Archive for the ‘Competitive advantage’ Category.

 

I have written (see here) earlier on the pharma industry in 2005. A few high profile patent challenge losses in 2005 and 2006, brought down the valuations for several companies. My basic thoughts about the industry have not changed

I have been analysing the industry further recently and can see two different business models.

The Domestic market focussed model

Most MNC’s like novartis, merck, pfizer come under this model. The key characterisitics of the model are

1. Subsidiary of a global MNC operating in india for the last few decades
2. The subsidiary operates as an extension of the global company and due to the patent law in the past, has introduced mostly the off-patent drugs.
3. Strong brands, marketing network and good return on capital and strong competitive advantage.
4. Possibility of introducing the drugs from global portfolio. However in some cases the parent company has an unlisted subsidiary and hence treats the listed one as a cash cow. In such cases the market is rightly giving a lower PE multiple due to the poor corporate governance attitude of the parent.
5. Strong cash flows due to minimal R&D and very low assets in the business as most of the manufacturing is sub-contracted.
6. Low growth in domestic market, marked by constant price controls (DPCO and new pharma policy) by the government on various essential drugs. This has resulted in poor topline and bottomline growth for several companies solely dependent on the domestic market.

The International market focussed model

1. This model is followed by the indian pharma companies such as ranbaxy, dr reddy’s, nicholas pharma etc
2. These companies are in the process of globalizing. Their approach to it has been through the drugs which are coming off patent (generics strategy). These companies have built a strong R&D infrastructure in india to develop these drugs coming off patents. They also have a marketing and legal infrastructure in foreign markets to file ANDA and other applications for these drugs as soon as they come off patents. If these companies win these cases, then they get a 180 day exclusive marketing period for these drugs. Post the exclusive period too, these companies are able to maintain good market shares. Thus these companies have created a value chain of R&D labs in india, and a distribution, marketing and legal infrastructure abroad to funnel these new drugs coming off patents.
3. These companies are following riskier strategy as these legal challenges are costly and if the company loses one, the entire money is down the drain.
4. The market was pricing earlier as if each of these ‘bets’ would pay off. However due to some high profile failures in the past, the market has started pricing the risk of the strategy now.
5. Some companies are also acting as outsourcers for the global pharma companies. This is the contract or custom manufacturing business. There a large no. of FDA approved facilities in india ( second largest in the world). Several indian companies now provide advanced manufacturing facitility to global pharma companies and are now doing accquisitions in this space to accquire complementary assets abroad.
6. The third segment of this model is the R&D segment where some of the top companies are now investing heavily in R&D to develop NCE and NDDS. Some of the molecules are now in the stage I and Stage II trials. Some companies such as DRL have licensed these molecules to other companies and they get royalties based on milestones. This is a high risk, high return startegy. However it is likely the larger pharma companies in india could go down this path and emulate their global counterparts.

It is easier to predict the cash flow and valuation of the domestic model as the overall business risk is lower in that model. The international business model has a higher upside, however the valuation seems to reflect that upside in several instances. All these international market focussed model has ‘real options’ embedded in it. However I do not have the skill to do the valuation of these options. It is often difficult to predict which Patent challenges would be successful and which ones will fail

For additional detail on the pharma industry see here. The article is dated, but useful to understand the various terms such as ANDA, Para I,II etc.

There are several good stocks in the pharma industry available at reasonable valuations. I have discussed about merck earlier. In addition I am looking at novartis and alembic too.

Caution : Stocks which i look at generally perform poorly in the short term as they are undervalued. Please do your own research before investing in them.

 
 

I was reading a book on economics and found the following basic types of competition

– Perfect monopoly
– Oligopoly or duopoly
– Monopolisitic competition
– Perfect competition

I find the above types instructive and a good way to analyse the long term economics of an industry. Let me define the specifics of each type and add a few more subtypes under each

Perfect monoply – As the name suggest, there is just one firm and can charge any price it wants. Obviously this is more in theory than practise, although we have had several monopolies in india till date. Overall monoplies are very profitable (if private) for the investor and bad for the consumer. Several examples come to mind – BSNL, MTNL, Indian airlines (in the past) and now Indian railways. These were (or could have been) extremely profitable (excluding railways) even after all the mismanagement and waste. In a nutshell a perfect monopoly or a close one is extremely profitable for an investor. I would also define a company a monopoly if it has a huge market share in its specific segment and can hold on to it due to some competitive advantage.

Oligopoly or duopoly – A limited number or just two firms in the market. Although not as profitable as a monopoly, I would say these companies are quite profitable and extremely good investments for the long run. Several companies come to mind in this group. For ex : Crisil and other rating agencies, asian paints and other paint companies. One specific point worth noting is that the barrier to entry in this industry are high and hence new entrants cannot enter easily into the industry. As a result the incumbents can earn good profits.

Monopolistic competition – A large number of companies with limited profitability. Barriers to entry are not too high and as a result new companies can enter the industry more easily. I would say most of the commodity companies fall under this group. For ex: cement, steel, Auto, Telecom etc. Few companies in this kind of industry enjoy high profits and generally the lowest cost provider has some kind of competitive advantage. As an investor I would look at companies which have some kind of low cost advantage, some other local or national competitive advantage and a good management. Bad management in such an industry can kill the company.

Perfect competition – A ideal or theorotical construct more than a practical scenario. In such an industry there is no competitive advantage at all, all companies are price takers and they earn only the cost of capital. I would say very few industries would fall in this group. Brokerage firms come close to perfect competition, but still this is more theory than reality.

The way to classify an industry in anyone of the above groups is to look at the following variables
– no of companies in the industry controlling 60-70% of the sales in the industry
– Avg profitability of the companies
– Relative Market share changes between companies over a period of time

By doing the above analysis, one can figure out the level of competition and as a result have a rough idea of the long term economics of the industry.

The above analysis is just a rough guideline or a starting point of a more detailed analysis of the industry and individual companies. However by doing the above assesment, I am able to understand the intensity of competition in an industry over a period of time

 
 

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )

But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?

According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.