API manufacturing finally getting the attention it deserves

A recent report from Candle Partners forecasts interesting trends for India’s pharma sector. While investors seemed to be gung ho about the sector’s potential, given its central role as a saviour during the pandemic, the report suggests that the sector has been a laggard in terms of returns. The good news is that API manufacturing is finally getting the attention it deserves, from promoters, PE investors and policymakers.

The report quotes data showing that over the last 12 months, the Indian pharma industry has been a substantial under-performer with a majority of the stocks giving double-digit negative returns while the overall market (BSE Sensex) delivered a +9 per cent return. While large caps have given a –ve 7 per cent median return, mid-caps have given a –ve 20 per cent median return. While the API segment did well in the 2019-2021 phase, the segment has given a –ve 24 per cent median return in the last 12 months.

An evaluation of a decade of historical data on the sector, segregated into formulations generics and APIs suggests where the industry could be headed. A low sales growth rate over the last five years, with reported revenue growth of 7 per cent, mostly due to flat growth in the US market, is probably the single largest reason for these low returns. The silver lining is that sales from India and ROW have made up for some of this lag, with the growth of ~10-12 per cent.

However, EBITDA margins dipped 8 per cent from 28 per cent in 2014 to an average of 20-21 per cent, but only after substantial cost rationalisation and cuts in R&D spends. Of course, R&D cuts are not good news at all. From 9 per cent in FY 16/FY 17 to the current 5-6 per cent levels, we could be reversing years of gains and future profits from R&D assets to survive in the near term.

But while formulation generics flounders a bit, the data show that the Indian API Industry has done better, with a five-year revenue CAGR of 15 per cent, and EBITDA margins consistently in the 24-28 per cent bracket.

However, both formulation generics and APIs have higher than desired working capital cycles. While formulations are at 173 days, APIs at 151 days are also on the high side.

Given these trends, the Candle Partners report prognosis for FY 2023 – FY 2024 is that that will be a substantial refocus on the India growth story by most large companies in this period. This is already happening with a surge in domestic formulations M&A over the last nine months. The report points out that deals worth ~Rs 4,000 crore have been executed, with media reports of possible deals worth another Rs 6,000-7,000 crores in the pipeline. With integration, we will hopefully see better EBITDA margins in the domestic businesses.

With the US business losing its sheen, even for market leaders like Dr Reddy’s Laboratories and Lupin, mid-sized Indian companies have become wary of making fresh Capex investments in regulated markets like the US, preferring to invest in other geographies.

On the other hand, there have been Capex investments in captive API manufacturing, bolstered by the China+1 strategy. Some companies have created separate companies/subsidiaries headed by professional management, a clear sign of the promise they see in APIs as a separate strong revenue stream. There is massive consolidation in the API space as well, with some players pursuing an aggressive inorganic growth strategy, creating API platforms with huge volumes to serve global clients. This is the best bet for India to play a major role in the China+1 move, supported by the PLI schemes.

The other interesting trend that the Candle Partners report highlights is the increasing interest and role of private equity (PE) capital in India’s pharma sector. The JB Chemicals-KKR deal could emerge as the template for mid-sized promoter-owned Indian pharma companies to ensure their legacy expands to the next level. PE funding comes with the management bandwidth to make the shift from volumes to value, a transition that could be painful and needs to be done right the first time. While financial gains should pick up, the migration of mid-sized players to the next level is important to ensure pharma entrepreneurship in the sector thrives.

Policy interventions also play a major role in ensuring pharma promoters continue to stay invested. The recently updated National List of Essential Medicines (NLEM) is being seen as more balanced than previous updates, as the Government did discuss this with the industry first. While the overall list has increased, some medicines have also been dropped from the NLEM.

But while balancing affordability with the profitability of the sector, the government will also need to ensure access to the right patients. Adding anti-infectives to the NLEM will reduce their price, but increased access could lead to overuse/misuse, adding to India’s burden of anti-microbial resistance (AMR), which caused more deaths in 2019 than malaria and HIV.