Quarter Review – July 2024 – India at midcycle?

Indian equity markets continued to deliver strong returns up 10% YTD in USD terms. Post elections, belief in continuity of the government policies of fiscal prudence and focus on supply side has resulted in continued outperformance of the cyclical sectors.

The business cycle bottomed out during Covid. Post Covid government kick started the capex cycle, private and household sectors have yet to meaningfully participate. In the last cycle GFCF/GDP peaked at 34% in FY12. It bottomed out at 27% in FY21 and reached 31% in FY24. The excess of the last cycle in balance sheet of banks and corporates have been cleaned-up with potential for upturn in corporate credit growth. Any major global setback is the key risk to the cycle.

Markets discount the future and the cycle upturn is reflected in the outperformance of small caps and cyclical sectors. While all indicators suggest that the cycle is not yet at its peak, for bottom-up stock pickers it is essential to ascertain how much is already discounted in the price.

Indian markets continue to report strong performance

Source: ELC, Bloomberg

Cyclical sectors continue to outperform

Source: ELC, Bloomberg

Stable macro – GDP growth to sustain at 6.5-7%

Source: ELC, MOSPI, RBI, Kotak

Private corporate and household capex yet to pick-up and leverage at all time low

Source: ELC, RBI, ACE Equity, *2100 listed cos excluding Financials & ITs

Markets trading at higher end of the trading range supported by strong domestic inflows

Source: MOSL

As discussed above, the macro backdrop is positive, but our focus remains on bottom-up stocks. In this note we take a closer look at the CDMO sector.

Contract Development and Manufacturing Organisation (CDMO)

CDMO undertakes contract development and manufacturing work for mainly new drug candidates (and/or generics). The key driver for the CDMO market is the underlying global pharmaceutical market which is expected to grow at 7-8% over the next 5-7 years. The last decade has seen introduction of biologic drugs which have taken a larger portion of the overall market over last decade. However small molecules drugs continue to remain important.

Source: ELC, Bernstein

India’s strength lies in its chemistry skills and hence the focus of the Indian CDMO players is on the small molecule drugs. This market is expected to grow at 5-6% over the next 5-7 years. The CDMO for small molecules is very fragmented. Smaller biopharmaceutical companies have a larger share of new drugs in the pipeline.

Source: Lonza

Although the industry is fragmented, not all companies scale and succeed. This is a B2B business and hence relations developed over the years become very important. Breadth and depth of service offered, manufacturing capacities created, superior execution is critical for success. The chances of success of a compound in R&D pipeline are low and hence the number of commercial assets vs early-stage compounds in the portfolio will determine the resilience of the business.

We look at three CDMO players Divi’s Labs, Laurus Labs and Neuland Labs more closely below:


Divi’s Lab

Divi’s Lab has been the most successful CDMO player from India. Strong chemistry skills, deep relationships with MNC pharma; judicious capital allocation has seen the company growth earnings by 22% CAGR from FY11 to FY16 and stock price also gave a similar return. The company faced FDA issues in FY16 which was a minor set-back and they quickly resolved the same. During COVID, the company got a huge opportunity to quickly scale up COVID drug molnupiravir for global supply to Merck which gave a one-time revenue boost. The company is expected to grow earnings by 25% over the next three years, however the market fears a lack of large opportunities to continue to drive earnings over the long term.

Source: ELC, Company

Laurus Labs

Laurus Labs is pivoting its business model from a generic ARV player to a CDMO player. The company history has been driven by generic product cycles for ARV’s. However, the company has strong chemistry skills and has been very aggressive in creating capacities for CDMO business. Investment in capacities has impacted margins and stretched the balance sheet at present. While in the long term Laurus should succeed, the lack of visible late stage CDMO pipeline is the risk for the medium-term. Current valuations reflect high market expectations.

Source: ELC, Company, * Market CAP CAGR FY17-24

Neuland Labs

A relatively small player but focused on CDMO since 2012. The first success came about in 2019. Given its size, the company has been working with smaller biopharma players. It has very good late-stage pipeline with two drugs commercialized and 2 more getting to market shortly.  As these molecules ramp, it gives 20-30% growth visibility over the next 3-4 years and steady cashflows for 7-8 years.  Increased cashflows will give the ability to invest in capacities and newer technologies like peptide chemistry. The company has a funnel of 80-90 molecules at various stages of development. Neuland was working on a stage 3 molecule with Karun Therapeutics. Karuna was recently acquired by Bristol Myers Squib for US14bn. This acquisition gives Neuland a chance to get entry into big pharma space. We have recently added Neuland laboratories to our portfolio.

Source: ELC, Company

As you would notice from our above discussions, we are always keen to evaluate opportunities that have a long runway and identify companies within these set of opportunities that have the capabilities to scale up and deliver profitable growth. It is equally important that when we buy into these opportunities the valuations are reasonable.

To sum up, India remains a strong macro story. There are and will be several opportunities that are available to us. The key is to identify the ones that can deliver strong long-term growth and are available at reasonable valuations.