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Posted on 17-May-2019 Comments  0

Pharma Stocks

Why pharma companies must take the lawsuit seriously

The pharma stocks had a bad week with the pharma index down by over 4% in the first day of the week itself. It all started with a Reuters news item stating that 44 states in the US had decided to file a lawsuit against 20 generic drug manufacturers, which included 7 Indian companies. The principal case was against Teva Pharmaceuticals but the lawsuit also indicted 19 other generic manufacturers for colluding with Teva for price fixing and artificially inflating prices of essential drugs. How serious could these charges really be?

Charges are serious

The charges are serious because the US continues to be India’s largest target market. The US allows generic drug makers to sell in the US so as to reduce the healthcare costs for Americans. If what the lawsuit alleges is true then Teva and 19 other companies have colluded to hike the prices of some of the essential drugs by up to 1000% in a short span of time. Of course, at these prices, the drugs were still cheaper but then the lawsuit alleges that these kinds of practices defeat the very purpose of allowing generics to function in the US. The seven Indian companies named in the lawsuit include Wockhardt, Reddy Labs, Aurobindo, Glenmark, Lupin, Cadila Healthcare and Taro. Now, Taro happens to be a subsidiary of Sun Pharma so effectively the entire India pharma industry comes under a cloud. The US takes these charges seriously!

How could it impact pharma?

As we have seen in the past, the US has been quite ruthless when it comes to handling cases of corporate frauds, price fixing and artificial inflating of prices. While the damages are hard to ascertain at this point of time, conservative estimates put out by Reuters pegs these penalties could be as high as $2 billion which will include disgorgement of gains and additional penalty imposed as a deterrent on these pharma companies. This needs to be seen in the light of the stringent norms that the US FDA is already applying on Indian facilities under Form 483 investigations. All  this comes at a time when the industry margins are diminishing, competition is hotting up and US pharmacies are consolidating their business better.

It may boil down to politics!

When Trump was elected, Indian pharma had breathed a sigh of relief. That is because Hilary Clinton had actually pledged to take on generic pharma companies and force them to cut prices. But recent actions of Trump have shown that he may not be too far behind when it comes to an opportunity at putting America first. We saw that in the case of China. For the Indian pharma industry, the message is quite clear. There is a long road ahead to redemption. Valuations and margins are unlikely to improve in a hurry. Investors must factor this into their strategy!

Regulating NBFCs

Government has to walk the thin line between regulation and growth

Back in 1997 there were around 40,000 NBFCs operating in India. Then in 1998 the RBI came up with stringent capital adequacy and asset classification norms for NBFCs to reduce the systemic risk after the CRB fiasco. By 2002 there were just about 10 NBFCs that were still functional. The one thing that the 1998 exercise highlighted was the need to strike that fine balance between better regulation and greater freedom to function in the market. The debate is back all over again on NBFCs.

First step on NBFC regulation

During the last few days, there have been two diverse incidents pointing at more stringent regulation of NBFCs. Firstly, the RBI has asked all NBFCs with more than Rs.5000 crore in AUM to appoint a chief risk officer (CRO) who would manage, regulate and modulate the risk of the NBFC on a real time basis. The CRO would be appointed with a fixed term and would report directly into the board of directors. This was intended to create a sounding board to avoid cases like IL&FS and Dewan Housing, where obvious lapses were never brought to light. The second announcement was the decision to hold the independent directors of IL&FS accountable for lapses in highlighting the lapses. This puts a much greater operational onus on the independent directors and could be especially relevant to NBFCs where such risks are most rampant. What does it mean?

Regulation is the right step

There is no gainsaying that NBFCs need to be regulated better for a variety of reasons. NBFCs have moved in a big way to fill the gap left by struggling PSU banks. A lot of semi urban and rural lending is happening through NBFCs, HFCs and MFIs. The PSU banks have found this useful in two ways. The NBFCs work as the last mile credit delivery channels for the PSU banks and banks can also buy out portfolios of such loans from NBFCs to meet their priority sector commitments. But, that also calls for better regulation in terms of capital adequacy, NPA recognition, evaluating asset liability mismatch etc. The cases of IL&FS and Dewan Housing have highlighted that NBFCs can also pose a very big systemic risk to the Indian economy.

Strike the delicate balance

NBFCs in India have reached a stage where they also need freedom to operate. Unlike in 1998, the problem with NBFCs is not about the regulatory framework. The issue is about monitoring and making it work. That is where risk management is a lot more critical. That is why sounding boards like independent directors and CROs become a key instrument for regulating the NBFCs. Unlike in 1998, banks are a lot more willing to give low cost credit to NBFCs and that has reduced cost of funds. Now it is time for the balance!

Soft Bankruptcy

India must handle soft bankruptcy cases a lot more deftly

CRISIL recently published a report about the Rs.70,000 crore collected through NCLT in the fiscal year 2018-19. The collections in the current fiscal are likely to be closer to Rs.1 trillion. According to CRISIL, this represents 43% realization that is at par with global best practices. That is the good news. But it also, at the same time, highlights our systemic inadequacy when it comes to dealing with soft bankruptcies. With hardly any fixed assets, these soft bankruptcies post the big challenge to India. How to go about addressing this issue?

Kingfisher, Jet and IL&FS

One can also include in this list, other companies like Gitanjali and Satyam, which are cases in soft bankruptcy. The big challenge in these cases is that they hardly have any worthwhile fixed assets on the ground and most of their assets are either in the form of goodwill, claims or skills. When the cookie crumbles, there is hardly anything on the books to dispose off. That is where the problem arises, because the implosion in value is substantial. Look at Kingfisher and later look at the way Jet has been handled. IL&FS is another case of corporate bankruptcy which could have been handled better. At the end of the day, it is really doubtful what shareholders could really get back and what would happen to these employees. All the three cases have highlighted India’s inadequacy when it comes to handling cases of soft bankruptcy.

Satyam versus Jet Airways

A test case of handling soft bankruptcy was the way Satyam was handled. It is not just about banks recovering their debt but companies like Satyam, IL&FS and Jet have larger social and economic externalities. In case off Satyam, the government and the MCA moved in quickly to assume control and also brokered the deal with Tech Mahindra. Of course, there was a restructuring and there were job losses too. But, the entire situation was handled with a lot of finesse and speed. Above all, the social and economic costs were kept at the bare minimum. In comparison, Jet and IL&FS look like ending up with nothing. That is where the US model could come in really handy.

Wheat from the chaff

In the US, the government is quick to intervene where the problem is cyclical or where externalities are huge. For example, the US government intervened to save Fannie Mae, Freddie Mac, Citi and GM due to the larger implications. However, the US government was also quick to let the likes of Enron, Bear Sterns and Lehman vanish from the scene altogether.  India needs to adopt this model quickly when it comes to handling soft bankruptcy. Soft bankruptcy allows promoters to get away through forced liquidation. India cannot afford to repeat the mistakes SBI made with Jet. It is time to act fast!

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