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How to Select the Best Pharma Stock | Pharma Sector Fundamental Analysis

How to Select the Best Pharma Stock | Pharma Sector Fundamental Analysis

Published on 05 December 2022 .Views 72 .Comments 0
In this article, we will understand the revenue source of Pharma Companies, what are the parameters to analyze this sector, and how can an investor analyze this sector. So, let’s get started!

General Business Model of the Pharma Business:

  • The process flow of the pharmaceutical value chain is as follows: Firstly company indulges in the research process of discovery of a molecule, followed by the development of the drug after successful discovery. Then manufacturing of the drug is scaled for mass production followed by marketing & sales
  • Pharma Companies are involved in various stages of this value chain. Some companies are also involved in the end-to-end process of this value chain while some offer expert services in niche areas such as Contract research and manufacturing services
  • Pharma Companies undertake a lot of capital expenditure along with investment in R&D(capital+revenue) from the cash generated from the business.
  • Pharma companies also undertake revenue expenditures such as paying for operational expenses, having high-quality paying for salaries of doctors, and supply chain management. Thus, profit is earned by the business if it generates enough revenue to meet these expenses.

Key Characteristics of Pharma Sector Business:

  • High fixed and operational costs
  • Highly capital-intensive business
  • The high gestation period of return on investment for R&D
  • Export Oriented Businesses
  • Newer Product/Patent Launches
  • Highly regulated business
  • Defensive sector against recession
  • Intense competition & price wars

Important Parameters for Pharma Sector:

1) Domestic Versus Export:

  • The amount of revenue companies earn from India & amount of revenue earned from countries other than India.
  • There is no ideal range but companies should maintain a balance between domestic & export  as exports earn more revenue  but exports are subjected to export regulations while domestic business is subjected to price control
  • For Example, as of FY22, Sun Pharma derives 65% of its revenue from outside India, and 35% revenue domestically.

2) Investment in R&D (%):

  • Investing in R&D to produce patented drugs results in much higher margins for the company compared to generic drugs(patents expired drugs) but the downside of investment in R&D is an increase in expense in case of failed research
  • The Ideal Range for Indian Pharma companies should be double digits investments, while the current average of Indian companies is around 7%
  • For Example, as of September 2022, Sun Pharma is having R&D of 5.28%.

3) New Product Launches/ANDA Filings:

  • Higher the number of products launched by the company during the year, the easier for the company to thrive in this competitive industry. ANDA filings refer to permission to sell off-patent generic products.
  • Higher the better for the company
  • For Sun Pharma, as of  September 2022 517, ANDA was approved by USFDA.

4) Capital Expenditure

  • Scalability is one of the important factors in Pharma companies. To scale up production they have to invest a lot of cash in MPP(Multipurpose Plants)
  • Higher the better for the company

5) M&A(Organic Growth):

  • Pharma companies also undertake Mergers & Acquisitions of other companies to leverage the core competencies of other companies which ultimately leads to the scalability of the business.
  • Higher the better for the company
  • Company Acquired Stake of 65.91% in Trikaal Medinfotech Private Limited

6) USFDA Inspections:

  • The majority of Pharma companies undertake exports of drugs to the US. US Food & Drugs Administration conducts periodical checks of the manufacturing units of companies & red flags the companies indulging in sub-quality manufacturing practices
  • USFDA inspection should be lower for the pharma companies.
  • 1 Facility red flagged by USFDA in past.

7) EBITDA Margin:

  • This is the ratio of earnings before interest, depreciation, and taxes compared to the revenue for the period
  • Higher the better as it shows how efficiently a company is managing its recurring cost. Ideally, the EBITDA margin should be higher than the double-digit figure.
  • The Operating Profit Margin of Sun Pharma stands at 28% as of FY22.

8) Return on Capital Employed (ROCE):

  • This is calculated by dividing net operating profit by the capital employed in the business
  • ROCE above 20% is considered to be good. For Sun Pharma it is 9.32% for FY22.

9) Debt-to-Equity Ratio:

  • This is the ratio of debt undertaken by the company in comparison to the amount of equity on its balance sheet
  • The D/E Ratio of the company increases when any new Capex is to be done for expansion which increases the risk of the company.
  • The D/E Ratio for Sun Pharma is 0.02. The D/E Ratio for Sun Pharma has generally been around 0.2 to 0.3 despite being a capital-intensive sector

10) Asset Turnover Ratio:

  • The ratio of sales compared to the Total Assets
  • Pharma sector being capital intensive, Asset Turnover becomes an important metric. Sun Pharma Asset Turnover Ratio ranges from 0.2 to 0.3, and it stood at 0.38 as of FY22.

Factors that are moats in the sector:

  • Well-known brand name with a lesser focus on generics
  • Good geographical distribution all over the world
  • Continuous Product launches & Topline/Bottomline Growth
  • Top Quality Manufacturing Practices
  • Higher investment in R&D is the biggest moat as successful R&D can generate higher returns compared to selling off-patent generic drugs.
  • Back ward integration serves as a strong moat as it leads to higher margins & surviving supply chain disruptions.
  • Advancement into CRAMS & Biosimilars can become future moats to avoid intense competition in generics.

What Should Investors Do?

The above-discussed parameters of the Pharma Sector are some key factors that an investor should carefully consider before making an investment decision in any Pharma stock. Follow due diligence before making any investment decisions.

Disclaimer: The information here is provided for reference purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent are commendation to buy or sell stocks or MF.
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