5 Best Strong Pharma Stocks For Tactical Buy Now with strong catalysts (Edelweiss Research Report)

The novel coronavirus, or COVID-19, pandemic has caused severe supply-side disruptions in various sectors, earnings will be cut by 10-15%. Pharma as a sector has emerged as a strong contender to drive the next leg of rally, whenever it comes. In anticipation, pharma stocks have seen a huge run up in the last 10 days. This is not just true for India, but globally too pharma companies has performed well. While in the short term, most companies will bounce back from the last 5 year of underperformance, this time around, the leader will be different. Hence, you need to choose your stocks carefully. Following are the strong Tactical Buy (long term potential also) with strong catalysts.

I. Ajanta Pharma – A turnaround story

Revival in the Africa business – Ajanta Pharma’s Africa business has been de-growing over the last 3 year (-9% CAGR over FY17-19). For 9MFY20, the company reported 19% growth. We expect growth to sustain ~10-15% over the next 2 years.

US business ramping up sharply – Within 4 years, the US generics business has ramped up to $70m from $2m. We expect the US business to ramp up to $100m by FY22, based on market share gains and new launches.

India business gradually recovers – India business saw 23% CAGR from FY12 to FY16. Due to regulatory changes in the dermatology business, the company has seen lower growth (just 6% CAGR) over the last 3 years. But the 11% CAGR in 9MFY20 suggests improvement in the India business.

Revival in all 3 geographies will lead to margin expansion and improvement in return ratios – We expect margin to improve to 31% by FY22 from 27% in FY19.

Valuation: We expect FY20/21/22 EPS of INR 53/70/83, respectively. At its April 8 closing price of INR 1,367.5, the stock trades at 23/19/16x FY20/21/22E P/E and FY22E RoCE of 20%.

What will makes us change our view – Degrowth in the Africa business. We are quite comfortable with its US/India growth numbers. We expect Africa to grow by 12% over the next 2 years.

II. Abbott India – A CAGR story

Strong track record – Abbott India has seen strong sales growth (organic: 15% CAGR; inorganic: 18%) in the last 10 years compared to an average 11% growth by other Indian pharmaceutical players. This has been driven by strong execution and acquisition of Piramal Healthcare’s domestic formulation business in May 2010.

Strong product portfolio – The company has a presence in high growth therapeutic categories – gastro, CNS (central nervous system), vaccines, OTC (Digene kind) and gynaecology – which led to better-than-industry growth.

Pure play India story – Abbott is pure play domestic story. It does face US Food & Drug Administration (USFDA) related inspection risk, which plagues other pharma players.

Valuation: We expect FY20/21/22E EPS of INR 313/360/416. At its April 8 closing price of INR 17,481, the stock trades at 56/49/42x FY20/FY21/FY22E P/E and FY22E RoCE of 23%.

What will make us change our view – The Indian government periodically issues a price cap on certain essential drugs. About 40% of Abbott’s portfolio falls under Drug Price Control Orders (DPCO), so any incremental coverage would pose a risk to earnings.

III. Dr Reddy’s Laboratories – New management, new story

India business is a key focus now – Despite its strong innovation capabilities since inception, Dr Reddy’s Laboratories doesn’t even fall in the top 10 domestic formulation players. Its India business was never a focus area for the management, which led to market share loss over a period of time. But for the new management, India will be a key focus area. It recently acquired a large portfolio from a competitor.

US business has some near-term catalysts – gNuvaRing ($800m, sole player post launch) H2FY21, gCopaxone ($4,000m, 3 player market) H2FY21 and recently acquired portfolio in the US.

Change of guard has started bearing fruits – DRL always had the highest SG&A (selling, general and administrative) expense, at 30%, compare to the industry average of 20%. However, in the last 1 year, SG&A expense has fallen to 23-24% levels, which has led to a 300 bps improvement in EBITDA margin on a 9MFY20 versus 9MFY19 basis.

Valuation: We expect FY20/21/FY22 EPS of INR 120/150/174. At its April 8 closing price of INR 3,683, the stock trades at 31/25/22x FY20/21/22E P/E and FY22E RoCE of 20%.

What will make us change our view – Any delay in gCopaxone launch can impact FY22E earnings significantly. Also, any USFDA issue with its Bachupally facility.

IV. Biocon – Participant of mega theme – biosimilar, also TINA

Global biosimilar market will grow 3x in next 5 years – The total biosimilar market size was pegged at $20bn in 2019 by various studies. The same is expected to touch $60bn by 2025, the highest growth category for pharma companies globally.

Biocon has proven its mettle by launching Pegfilgrastim ($4bn) in the US last year. Last month, it received approval for Lantus ($6bn).

Biosimilar is sticky business unlike generics – Historical data from Inflectra/Remsima (Remicade), Benepali (Enbrel), which has been launched in the last 4 years, has seen stable to increasing market share with manageable pricing risks.

Valuation: We expect FY20/21/22 EPS of INR 7.5/10.2/13.4. At its April 8 closing price of INR 327, the stock trade at 43/32/24x FY20/21/22E P/E and FY22E RoCE of 12%. The lower RoCE is due to its huge Malaysian facility.

What will make us change our view – Any facility related USFDA action, which is difficult to pre-empt.

V. Laurus Labs – A classic investment story

Large capex is over – The company has spent INR 900 crore over the last 3 years to build capacity, which has led to negative free cash flow. We expect the company to start generating free cash flow from FY21.

Business will shift from API to formulation – Formulation will account for 30% of overall sales in FY20E compare to just 3% in FY19. This will boost return ratios and provide long-term visibility compare to API (active pharmaceutical ingredients), which are opportunistic/cyclical in nature.

Growth at a reasonable price – Earnings will shoot up to INR 34 per share in FY21E from INR 9 per share in FY19. The stock currently trades at 12x FY21E P/E. RoCE is seen improving to 13% in FY21E from 6% in FY19.

Valuation: We expect FY20/21/22 EPS of INR 24/34/37. At its April 8 closing price of INR 391, the stock trades at 17/12/11x FY20/21/22E P/E and FY22E RoCE of 14%.

What will make us change our view – Our margin assumption for FY21/22 is 22%. Any pricing pressure in API/formulation can impact EPS significantly.