The operating margins in the business of generic active pharmaceutical ingredients that have been under pressure for drugmakers are likely to recover in the short term as decline in prices bottom out, according to Chirag Dagli of DSP Healthcare Fund.
"In the commodity part of the business, margins have been under pressure across the board as prices were correcting," the fund manager told NDTV Profit. "But over the last couple of quarters, for many products, prices have now stopped falling further and stabilised in some sense."
He said multiple opportunities exist within the broader healthcare theme, expecting the contract development and manufacturing companies to clock growth in mid-teens. Hospitals and diagnostics will be lower but still at a 12–14% range, while India-focused pharma will be around 10%.
"Companies are talking about a very sharp recovery in the second half of the year and typically for all CDMO companies as a seasonal factor. Their own order books, pipelines were such that the second half of this fiscal was expected to see a very strong recovery of the low base of the first half," said Dagli, who manages Rs 2,934.2 crore under the fund.
Potential negative triggers in pharma could be regulatory actions and price controls, he said. This includes actions taken by the US Food and Drug Administration on manufacturing facilities, rules for hospitals, and domestic price control measures.
He said the fund avoids investment in pharma companies where there is a high profit contribution from a small pool of products and valuations are stretched.
"Wherever there isn't very high or not as high product concentration, those companies still we continue to own. A combination of higher multiples with higher product concentration is an absolute avoid," Dagli said.
Watch The Conversation Here
Here Are The Excerpts
The last 10 days, pharma has made its presence felt and how, from being a defensive sector to actually having a good performance in 2023 as well. But more importantly, this whole murmurs and then the subsequent passage of the Biosecure Act brought the CDMO players in focus. A virus here, a disease there, keeps diagnostics and healthcare in focus as well.
Chirag, your fund’s performance has spoken volumes about how well you guys have managed this space. I'd love to understand what you think about these things now. So first up, I'm going to bucket my conversation into two or three spaces. I will start off with the recent news flow on the U.S. Biosecure Act. A lot of chatter around this, a lot of talk about how, albeit, while it's long term, there is a massive opportunity for CDMO, CRO players. Do you agree? What do you think about this?
Chirag Dagli: So clearly, there is an opportunity. Indian players are at the forefront of this opportunity. We've been very good at chemical synthesis for a very long time and if you see while this opportunity has always been there, it is only a very gradual process that you know this increase happens, and what the Biosecure Act will do is that it will essentially accelerate that change.
If you see through Covid, everybody has been trying to de-risk their vendor supply chain. In Covid, we saw a lot of challenges. So all innovators have been trying to do if they are largely in China, then China plus one, if they're largely in Europe, then Europe plus one, and so on and so forth.
Clearly, India is at the centre of whether you want to do Europe plus one or China plus one. So this has been going on for a while, you know, below the seams, while the legislation has now come but this has been in the process, in the progress, in discussions in boardrooms for better part of the last 12 months, and which is why you see most of the CDMO players in India reporting very, very strong inquiries, you know, very strong numbers in terms of the RFPs proposals that they are actually seeing.
Okay, So Chirag, now just trying to understand again, and maybe it's a repeat question of just trying to understand, do you reckon that the benefits of something like this, potential benefits, could come in soon, could it be delayed and a lot of people were saying that the second half of the current fiscal year will probably start seeing some green shoots for the CDMO or CRO space.
In fact, the companies were saying as well that, forget the first half, but the second half will be very strong. I'm just trying to understand, could the Biosecure Act passage lead to that, or are there other factors and do you also believe that while they've kind of lagged in the last six to nine odd months, that the next six to nine odd months could be constructive for them?
Chirag Dagli: So 100% and this is irrespective of the Biosecure Act. The Biosecure Act is just, it is just still in process of getting official and so on and so forth. Anyway, companies are talking about a very sharp recovery in the second half and typically for all CDMO companies, the second half is much better than the first half.
So, a little bit of that is seasonal, but also their own order books, their own pipelines were such that the second half of this fiscal was expected to see a very strong recovery of the low base of the first half.
Okay and final question on this, Chirag, again, I know it's a very difficult one, but as investors, or as an investor or a fund manager, you're building out a hypothesis and then hoping for it to work. My question is, is your hypothesis over strong growth for the next few years? Based on Biosecure, RFQs, etc, for this, CDMO CRO bucket. Is it possible to predict two, three years out or are you playing it by the year?
Chirag Dagli: No, I think it's a little more longer term, kind of a long, strong runway to grow. That's what you know. Whether it is Biosecure or it is China plus one strategy that innovators have been following for post Covid, it basically paves the way for a very strong, you know, opportunity for Indian players.
We've been very strong at chemical synthesis historically, and this is basically this plays to that strength. The opportunity has been present for a very long time. You know, we can keep growing at that double digit kind of, that kind of opportunities present is, is what we essentially say.
Okay, so you reckon that it's maybe a five to seven-year runway of growth possible because of all of these factors and could it be like above mid-teens growth, or higher than that or is it difficult to call?
Chirag Dagli: What companies are effectively saying is that that is how they're thinking about the growth opportunity. See it can be anything. There can be many things that can go wrong. Their clients, products have to do well in the market. So, there are lots of ifs and buts, but the opportunity certainly is present.
Just a segue, because some of these companies are also manufacturers of APIs, right? What about that bucket because there is this hope that API growth will pick up, I mean, Granules has mentioned that in the last few conversations, their numbers have looked okay to some of the other companies have shown that too. Is that looking okay or is it very seasonal in nature, per se?
Chirag Dagli: So today, what is happening in APIs is that margins are under a lot of pressure for the generic API business, in some sense, the commodity part of the business, margins are under pressure, across the board, prices are correcting. But what we've seen of late, maybe over the last couple of quarters, has been that for many products, prices on the lows have now stopped falling further and stabilised in some sense.
So, API margins are at I would imagine such lows that I think they can only they will truff out over here and probably pick up from here on, you know, as we go along. But clearly margins are under pressure for the generic API business.
Chirag, the other aspect is what to do with some of the recent developments that have happened in companies kind of specialising in that specialty drugs? I mean, suddenly we saw policy moves around cancer drugs, and some of the companies in that bucket have done really well. There have been other examples as well.
Do you believe specialty drug makers could actually have a stronger runway, now that insurance is also percolated, or health insurance has percolated, and people might have access to expensive treatments, which was not a case maybe 10 years ago. So just trying to understand, could specialty drugs of all kinds be showing a strong runway of growth and are Indian companies there to benefit from this?
Chirag Dagli: So, specialty opportunity in India. Let's break the two pieces. One is in the developed market, like the U.S. and Europe, etc. and then there's obviously in India.
In India, I think we've seen most of the multinationals actually prioritise new product launches in India along with the developed market. So, this is a big change. I mean, it's a gradual change that has happened. But, you know, 10 years back, this was probably not there. Five years back, a little bit of this was there. Now increasingly, we're seeing most of the multinationals actually launch their new products, their patented products, in India, along with the developed world. So that's clearly something they see the potential for India.
You know, this is such a large market. 140 crore population, whichever way you slice and dice this, there will be a small market, like a Switzerland or a France that will just pop out of that. So, you know, the opportunity is clearly there, companies appreciating that, multinationals appreciating that, and certainly launching products, you know, on pattern products, along with the rest of the world, in India. Now, that's the India piece.
In the meanwhile, you know, incremental innovation, and a little bit of, you know, innovation that has been going on. That has been going on for a very long time, and that continues in the Indian market.
Now coming to the specialty part in the developed world, some of our larger companies have actually shown the way that this is not a small, this is a very, very balance sheet heavy, very, means a lot of cash flow, long gestation period, etc., to do well in the specialty piece. But some of our leaders in India have actually risen up to that opportunity and shown the way of how, you know, they can succeed, of, you know, selling specialty patented drugs in the developed world and more of this will happen, I think, as some of the companies lower down also, you know, reach a certain threshold of financial cash flows, they will also look to enter some of these markets with our own specialty products.
But that's some time away before we start seeing some, you know, where we can say that Indians are now doing very well in specialty, in the US. I think today, we are only seeing a couple of companies as a trend; it might take some time for it to develop.
Okay. Where within this whole healthcare construct, or the healthcare space, are you the most constructive because there are various buckets here, where are you most constructive and why?
Chirag Dagli: So, as I always say, you know, healthcare is not just one sector. There are multiple buckets. You put the India formulations, the export formulations, API, CDMO, hospitals, diagnostics and you know, now we have retail pharmacies as well. So multiple of these buckets, each of these have the opportunity to grow in double digits kind of range, is how we are, kind of thinking about this top down.
Now, as far as you know, generally these markets, these businesses, don't have too many cycles, per se. Sure, they will go through a little bit of, you know, RM, prices, volatility, some bit of seasonality in demand, etc. But by and large, businesses are not very cyclical.
If you look at a long-term chart of demand, of these products, of each of these, you will see a secular kind of, you know, increase. So that kind of continues. But capital markets have their own cycles of, you know, whether they prefer this versus that, depending on news flows and so on and so forth. So capital markets have their own cycles within these buckets, the businesses themselves don't have too many cycles. The only piece which is cyclical in the entire basket of multiple segments is commodity US generic business, which goes through a bit of a cycle.
In the last 12 months, we've seen a little bit of an upcycle from the lows. We've seen a little bit of an upcycle in the US generic business, and that, I think will continue for some time. So, that's just the, you know, lay of the land and if you ask me, where is the opportunity? I think the opportunity is across the board in each of the buckets.
There are stocks, there are opportunities to, you know, invest in. But if you just, you know, kind of list down the multiple buckets in terms of growth, then clearly CDMO API will be up there in terms of the mid-teens kind of growth potential, whereas hospitals, diagnostics will be somewhere lower, maybe in the 12–14% kind of range. Then you'd have Indian pharma, which will be in the 10–11% kind of range. So that is how the growth, you know, will stack up. That's how we broadly look at it.
But Chirag, relative to the valuations existing would the higher growth companies still be the favourites because they might be trading expensive. I mean, I look at the valuations of Syngene, Laurus, etc. they are very, very expensive companies. So do they still remain favourites or I'm not saying they are your favourites, but I'm just trying to understand that in the pecking order some of them might be expensive as well. So valuations versus growth perspective, what would stand to be the favourites?
Chirag Dagli: So, I mean, I think across the board, most sub-segments have seen a big derating. Even in India, businesses which used to trade at a premium to, you know, export businesses even on higher multiples 12 months back, those businesses have actually been re-rated much higher.
So tough to call, you know, separate out a section where you know, you will see that this is an entire space. The valuations are very attractive. Within spaces, you have to keep looking for opportunities is how we think about this.
Now, hospitals, let me try and come to this. A lot of chatter around new bed addition consolidation within this space, with the larger chains gaining over some of the others, that's the other piece that I hear and then I hear, of course, about the fact that, or about the possibility that branded chains would stand head and shoulders above the others, and therefore gain both in revenue growth and valuations. I'd love to understand how you think about hospitals?
Chirag Dagli: So clearly, what we've seen in the last three years is that most hospital companies have reported double digit R pop growth and clearly, that's not something that's sustainable. A part of this is a mix of both cases improving the maturity profile of the hospital overall, improving.
Clearly that you know, sustaining double digit R pop growth looks unlikely as we go along. I think a more reasonable expectation would be the, you know, a single digit R pop growth, and probably a single digit kind of patient's volume growth, and that blended into an overall, you know,12-13% kind of growth is the construct in the hospital space.
When you think of the larger chains, the listed ones, clearly, they're getting market share. Clearly, we're seeing that there's a lot of potential for these companies.
So, two things are happening. One is that in their core markets, where they have a very strong brand name, they are expanding brownfield capacities at existing locations. The other thing that is also happening is standalone hospitals are actually getting corporatised in some sense, you know, selling themselves out to corporate chains. This works well for both.
So, let's say if there's a doctor running, you know, a 100–200 bed hospital in a city, a doctor can, you know, take it only so much because he's doing both the administrative work as well as the clinical practice. When they get attached themselves to a corporate structure, the admin part just goes out.
The corporate structure manages the admin part, whereas doctors can just focus on their clinical practice. So, it's a win-win for both and that structure, we're increasingly seeing a lot more come through.
I think as far as the opportunity to grow on their own, this whole brownfield expansion in cities where they're already present and have a very strong presence, that also seems to be continuing. So the opportunity is certainly there. Most companies are talking about doubling bed capacities over the next four to five years, at the very least.
Okay, between hospitals versus diagnostics, a lot of people tend to make that comparison. We're trying to think whether we want to buy either or do you kind of look at them that way and do you have a favourite between the two?
Chirag Dagli: So, it looks tough to compare the two businesses. Hospitals are asset intensive business, high entry barriers. You know, you need almost 100 licences to start a hospital. So, if you and I decide to put up a hospital in a location today, the hospital will come up in three years. It will run at Ebitda losses for another two, maybe three years, and then start making money.
So, there are very high entry barriers in hospitals. Diagnostics on the other hand, there's hardly any capital required in the business, very low entry barriers, etc. So, the two businesses are very, very different. Both offer similar growth, I would say maybe plus minus, you know, some bit. But similar growth, but capital efficiency is much higher in diagnostics.
So, to pick favourites, it’s difficult, I would say valuations across the board are high. Within pathology, or rather within diagnostics, it is much easier to pick up a radiology business, because it's much more difficult to disrupt a radiology business and within hospitals, just much easier to pick up a multispecialty hospital chain, which can deploy the capital that its existing beds are generating, the cash flows and existing beds are generating to grow and, you know, build more beds.
So that's how we think about this, rather than comparing diagnostics with hospitals. You try to compare within hospitals, which are the hospitals that can potentially, you know, grow through internal approvals and from the existing beds that are there in their base, the capital that is generated from there can they deploy into newer markets, newer geographies to grow, is how we kind of think about it.
Are you constructive hospitals? Are you constructive on diagnostics currently?
Chirag Dagli: Constructive, but valuations are punchy and, you know, one of the things we've seen in diagnostics is that, you know, pre-Covid, all of these companies used to grow in the mid-to-high teens range. Through Covid, there was a lot of challenge, you know, etc. and growth x of the Covid business actually come down to very early double digits, 10, maybe 11% that kind of a number, and that now is inching back up to 13%, 14% is what we are seeing.
We're seeing a little bit of growth acceleration come back in the diagnostic companies. That's one change that we see. But that said, clearly, valuations are punchy.
Okay, valuations remain punchy indeed. The last couple of pieces that I would want to understand from you, where is it that you believe the next triggers of growth come in, again, a very wide bucket. So it's a bit of an open ended question, because you yourself counted about seven or eight buckets, so no one trigger will work for each but still trying to understand, because you probably look at the whole space, or from within the buckets that you look at, where is it that the next big trigger is likely to come in like for CDMO, the Biosecure Act, was supposedly the big trigger in the minds of people. Where do you think the next big trigger comes in for any of the buckets that you are looking out for?
Chirag Dagli: I think the next big negative trigger can be some regulatory action. Clearly, that's one of the big pieces that worries us a little bit, and this is across businesses, whether it is in pharma manufacturing, whether it is the US FDA, or it is hospitals or, you know, or the domestic market, you know, price control and so on. So that is something that is a little bit of a, you know, uncertainty there.
Apart from that, in terms of growth trigger. I think this business across the board, just keeps chugging along. CDMO, while today we talk about the Biosecure Act, etc. But you know the underlying trends of doing this, de-risking away from China or away from Europe, this has been around for the better part of the last 12 to 18 months.
So, I'm not sure if I can identify the milestone that this is going to happen and that's going to lead to the next big, you know, move, etc. I'm not sure if I'm able to identify any such, you know, events or triggers.
My final question to you, Chirag, and that is on the big pharma out of India, which have this large US exposure, or global exposure and I'd heard enough people talk about how the pricing pressure might go off, then talks of the pricing pressure coming back, then Revlimid helping some of these players in posting very strong revenue and then conversation now starting to come in of generic Revlimid or some other drugs are probably ending the massive revenue boost that they gave to two or three companies in particular, but maybe a lot of others too.
So I'm trying to understand what happens to the Sun Pharmas, Reddys, Ciplas, Lupins of the world, Aurobindos of the world, over the course of the next 24 months. How do you see that picture?
Chirag Dagli: So, two things happen. One is that the US-based business, which is the traditional commodity genetic kind of business that continues to chug along, price erosion remains fairly benign and that prognosis that we have that price erosion will remain benign, that will continue over the next, you know, 12 months for sure.
As far as big products are concerned, Revlimid is just one of them. You know, as far as the big products are concerned, some of these will just stop off. So Revlimid will become a fairly commodity product starting January 2026, maybe earlier, as this is a date certain, and you know, it's a market, so players may behave differently. So that's certainly happening.
The way we are approaching this is that companies where there's a very high profit contribution from a couple of products, and where valuations are also little punchy, we're staying away from such companies, is how we are, kind of thinking about this.
Wherever you know, there isn't very high or not as high product concentration, you know, those companies still we continue to own. So a combination of higher multiples with higher product concentration is an absolute avoid. This is how we are kind of today, thinking about this whole U.S. business across multiple players.
Disclaimer: The views and opinions expressed by the investment advisers on NDTV Profit are of their own and not of NDTV Profit. NDTV Profit advises users to consult with their own financial or investment adviser before taking any investment decision.
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