The good, the bad and the ugly in Indian pharma

Chirag Talati, Analyst, Kotak Institutional Equities (KIE), gives an insight on the recent global currency movements and the risks they pose to Indian pharma. Excerpts from the report

Recent global and currency movements have exposed the risks to Indian pharma’s ex-US growth profile and with a $2.2 billion revenue exposure to cross currencies, sharp movements as seen for rouble will hurt growth and margins. While Russia/ CIS and Venezuela are set to have a material impact on a few companies, notably Dr Reddy’s Laboratories Ltd (DRRD), the Indian Rupee (INR) depreciation versus the United States dollar (USD) should help absorb some of this impact partially. Net impact is a -5 to +2 per cent change in EPS estimates with DRRD being the most impacted.

The good — rupee depreciation versus dollar to benefit the sector

According to KIE economists, INR should see steady depreciation, albeit to a much lesser degree than other emerging markets. KIE economists forecast the USD/INR to average ~63 in FY2016 compared to 61 in FY2015 and 65 over the longer term. Ceteris paribus, increasing exposure to the US will provide a strong cushion to Indian pharma ($9 billion+ revenue exposure for the sector), with our analysis suggesting the highest sensitivity for Sun Pharmaceutical Industries Ltd (SUNP), which should see margin benefit of 50 bps and EPS upgrade of 160 bps for every one per cent rupee depreciation. This is followed by LPC (30 bps margin/ 120 bps EPS), DRRD (18 bps margin/90 bps EPS) and Cipla (5 bps margin/23 bps EPS).

The bad — negative impact from cross-currency moves for Japan, Brazil, SA

The euro (EUR), South African rand (ZAR), Brazil real (BRL), Japanese yen (JPY) and Australian dollar (AUD) depreciated by five per cent, four per cent, 11 per cent, 10 per cent and seven per cent against the dollar compared to the September 2014 quarter with the cross-currency impact highest for ZAR, BRL and JPY. Indian pharma’s combined exposure to these currencies stands in excess of $1.5 billion in revenues with Cipla having the highest exposure (18.5 per cent of revenues), followed by DRRD (13 per cent), LPC (17.6 per cent) and SUNP (six per cent) among our covered names. In case of further cross-currency moves, KIE expects DRRD to have a hit from euro depreciation (10 bps margin and 40 bps EPS for one per cent depreciation), while Cipla will see a negative hit from ZAR (13 bps margin and 58 bps EPS for one per cent depreciation) and LPC will be impacted by JPY (10 bps margin and 20 bps EPS for one per cent depreciation). SUNP is likely to have higher sensitivity to the euro though it could be negatively hit due to Ranbaxy Laboratories Ltd’s (RBXY) exposure to euro and ZAR (11 per cent of RBXY and seven per cent of pro-forma).

The ugly – FYTD 40 per cent depreciation of ruble versus rupee to hurt DRRD

The sector has a combined exposure in excess of $600 million to Russia/ CIS, Venezuela, Bolivia and Nigeria. KIE believes this basket is also one of the most profitable given the pricing scenario in countries like Russia, low competitive intensity in countries like Venezuela as well as lack of any major R&D spend for the region, which lifts the contribution margins. Since FY2012, Indian companies also benefitted from rupee depreciation versus Russian rouble (RUB) (+seven per cent and + five per cent for FY2013 and FY2014 respectively). Among our coverage universe, DRRD has the highest exposure with ~16 per cent of its revenues from Russia/ CIS and Venezuela combined (-10 bps margin and -40 bps EPS for one per cent depreciation). Despite having the cleanest country profile, SUNP will now start to see negative hits from RBXY, which has 13 per cent of its revenues and 20 per cent of its earnings before interest, taxes, depreciation, and amortisation (EBITDA) exposed to the basket.

DRRD to bear the highest impact, followed by LPC, Cipla and SUNP

On a net basis, KIE estimates a positive impact for LPC and SUNP owing to the disproportionate reliance on the US market and raise KIE’s estimates by up to two per cent. KIE sees DRRD having a negative hit from the basket due to the sharp RUB depreciation and potential devaluation of Venezuelan bolivar and KIE cuts its own estimates by two to five per cent as the RUB exposure is partially offset by dollar. KIE also tweaks out target price for DRRD marginally to Rs 3,175 (versus Rs 3,130 earlier). KIE estimates for Cipla and Lupin change by +/-2 per cent while Biocon estimates are reduced by three to five per cent.

Five to 20 per cent of revenues in non-USD currencies for KIE’s coverage universe

Indian pharma companies derive seven to 32 per cent of revenues from non-USD foreign currencies with SUNP having the lowest exposure and DRRD having the highest exposure at ~7.5 per cent and 32 per cent respectively. Among the major non-USD foreign currencies, EUR, RUB, ZAR and JPY account for four to six per cent, three to five per cent, two to three per cent and two to three per cent respectively of total revenues for companies under coverage.

Headwinds from several cross currencies partially offset by USD tailwind

For the past two years, Indian pharma companies benefitted materially from INR depreciation against USD, EUR and RUB. While the impact of USD/INR dynamic is understood by the market, even other currencies like ruble had been supporting growth. For example, for the past eight quarters, DRRD reported currency growth in Russia far outstripped the constant currencies growth. With USD strengthening against most currencies, the tailwind could potentially turn into a headwind for euro and rouble exposure, while yen, real and rand exposure will continue to be a drag. KIE also notes that potential impact from devaluations in countries like Venezuela is not yet factored into estimates and could meaningfully hurt growth of companies like DRRD, which has been benefiting from stronger growth in the region for past two to four quarters.

Assessing margin and EPS sensitivity to various currencies

KIE presents estimates of sensitivity of EBITDA margins and EPS estimates for one per cent depreciation of INR versus USD as well as one per cent appreciation of INR on cross-currencies for other leading currencies. KIE believes DRRD has the worst currency exposure with impact from RUB, EUR and ZAR set to hit its profitability on a standalone basis, with its USD sensitivity too lower than peers due to large amount of outstanding hedges. While Cipla and Lupin are also likely to face headwinds due to ZAR and JPY/ZAR exposure respectively, given the low amount of cash flow hedges for both the companies (sub-$150 million versus USD), INR depreciation versus USD will help to absorb chunk of the negative impact. The impact on working capital is difficult to quantify though the possibility of write-offs in Russia/ CIS and Venezuela cannot be ruled out for DRRD. Net impact is that KIE tweaks its estimates by -0.5 per cent to four per cent for the companies under our coverage with DRRD having the highest 5.3 per cent cut to FY2017 EPS. KIE also tweaks its target price marginally for DRRD upwards to Rs 3,175 to account for roll-forward by three months on our DCF.