Hey! In one of my earlier posts I had talked about Investing in Optionalities, which I followed up with a post on How to Find & Evaluate such Optionalities. In this post I am going to talk about Natco Pharma.
Natco is one of the finest examples of an Optionality led business that is headed by one of the most Astute management who understands Optionality Thinking.
The Business- Innovation Challenger
If I were to summarize the business model of Natco, it would be that they are Innovation Challenger.
Generic drugs business has become highly competitive globally as there are a large number of players targeting the same opportunities, resulting in lower profitability. Natco’s business model from the very beginning has been to avoid participating in such highly competitive areas.
And one of the primary ways to accomplish this strategy is to challenge an innovator drug’s patents. And in the US market, there is a proper process through which generic pharma companies can do exactly this.
Para IV/FTF Business Model
In the US, for any pharma company to launch a generic version of a drug, it has to file an application with the FDA (Food & Drug Administrator) called as ANDA (Abbreviated New Drug Application). And there are multiple types of ANDAs.
1. Para II- A Para II filing is made when a drug is already off patent.
2. Para III- A Para III filing is made when the generic company has no plans to sell the drug until the innovator drug is off patent.
3.Para IV- A Para IV filing is made by a generic company when it believes that its product does not infringe on the innovator’s patents or it believes that the innovator’s patents are not valid or enforceable.
The innovator in this case has 45 days to challenge/sue the Generic company for its patents. If the innovator does this, then the FDA holds the generic approval for 30 months or till the patent litigation is clear (whichever is earlier). Based on the outcome of such a patent case either by court or mutual settlement, the FDA then approves/disapproves the ANDA.
The interesting part here is that, the first generic company that makes a Para-IV filing and clears the patent litigation gets 180 days exclusivity; and this is called an FTF filing (First-to-File). This exclusivity ensures that such generic company is the first company to market the generic version of the drug before everyone else and thus is able to garner large market share.
Natco has been able to do quite well in the US markets which it entered near 2010 on the back of its strategy to focus only on niche opportunities, with multiple key firsts to its name.
Natco currently has a strong pipeline of such Para-IV filings that will play out in this decade. In the near term, gRevlimid is the key opportunity that will play out from FY22; will discuss Revlimid separately later.
Within the Domestic business as well, Natco has the same playbook of going after complex, difficult to enter and patented products.
In domestic business, Natco’s primary focus has been on the high value and less competitive Oncology (cancer related) products wherein the company has a history of challenging innovator’s patents to launch generic versions of oncology drugs at affordable prices for the first time in India. Natco is the leader in the domestic oncology space with ~20% market share.
And here as well, Natco has quite few feats on its name.
Natco’s first launch in the oncology space was a generic version of Gleevac (imatinib mesylate) under the brand of Veenat. Natco was among the few companies that were challenged by the Innovator Novartis for patent infringement that resulted in the famous Novartis v. Union of India & Others case which was the first time in India when a patent litigation was fought. After this Natco continued to launch various other drugs in its Oncology basket.
In 2011, Natco had applied to Bayer for a license to manufacture & sell its cancer drug Nexavar, which Bayer rejected. Owing to this, Natco challenged Bayer’s patent by invoking section 92 of The Patent Act, 1970, that allows a 3rd party to make use of a patent without the permission of the patent holder if certain conditions are fulfilled. In 2012, Natco became the first company (probably the only one till now) in India to receive a compulsory license against a patent and was able to add the generic version of Nexavar to its oncology basket of products.
In 2015, Natco entered the Hepatology segment when it launched 3 key products in the segment that it in-licensed from Gilead and Bristol Myers Squibb. Natco was able to quickly capture 60% of the market through these products as it was an early entrant and also because it was able to establish a strategic tie-up with Laurus Labs for quick & competitive access to key APIs (raw materials for drugs).
In 2017, Natco entered the Cardiology & Diabetology segment in the domestic market with the same strategy. It has already launched a few products in this segment, some of which are first time launch in India and has already challenged patented drugs in the segment from the likes of Astrazeneca (Brilinta & Farxiga) and Bristol Myers Squibb (Apixaban).
In another testament to its business model, Natco is looking to enter into the Domestic Agrochemical space with the same strategy. Natco is looking to be the 1st generic player for CTPR products which are currently patented products of FMC Corporation (Large American Chemical Company). Natco has already received approval for these products and is currently facing patent litigation in courts, a decision of which is expected in a few months. If successful, this would be another feat for Natco and a large opportunity given that the end market for these products is quite large at over Rs2000 crores. Second product that Natco is looking to launch in this segment is the first of its kind product in India for cotton crops, the technology for which it has in-licensed from an Indian company.
To sum up Natco’s business model and If history has to show for anything, it is that Natco is focused on niche opportunities that involve Complexities and Innovation Challenges.
Management-
In my earlier post of How To Find & Evaluate Complex, Non-Linear and Optionality Opportunities, I had highlighted the importance of an Astute Management in Optionality driven Opportunities and listed few points to judge the management from the Optionality point of view-
1. Management should not be someone who is comfortable with status quo; they should be open to identify & execute on Optionalities.
2. Management needs to understand probabilistic and optionality thinking, which is all about Risk:Reward balance.
3. Management should also have the bandwidth to execute such opportunities like access to capital or an inside view of a new opportunity.
Natco’s long and continued focus on catering complex & optionality driven opportunities that involves litigations with high Risk:Reward dynamics but offers non-linear growth is a true testament of management understanding of Optionality here. And it is not only that they have followed this business model in the US markets, but it is something that they have followed in every business segment that they have ventured including the Domestic Formulations earlier and now the Agrochemicals segment.
And it is not just that they are only chasing the large optionality led opportunities, but they also clearly understand the risks attached to such a business model and have looked to manage the same. In its early days in the US markets around 2010, even though Natco was just a small company with <1000 crores of market cap, it was pursuing litigation on several large opportunities like gCopaxone which was a $3.4 billion drug at that time.
Snippet from FY13 Annual Report Highlighting the opportunities being targeted by Natco-
In order to finance the litigation for such massive opportunities and to address adverse impact of such litigations, Natco earlier settled for lower profit sharing of ~30-33% with its marketing partners than the typical 50%, such that a large part of such risks was borne by Natco’s marketing partners. An interesting fact here is that as Natco as a company has grown bigger and as its capacity to bear risk has increased, Natco is now entering into a larger 50% profit sharing deals with its marketing partners for newer products like gImbruvica. This is a clear indication that management is looking to capture a larger pie of the profits from the opportunities as its risk bearing capacity increases. In the recent concall, management here has even indicated strong intentions to establish its own front-end marketing presence in order to increase its share of profits to 100%.
(Note: In the US generic business, most small-mid size Indian companies do not have a front-end marketing presence and so they partner with established companies in the US wherein the Indian company is responsible for R&D and manufacturing, while the US partner looks after the approvals and marketing. In typical arrangements, the Indian company gives the drugs to the US partner at cost, which are then sold by the US partner. And then the net profit & loss is shared between the companies. Typically, the deals are 50:50 profit sharing)
Here are few snippets highlighting Natco’s Management take on the Risk:Reward dynamics of their Optionality led business model-
FY14 Annual Report-
Natco’s Q4FY19 Concall-
Natco’s Q4FY21 Concall-
Another interesting thing that I have observed is that Rajeev Nannapaneni understands how to use capital markets to Natco’s advantage (in a legal way and not something that hurts minority shareholders).
If one looks at the capital history of Natco over last 10 years, the company has raised fresh capital four times and each time the capital raise was at opportunistic time when the stock was at new highs. Similarly, when the stock was stagnant and was trending lower over the last 3 years, the company did a buyback at an opportunistic time at lower levels.
There is one more interesting event here- When the company raised capital from CX Partners in 2013, it also signed an upside sharing agreement with the investor such that if Natco is able to deliver a return greater than certain IRR, then the investor (CX Partner) will share a part of such extra returns with the company. Natco actually received Rs48 crores in FY20, when CX partners fully exited the company.
This is some another level display of skills in leveraging capital markets for value creation for the shareholders. Natco’s market cap has grown by over 40x in the last 10 years.
Issues with the Business Model
Till now we have discussed all the good parts of Natco, but there is one major issue in Natco’s business model- at least from the long-term perspective.
The generic drugs business (specially in the US) is one that de-grows over time. Once a drug goes generic it increasingly faces competition from an increasing number of players, all of whom are looking to grab a share of the market. This results in a sharp fall in prices of the drug, which can be as high as 90% in 2-3 years, so the business from a particular drug in most cases is trending lower. This puts a pharma company in a peculiar situation such that the new drug launches not only have to cover up for degrowth in existing business, but also have to provide for growth over and above that for business as a whole to grow. And this is one of the issues that was being faced by large Indian pharma companies over the last few years wherein pricing pressure is existing business was not being covered by the new launches.
This problem is even more accentuated for Natco’s business model wherein the portfolio is concentrated in few select niche opportunities wherein Natco is either the 1st generic player or among the select few players who enjoy very high profitability in the initial period and once the competition comes, which it eventually does (even though relatively later given the FTF and Complex drugs) the fall is even more pronounced. This results in business seeing a huge jump when a new drug is launched and if there is no new major launch to cover up for reduction in profitability of previous launch then the business can see major decline.
Natco has faced this very issue in the last few years.
(Edelweiss report highlighting degrowth in Tamiflu which was cushioned by new Launches of Copaxone and Doxil)
Going ahead gCopaxone is going to face pressure as well given that more generic players like Biocon and Dr.Reddy’s are looking to enter the market which is currently held by only 3 players including Natco.
In the domestic business as well, Natco has faced some challenges in the last few years. Within the Domestic Oncology segment, the company has faced pricing pressures due to pricing control enacted by the government in some of Natco’s products. Then in the Hepatology segment, the business has decreased from a peak of Rs480 crores a year to Rs120 crores a year due to increased competition and also due to the fact that the disease is acute in nature wherein the patient is cured and does not require the drug after initial treatment.
Natco’s management is cognizant of this issue in their business and is looking to address the same with various initiatives to broad base its business. Company has over the years diversified into other export markets of Canada and Brazil. Within the domestic business, the company has expanded its product base by foraying into additional segments of Cardiology & Diabetology. Further, entry into the Agrochemical segment is on the back of the same plan to diversify the revenue base.
Snippet from Q3FY21 concall wherein Management acknowledged the same and highlighted the initiatives-
Revlimid Opportunity
Revlimid is a drug used for treatment of multiple myeloma (a form of cancer) and is among the top 5 selling drugs globally with global sales of ~$12 billion and ~$8 billion sales in the US. The drug is under patent protection till 2027 and is owned by Celgene (part of BMS). Celgene has settled patent litigations with five companies including Natco, which will allow generic companies to enter the market in 2022 with volume limitations till 2025 and without volume limitations in the last year of patent in 2026 post which drug will go generic.
For a large section of the market, Natco Pharma is all about the Revlimid opportunity and yes, it is going to be a big catalyst that will drive numbers for Natco over the next few years.
Natco was the first Para-IV applicant for this drug and has settled first with the innovator Celgene in 2015. Under the terms of settlement, Celgene will allow Natco (with its Partner Teva; 33% profit share for Natco) to sell generic version of Revlimid from March’22 with volume limitation of mid-single digit % of total volume dispensed in US during 1st full year. Volume limitation will increase gradually every 12 months up 33% till March’25. Natco will then acquire a license to sell generic version of Revlimid without volume limitation commencing in January’26.
This is a massive massive opportunity for Natco given that the end market is worth over Rs50,000 crores and Natco’s market cap currently is ~20,000 crores. Plus, Natco would be the 1st company to launch the generic version before other companies as all other settlements have indicated a launch date sometime post Natco’s launch date of March’22; most likely other players will enter sometime in August’22 which covers 180 days exclusivity to Natco.
Further, there are some indications that Natco has the highest ceiling of volume limitation among all companies; other companies might be limited to a single digit % in the final year of 2025 compared to Natco’s 33%. This should theoretically mean that Natco will continue to see increasing market share over the next few years till 2025.
Revlimid has been one of the most anticipated generic opportunities of this decade with ten players challenging innovator’s patent. Of these five players have already settled with Celgene and the remaining five might also settle in the coming time, this can crowd the market and thus reduce the attractiveness of the opportunity for Natco.
Plus, this is one of the unique cases wherein an innovator has settlement with multiple players with certain volume limitations. So how the market formation will happen for such a drug is extremely difficult to anticipate. Companies like Natco, Cipla and Dr Reddy all of whom have settlements for Revlimid have avoided giving any specifics into how they expect the market formation to happen.
Theoretically, if all the companies have limits as to how much volumes they can sell and thus can grab only a limited market share, the competitive levels for Revlimid should be in check and the price erosion should be limited. But in the real world scenario, the actual market formation could be totally different.
Cipla in one of their concall have stated something on similar lines and has also cautioned that a situation like this has never happened and thus they can be totally wrong about it. Bristol Myers Squibb (owner of Celgene) has continued to maintain a stance since the acquisition of Celgene in early 2019 that they expect Revlimid revenues for them to fall in a slope fashion and that they do not see a sharp & dramatic fall till 2026.
Cipla’s Q3FY21 Concall-
In totality the market formation is unclear and extremely difficult to anticipate.
The best scenario for Natco would be a situation wherein the market does not witness major pricing pressure and thus with growing volume limits each year, Natco will be able to deliver continued strong growth till FY26 in Revlimid sales and it being a large product, Natco as a whole will also deliver strong growth year-after-year.
The worst-case scenario would be that post the entry of remaining players who have settled and possible future settlers, the price erosion is so large that increasing volume limits are not sufficient to grow Revlimid sales, in which case Natco will see Revlimid sales peak in FY23.
And this is one of the major hurdles for Natco from a medium-long term perspective, depending on when Revlimid sales peak, it could put Natco in an extremely difficult position wherein there won’t be enough other opportunities for Natco to scale to the peak created by Revlimid and grow over it. Even though Natco does have a strong Para-IV pipeline, but at the moment all those opportunities together are less than the current Revlimid opportunity.
But without doubt Revlimid would be a game changer for Natco and Natco will make large profits given a massive opportunity size (Natco has a settlement for Canada as well, with launch in 2022), first launch and a possible larger market share limitation.
But the question is how much will Natco make and for how long?
To Summarize-
The Good-
1. Natco has a unique business model led by capable management who understands Optionalities.
2. Revlimid would be a game changer for the company as it is a huge opportunity wherein Natco has a better settlement.
3. Huge cash flows from Revlimid in the hands of such a management could lead to Natco materializing some interesting Opportunities & Optionalities.
4. Focus on broad basing the revenues through initiatives like Agrochemicals, Expansion into other areas in the Domestic business and Other Foreign markets would help reduce the volatility in the business while keeping its unique business model intact.
The Bad-
1. Near-Medium Term is fully driven by a single product opportunity of Revlimid wherein the market formation is hard to ascertain.
2. Revlimid can result in a large peak post which the business can go through a period of lull trying to catch up to previous business peak.
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