Some very rudimentary observations about the pharma industry
- More than 20 companies that trade at a market cap > 10,000 Cr
- All of them are profitable at an average promoter holding of 55%+
- Mid size companies as of date are tracking better on capital efficiency that the large ones. The large ones have grown at 10%+ even during the past 5 years
- Barring the 2015-2019 period, more often that not pharma has made money for investors
- On an average the gross asset turns is around 2.5x, for specialized players this can go as low as 1x but with much higher margins to ensure ROCE stays above the 20% mark unless there are huge R&D investments
Unit Economics
At a gross asset turns of 2x, one needs 100 Cr capex to make revenue of 200Cr. Assuming a working capital cycle of 120 days, this revenue base will have approx 70 Cr stuck in working capital. Hence on a capital employed base of around 170 Cr, to make the ROCE threshold of 20% pre tax, the EBITDA margin (assuming depreciation to gross block of around 6%) will need to be higher than 20% - which most companies manage to do.
For this reason my take is that making money in a pharma business consistently does not take too much of management skill. This is one of those business segments (like IT services) where an average management can be profitable on a consistent basis and grow the business at a hygienic number.
Extending this very same logic, I see greater value in reducing risks than chasing after the mythical unicorn which can net multibagger returns from the current price. Such multibagger returns tend to occur in industries where you have a consolidated market structure and 1-2 players end up dominating the industry for years to come. I just do not see this happening in pharma unless one has very deep domain knowledge and understands all perspectives well - product development & research, developments in customer facing markets, regulatory oversight, legal and other perspectives. None of our pharma companies are into high end research anyway, so the possibility of outsized returns from a single drug/R&D endeavour that can last for years is close to NIL.
So my expectation from the pharma basket is to look for 15-20% return over the medium term while minimizing risks on the regulatory & legal fronts. Now PAT growth by itself may well deliver 12-15% for a decently run pharma business, so the 15-20% target is actually immensely doable.
I hence prefer the principles of elimination for the pharma sector rather than selection. One also has a lot of choices in this sector, so practical considerations should matter too.
My ideal mix would be -
- One strong domestic market focused business that is not too expensive
- 1-2 API makers that are well positioned to benefit from the local manufacturing drive one is likely to see
- 1-2 formulation heavy businesses selling into markets where the regulatory environment is either easy or getting easier, these need to be able to deliver around 20% revenue growth. Also track the commercialization schedule of ANDA’s already filed over the past 3-4 years. The easiest way of siphoning off money in a pharma business is ghost R&D and one needs to spend some time to rule this possibility out
- Niche player only if one is willing to do the work it takes to understand the business really well and quantify the risks involved
What I would want to avoid -
- Those with a history of US FDA observations where things could not be resolved within reasonable time
- Organizations with promoter pledging, history of frequent capital raising and M&A activity
- Those that are tracking very low on ROCE (which means a lot of investments have been made which are yet to bear results and one does not have a handle on when these could pay off and to what extent)
- Businesses that are too expensive relative to the growth prospects