Multinational pharma companies have been stunners at the bourses over the past one year. Darlings of the stock market in the late nineties, analysts preferred to turn their backs on MNC pharma companies while recommending domestic large-cap companies, citing their huge potential in the US generics market and the research capabilities of companies like Dr Reddy's. Over the past year or so, however, the tide appears to have turned.

Sample this: in the last one year ended September 30, 2004, Aventis has returned 89.52 per cent while Novartis has appreciated 121.32 per cent. However, large-cap Indian pharma firms have disappointed, with Ranbaxy showing an appreciation of just 13.10 per cent and Cipla 43.79 per cent, and Dr Reddy's declining 30.31 per cent. Mid-cap India pharma firms have, however, outperformed even the multinationals (see table).

While a part of the gains recorded by MNC pharma companies can be explained by the superior operating performance resulting from restructuring efforts made by these companies, the market is already paying a price for the potential gains due to patent protection post-2005. Will companies really grow enough to justify market expectations? Maybe, but it is too early to tell.

What is comforting is the financial health of MNCs, which is the result of active restructuring. Companies have been merged - Sandoz and Ciba, and Pfizer and Parke Davis - resulting in greater synergies and efficiencies. Product portfolios have been pruned, tail-end products sold.

As Mahesh Chhabria of Enam points out, the core return on investment net of cash and cash equivalents is strong, thanks to the restructuring that has happened in many of these firms. For example, there have been asset sales and VRS schemes, and these have resulted in some cash accretion to balance-sheets.

"The capital employed has shrunk net of cash and core RoIs are strong and growing. Therefore, the core RoI/PE is better than some of the Indian pharma companies which are in an expansion mode."

The market also seems to be anticipating growth post-January 2005 when India will have to provide protection to intellectual property rights and pharmaceutical products invented post-January 1995 will have to be granted product patents.

However, it may take a while, say two years, for the impact of the new patent regime to be visible. That's because it takes around 10-12 years for a product to be patented and launched commercially. So, only those drugs that have not yet entered phase III trials would be eligible for patent protection.

Sandip Sabharwal, who manages a pharma fund at SBI Mutual, says he will not put more than 10 per cent of his fund into MNC stocks since the next two years are not likely to see strong growth. "There are better plays in Indian pharma," he says.

The fund currently holds Aventis, GlaxoSmithKline and Pfizer. According to Gaurav Misra, analyst, Alchemy Shares, based on valuation metrics like P/E, MNC pharma stocks may seem fairly valued, but on a discounted-cash-flow basis over a seven- to 10-year period, there could be a gap between the fair value and the current market price.

For instance, in the case of Aventis, there could still be a 20 per cent upside. Aventis trades at 17.5x CY05 while on the 10-year DCF, the fair value would be in the region of Rs 1,050. Misra believes that the growth in many of these companies will be back-ended and moderate in the ensuing two to three years and picking up thereafter.

Murali Krishnan, director (research), Anand Rathi, says the approach would have to be selective, adding that there are concerns on whether some MNCs will bring their products to India via 100 per cent subsidiaries or existing listed companies.

"Post-2005, there is no reason for them to manufacture products in India; they need simply market them here," he says. Krishnan feels that on valuation parameters, they are not cheap vis a vis Indian players. Moreover, even in the case of Aventis, he says, there is no clarity on what the new parent Sanofi's strategy will be after the buy-back.

One could, however, look at companies like Wyeth, which are in niche segments or GSK, which plans to bring in India-specific products post-patent expiry.

Concerns persist...

While waiting for a patent-protected regime, MNCs are anxious that the government should not expand the scope of compulsory licensing but should enforce it in the strictest sense - only if there is an epidemic of, say, AIDS.

As Ranjit Shahani, vice-chairman, Novartis, says, "Broadening the scope of compulsory licensing for other diseases such as diabetes or cardiovascular, as one section of domestic industry is asking, would make a mockery of the compulsory licensing provision and will send wrong signals about the quality of IPRs in India."

Though MNCs may bring in products, they could be expensive (there is no clarity on what kind of price controls will be enforced). Therefore MNCs may not be able to sell big volumes. Only 5 per cent of the population is covered by health insurance; so even with drug prices being the lowest in the world, they are out of reach for two-thirds of the population.

Moreover, what kind of transfer-pricing agreement the parent has with the subsidiary will determine profits of the subsidiary. It is believed that local subsidiaries will not have too much bargaining power. Kal Sundaram, managing director, GSK, however, says India-relevant factors such as low affordability will be taken in consideration while introducing the new products.

... but the opportunity is big

MNCs account for about 25 per cent of the market and this could go up by 10-20 per cent in the next five to 10 years. In 1970, when product patents were in place, MNCs had the lion's share of 85 per cent. Today when a new research molecule is launched, MNCs get about 25-30 per cent of the marketshare with the rest going to generic players.

Shahani says with protection coming in, MNCs are likely to get 100 per cent marketshare for their patented molecule till the patent expires. Overall, however, patented products would account for only 10 per cent of the Rs 26 billion domestic formulations market.

Local firms need a makeover

Where will that leave the domestic players? In the new IPR regime, domestic firms will not be able to copy products through reverse engineering and so will have very few new launches. New products have contributed significantly to their growth and products launched in the last five years account for about 30-35 per cent of the domestic formulations turnover of these companies.

To survive, they have to change the way they do business. For generics players there is enough of an opportunity. As Shahani observes, since over 97 per cent of the drugs in the essential drugs list of the World Health Organisation are out of patent, Indian firms can continue to market these generics or branded generics. There is also a huge export opportunity for generics as over $50 billion worth of drugs are coming off patent in the next few years.

Opportunities for co-marketing and in-licensing will abound. Mid-sized companies in Europe and USA, which have niche products could in-license them to Indian firms.

There are also opportunities for co-marketing and co-promotion by which Indian firms can leverage their strengths in manufacturing, distribution and field coverage. Many large companies are shedding their old products and selling them outright to Indian companies.

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