as continued scale-up in the Specialty and India business will drive operating leverage and help offset weakness in the Generics business.

Although analysts at IIFL Capital Services also like Cipla for its diversified pipeline for the US market across several respiratory products (Advair, Qvar, Dulera, Symbicort) and complex injectables (Lanreotide, Abraxane, Saxenda, Forteo, Vasostrict) as well as its high exposure (~45%) to the India Pharma Market, they believe Cipla’s current valuations (~26x FY24 estimated ex-Revlimid EPS) leave limited scope of upside in the near-term and is already discounting ~16% ex-Revlimid EBITDA CAGR for the company over FY23-25.

India Hospitals – Sanguine outlook despite capacity additions from FY25; IIFL Capital Services prefers KIMS, Rainbow, Apollo

The India healthcare delivery market is expected to sustain its 13-14% CAGR over the next 4-5 years driven by increasing prevalence of chronic diseases, rising affordability levels, expanding medical tourism under Indian government’s ‘Heal in India’ initiative, and Indian government’s push on primary healthcare in rural markets. With most hospital players focused on consolidating bed capacities over the past 5 years, the hospital sector’s EBITDA margins/RoIC (pre-tax) expanded ~800/1500bps to ~23/22% respectively over FY17-H1FY23, thereby driving a rerating for the sector.

While most hospital companies have indicated plans to expand bed capacities by ~30-70% over the next 4-5-year period, and part of this incremental capacity will start getting commissioned from end-FY24, analysts at IIFL Capital Services believe the drag from new capacities on consolidated financials will be significantly lower than it used to be in the past. Hence, the sector’s margins/return ratios will broadly sustain, which will also be aided by further improvement in occupancies of existing hospitals and ARPOB growth, driven by rationalization of institutional business and increase in international patient volumes. Given EBITDA growth expectations of ~15/20% CAGR for large/mid hospitals over FY22-25 and current valuations, analysts at IIFL Capital Services find relative value in Apollo/Fortis among large-cap stocks and KIMS/Rainbow among mid-caps.

India Diagnostics – Limited visibility regarding base business growth reverting to pre-COVID levels

The Indian diagnostic players, after having benefitted from COVID-testing and associated high operating leverage in the business in FY21/22, have had a difficult year (CY22) owing to growth recovery in the non-COVID business (currently 6-10% on 3-year CAGR basis) being below pre-COVID levels (of 13-14%). While heightened competitive intensity in the diagnostic sector has driven pricing pressures predominantly in the wellness segment, both Dr Lal and Metropolis have been able to maintain GMs at pre-COVID levels of ~77-78%, thereby implying that new competition has had limited impact on the pricing dynamics of organized players.

However, volume growth and base business trends for all organized diagnostic players are still trending below pre-COVID levels and there is limited visibility on when the base business growth will revert to pre-COVID levels. Analysts at IIFL Capital Services expect the diagnostic stocks to continue to consolidate in H1CY23, till visibility on the base business growth improves.

With diagnostic stocks having corrected 40-60% in CY22, valuations are back to pre-COVID levels of ~35-40x 1-year forward PER versus ~65-70x during the COVID peak. However, Dr Lal continues to trade expensively at ~55-60x 1- year forward PER and analysts at IIFL Capital Services find relative value only in Metropolis (~70% network expansion by FY24/25, strong presence in specialized testing segment, increasing B2C revenue share led by Hitech acquisition) among the diagnostic stocks.