Diagnostic Sector Set For 10% Growth In Coming Years, Says InCred's Aditya Khemka

Aditya Khemka: So what has stood out are two things. Number one, you know, the large-cap pharma companies or the unbranded generic companies they've done fairly well compared to our expectations. I think they've done better than what we had expected and that doesn't seem to be driven by the broader market rally because we still don't see enough evidence to infer that the broader unbranded generic market fundamentals are improving. But there are product specific opportunities which are playing out well for the unbranded guys, so that is something that has outperformed our expectations.

On the other hand, we have seen hospitals underperforming expectations, and we have been saying that the valuations of hospitals have probably run far behind, you know, what was fairly intrinsic value, and hence, now that the hospital's earnings momentum is slowing down or normalising. I think hospital stocks seem like a difficult trade at this point and lastly, diagnostics have done phenomenally well. Their top line growth has been far beyond our expectations, margins and been a little I should say subdued. But I think that's mostly driven by the need for capacity expansion or the need for geographical footprint expansion. Hence, you know, that has depressed margins for diagnostics. But I think that as always is temporary because once the expansion starts bearing revenue, you will see the margins expanding to normal again.

Aditya Khemka: Sure. So I think Revlimid, all of us know it's a known fact that in 2026 the product goes off, the patent goes off and there will be stiff competition price erosion, and you know these companies which are making $200-$300 million on their product today, that number will fall to I don't know 10-20-$30 million. So it will become like any other product opportunity in the past. So I think  there's clearly a deadline after which Revlimid will not help earnings. In fact, it will hurt earnings because it is currently a large part of your earnings and then it will go down to virtually zero or any insignificant number. So when does the market start discounting that it's a puzzle that it's anybody's guess market should have already discounted it if you ask me, because we always look one year forward in terms of price targets and hence two year forward in terms of earnings and two years forward in Revlimid will have no impact on the earnings that you project for these companies.

Hence a market should have already started discounting that. But I think it is also an element of momentum of the market. So if the market is in momentum stock prices are flaring. Then you know these things, the fundamentals take a backseat, is more about the P/E multiples and you know what cash flow you can generate this year and visibility for the next two quarters. I think those things take more of a front seat in a situation like this. So no doubt the unbranded pharma companies will have a tough time two years down the road for sure in displaying any growth in earnings. When the market starts discounting that I think your guess is as good as mine. It's just a matter of perspective there.

Aditya Khemka: So unfortunately, I think the response to this question is very company specific, you know, something like a Syngene or a Newland may have a tough FY25 because they had a great FY24. So see, the CDMO business, especially when you deal with innovators, tends to be lumpy. Now the lumpiness is not just within a quarter, sometimes it is within years also.. So an innovator might give you a project you should finish in year one and he may not give you another project in year three, so in which case your year two over year one will not look like a good year because you did a project in year one which is not recurring in year two. Similarly, let's say if you are contract manufacturing innovators' products, he just might buy enough inventory for two years. into two quarters and then for the next one and a half years, you don't have any orders for the same product, from the same innovator and hence you know, your again, year two will look difficult compared to year one, because you have recognised all the revenue in year one and year two will not have much of revenue from that product.

So, yes, you have to be prepared for lumpiness, the lumpiness can be within quarters and can be within years. But if you take a five-year view, which is generally how we operate, we operate with a five-year view of, you know, where the stock or where the earnings would be in five years, then this lumpiness doesn't bother you. In fact, every dip gives you an opportunity to add and you know, so that you can build a sizable position by the end of the fifth year. I think that is where things look really, really good for the CDMOs based out of India. But yes, FY25 would be difficult for companies like Syngene or Newland. You know, so again, which is why I said it is company specific. It's not going to be, you know, a routine thing for everybody. FY24 for Newland was a great year, but FY24 for Hikal despite it also being a CDMO player, it wasn't great. So you have to look at it from an individual business standpoint and not really from the CDMO sector standpoint.

Aditya Khemka: So here again, I'll give you two examples and again, these are not buy/sell recommendations but just what we have observed over the past two, three years, you know, Divi’s Lab a couple of years back announced huge capex plans and they had huge CDMO capacity that they had built. They just didn’t get the orders. So post Covid, I think their ability to get more contracts on the CDMO side just sort of flattened out and now the capacity is on stream, but they're waiting and they're hunting for customer orders. On the other hand, you know, you had a Newland, which built capacity once they had the orders which could justify the capacity. So, you know, it's totally dependent on the management of the company. 

Some of these companies, you know, work on the basis that there is a Biosecure Act in place in the U.S., and hence customers will look for alternatives and hence I should prepare the capacity and be prepared for customers who come with inquiries to me. On the other hand, some other players take a route where they say, let the customer come to me, give me an inquiry, let him confirm an order and that's when I start building the capacity. I tell him that there will be a six month,  one year lag between the placement of the order and the execution of the order. In that time, I will put the capacity in place and execute his order. So it's again something that is completely dependent on the company. To my understanding, Laurus seems to be a company where their installing capacity, and they're pretty confident that they will get orders, but I don't think they have orders in hand for the capacity that they're installing and that's more on the Divi’s approach and less of Newland’s approach if you ask me.

But you know that's the way they are operating. There's no good or bad here because all four or five years, given how the global CDMO landscape is evolving. All of them will get orders with this is just going to be too much business for anyone to miss out on it. But yes, in between guys who build capacities but don't have orders to execute on their capacity will show some lumpiness in operating margins and all that. That again investors will have to bear because you are taking a four-five year call when you're investing in CDMO, it’s not really a one year or a two quarter call.

Aditya Khemka: So again, no sector level point here because the diagnostics sector might grow at 10% over the next 4-5 years. You would have companies like Krishna, they had their concall yesterday. They said 25 to 30% topline CAGR over the next three to five years. That's because they're sitting on a very small base and they are in a space where there is very limited competition, and the time is probably 10-12 times the existing time.

So there is a huge target action market that is far higher than what we have currently in the space. So you know, they talk about all those things. So they might grow at 25-30%  if you were to believe management commentary over the next four, five years, something like Thyrocare, they spoke of mid-teen topline earnings growth over the next four, five years, because they have expanded their PIN codes from 4000 to some 8,000 PIN codes. They have expanded the number of franchises from 3000 to 9000, or 8500. These new franchises will give them business over the next four, five years. So they will probably grow much higher than the market. On the other hand, you had a Dr.  Lal or Metropolis for probably without inorganic to grow faster than the market may be difficult given the size that they are sitting.  So I would say if you have to talk about diagnostics as a sector, yes, 10% growth is something you know one should be comfortable with. But if you want to talk about individual stories, you will have huge digressions in growth within individual businesses within diagnostics.

Aditya Khemka: So if you look at history, particularly in the case of Krishna, because Krishna is the company which is talking about 25-30% growth. If you look at their history, they have grown at 35% CAGR topline. Obviously they were much smaller. You know, historically speaking the starting point was much smaller than today's revenue. But in Krishna, you know, what you get is you get some visibility unlike a Metropolis or Dr. Lal or even a Thyrocare, where, you know, you have to believe that if they're open stores, they'll be able to kind of monetise the stores or they'll be able to monetise the franchisees. That's an assumption that we make. In Krishna, the visibility is likely higher, because they have tenders which are in the public domain. So they won the tenders and if the tender size is in public domain in which market that tender is in public domain, what pricing they won the tender is in public domain. 

So if you just build out revenues as per the tenders and they have won and they will probably execute over the next two, three years. So we have enough data to justify the next two to three years of 30-35% or 25-30% growth to Krishna diagnostics. But, you know, again, that's the visibility we have for the next two, three years. Beyond that they will need to win more tenders to justify growth of 25-30% beyond the next two or three years. So it's obviously an ongoing process and B2G in  diagnostics is a very, very nascent business. But what we have observed is that every government when they renew the contract with a company like Krishna, they increase the size of the contract by 2-3x. So the Rajasthan contract when it expired in August. 22 was a Rs 70 crore per annum contract, and the new contract which they have been, you know, in the process of awarding that contract can be of 300 crores  contract from the same state. So 70 crore per annum revenue to 300 crore, that will happen from the same contract. So the point is that the time is far bigger than you know, which is currently represented by the revenues. 

Aditya Khemka: So hospitals, I think earnings momentum is undoubtable. I think India was a market where, you know, the number of hospital beds that we deserve, what we need, is far higher than the number of beds we have. So there was clearly a supply demand gap in the segment. I think all this greenfield, brownfield expansion done by different hospital chains is addressing that gap. So I don't think earnings momentum is under question in a significant way. Again, it can be different from an individual stock standpoint, but at a sectoral level. I don't think there is any challenge in terms of earnings momentum. I think what investors need to be very cognisant of is at what price you buy that story. So if you buy a hospital at five times free cash flow yield, and the hospital is growing at 10% topline, 15% bottom line, that's a great investment. But if you're buying a hospital at one, 1.5% free cash flow yield, and the growth is similar to 10% top line 15% bottom line, you're probably not going to make money for a while. So you know, the entry point matters and the entry point decides the returns that you make over the next three to five years. So I would say that one needs to be cautious of the hospital space in terms of entry point today. I think some of these stories have done far beyond their intrinsic values.