Ind-Ra-Mumbai-12 March 2020: India Ratings and Research (Ind-Ra) believes the Covid-19 outbreak is unlikely to impact the credit profiles of Ind-Ra rated pharmaceutical companies in the near term, despite the pharma industry’s heavy reliance on Chinese activated pharmaceutical ingredients (API) and intermediates. Nonetheless, in case the supply disruption continues over the next three-to-nine months, the pressures on credit buffers could intensify and rating transitions would be imminent, especially in case of the entities rated ‘IND A’ and below. Furthermore, if the disruption spills beyond the next nine-to-12 months, some of the higher rated corporates could face downward pressure.
Limited Backward Integration for Indian Formulation Players: China is the world’s largest exporter of APIs and intermediates. Approximately 70% of India’s total API requirement is met by imports from China. Ind-Ra’s portfolio consists of 19 pharma-formulation manufacturing issuers that are rated ‘IND A-’ and above. Among these entities, only nine have their own API manufacturing facilities, and only one entity manufactures intermediates. The degree of backward integration is lower for players rated ‘IND A’ or below, thereby making them more vulnerable to supply disruptions vis-à-vis higher rated players.
Even in the case of issuers who are backward-integrated, their own API and intermediates manufacturing capacities might be able to cater to only a limited portion of their requirements. Furthermore, players with API manufacturing facilities too are likely to be dependent on Chinese imports for supplying the intermediates necessary to manufacture APIs.
Additionally, Ind-Ra’s coverage includes 6 API manufacturers, of which 3 of them are integrated backward and have intermediate manufacturing facilities.
Current Disruption Could be Worse than Supply Shortfall in FY17: In FY17, the pharma industry had witnessed a disruption in supplies from small and mid-sized Chinese API and intermediate product suppliers. This has provided a valuable baseline scenario for the agency’s analysis. In FY17, a change in environmental regulations in China had forced many players to either upgrade their manufacturing facilities or shift their production facilities to other parts of the country. The resultant supply disruption had led to increased volatility in API and intermediate prices across the globe. However, the production returned to normal levels within two quarters. Therefore, while Indian pharma-players were definitely affected by the shortfall, the impact on their profitability was short-lived.
With respect to the Covid-19 issue, however, if the outbreak is not contained over the next three months, the extent of disruption in supply is likely to be far greater than that in FY17, resulting in pressures on cash flows of pharma-formulations players.
Lower Rated Players at Higher Risk; API Players Could be Less Affected: Ind-Ra’s analysis indicates that the headroom available to players rated ‘IND AA-’ and above is significantly higher vis-à-vis those with lower ratings. Given the low degree of backward integration, the agency believes that half of the companies in the ‘IND A’ category could face pressures on their credit metrics in the next three-to-nine months. On the other hand, majority of the companies rated ‘IND AA’ and ‘IND AAA’ have the liquidity buffer necessary to absorb the effect of lower capacity utilisation and pressures on margins, if any – even up to the next 12 months.
The immediate pressure is likely to be low, given that most pharma players tend to increase their inventory levels in December in preparation for the Chinese New Year leave in January/February. Ind-Ra understands that these players, thus, have adequate inventory to carry on their production without any major disruption at least for the next one month.
API manufacturers are likely to be affected in the near term, given that they remain dependent on imports from China to meet the demand for intermediates, which are necessary to manufacture APIs. Nonetheless, the impact of lower asset turnover could be offset by the rise in prices of APIs, in India and globally, on account of a shortage in Chinese supplies. This could mitigate the credit impact on API players, at least in the near term.
Higher Share of Exports Likely to Augur Well for Formulation Players: The ability of Indian players to pass on the increase in API prices in the domestic market is likely to be restricted. Some products are covered under the price control regulations, wherein prices typically move in line with the wholesale price index. For the other products, price hikes are required to be restricted to up to 10% in any given year. However, there are no such restrictions in the export markets. With global API prices likely to go up, formulation manufacturers globally are likely to be able to pass on the rise in production costs.
Given the high share of exports across the industry, Ind-Ra believes that the ability to maintain or even increase margins in the exports market could extenuate some of the pressures on the cash flows of the pharma players.
Alternate Suppliers Could Ease Some Pressure in Short Term: Since FY17, several Indian formulation manufacturers have diversified their supply chains away from China, with the absolute quantum of API imports falling sharply to USD408 million in 2018 from USD866 million in FY14. However, the reliance remains high.
Various American, and Central and Eastern European countries too are major suppliers of APIs. However, with the gradual spread of the Covid-19 to large parts of Italy and Spain, supplies from Central European countries are likely to be affected in the near-to-medium term. This would provide an opportunity to Eastern European, American and other suppliers to ramp up their production and partially bridge the gap created by the relatively low supplies from China in FY21.-MB Bureau