The vanishing industry

Foreign interest in local companies could boost valuations of pharmaceutical stocks
Why are Indian pharmaceutical companies selling out to multinational corporations? After Ranbaxy Laboratories promoters divesting their stake and Piramal Healthcare selling its formulation bussiness, the low-profile Paras Pharmaceuticals is the latest to cash out. If this trend continues, there will not be many homegrown Indian companies or brands left. There is nothing surprising about acquisitions in the pharmaceutical space. Indian companies too have swooped on mostly distressed assets abroad to gain access to new markets, technology or products. The restrictive pre-reforms era capped foreign holding in pharmaceutical companies at 49%. This cramped foreign companies’ ability and enthusiasm to grow the market or introduce new products. Second, the stifling Drug Prices Control Order imposed MRP ceiling on drugs categorised as essential, squeezing margin. Foreign companies could do nothing but fret as Indian companies prospered by reverse engineering patented drugs and selling them for a fraction of the price of the original. Not only that, many license holders ‘loaned’ manufacturing to others. Liberalisation enabled many MNCs to convert their Indian affiliates into full-fledged subsidiaries. Being in charge of their operations in India increased their comfort in introducing latest innovations in the Indian market. A large number of patented drugs became ripe for picking, prompting Indian companies to shift focus from the tightly controlled domestic market to overseas potential.

The biggest obstacle for Indian pharmaceutical companies to fully tap the ongoing opportunities is capital, particularly long-gestation funding. Legal challenges from patent holders to generics marketed in the western markets have drained many front-ranking companies. Besides drugs that manage to clear the scrutiny of patent holders and regulatory bodies have only six months to profit before other imitators are let in. Introduction of patented products is lengthy and resource guzzling process without any certainty of success. Many pharmaceutical companies have separated their R&D units as these started proving a drag on their bottom lines. The Indian sector is, thus, facing the twin challenges of penetrating the generics markets in the developed economies and trying to create new products that would earn them fat margin. Both these problems require attaining scale. The regimented market and disregard for process patent till a few years ago meant that most pharmaceutical firms have remained stunted in growth. As a result, the sector is proliferated with small- and medium-scale units. Till recently investors too seemed wary of these stocks. Despite the support from parent that made them attractive, MNC affiliates had limited growth prospects due to their reluctance to introduce blockbuster drugs due to pricing caps and competition from copycat products from Indian manufacturers working on thin margin and opaque functioning.

Much has changed over the last decade. Many drugs have been taken out of pricing control. The opening of the generics export market has unshackled the industry. At the same time, this has exposed its inadequacies: lack of innovations, processing capacity in need of upgradation to become compliant with best global practises, and regulatory pressures at home and abroad. The growth options for the pharmaceutical sector are, therefore, limited. Emulate the tech industry and because a process outsourcing hub and supplier of intermediates or turn attention to over-the-counter products and build them into brands in the local market. Many manufacturers have chosen contract research and manufacturing for third parties. The lure of the unexploited rural market and the booming lifestyle segment have provided an impetus to some others and even attracted fast-moving consumer goods companies to over-the-counter products. It was not only the Indian market that was transforming. Seismic shifts were also taking place in the developed markets. Many global players concentrating on the patented product market were faced with the prospect of drying up of revenue stream. On the other side, there were openings in the generics market. This presented them with two choices: produce the generics themselves or outsource them. Some preferred to buy out generics capacity in emerging markets to service the developed as well as the domestic markets. Snapping up of local OTC brands is but an extension of the MNCs’ strategy to make up for the lost time during the pre-reforms era. A known brand makes the task of establishing footprints in the domestic market so much easier. It can also complement and supplement the existing product basket of the acquirer. Unwittingly, the rich valuation of recent deals could also unleash capital infusion, thereby triggering a re-rating of the sector.
MOHAN SULE

Reality check

Investors may not be forgiving of promoters with questionable track record of doing business

A month ago, the political establishment was basking in the glow of US President Barak Obama’s endorsement in parliament of India’s ambition of a permanent UN Security Council seat. Euphoria has given way to gloom. Leave alone being viewed as a responsible power ready to take its rightful place in global affairs, India is more likely resembling a banana republic, as noted by Ratan Tata. Everything seems to be on sale. One of the visible success stories of reforms is the opening up of the telecoms sector. The monthly increase in subscriptions of telecoms companies has come to symbolize India’s growth story just as the price of a McDonald burger is used to compare purchasing power across nations. It is now becoming clear that Indian taxpayers have paid a steep price to become mobile. Call rates may have dropped to one of the lowest in the world but at the expense of the government treasury. Precious airwaves were sold without calling for bids. Rules were altered to benefit a few. Some of the beneficiaries were investors, subsequently cashing out for huge profit. The revenue lost could have been put to use to reduce fiscal deficit or improving social sectors like education and access to drinking water. There have been two adverse fallouts besides the notional loss: serious long-term players are facing a squeeze due to the crowding of the field. Second, the initial rapid expansion in subscribers attracted fly-by-night operators for the quick gains.

The start of the third-generation telephony services could trigger consolidation, with those failing to win the bids in the auction likely to fall aside. Presence of fewer players could see the return of pricing power to the sector. On the other side, raising capital from the market would become difficult for those suspected of bagging licenses other than on the strength of their financial track record. Along with these stocks, financial services companies and banks whose officials were involved in the bribes-for-loans scandal, too, took a knock. Diversion of client funds to stock markets for proprietary trading and fudging of accounts are recurring frauds. Besides exposing inadequate internal controls, the latest scam also throws light on the opaque system of sanctioning loans, vesting discretionary powers in the hands of a few. Perhaps this again is the result of competition, whose offshoot could be lending rates lower than those publicized to select borrowers, or the tightening of norms to avoid bad assets leading to desperate borrowers resorting to back channels. Also, the biggest client of the financial services companies and banks of late is the real estate sector, which operates in a hazy environment of cronyism. As in the stock markets, the returns can be phenomenal in a short period of time. The entire value chain from borrowing to investing to repaying is subjected to volatility arising from changes in interest rates, developmental rules and environmental clearances. Regulations govern their operations but not the end price, which is supposed to be determined by the demand-supply equilibrium like the telecoms sector.

Initially, costs were high for users of cellular services due to the entry of limited players. Yet demand was strong, attracting more entities. Due to spectrum constraint, there could not be unrestricted access to the market, opening a window of opportunity to profit from hoarding or cornering of airwaves by means fair or foul. The real estate sector, too, is in a similar situation: scarce resources. Hence, covert or overt tie-ups with financial institutions to open the tap on one side and with those who have the power to release land on the other side. The question now is: will India’s growth story suffer due to these eruptions? The latest disclosures could result in much needed cleansing: coalition partners in government may not get away with any outrageous demand. There is recognition of the need for transparency in the real estate sector as it is an important component of economic growth. The trend of auctioning assets and listing of developers are steps in this direction. The Reserve Bank of India, which deserves credit for keeping our banks safe, is no doubt monitoring the financial services sector, increasingly weighed down by bad loans. Capping exposure to the real estate sector, however, is not the solution as it will aggravate the liquidity crisis and bring down the economy. Nonetheless, what has to be understood is that Indian investors may forgive a company becoming a BIFR case due to error of judgment or competition but is unforgiving of stocks whose promoters stand accused of employing questionable practices to be in business.

MOHAN SULE

Divide to rule

To reduce currency risks, companies should separate their facilities catering to domestic and export markets

Many investors have come to grief while timing the market. The market has the capacity to prove even the most conservative projections about its direction wrong. Early this month, the hiking of short-term policy rates by the Reserve Bank of India and the beginning of the second round of injecting liquidity by the US Federal Reserve were expected to increase the inflow of foreign funds. The market even came close to crossing its record high level of 21,000. The central bank was getting restless and was hinting at controls to make managing the currency and inflation easier. But, within days, the tide turned. Lower manufacturing growth in September and fear of the debt crisis spreading to Portugal and Ireland after the European Union bailout of Greece prompted foreign investors to withdraw from the emerging markets. In addition, expectation of China raising interest rates, following some other Asian countries, to cool its economy raised fears that demand for commodities would dip. The 2G telecom scam weighed on market sentiments. The flashpoint in the Korean peninsula shaved off nearly 600 points in intra-day trading. Suddenly, the world looked a much different place than it was a fortnight ago. Possibility of another round of slowdown seems real. After remaining subdued during the book building of the Coal India IPO, the Indian market had bounced back after its closure early November. On 16 November it slipped below 20,000 in intra-day trading and on 24 November was down nearly 1,500 points from its peak.

The volatility in the market reinforces the belief propounded by this column that, for sustainable growth, the world has to become flat once again. The bull-run in 2003 was due to low interest rates throughout the world. Similarly, central banks around the globe coordinated their quantitative easing following the credit crunch triggered by the collapse of Lehman Brothers in September 2008. Subsequently, major economies including the US, China and India announced fiscal stimulus of tax cuts to revive consumption. These measures were expected to pull up global economy. This did not happen. Only the emerging economies spurted as the debt crisis spread in Europe and the US’s slow recovery was not accompanied by growth in employment. The net result has been soaring prices of commodities despite half the world’s economies still in slow motion. This has had the effect of boosting input prices at a time manufacturers in the emerging economies had embarked on ramping up production anticipating rise in usage. The choice was to absorb the cost or pass it to the consumers. Some sectors where consumption exceeded supply did so. Margin of others is under pressure because any sudden price hikes would have had an adverse impact on their share in competitive markets. The domestic market is, thus, mimicking the imbalance in recovery of global economy.

Integration implies that the distortions of the kind seen today are erased. Manufacturers or services providers can achieve economies of scale by viewing the world as their supplier as well as the marketplace. Outsourcing of some back-office functions, production of parts, and assembly of finished products from components sourced from different corners of the world enables companies to make available products and services at the same price across the world. But the global financial crisis has disrupted the rhythm. Companies scaling up to global benchmarks may have to turn inwards to keep their capacities running. All may not be able to do so. The Indian market does not have enough capacity to absorb the IT services currently being exported to the US and Europe and China’s factories need the US market to keep humming. Infrastructure projects are dependent on capital from the developed economies. Instead of spurring local industry, low interest rates in the US have resulted in funds flowing to countries with better yields. Hence, reverse outsourcing is required, with companies in emerging economies using home capacities to service the huge domestic markets and snapping up distressed assets in the west by taking advantage of the cheap money, thereby boosting local jobs and market for their products and also cushioning the home facilities from currency risks. Many Indian manufacturing and services companies including those in the IT sector and Bharti Airtel in the telecom space are embracing this model. The most remarkable has been Tata Motors’ revival of the ailing Jaguar Land Rover company to cater to the western markets instead of trying to build and export luxury cars out of India.
MOHAN SULE