IndiaEquityResearch Pharmaceuticals

July11,2011

SectorReport
Keyindices July11,2011 Sensex BSEHC Nifty 18,721 6,431 5,616 1m 2.5% 1.7% 2.4% 3m 2.8% 5.0% 2.9% 6m 2.5% 1.4% 2.4%

Pharmaceuticals
Indiaformulations:Needtoovercomeneartermripples
Slowinggrowthofcorporaterevenuefromdomesticformulationsmay reflectareversiontomean,partlyfromthelackofasevereepidemic thatcouldliftgrowthtohighteens.Theindustryalsofacesheadwinds from a likely pileup of inventory in the trade channels and declining growth from new products. A rising gap between companylevel and trade sales suggests pricing pressure has extended into the chronic segment. Nearterm earnings may face some erosion due to rising operating costs and investments in marketing and promotions. Diversified revenues could protect overall profitability though our study does not reveal correlation between stock performance and revenuemix.WeremainpositiveonCDH,CIPLAandTRP. Reversiontomeanmaydepressgrowthatcorporateend
FY06 FY07 FY08 FY09 FY10

Growthindomesticformulationsmarket
20% Growth(yoy)incorporaterevenue 3yrmovingaverage

15%

10%

5%

0%

Wideninggap:Colevel&tradesales(INRbn)
Trademargin(INRbn) Netsalesofcompanies(INRbn) Netsalesofcompaniesas%oftradesales(RHS) 160 120 92.8% 80 40 Mar08 Mar09 Mar10 Mar11

The deceleration in domestic formulation sales seen in recent quarters may persist in FY12 as growth reverts to mean. Growth beyond the sustainable FY11 range of 12% and 15% p.a. may only happen in years with severe epidemics. Neartermgrowthatthecorporateendmaybehurtbyapossibleunwindingof inventory, pricing pressure and decline in growth from new products. Some data suggests that growth near the retail end may have bottomed out in Mar11.Therisinggapbetweenrevenueatthecorporateendandthatnearthe 100% retailendsuggestspricingpressurehasextendedintochronictherapies.
95% 90%

UpswingincostsmayweighonprofitabilityofIndianformulations
The high profitability of domestic formulations also amplifies the impact of slower growth on EPS. If revenue growth for FY12fFY14f were to be 1%2% lowerthancurrentforecasts,theEPSCAGRcould shrinkbyupto3%,evenif some variable costs were to be cut. Companies have invested significantly in sales, marketing and promotions e.g. the number of MRs has risen by up to 40%intwoyears.Largeriseisalsoseenincostsforfreight,fuelandoverheads. The combination of rising costs and slowing revenue growth has likely contributedtoac200bpyoyfallintheFY11coreEBITDAmargin

84.9% 85% 80%

Contributiontogrowth
20% Price Volumes Newproductintroductions 15%

MNCscompetitiveintensitymayberising
Afteryearsoflaggingbehindlocalcompanies2010sawthegrowthindomestic pharmasalesofMNCsvirtuallycatchupwithindustrygrowth.Otherindicators suggest MNCs have large ambitions in the domestic market. This may sustain thecompetitiveintensityindomesticformulations.

10%

5%

Diversificationcouldbetheneartermprotectivefactor
2006 2007 2008 2009 2010

0%

Subdued nearterm growth could pull down the perceived attraction of domestic formulations to investors from the highs of 2010. A diversified revenue mix could protect nearterm earnings. However, the relative performanceofstocksdoesnotseemtobecorrelatedwithrevenuemix.The highprofitabilityofthesegmentislikelytopreserveitsattractiontoinvestors whilethemarketcapitalizationofthestocksisalsoinfluencedbyotherfactors. WeretainourlongtermpositiveviewonCIPLA(Buy,TPINR370),CDH(Add,TP INR1,020)andTRP(Add,TPINR700).
MonicaJoshi,+9102266842852 [email protected]

Pleaserefertothedisclaimertowardstheendofthedocument.

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Reversiontomeanmaydepressgrowthatcorporateend
ThedecelerationinthecompanyleveldomesticformulationsalesofpharmaceuticalcompaniesseenintheDec10and Mar11quartersmaypersistinFY12.SoftergrowthforFY11(15.3%yoy)followedthe10yearhighof18.0%forFY10 and suggests it may be reverting towards the longterm mean. Apart from the cyclical reversion, nearterm growth couldalsobeweakened,atthecorporateend,byapossibleunwindingofinventorythatmayhavepiledupinthetrade channels; inventory pile up may also inflate stock returns over the mediumterm. We also observe a decline in the amountofgrowthstemmingfromnewlaunches;ifthistiesinwithadeclineinproductlaunchesitcouldimpactfuture industrygrowth.SomedataindicatesthatthegrowthneartheretailendmayhavebottomedoutintheMar11quarter evenasgrowthatthecorporateendcontinuedtodrop.Ourstudysuggeststhatthestableannualgrowthrangelies between12%and15%.Highteensgrowthisonlyseeninyearswithsevereepidemicssuchaschikungunya(FY07)and H1N1(FY10).Weobserveawideninggapbetweenrevenuereportedbymanufacturersandsalesneartheretailend. Thissuggestspricingpressurehasextendedbeyondtheacutesegmentintochronictherapies.Ourinteractionwiththe tradesuggeststhatdistributorstooarefacingthepinchfollowingtheriseinlogisticsandoverheadcosts.Besides,the tradesinvestmentinworkingcapitalhasbeenonincreasingfollowingthepileupofinventory.

Growthstaysindoubledigitsbut,nolongerinthehighteens
After a strong performance in the preceding year, growth rate in the domestic pharmaceutical formulationmarketasawholesloweddowninFY11.IntheDec10andMar11quartersparticularly,the slowdownhasbeensufficientlyglaring,placing,inourview,aseriousriskonforecastearnings.Being amongstthemostprofitableshareoftherevenuepie,afterexclusiveproductopportunitiesintheUS, aderailmentingrowthfromthedomesticsegmentcouldmateriallyalterprofitability. Exhibit1: Growthinthedomesticformulationsmarket
20% Growth(yoy)inaggregatecorporate revenue 3yrmovingaverage 15%
Accelerat ion in FY10 lift ed growth well above long-t erm mean Reversion to mean under way

10%

5%

0% FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11

Source:Industry,AvendusResearch

Between FY08 and FY11, the threeyear moving average growth has stabilized between 13% and 14.8%. This, we believe, is likely to be a longterm, sustainable average growth rate for the market. Needlesstosay,withinthis,variationswouldexistbetweencompanies.

Wideninggapbetweencompanylevelandtradegrowth
Whilethecompanyreportedsaleswouldalwaysbelowerthantheendconsumersalesasgoodsget markedupacrossthetradechannelweseeastrong,growingdisconnectbetweencompanyleveland tradegrowth. Forthepurposeofanalysis,weclubasetoflargetomidsizeddomesticformulatorstoquantifythe impactofslowdowninthesegment.OurpeersetforExhibit2consistsofCadilaHealthcare(CDHIN, Add),Cipla(CIPLAIN,Buy),Dr.ReddysLaboratories(DRRDIN,NR),GlaxoSmithKlinePharma(GLXOIN, Pharmaceuticals 2

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NR), Glenmark Pharmaceuticals (GNP IN, Add), Lupin (LPC IN, Hold), Ranbaxy Laboratories (RBXY IN, NR), Sun Pharmaceutical Industries (SUNP IN, NR), Torrent Pharmaceuticals (TRP IN, Hold) and UnichemLaboratories(TRPIN,Add).NumbersforSUNPhavebeenadjustedthroughtheMar09Sep09 quarter(adjustingforcINR2bnnonrecurringrevenuesbunchedupintheMar09quarter,withaspill overspreadequallybetweentheJun09andSep09quarters).ForGLXO,weconsider92%ofreported total quarterly revenues to be contributed by the domestic formulations business, inline with the annualaverage.WehaveignoredPIHCfromthepeersetasthecompanysSep09Mar11revenuesare notcomparablewiththeprecedingquarters,followingthesaleofthesegmenttoAbbottLaboratories (ABTUS,NR). Exhibit2: Quarterlydomesticformulationsrevenuetrendfor10companiesinpeerset
45 Domesticrevenues(INRbn) Growth(RHS) 21%

30

14%

15

7%

Dec07 Mar08 Jun08 Sep08 Dec08 Mar09 Jun09 Sep09 Dec09 Mar10 Jun10 Sep10 Dec10 Mar11
Source:Companies,Industry,AvendusResearch

0%

The growing disconnect between growth at companylevel and near the retailend can be best explained with the graph in Exhibit 3 and Exhibit 4. We track the annual and quarterly trends in the dataasreportedatthecompanylevelontheonehandandbytheindustryontheother.Weconsider ninecompaniesthisexerciseCDH,CIPLA,DRRD,GLXO,GNP,LPC,RBXY,TRPandUL.Together,these companies represent c28.3% of the market. We have deliberately excluded SUNP for the purpose of thisanalysis,giventhedistortioninthecompanysFY09andFY10domesticformulationrevenues. Weobservethatthecompanylevelreportedsales(inquarterlyandannualfinancialstatements)asa proportionofconsumer/tradelevelsaleshavebeenfallingquitedramaticallyovertherecentyears. Exhibit3: Wideninggapbetweengrowthatcompanylevelandnearretailend(INRbn)
Within4yearsthe marginsoftradechannels onformulationshave morethandoubled.
160 Trademargin(INRbn) Netsalesofcompanies(INRbn) Netsalesofcompaniesas%oftradesales(RHS) 120 92.8% 80 90% 95% 100%

40

84.9%

85%

Mar08 Mar09 Mar10 Mar11

80%

Source:Companies,Industry,AvendusResearch

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What is more interesting, we observe, that over the most recent quarters, the downward swing has onlymagnified.Exhibit4plotsthetrendofcompanyendrevenueasproportionofsalesnearretailend overthepast14quarters.Whilethereisseasonalitybetweenquarters,thebroadertrendindicatesa decline,whichhasamplifiedoverthelast23quarters. Exhibit4: Companyendrevenueasaproportionofsalesnearretailend(quarterly)
Decliningtrendwith fallingtroughsinlast quarterofthecalendar year.
100%

95%

90%

85%

80% Dec07 Mar08 Jun08 Sep08 Dec08 Mar09 Jun09 Sep09 Dec09 Mar10 Jun10 Sep10 Dec10 Mar11
Source:Companies,Industry,AvendusResearch

Similarly, the gap between reported growth rates from the two datasets company level and near retailendgrowthhaswidened(Exhibit5).Weconsiderthesamepeersetofcompaniesasincluded in Exhibit 2, except SUNP, to iron out distortions in quarterly sales (SUNP reported an abnormal bunchingupofdomesticrevenuesintheMar09quarter,whichhadaspilloverimpacton1HFY10).
Yoysalesinchedupin theMar11quarterbut, salesatthecompanyend slippedclosetoa10 quarterlow.

Exhibit5: Wideninggapbetweencompany(9companies)andtradereportedsalesgrowthforpeerset
Reportedcompanygrowth 20% Reportedtradegrowth

15%

10%

5% Dec08 Mar09 Jun09 Sep09 Dec09 Mar10 Jun10 Sep10 Dec10 Mar11

Source:Companies,Industry,AvendusResearch

The graph above suggests that the gap between companyreported and near retailend growth has widenedto650bpasharpchangefromtheaverage170bpgapseenintheimmediatelypreceding sixquarters.ThelasttimethisgapwasseenwasintheDec08andMar09quarters. So, what is causing this disconnect to amplify? We believe acute pricing pressure price discounts offeredbycompaniesandinventoryliquidationbythetradecouldberesponsiblefortheslowdown atthecompanylevel.

Pharmaceuticals 4

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Pricingpressureinacutes,stiffeningcompetitioninchronics
Though the FY11 market growth of c15.3% is health in itself, the marked slowdown in the recent quarters, has had a dampening impact on investor sentiments, particularly in 2HFY11. While pricing pressurehasbeenintensifying,particularlyintheacutesegment,chronictherapiestoohavefacedthe brunt of increasing competition. Trade intermediates confirm that discounts to the channel and increasing.Thesediscounts,webelieve,areafalloutoftheneedtomaintainmarketsharesontheone hand,andliquidationofslowmovinginventoryontheother.

Likelypileupofinventorycouldinflatestockreturninmediumterm
Ourinteractionwiththetradesuggeststhatstockreturnstopharmacompaniescouldsnowballintoa problemoverthecomingquarters.Inabidtomeettheirsalestargets,overthelast1824months,we believevolumeshavebeenpushedbeyondwhatcanbereasonablyabsorbedbythetrade,stuffingthe pipelinewithinventory.Thisexplainsthesuddenmonth/quarterendrushtobookordersthepharma industryhashistoricallyseenarushinsalesattheendofareportingperiod;however,accordingtothe trade, the concentration of periodend revenue booking has accelerated in the recent years. This inventoryfindsitselfcirculatinginthemarket,andasitnearsitsexpiry,wouldbeanaddedburdenon pharma companies. Besides, as new products get launched, older molecules/combinations find few takers,makingtheinventoryobsolete.Thistooislikelytofinditselfbackintothepharmacompanyas sales return. While it is difficult to ascertain the quantum of stock returns, many trade intermediarieshaveconfirmedthegrowingmenace. The divergent trend seen in the yoy growth for the Mar11 quarter adds to the indications of inventorypileupalongthedistributionchain.Exhibit5revealsthatgrowthneartheretailendendrose alittlefrom15.7%(Dec10)to16.0%(Mar11).However,atthecompanyend,growthfellfurtherfrom 13.2%(Dec10)to9.5%(Mar11).

Slowinggrowthfromnewlaunchessuggestspossiblepeaking
Asopportunitiesdwindle,newproductlaunchesacrosstheindustryhavestagnated.Whiletheoutlook is unclear, the number of new product launches/line extensions is likely to fall as fewer molecules become available to copy for the Indian markets. Even as this slowdown is unlikely to have an immediateimpactonneartermgrowth,overthemediumterm,itislikelytopinchtheindustry. Exhibit6: Newproductlaunches
CDH CIPLA DRRD GNP LPC SUNP TRP UL Source:Company,AvendusResearch FY07 39 14 21 25 NA 36 49 15 FY08 35 23 21 37 NA 37 52 29 FY09 55 31 36 24 54 42 15 19 FY10 60 32 62 25 42 48 55 19 FY11 60 NA 48 17 41 39 38 20

Exhibit7: Contributionofnewproductstosegmentgrowth
CDHnewlaunchesinFY10;contributioninFY10 DRRDnewlaunchesinFY11;contributioninFY11 DRRDnewlaunchesinFY10;contributioninFY10 SUNPnewlaunchesduringFY07FY10;contributioninFY10 ULnewlaunchesinFY11;contributioninFY11 Source:Company Contributionto segmentgrowth 2.5% 4.0% 5.0% 5.1% 1.7% Totalsegment growth 12.2% 15.1% 19.8% 15.4% 7.3%

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Exhibit8: Growthcomponentsforthedomesticindustry
Newproductintroductions 20% Volumes Price

15%

10%

5%

0% 2006
Source:Industry

2007

2008

2009

2010

Foodinflationmaynothaveadirectbearingontheindustry
TheabsenceofepidemicsinFY11,suchasthechikungunyaoutbreakin200607andtheH1N1scarein 200910,hasalsoresultedinaslowdown,particularlyintheacutecaresegment.Coupledwiththat, the persistent high food inflation, has also impacted sales, according to some industry participants. However, our analysis suggests that food inflation does not have a direct bearing on the industrys growth. Exhibit9: Foodinflationanddomesticpharmamarketgrowth(II)
20% Averageannualfoodinflationofprecedingyear Pharmagrowthinrelevantyear 16%

12%

8%

4% Mar07

Mar08

Mar09

Mar10

Mar11

Source:BRI,Industry,AvendusResearch

Tradecommissionsrise,butcostsmayposeachallenge
Whiletheeffectivecommissiondeliveredtothetradeappearstohaverisen(seeExhibit3),itmaynot necessarily support an improvement in their profitability. The margins for the trade channel and the chemistsareprescribedbyanagreementbetweentheAIOCD,theOPPIandthePADMALinSep84.For distributors,theprescribedrangeofmarginisbelievedtobebetween8%and10%ofMRP.Inaddition tothis,retailersarepermittedamarginofupto20%onMRP. However,thedistributorstooseemtofacingincreasedstress,partlyarisingfromgrowingcompetition withinthetradechannelsand,riseinworkingcapitalinvestments.Ourinteractionwiththetradealso suggeststhatdistributorsarefacingthepinchfollowingtheriseinlogisticsandoverheadcosts.This, webelieve,hastickedoffariseinconsolidationwithindistributors. Pharmaceuticals 6

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UpswingincostsmayweighonprofitabilityofIndianformulations
Thepastcoupleofyearssawformulationscompaniestakeonlargeadditionalcostparticularlyinsales,marketingand promotion.OurstudyrevealsthattheaggregateMRsacrossallcompaniesmayhaverisenby30%40%.Thissurgein fieldadditionstiesinwithseveralcompaniesexpansionintonewtherapeuticorgeographicsegments.Thisalsodrives ajumpinpromotionexpense.Othercoststhatarerisingrapidlyarefreight,fuelandoverheads.Thecombinationofthis accelerationincostscoupledwiththeslowinggrowthinrevenuehascontributedtotheFY11coreEBITDAmarginofa select group of companies declining by c200bp yoy. Across a wider set of listed companies domestic formulations comprisebetween12%and93%ofaggregaterevenue.Thissegmentcontributesdisproportionatelymoretoearnings andthustheongoingslowinggrowthcouldhavealargeimpactonnetprofits.Ourstudyexaminesascenariowhere FY12fFY14f domestic revenue growth is 1%2% below our current forecasts. We find that even if the companies succeedinholdingdowngrowthinsomeelementsofvariablecost,suchasincentivestoMRs,theearningsCAGRfor theforecastperiodcouldshrinkbyupto3%.

Surgeinfieldforce;30%40%riseoverlast2years
Most companies have expanded their field strength over the past two years, with some such as TRP bulgingtheirsalesforcebyashighas20%inasingleyearalone.Estimatessuggestthattheindustry hasswelledbyupto35%intotalMRstrengthoverthelasttwoyears.Theneedtohireandretainthe field force has tumbled over to raise the cost of manpower, ruffling the cost structure in pharma companies. We consider five predominantly domestic pharma companies CIPLA, GLXO, CDH, TRP and UL (standalone financials) to assess the impact of rising manpower costs. While CDH and TRP have overseassubsidiariesontheonehand,andcompanieslikelyCIPLAandULhaveaddedsignificantlyin shopfloor/manufacturing labor on the commissioning of new plants on the other, we believe, the impactoffieldforceaddition,couplewiththenormalaveragewagerateinflation,isamplyreflectedin thepeersetscumulativeemployeecost. Exhibit10: Trendinemployeecostvisvisrevenuegrowth
(INRmn) CDH CIPLA GLXO* TRP UL Total Domesticformulationrevenuesofpeerset Totalrevenuesofpeerset Mar07 1,850 1,846 1,537 2,488 555 8,276 46,640 85,761 Mar08 2,469 2,555 1,557 2,325 619 9,525 51,729 97,372 Mar09 3,109 2,714 1,728 2,565 731 10,846 60,949 117,187 Mar10 3,930 3,191 2,094 3,162 759 13,135 67,400 133,212 Mar11 5,579 5,410 2,409 3,895 1,055 18,858 77,634 155,799 CAGR (FY08FY11) 31.8% 30.8% 11.9% 11.9% 17.4% 22.0% 13.6% 16.1%

Source:Companies,AvendusResearch*C/Yend

ThelargestyoyincreasehascomeinFY10andFY11,reflectingthefieldforceexpansionundertaken by these companies over the two years. For companies like CIPLA (added c500 MRs, i.e. a c10% additioninFY11)andGLXO(majorityadditionsend2010/early2011),thefullimpactofinvestmentsin the field are yet to be seen; for others such as CDH, which plans c500 additions in FY12f (c12% of existing MR strength), rising employee cost is likely to remain a critical component of the income statement. AsMRadditionscontinueontheonehand,andrevenuegrowthslowsdownontheother,fieldforce productivity has been on the decline. Two examples stated below include average field force productivityforCIPLAandLPCreportedasrevenueinINRmn/MR/year. Pharmaceuticals 7

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Exhibit12: LPCsfieldforceproductivity
4.0

Exhibit11: CIPLAsfieldforceproductivity
5.2

4.9

3.9

4.6

3.8

4.3

3.7

4.0 Mar08 Mar09 Mar10 Mar11

3.6 Mar08 Mar09 Mar10 Mar11

Source:Company,AvendusResearch

Source:Company,AvendusResearch

Questionsonstaffretention,qualityaretakingupmindshare
As the industry as a whole moves towards massive hiring, companies are struggling to attract and retain field force. Attrition rates have been on the rise over the past years, with pharma companies losingstaffnotonlytocompetition,butalsotoalternativeindustriesincludingfinancialservices,BPOs andretail.Webelievetheaverageattritionlevelfortheindustrystandsbetween22%and25%,with somecompaniesrecordingattritionratesclosetoastaggering30%. Thescrambletohirestaffhasresultedintheaveragequalityofrecruitstohavefallen,accordingtothe trade.Trainingprocessescouldthusgetmorecumbersomeandlengthy.

Noexpensessparedonthemarketingandpromotionsfront
As companies add to their field force, and at the same time scramble to maintain market share, promotionalcosts,inabidtoimprovemindsharewithdoctors,arealsoaddingup.Withalargerfield force, doctor promotional campaigns are gathering momentum. For a bunch of domesticfocused pharmacompanies,withlimitedfrontendmarketingpresenceoutsidethecountry(exceptinthecase ofTRP),sellinganddistributionexpenses,includingcommissiononsales,havegrownatCAGRof14.4% duringFY08FY10,asagainstadomesticrevenuegrowthof13.1%. Exhibit13: Trendinsellinganddistributionexpensesvisvisdomesticrevenuegrowth
(INRmn) CDH CIPLA GLXO TRP UL Total Domesticformulationrevenuesofpeerset Source:Companies,AvendusResearch Mar07 2,525 1,978 776 1,618 490 7,388 46,640 Mar08 3,285 2,530 744 1,473 600 8,631 51,729 Mar09 4,154 2,306 697 1,955 608 9,720 60,949 Mar10 4,986 2,134 1,043 2,277 613 11,053 67,400 CAGR (FY08FY10) 25.5% 2.6% 10.3% 12.1% 7.8% 14.4% 13.1%

Note:Selling&distributionexpensesforCDHhavebeenadjustedforthoseofZydusWellness(ZYWL IN,Hold).

TooearlytoassessimpactofDraftCode
ADraftCodeofMarketingPracticesfortheIndianPharmaceuticalIndustrywhichwasreleasedinearly Jun11 proposes restrictions on promotional activities by the pharma industry. If implemented, there wouldbeamajorimpactonthemarketingandpromotionbudgetsofthecompaniesaswellasontheir abilitytopersuadetradechannelsandmedicalpractitionerstopromotetheirproducts.

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Pressureonprofitabilitytopersist
Besides the addition in field strength and the increase in selling & promotion expenses, capacity expansion by some players (CIPLA, UL) has also exerted a strain on core operating margins. The two companies have witnessed a oneway downstreet in core profitability as relatively weak sales are insufficienttoabsorbcostadditions. Ananalysisofourpeersetfordomesticformulationcompaniessuggeststhatcoremargins(i.e.EBITDA margin excluding other operating income) have dropped from 21.3% and 22.7% in FY09 and FY10, respectively,to20.5%inFY11. Exhibit14: CoreEBITDAmarginsofcompanies
(INRmn) CDH CIPLA GLXO TRP UL TotalcoreEBITDA Totalnetsales(exotheroperatingincome) CoreEBITDAmargin Source:Companies,AvendusResearch Mar07 3,087 6,877 5,019 1,249 996 17,228 85,761 20.1% Mar08 4,016 6,411 5,375 1,665 950 18,416 97,372 18.9% Mar09 5,621 9,591 5,777 2,558 1,462 25,008 117,187 21.3% Mar10 7,277 11,280 6,546 3,377 1,749 30,229 133,212 22.7% Mar11 8,607 11,433 7,378 3,047 1,546 32,010 155,799 20.5%

Exhibit15: CoreEBITDAmargin
24%

22%

20%

18% Mar07

Mar08

Mar09

Mar10

Mar11

Source:Companies,AvendusResearch

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Exhibit17: ULQuarterlyEBITDAmargintrend
27%

Exhibit16: CIPLAQuarterlycoreEBITDAmargintrend
25%

20%

22%

15%

17%

10% Sep07 Mar08 Sep08 Mar09

Sep09 Mar10 Sep10 Mar11

12% Sep07 Mar08 Sep08 Mar09

Sep09 Mar10 Sep10 Mar11

Margin pressure brought in by a combination of low revenue growth, high sales, marketing and promotionalcosts,andadditionalexpensesbroughtinbynewlycommissionedassetsaredepictedin thegraphsbelow.CIPLAcommissioneditscINR8bnIndoreSEZinearlyFY11,whileULcommissioned assetsatSikkimandBaddiearlyduringtheyear.

couldputearningsatrisk
The domestic pharmaceutical market is amongst the most profitable part of the revenue pie, after exclusiveproductopportunitiesintheUS.Iftheslowdowninthesegmentweretopersist,itislikelyto put earnings of the industry particularly companies with a high revenue exposure to the domestic marketatrisk. Exhibit18: Shareofdomesticformulationsintotalrevenues(FY11)
Companies GlaxoSmithKlinePharma* FDCLtd PfizerIndia** AventisPharma* UnichemLaboratories IndocoRemedies AlembicPharma Cipla SunPharma TorrentPharma Ipca CadilaHealthcare GlenmarkPharma Lupin PanaceaBiotec RanbaxyLaboratories* Dr.ReddysLaboratories Biocon TotalNetsales (INRmn,FY11) 21,511 7,076 11,696 10,850 8,171 4,785 11,990 61,303 57,214 21,220 18,825 44,647 29,491 56,478 11,434 85,355 72,368 23,005 Revenueshare fromdomesticformulations 93% c90% 81% 80% 70% 64% c54% 45% 41% 38% 37% 35% 29% 27% 26% 18% 16% c12%

Source:Company,AvendusResearch*C/YendedDec10;**16mendedMar11

Note: FDC Ltd (FDCLT IN, NR), Pfizer (PFIZ IN, NR), Aventis Pharma (AVEN IN, NR), Indoco Remedies (INDR IN, NR), Alembic Pharma (ALBC IN, NR), Ipca (IPCA IN, NR), Panacea Biotec (PNCB IN, Add), Biocon(BIOSIN,Add). Pharmaceuticals 10

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The view from industry participants is divided. While most believe that the Indian pharma market remains amongst the most attractive globally, the mediumterm growth estimates are diverse. The industry, in our view, has braced itself for a 12%15% growth in FY12f at the lower end of the spectrum,itcouldmeanamorethan300bpfallfromthepreviousyear. Exhibit19: Sensitivitytoearningsonasustainedslowdowninthedomesticformulationssegment
UL TRP CIPLA CDH LPC Source:AvendusResearch Domesticformulations CAGRFY12fFY14f Original 10.6% 14.4% 13.5% 14.5% 16.8% Sensitivity 9.2% 13.1% 12.2% 13.1% 15.4% Changeinearnings(PAT) FY12f 5.0% 2.6% 2.1% 1.9% 1.8% FY13f 6.4% 3.7% 2.8% 2.7% 2.6% FY14f 7.6% 4.5% 3.3% 3.4% 3.3%

Fromourbuildingrowthnumbersforthedomesticformulationsbusinessforeachcompany,welower the growth rate by 2% during FY12f and 1% each for FY13f/FY14f. Our CAGR for the purpose of assessingsensitivitythusfallsbyanaverageofc135bpduringFY12fFY14f.Predictably,earningsloss would be more for companies with a higher exposure to domestic formulations (as a proportion of sales). Our estimates for the purpose of ascertaining sensitivity assume variable costs (material expenses, direct manufacturing overheads and other variable costs) to change in proportion to lower sales. Material cost is lowered to the extent of proportionate drop in domestic sales numbers, leaving the othermaterialexpenses(forAPIsandexports)constant.This,inourview,iscritical,asthedomestic formulationssegmentisamongstthemostprofitableongrossmargins.Weassumethekeyoverheads ofemployeecosts(whichincludeMRfixedandvariablepays),selling&promotionalexpensesandR&D expensestoremainfixed. TheestimatedimpactofslowergrowthcouldbefinetunedifthevariableelementoftheMRexpense weretobequantified.TheincentivestructureforMRsisbasedonsalestargets.Whileitisdifficultto identifyandcomputeintricaciesonvariablecompensationstructuresbetweencompanies,webelieve thevariablecomponentcouldsignificantlyalterourthesisonsensitivitytoearnings.Thisisparticularly trueforcompaniesearningsthelargestpieoftheirrevenuesfromdomesticformulations.Weworkon two companies UL and CIPLA to assess impact of variable payouts to MRs. We assume marginal fieldexpansionovertheprojectedperiod,particularlyinFY13f/FY14f,wherewehavelimitedvisibility. Exhibit20: ComputingsensitivityonvariableMRpayforUL
FixedannualcomponentoftotalMRspay(INRmn) Assumingvariableoutflow@50% TotalMRcost(INRmn) Sensitivitytodomesticformulationgrowth Revisedvariablecomponent(INRmn)(INRmn) Sensitivitytoearnings Source:AvendusResearch FY11 216.0 108.0 324.0 FY12f 234.0 117.0 351.0 3.2% 70.2 0.5% FY13f 240.0 120.0 360.0 11.8% 107.6 5.4% FY14f 246.0 123.0 369.0 12.9% 110.0 6.8%

Thus,fromanearningsshockof5.0%/6.4%/7.6%duringFY12f/FY13f/FY14f,adjustingforvariableMR pay,sensitivitytoearningscouldstandat0.5%/5.4%/6.8%.Inourview,however,arealisticnumberis likelytosettlesomewhereinthisrange.Thisislikelyasvariablepayoutstakesometimetoadjustand companies,intheirrushtoretainstaff,refrainfromcuttingonvariableincentives.SimilarlyforCIPLA, earnings sensitivity may come down from 2.1%/2.8%/3.3% during FY12f/FY13f/FY14f (as stated in Exhibit19)to1.2%/2.4%/3.0%onadjustedvariablepayoutstoMRs.WeassumeCIPLAtorewardtheir MRsatc25%premiumtoULonthefixedcomponentandassumeavariableproportionof75%. Pharmaceuticals 11

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MNCscompetitiveintensitymayberising
A comparison of the annual growth reveals that domestic pharma sales of MNCs have almost caughtup with the industrygrowthin2010.OverthelasttwoquartersDec10andMar11leadingpharmaMNCplayersinIndiahave beatentheirdomesticcounterpartsgrowthrateinthedomestic formulationmarket.Theoutperformance hastobe viewedincontextofahistoricallyweakerthanmarketgrowthreportedbythispeerset.Withtheirrenewedinterestin themarketplace,themomentumislikelytocontinue.

AreMNCsfacingtheheatbetter?
OverthelasttwoquartersDec10andMar11leadingMNCplayersinIndia(GLXO,AVENandPFIZ) have beaten their domestic counterparts growth rate in the domestic formulation market. The outperformancehastobeviewedincontextofahistoricallyweakerthanmarketgrowthreportedby thissegment. Exhibit21trackstheannualreporteddomesticformulationsalesandgrowthofthreeMNCpharmas operating out of India GLXO, AVEN and PFIZ (data for Y/E Nov). In Exhibit 22, we adjust sales and growth numbers to reflect GLXOs vaccine business (key growth driver, particularly in 2009 with the launchofCervarix)andadjustmentofRabipursalesforAVENduring2007. OurdomesticcompanypeersetforExhibit23considersquarterlydomesticrevenuesforCDH,CIPLA, DRRD, GNP, LPC, RBXY, TRP and UL. We do not include SUNP as quarterly revenues for the Mar09 Sep09quarterswouldentailadjustmentsofoneoffsalesduringMar09.

Lowhistoricgrowthbaseishelpingthesegment
AcomparisonoftheannualgrowthrevealsthatdomesticpharmasalesofMNCshavealmostcaught up with the industry growth in 2010. A study of the quarterly growth also reveals the same trend. Whetherthistrendwouldsustaininthelongrunisunclear.However,withtheirrenewedinterestin the market place, the momentum is likely to continue. Companies in this segment are adopting strategies unheard of before, including making aggressive inroads in branded generics. As these companies pump up new launches (primarily in the generic space, with few brand additions as well, includinginlicensedproducts),growthfromnewproductintroductionsislikelytostaystrongoverthe mediumterm.Onalowbaseofthelegacyyears,newproductintroductionscankeepthemomentum alive.Thiscomparesagainstthestagnationofnewlaunchesfordomesticcompanies. Exhibit21: MNCReporteddomesticsalesandgrowth
36 Cumulativereporteddomesticsales (INRmn) Growth(RHS) 27 15% 16%

Exhibit22: MNCAdjusteddomesticsalesandgrowth
36 Adj.cumulativedomesticsales Growth 12% 12% 27 12% 15% 16%

18 7% 9 2007 2008

7%

8%

18 6%

8%

4% 2009 2010

9 2007 2008 2009 2010

4%

Source:Companies,AvendusResearch

Source:Companies,AvendusResearch

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Exhibit23: QuarterlygrowthofMNCsanddomesticcompanies
25% MNCgrowth 20% Domesticcosgrowth

Exhibit24: AnnualdomesticpharmagrowthofMNCs&industry
20% MNCgrowth 15% Industrygrowth

15%

10%

10%

5%

5% Mar10

0%

Jun10

Sep10

Dec10

Mar11

2008
Source:Industry,AvendusResearch

2009

2010

Source:Companies,AvendusResearch

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Diversificationcouldbetheneartermprotectivefactor
Withgrowthrateslikelytostaysubduedforacoupleofquarters,atleast,theexposuretothedomesticformulations marketmaynotbeperceivedaspositivelyasitwasin2010.Playershavenotindicatedanycutbacksinfieldhiringand promotionalplans,whichwouldmeanthatmarginpressurefortheindustryislikelytocontinue.Primafacie,thelarger thecontributiontorevenuefromdomesticformulationsthelargeristheriskposedtoneartermearningsgrowth.So,a diversifiedmixofrevenuesisanecessary,butnotsufficient,conditiontopreserveequityvaluation.Ourstudyofthe relativeperformanceofprominentstocksdoesnotrevealasignificantcorrelationwiththeproportionofrevenuefrom the domestic formulation segment. We continue to believe, the Indian formulations business remains a promising opportunity. The segments ranking as being amongst the most profitable SBUs for the industry is unlikely to alter, though near term hiccups would be felt for a while. Besides, for companies in the pharma industry, a host of other factors,otherthangrowthratesintheIndianbusiness,areatwork.Weretainourlongtermpositiveview onCIPLA (Buy,TPINR370),CDH(Add,TPINR1,020)andTRP(Add,TPINR700).

Mixofrevenuescanhelptowithstandneartermheadwinds
Thegraphbelowtrackstherelativeperformanceofdominantdomesticformulatorscomparedtothe SENSEX over a six month horizon (Yaxis) and their respective revenue share from domestic formulations(Xaxis). Exhibit25: RelativeperformancetoSENSEX(6m)andrevenuesharefromdomesticformulations
30%

6mpricechangerelativetoSENSEX

CDH

20%
TRP

10%
RBXY SUNP LPC CIPLA GNP GLXO

0% 10% 20%
DRRD

UL

30% 0% 40% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Shareofdomesticformulationsintotalrevenue
Source:Bloomberg,AvendusResearch

WebelieveDRRD,RBXY,LPCandGNParelikelytobetheleastrisktotheneartermheadwindsthe domestic formulations business may face. While various factors are at force (the companys performance in segments other than domestic formulations, exclusive product opportunities and regulatory issues, amongst others), purely on mapped concerns in the domestic business, their underperformancetothebroaderindexislikelyoverplayed. We also believe UL, with its strong (28%) underperformance to the SENSEX (6m), prices in the strongdecelerationexpectedinitsdomesticbusinessforFY12f(factoredintoournumbers). CDH (c14% and c25% outperformance to the SENSEX over 3m and 6m, respectively) is probably most at risk with the underlying ripples in the domestic market. Similarly, GLXOs sheer revenue share from the segment (least diversified in our peer set) puts the company most at risk to a decelerationinrevenues.However,ariseinnewproductintroductionsfromthecompany,coupled withanaggressivepricingstrategyinbrandedgenerics,maylowertheimpact. We continue to believe, the Indian formulations business remains a promising opportunity. The segments ranking as being amongst the most profitable SBUs for the industry is unlikely to alter, Pharmaceuticals 14

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thoughneartermhiccupswouldbefeltforawhile.Besides,forcompaniesinthepharmaindustry,as statedearlier,ahostofotherfactorsareatwork. We retain our longterm positive view on CIPLA (Buy, TP INR370), CDH (Add, TP INR1,020) and TRP (Add,TPINR700). Exhibit26: Absoluteandrelativepriceperformanceofkeydomesticformulationcompanies(asofJuly11,2011)
Companies Absoluteperformance CDH CIPLA DRRD GLXO* GNP LPC RBXY* SUNP** TRP UL BSETHC SENSEX 3m 11.5% 2.7% 4.6% 8.5% 4.3% 11.6% 10.0% 12.1% 11.7% 6m 22.8% 5.3% 7.8% 2.3% 12.3% 1.0% 1.7% 6.1% 17.1% 1yr 44.0% 2.7% 5.3% 10.4% 11.2% 18.8% 18.9% 44.9% 14.4% 13.7% 11.9% 5.0% RelativetoSENSEX 3m 14.4% 5.5% 1.8% 11.3% 7.1% 14.4% 22.8% 14.9% 16.4% 15.6% 7.2% 6m 25.2% 2.8% 5.4% 0.2% 9.8% 3.5% 0.8% 8.6% 14.2% 27.7% 0.4% 1yr 39.0% 7.7% 0.3% 5.4% 6.2% 13.8% 13.9% 39.9% 12.1% 18.7% 6.2% Domestic formulationsales CAGRFY09FY11 Comments 13.4% 12.3% 13.1% 11.7% 15.7% 17.8% 9.3% 19.0% 13.0% 9.0% 6thlargestinIndia;c60%revenuesfromchronictherapies;17 brandsintop300;leaderinGIandgynecology. 2ndlargestinIndia;leaderinrespiratory,ARV;dominantin urology;20brandsintop300. GIandpainmanagementleadproductbasket;lowcontribution fromchronics;leadinginbiosimilarforay;4productsinthe market(c5%ofsegmentsales). 4thlargestinIndia;leaderinthepain/analgesicandderma; acutesformc95%ofbusiness,ledbyAIs. Amongstleadingplayersinderma;c5brandsintop300. 7thlargestinIndia;4brandsintop300;successfully transitionedfromacutetochronictherapiesinthelast5years; activeinproductinlicensing. 3rdlargestinIndia;AIsconstitutelargesttherapysales; launchedprojectViraattopropeldomesticbusiness. 5thlargestinIndia;morethan60%ofsalesfromchronics; leaderinCNS,CVS;amongstleadingcompanyinantidiabetics, GI. 60%ofsalesfromchronictherapies;amongstthetop5 companiesintheCNSandCVS;6brandsintop300. c60%ofrevenuecontributionfromchronictherapies;4th largestinCVS;3brandsintop100,5intop300.

18.4% 30.1% 5.0% 2.8% 1.4% 2.5%

Source:Company,Bloomberg,AvendusResearch*C/Yendedcompanies,**SUNPadjustedforVATandINR2bnexcesssalesinFY09

Exhibit27: Valuationsummaryofkeystocksmentionedinthisreport(asonJuly11,2011)
(INRmn) Rated BIOS CDH CIPLA GNP LPC PIHC TRP UL Unrated DRRD SUNP GLXO* RBXY* CMP (INR) 3,675 NetProfit 3,113 4,029 18.4 34.7 12.0 17.0 19.3 EPS 15.6 40.2 13.4 24.0 18.9 119.0 37.0 10.6 MCap/Sales MCap/EBITDA 19.5 27.1 27.2 18.1 23.6 0.5 20.8 15.5 26.1 28.7 35.2 15.5 P/E 23.0 23.4 24.5 12.8 24.1 3.3 18.0 15.4 18.9 25.0 29.8 23.8 17.8 19.5 19.5 14.3 19.6 3.3 15.0 11.5 16.6 21.1 26.4 16.0 MCap Mar11 Mar12f Mar13f Mar11 Mar12f Mar13f Mar11 Mar12f Mar13f Mar11 Mar12f Mar13f Mar11 Mar12f Mar13f 20.1 2.6 3.5 2.9 12.7 13.310.8 48.4 4.2 3.6 3.1 19.016.013.5 16.8 4.2 3.8 3.3 19.717.514.3 21.4 2.8 2.3 2.1 13.9 8.4 9.0 23.3 3.5 3.3 2.8 17.3 16.113.4 121.9 2.6 1.8 1.8 80.4 3.23.2 44.2 2.6 2.3 2.0 14.5 11.810.2 14.2 1.8 1.7 1.5 9.89.67.5

358.1 71,620 941.4 192,740

7,1108,224 9,905

328.2 263,519 9,671 10,750 13,519 306.5 82,843 4,578 6,486 5,775 456.5 203,713 8,625 8,443 10,381

397.5 66,466 128,837 20,601 21,100 767.3 665.0 56,265 2,702 3,133 3,739 31.9 163.5 14,755 504.9 520,000 952959 1,284 10.5

1,539.8 260,700 9,989 13,661 15,592 59.1 81.4 92.5 3.5 2.9 2.6 16.913.211.8 18,161 20,965 24,273 17.6 20.2 23.9 9.1 7.1 6.1 26.4 22.018.6 2,329.4 197,307 5,606 6,3877,652 66.2 78.1 88.2 9.2 8.1 7.1 25.6 22.319.4 550.9 232,129 14,968 9,989 14,940 35.6 23.1 34.4 2.6 2.5 2.2 12.4 14.0 10.7

Source:Bloomberg,AvendusResearch

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I,MonicaJoshi,PGDBM,researchanalystandauthorofthisreport,herebycertifythatalloftheviewsexpressedinthisdocumentaccuratelyreflectourpersonalviewsaboutthe subject company/companies and its or their securities. We further certify that no part of our compensation was, is or will be, directly or indirectly related to specific recommendationsorviewsexpressedinthisdocument.

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DisclosureofInterestStatement(asofJuly11,2011)

Indiancompanies Alembic AventisPharma Biocon CadilaHealthcare Cipla Dr.ReddysLaboratories FDCLtd GlaxoSmithKlinePharmaceuticals GlenmarkPharmaceuticals IndocoRemedies IpcaLaboratories Lupin PanaceaBiotec Pfizer PiramalHealthcare RanbaxyLaboratories SunPharmaceuticalIndustries TorrentPharmaceuticals UnichemLaboratories ZydusWellness Internationalcompanies AbbottLaboratories

Analystownership ofthestock No No No No No Yes No No Yes No No No No No No No No No No No No No

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