Pharma Profits Set To Surge, Says InCred's Aditya Khemka

Khemka suggests a cautious approach about stock picking as most Covid-dependent firms aren't going to show an impressive margin.

<div class="paragraphs"><p>(Source:&nbsp;<a href=";utm_medium=referral&amp;utm_content=creditCopyText">National Cancer Institute</a>/&nbsp;<a href=";utm_medium=referral&amp;utm_content=creditCopyText">Unsplash</a>)</p></div>
(Source: National Cancer InstituteUnsplash)

There would be a significant growth in pharmaceutical firms' profit as raw material costs are falling with China reopening, according to InCred PMS Fund Manager Aditya Khemka.

There has been an 11% top line growth in the past two years against a 3% net profit growth at a compound annual growth rate, Khemka said in an interview with BQ Prime's Niraj Shah.

The fund manager listed three factors why the profit after tax growth has lagged so far:

  • Raw-material pressure increased as most of it is imported from China and the yuan has been high due to the pandemic and many other reasons. This didn't allow the PAT and top line figures to grow in sync.

  • Logistics costs rose due to limited export containers. It made the average cost per container more expensive and pushed the cost below the gross margin.

  • The ability to pass the cost to the customer was affected as price increases were just not enough to cover for the cost escalation, resulting in a decrease in margins.

What's Changing?

As China reopens, material costs are reducing. It is expected to ease raw material and supply chain pressure, and feed margin growth where prices are already high.

"If FY24 were to experience a 11–12% top line growth and a 30–35% PAT growth, which is three times the growth in top line, then the top line and PAT growth in the past three years would have been the same," Khemka said.

If the margins improve to pre-Covid times in the coming years, a 30–35% PAT growth will be seen at a fund level. He said the possibility of this happening is high, citing corrections in raw material prices.

Safe Space To Invest?

Khemka said healthcare is a good place to invest currently, keeping in mind long-term appreciation and capital preservation. The demand for healthcare is non-discretionary and it eventually leads to restoration of growth, margin and multiples.

The only factor to consider is the time it takes to reach that restoration, he said. However, the timeline is not the most important parameter to consider while investing in this space.

Therefore, earnings upgrade will definitely take place even though the healthcare sector is at its lowest weightage of 4% in India currently. It will show up in the coming quarters of the next year, according to Khemka.

Branded And Unbranded Generics

Khemka said the past quarter showed "surprisingly positive" earnings as the US went through a severe flu season, during which co-prescription of other drugs increased for that time period. But it does not continue in the coming quarters as the flu season is temporary.

He also pointed out that unbranded generics have pricing and regulatory risks looming around them. It does not seem to wither out anytime soon unless a dramatic rationalisation in capacity of suppliers is seen.

Hence, the fund manager said, margins cannot grow if the price continues to fall no matter if the proportion of the fall decreases.

On the branded generics side, Khemka said: "We like the space as it will soon see lower cost and higher price, leading to better topline growth."

Stock Picking

Khemka suggested a cautious approach about stock picking as most Covid-dependent companies are not going to show an impressive margin or supply growth as they were during the pandemic.

He cited the examples of Divi's Laboratories Ltd. and Laurus Labs Ltd., which faced an impact on the supplies of their generic active pharmaceutical ingredient. It lowered revenue and hit margins, while the pricing went down and the volume stayed intact.

It is preferred to choose stocks where custom synthesis is a larger part of the profit pool than the generics in this space. Having said that, this area has high potential for growth and profits provided investment is made in the right set of stocks.

Hospitals And Diagnostics

Hospitals that are "old-chained" are closer to their peak margins and return on equities. Therefore, the incremental RoE will be a tough task, according to Khemka.

He underscored that factors such as digitisation, price increases and reduction in average length of stay will help improve margins. But a meaningful uptick will be a little challenging for the mature chains in contrast to the younger chains.

The younger chains have a lot more scope for growth with outsized returns where global hospitals don't give more than 20% RoE, Khemka said.

Prices in the diagnostics space have not only come to a standstill, but have also declined in recent times. The space mostly comprises small and mid-caps, which are currently not in favor of customer sentiment in the market. The valuations are also at its cheapest in this space at the moment, hinting that the sector is close to its bottom line.

Watch the full interview here: