Pharma deep dive: Not the time to buy hospitals, bullish on diagnostics, says Incred’s Khemka

Aditya Khemka also explained the dynamics of the bulk drugs space, and what investors need to be mindful of in the sector.

Aditya Khemka has tracked the pharma sector for 17 years – as an analyst and as a fund manager. At Incred PMS, he manages its Rs 200 crore healthcare fund.

In a conversation with Moneycontrol, Khemka spoke about the nuances of the healthcare space, why the push towards generic drugs in India won’t work, the reason to avoid shares of hospital chains for now, and the companies that interest him in the diagnostics, formulations and bulk drug segments. He also explained the dynamics of the bulk drugs space, and what investors need to be mindful of in the sector. Edited excerpts:

Pharma shares are back in favour with investors. What is driving this trend? Do you see it sustaining?

To understand what is happening now, we need to look at what happened in the last couple of years—between FY21 and FY23. COVID boosted the revenues of pharma and diagnostic companies. So COVID-related revenues surged and the regular business went down. And since margins were higher for the COVID business, profits rose sharply.

When COVID ended, the revenue and margin spike vanished and the contribution from the regular business with normal margins increased. At the same time, since China took longer to come out of lockdown, chemical prices remained high. Around 80-90 percent of Indian pharma companies’ raw materials come from China, so more pressure on margins because of costly raw materials. Plus you had high freight costs and high power costs. All this hurt operating profits and the bottom line in a big way.

With China emerging out of the lockdown, chemical prices have collapsed. Bad news for chemical companies, but good news for pharma companies. Freight and power costs too declined significantly, so a big boost for margins of pharma companies. That is what has got investors excited about the sector again.

Also read: Prashant Khemka is bullish on pharma and specialty chemicals companies. Here’s why

Which pockets of pharma are investors most interested in right now?

There are three buckets—unbranded generics, which is your US, European business, branded generics, which is your Indian and emerging market business, and then there is the API (active pharmaceutical ingredients) or bulk drug firms. Right now, it appears maximum investor interest is in unbranded generics.

I feel the unbranded generics business model is not a sustainable business model. It's a commodity business, where supply is higher than demand. It is a treadmill. So if I'm a pharma company doing unbranded generic business, my FY21 revenue is, let's say, $100 million. My FY22 revenue from the same products will fall to $95 million because of a 5 percent price erosion. To make up for that, I must launch more products. And this is a never-ending cycle.

So why the sudden interest then?

One reason is the fall in input costs. The big reason is the launch of generic Revlimid (a cancer treatment drug). The market for Revlimid is huge, around $7 billion annually. And most of these pharma companies, Sun Pharma, Dr Reddy’s, Cipla, Cadilla, they have all launched the generic version.

And there is a very weird settlement in Revlimid where the innovator has capped the market share each generic producer can have. Because of that, none of the companies is engaging in a price war because the very idea of cutting prices is to gain market share. When you know you can’t exceed a certain market share, there is no point in cutting prices.

The market is thinking the base business has improved, but my guess is that much of those revenues are coming from Revlimid. Some companies are making as much as $200 million from Revlimid. But the settlement with the innovator is valid only till 2026. What happens when a major revenue simply vanishes one fine morning? I don’t want to take that gamble. Maybe I am wrong or maybe I will be proved right.

There is a view among some money managers and analysts that US generic companies are under pressure because of rising interest rates and they can no longer engage in the price wars of the past. Would this reduce the rate of price erosion for unbranded generics firms and ease the pressure on them to launch new products constantly?

The price erosion has been a constant over the past many years. The exception was the period immediately after COVID broke out, as supply chains were affected. But over the next year or so, prices fell twice the normal rate to make up for the unexpected rise. My simple view here is that prices will continue to erode no matter what, even if the rate slows down. A slower rate of price erosion is not a positive, only an appreciation in prices is.

So what are you buying?

I am buying branded generic companies. These companies do very small business in the US. Largely, their business is in India and the emerging markets. India and the emerging markets are different from the US because pharma companies can have their own brands.

In the US, companies cannot have a brand… There, if a patient with fever goes to the doctor, the doctor prescribes paracetamol. He goes to the pharmacy and says, give me paracetamol. Pharmacist will tell him, I have one from Dr Reddy’s, one from Cipla, one from Cadilla. Which paracetamol do you want? Patient will say give me the cheapest one. He doesn't care. He is buying paracetamol. It has to be the cheapest.

In India, when a patient goes to the doctor, the doctor writes Dolo. Patient goes to the pharmacist and asks for Dolo and pays up. He never asks the price beforehand because the prescription says Dolo. That's the difference between a brand and a commodity market.

But in India too, there is a push for unbranded generic medicines. Won’t that affect Indian pharma companies’ earnings at some point?

So, the push in India for unbranded generics started in 1992. Since then, various bodies have come up with guidelines, but there has been little progress. There are many reasons this won’t work in India.

First of all, the notion that unbranded generics are cheap needs to be questioned. The US is the biggest unbranded generic market and it is the most expensive pharma market in the world. The next biggest unbranded generic market in the world is the UK and it is the second most expensive. There is Australia, South Africa, Japan, and China – all of them rank among the most expensive pharma markets of the world.

Then there is the matter of employment. There are 50 lakh people employed at chemists and 14 lakh medical representatives (MRs). All the MRs will be out of a job, while chemists will have to do with fewer staff because margins will drop sharply and they will have to lower their fixed costs.

But the bigger issue is that of quality. In countries with unbranded generics, the quality control standards are high. That is not the case with India. If you go to some of the manufacturing facilities, you won’t feel like having any medicine. I have seen people using shovels to put powder inside the machines.

In the absence of quality control standards, the companies using the worst manufacturing processes will be able to price their drugs the cheapest and compete with the companies with better manufacturing practices. And the loser will be the consumer.

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Hospital stocks too have seen a lot of interest. Are you a buyer in them at these levels?

All the hospital stocks – Apollo, Fortis, Narayana – are at all-time highs and all-time high valuation multiples, be it PE, EV/EBITDA, price to book, whatever. We have been bullish on hospitals for the past 3-4 years. And now we have turned a little negative because valuations have reached a level where we don't feel we can make money for our investors.

Hospitals have done well in the past 2-3 years because there was no capex. Hospitals are a business where when you do capex, your new facilities take 2-3 years to break even. So from an investor standpoint, what you get to see is a deteriorated balance sheet and a deteriorated P&L (profit and loss) account.

The opposite happens when the hospital stops capex. Now suddenly, as the footfalls increase, the losses will narrow, the company breaks even and then becomes profitable. That will give it the cash flow to repay debt. Margins will look better, interest costs will come down, ROE will look better. That is exactly what happened in the past 2-3 years. Most of these hospitals had done meaningful capex, and all their facilities are now productive, profit-making.

And now some of these hospitals have again started on a capex journey because they need to grow. Which is where we are again turning negative. We are saying the past cycle has played out. Now is not the time to be bullish on hospitals.

What about diagnostics? The stocks fell steeply last year but now appear to be stabilising. Do you see them getting rerated any time soon?

The main worry has been about online medical platforms like Tata 1MG and Netmeds offering discounted rates for tests and putting the traditional players out of business. The concerns are overdone.

Healthians, founded by cricketer Yuvraj Singh in Delhi back in 2014, is an online platform offering discounted diagnostic services. Despite being around for seven years, when I last checked the Ministry of Corporate Affairs website, their financial data for 2021 revealed that they had generated Rs 70 crore in revenue and Rs 45 crore in profit after tax. Also, Healthians primarily operated in the Delhi NCR region, which is also the focus area for Dr Lal (Path Labs). But Dr Lal's numbers in the last 6-7 years have been phenomenal.

This situation is akin to what happened with Amazon Pantry and DMart in retail. Initially, people thought Amazon Pantry would replace DMart due to lower prices and convenience. But DMart has held its ground because some products, especially health-related ones like food and medicine, require trust and a physical presence.

In the case of diagnostics too, people are sceptical about fully trusting online platforms with critical health tests. So, despite online competition, traditional players like Dr Lal and Metropolis are still performing well and have even raised their prices.

But will earnings growth come anywhere close to levels seen a couple of years ago?

What we believe is that maybe Dr Lal or Metropolis will have a tough time growing at the same rate that they were growing. They will still grow, but not at the same rate that they were growing before this event happened.

So there are three models in the diagnostics space – conventional premium, conventional discounted, and discounted online. We are into discounted conventional. We are guessing the conventional format works, it has the trust element to it, and the discounted prices work because that also plays for the volume growth in a market like India.

Which stocks in particular do you like in this space?

We own Thyrocare. They are cheaper than Dr Lal, Metropolis by 30, 40, 50 percent, depending on which test you are going to do. They get 75 percent of their revenue from tier 3 and tier 4 cities. We are OK with that. Anyways, tier 3, tier 4 guys don't have access to your Metropolis, Dr Lal, or the online platforms because smartphone penetration is low.

The second stock we own is Krishna Diagnostics. Krishna is B2G – business with the government. They cater to the poor at the lowest price point possible because the government negotiates the rate on behalf of the people. It's all about lower prices, higher volumes.

And radiology. Radiology cannot be done online… You have to go for the X-ray. We agree that some price sensitisation has come up. But we also feel that the conventional format is where the volumes will lie. Because trust lies in the conventional format, not in online.

Tell us about bulk drugs. What are the dynamics at play right now and what should investors looking to invest in bulk drug companies focus on?

Bulk drug companies did not do well for the last couple of years, after raking in a windfall during COVID. Their customers over-ordered, fearing a supply disruption, and bulk drug companies had the pricing power. Then customers stopped buying because they had enough stock and prices crashed.

This year, what we are seeing is normalisation of volume growth as clients have resumed purchases, and normalisation of cost. Pricing is still not good because of too much competition.

Within bulk drugs, there are two types of players. There are players who supply generic bulk drugs and there are players who supply bulk drugs to innovators like GSK, Novartis, Sanofi. These big pharma companies look at themselves as researchers and marketers, not manufacturers. But when you are an innovator, the only true asset you have is the intangible asset, the formula of the drug that you are making.

Now, if you have to get it manufactured by a third party, you have to share the formula. So if the third party is not reliable and he leaks the formula or if he steals the formula, the innovator is done for. So it's a very tough business to get into because you have to win the trust of your customer.

But if you succeed in doing that, they will not care about the cost. Because your product is like 1 percent of their (innovator’s) cost. They'll pay you any price that you want as long as you can deliver on trust, consistency, quality and quantity. That is a beautiful business to be in.

Very few of these bulk companies in India operate in this space. Syngene, Divi’s Lab, Neuland, and Hikal are the big players here. Except for Divi’s, which we think is overvalued right now, we own the other three.

But in the generic business, pricing is a problem. Because if the customer is under pressure, he will try to squeeze the supplier.

Also read: Some smallcap stocks may fall 50-70%; power, defence scrips overstretched: Prashant Khemka

The growing penetration of health insurance is seen as a key growth trigger for the sector. What are your thoughts? Do you own any stocks here?

We had always liked insurance. I launched this fund in February 2021 and always wanted to own a couple of insurance companies. Valuations were beyond my wildest imaginations. So for nearly two years or so, we had no exposure to the sector. But then the budget thing happened and insurance stocks started falling… So we bought a couple of insurance stocks at that price.

Insurance is a very long-run vehicle within India. Be it health insurance, be it life insurance, we are an under-insured market. And it is a part of the healthcare ecosystem.

The way we see it, eventually the market will become more organised. We are currently a market which is 70 percent out-of-the-pocket, 30 percent insurance. Over time, this will reverse. As insurance becomes bigger, then the insurance guys will negotiate on behalf of their audience and then they can bring down the healthcare cost.

So, we don't want to be exposed to only one side of this equation. We want to be exposed to both sides of the equation as an investor. We are saying, okay, so all these companies will benefit as long as out-of-pocket is higher. But as insurance becomes stronger, let us have insurance stocks also. So that when they become stronger, they will give us a return that these guys will not be able to deliver if there is pricing pressure on them because of the insurance guys.