India Ratings and Research (Ind-Ra) opines that the likely pick-up in United States Federal Drug Administration (USFDA) inspections during 2023 and 2024, while having an impact on some facilities and entities, will be less disruptive for the sector compared to the situation during 2015-2016.

Indian pharma companies have increasingly de-risked their operations to mitigate cash flow impact of this disruption by slowly and steadily increasing sales to non-US markets, focusing on high margin and high RoE branded generics, and increasing the share of API manufacturing. Additionally, companies have worked towards strengthening their processes with the help of global regulatory consultants and improved training and automation to comply with USFDA requirements.

Also, entities have focused on diversification, in terms of production facilities across geographies and using third-party filings. However, players with significantly higher exposure to the US markets and a low level of diversification could still see some impact if FDA inspections are unsuccessful.

The anticipated pick-up in inspections could also provide clarity and visibility on the facilities awaiting approvals for the past three to four years with some of them already receiving the necessary approvals in 2022. Moreover, given the pick-up in inspections, Ind-Ra sees some possibility of lowering competitive pressures in the existing abbreviated new drug applications (ANDAs).

During the absence of inspections in the past two years, the competition had increased in the existing ANDAs and the proportion of new ANDA approvals to existing approvals had fallen, resulting in pricing pressure becoming much more pronounced. In Ind-Ra’s opinion, the increase in the proportion of Official Action Indicated (OAI) in 2021 and 2022 largely reflects the low base of inspections, and this is likely to revert to its historical rate of 10-15% as the inspections pick up.

The top 15 Indian pharma players have continued to experience anaemic growth in the US market over the five years ended FY22 average CAGR of 0.5% compared to an average CAGR of 19.3% between FY12-FY17, given the increasing consolidation of distributors and the resultant pricing pressures.

With EBITDA margins and returns from the US business remaining muted, diversification into other markets has resulted in the contribution from the US declining to 32% in IHFY23 from 39% in FY17, providing cushion to any potential disruption on account of OAIs. Ind-Ra expects the trend to continue as the attractiveness of the US business continues to wane in relation to the domestic market as well as exports to some of the non-regulated markets. Ind-Ra has also witnessed players scale down or close the US operations. Ind-Ra believes that the high proportion of OAIs which increased to 71% and 35% during 2021 and 2022 (till November) reflects the limited number of inspections carried out by USFDA post the COVID-19 pandemic. While these seem high, Ind-Ra expects that the proportion of OAIs from the total inspections carried out to revert to 10%-15% as the pace of inspection normalises to pre-COVID levels

Pharmaceutical companies will continue to benefit from increasing sales contribution of the domestic markets while growth in the export markets could remain flat in FY23. Gross margins for the companies exposed to exports could come under some pressure. API manufacturers will see significant capex on account of the Production-linked Incentive schemes.

The ongoing pressure in the export markets (especially relating to regulated markets) and cost inflation would continue to impact the sector in FY23 compared to its performance in FY22. But overall, the momentum in the domestic market, traction on China+1 opportunities and pickup in new growth markets such as biosimilars would largely offset the pressure from price erosion in developed markets.

The rating outlook for the sector remains stable for FY23, driven by low leverage and adequate liquidity. Few issuer-specific risks driven by vaccine drop-offs and high exposure to crude derivatives could impact EBITDA margins and cash flows and negatively impact the ratings.