Contract Drugmakers Grapple With Reality Check After Covid Exuberance

Pharma contract manufacturing and research firms witnessed a disappointing third quarter, raising concerns among investors for a sector that was considered one of the best bets during the pandemic.

The revenue and margin for the Contract Development and Manufacturing Organisation segment saw a year-on-year slump. As a result, most stocks in the category are trading close to their 52-week lows and analysts do not see an immediate growth trigger for the sector.

According to Abdulkader Puranwala, pharma analyst with Elara Capital, it was the exceptional increase in demand during the pandemic that led to unrealistic expectations and stock price run-ups.

The market leader in the CDMO segment, Divis Laboratories Ltd., has been downgraded by several brokerages following its Q3 results. Kotak Securities has revised its ratings from ‘reduce’ to ‘sell’, HSBC has lowered its rating from ‘hold’ to ‘reduce’, and Phillip Securities has changed its rating from ‘buy’ to ‘neutral’.

High Covid base and channel inventory hurt the third quarter performance for most companies in the segment.

During the pandemic, a majority of CDMO companies received large orders for active pharmaceutical ingredients and drugs related to Covid-19 therapies, resulting in exponential sales growth. However, as the pandemic waned, the demand for these drugs declined and their revenue contribution became almost negligible.

Additionally, drugmakers stocked up on excess inventory that was not fully used up, dragging down new orders. It is expected to take a few more quarters for the channel inventory to return to normal.

In its Q3 FY23 conference, Divis Labs reported that raw material prices had gone up and there were pressures on the sales prices of the API. But the company has been optimistic about "growth and also profitability growth" in the coming quarters.

According to analysts, the long-term growth opportunity for the sector remains intact, aided by ‘China-plus-one’ shift and cost benefits. However, investors may need to wait until at least the second half of FY24 to see any upside.

Despite the current setback, these companies are otherwise well-positioned as their revenues are considered sticky, according to Sriraam Rathi, India analyst for pharma and healthcare at BNP Paribas. "Companies do not usually change their suppliers because they require regulatory approvals," he told BQ Prime. "Thus, they usually stick to the same two to three suppliers."

While some of these companies are trading below their March 2020 levels, they have not underperformed when compared to pre-pandemic levels, Puranwala said. However, he expects to see further correction in stock prices.

Rathi advised investors to “definitely add good companies when they see further correction”, but also said that investors may have to be patient as this sector "might not generate immediate interest".

Here's what analysts have to say about some listed CDMOs:

• Divis' third-quarter performance lagged and margin fell to multi-year low of 23.9%.

• However, Elara Capital's Puranwala said investors should not penalise a good business and wait for one more quarter.

• BNP Paribas' Rathi said the CDMO-API model provides consistency in revenues. It has a 'buy' on Divis.

• Generic API business is scalable and CDMO offers high margins, but depends on regulatory approvals of the innovator's molecules.

• Navroz Mahudawala, founding partner and managing director at Candle Partners, said that the CDMO-API model is the most sustainable over the longer term.

• Vishal Manchanda, pharma analyst at Systematix, said that the company has an ex-Covid growth rate of around 12%.

• The valuation at about 60 times PE multiples, on a normalised trailing earnings base, is high and Manchanda expects the valuations to fall more.

• Mahudawala said that the API-CDMO model was sustainable for companies working closely with the innovators. Suven Pharma, too, is one of them, he said.

• According to Rathi, the company has the potential to become a large CDMO player.

• Puranwala said that with the management shift and private equity coming in, the company may be able to replicate the Divis model.

• Manchanda said that the company currently has some of its own abbreviated new drug applications, or ANDAs, in the U.S. This could lead to some conflict of interest and make it a less preferred partner for innovators, he said.

• B&K Securities has chosen Suven Pharma as one of its top picks in the space.

• B&K Securities in a report said:

  • Specialty CDMO is on track to commercialise a fourth molecule in FY24.

  • On track to file 40 ANDAs by FY23.

  • Has a capex of Rs 600 crore in tranches.

  • Has sold a 50% promoter stake to Advent PE.

  • The merger with Cohance will help the company "emerge among the top three CDMO plays in India".

• Gland Pharma is a CDMO company targeting injectable formulations.

• Puranwala picked a CDMO with distinguished manufacturing capability as his second top pick after the API-CDMO model.

• Mahudawala said that the injectable CDMO space still has sizeable entry barriers as only a few players have those capabilities in India.

• "However, there has been a capacity build-up that has happened over the last three to four years, and just as solid dosages, we may see overcapacity building up in the years to come," he said.

• Manchanda said that Neuland Labs has a good business proposition and currently, its valuations are also relatively comfortable.

• It could be evaluated as a potential investment opportunity, he said.

• However, Puranwala said that it may take time for the company to scale operations and enjoy economies of scale.

• Companies involved in formulation CDMOs are the third pick.

• Rathi explained that globally, product trials are increasing and therefore, an opportunity exists.

• The company follows a slightly different CDMO model.

• It derives a large portion of its revenues from the provision of contract research organisation services.

• B&K Securities has picked Syngene International as one of its top picks in the space.

• B&K Securities listed the following as key triggers:

  • Ramp-up at the Mangaluru facility.

  • Commencement of the Zoetis deal in Q1 FY24.

  • Investment in the sterile injectables facility.

• Mahudawala said that the geographies being targeted and the number of manufacturing sites that each operates are critical to judge a CDMO's capabilities.

• Manchanda said that for a CDMO business operating from India, it is possible to earn Ebitda margins to the extent of 50–60%.

• However, for companies operating from Europe or the U.K., only margins of around 20% are possible, he told BQ Prime.

• Piramal Pharma seems to be facing operating margin pressure because of cost of operations outside India, he said.