Bulk Drugmakers Continue To Face Margin Pressure But Analysts Aren't Deterred

Most bulk drug manufacturers witnessed pain in their margins in the first half of fiscal 2023 and analysts expect the near-term outlook to remain blurry even as companies say cost pressures are easing.

Shares of most API makers have fallen in the past year amid pressures on their margins. Analysts, however, are optimistic on the medium-to-long term outlook.

''Active pharmaceutical industry should see the growth rationalise between 8-10%,'' said Sriraam Rathi, associate director-pharma and healthcare, BNP Paribas.

Abdulkader Puranwala, pharma analyst with Elara Capital expects the average margins for API companies to stabilise in the range of 15-18% from the third quarter ended December onwards, as against the current 12-13% average for the industry.

"Though raw material prices are easing from their peaks, high cost inventory and elevated energy costs have taken a toll on the operating margins in H1," said Vishal Manchanda, pharma analyst with Systematix.

Divi's Laboratories Ltd. said, in its recent post-earnings call, that the prices of some base metals such as lithium and iodine have multiplied several times since last year, and the company expects the trend to persist. Some solvents like Toluene continue to increase, the management said.

BNP Paribas' Rathi told BQ Prime that input inventory stocking at higher purchase prices due to supply-chain issues and normalisation in sales over a high base of the previous year have caused revenue to decline in the last three to four quarters.

Aditya Khemka, fund manager at InCred PMS Healthcare, said most companies that are seeing pain are those that cater to API for generic drugs. "Here, the businesses suffer from inability of being able to pass on these input price hikes to customers since end product margins are under severe pressure in most major markets (U.S. and Europe)."

Khemka expects the medium- to long-term outlook to be bright for API manufacturers.

"As the cost benefits enjoyed by Chinese manufacturers vis-a-vis India, in terms of labour, power, pollution and capital continue to diminish with better intellectual property protection under Indian laws and ongoing political hostility of China towards the world, India stands to emerge as the best alternative for supply chain diversification going forward."

In the next 10 years, Indian bulk drug manufacturers are therefore expected to see incremental growth, he said. "Indian industry will not shrink but only gain incremental revenues and market share from current levels."

Also, with regards to a five-year outlook, he said the companies that are into capacity expansion will start seeing good returns. "They will attain a phase of debt repayment, capex utilisation and better margins."

Manchanda expects competitive positioning for Indian API players to improve in the medium-to-long term due to production-linked incentive scheme, allowing them to benefit from China substitution.

Rathi said production-linked incentives announced by the central government will yield an incremental upside for the companies by making India more competitive from FY24 onwards.

In the post-earning calls, most companies suggested that input cost pressures are easing.

"We have seen prices of some of the key raw materials softening and expect the trend to continue in the upcoming quarters, thereby, improving our margins and profitability," Hikal Ltd. said.

Divi's Labs said "raw material procurement and availability issues have slightly stabilised and prices for some raw materials marginally reduced compared to previous quarter, while for a few, it continues to increase".

According to Puranwala, supply-chain issues easing out could cause the cycle to turn for the better. He expects some stability in API margins in the range of 15-18% but does not see them going back to above 20% average margin range of Covid-19 years.

For Manchanda, while PLI scheme has started to deliver, the larger benefit is likely to come from substitution of fermentation-based API and intermediates but it will take a while to reflect.

Rathi, however, had a sobering take. "While raw material costs seem to be normalising, they are still higher than pre-Covid levels. There is no trigger for immediate growth of these companies."

He expects some operating leverage from inventory rationalisation, but reliance on China for more than 50% of inputs will continue to impact the near-term outlook, he said.

API companies including Divi's Laboratories Ltd., Laurus Labs Ltd., Solara Active Pharma Sciences Ltd., Aarti Drugs Ltd., IOL Chemicals and Pharmaceuticals Ltd., Supriya Lifesciences Ltd., Glenmark Lifesciences Ltd., and Biocon Ltd. have recently expanded capacities.

That means while softening of input prices should help margins, API makers won't be able to increase prices, as recently added capacities could lead to competition, according to Manchanda.

Khemka agreed that benefits are expected after a couple of years. Performance is expected to remain muted, and earnings and balance sheets will be under pressure until the capacities are monetised, he said.

Khemka said among API manufacturers, he is bullish on companies that manufacture bulk drugs for custom synthesis. These are companies that supply to innovators and, therefore, have the ability to pass on price hikes to customers.

While mid-to-long term is more predictable and less volatile, he said that near-term visibility is also not too bad for these players, since they can pass on some portion of the costs.

Companies such as Neuland Laboratories Ltd., Hikal, Divi's Labs, and Suven Lifesciences have a high contribution from this business.

Rathi said such companies stand to gain as it's a sticky business. "Limited competition protects margins."

Khemka, however, is less sanguine about makers of APIs for generic drugs. "These companies might find it hard to make a decent return on equity for the next three years, as price wars continue intensifying and squeezing their margins," he said.

However, they may witness normalised volume growth from next year onwards as base will normalise, he said, adding that de-stocking will help.

However, for such companies, uncertainty continues to persist around prices, Khemka said. It also depends on price erosion in the U.S.

Solara Active Pharma Sciences, IOL Chemicals and Pharmaceuticals, Supriya Lifesciences and Granules India Ltd. are some of the companies in this category.

Elara Capital's Puranwala picked Divi's Labs as his top bet among API makers, followed by Aarti Drugs, and Laurus Labs, citing a promising long-term outlook.