Side effects

The problems of some pharma companies with the US regulator might stem from efforts to keep prices low

By Mohan Sule

Quality issues have ceased to shock Indian consumers over the years. The aftereffects of adulteration and usage of substandard ingredients resulting in temporary or permanent health setbacks and injuries and even casualties are common, grabbing attention for a few days. Yet no one stops buying consumer goods, shifting to new houses, partaking wedding meals, or visiting restaurants. This is in the belief that the latest horror is an aberration and there are competent authorities to keep vigil on the essential items of consumption. Auditors, for instance, are anointed as the conscience keepers of investors and are expected to go through the numbers of companies with a fine tooth. Their signatures on balance sheets imply that they have indeed performed the task expected of them. Regulators are supposed to keep the interest of investors and users above those of issuers, producers and other market intermediaries. The board of directors acts as a check to ensure that in its focus on the shareholders, the management team does not circumvent corporate governance. Even so many of them fail in their fiduciary duty on quite a few occasions. Poor quality of medicines is in the spotlight after the US Food and Drug Administration pulled up Ranbaxy Laboratories and Wockhardt. Despite the furor, the local regulator’s silence is surprising.

The controversy has come at a delicate junction. During the downturn of the last four years, big-ticket investors had gravitated towards companies in this sector for two reasons. Like FMCG, demand for drugs is inelastic. In recent years, many producers have emerged as important global players on par with some from the tech industry. Cheap generic drugs, like low-wage IT workers, are increasingly finding acceptance in the developed markets. A growing number of MNCs is outsourcing manufacturing to India similar to the back-office work being offshored by the global financial services sector. Some mid-size manufacturers have leapfrogged into the big league on the back of such production contracts and exports of their generics. Ironically, Daiichi of Japan bought controlling stake in Ranbaxy to ride the generics boom. If recession in the US and euro zone exposed how vulnerable our tech sector is to the well being of their customers, the revelation of flouting of good manufacturing practices by two mainline players has the potency to slow down or even scotch the growth of a sector that is yet to reach its full potential. To ring-fence the industry, it is necessary for the domestic quality control body to launch a nationwide inspection of facilities to weed out players who have stepped out of the line to demonstrate that shoddy manufacturing is not all pervasive. Going by the experience of the tech industry, this is not difficult to achieve. Many clients of Satyam Computer Services stood by the company, distinguishing between the talent pool and the promoters. Also, there was hardly any impact on the business of other players such as Infosys, TCS and Wipro.

Even as action is being taken on the ground level, there is need to introspect. How much of the blame can be apportioned to the greed of promoters and how much to faulty policies that have spawned an industry known for reverse engineering rather than innovation? In its bid to keep prices of drugs affordable, the government may have indirectly encouraged manufacturers to take shortcuts. Price control of essential drugs meant that companies had to remain small in scale. In the meantime, there was also a transformation in the composition of diseases as India embarked on the growth path and accepted the product patent regime in 2005 after joining the World Trade Organisation. Though MNCs hold patents for many lifestyle diseases, the expiry of some earlier varieties opened a window of opportunity for Indian producers. So much so that the share of exports of frontline player is equal or more than domestic revenue. However, penetrating the market by being the first to file molecules and compounds is just one step. To establish a lasting presence requires a change in attitude to what constitute acceptable practices to keep the cost of operations low. It is in this crossfire that the Indian pharmaceutical industry is caught. Some like Sun Pharmaceutical and Glenmark have made spectacular progress in the crossover. Many more will do so in the medium term. What is crucial is that in their race to capture market share by producing cheaper versions they do not lose sight of the fact that they operate in a space that is more fragile than that of other industries. Consumption of medicines is not a ‘want’ but a ‘need’. Many prescriptions for complicated diseases are patents, leaving no choice for consumers. As for policy makers, the episode is another reminder that controlled pricing can lead to a blowout.

Liquidity injection

The Rs 29000-crore infusion by Unilever could see capital going to assets in need of funding instead of gold and property

By Mohan Sule

Cash can be a blessing as well as a problem. For companies, reserves are primarily a buffer against downturn, when inventories rise, products are slow in moving, customers demand discounts and stretching of the payment cycle, and credit is required to service working capital. RIL used some of its reserves for additional depreciation charges arising from revaluation of its plants and machinery. The market loves companies financing their expansion through internal accruals. For investors, its presence on the balance sheet indicates a healthy operating margin. At the same time, the increasing size of cash pile adversely impacts the return on equity. Consequently, there is clamor from investors to use it to grow the business by undertaking expansion, which would be a cause for capital gain. There is also pressure to share some of it with the shareholders through dividends or as bonus shares. Of late, companies are offering to purchase shares to reduce capital, which boosts earning and invites better discounting. The tendency to dip into reserves is more noticeable during a bearish phase. Besides using this method to support the stock, lack of effective channels to expend is a vital factor in distributing cash. This is not so during a bull run. Besides, the attraction of dividend yield diminishes as stock prices surge. Buybacks and delisting become expensive.

The way a company prefers to consume its cash influences the market’s attitude towards the stock. Those offering dividend, tax-free in the hands of investors, are favored though they may belong to mature industries because of the predictability of their payout. On the other hand, fund-guzzlers are viewed with caution despite the opportunity to buy cheap and scope for appreciation as they mostly operate in the emerging sectors of the economy. For a time it did seem Indian investors were buying into this growth story from the huge response to the Rs 11600-crore Reliance Power IPO, the last of the big-ticket issue before the collapse of the primary market in 2008. Policy paralysis, regulatory overhang and shortage of raw materials have snuffed out the potential of the infrastructure sectors, including telecom, that had lured investors for a while. Buybacks are taken as a sign that growth has peaked and the company does not see many opportunities to expand market share. RIL had to resort to share mop-up to prop up the stock beaten down due to fall in natural gas production. Dell of the US is taking the company private as smartphones and tablets have disrupted the desktop and laptop market. Hindustan Unilever is an interesting case. Parent Unilever is increasing stake in the Indian company to the maximum permissible of 75% to stay listed but triggering speculation that the MNC might go private sometime in future as the margin and revenue come under pressure due to competition. The flawed reverse bookbuilding process mandated by Sebi will ensure investor interest in the stock in the hope of extracting a sumptuous exit price. The shares might even enjoy still steeper valuations, going against the conventional logic that stocks slip after buyback is completed.

What happens to the cash that is returned to investors through the various mechanisms? It will not be surprising if it is deployed in risk-averse fixed income instruments or locked up in gold or real estate. The Rs 29000 crore that Unilever is going to inject into the Indian stock market comes at a different time. There are reasons to believe that some of this largesse might finds its way back into the equity market, which is at a critical juncture. The US Federal Reserve has indicated it might gradually wind up its pump-priming program against the backdrop of return of risk-taking. The Indian market is benefiting from the spillover emerging from the surging Dow Jones Index Average and Nikkei indices. Indians are still buying gold in record numbers despite its declining value. The current account deficit expanded in April 2013 mainly due to higher gold imports. Yet, the difference over the four-and-a-half years since the global market meltdown is that purchases seem to be for consumption rather than for investment. Decent return from real estate looks slim at the current level. On the other hand, cheap sunrise sectors that need capital rather than FMCG counters with stretched valuations could lure investors. Pressure from foreign investors could even prod companies in the infrastructure space to improve their corporate governance and the government to initiate reforms that would allow players easy entry and exit and flexibility in sourcing supplies and pricing. In that sense the cash infusion by Unilever and other MNCs that might be tempted to follow the FMCG giant would be a welcome liquidity injection in the Indian equity market.