Institutional Equities - Nirmal Bang Sector - 1 November 2011.pdf · of drugs under the new list of essential medicines, etc), a ... Companies Torrent Pharma ... Institutional Equities

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A Bitter-Sweet Pill We tested the pharmaceutical sector’s vulnerability to macro headwinds, after it outperformed the broader market by a sharp 7% in the past one year, and have arrived at a conclusion that the current premium of 50% relative to the Sensex is unlikely to sustain because of two reasons: a) The pressure on domestic earnings has not yet been fully discounted by the market and also as research and development(R&D)/marketing costs rise in the wake of intense competition, there is likely to be pressure on the PE multiple, and b) With a growing multinational presence, concerns regarding a hike in drug prices have resurfaced and may trigger policy change by the government (such as stricter scrutiny of foreign investments in brownfield projects, increase in the number of drugs under the new list of essential medicines, etc), a move that will significantly erode the sector’s premium valuation.

Moderation likely in domestic formulations business growth: We see the growth in domestic formulations business moderating to 12-14% in FY12 from 16% CAGR in the past two years as intense competition and pricing pressure in acute therapies dents volume growth. Marketing and R&D expenses, which have so far managed to remain stable, are also likely to increase as companies struggle to maintain their market share.

Regulatory risks resurface: Following the recent spate of takeovers of Indian companies by MNCs, concerns regarding a hike in drug prices have resurfaced, triggering speculation about tackling it through policy measures. Recently, a high-level inter-ministerial-group headed by Prime Minister Manmohan Singh decided to bring all foreign investments in brownfield projects – currently cleared through the automatic route – under the purview of the Competition Commission of India (CCI), rendering it to stricter scrutiny. Further, the talk of a revised new list of essential medicines (NLEM), which will bring an additional 311 drugs under price control (nearly half of the industry’s output, as per rough estimate), has started gathering steam and would cap any near-term expansion in the sector’s PE multiple, in our view.

International markets are harbinger of next growth phase: We believe the international growth drivers led by the US generics market (which is in a multi-year cyclical upturn given the impending patent cliff), and emerging markets (owing to favourable demographics and similarity with the domestic market) still hold and would

partially cushion any erosion in PE multiple

Stock ideas: Torrent Pharmaceuticals (TPL) and Glenmark Pharmaceuticals (GPL), owing to their discounted valuations and strong earnings trajectory are our top Buy ideas, while Sun Pharmaceutical’s near-term growth looks fully priced in and therefore gets our Hold rating. We assign a Sell rating to Cipla because of muted growth profile and declining return ratios. We also have a Sell rating on Cadila Healthcare owing to lack of clarity on growth drivers for its US$3bn revenue target by 2015. Barring TPL and GPL, FY13 PAT estimates for other companies in our coverage universe are 4-10% below consensus estimates, given our expectations of a slowdown in domestic market growth and pressure on margins.

View: Negative

Praful Bohra [email protected] +91-22-3926 8175

One Year Indexed Performance

Source: Bloomberg

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Healthcare index Sensex

1 November 2011

Pharmaceutical Sector

Market cap CMP Target Up/ EPS (Rs) P/E (x) RoE (%)

Company Rating Rsbn US$ bn (Rs) Price Down(%) FY11 FY12E FY13E FY11 FY12E FY13E FY11 FY12E FY13E

Torrent Buy 49 1.0 575 715 24 31.9 38.9 49.7 18.0 14.8 11.6 29.2 28.9 29.9

Glenmark Buy 82 1.7 310 362 17 16.8 19.1 22.4 18.5 16.3 13.8 17.4 18.4 21.3

Sun Pharma Hold 527 10.8 503 513 2 18.0 21.1 22.8 28.0 23.9 22.1 21.5 21.2 19.6

Cipla Sell 239 4.9 295 268 (9) 12.3 14.2 15.7 23.9 20.8 18.8 15.7 16.0 15.4

Cadila Sell 158 3.2 758 743 (2) 34.7 40.5 45.9 21.8 18.7 16.5 37.4 33.2 29.5

Source: Company, Nirmal Bang Institutional Equities Research


4 Pharma Sector

Table of Contents

Stock ratings..……………………………………………………………….……..…..….…..………...….05

High growth expectations leave little room for error………………………………….……………...….08

Pharma sector still a defensive bet ………………………………………………………….……………09

Valuation close to peak level..……………………………………………….…………………………….10

Rising distributor bonus - a lead indicator of slowing volume…………………………………………..10

Torrent Pharma, Sun Pharma are best bets on domestic growth story………….……….……..……14

Regulatory risks resurface……………………………………………………………………..…….…….15

International markets – Harbinger of the next growth phase…………………….……………...…..…17

Collaboration is the new world order…………………………………………………………..…….……20

Companies

Torrent Pharma …..………………………………………...…………………….………….……..….……23

Glenmark Pharma……………………………………………………………………………...…….….…..35

Sun Pharma…………..…………….…………………………………………………………….……..……47

Cipla…………………………………………………….……………………………...…………..……….…57

Cadila Healthcare..…………….……………………………………………………...……….….……..….67


5 Pharma Sector

Stock Ratings

Torrent Pharmaceuticals - Rating: Buy; Target Price: Rs715

Torrent Pharma’s strong domestic formulations business, with 60% of its portfolio focused on chronic therapies, and increasing scale in international business will catapult it to the next phase of growth, leading to 25% earnings CAGR over FY11-13E and sustainable RoE of 30%. A steep 10-20% discount in PE multiple versus other mid-cap stocks implies the market is underplaying the positives and we believe the stock would get re-rated closer to comparable peers.

Glenmark Pharmaceuticals - Rating: Buy; Target Price: Rs362

We remain upbeat on Glenmark Pharma’s base business growth and expect its stock to get re-rated as visibility increases on improvement in its balance sheet. The current PE multiple of 13.5x is at a steep 35% discount to its five-year average and ~30% discount to the sector’s average, which we believe is unjustified, given a 26% CAGR in core earnings over FY11-13E and a robust business model.

Sun Pharmaceutical Industries - Rating: Hold; Target Price: Rs513

With ~25% re-rating in PE multiple in the past 18 months, we believe Sun Pharma’s growth trajectory and Taro-related upsides are well discounted in the share price, leaving very little scope for appreciation. While the company’s premium valuation will stay, led by strong domestic market positioning, healthy balance sheet and robust capital efficiency, we see limited levers for PE multiple expansion, especially in view of a stagnating Para IV pipeline and risk of potential liability from Protonix litigation.

Cipla - Rating: Sell; Target Price: Rs268

Cipla’s partnership-based export model has failed to revive the company’s fortunes despite significant capacity addition, while its domestic business faces intense competition from peers. Key stock catalyst like the launch of combination inhalers is still 15-18 months away, and we believe its subdued capital efficiency following an additional Rs10bn of planned capex would steer further contraction in PE multiple.

Cadila Healthcare - Rating: Sell; Target Price: Rs743

Cadila Healthcare’s protracted rally over the past two years, led by a 48% CAGR in earnings and 928bps/723bps improvement, respectively, in RoE/RoCE, is likely to pause as the current valuation fully captures the strong earnings trajectory and further PE multiple expansion will be capped by the warning letter issued by USFDA in respect of its injectables facility. Moreover, a hazy roadmap for its US$3bn revenue target by 2015 is likely to keep the investors on the sidelines.


6 Pharma Sector

Exhibit 1: Our estimates versus consensus expectations

(Rsmn) Revenue EBITDA EBITDA margin (%) PAT

FY12 NBIE Consensus Variance (%) NBIE Consensus Variance (%) NBIE Consensus Variance (bps) NBIE Consensus Variance (%)

Torrent Pharma 25,054 25,179 (0.5) 4,843 4,521 7.1 19.3 18.0 137.6 3,293 3,269 0.7

Glenmark 34,681 35,809 (3.2) 8,488 9,008 (5.8) 24.5 25.2 (68.1) 5,152 5,940 (13.3)

Sun Pharma 72,364 73,188 (1.1) 23,722 24,099 (1.6) 32.8 32.9 (14.7) 21,845 21,296 2.6

Cipla 70,024 70,678 (0.9) 15,894 15,692 1.3 22.7 22.2 49.5 11,392 11,472 (0.7)

Cadila Healthcare 52,007 53,158 (2.2) 12,199 11,595 5.2 23.5 21.8 164.5 8,295 8,167 1.6

(Rsmn) Revenue EBITDA EBITDA margin (%) PAT

FY13 NBIE Consensus Variance (%) NBIE Consensus Variance (%) NBIE Consensus Variance (bps) NBIE Consensus Variance (%)

Torrent Pharma 28,810 29,632 (2.8) 5,922 5,463 8.4 20.6 18.4 211.9 4,203 3,922 7.2

Glenmark 38,913 40,216 (3.2) 8,899 9,333 (4.6) 22.9 23.2 (33.8) 6,057 6,027 0.5

Sun Pharma 80,136 86,116 (6.9) 26,124 28,632 (8.8) 32.6 33.2 (64.8) 23,609 25,144 (6.1)

Cipla 76,957 81,390 (5.4) 17,248 18,620 (7.4) 22.4 22.9 (46.4) 12,594 13,829 (8.9)

Cadila Healthcare 61,477 63,078 (2.5) 13,873 14,215 (2.4) 22.6 22.5 3.2 9,395 10,223 (8.1)

Source: Bloomberg, Nirmal Bang Institutional Equities Research

Torrent Pharmaceuticals: We are 7% above consensus on FY13 PAT owing to our higher-than-consensus margin forecast of 20.6%, led by increased contribution from Brazil and India (the top two geographies in terms of profitability), break-even in the US business, higher capacity utilisation at the recently commissioned Sikkim facility and operating leverage as other international geographies attain scale. Additionally, we also assume marginally lower tax rate of 17% in FY13 as the utilisation rate improves at the Sikkim facility.

Glenmark Pharmaceuticals: For FY13, our revenue projection is 3% below consensus estimate, while our margin forecast is 34bps below consensus. We assume conservative margin expansion in FY13, as we do not factor in any milestone income in our estimates due to uncertainty on the timeline as well as the quantum. Further, we also factor in lower interest costs on reduced debt and on prospects of interest rates peaking out in FY13, which consequently drives our PAT in line with consensus estimate.

Sun Pharmaceutical Industries: Our FY13 revenue and PAT estimates are 7% and 6% below consensus estimates, respectively, as we expect domestic growth to moderate to 16%, led by a high base of FY12 and slowing growth momentum in Indian formulations market. We also expect modest growth in Taro because of increased competition in its core therapies and key products like Imiquimod cream, which accounts for 5% of our FY12 revenue estimate for Taro.

Cipla: Our FY13 revenue and PAT estimates are 5% and 9%, respectively, below consensus estimates, The sharp variance primarily stems from our cautious stance on the company’s export business, which we believe will remain muted on account of: a) High base of API business because of Olanzapine supply to Teva in FY12, b) Subdued ARV business growth following the company’s focus on participating only in high-margin tenders, and c) Back-ended ramp-up at Indore SEZ, as we expect the USFDA’s approval to come in 2HFY13. Notably, we have also assumed a 20% shift in existing export volumes to Indore SEZ, as we believe the sharp ramp-up in 1QFY12 was partly led by the shift in existing volumes to Indore SEZ.

Cadila Healthcare: We are 8% below consensus estimate on FY13 PAT, as we assume moderate growth for its wellness business in view of increased competition from Hindustan Unilever and Johnson & Johnson and in the absence of new launches planned in FY13. We also expect a back-ended ramp-up in API supply for its JV with Nycomed, as the the latter gets integrated with Takeda. In addition, we assume higher depreciation and interest costs as Cadila integrates Neshers assets with effect from 2HFY12.


7 Pharma Sector

Exhibit 2: Peer comparison

Market Cap

(US bn)

EPS CAGR (FY11/CY10-

FY13/CY12E)

P/E (x) P/BV (x) RoE (%)

FY12/CY11E FY13/CY12E FY12/CY11E FY13/CY12E FY12/CY11E FY13/CY12E

Indian companies

Sun Pharma 10.6 12.6 23.9 22.1 4.7 4.0 21.2 19.6

Cipla 4.8 12.8 20.8 18.8 3.1 2.7 16.0 15.4

Cadila 3.2 15.0 18.7 16.5 5.5 4.4 33.2 29.5

Glenmark 1.7 26.0 16.3 13.8 3.3 2.7 18.4 21.3

Torrent Pharma 1.0 24.7 14.8 11.6 3.9 3.1 28.9 29.9

Ranbaxy* 4.4 3.8 19.9 15.8 3.3 2.8 18.5 19.2

Dr Reddy’s Labs* 5.8 20.5 20.9 18.1 5.0 4.1 26.2 24.8

Lupin* 4.3 18.1 21.3 17.7 5.1 4.1 26.2 25.3

GSK Pharma* 3.6 13.4 26.9 23.3 8.2 7.2 30.9 33.2

Biocon* 1.4 11.1 19.5 15.9 3.1 2.7 17.1 17.9

Aurobindo* 0.8 10.4 7.0 5.6 1.3 1.1 19.8 21.2

Average

15.8 19.4 16.3 4.2 3.5 23.3 23.4

Global comparison

Teva* 39.8 12.0 8.4 7.4 1.5 1.3 17.5 18.4

Mylan* 8.6 21.3 10.1 8.5 2.1 1.8 23.8 25.5

Watson* 9.3 29.7 15.5 12.0 2.3 2.0 15.1 17.3

Average

21.0 11.3 9.3 2.0 1.7 18.8 20.4

*Indicates Bloomberg estimates



8 Pharma Sector

High growth expectations leave little room for error

The domestic pharmaceuticals sector has come off its incongrous highs touched in December 2010, but is still trading at 19.5x one-year forward earnings, or at a 10% premium to its past five-year average. Over the past 18 months, the sector has traded at a 20-50% premium to the Sensex, largely reflecting the strong growth trajectory in domestic market (over 16%YoY growth in FY2009-11 versus 10-12% CAGR over FY2000-09) as well as international markets (US patent cliff, emerging market opportunity, rising genericisation in other regulated markets etc). Further, the unrealistic valuations of Ranbaxy Laboratories (over 5x revenue) and Piramal Healthcare’s domestic formulation business (over 9x revenue) have also shored up the PE multiple as MNCs continue to scout for growth opportunities. The current premium of 50% (relative to the Sensex) is at a five-year high and leaves little room for error, in our view.

Exhibit 3: Sector multiple discounts high growth expectations leaving little room for error


Testing for vulnerability, we see the current valuation premium unsustainable

We have tested the sector’s vulnerability for macro headwinds and have drawn a conclusion that the current valuation premium is unlikely to sustain because of two reasons: a) We believe the pressure on domestic earnings is not yet fully discounted by the market and as R&D and marketing expenses rise in the wake of rising competition, we see pressure on PE multiple and b) With growing MNC presence, concerns regarding a hike in drug prices have resurfaced and may trigger policy changes by the government (such as stricter scrutiny of foreign investments in brownfield projects, increase in the number of drugs under NLEM etc), a move that will significantly erode the sector’s premium valuation. We, however, believe that international growth drivers led by the US (which is in a multi-year cyclical upturn given the impending patent cliff) and emerging markets (owing to favourable demographics and similarity with domestic market) still uphold and would partially cushion any erosion in PE multiple.

Exhibit 4: Indian pharma sector’s current premium to Sensex at five-year high


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9 Pharma Sector

Pharma sector still a defensive bet

Despite a growth profile similar to high beta sectors and lower capital efficiency compared to typical defensive sectors (like FMCG), we believe the pharmaceutical sector still remains a defensive bet during a downturn, given the inelastic demand for drugs. To put things in perspective, even with a contraction of PE multiple from 19x to 13x in the downcycle of 2008, the sector still outperformed the broader index by ~13%, as against ~270% underperformance in the previous bull cycle (January 2003-December 2007). Notably, this time around the leverage is below 1x for most companies, which we believe was one of the key reasons for contraction in the PE multiple in 2008 (e.g Glenmark Pharma, Aurobindo Pharma). We are thus far more comfortable with 18x PE multiple, in line with the long-term average but at a 40% premium to Sensex (down from 50% currently), which we feel is justified by the sector’s defensive nature in the wake of current uncertainity in domestic equity market (refer our Strategy Report dated 11 August 2011).

Exhibit 5: 2008–Pharma sector’s premium/discount to Sensex Exhibit 6: PE ratio-Sector’s resilience during 2008 downcycle

Source: Bloomberg, Nirmal Bang Institutional Equities Research Source: Bloomberg, Nirmal Bang Institutional Equities Research

Rating criteria for individual companies

For companies in our coverage universe, we have used relative PE multiple as our main rating criteria, while we have valued R&D/Para IV pipeline seperately using the net present value (NPV) method. We believe relative valuation is an appropriate method for Indian generic companies, given the limited revenue visibility and tendency of regulatory risks (policy changes, USFDA warning letters, product litigations, etc) in regulated and semi-regulated markets to materially distort earnings over the long term. Additionally, using the NPV method enables us to avoid overweighing short-term events like 180-day marketing exclusivity or embedded option value of R&D pipeline.

To arrive at a relevant PE multiple, we have assigned grades (1 represents the lowest, while 5 represents the highest) to the following six parameters, which, in our view, are key for the valuations to uphold: a) Quality of earnings (earnings visibility, low dependence on one-off contributors like Para IV opportunities, dossier income, tender revenues, etc), b) Domestic market positioning (therapeutic/segment leadership, portfolio concentration on chronic therapies), c) EBITDA margin, d) Capital effeciency (RoE, RoCE), e) Balance Sheet strength (DE ratio, cash flow generation, working capital management), and (f) Management track record (project execution track record, corporate governance, etc). Depending on their positioning, we have graded individual companies on each of these parameters, which forms the basis of our call on a particular stock.

On our valuation framework, we value Sun Pharma at a premium while the remaining stocks are valued at a discount. We believe Cipla and Cadila should trade at lower multiples, owing to their declining return ratios, while Glenmark and Torrent Pharma have a lower scale of operations compared to major peers, and thus the discount. Despite the discounted valuations, Torrent Pharma and Glenmark Pharma are our top Buys with 24% and 17% upside, respectively, from their CMP.

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10 Pharma Sector

Exhibit 7: Valuation framework for companies in our coverage

Rating criteria

Torrent Pharma

Glenmark Pharma

Sun Pharma

Cipla Cadila

Healthcare Comments

Quality of earnings 5 3.5 3.5 3.5 3.5 3.5

Sun has high contribution from 180-day marketing exclusivity, while Cipla receives a significant chunk of its revenue from volatile ARV tenders and technological income. Cadila’s earnings are highly reliant on Hospira and Nycomed JV, which again is dependent on exclusive opportunities. Torrent’s German business is highly dependent on tender revenues, while Glenmark's revenues are boosted by milestone income from partners

Domestic market positioning

5 3.5 3.5 5.0 5.0 5.0 Torrent Pharma and Glenmark are relatively smaller players in domestic market

EBIDTA margin 5 2.5 4.0 5.0 4.0 3.5 Glenmark to witness the highest margin expansion, while Sun will still enjoy best-in-class margins despite a decline over the next two years. We believe impact of high fixed cost base is already reflected in Torrent's margins, and expect a 218bps improvement over FY11-13E

Capital efficiencies 5 5.0 4.0 3.5 3.0 3.5 Cipla's return ratios have been consistently declining and are the lowest amongst comparable peers

Balance sheet strength

5 4.0 3.0 5.0 5.0 5.0 Glenmark's Balance Sheet, while highly leveraged, has significantly improved over the last one year

Management track record

5 4.0 3.0 5.0 5.0 5.0 Glenmark's policy of capitalising its R&D expenses is not looked upon favourably by investors, though the company has now aborted the practice

NBIE sector P/E (FY13)

18 18 18 18 18 18

Premium/(discount) - -20% -15% 25% -5% -10% We assign a premium to Glenmark's proven R&D capabilities and value it higher than Torrent, while Cipla is valued at a marginal premium to Cadila owing to its larger scale of operations

NBIE company P/E (FY13) 14.4 15.3 22.5 17.1 16.2

Torrent Pharma Glenmark Pharma Sun Pharma Cipla Cadila Healthcare

EBIDTA

EBIDTA Margin in FY11 (%) 18.4 20.1 33.7 21.0 22.2

Margin Expansion over FY11-13 (bps) 218 279 (112) 170 36

Capital Effeciency

FY13E RoE (%) 29.9 21.3 19.6 15.4 29.5

Delta over FY11 (bps) 76 392 (188) (29) (795)

FY13E RoCE (%) 23.6 16.4 17.4 15.6 25.7

Delta over FY11 (bps) 106 661 (98) (26) (274)

Balance sheet strength

Net DE in FY11 (x) 0.09 0.93 Zero Debt 0.07 0.37

WC/Sales in FY11 (%) 11 55.2 48.2 56.4 22.1

Source: Nirmal Bang Institutional Equities Research

Valuation close to peak level

After a sharp 7% outperformance in the past one year, the sector’s 50% valuation premium against the Sensex is at a five-year high, leaving little room for error. We have tested the sector’s vulnerability for macro headwinds and have drawn a conclusion that the current premium is unlikely to sustain for two reasons: a) We believe the pressure on domestic earnings is not yet fully discounted by the market and as R&D and marketing costs rise in the wake of intense competition, we see pressure on the PE multiple, and b) With a growing MNC presence, concerns regarding a hike in drug prices have resurfaced and may trigger policy changes by the government (such as stricter scrutiny of foreign investments in brown-field projects, increase in the number of drugs under NLEM, etc), a move that will significantly erode the sector’s premium valuation.


11 Pharma Sector

Domestic formulations - Smooth ride so far, turbulence ahead

We see domestic formulations growth moderating to 12-14% CAGR in FY12 from 16% in the past two years, as intense competition and pricing pressure in acute therapies dents volume growth. Marketing and R&D expenses, which have so far managed to remain stable, are also likely to increase as companies struggle to maintain their market share. We believe domestic profitability is critical for sustaining the valuation as firstly, it contributes 30-50% to overall profit in the case of most companies and secondly, it helps to fund their overseas expansion plan. So far, we believe the market has underplayed these factors and expect pressure on PE multiple, as additional data become available.

Exhibit 8: Domestic growth hurt by rising competition, pricing pressure in acute therapies

*Sun Pharma 1QFY11 growth is on an adjusted base of 1QFY10 while 1QFY12 growth is inclusive of VAT, for comparison purposes. Source: Companies, Nirmal Bang Institutional Equities Research

Change in aspirations of MNCs pose a challenge to domestic players

After Ranbaxy Laboratories and Piramal Healthcare’s deals with MNCs, the competitive landscape has shifted considerably in favour of MNCs who now account for ~25% of the domestic market (as against 16% two years ago). Notably, MNCs’ stance is much more aggressive than in the past– their field force has expanded rapidly in the past two years, new product launches have picked up momentum, old/matured brands have been rebuilt through the OTC route and drug pricing is much more aggressive, and in some cases much below their Indian counterparts. Moreover, for the first time, MNCs are contemplating to follow an India-specific pricing model. We believe this new found aggression stems from a change in their aspiration - MNCs now see India as a key growth driver, rather than “just another destination”. Given their inherent edge owing to easy access to parent company’s portfolio and deep pockets, we believe MNCs will continue to give severe competition to domestic players.

Exhibit 9: Market share of Top 10 players – Tilt in favour of MNCs Exhibit 10: Field force ramp-up by MNCs in past two years

Source: ORG-IMS, Industry, Nirmal Bang Institutional Equities Research Source: Industry, Nirmal Bang Institutional Equities Research

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12 Pharma Sector

Rising distributor bonus - a leading indicator of slowing volume

Another key point to note is rising bonus to distributors - we believe this is a natural corollary of slowing volume and increased competition; for e.g. in anti-infectives, where the volume off-take has considerably slowed down, the highest bonus payment was witnessed in recent times. On an average, bonus payment by the sector (as a percentage of net sales) has gone up from 2% in March 2008 to 3.5% in June 2011, with aggressive companies like Mankind offering bonus as high as 22%. So far, and naturally so, this is confined only to acute therapies with three therapies - anti-infectives, genito-urinary and metabolic diseases - accounting for ~80% of total bonus payment. Barring Cipla and Cadila Healthcare, other large players have so far refrained from making aggressive bonus payment, but we expect them to catch up with the trend soon as competition intensifies.

Exhibit 11: Anti-infectives register highest bonus payment (%) Exhibit 12: Bonus payment to distributors likely to remain high

Source: All India Organization of Chemists & Druggists (AIOCD) Source: All India Organization of Chemists & Druggists (AIOCD)

Restructuring business models

As the growth profile diversifies from traditional acute therapies and urban markets to fast growing lifestyle diseases and under-tapped Tier-II/rural markets, we believe a uniform business model is unlikely to work and companies will have to vary their strategy in terms of pricing, products, selling approach, financial returns etc. So far, the large companies have taken a lead in this direction – the average field force size has increased by ~80% in the past three years in the case of top 10 players, a substantial portion of which is deployed in Tier-II/rural markets. On the other hand, some companies are aggressively strengthening their position in the chronic segment, with established players like Sun Pharma and Torrent Pharma adopting therapy-wise divisional approach along with a dedicated sales force to build brand loyalty among specialist and super-specialist doctors while others like Ranbaxy and Cipla, traditionally focused on acute segments, are also aggressively building up their chronic portfolio.

Exhibit 13: Changing market dynamics leading to restructuring of business models

Medium-term scenario Top 15 players Cos ranking 16-25 Others

49% of industry sales 18% of industry sales 33% of industry sales

Domestic formulations market

Top players Mid-sized players Small players

Change in product mix* Yes Yes Yes

Expanded marketing and sales strength

Yes Yes Yes

New Drug Delivery systems (NDDS)

Currently, efforts made by top 10-12 players, others to follow

A number of companies in this basket making efforts in this direction; to increase gradually

May not try

In-licensing of molecules Yes, already happening on a small scale in value terms

Will try to seek partners, but will have to make efforts to increase MNCs’ confidence

No, will seek partners, but will face low confidence of MNCs

Impact on margins (Domestic)

Moderate pressure due to rising competition from mid-sized players

Sales to rise, but margins may remain under pressure

Sales to rise, but will witness highest margin pressure

*Focus on chronic therapies

Source: Industry; Nirmal Bang Institutional Equities Research

Anti-Infectives, 36.9

Genito Urinary & sex hormones, 32

Alimentary tract & Metabolism, 11.8

Others, 19.3

3.4

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13 Pharma Sector

Exhibit 14: Tier-II/rural market initiatives of large players

Company Rural initiative Year of launch Comments

Ranbaxy Viraat Jan-2010 Aim to expand reach to 350,000 rural doctors by 2012 from 200,000 currently

GlaxoSmithKline Reach Jan-2010 Second-largest player in rural India after Mankind.

Sanofi Aventis Prayas Feb-2010 Through Prayas, Sanofi intends to empower around 150,000 doctors across 60,000 towns and villages by 2015.

Novartis Arogya Parivar Sep-2008 Already covers 30,000 villages across 11 states.

Torrent Pharma Extra urban Sep-2009 Increasing reach in Tier II-IV cities, has added 300-400 people.

Source: Industry, Nirmal Bang Institutional Equities Research

Strategies in right direction, but caveats attached

While the strategies are in the right direction, we believe they have caveats attached. To cite an example, increased staff costs because of aggressive field force expansion and higher attrition rate has shrunk margins by 150-200bps, on an average, in the past two years. While the pace of sales force addition is likely to moderate going ahead, we expect the attrition rate to continue to remain high at 25-30%. In addition, we expect SG&A expenses - which have managed to remain stable so far - to catch up, led by higher marketing and promotional expenses as companies struggle to maintain market share. We expect the pressure on margins of companies expanding in rural markets to further rise because of lower gross margin owing to differential pricing, lower affordability, launch of matured products and longer gestation period of around three years.

Exhibit 15: Employee costs trend of leading domestic firms Exhibit 16: SG&A expenses: Resilient so far, but likely to rise

*We take these four companies, given higher concentration of domestic business in their revenue

Source: Company; Nirmal Bang Institutional Equities research

Exhibit 17: Margin profile of companies in our coverage universe

Margin Profile FY13 (%) Variation over FY12 (bps)

Torrent Pharma 20.6 122

Glenmark 22.9 (160)

Sun Pharma 32.6 (18)

Cipla 22.7 (29)

Cadila Healthcare 22.6 (89)


12-14% growth sustainable

We believe 12-14% growth is sustainable as the benefits of recent field force addition is still to fully reflect in revenue and would partially offset pricing pressure in acute therapies, while increased penetration will keep the momentum going in rural markets, currently growing at 25-30% (almost 2x the urban markets). Further, growing urbanisation and favourable demographics will continue to result in lifestyle diseases, which are witnessing strong traction (growing at 16-18%) since the past two to three years.

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Torrent pharma GSK Cadila Cipla

FY08 FY09 FY10 FY11

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Torrent pharma GSK Cadila Cipla

FY08 FY09 FY10 FY11

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14 Pharma Sector

Exhibit 18: Rural markets to contribute to incremental growth Exhibit 19: Rising prevalence of chronic diseases

*figures have been rounded off

Source: Mckinsey estimates

Source: Mckinsey estimates

Torrent Pharma, Sun Pharma are best bets on domestic growth story

From our coverage universe, we believe Sun Pharma and Torrent Pharma are the best bets on the domestic growth story, given their high exposure to lifestyle-related diseases, while Glenmark Pharma is likely to benefit from a low base and continue to grow above the industry average, despite lower concentration on chronic diseases. While we acknowledge Cipla’s efforts to revive its subdued domestic business, given its high base and concentration on acute therapies, we expect it to grow below industry average. Cadila Healthcare, on the other hand, is likely to see a rebound from 2HFY12 and is expected to grow in line with the industry.

Exhibit 20: Domestic market profile of leading companies

Companies Domestic

formulations contribution

Chronic portfolio

Field force

FY08 FY11

New product launch (FY11)

Top 10 brand contribution (FY11)

Total brands

Top three therapies

Torrent Pharma 40% 62% 2,200 3,600 30 42% NA CVS, CNS, gastro-intestinal

Glenmark 30% 24% 1,800 2,300 17 37% 435 Dermatology, CVS, anti-infective

Sun Pharma 40% 61% 2,000 2,700 39 20% 727 CVS, CNS, gastro-intestinal

Cipla 46% 45% 3,000 6,000 NA 27% 1,388 Respiratory, anti-infective, CVS

Cadila 38% 35% 1,900 4,500 60 29% 1,215 CVS, gastro-intestinal, gynaecology

Lupin 32% 47% 1,800 3,800 41 21% 839 CVS, anti-infective, anti-tuberculosis

Ranbaxy 21% 25% 2,200 4,500 NA 36% 806 Anti-infective, CVS, pain/analgesics

Source: ORG-IMS, Industry, Nirmal Bang Institutional Equities Research

3.3

2.82.5

1.3

0.2

4.9

3.7

2.7 2.7

0.2

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2

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6

Coronary heart diseases

Diabetes Asthma Obesity Cancer

2005 2015

(%)


15 Pharma Sector

Regulatory risks resurface

Following the recent spate of takeover of domestic companies by MNCs, concerns regarding a hike in drug prices have resurfaced, triggering speculation about the government tackling it through policy measures. Recently, a high-level-inter-ministerial-group headed by the prime minister has decided to bring all foreign investments in brown-field projects – currently cleared through the automatic route – under the purview of the Competition Commission of India (CCI), rendering it to stricter scrutiny. Further, talks over the introduction of revised new list of essential Medicines (NLEM) - which will bring additional 311 drugs under price control - has started gathering steam, and will cap any near-term expansion in the sector’s PE multiple, in our view.

Fears of drug price hike may trigger policy measures

Upholding the recommendations of an expert committee headed by Mr Arun Maira, member, Planning Commission, a high-level-inter-ministerial group led by the prime minister has recently decided to continue with 100% FDI in green-field projects through the automatic route, while rendering foreign investments in brown-field projects for stricter scrutiny, through clearance by the Foreign Investment Promotion Board (FIPB) for the initial six months and later through the CCI, once the enabling regulations are finalized for effective oversight of the sector. Additionally, as per media reports, the Maira report also recommends use of compulsory license to tackle drug price increases.

While the decision overrules any concerns over restriction of FDI in the sector, we believe it clearly spells out the government’s cautious stance on the increased number of mergers and acquisitions in the sector, and additional policy measures on the same will negatively impact the sector’s premium valuations, in our view. Issue of compulsory licensing has been strongly opposed by industry bodies such as Organization of Pharmaceutical Producers of India (OPPI) and other foreign lobby groups, and we believe the move is unlikely to control drug price increase, given the low contribution of patented products (less than 0.25% of overall pharmaceutical market). Moreover, patented products are also subject to mandatory price negotiations before being granted marketing approval.

b) 2-10% impact on sector’s earnings in case of new NLEM

Following a Supreme Court directive, an expert group recently finalised a revised national list of essential medicines (NLEM), which includes 348 medicines under its ambit. The new list is not very different from NLEM 2003, with 47 deletions and 43 additions. We believe the revised NLEM, if approved, would have significant repercussions for the industry. Inclusion of additional 311 drugs (37 drugs from the revised list are already under price control) under the ambit of DPCO (Drug Price Control Order), will bring nearly half of the industry’s output under price control from 25% currently (as per industry estimates). Based on our rough calculations, we believe the sectors earnings are likely to be impacted to the extent of 2-10%; the risk being higher for MNC’s.

Exhibit 21: MNCs likely to be impacted more in case of new NLEM

Company % of domestic revenue under DPCO

Torrent Pharma 10%

Cadila 12%

GSK Pharma 26%

Abbott 26%

Sanofi Aventis 33%

Source: Industry

c) NPPA’s recovery action on overcharging for drugs remains an overhang

Recently, a Supreme Court order directing GSK to pay Rs712mn on the grounds of overcharging has brought to light the long-drawn battle between the NPPA and pharmaceutical companies. Latest NPPA list (July 2011) pegs total recoverable amount at Rs23.6bn, with Cipla alone accounting for 66%. While only 9% of the total amount has been recovered so far by the NPPA (since its inception), outstanding arrears continue to increase. NPPA is now making concerted efforts to recover the dues (including referral of overcharging cases to concerned district collectors to initiate recovery proceedings against the companies), thus increasing the risk, especially for Cipla.


16 Pharma Sector

Exhibit 22: Cipla to be impacted the most if NPPA demand for overcharging materialises

(Rsmn) Overcharged amount Recovered so far In %

Cipla 15,551 0 0%

Sun Pharma 1 1 100%

Ranbaxy 1,362 303 22%

Dr Reddy’s Labs. 393 156 40%

Lupin 347 0 0%

Glenmark Pharma 0 0 100%

Cadila Healthcare 421 48 11%

Torrent Pharma 1 1 100%

GSK Pharma 181 139 77%

Pfizer 118 55 47%

Source: National Pharmaceutical Pricing Authority


17 Pharma Sector

International markets – Harbinger of the next growth phase

We believe international growth drivers still uphold and will partially cushion the fall in PE multiple. There are two reasons for this, firstly, given the similarities between domestic and most emerging markets (branded generics, out-of-pocket expenses, proven product portfolio), Indian generics are well poised to grow. These are fast growing markets, which are expected to contribute more than half of the incremental global revenue in the next five years. Secondly, the US generics market, the biggest market for Indian generics overseas, is in a multi-year cyclical upturn as drugs worth US$95bn go off-patent from 2011-15. So far, Indian companies have done very well in the US – revenue has grown at a 30% CAGR, from US$622mn to US$2.3bn over the past five years, led primarily by Para IV/exclusive opportunities. Together, these markets represent 40-50% of the revenue for Indian generics and are thus important growth drivers; more so in the wake of slowing domestic momentum.

Exhibit 23:Patent Expiries: US generics in multi-year, cyclical upturn Exhibit 24: Global pharma revenue break-up (%)

Source: ORG-IMS, USFDA, Industry Source: ORG-IMS, Industry

Impressive performance in the US market so far

So far, Indian companies have done very well in the US. In the past five years, revenues have shown a robust 30% CAGR, from US$622mn to US$2.3bn, 50-60% of which is contributed by Para IV/exclusive opportunities, as per our estimates. Our analysis indicates Indian generics participated in ~US$26bn, or 35%, of the opportunity of US$75bn of drugs which went off-patent during this period. Assuming 85% price erosion (average of marketing exclusivity and commoditised opportunities) we believe the cumulative market share should be closer to 10%, a commendable achievement considering the relatively late entry in the US (most companies entered post 2005). We believe the success of Indian generics in the US results from their expertise in reverse engineering, backward integration and regulatory understanding, and we expect this to continue going forward.

Exhibit 25: ANDA approvals of Indian players Exhibit 26: Participation of Indian generics 2006-10 patent cliff

Source: USFDA, Nirmal Bang Institutional Equities Research Source: ORG-IMS, USFDA, Industry

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(US$bn))

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Pharmemerging

South Korea

Japan

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Canada

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20102015

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18 Pharma Sector

Well prepared for the next wave of patent expiry

We expect the opportunity from impending 2011-15 patent cliff to be equally big, if not more than the 2006-10 cycle. As per our database, Indian generic players have exposure to ~70% of the products whose patents expire in the next five years, with Sun Pharma, Ranbaxy, Dr Reddy’s Laboratories, Lupin and Glenmark Pharma having an exposure of 35%, 28%, 29%, 18% and 2%, respectively. While the exposure is higher than the last cycle, we believe a number of these opportunities are commoditised (more than five to six players), thus implying limited upside. Based on our analysis, we believe 50-60% of these opportunities would involve multiple players, while the remaining 40-50% will be limited competition opportunities. Assuming a 10% market share (similar to the last cycle), we believe Indian generics are likely to see US$1-1.5bn of revenue upside over 2011-15, more than half of which is likely to materialise in the next two years, implying 16-17% revenue CAGR.

Exhibit 27: Indian firms have exposure to almost 70% of patent expiry opportunities in next five years

*Companies included are Sun Pharma, Ranbaxy, Dr Reddy’s, Lupin & Glenmark, Source: ORG-IMS; Nirmal Bang Institutional Equities Research

Building supplementary platforms

Apart from the exclusive opportunities, Indian generic players are also expanding in niche, less competitive therapies to sustain the growth momentum. To cite an example, Lupin is aggressively filing for generic oral contraceptives, a US$1.6bn market currently dominated by two players, while Cadila Healthcare is building a base in injectables and trans-dermals. This is important as firstly, it helps to protect margins as the US is a highly competitive market and secondly it ensures sustainability of revenue in the long run. Technology (products with technological advantage), manufacturing base (vertical integration, dedicated facilities, etc) and product depth (full basket of products e.g. oral contraceptives) are generally the key differentiating factors, in our view.

Exhibit 28: Indian companies increasing their focus in niche therapies

Company Niche focus areas

Lupin Opthalmologics, oral contraceptives, dermatology and respiratory

Cadila Injectables, nasals, trans-dermals, controlled substances

Glenmark Dermatology, controlled substances, oncology, extended release

Cipla Inhalers

Dr Reddy’s Cardiology, dermatology

Sun Pharma Dermatology, controlled substances

Source: Industry; Nirmal Bang Institutional Equities Research

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60

70

80

90

2011 2012 2013 2014 2015

(%)


19 Pharma Sector

Emerging markets – Growing in importance

While the US has been the cornerstone of international growth so far, emerging markets have gradually grown in importance, contributing ~21% of revenue for companies in our coverage universe in FY11. These are fast growing markets, expected to contribute more than half of the incremental global revenue, in the next five years. Indian companies, backed by their vast experience in branded generics, have registered a healthy 25% CAGR during FY06-11 in emerging markets. Most of these markets have similar market dynamics like India (branded generics, out-of-pocket expenses, shifting focus on chronic therapies, etc), which puts them in a strategically better position owing to a proven product portfolio.

Exhibit 29: Emerging markets’ contribution to overall revenue of companies under our coverage

Source: Companies; Nirmal Bang Institutional Equities Research

Focusing on what matters

We believe the domestic players are well positioned in emerging markets against the incumbents - owing to their cost effectiveness - and against the MNCs - due to their experience in branded generics - which is very different from selling innovative drugs. We believe their focus is still likely to be limited to four to five key markets as micro dynamics vary across different markets, mainly in terms of competition, financial expectations, cultural gaps etc. To cite an example, while Indian generic players have so far grown impressively in Russia and Brazil, their presence in China is still negligible owing to cultural barriers, longer time lag in building commercial infrastructure and difficulty in competing with them on the costs front. Based on our discussion with the companies, we believe Russia/CIS, Brazil, Mexico, Japan and Africa are likely to be the focus markets for Indian generic players going forward.

Exhibit 30: Top seven markets constitute ~70% of emerging markets

*figures are rounded off

Source: ORG-IMS; Nirmal Bang Institutional Equities Research

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Cipla Torrent Pharma Glenmark Sun Pharma Cadila Healthcare

(%)


20 Pharma Sector

Collaboration is the new world order

Unrealistic valuations of Ranbaxy Laboratories by Daiichi Sankyo (over 5x revenue) and of Piramal Healthcare’s domestic formulations business (over 9x revenue) by Abbott have set up a tall order for MNC peers to match. Clearly, the trend has shifted towards partnerships, which we believe is a much cost-effective way to play on the natural strengths of Indian companies in manufacturing and product portfolios. We see these partnerships as long-term positives for MNCs as well as Indian generic players. For MNCs, it gives them direct access to a diversified and a large generic basket without having to invest substantial time on development, registrations etc. For domestic generic companies, it helps them to leverage the wide distribution network of MNCs, thereby driving volumes. Notwithstanding the selective opportunities which still remain attractive acquisition targets, we believe partnership as a trend is likely to continue, going forward.

Company

MNC Nature of deal

Valuation (Revenue multiple)

Rationale Comments

Piramal Healthcare Abbott Acquisition 8.7 Gain dominance in the high-growth domestic market

Through this deal, Abbott gained the top slot in India with ~7% market share

Ranbaxy Daiichi Sankyo

Acquisition 5.2 Strong generic presence, wide product portfolio, low-cost manufacturing facilities and dominance in India

Marks Daiichi’s entry into the highly promising generics segment, a strategy adopted by most MNCs to make up for the lost revenues from patent expiry.

Sun Pharma Merck Joint Venture - Leverage Sun’s strong expertise in the branded generics segment

Unlike other deals, this partnership is essentially for future product developments, and hence, the upside is of long-term nature.

Torrent Pharma Astrazeneca Partnership - Leverage Torrent’s portfolio in the branded generics segment

As per the deal, Torrent will supply 18 generic products for nine key emerging markets.

Cadila Abbott Partnership - Leverage Cadila’s portfolio in the branded generics segment

Cadila will supply 24 branded generics products for 15 emerging markets, with an option to add another 40 products.

Dr Reddys GSK Partnership - Leverage Dr Reddy’s portfolio in the branded generics segment

Dr Reddy’s will supply 100 branded generics products across a number of emerging markets. Over US$100mn revenue expected in three years.

Aurobindo Pfizer Partnership - Access to a wide product portfolio

Initial deal was for supply of 38 generic products in the US, 20 in Europe and 11 in France, primarily in CVS and CNS segments. Partnership was subsequently extended to cover 55 oral dosages and 5 sterile injectable products. Includes licensing income of US$100mn in three years.

Aurobindo Astrazeneca Partnership - Access to a wide product portfolio Aurobindo will supply formulations and sterile products for emerging markets.

Claris Lifesciences Pfizer Partnership - Leverage Claris’ niche portfolio of sterile injectables

Supply of 15 generic products, mostly injectables.

Strides Arcolab Pfizer Partnership - Leverage Strides’ niche portfolio of sterile injectables

Strides will supply of 40 sterile injectables and oral products to the US. Includes licensing income of US$100 mn.

Biocon Pfizer Partnership - Access to Biocon’s insulin portfolio-Insulin and Insulin analogues

Includes upfront payment of US$200mn, of which US$100mn has been received, while US$150mn would be received through milestone payments.



21 Pharma Sector

PER charts: Partnerships drive re-rating

Exhibit 31: Dr Reddy’s Exhibit 32: Aurobindo

Exhibit 33: Torrent Pharma

Exhibit 34: Cadila Healthcare


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Torrent Pharma

Re-rating Due Torrent Pharma’s strong domestic business, with 60% of its portfolio focused on chronic therapies, and increasing scale in international business will catapult it to the next phase of growth, leading to 25% earnings CAGR over FY11-13E and sustainable RoE of 30%. A steep 10-25% discount in PE multiple versus other mid-cap stocks implies the market is underplaying the positives and we believe the stock would get re-rated closer to comparable peers. We assign a Buy rating to the stock with a target price of Rs715, implying an upside of 24% from the current market price.

Stock trading at steep discount to peers, merits attention: Torrent’s current valuation discount of 10-25% relative to mid-sized peers and 35% relative to the sector sharply undervalues the company’s strong earnings CAGR of 25% expected over FY11-13E (higher than the sector’s earnings CAGR of 15-16%), significantly higher RoE/RoCE of 30%/24% than peers, under-leveraged Balance Sheet and one of the best managed working capital cycle in the industry. Moreover, its strong focus on the chronic disease segment augurs well for long-term growth, justifying a re-rating closer to mid-cap peers.

Investors’ concerns on margins front fully priced in: Recent correction in one-year forward PE multiple from 15x in June 2011 to 12.8x (15% fall versus 9% for the sector) has fully priced in investors’ concerns on the company’s tepid near-term margins, in our view. We forecast a cumulative 218bps improvement in margins over the next two years, helped by break-even in the US business and operating leverage in other international geographies as the scale increases, which consequently drives our FY13 PAT 7% above consensus estimate. Torrent has shown marked improvement with a 162bps YoY expansion in margins in 1HFY12 and the management’s guidance of 19-20% margins in FY12 indicates this improvement in sustainable.

Gaining scale in key geographies:Torrent derives 60% of its domestic revenue from three of the fastest growing therapies (cardiovascular, central nervous system and anti-diabetes) and is therefore likely to maintain above industry growth trajectory, while its expansion in rural/Tier-II markets will ensure strong volume growth as these markets are growing at the rate of 25-30% per year, nearly 2x the growth in urban markets. With increasing scale, the US business is expected to break even in FY13, while Brazil, its largest market outside India, is expected to grow in line with the industry on the back of planned new launches (30-35 launches in next four years).

Valuation: Based on our valuation framework, we value Torrent Pharma at 14.4x FY13E EPS of Rs50 to arrive at a target price of Rs715. Our TP is pegged at a 20% discount to our target sector multiple of 18x, lower than the current discount of 30% and a 10% premium to its historical five-year average.

BUY

Sector: Pharmaceutical

CMP: Rs575

Target Price: Rs715

Upside: 24%


Key Data

Current Shares O/S (mn) 84.6

Mkt Cap (Rsbn/US$bn) 49.0/1.0

52 Wk H / L (Rs) 687/497

Daily Vol. (3M NSE Avg.) 33,474

Share holding (%) Q4FY11 Q3FY11 Q2FY11

Promoter 71.5 71.5 71.5

FII 3.7 4.3 4.9

DII 12.8 12.7 12.3

Corporate 4.1 3.8 3.8

General Public 7.9 7.7 7.5

One Year Indexed Stock Performance

Price Performance (%)

1 M 6 M 1 Yr

Torrent 7.4 (3.3) 5.1

Nifty Index 7.8 (7.4) (11.5)

Source: Bloomberg

Y/E March (Rsmn) FY09 FY10 FY11 FY12E FY13E

Revenue 16,307 19,160 22,265 25,054 28,810

YoY (%) 20.4 17.5 16.2 12.5 15.0

EBITDA 2,587 4,208 4,092 4,843 5,922

EBITDA (%) 15.9 22.0 18.4 19.3 20.6

Adj PAT 1,928 2,312 2,702 3,293 4,203

YoY (%) 43.2 19.9 16.8 21.9 27.7

Fully DEPS 22.8 27.3 31.9 38.9 49.7

RoE (%) 33.2 31.2 29.2 28.9 29.9

RoCE (%) 20.3 27.1 22.6 22.3 23.6

P/E (x) 26.4 21.0 18.0 14.8 11.6

EV/EBITDA (x) 19.8 11.9 12.1 10.3 8.3


1 November 2011


24 Torrent Pharma

We are 7% above consensus estimate on FY13 PAT

Our PAT estimate for FY12 is broadly in line with consensus, despite our estimate on margins being 138bps higher than consensus as we expect depreciation to increase in 2HFY12, in line with the past trend. The variance in FY13 earnings, however, stems from our higher-than-consensus margin forecast of 20.6%, led by increased contribution from Brazil and India (the top two geographies in terms of profitability), break-even in the US business, higher capacity utilisation at the recently commissioned Sikkim facility and operating leverage as other international geographies attain scale. We also assume marginally lower tax rate of 17% in FY13, helped by the Sikkim facility, which consequently drives our PAT 7% above consensus estimate.

Exhibit 1: Our expectations versus consensus estimates

(Rsmn) NBIE Bloomberg

Cons. Variation

(%) NBIE

Bloomberg Cons.

Variation (%)

Revenue 25,054 25,179 (0.5) 28,810 29,632 (2.8)

EBITDA 4,843 4,521 7.1 5,922 5,463 8.4

EBITDA margin (%) 19.3 18.0 138bps 20.6 18.4 212 bps

PAT 3,293 3269 0.7% 4,203 3,922 7.2


Exhibit 2: Key revenue assumption

(Rsmn) FY11 FY12E YoY growth (%) FY13E YoY growth (%)

India 8,353 9,689 16.0 11,240 16.0

Latin America 3,519 4,095 16.4 5,005 22.2

Germany 2,986 3,360 12.5 3,482 3.6

US 1,093 1,760 61.0 2,130 21.1

Europe 1,244 1,440 15.8 1,600 11.1

RoW markets 1,276 1,440 12.9 1,600 11.1

Russia and CIS 584 600 2.7 700 16.7

Contract manufacturing 2,096 2,480 18.3 2,880 16.1


Exhibit 3: Bloomberg consensus revenue trend Exhibit 4: Bloomberg consensus earnings trend


24,000

27,000

30,000

33,000

Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11

BBG FY12 BBG FY13 NBIE FY12 NBIE FY13

(Rsmn)

2,500

3,000

3,500

4,000

4,500

Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11


(Rsmn)


25 Torrent Pharma

Rating Rationale

Steep discount to peers unjustified

We believe Torrent Pharma’s current valuation discount of 10-25% relative to other mid-sized peers and 35% relative to the sector sharply undervalues the company’s strong earnings CAGR of 25% expected over FY11-13E (higher than the sector’s earnings CAGR of 15-16%), significantly higher RoE/RoCE of 30%/24% than peers, underleveraged balance sheet and one of the best managed working capital cycle in the industry. Moreover, the company’s strong focus on the chronic segment augurs well for long-term growth, justifying a re-rating closer to mid-cap peers.

Torrent Pharma currently trades at a steep 10-25% discount to mid-cap peers like Glenmark Pharma and Biocon, despite a comparable growth profile, significantly higher return ratios and a healthy balance sheet. Historically, the stock has traded at a low PE multiple owing to: a) Relatively lower scale of operations, b) Concerns related to muted domestic growth and that of its German subsidiary, Heumann, and c) Muted margin profile. The company’s domestic business has recovered sharply, showing a 16% CAGR over the past two years, while it achieved break-even at Heumann in FY10. Further, the break-even at its US business and operating leverage in key international geographies will drive a cumulative 218bps improvement in margins over FY11-13E. While Glenmark and Biocon get a premium because of their research and development (R&D) pipeline, we note the valuation discount is too steep as with increased scale Torrent’s financial profile now compares well with these two companies, thereby justifying a re-rating closer to them.

Exhibit 5:Premium/discount to Biocon Exhibit 6: Premium/discount to Glenmark


Exhibit 7:Revenue profile - compares well with peers Exhibit 8: Profitability gap with peers is narrowing down

Source: Bloomberg estimate for Biocon; Nirmal Bang Institutional Equities Research

Source: Bloomberg estimate for Biocon; Nirmal Bang Institutional Equities Research

(80)

(70)

(60)

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(40)

(30)

(20)

(10)

-

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(%)

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FY09 FY10 FY11 FY12E FY13E

Glenmark Biocon Torrent Pharma

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Glenmark Biocon Torrent Pharma

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26 Torrent Pharma

Exhibit 9: Peer comparison

Company EPS CAGR (FY11-13) (%) ROE (%) P/E (x) P/BV (x)

Torrent Pharma 25.0 29.9 11.6 3.1

Biocon 11.1 17.9 15.8 2.7

Glenmark Pharma 26.0 21.3 13.5 2.6

*Bloomberg estimates


Concerns on margins front fully priced in

The recent PE multiple correction, from 15x in June 2011 to 12.8x (15% fall versus 9% decline for the sector), has fully priced in investors’ concerns regarding the company’s tepid near-term margins, and we believe a gradual improvement in margins over the next two years will narrow its discount compared with peers. Torrent has shown a marked improvement with a 162bps YoY expansion in 1HFY12 and the management’s guidance of 19-20% margins in FY12 indicates the improvement in margins is sustainable. We forecast a cumulative 218bps improvement in margins over the next two years, led by higher capacity utilisation at its recently commissioned Sikkim facility, break-even at the US business and operating leverage as other international geographies attain scale.

Exhibit 10:PE Exhibit 11: P/BV


Strong free cash flow generation, return ratios

We expect Torrent to generate Rs2.1bn free cash flow by FY13, significantly higher than Rs1.4bn in FY11, led by strong operational performance and a remarkably well-managed working capital cycle (of 41 days, perhaps the lowest in the industry). This is despite a planned capex of Rs4bn over the next two years, almost equal to the Rs4.8bn capex in the past five years. We expect strong earnings growth, coupled with margin expansion and increased capacity utilisation level at the recently commissioned Sikkim facility, to drive a cumulative 76bps/106bps improvement in RoE/RoCE, respectively, by FY13.

Exhibit 12:Strong FCF generation Exhibit 13: Return ratios

Source: Company, Nirmal Bang Institutional Equities Research Source: Company, Nirmal Bang Institutional Equities Research

0

5

10

15

20

25

30


(x)

0

1

2

3

4

5

6


(x)

(1,000)

(500)

-

500

1,000

1,500

2,000

2,500

FY07 FY08 FY09 FY10 FY11 FY12E FY13E

(Rsmn)

33.231.2

29.2 28.9 29.9

20.3

27.1

22.6 22.323.6

0

5

10

15

20

25

30

35


ROE (%) ROCE (%)

(%)


27 Torrent Pharma

Assign Buy rating with a target price of Rs715

Based on our valuation framework, we value Torrent Pharma at a 20% discount to our target sector multiple of 18x FY13E EPS of Rs50 to arrive at a target price of Rs715, implying a 24% upside from the current market price. At our target multiple, Torrent will trade at a 10% premium to its past five-year average, at 10-15% discount to Glenmark and Biocon (owing to their R&D premium) and ~10% premium to the Sensex, which, we believe is justified by its strong growth profile, Balance Sheet strength, and relatively higher capital effeciency as compared to companies figuring in the Sensex.

Exhibit 14: Target price calculation

Sector PE (x) 18

Premium to sector (%) (20)

Torrent's PE (x) 14.4

FY13E EPS 50

a) Base business value 715

b) Para IV value 0

Target price (a+b+c) 715


Exhibit 15: Premium/discount to Sensex and sector


(100)

(80)

(60)

(40)

(20)

-

20

40

60

80

100

Oct

-05

Ap

r-0

6

Oct

-06

Ap

r-0

7

Oct

-07

Ap

r-0

8

Oct

-08

Ap

r-0

9

Oct

-09

Ap

r-1

0

Oct

-10

Ap

r-1

1

Oct

-11

Premium to Sensex Premium to Sector

(%)


28 Torrent Pharma

Best bet on domestic pharma growth story

Chronic disease segment focus + Rural expansion = Strong domestic growth

We believe Torrent Pharma is the one of the best bets on the domestic pharma growth story, with a balanced mix of a strong chronic disease drug portfolio and volume growth in rural/Tier-II markets. Torrent derives 60% of its domestic revenue from three of the fastest growing therapies - CVS, CNS and diabetes - and is therefore likely to maintain its above industry growth trajectory. On the other hand, its expansion in rural/Tier-II markets will ensure strong volume growth, as these markets are growing at 25-30% every year, nearly 2x the growth in urban markets. Domestic market growth is important, as it contributes 50-60% to profitability and is an important driver of higher-than-market RoE. We expect 15% domestic revenue CAGR over the next two years, as the benefits of recent field force addition start reflecting in revenue and also as contribution from rural markets increases.

Exhibit 16: Domestic formulations- Therapy-wise break-up Exhibit 17: Domestic formulations revenue trend

Source: Company; Industry Source: Company, Nirmal Bang Institutional Equities Research

Chronic inclined portfolio ensures above-industry growth

Torrent derives nearly 60% of its domestic revenue from three therapies - CVS, CNS and anti-diabetes - which in turn has helped the company grow at an impressive 17% CAGR over FY06-11, significantly higher than the industry growth of 14%. Particularly, in core therapies - CVS (market share of 4.3% - MAT March 2011) and CNS (market share of 5.5% - MAT March 2011) - its growth has been relatively strong at 17% and 19% CAGR, respectively, over FY06-11. Key growth drivers for these therapies (increasing urbanisation, rising stress level, etc) remain intact and we thus believe the outperformance will continue.

Exhibit 18: Growth break-up for Torrent’s portfolio

Growth rates (%) FY07 FY08 FY09 FY10 FY11 Five-year CAGR

Comments

CVS 38.8 14.4 7.0 16.1 8.8 16.5 Together, these therapies constitute 60% of

Anti diabetec 38.8 61.8 24.8 16.1 (17.6) 21.8 domestic portfolio

CNS 60.8 3.0 7.0 10.5 21.2 18.9

Anti-infectives 12.8 (17.0) 7.0 27.7 36.4 11.8 Ramp-up in the past two years led by increased penetration in rural markets Gastro-intestinal 25.6 7.9 7.0 16.1 15.4 14.2

Others 85.1 34.9 (14.4) 16.1 44.3 29.0

Pain management 73.5 (13.7) 7.0 16.1 15.4 16.5


Strong brand equity

Torrent enjoys strong brand equity with doctors, with six brands in the top 300 and 36 brands in leadership position in their respective molecular segments. This has helped Torrent to retain market share across core therapies, even while the other smaller players lost market share. Over the past five years, Torrent’s market share in CNS improved by 100bps to 7.6%, while it managed to maintain CVS market share at 6.2% despite severe competition.

Cardiovascular, 33%

Anti-Diabetec, 5%

Anti-Infectives, 13%

Neuro-Psychiatry, 21%

Gastro-Intestinal, 19%

Other, 5%Pain

Management, 4%38.8

7.9 7.0

16.115.4

0

5

10

15

20

25

30

35

40

45

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

FY06 FY07 FY08 FY09 FY10 FY11

Domestic Revenues YoY Growth (%)

(Rsmn) (%)


29 Torrent Pharma

Exhibit 19: Market share trend in top therapies Exhibit 20: Revenue contribution from top 10 brands

Source: Company; Industry

Regular launch of products fills portfolio gap

Regular product launch to fill portfolio gap as well as to widen coverage is an important part of Torrent’s domestic market strategy. Over the past five years, the company has consistently launched 40-50 products each year (except in FY09), in line with its larger peers. Importantly, new products launched have accounted for nearly half of its incremental growth during this period. With planned launches of 50-60 products in FY12, we believe the new launches will continue to remain a key driver for domestic business.

Exhibit 21: Domestic Growth break-up Exhibit 22: New product Introductions


Rise in field force strength to increase market coverage

Like most peers,Torrent has also increased its field force by a massive 1,250 medical representatives (~44% increase) over the past two years, as it expanded aggressively in Tier-II/rural markets as well as foray into newer therapies like gynaecology. Its current field force stands at 4,059 medical representatives (MRs) and the focus in now on improving productivity rather than further addition of MRs. Although better than the previous years, Torrent’s field force productivity at Rs2.5mn/MR is among the lowest (as most of the field force addition was done recently) in the industry and has huge scope for improvement. We believe the benefits of recent field force addition are still to reflect in revenue and should lead to strong recovery in 2HFY12.

6.2 6.26.7

6.4 6.4 6.26.6

7.47.8 7.8 7.7 7.6

0

1

2

3

4

5

6

7

8

9


Cardiovascular Neuro-Psychiatry

(%)

0

5

10

15

20

25

30

35

40

45

Sun Pharma Cipla Glenmark Cadila Torrent Pharma Lupin

(%)

(2)

-

2

4

6

8

10

12

14

16

18

FY08 FY09 FY10 FY11

Volume Growth New products (introduced last year) New products (introduced current year)

(%)

43

4952

15

55

38

0

10

20

30

40

50

60



30 Torrent Pharma

Exhibit 23: Field force addition

Source: Company, Industry

Rural expansion revives growth in acute therapy portfolio

Torrent’s expansion in rural/Tier-II markets has revived its growth in key acute therapies – the top two acute therapies such as anti-infectives and gastro-intestinal have registered 36% and 15% YoY growth, respectively, in FY11. With a field force size of nearly 400 people, Torrent intends to significantly enhance its presence in rural/Tier-II markets, which are growing at 25-30% every year, nearly 2x the growth in urban markets.

Gaining scale in international markets

Brazilian business on strong footing

With a 6.8% market share, Torrent is the largest and the best-positioned Indian player to capitalise on strong growth prospects in Brazil, a US$15bn market growing at 15% for the past five years. The company has successfully replicated its Indian model, building a strong portfolio of 27 products across key therapies like CVS, CNS and anti-diabetes. Further, 31 products are awaiting approval, of which six are likely to be approved during FY12, as per the management. The company’s revenue CAGR of 16% over FY09-11 has largely been in line with the market coverage, and we forecast 18% revenue CAGR growth over FY11-13E as the pace of new launch picks up (the company plans to launch 30-35 products by 2014-15).

Exhibit 24: Brazil portfolio break-up Exhibit 25: Brazil revenue trend


Heumann operations stabilising

Similar to Dr Reddy’s Laboratories’ experience with Betapharm, Torrent’s acquisition of Heumann (based in Germany) in FY06 for Rs172mn backfired as the market dynamics changed from branded-generic to generic-generic, leading to significant price decline subsequently. While Torrent, through a series of cost-cutting measures (sales force reduction from 130 to 15, shift in manufacturing of over 25 products to India, etc), managed to break-even Heumann in FY10, it still remains a drag, with only 3% contribution to overall profit. With no fresh tenders coming up, we incorporate a 5% decline in Heumann’s tender-based business (55% of revenue) and 22% CAGR in non-tender based revenue (remaining 45%) over FY11-13E with stable margins on the back of planned launch of 12 products in FY12.

2,9542,761 2,812

3,364

4,059

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2007 2008 2009 2010 2011

CVS, 41%

CNS, 41%

Oral Anti-Diabetes, 19%

44.2

6.2

44.9

17.215.1

0

5

10

15

20

25

30

35

40

45

50

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000


Revenues Growth YoY (%)

(Rsmn) (%)


31 Torrent Pharma

Exhibit 26: Heumann – Revenue, PAT trend

Source: Company

US revenues inching up

Torrent’s US revenue has scaled up from US$6mn in FY09 to US$25mn in FY11, led by market share gains in key products like Citalopram (anti-depression; 28% market share) and Zolpidem (Insomnia;~22% market share). This is impressive, considering its relatively late entry in the US. While most of its pipeline is focused only on ’me-too’ generics, we believe Torrent will continue to grow strongly on a low base and through monetisation of its pending pipeline of 32 products. We forecast a 47% CAGR in US revenue over FY11-13E, led by planned launch of 10-12 products over the next two years and market share gains in its existing portfolio. Importantly, the US market is closer to break-even (the management has given guidance of break-even in FY13) and should increasingly contribute to earnings as revenue gains scale.

Exhibit 27: US revenue to rise on low base, monetisation of pending product pipeline


Contract manufacturing agreements provide revenue stability

We believe the product partnership pacts with MNCs provide a proxy play on the international growth opportunity, saving the risk of setting up front ends. Besides the one-time milestone income which boosts cash flow, such contracts ensure long-term revenue stability. Leveraging its strong manufacturing capabilities, Torrent recently entered into product partnerships with two MNCs – AstraZeneca (18 branded generic products for 9 emerging markets) and an undisclosed company (50 products on non-exclusive basis for various emerging markets) to supply branded generics for emerging markets.

While both these partnerships are more medium-term opportunities, with no contribution to our earnings estimates for the next two years, we note that milestone income from these companies will continue to boost cash flow. So far, Torrent has received Rs920mn as milestone income, while the management expects additional income in the current year. In the near term, we expect contract manufacturing revenue to be driven largely by the Novo Nordisk contract, which has ensured stable revenue (13% CAGR over the past three years) so far. Torrent recently commissioned a new facility at Indrad with a capacity to manufacture additional 26mn vials, which coupled with the rising diabetic population in India, will drive our expected 16% revenue CAGR over the next two years.

(500)

0

500

1,000

1,500

2,000

2,500

3,000


Revenue PAT

(Rsmn)

278

909

1,093

1,760

2,130

0

500

1,000

1,500

2,000

2,500


(Rsmn)


32 Torrent Pharma

Exhibit 28: Contract manufacturing agreements ensure revenue stability


Key risks

Slowing growth in domestic market – Torrent derives almost 40% of its revenue from the domestic market and will thus be highly impacted if there is a slowdown. Moreover, if the recent field force addition fails to scale up as expected, its margins will get further impacted owing to high fixed cost base, thereby delaying the re-rating of the stock. We however, believe the company will relatively be better-off than peers in case of a slowdown because of higher portfolio inclination towards chronic therapies

Pricing pressure in rest of Europe (excluding Heumann): Torrent derives almost 6% of its revenue from Europe, which is currently reeling under intense pricing pressure. While Torrent is countering this through new product launch (has identified 30 products for launch by FY15) and increasing its geographical reach through direct field force presence in Romania and UK, we believe any delay in new product approvals or further price cut will adversely affect our estimates.

Russia operations volatile: Torrent’s Russian operations have been highly volatile, hurt by high payment default, poor liquidity condition and regulatory changes. Over the past two years, Russian revenue declined by 6% CAGR, even on a low base. The company is currently consolidating its presence in the Russian market by renegotiating the credit limit with distributors, which should reflect in revenue from FY13 onwards. We have assumed a moderate 9% CAGR over FY11-13E in Russia, which may be impacted if the company’s efforts do not pay off.

Currency risk: Torrent derives almost 60% of its revenue from exports, mainly in terms of US dollar, euro and Brazilian real. Fluctuation in currency exchange rates may affect realisation and lead to negative impact on profitability.

0

500

1,000

1,500

2,000

2,500

3,000

FY08 FY09 FY10 FY11 FY12E FY13E

(Rsmn)


33 Torrent Pharma

2QFY12 performance – Key highlights

Torrent reported a strong 18% YoY growth in revenue, led by strong performance across key geographies like the US (up 57% YoY), Brazil (up 34% YoY), Germany, primarily Heumann (up 28% YoY), and rest-of- the-world markets excluding India (up 20% YoY). Indian market growth was muted at 7% YoY, in line with expectation.

Margins stood at 20.6%, up 39bps YoY but down 306bpsQoQ, as 1QFY12 included higher dosser licensing income of Rs170mn as against Rs96mn in 2QFY12.

Reported PAT stood at Rs1bn, up 31%YoY, helped by better operating performance and lower tax rate on commissioning of Sikkim facility.

Exhibit 29: 2QFY12 performance

Rsmn 2QFY11 1QFY12 2QFY12 YoY (%) QoQ (%) 1HFY11 1HFY12 YoY (%)

Net revenue 5,815 6,475 6,833 17.5 5.5 11,225 13,308 18.6

Total material costs 1,832 1,959 2,221 21.2 13.4 3,473 4,180 21.2

% of revenue 31.5 30.3 32.5 - - 30.9 31.4 -

Staff costs 991 1,115 1,161 17.1 4.1 1,913 2,276 17.1

% of revenue 17.0 17.2 17.0 - - 17.0 17.1 -

R&D expenses 329 330 317 (3.6) (3.8) 643.8 647 (3.6)

% of revenue 5.7 5.1 4.6 - - 5.7 4.9 -

Other expenses 1,488 1,540 1,728 16.1 12.2 2,899 3,268 16.1

% of revenue 25.6 23.8 25.3 - - 25.8 24.6 -

EBITDA 1,175 1,531 1,407 19.7 (8.1) 2,297 2,938 19.7

EBITDA margin (%) 20.2 23.6 20.6

20.5 22.1

Other income 25 24 43 71.4 74.2 47.1 67 71.4

Interest 34 41 29 (13.3) (27.7) 58.2 70 (13.3)

Depreciation 155 202 201 29.7 (0.6) 296.9 403 29.7

PBT (before exceptional items) 1,012 1,313 1,219 20.5 (7.2) 1,989 2,532 20.5

Exceptional items 0.0 (1.0) (8.0)

0.0 (9.0)

PBT (after exceptional items) 1,012 1,313 1,211

1,989 2,524

Tax 250 287 212 (15.3) (26.4) 484.5 499 (15.3)

Reported PAT 762 1,025 1,000 31.2 (2.5) 1,504 2,025 31.2

PAT margin(%) 13.1 15.8 14.6 - - 13.4 15.2 -



34 Torrent Pharma

Financials Exhibit 30: Income statement


Net sales 16,307 19,160 22,265 25,054 28,810

% growth 20.4 17.5 16.2 12.5 15.0

Raw material costs (5,348) (5,710) (6,965) (7,878) (9,200)

Staff costs (2,565) (3,162) (3,895) (4,406) (4,993)

R&D expenses (1,119) (1,202) (1,388) (1,485) (1,683)

Others (4,687) (4,879) (5,924) (6,442) (7,012)

Total expenditure (13,719) (14,953) (18,173) (20,211) (22,888)

EBITDA 2,587 4,208 4,092 4,843 5,922

% growth 27.6 62.6 (2.8) 18.4 22.3

EBITDA margin (%) 15.9 22.0 18.4 19.3 20.6

Other income 238 216 347 413 449

Interest costs (393) (291) (387) (426) (420)

Depreciation (423) (661) (626) (815) (887)

Profit before Tax 2,009 3,472 3,427 4,015 5,064

% growth 34.8 72.8 (1.3) 17.2 26.1

Tax (78) (1,160) (725) (723) (861)

Effective tax rate (%) 3.9 33.4 21.2 18.0 17.0

Net profit 1,931 2,312 2,702 3,293 4,203

% growth 43.4 19.7 16.8 21.9 27.7

Extraordinary items (88) 0 0 0 0

Reported net profit 1,844 2,312 2,702 3,293 4,203

% growth 36.9 25.4 16.8 21.9 27.7

Adjusted net profit 1,928 2,312 2,702 3,293 4,203

% growth 43.2 19.9 16.8 21.9 27.7

Reported EPS (Rs) 21.8 27.3 31.9 38.9 49.7

% growth 36.9 25.4 16.8 21.9 27.7

Adjusted EPS (Rs) 22.8 27.3 31.9 38.9 49.7

% growth 43.2 19.9 16.8 21.9 27.7

DPS (Rs) 4.0 6.0 8.0 9.7 12.4

Payout (%) 21.5 25.6 29.1 29.1 29.1


Exhibit 32: Balance Sheet


Equity 423 423 423 423 423

Reserves 6,086 7,887 9,801 12,137 15,119

Net worth 6,509 8,310 10,224 12,560 15,542

Short-term loans 505 488 192 222 252

Long-term loans 4,321 4,736 5,529 6,099 6,694

Total loans 4,826 5,224 5,721 6,321 6,946

Deferred tax liability 584 499 480 480 480

Minority interest 0 0 16 16 16

Liabilities 11,919 14,033 16,440 19,377 22,984

Gross block 7,206 8,129 9,643 11,643 13,643

Depreciation 2,094 2,718 3,287 4,102 4,989

Net block 5,113 5,411 6,355 7,540 8,654

Capital work-in-progress 534 1,098 2,186 2,186 2,186

Long-term Investments 190 190 200 247 610

Inventories 2,645 3,236 5,048 4,340 5,084

Debtors 2,666 2,982 3,404 4,006 4,693

Cash 2,300 3,883 4,788 5,073 6,417

Liquid Investments 1,204 1,221 1,260 1,260 1,260

Other current assets 1,923 1,506 2,106 2,375 2,782

Total current assets 10,738 12,828 16,606 17,054 20,235

Creditors 3,134 3,836 6,994 5,537 6,271

Other current liabilities 1,522 1,660 1,913 2,113 2,430

Total current liabilities 4,656 5,496 8,907 7,650 8,701

Net current assets 6,082 7,333 7,699 9,403 11,534

Total assets 11,919 14,033 16,440 19,376 22,984


Exhibit 31:Cash flow


EBIT 2,164 3,547 3,466 4,028 5,035

Inc./(dec.) in working capital (562) 100 426 (1,589) (1,052)

Cash flow from operations 1,603 3,647 3,892 2,439 3,983

Other income 238 216 347 413 449

Depreciation 423 661 626 815 887

Interest paid (-) (393) (291) (387) (426) (420)

Tax paid (-) (78) (1,160) (725) (723) (861)

Dividends paid (-) (346) (396) (592) (787) (957)

Net cash from operations 1,446 2,677 3,161 1,732 3,082

Capital expenditure (-) (458) (1,487) (2,601) (2,000) (2,000)

Net cash after capex 987 1,190 560 (268) 1,082

Inc./(dec.) in short-term borrowing 324 (18) (296) 30 30

Inc./(dec.) in long-term borrowing 905 416 792 570 595

Inc./(dec.) in borrowings 1,228 398 497 600 625

Inc./(dec). in investments (849) (17) (48) (47) (363)

Cash from financial activities 380 381 449 553 262

Others (250) 12 (104)

Opening cash 1,183 2,300 3,883 4,788 5,073

Closing cash 2,300 3,883 4,788 5,073 6,417

Change in cash 1,116 1,583 905 285 1,344


Exhibit 33:Key ratios

Y/E March FY09 FY10 FY11 FY12E FY13E

Per share (Rs)

Reported EPS 21.8 27.3 31.9 38.9 49.7

Adjusted EPS 22.8 27.3 31.9 38.9 49.7

DPS 4.0 6.0 8.0 9.7 12.4 BV/share 76.9 98.2 120.8 148.4 183.7 Dividend payout (%) 21.5 25.6 29.1 29.1 29.1 Performance ratios (%) RoE 33.2 31.2 29.2 28.9 29.9 RoCE 20.3 27.1 22.6 22.3 23.6 Valuation ratios (x) P/E

26.4 21.0 18.0 14.8 11.6 P/BV

7.5 5.9 4.8 3.9 3.1 EV/Net sales

3.1 2.6 2.2 2.0 1.7 EV/EBITDA

19.8 11.9 12.1 10.3 8.3 Efficiency ratios

Asset turnover (x) 1.1 1.0 0.9 0.9 1.0

Working capital/sales (x) 0.2 0.1 0.1 0.1 0.1

Receivable days 61 59 59 61 61

Inventory days 61 64 87 66 66

Payable days 83 94 140 100 100



Initi

atin

g C

over

age

Reuters: GLEN.BO; Bloomberg: GNP IN

Glenmark Pharmaceuticals

All Set to Make a Mark We remain upbeat about Glenmark Pharmaceuticals’ base business growth and

expect its stock to re-rate as the visibility increases on Balance Sheet improvement. Monetisation of niche products like Malarone, Oxycodone and Cutivate as well as its pending product pipeline (especially in the US) and recovery in base business margins is expected to result in a strong 26% CAGR in core earnings and drive 392bps/661bps improvement in RoE/RoCE, respectively. We assign a Buy rating to the stock with a target price of Rs362, implying a 17% upside from the CMP.

Multiple levers for margin expansion; RoE/RoCE to follow: With a balanced mix of niche/exclusive product launch in the US and a turnaround in LatAm (specialty business) and Eastern Europe (branded generics), we expect Glenmark’s margins to witness a strong 279bps expansion over FY11-13E. Consequently, RoE/RoCE expansion will follow with an improvement of 392bps/661bps, respectively, as the operating leverage plays out.

Base business on strong growth trajectory: We expect Glenmark’s base business revenue to show a healthy CAGR of 17% over FY11-13E. Strengthening presence in core therapies is expected to sustain 18% growth in India, while monetisation of pending drug pipeline (40 awaiting approvals, including niche products) and market share gains via exclusive launches like Malarone, Cutivate and Oxycodone are expected to lead to over 18% CAGR in the US over the next two years. Besides, the focus on ‘power brands’ and replication of Indian model would lead to a strong 27% CAGR over FY11-13E in LatAm and SRM markets.

Visible signs of Balance Sheet improvement: Glenmark’s receivable days have come down to 125 in June 2011 (from 144 in March 2011), while its leverage has reduced to 0.75x (June 2011) from 0.93x (March 2011), helped by milestone income from partners and we expect it to further come down to 0.51x in FY13E. We believe the Balance Sheet improvement is closely monitored by investors, and further validation will narrow the stock’s current valuation discount to peers.

Valuation: Based on our valuation framework, we value Glenmark’s core business at Rs343/share, assigning a PE multiple of 15.3x FY13E EPS of Rs22, at a 30% discount to its five-year average and a 15% discount to our target sector multiple. We add Rs5.2/share (20% discount for execution risks) for its Para IV pipeline and another Rs14/share for Crofelemor opportunity, valuing it at a 65% success probability and thus arriving at our target price of Rs362.

BUY


CMP: Rs310

Target Price: Rs362

Upside: 17%


Key Data



52 Wk H / L (Rs) 390/241



Promoter 48.3 48.3 48.3

FII 31.2 31.9 33.2

DII 6.9 6.9 6.4





1 M 6 M 1 Yr

Glenmark (4.3) 3.3 (8.7)

Nifty Index 7.8 (7.4) (11.5)

Source: Bloomberg


Revenue 20,402 24,124 29,491 34,681 38,913

YoY (%) 5.5 18.2 22.2 17.6 12.2

EBITDA 4550 6196 5923 8488 8899

EBITDA (%) 22.3 25.7 20.1 24.5 22.9

Reported PAT 1917 3245 4532 5152 6057

YoY (%) (69.7) 69.3 39.7 13.7 17.6

Adjusted PAT 2852 3245 3816 4209 6057

YoY (%) (35.2) 13.8 17.6 10.3 43.9

Fully DEPS 7.7 12.0 16.8 19.1 22.4

Adj EPS 11.4 12.0 14.1 15.6 22.4

RoE (%) 18.3 16.4 17.4 18.4 21.3

RoCE (%) 11.1 12.4 9.8 14.4 16.4

P/E (x) 27.2 25.8 22.0 19.9 13.8

EV/EBITDA (x) 22.9 16.4 17.4 12.0 11.2


60

70

80

90

100

110

120

Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11

GLENMARK PHARMA NSE S&P CNX NIFTY INDEX

1 November 2011


36 Glenmark Pharma

Valuation at a steep discount warrants attention

Glenmark trades at a steep 35% discount to its five-year average PE multiple of 22x and ~30% discount to the sector’s average of 19.5x. The sharp drop in PE reflects investor apprehension regarding its muted US growth in the past two years, stretched Balance Sheet, higher working capital cycle and deterioration in margin profile.

Exhibit 1: PE ratio: Glenmark trading at significant discount to historical mean


While we acknowledge the concerns the market has, we believe the management is currently addressing them. The company’s receivable cycle (125 days in June 2011 versus 157 days in March 2010 and 144 days in March 2011) has shown marked improvement, while leverage has reduced to 0.75x (June 2011) from 0.93x (March 2011) as milestone payments from its partners helped repay debt and we expect it to further reduce to 0.51x in FY13. Moreover, transition to IFRS has cleaned up its Balance Sheet, as the company undertook a massive Rs4.5bn intangibles write-off in 4QFY11.

For the base business, we expect the growth trajectory in domestic market to continue, while monetisation of its pending pipeline of 40 ANDAs, including for niche products (Oxycodone, Malarone, oral contraceptives), is expected to sustain over 18% CAGR in the US for the next two years. This, coupled with break-even in branded generics business in Europe and LatAm markets, will lead to a cumulative margin expansion of 279bps over the next two years.

Current valuation does not assign any value to R&D pipeline

Glenmark’s re-rating/de-rating, in the past was linked to announcements pertaining to its R&D pipeline. The company has cumulatively garnered ~US$200mn by out-licensing its molecules, the highest so far by any Indian company. However, owing to negative setbacks on its past out-licensed molecules (Oglemilast, Melogliptin, GRC 6211), we believe currently the market is not assigning any value to its R&D pipeline.

0

10

20

30

40

50

60

70

80

90


(x)


37 Glenmark Pharma

Exhibit 2: Glenmark re-rating/de-rating linked to news flow on R&D pipeline


While we believe that it’s premature to value molecules in Phase I and II stages, where most of its pipeline lies, we believe Crofelemor (HIV-related diarrhoea; peak estimated sales $80mn in ROW markets), which completed Phase III trials recently, is a promising near-term opportunity and we expect the company to launch the product in the ROW markets in 2012. As per an agreement with Napo Pharmaceuticals, Glenmark has exclusive rights to market the drug in ROW markets (140 countries), and additionally supply APIs to Salix (which owns US rights). We value Crofelemor at Rs 14/share, assigning a 65% success probability. At this point, we do not assign any value to its remaining pipeline including GRC 15300 and GBR 500 out-licensed to Sanofi Aventis, as they are still at an early stage. However, we also note that historically Glenmark has been able to out-license Phase I and II molecules, and thus can surprise positively.

Exhibit 3: R&D pipeline

Molecule Indication Clinical status Target Comments

GRC 8200 (Melogliptin) Diabetes (Type II) Completed Phase- IIB studies

DPPIV inhibitor Returned by Merck; Glenmark is conducting clinical trials on its own and is looking for out-licensing

GRC 4039 (Revamilast) Respiratory, inflammatory disorders, asthma and rheumatoid arthritis (RA)

Completed Phase- I studies

PDE4 inhibitor Phase- IIB initiated for asthma and RA in five countries; plan to start Phase III for one indication by FY13

GRC 10693 (Tedanilab) Neuropathic pain, osteoarthritis and other inflammatory disorders

Completed Phase- I studies

CB-2 receptor agonist

Expects to initiate Phase- II study in 2012

GRC 15300 Neuropathic pain, osteoarthritis and other inflammatory disorders

Phase- I TRPV3 antagonist Out-licensed to Sanofi - received milestone payment of US$20mn with potential of US$305mn and royalty payment

GRC 17536 Neuropathic pain, Respiratory disorders

Phase- I TRPA1 inhibitor Filing for Phase- II POCs planned in 2HFY12

GBR 500 Anti-inflammatory, multiple sclerosis, Crohn's disease

Completed Phase- I study

Monoclonal anti-body

Out-licensed to Sanofi - received milestone payment of US$50mn with potential of US$613mn and royalty payment

GBR 600 Anti-platelet

Completed pre-clinical trials

Monoclonal anti-body Will commence Phase- I study

In-licensed

GBR 900 Pain management Pre-clinical trials Monoclonal anti-body

Licensed from Lay-line Genomics; Glenmark has exclusive IP rights. IND enabling studies to be initiated in FY12

Crofelemer HIV-related diarrhoea Completed Phase- III CFTR inhibitor In-licensed from Napo; completed Phase- III trials for HIV-related diarrhoea in US and Phase- II for acute adult diarrhoea in India

Source: Company

0

100

200

300

400

500

600

700

800

1/1/2004 10/6/2005 24/11/2006 15/05/2008 13/11/2009 2/5/2011

Oglemilast outlicensedto Forest

Oglemilast outlicensedto Tejin

Melogliptin outlicensed to Merck

GRC 6211 outlicensed to Eli Lilly

Melogliptin returned by Merck

Oglemilast valued at "0"

GRC 6211 suspended

TRPV3 portfolio outlicensed to Sanofi

GBR 500 outlicensed to Sanofi

Oglemilast outlicensedto Forest

Oglemilast outlicensedto Tejin

Melogliptin outlicensed to Merck

GRC 6211 outlicensed to Eli Lilly

Melogliptin returned by Merck

Oglemilast valued at "0"

GRC 6211 suspended

TRPV3 portfolio outlicensed to Sanofi

GBR 500 outlicensed to Sanofi


38 Glenmark Pharma

We value Glenmark at a discount to the sector

Based on our valuation framework, we value Glenmark’s core business at Rs343/share, assigning PE multiple of 15.3x FY13E EPS of Rs22, which is at 30% discount to its five-year average and at 15% discount to our target sector multiple of 18x. Though improving, we feel Glenmark’s Balance Sheet requires further validation for a re-rating. We add Rs 5.2/share (20% discount for execution risks) for its Para IV pipeline and another Rs14/share for the Crofelemor opportunity, valuing it at a 65% success probability, and thus arriving at our target price of Rs362.


Sector PE (x) 18.0

Discount to sector 15%

Glenmark's PE (x) 15.3

FY13E EPS 22.4


NPV of Para IV pipeline 6.5

Discount for execution risks 20%

b) Para IV value 5.2

c) NPV of R&D pipeline 14.1

Target price (a+b+c) 362

Source: Nirmal bang Institutional Equities Research

How we differ from consensus estimates

Our FY12 PAT estimate is 13% below consensus expectation, as we include a one-time royalty payment of US$29mn to Paul Capital. Consequently, our interest costs assumption goes up, as we believe the entire payment will be made through additional debt. For FY12, we have also factored in US$5mn milestone income in addition to US$50mn received from Sanofi.

For FY13, our revenue projection is 3% below consensus estimate, while our margin forecast is 34bps below consensus. We assume conservative margin expansion in FY13, as we do not factor in any milestone income in our estimates due to uncertainty on the timeline as well as its quantum. Further, we also model in lower interest costs on reduced debt and as we expect the interest rates to peak out in FY13, which consequently drives our PAT in line with consensus estimate.

Exhibit 5: Our estimates vs consensus expectations

FY12E FY13E

(Rsmn) NBIE

estimates Bloomberg consensus

Variation (%)

NBIE estimates

Bloomberg consensus

Variation (%)

Revenue 34,681 35,809 (3.2) 38,913 40,216 (3.2)

EBITDA 8,488 9,008 (5.8) 8,899 9,333 (4.6)

EBITDA margin (%) 24.5 25.2 (68bps) 22.9 23.2 (34bps)

PAT 5,152 5,940 (13.3) 6,057 6,027 0.5


Exhibit 6: Consensus revenue trend Exhibit 7: Consensus earnings trend


25,000

30,000

35,000

40,000

45,000

May

-10

Jun-

10

Jul-1

0

Aug

-10

Sep

-10

Oct

-10

Nov

-10

Dec

-10

Jan-

11

Feb

-11

Mar

-11

Apr

-11

May

-11

Jun-

11

Jul-1

1

Aug

-11

Sep

-11

Oct

-11


(Rsmn)

4,500

5,500

6,500

7,500

Ma

y-1

0

Jun

-10

Jul-1

0

Au

g-1

0

Se

p-1

0

Oct

-10

No

v-1

0

De

c-1

0

Jan

-11

Fe

b-1

1

Ma

r-1

1

Ap

r-1

1

Ma

y-1

1

Jun

-11

Jul-1

1

Au

g-1

1

Se

p-1

1

Oct

-11


(Rsmn)


39 Glenmark Pharma

Investment arguments

Base business on strong growth trajectory

We expect Glenmark’s base business revenue (excluding milestone income) to show a healthy CAGR of 17% over FY11-13E. With India and the US contributing 60% to the company’s revenue, they will be key growth drivers. Strengthening presence in core therapies will sustain 18% growth in India, while monetisation of pending drug pipeline (40 awaiting approvals including niche products) and market share gains via exclusive launches like Malarone and Oxycodone will lead to over18% CAGR in the US over the next two years. Besides, the focus on ‘power brands’ and replication of Indian model, will lead to a strong 27% CAGR over FY11-13E in LatAm and semi-regulated markets (SRM).

US market – Resuming the right course

Glenmark has been a laggard in the US market over the past two years owing to delay in product approvals and setback for two of its key products-Tarka and Nitroglycerin. However, with the recent spate of approvals (19 in FY11 - highest among Indian companies) and exclusive launches like Oxycodone (3QFY11), Malarone (3QFY12) and Cutivate (4QFY12), we expect revenue to rebound sharply in FY12. Further, market share gains in limited competition products like Adapalene and Calciproteine will ensure over 18% growth in US revenue in next two years.

Exhibit 8: US revenue profile


Carving a niche for itself

Glenmark has scaled up its US revenue to US$185mn in a short span of time, showing a CAGR of 71% over FY06-11. Key to this growth has been its strategy of focusing on small-sized, low competition products in niche segments like dermatology, controlled substances, oncology and extended release substances. Aggressive filings over the past four-five years have helped in building a strong portfolio of products across these therapies. Including tentative approvals, the company currently has over 69 ANDAs approved in the US, while 40 ANDAs await approval (of which 60-70% are limited competition opportunities). The company is now aggressively filing ANDAs (15 filings; 9 pending approval) in the US$4bn oral contraceptive market, a highly lucrative segment, in our view, given the limited number of players.

Exhibit 9: ANDA profile

Focus therapy Pending Authorised to distribute Total filings Market size (USDmn)

Dermatology 3 18 21 363.7

Hormones/oral contraceptives 9 6 15 1,179.3

Modified release 3 6 9 376.5

Para IV filings 13 0 13 7,930.4

Controlled substances 0 3 3 84.3

Immediate release 12 36 48 8,082

Total 40 69 109 18,016

Sales as per IMS for MAT June 2011

Source: Company

-(1.5)

15.5

25.6

11.7

(5)

0

5

10

15

20

25

30

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000


US Revenues YoY Growth (%)

(Rsmn) (%)


40 Glenmark Pharma

Pick-up in approvals after a two-year pause

Glenmark’s growth slowed down in FY10 owing to delay in approvals by the USFDA. However, with 19 (approvals in FY11 highest among Indian players, growth is expected to rebound strongly from FY12 onwards; lag of three-six months before revenue ramp-up from newly launched products). Further, market share gains in recently launched products like Adapalene (dermatology, US$10-11mn annual run rate; two-player market; 25-30% market share) and Calcipotriene (dermatology; US$10mn annual run rate) will bolster US revenue. We expect the company to launch 12-15 products over the next two years.

Exclusivity/limited competition products to be key drivers

We believe key products like Oxycodone and Malarone can enjoy extended marketing exclusivity as there are no other generic filers. Together, these products contribute 3%/4% to our revenue estimate and

11%/13% to our profit estimates for FY12/13, respectively.

Oxycodone (controlled substances; US$16 mn): While current market dynamics for Oxycodone are not so favourable (four-five players), we feel that once the USFDA is assured of enough supplies it will force other generics out of the market (likely in next three-six months), requiring them to file new ANDAs for the drug referencing Glenmark’s product. This will leave Glenmark as a sole player in the market. Assuming the current average approval time of 20-24 months, we believe the company will have the pricing power for at least two years, before the generics re-enter the market.

Malarone (anti-malarial; US$61 mn): Glenmark launched Malarone in September 2011 under a royalty bearing licence, as per its settlement with GSK. As per the management, currently there are no other filers for this product, thus implying another two years of revenue before competition creeps in (new filers will trigger a mandatory 30-month stay). We expect Glenmark to garner US$11mn and US$23mn in FY12 and FY13, respectively, assuming 25% price erosion and 50% market share.

Exhibit 10: Para IV pipeline

Product Brand Innovator Market size (US$ mn)

Litigation status

Approval status Market dynamics

Ezetimibe Zetia Schering plough 1,300 Case settled Tentative approval Will launch on 12 December 2016; GPL has FTF; Other suitors are Mylan (30-month stay to get over in December 2012) and Teva (30-month stay to get over in January 2013)

Fluticasone lotion 0.005% Cutivate Nycomed 48 Case settled Final As per the settlement, Glenmark will launch the drug in March 2012, or earlier in certain circumstances

Atovaquone+ Proguanil Hcl Malarone GSK 61 Case settled Final Launched end-September 2011 as per the settlement with GSK; No other generic filers; We expect earliest generics to enter the market in 2014

Hydrocortisone Butyrate Cream

Locoid lipocream

Triax & Astellas 38 Case settled Awaited --


Oral contraceptives – Long-term driver

The generic US oral contraceptive (OC) market (size ~US$1.6bn) is currently dominated by Teva and Watson, who together account for more than 90% of the volumes. OC requires dedicated facilities and are thus unviable for many to enter. Further, in order to compete with established generic players, new entrants will have to offer the entire product basket to make a meaningful dent in the existing market share. Glenmark is aggressively filing in this segment and till date has filed for 15 products, of which it has received 6 approvals (cumulative market size of $1.1bn on innovator price) and plans to file another 15. Though small, all these products have limited competition (two-three players), and hence, can be rewarding from the profitability point of view.


41 Glenmark Pharma

Domestic formulations: Limited focus, strong growth

With a 17% CAGR over FY09-11, Glenmark’s growth compares well with most large peers, even while 75% of its portfolio remains focused on acute therapies. Key to this growth has been its strategy to strengthen base in core therapies and focus on power brands. We note the company has consistently managed to improve market share in core therapies, despite the lower pace of new launches (20-25 versus 50-60 for most peers), and lower market coverage with around 450 brands (as compared to over 800 of most large-sized peers).

Exhibit 11: Market share trends in the past one year Exhibit 12: Top 10 brands’ contribution to domestic revenue

Source: Company, Nirmal Bang Institutional Equities Research Source: Bloomberg, Nirmal Bang Institutional Equities Research

Expect growth momentum to continue

Five therapies - dermatology, anti-infectives, respiratory, cardiology and anti-diabetics - contribute around 85% to domestic revenue, of which four are growing above industry average. We thus believe Glenmark will continue its growth momentum, and clock in 18% CAGR over FY11-13E, higher than the industry average, as a result of planned addition to sales force (10-15% over the next two years) and regular product introduction (25 products planned each in FY12 and FY13).

Exhibit 13: Therapy-wise break-up Exhibit 14: Domestic revenue trend


Semi-regulated markets: Replicating India business model

Replicating its India business model, Glenmark’s focus in semi-regulated markets (SRM) has been on building brands in core therapies (dermatology and respiratory) - key markets being Africa, Asia and Russia/CIS. In Africa and Asia, the top nine brands contributed more than 75% to revenue, with over 50% contribution from dermatology and respiratory segments. Revenue CAGR at 31% over FY06-10 was driven by aggressive product registrations as well as entry into new markets. While FY11 was largely flat, we expect Glenmark to register 27% CAGR over FY11-13E, as we remain fairly optimistic about the improving economic scenario in emerging markets.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

Cardiology Dermatology Respiratory Gynaecology

MAT Mar-2010 MAT Mar-2011

(%)

0

5

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15

20

25

30

35

40

45

Su

n P

ha

rma

Cip

la

Gle

nm

ark

Ca

dila

To

rre

nt P

ha

rma

Lu

pin

Ra

nb

axy

(%)

Anti-diabetec, 5%

Dermatology, 31%

Anti-infectives, 16%

Respiratory, 16%

Pain/Analgesics, 6%

Gastrointestinal, 3%

Gynaecological, 2%

Neuro/CNS, 1%

Opthalmologics, 2%

Vitamins, 1%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000


(Rsmn)


42 Glenmark Pharma

Exhibit 15: SRM revenue trend


LatAm business on the verge of break-even

On a low base, Glenmark’s specialty business in LatAm markets (6% of revenue) has witnessed strong revenue traction in FY11 with 41% YoY growth. Around 75% of this business comes from Brazil, which has strongly rebounded post restructuring. Other markets like Mexico and Venezeula have also started contributing meaningfully. Shift in LatAm business towards the prescription-based model from the tender-based model has led to higher marketing costs, which hit profitability in FY10. However, with higher revenue, the company is now EBITDA positive in this market. We have factored in 30% CAGR in these markets over FY11-13E.

Exhibit 16: LatAm revenue: Inventory de-stocking, currency depreciation hit business in 2009, 2010


Visible signs of Balance Sheet improvement

Glenmark’s progress on improvement of its balance sheet is closely watched by investors, and is crucial for re-rating its stock. The company has a high gearing (0.93x in FY11 post IFRS transition) and one of the highest receivable cycle of 144 days (excluding milestone income) in the industry. Signs of improvement are already visible, and further validation will narrow the discounted valuation compared with peers.

After a huge write-down of Rs4.5bn worth of intangibles ( possibly, including capitalised R&D) in 4QFY11 on transition to IFRS, and the management’s approach to discontinue capitalising R&D going forward, we believe investor concerns regarding overstatement of earnings, due to capitalised R&D should partly recede.

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500


(Rsmn)

0

500

1,000

1,500

2,000

2,500

FY05 FY06 FY07 FY08 FY09 FY10 FY11

(Rsmn)


43 Glenmark Pharma

Exhibit 17: Impact of transition to IFRS on key balance sheet items

(Rsmn ) IGAAP IFRS YoY (%) Comments

Reserves 23,282 20,102 (14) Charge of Rs4.5bn on reserves following fair valuation of assets

Total Loans 18,694 21,005 12 Additional debt of Rs900mn in FY11, and addition of factoring costs of Rs1.5bn (earlier classified as contingent liability) being partly reclassified as debt and partly receivables

Deferred Tax Liabilities/(Assets) 710 (1,081) - Arising out of difference in depreciation, as Rs4.5bn worth of assets get knocked off

Net Block 17,873 20,666 16 Write-off of Rs4.5bn of intangibles. We believe this also includes capitalised R&D costs. Increase in fixed assets is due to: a) Tansfer of Rs1.4bn from CWIP, and b) Rs700mn from capitalised R&D

Capital work-in-progress 6,008 1,457 (76) ~Rs1.4bn moved from CWIP to assets;

Debtors 10,783 11,308 5 Factoring costs classified as receivables under IFRS


The receivable cycle, despite an increase in overall receivables due to IFRS transition, has witnessed significant improvement and is down to 125 days currently, from 157 in March 2010 and 144 in March 2011.

Exhibit 18: Working capital to sales: Significant improvement in FY11

Source: Company, NBIE

Current debt (end June 2011) stands at ~Rs18bn (excluding the reclassified factoring costs of Rs1.5bn and assuming the payment to Paul Capital will be made by the debt route), down from Rs19.5bn as of end March 2011, implying a significant improvement in net DE from 0.93x in FY11 to 0.71x in FY12E.

Exhibit 19: Net debt/equity is on a declining trend Exhibit 20: Improving interest coverage ratio


0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9


(x)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

(x)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0


(x)


44 Glenmark Pharma

Multiple levers for margin expansion; RoE/RoCE to follow

With a balanced mix of niche/exclusive product launch in the US and turnaround in LatAm (specialty business) and Eastern Europe (branded generics), we expect Glenmark’s margins to witness a strong 279bps expansion over FY11-13E. RoE/RoCE expansion, consequently, will follow with an improvement of 392bps/661bps, as operating leverage plays out.

Key levers for margin expansion would be:

Increasing share of limited competition opportunities like Adapalene, Calciprotiene, etc, in the US, which

enjoy higher-than-average margins, will lead to structural improvement in gross margin.

LatAm markets (specialty business) and Eastern Europe (branded generics) achieving break-even at the

end of FY11.

Higher-than-average margins in exclusivity/Para IV launches like Oxycodone, Malarone and Cutivate.

Exhibit 21: RoE/RoCE to see improvement in next two years Exhibit 22: Multiple levers for margin expansion


Investment risks

Adverse court ruling in Tarka case can lead to a penalty of US$16mn for Glenmark. The company plans to appeal the negative ruling by New Jersey district court.

Deterioration in working capital cycle will be closely watched as Glenmark already has higher working capital cycle than its peers

Lower- than-anticipated market share in key products like Malarone, Oxycodone and Cutivate

Regulatory issues like delay in product approvals by the USFDA, manufacturing issues, etc

R&D setbacks on out-licensed TRPV3 portfolio can hamper future milestone payment. Currently, we have not factored in any such valuation in our estimates.

Currency appreciation, as more than 60% of the company’s revenue comes from exports

0

5

10

15

20

25

30

35

40

45


RoE RoCE

(%)

0

5

10

15

20

25

30

35

40

45


Margins (excl. milestones) Margins (incl. milestones)

(%)


45 Glenmark Pharma

Exhibit 23: Quarterly summary

(Rsmn) 1Q11 1Q12 YoY (%)

Net revenue 6,963 8,685 24.7

Total material costs 1,878 2,308 22.9

% of revenue 27.0 26.6 -

Staff costs 1,034 1,346 30.3

% of revenue 14.8 15.5 -

Other expenses 1,711 2,062 20.5

% of revenue 24.6 23.7 -

EBITDA 2,340 2,969 26.8

EBITDA margin (%) 33.6 34.2

Other income 116 123 6.6

Interest 277 408 47.1

Depreciation 327 264 (19.4)

PBT (after exceptional) 1,851 2,420 30.7

Tax 296 318 7.5

Reported PAT 1,556 2,102 35.1

PAT margin (%) 22.3 24.2 -

*4QFY11 numbers are not reported due to transition to IFRS



46 Glenmark Pharma

Financials

Exhibit 24: Income statement


Net sales 20,402 24,124 29,491 34,681 38,913

% growth 5.5 18.2 22.2 17.6 12.2


Staff costs (2,869) (3,092) (5,103) (5,394) (6,148)

R&D expenses (878) (772) (1,350) (2,000) (2,000)

Others (5,525) (6,222) (7,197) (7,873) (9,145)


EBITDA 4,550 6,196 5,923 8,488 8,899

% growth (43.2) 36.2 (4.4) 43.3 4.8

EBITDA margin (%) 22.3 25.7 20.1 24.5 22.9

Other income 1,793 504 1,444 335 778

Interest (1,457) (1,655) (1,605) (1,586) (1,266)

PBDT 4,885 5,045 5,762 7,237 8,412

% growth (36.0) 3.3 14.2 25.6 16.2

Depreciation (1,027) (1,206) (947) (1,185) (1,298)

Profit before tax 3,858 3,839 4,815 6,052 7,114

% growth (44.2) (0.5) 25.4 25.7 17.6

Tax (754) (529) (237) (847) (996)


Net Profit 3,104 3,310 4,578 5,204 6,118

% growth (49.3) 6.6 38.3 13.7 17.6

Extraordinary items (1,170) 0 0 0 0



% growth (69.7) 69.3 39.7 13.7 17.6


% growth (35.2) 13.8 17.6 10.3 43.9

Reported EPS (Rs) 7.7 12.0 16.8 19.1 22.4

% growth (69.9) 57.2 39.4 13.7 17.6

Adjusted EPS (Rs) 11.4 12.0 14.1 15.6 22.4

% growth (35.6) 5.6 17.4 10.3 43.9

DPS (Rs) 0.4 0.4 0.4 0.4 0.4

Payout (%) 6.1 3.9 2.8 2.5 2.1


Exhibit 26: Balance Sheet Y/E March (Rsmn) FY09 FY10 FY11 FY12E FY13E

Equity 251 270 270 270 270

Reserves 15,731 23,282 20,102 25,185 31,172

Net worth 15,982 23,552 20,372 25,455 31,442

Short-term loans 9,359 4,100 14,802 14,802 14,802

Long-term loans 11,585 14,593 6,202 5,023 3,023

Total loans 20,943 18,694 21,005 19,826 17,826

Deferred tax liabilities/(assets) 569 710 (1,081) (1,081) (1,081)


Liabilities 37,526 43,086 40,563 44,466 48,453

Gross block 18,385 21,755 23,834 26,334 28,834

Depreciation 2,723 3,882 3,168 4,353 5,650

Net block 15,662 17,873 20,666 21,981 23,184

Capital work-in-progress 5,454 6,008 1,457 1,457 1,457

Long-term Investments 181 181 281 0 0

Inventories 6,302 7,085 8,070 9,442 10,946

Debtors 9,553 10,783 11,308 11,932 13,326

Cash 715 1,070 1,986 1,717 1,835



Creditors 3,435 2,972 6,686 5,382 6,167




Total assets 37,526 43,086 40,563 44,466 48,453




EBIT 3,523 4,990 4,080 6,124 7,601

Inc./(dec.) in working capital (3,770) (2,448) 1,805 (3,139) (2,667)

Cash flow from operations (247) 2,542 5,885 2,985 4,934

Other income 1,793 504 1,444 335 780

Depreciation 1,027 1,206 947 1,185 1,298

Interest paid (-) (1,457) (1,655) (1,605) (1,586) (1,266)

Tax paid (-) (754) (529) (237) (847) (996)

Dividends paid (-) (117) (126) (126) (126) (126)

Net cash from operations 244 1,943 6,308 1,945 4,623

Capital expenditure (-) (9,226) (3,924) 2,472 (2,500) (2,500)

Net cash after capex (8,983) (1,981) 8,780 (555) 2,123

Inc./(dec.) in short-term borrowing 3,179 (5,258) 9,448 (3,179) (1,500)

Inc./(dec.) in long-term borrowing 7,855 3,009 (7,138) 2,000 (500)

Inc./(dec.) in preference capital 0 0 0 0 0

Inc./(dec.) in borrowings 11,034 (2,250) 2,311 (1,179) (2,000)

Inc./(dec). in investments 7 0 (100) 281 0

Equity issue/(buyback) 2 19 0 0 0

Cash from financial activities 11,043 (2,230) 2,211 (898) (2,000)

Others (2,911) 4,567 (10,076) 1,184

Opening cash 1,565 715 1,070 1,987 1,715

Closing cash 715 1,070 1,986 1,717 1,835

Change in cash (850) 355 916 (270) 119




Per share (Rs)

Reported EPS 7.7 12.0 16.8 19.1 22.4

Adjusted EPS 11.4 12.0 14.1 15.6 22.4

DPS 0.4 0.4 0.4 0.4 0.4

BV/share 63.8 87.3 75.4 94.2 116.3

Dividend payout (%) 6.1 3.9 2.8 2.5 2.1

Performance ratios (%)

RoE 18.3 16.4 17.4 18.4 21.3

RoCE 11.1 12.4 9.8 14.4 16.4

Valuation ratios (x)

P/E 27.2 25.8 22.0 19.9 13.8

P/BV 4.9 3.6 4.1 3.3 2.7

EV/net sales 5.1 4.2 3.5 2.9 2.6

EV/EBITDA 22.9 16.4 17.4 12.0 11.2

Efficiency ratios

Asset turnover (x) 0.6 0.5 0.6 0.7 0.7



Inventory days 113 107 103 103 103

Payable days 79 60 104 75 75



Initi

atin

g C

over

age

Reuters: SUN.BO; Bloomberg: SUNP IN

Sun Pharmaceutical Industries

Fairly Valued With a 20% re-rating in PE multiple in the past 18 months, we believe Sun Pharma’s growth trajectory and Taro-related upside are well captured in the share price, leaving little scope for any error. While the premium valuation will stay – led by strong domestic market positioning, healthy Balance Sheet and robust capital efficiency – we see limited levers for PE multiple expansion, especially in view of stagnating Para IV pipeline and the risk of potential liability from Protonix litigation. We assign a Hold rating to the stock with a target price of Rs513, implying a 2% upside from the CMP.

Upside discounted; Near-term performance contingent on various factors: With a 20% re-rating of PE multiple in the past 18 months, we believe Sun Pharma’s growth trajectory and Taro-related upside are well captured in the share price, leaving little scope for error. Our estimates are broadly in line with consensus estimates and we believe the company’s near-term performance is contingent on numerous factors the, outcome of which will decide stock movement, either way. On the negative side, a stagnating Para IV pipeline and the risk of potential liability from Protonix litigation will cap PE multiple expansion, while value unlocking through potential acquisitions and speedy resolution of Caraco issue are key upside risks.

Domestic formulations business looks promising: Even as the industry struggles to maintain volume growth in domestic market, Sun Pharma stands out from the crowd owing to a) Its high exposure towards lifestyle diseases (60% of portfolio), b) Leadership in key therapies like psychiatry, neurology, cardiology ophthalmology, orthopaedics and gastro-enterology, and c) Its ability to gain market share (4.4% currently as per AIOCD). With a 20%CAGR in the past five years, Sun Pharma is among the fastest growing companies in India and has consistently outpaced industry growth. We believe the outperformance will continue and expect the company’s domestic revenue to show 18%CAGR over FY11-13E.

Taro operational turnaround is the key: Strategically, we believe Taro is an excellent fit for Sun Pharma, given its strong US presence and minimal product overlap. The important driver, however, is its operational turnaround. Taro’s EBITDA margin has improved substantially from 22% in 2010 to 31% in 1HCY11, partly driven by lower remediation charges and stagnant R&D expenses. Even then, we note the margins are lower than Sun’s base business margin of 32-33% and are likely to decline in subsequent quarters on increased competition and higher R&D expenditure.

Valuation: We value Sun Pharma at 22.5x FY13E EPS of Rs23, at a 25% premium to our target sector multiple of 18x, to arrive at a target price of Rs513, implying a 2% upside from the CMP. Our target multiple is at a 15-20% premium to peers like Cipla and Dr Reddy’s Laboratories, which we believe is justified, given the superior margin profile and potential value unlocking through acquisitions.

HOLD


CMP: Rs503

Target Price: Rs513

Upside: 2%


Key Data

Current Shares O/S (mn) 1,036


52 Wk H / L (Rs) 603/392

Daily Vol. (3M NSE Avg.) 1,166,923

Share holding (%) Q4FY12 QFY12 Q2FY11

Promoter 63.7 63.7 63.7

FII 18.5 18.6 19.1

DII 7.1 7.2 6.5





1 M 6 M 1 Yr

Sun Pharma 9.1 8.3 15.1

Nifty Index 6.8 (8.2) (13.7)

Source: Bloomberg

Y/E Mar (Rsmn) FY09 FY10 FY11 FY12E FY13E

Revenue 42,723 41,028 58,341 72,364 80,136

YoY (%) 27.3 (4.0) 42.2 24.0 10.7

EBITDA 18,640 13,633 19,672 23,722 26,124

EBITDA (%) 43.6 33.2 33.7 32.8 32.6

Adj PAT 18,178 13,512 18,609 21,845 23,609

YoY (%) 22.3 (25.7) 37.7 17.4 8.1

Fully DEPS 17.6 13.0 18.0 21.1 22.8

RoE (%) 30.2 18.2 21.5 21.2 19.6

RoCE (%) 26.8 15.3 18.4 18.1 17.4

P/E (x) 28.7 38.6 28.0 23.8 22.1

EV/EBITDA (x) 27.1 37.9 25.6 20.9 18.7


1 November 2011


48 Sun Pharma

We are 6% below consensus estimate on FY13 PAT

Our revenue and PAT estimates are broadly in line with consensus estimates for FY12, although 4% below the lower end of the management’s revenue guidance of 28-30% as we have not excluded VAT (not disclosed separately) and discontinued third party revenue from our FY11 base. Adjusting for third party revenue and assuming 3% VAT, we believe our estimates would meet the lower end of the management’s guidance. On a high base, Sun’s guidance is impressive and possibly driven by: a) Strong growth trajectory in India; management expects 18-20% growth b) Full first year reflection of Taro integration, as last year’s base includes six months’ revenue, c) Upside from a large pending US pipeline of 151 ANDAs, d) Upside from niche opportunities like Taxotere, Prandin, Gemzar etc, and e) Rising contribution from emerging markets.

Our FY13 revenue and PAT expectations are 7%/6% below consensus estimates, as we expect domestic growth to moderate to 16% in FY13 led by a high base of FY12 and slowing growth momentum in domestic market. We also expect modest growth in Taro following increased competition in core therapies and in key products like Imiquimod cream, which constitutes 5% of our FY12 revenue estimate for Taro.

Exhibit 1: Our expectations vs consensus estimates

(Rsmn) NBIE


Variation (%) NBIE

Bloomberg consensus

Variation (%)

Revenue 72,364 73188 (1.1) 80,136 86,116 (6.9)

EBITDA 23,722 24099 (1.6) 26,124 28,632 (8.8)

EBITDA margin (%) 32.8 32.9 (15bps) 32.6 33.2 (65bps)

PAT 21,845 21296 2.6% 23,609 25,144 (6.1)


Exhibit 2: Consensus revenue estimate

Exhibit 3: Consensus PAT estimate


40,000

50,000

60,000

70,000

80,000

90,000

Feb

-10

Apr

-10

Jun-

10

Aug

-10

Oct

-10

Dec

-10

Feb

-11

Apr

-11

Jun-

11

Aug

-11

Oct

-11


(Rsmn)

10,000

15,000

20,000

25,000

30,000

Fe

b-1

0

Ap

r-1

0

Jun

-10

Au

g-1

0

Oct

-10

De

c-1

0

Fe

b-1

1

Ap

r-1

1

Jun

-11

Au

g-1

1

Oct

-11


(Rsmn)


49 Sun Pharma

Fairly valued

With a 20% expansion in PE multiple post announcement of Taro acquisition in June 2010, we believe Sun Pharma’s strong earnings trajectory and Taro-related upsides are well captured in its share price, leaving little scope for further appreciation. In the near term, we believe the stock’s performance is contingent on numerous factors the, outcome of which will decide stock movement, either way. On the negative side, a stagnating Para IV pipeline and the risk of potential liability from Protonix litigation will cap PE multiple expansion, while value unlocking through potential acquisitions and speedy resolution of Caraco issues are key upside risks.

We assign a Hold rating and a target price of Rs513 to the stock, implying an upside of 2% from the current level. Our target price is pegged at: a) 25% premium to our target sector multiple of 18x, b) 35% premium to five-year average multiple, and c) 70% premium to Sensex against a 15% average premium historically, owing to its strong defensive appeal and significantly higher margin profile than Sensex companies.

Exhibit 4: PER – Sun’s multiple has expanded 20% post announcement of Taro acquisition


Sun Pharma scores the best on our valuation framework and we believe the premium valuation is justified by a) Strong domestic franchise, with more than 60% contribution from chronic therapies and leadership position in key therapies like CVS, CNS etc b) Balance sheet strength, with a net cash of ~US$1bn c) Management track record, with a strong execution record and a disciplined M&A strategy, and d) RoE and RoCE of 22%/18% respectively, driven by its best-in-class margin profile.


Sector PE (x) 18.0

Premium to sector 25%

Sun's PE (x) 22.5

FY13E EPS 22.8


b) Para IV value 0

Target Price (a+b+c) 513


Exhibit 6: Premium to sector, Sensex justified


0

5

10

15

20

25

30

Oct

-05

Ap

r-0

6

Oct

-06

Ap

r-0

7

Oct

-07

Ap

r-0

8

Oct

-08

Ap

r-0

9

Oct

-09

Ap

r-1

0

Oct

-10

Ap

r-1

1

Oct

-11

(x)

Announcement of Taro acquisition

(60)

(40)

(20)

-

20

40

60

80

100

120


Premium/discount to Sector Premium/discount to Sensex

(%)


50 Sun Pharma

Rating Rationale

Domestic formulations - Stand out from the crowd

With a 20% CAGR over the past five years, Sun Pharma is among the fastest growing companies in India and has one of the most profitable domestic franchises contributing over 50% to profit. Even as other domestic players struggle to maintain volume growth, the company stands out from the crowd owing to: a) High exposure to lifestyle diseases (60% of portfolio), b) Leadership in key therapies like psychiatry, neurology, cardiology ophthalmology, orthopaedics and gastro-enterology, and c) Its ability to gain market share (4.4% currently as per AIOCD), without expanding its field force in large numbers or venturing in non-urban markets. Also, we believe competition risks are minimal for Sun Pharma as the company enjoys a strong relationship with specialists and super-specialists, which takes a substantial amount of time to build. We thus believe the company will be able to maintain its growth trajectory and expect 18% CAGR (excluding VAT and discontinued third party revenue) in domestic revenue over FY11-13E.

Exhibit 7: Domestic formulations–Therapy-wise break-up(%) Exhibit 8: Domestic formulations revenue trend


Strong US growth led by Para IV opportunities/acquisitions

Sun Pharma’s US revenue has shown 49% CAGR over FY07-11, led by monetisation of key Para IV/exclusive opportunities like Protonix (GERD), Eloxatin (oncology) and Trileptal (CNS) as well as Taro acquisition. These products have together contributed ~US$500mn over FY08-11, as per our estimate. Its base business – excluding Taro and Para IV opportunities – has largely remained muted with 9% CAGR (as per our estimate) over the past four years.

Exhibit 9: Sun’s (including Taro) US portfolio break-up Exhibit 10: US revenue growth trend


Neuro Psychiatry, 28

Cardiology, 19Diabetelogy, 14

Gastroenterology, 11

Others, 8

Gynecology & Urology, 7

Musculo-skeletal & pain, 5

Opthalmology, 5Anti-asthmatic and

Anti-allergic, 4

(15)

(10)

(5)

0

5

10

15

20

25

30

35

40

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000


Domestic revenues Growth rate

(Rsmn) (%)

89

53

20

15

13

12

7

6

10

Skin

CNS

CVS

Pain

Allergy

Oncology

Metabolism

Cough/Cold

Others

0

100

200

300

400

500

600

700

800

900


Base business revenues Para IV Taro

(US$ mn)


51 Sun Pharma

Taro – Operational turnaround is the key

Strategically, we believe Taro is an excellent fit for Sun Pharma, given its strong US portfolio and minimal product overlap (Taro has a strong dermatology and OTC portfolio, where Sun is minimally present); the important driver, however, is operational turnaround. Taro’s EBITDA margin has improved substantially from 22% in CY10 to 31% in 1HCY11, partly driven by lower remediation charges (as the warning letter for its Canadian facility was withdrawn) and R&D expenses. Even then, we note the margins are lower than Sun’s base business margins of 32-33% and are likely to subside in the subsequent quarters on increased competition and higher R&D expenditure.

Exhibit 11: Taro’s margins improved significantly in 1HCY11


Initial focus is to step up R&D investment

Sun Pharma’s initial focus is to step up Taro’s R&D investment, which has largely remained stagnant at around US$35mn over the past three years. We believe this possibly points to a weak future pipeline; this was also indicated by Sun’s management at recent conference calls. Taro currently has two NDAs under development, both of which are in early stages, and 24 ANDAs pending approval. For FY12, Sun Pharma has given a guidance of over 6% R&D expenditure, almost 100bps higher than the previous year.

Exhibit 12: Taro’s R&D largely stagnant over past three years


0

5

10

15

20

25

30

CY07 CY08 CY09 CY10 CY11E CY12E CY13E

(%)

0

2

4

6

8

10

12

14

16

0

5

10

15

20

25

30

35

40

CY06 CY07 CY08 CY09 CY10

(US$ mn) (%)


52 Sun Pharma

We factor in 8% revenue CAGR over next two years

Notwithstanding a strong 1H2011, we expect Taro’s growth to moderate going forward and factor in 8% revenue CAGR over the next two years as we believe Taro’s future pipeline will be weak because of stagnant R&D expenditure over the past three years. Consistent to our muted expectations, Taro, in its 2QCY11 SEC filing, cited increasing competition to have a negative impact on its sales and margins in the coming quarters. Our estimates assume US$19mn and US$36mn of revenue in FY12 and FY13 from the launch of Imiquimod cream (Market size: US$293mn, five-player market with Nycomed and Perrigo controlling ~90% of the market), for which Taro has received approval in April 2011, but the launch has not yet been confirmed. We expect Taro’s base business margins to stabilise around 28.5% in CY11E and CY12E, lower than 1HCY11 average of 31%, as we expect an increase in R&D expenses. Taro accounts for 26% and 24% of our FY12 and FY13 revenue forecasts, respectively.

Excluding Taro, we expect flat US revenue growth

Excluding Taro, we expect Sun Pharma’s base US revenue to remain flat over FY11-13E because of lack of material product opportunities and higher base of FY11, led by one-time sales of Pantoprazole and Eloxatin. Barring Taxotere, Gemzar and Prandin, we do not foresee any large scale opportunities that can swing earnings materially. We have factored in US$68mn and US$49mn from Taxotere in our FY12 and FY13 revenue estimates, respectively, while we have included Prandin in our FY13 revenue estimate on the expiry of six-month marketing exclusivity. Caraco’s progress on remediation has been slower than expected and we do not see meaningful contribution before FY13. Even if Caraco warning letter issue is resolved, we believe the ramp-up will only be gradual as we believe the USFDA will closely scrutinise each product before it reaches the market.

Exhibit 13: Sun’s Para IV settlements

Brand name

Generic name Brand sales (US$mn)

Launch year

Comments

Exelon rivastigmine 346 2010 Launched along with Watson in July 2010

Astelin azelastine 259 2011 Apotex launched under licence from Meda Pharma in March-2010; Sun Pharma yet to receive approval

Stalevo carbidopa, levodopa and entacapone

138 2012 Orion has settled with Wockhardt and Sun; Wockhardt has FTF and will launch in September 2012. Post marketing exclusivity period, Sun Pharma will also launch its product.

Comtan entacapone 96 2013 Will launch on 1 April,2013, post Wockhardt's marketing exclusivity.

Namenda memantine 1,338 2015 Shared with multiple players.

Ethyol amifostine 80 2008 Launched along with Watson in July 2010.

Clarinex desloratadine 205 NA Settled with Schering; likely launch on 1 July 2012 with 8-9 other players.

Depakote divalproex 786 NA -

lexapro escitalopram 2,818

Paediatrics exclusivity expired on 12 March 2011; Teva is FTF; Caraco will launch after AG, FTF and another generic player’s launch; Multiple filers with tentative approvals (8-9); We expect the product launch in October 2012.

Allegra fexofenadine Hcl 29 NA

Source: Bloomberg, USFDA, Industry


53 Sun Pharma

Exhibit 14: Sun’s Para IV pipeline

Brand Form API Innovator Sales

(US$mn) First patent

expiry Comments

Abilify Tablet aripiprazole Otsuka 4598 20 Apr 2005 US district court upheld Otsuka's patents till 20 April 2015. Sun has appealed against the ruling and the verdict is awaited. Four other companies including Teva, Sandoz, Apotex and Synthon are in litigation

Actonel Tablet risedronate P&G (& Merck) 792 22 Nov 2011 Judgement awaited

Allegra-D24

ER tablet fexofenadine/ pseudoephedrine

Aventis 500 11 Nov 2012 Dr Reddy’s has launched the generic version

Allegra Tablet fexofenadine Hcl Aventis 29 26 May 2014 Matter settled with Aventis

Boniva Injection ibandronate Roche 695 17 Mar 2012 Five companies including Sun have tentative approval

Crestor Tablet rosuvastatin Astrazeneca 2797 8 Jan 2016 Shared FTF with 7-8 players

Cymbalta Delayed-release capsule

duloxetine Eli Lilly 3172 11Jun 2013 Shared FTF with 6-7 players; US district court ruled against generic filers in April 2011

Focalin Tablet dexmethylphenidate Novartis 21 4 Dec 2015 -

Gabitril Tablet tiagabine Cephalon 51 30Sep 2011 Sun is likely to launch in March 2012 after the expiry of pediatric exclusivity

Glumetza Extended release tablet

metformin Depomed 42 19 Sep 2016 Sun has filed for 500 mg and 1gm; Multiple players in 500mg; Lupin has FTF on 1gm

Gleevec Tablet imatinib Novartis 1285 4 Jul 2015 Sun is the FTF.

Lunesta Tablet eszopiclone Sepracor 792 16 Jan 2012 Shared FTF with multiple players; Launch likely in November 2013 or May 2014 in case of grant of pediatric exclusivity.

Lyrica Capsule pregabalin pfizer 1443 8 Oct 2013 Multiple FTF filers.

Nexium IV Injection esomeprazole Astrazeneca 6290 27 Nov 2014 Ranbaxy has settled with AstraZeneca, to launch in May 2014 along with Teva

Nisapan ER tablet niacin Kos Pharmaceuticals (Abbott Labs)

1139 20 Sep 2013 Teva is most likely the FTF.

Plavix Tablet clopidogrel Bristol-Myers Squibb 6166 Expired Apotex lost the litigation against Sanofi/BMS and paid US$441mn in 2010 for its at-risk launch; Paeditric exclusivity ands on 17 May 2012.

Precedex Injection dexmedetomidine Hospira (Orion) 107 6 Sep 2011 Sandoz is the FTF; Caraco is the only other company to be sued.

Protonix IV For injection pantoprazole Wyeth / Altana 80 19 Jan 2011 Sun is likely the FTF.

Ryzolt Extended release tablet

tramadol ER Purdue Pharma 15 10 May 2014 Judgement awaited.

Strattera Capsule atomoxetine Eli Lilly 524 26 May 2017 Eli Lilly won the litigation on appealing in the US federal court, which overruled the earlier decision and thus the generic competition is delayed. Sun is the FTF with 6-7 other players

Temodar Capsule temozolomide Schering 391 11 Feb 2014 Teva is the FTF and has settled with Merck for launch in August 2013; Sun is para IV and will mostly launch after Teva

Uroxatral ER tablet alfuzosin Sanofi-Aventis 247 18 Jan 2011 Multiple FTFs.

Xyzal Tablet levocetirizine Ucb And Sepracor 177 24 Sep 2012 Synthon is the FTF.

Yaz Tablet drospirenone and ethinyl estradiol

Bayer Corp 751 29 Oct 2013 Judgement awaited.

Source: Bloomberg, USFDA, Industry


54 Sun Pharma

Earnings CAGR of 13% over FY11-13E

We expect Sun’s revenue to show 17% CAGR over FY11-13E, led by continued traction in its chronic focused domestic business (18% CAGR), Rest of the world markets (22% CAGR) and US revenue (21% CAGR) are driven by niche opportunities like Taxotere, Gemzar, Prandin and contribution from Taro. There can be upside to our estimates if Sun Pharma is able to resolve Caraco issue by FY13. We expect the margins to cumulatively decline by 112bps over FY11-13E, owing to lower margins at Taro and declining contribution from high margin Para IV opportunities. We assume higher tax rates in FY13, as tax benefits for Taro are likely to deplete in FY12, which consequently drives our expected 13% CAGR in PAT, 6% below consensus estimate. Decline in margins and increase in the proportion of low-yield cash will consequently will drive RoE/RoCE lower by 188bps/98bps over FY11-13E.

Exhibit 15: Sun’s financial profile

Source: Company; Nirmal Bang Institutional Equities Research

Strong Balance Sheet gives flexibility to pursue inorganic growth

With cash on its books at US$1bn, Sun Pharma has already stated its intention to grow in the US and other large emerging markets (Russia, Brazil, China, Mexico, etc) beyond the current footprint through acquisitions. Given its history of buying underperforming assets and then turning them around, we believe the company may be looking at a similar option. As earlier indicated by the management, the company is looking for a sizeable entity to further scale up operations, rather than making small acquisitions. Current yield on cash (plus investments) is 3%, as most of the cash is deployed in long-dated mutual fund schemes and is value destructive (adjusted for cash plus investments, its RoCE stands at an impressive 27%). We believe any value unlocking through potential acquisition will be positive for Sun Pharma.

Key risks

Unfavorable ruling in the Protonix case can lead to substantial penalty. Even assuming 1x of profit, the amount can be as high as US$300mn. This may also delay its acquisition plan.

Prolonged Caraco issue will lead to downgrade in FY13 earnings, as we believe consensus is expecting a resolution by FY13

Higher-than-expected price erosion in Taxotere would lead to earnings downgrade, as it contributes 7%/4% to our FY12/13 EPS estimates, respectively. Marketing transition from Caraco post January 2012, may lead to supply disruption and confusion in the market place.

0

5

10

15

20

25

30

35

40

45

50

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000


Revenue PAT EBITDA margin

(Rsmn) (%)


55 Sun Pharma


Y/E March (Rsmn) 1QFY11 4QFY11 1QFY12 YoY (%) QoQ (%)

Net revenue 13,997 14,633 16,357 16.9 11.8

Total raw material costs 3,357 3,132 4,071 21.3 30.0

% of revenue 24.0 21.4 24.9 - -

Staff costs 1,246 2,540 2,786 123.6 9.7

% of revenue 8.9 17.4 17.0 - -

Other expenses 3,235 4,525 4,026 24.5 -11.0

% of revenue 23.1 30.9 24.6 - -

EBITDA 6,160 4,436 5,474 (11.1) 23.4

EBITDA margin (%) 44.0 30.3 33.5 - -

Other income (87.6) 659.3 653.1 (845.5) (0.9)

Interest Income 203.2 448.4 315.5 55.3 (29.6)

Depreciation 402 482.1 647.2 61.0 34.2

PBT (before exceptional items) 5,873 5,062 5,796 (1.3) 14.5

Exceptional items - - - - -

PBT (after exceptional items) 5,873 5,062 5,796 (1.3) 14.5

Tax 97 22.4 142.7 47.1 537.1

Minority interest 133.1 611.9 643.1

Reported PAT 5,643 4,428 5,010 (11.2) 13.2

PAT margin(%) 40.3 30.3 30.6 - -

Source: Company; Nirmal Bang Institutional Equities Research


56 Sun Pharma

Financials Exhibit17: Income statement


Net sales 42,723 41,028 58,341 72,364 80,136

% growth 27.3 (4.0) 42.2 24.0 10.7


Staff costs (3,401) (4,008) (7,996) (11,578) (12,822)

R&D expenses (3,099) (2,083) (3,077) (4,500) (5,129)

Others (9,028) (10,326) (12,990) (14,473) (15,226)


EBITDA 18,640 13,633 19,672 23,722 26,124

% growth 20.2 (26.9) 44.3 20.6 10.1

EBITDA margin (%) 43.6 33.2 33.7 32.8 32.6

Other income 868 910 1,386 1,701 1,883

Interest 1,217 1,139 1,342 1,810 2,000

Depreciation (1,233) (1,533) (2,041) (2,586) (2,869)


% growth 21.9 (27.4) 43.9 21.1 10.1

Tax (712) (679) (836) (1,232) (1,900)


Net profit 18,781 13,471 19,522 23,415 25,239

% growth 21.1 (28.3) 44.9 19.9 7.8

Extraordinary items (603) 41 (913) (1,569) (1,629)


% growth 22.3 (25.7) 37.7 17.4 8.1

EPS (Rs) 17.6 13.0 18.0 21.1 22.8

% growth 22.3 (25.7) 37.7 17.4 8.1

DPS (Rs) 13.7 13.8 3.5 4.2 4.6

Payout (%) 17.7 24.6 22.7 24.2 24.2




Equity 1,036 1,036 1,036 1,036 1,036

Reserves 69,414 77,254 93,798 110,365 128,271

Net worth 70,449 78,289 94,833 111,401 129,306

Short-term loans 117 695 695 695 695

Long-term loans 1,672 1,016 3,561 557 557

Total loans 1,789 1,712 4,256 1,252 1,252

Deferred tax liabilities/(assets) (679) (890) (3,652) (3,652) (3,652)

Minority interest 1,970 1,932 8,472 10,041 11,670

Liabilities 73,529 81,042 103,908 119,041 138,576

Gross block 24,730 27,401 44,265 48,765 53,265

Depreciation 6,851 8,013 10,053 12,639 15,508

Net block 17,879 19,388 34,212 36,126 37,757


Long-term investments 18,595 30,664 22,310 25,770 32,890

Inventories 9,757 10,739 14,794 18,294 20,279

Debtors 8,811 11,748 11,716 14,487 16,060

Cash 16,690 6,073 21,936 25,769 32,892



Creditors 2,543 2,408 7,517 9,455 10,499




Total assets 73,529 81,042 103,908 119,041 138,576




EBIT 17,407 12,100 17,631 21,136 23,255

Inc.(/dec )in working capital 1,029 (4,664) (1,310) (7,107) (4,088)


Other income 868 910 1,386 1,701 1,883

Depreciation 1,233 1,533 2,041 2,586 2,869

Interest paid (-) 1,217 1,139 1,342 1,810 2,000

Tax paid (-) (712) (679) (836) (1,232) (1,900)

Dividends paid (-) (2,547) (3,214) (3,321) (4,098) (5,278)


Capital expenditure (-) (7,925) (2,548) (16,864) (4,500) (4,500)

Net cash after capex 10,570 4,577 68 10,296 14,243

Inc./(dec.) in short-term borrowing (251) 578 - - -

Inc./(dec.) in long-term borrowing 604 (656) 2,544 (3,004) -

Inc./(dec.) in preference capital - - - - -

Inc./(dec.) in borrowings 353 (77) 2,544 (3,004) -

(Inc./(dec). in investments (11,035) (12,069) 8,354 (3,460) (7,120)

Equity issue/(buyback) - - - - -

Cash from financial activities (10,682) (12,146) 10,899 (6,464) (7,120)

Others 4,413 (3,049) 4,897 - -

Opening cash 12,389 16,690 6,073 21,936 25,769

Closing cash 16,690 6,073 21,936 25,769 32,892

Change in cash 4,302 (10,618) 15,864 3,833 7,123




Per share (Rs)

Reported EPS 17.6 13.0 18.0 21.1 22.8

Adjusted EPS 17.6 13.0 18.0 21.1 22.8

DPS 13.7 13.8 3.5 4.2 4.6

BV/share 68.0 75.6 91.6 107.6 124.9

Dividend payout (%) 17.7 24.6 22.7 24.2 24.2


RoE 30.2 18.2 21.5 21.2 19.6

RoCE 26.8 15.3 18.4 18.1 17.4


P/E 28.7 38.6 28.0 23.8 22.1

P/BV 7.4 6.7 5.5 4.7 4.0

EV/Net Sales 11.8 12.6 8.6 6.9 6.1

EV/EBITDA 27.1 37.9 25.6 20.9 18.7

Efficiency ratios

Asset turnover (x) 0.8 0.6 0.7 0.8 0.7




Payable days 75 110 73 73 73



Initi

atin

g C

over

age

Reuters: CIPL.BO; Bloomberg: CIPLA IN

Cipla

Not Out of the Woods Yet Cipla’s partnership-based export model has failed to revive its fortunes despite significant capacity addition, while its domestic business is facing significant competition from peers. Key stock catalyst - the launch of combination inhalers - is still 15-18 months away and we believe its subdued capital efficiency following an additional Rs10bn of planned capex will steer further contraction in PE multiple. We assign a Sell rating to the stock with a target price of Rs268, implying a 9% downside from the current market price.

Capital efficiency under pressure: Cipla’s aggressive capex of Rs31bn (~56% of EBITDA, 26% CAGR) in the past five years has significantly eroded its capital efficiency, as earnings with a 10% CAGR failed to keep pace. Consequently, its RoE/RoCE nearly halved from 34%/26%, respectively, in FY06 to 16% in FY11, while asset/turnover at 0.8x currently is the lowest in its history.

FY12 revenue growth guidance of 10% is uninspiring: This is more so in the backdrop of significant capacity addition in recent times and an expected recovery in domestic market from 2HFY12. We believe the company’s muted export growth is likely to continue owing to: a) High base of API business due to Olanzapine supply to Teva in FY12, b) Subdued ARV business in line with the company’s focus to participate only in high-margin tenders, and c) Back-ended ramp-up at Indore SEZ as we expect the USFDA’s approval to come only in 2HFY13. Consequently, our FY13 revenue and PAT estimates are 5%/9% below consensus estimates, respectively.

Key stock catalysts still far-fetched: Cipla’s launch of generic combination inhalers in Europe is still 15-18 months away, as indicated by the management at the 1QFY12 results conference call. We believe this can be a substantial opportunity for Cipla, as our back-of-the-envelope calculations suggest this can add US$67mn to revenue and US$30mn, or Rs1.5, to EPS per annum.

Valuation: We value Cipla at 17.1x target PE on FY13E EPS of Rs15.7, to arrive at a target price of Rs268, implying a 9% downside from the CMP. Our target price is pegged at a 5% discount to our target sector multiple of 18x and ~25% discount to its five-year average, to factor in muted growth profile and continuing deterioration in return ratios.

SELL


CMP: Rs297

Target Price: Rs268

Downside: 9%


Key Data



52 Wk H / L (Rs) 381/273

Daily Vol. (3M NSE Avg.) 1,366,993

Share holding (%) Q4FY11 QFY12 Q1FY12

Promoter 36.8 36.8 36.8

FII 19.3 19.1 18.4

DII 18.7 18.6 19.1





1 M 6 M 1 Yr

Cipla 5.8 (3.8) (15.7)

Nifty Index 7.7 (7.4) (11.5)

Source: Bloomberg


Revenue 52,343 56,249 63,218 69,066 75,903

YoY (%) 24.1 7.5 12.4 9.3 9.9

EBITDA 12,263 13,330 13,291 15,894 17,248

EBITDA (%) 23.4 23.7 21.0 23.0 22.7

Adj PAT 7,755 10,826 9,896 11,392 12,594

YoY (%) 10.6 39.6 (8.6) 15.1 10.6

Fully DEPS 10.0 13.5 12.3 14.2 15.7

RoE (%) 19.1 21.1 15.7 16.0 15.4

RoCE (%) 21.6 20.2 15.9 16.4 15.6

P/E (x) 29.5 21.8 23.9 20.8 18.8

EV/EBITDA (x) 20.0 17.7 18.1 15.1 13.9


1 November 2011


58 Cipla

Declining return ratios to steer contraction in PE multiple

Cipla has historically traded at higher-than-market PE multiple and at a significant premium to peers owing to its low risk, steady return business model and strong capital efficiency. However, a sharp drop in RoE/RoCE by 1862bps/1032bps in the past five years, led by an aggressive capex drive of ~Rs31bn (26% CAGR) and subdued earnings growth (10% CAGR), has eroded this premium and the stock is now trading at 18.8x, almost in line with the sector and ~15% discount to its five-year average. We believe the stock has potential for further downside, as with an additional Rs10bn of planned capex and the management’s guidance of muted 10% revenue growth in FY12 we expect its return ratios to remain subdued, which will steer a further contraction in PE multiple.

Exhibit 1: Erosion in Cipla’s premium compared to the sector

Source: Bloomberg; Nirmal Bang Institutional Equities Research

Based on our valuation framework, we value Cipla at 17.1x target PE on FY13E EPS of Rs15.7 to arrive at a target price of Rs268, implying a 9% downside from the CMP. Our target multiple is pegged:

At a 5% discount to the sector’s average to factor in muted growth profile

At a 25% discount to its five-year average to factor in sharp deterioration in return ratios

At a 30% premium to Sensex owing to defensive nature of the stock


Sector PE (x) 18.0

Discount to sector 5%

Cipla's PE (x) 17.1

FY13E EPS 15.7


b) Para IV value 0

c) NPV of R&D pipeline 0



Exhibit 3: P/E Exhibit 4: P/BV


(40)

(20)

-

20

40

60

80 A

pr-

05

Oct

-05

Ap

r-0

6

Oct

-06

Ap

r-0

7

Oct

-07

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-08

Ap

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-09

Ap

r-1

0

Oct

-10

Ap

r-1

1

Oct

-11

Cipla still trades in linewith the sector, despite adeteriorating financialprofile, and may havefurther downside

(%)

0

5

10

15

20

25

30

35

40

Ap

r-0

5

Oct

-05

Ap

r-0

6

Oct

-06

Ap

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(x)

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Ap

r-0

9

Oct

-09

Ap

r-1

0

Oct

-10

Ap

r-1

1

Oct

-11

(x)


59 Cipla


Our FY12 revenue and PAT estimates are broadly in line with consensus estimates, while our FY13 revenue and PAT estimates are 5% and 9% lower, respectively. The variance primarily stems from our cautious stance on the company’s export business, which we believe will remain muted on account of: a) High base of API business due to Olanzapine supply to Teva in FY12, b) Subdued anti-retroviral business in line with the company’s focus to participate only in high-margin tenders, and c) Back-ended ramp-up at Indore SEZ, as we expect the USFDA approval to come only in 2HFY13. Notably, we have also assumed a 20% shift in existing export volumes to Indore SEZ, as we believe the sharp ramp-up in 1QFY12 was partly led by shift in existing volumes. Unlike peers, Cipla has so far refrained from chasing high risk, high return Para IV opportunities directly and we believe its partnership-based export business is unlikely to throw up any positive surprise.

Exhibit 5: Our estimates vs consensus expectations

FY12E FY13E

(Rsmn) NBIE Bloomberg

Cons Variation

(%) NBIE

Bloomberg Cons

Variation (%)

Revenue 70,024 70,678 (0.9) 76,957 81,390 (5.4)

EBITDA 15,894 15,692 1.3 17,248 18,620 (7.4)

EBITDA margin (%) 22.7 22.2 49.5bps 22.4 22.9 (46.4bps)

PAT 11,392 11,472 (0.7) 12,594 13,829 (8.9)

Source: Bloomberg; Nirmal Bang institutional equities Research

Exhibit 6: Consensus revenue trend Exhibit 7: Consensus earnings trend


60,000

65,000

70,000

75,000

80,000

85,000

Jan

-10

Ma

r-1

0

Ma

y-1

0

Jul-1

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Oct

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(Rsmn)

8,000

12,000

16,000

20,000

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b-1

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Jun

-11

Au

g-1

1

Oct

-11


(Rsmn)


60 Cipla

Rating Rationale

Capital efficiency under pressure

Cipla’s aggressive capex drive of Rs31bn (~56% of EBITDA; 26% CAGR) in the past five years has significantly eroded its capital efficiency, as earnings at a 10% CAGR failed to keep pace. Consequently, RoE/RoCE nearly halved from 34%/26%, respectively, in FY06 to 16% in FY11, while asset/turnover at 0.8x is currently the lowest in its history. We believe the high capex phase is far from over – spare capacities are a pre-requisite for its partnership-based export model and thus additions are likely to continue. Notwithstanding improving capacity utilisation at Indore SEZ, we expect RoE/RoCE to remain subdued at 15%/16% in FY13E, led by an additional Rs10bn of planned capex and our expectation of muted 13% earnings CAGR.

Exhibit 8: Revenue growth fails to keep pace with capex growth Exhibit 9: RoE/RoCE on the decline


Uninspiring FY12 guidance

Cipla’s FY12 revenue guidance of 10% growth is uninspiring, more so in the backdrop of huge capacity addition and field force expansion recently. Given the management’s expectations of a rebound in domestic growth from 2HFY12 on increased penetration by the recently expanded field force, the weak guidance primarily assumes muted export growth to continue, in our view. We believe the weakness stems from the company’s cautious stance on its low-margin anti-retroviral (ARV) business, which contributed ~30% to export revenue in FY11. Contribution from this segment dropped to 22% in 1QFY12 and is likely to remain subdued owing to participation in only high-margin tenders.

Exhibit 10: Key revenue drivers

(Rsmn) FY08 FY09 FY10 FY11 FY12E FY13E

Domestic revenue 19,867 22,793 25,113 28,178 31,502 35,172

Growth (%) - 14.7 10.2 12.2 11.8 11.7

Exports - Formulations 15,703 21,725 23,188 26,756 28,702 32,312

Exports - Bulk drugs 5,400 5,819 5,802 6,792 8,212 7,816

Total exports 21,103 27,544 28,989 33,548 36,914 40,128

Growth (%) - 30.5 5.2 15.7 10.0 8.7

Total revenue 40,970 50,337 54,103 61,726 68,416 75,300

Other operating income 2,205 2,902 2,719 1,882 1,608 1,657

Total income 43,175 53,239 56,822 63,607 70,024 76,957

Growth (%) - 23.3 6.7 11.9 10.1 9.9


0

5

10

15

20

25

30

35

40

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

Capex Growth Revenue Growth

(%)

0

5

10

15

20

25

30

35

40

0.0

0.2

0.4

0.6

0.8

1.0

1.2

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

Asset Turnover ROCE (%) ROE (%)

(%)(x)


61 Cipla

Export business highly dependent on ARV tenders

Cipla’s export growth is highly dependent on the low-margin ARV business – excluding Africa (primarily ARV tender business); its growth has largely remained subdued at 11% CAGR over FY07-11. With the management’s guarded stance on this segment and another 15-18 months’ lag in the launch of combination inhalers, we believe export growth will remain muted at 9% CAGR over FY11-13E. Our assumption factors in: a) Subdued ARV business in line with the company’s focus to participate only in high-margin tenders, b) High API base of FY12 owing to Olanzapine supply, and c) Back-ended ramp-up in Indore SEZ, as we expect the USFDA’s approval only in 2HFY13.

Exhibit 11: FY11 exports break-up: Africa sales mainly via tenders Exhibit 12: Excluding Africa, FY11 export growth muted at 2%


Ramp-up at Indore SEZ is partly on shift in existing volumes

We believe the substantial ramp-up at Indore SEZ in 1QFY12 (contribution of Rs1.4bn vs Rs1bn in FY11), was partly on account of shift in existing volumes (Exhibit 13). The company’s management expects Indore SEZ to account for over 10% of exports in FY12, which in the absence of major regulatory approvals (from the US and Europe), possibly indicates a significant volume shift from existing plants. We have assumed 20% of existing volumes to shift to Indore SEZ in FY12. Further, we expect a back-ended ramp-up in capacitiy, as we assume the USFDA’s approval only in 2HFY13 (the US regulator’s inspection is yet to take place, as per the disclosure made at Cipla’s 1QFY12 results conference call).

Exhibit 13: Sharp drop in export of formulations indicates major volume shift to Indore


Middle East, 9%

North, Central and South America, 23%

Africa, 42%

Europe, 14%

Australiasia, 12%

0

10

20

30

40

50

60


Exports Growth Ex Africa exports Growth

(%)

Last four year performance is highly reliant on ARV revenues

Indore SEZ, 600

ARV, 2,228

Others, 4,599

4QFY11 (Rsmn)

Indore SEZ, 1,400

ARV, 1,449 Others, 3,739

1QFY12 (Rsmn)


62 Cipla

Domestic business facing challenges on multiple fronts

Cipla’s dominant position (5.3% market share; second largest player) in the domestic market is challenged on multiple fronts, with the growth rate dropping below industry level (11% CAGR versus 16% CAGR of the industry) in the past two years. Strong competition from MNCs and other regional players in acute therapies (60% of domestic portfolio), relatively weaker presence in fast growing lifestyle diseases segment and lower contribution from new launches are some of the key reasons, in our view. The pace of new launches has also slowed down (30-35 per year v/s 50-60 for peers) while channel bonus payments – a lead indicator of slowing volumes– have shot up to 11% of net sales (as against industry standard of 3.5%), second only to Mankind. In response, Cipla has substantially increased its field force size by 1,500 medical representatives (~25%) in the past two years and entered into newer therapies like neurology, psychiatry and oncology, strengthening its much needed presence in the lifestyle diseases segment. We believe this is likely to reflect with a lag, and expect Cipla to clock in a 12% CAGR in domestic revenue over FY11-13E.

Exhibit 14: Bonus payment-One of the highest in the industry Exhibit 15: New product launch witnessing slow pick-up

Source: AIOCD Source: AIOCD

Lower technology income, although positive, is a drag on earnings

Cipla’s earnings sensitivity to the highly volatile technology income is declining. This has relevance, as due to limited disclosure on such contracts it is difficult to ascribe multiples to such income. Technology income (received for achieving milestones in generic product development) has been as high as 20% of PBT in the past, but the management expects this to decline in future, based on current visibility. We believe the lower technological fees are indicative of future technical registrations (HFA inhalers, novel drug delivery-based), s on the base business earnings, as it directly adds to the bottom-line.

Exhibit 16: Technology fees-High delta to earnings in the past


3.4

0.8

11.2

2.40.9 1.5

5.7 6.3

22.2

0.51.9

0

5

10

15

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er

Lu

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(%)

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10

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25

30

IPM

Cip

la

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axy

Su

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Pira

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Aris

to

Volume Price New Launches

(%)

0

5

10

15

20

25

0

500

1,000

1,500

2,000

2,500


Technology Fees As a % of PBT

(Rsmn) (%)


63 Cipla

1QFY12 margins sustainable, but not enough for pull-back rally

Cipla’s 1QFY12 margin of 23.8% improved 513bps QoQ, primarily on lower ARV sales, break-even at Indore SEZ and contribution from high-margin APIs. We believe this is more or less sustainable, but on their own they won’t be enough for a pull-back rally in the share price. While we expect domestic margins to remain under pressure, overall we forecast a cumulative 170bps improvement in FY11-13 margins led by: a) Capacity ramp-up at Indore SEZ, b) Supply of high margin APIs including Olanzapine API to Teva, and c) Better product mix, with declining contribution from low-margin ARV tenders.

Exhibit 17: EBITDA margin trend


Key stock catalysts still far away

Cipla’s launch of generic combination inhalers in Europe may still be 15-18 months away, as indicated by the management during the 1QFY12 results conference call. We believe the company is aggressively gearing up for the launch in Europe, where patents for key products like Seretide (Fluticasone+Salmeterol; US$2.5bn) and Symbicort (Budesonide+Formoterol; US$1bn) are expiring. Capacities have been ramped up (by ~2x in the past five years) and tie-ups are in place (Neolab in UK). Currently, four players (Teva, Sandoz/Hexal, Mylan, Neolab) are gearing up for the launch of generic combination inhalers in Europe. Of these, Sandoz has ordered its first batch of the inhaler device (Gyrohalers) from partner Vectura in November 2010 and may be close to launching generic Seretide, while Teva is planning to make a filing for generic Symbicort in CY11 and Seretide in CY12. Cipla, through its partner Neolabs, had filed for regulatory approval for launching generic Seretide in the UK in September 2008 (after the expiry of GSK’s data exclusivity) and is currently awaiting approval. We believe this can be a substantial opportunity for Cipla, as our back-of-the-envelope calculations suggest this can add US$67mn to revenue and US$30mn, or Rs1.5, to EPS per annum.

Exhibit 18: Combination patents for Seretide revoked in a number of European countries

UK Seretide combination’s patent was revoked in 2004.

Belgium In January 2011, Sandoz initiated revocation action against Seretide combination patent. Trial is not scheduled.

France Sandoz has initiated revocation action against Seretide combination patent. Trial was scheduled for June 2011. The basic patent expired in September 2010, but is subject to SPC which extends protection until September 2013.

Germany Seretide combination patent revoked on 23 February 2010 for lack of innovation in response to action taken by Mylan, Hexal, Neolab and Ivax (Teva).

Ireland Seretide combination patent revoked on 26 June 2009 in response to action by Ivax (Teva). GSK has appealed against the decision to revoke the patent.

Netherlands Supplementary protection certificate (SPC) revoked for Seretide in response to action taken by Sandoz and Hexal on 26 January 2011.

Source: Bloomberg, Industry

18

19

20

21

22

23

24

25


(%)


64 Cipla

Key upside risks

Developments on acquisitions/tie-ups

While product-specific partnerships have long been the basis of Cipla’s export business, recent acquisitions/tie-ups in the Indian pharmaceutical space have rekindled speculation about a similar deal for the company. Cipla’s management has categorically denied speculation relating to acquisition, but has confirmed talks with MNCs for product/geography specific tie-ups. A closer look at past deals point to the following factors that MNCs look at before calling the shots: a) A wide product portfolio b) Clean FDA record (manufacturing, regulatory, etc) c) Strong presence in niche/low competition segments and, d) Strong presence in emerging markets, including India.

We believe Cipla has all of these as:

a) The company is one of the largest players in India with a 5.3% market share, second only to Abbot (post acquisition of Piramal Healthcare’s domestic business). This is significant as MNCs are aggressively looking at establishing their base in high growth emerging markets.

b) With more than 6,000 product registrations and a presence in more than 180 countries, Cipla has one of the largest product portfolios among Indian companies. In India. It has more than 1,350 brands and a field force of 7,000 medical representatives, the highest in the industry.

c) The company boasts of one of the largest manufacturing infrastructure in India, with approvals from most global regulatory bodies. Unlike peers, its record with USFDA and other authorities is clean and except for 483 of negligible nature, it hasn’t received any other negative observations.

d) Cipla is one of the largest suppliers of inhalers globally and commands over 60% market share in India. Expiring patents for key products like Seretide (US$2.5bn), Symbicort (US$1bn) presents a lucrative opportunity for the company.

Downside risks

Cipla runs the biggest risk among peers if NPPA drug overcharge claims materialise

Latest NPPA list (July 2011) indicates total recoverables for overcharging stands at Rs23.6bn, with Cipla alone accounting for 66% (Rs15.5bn). Cipla has challenged this claim and currently the matter is sub-judice. While Cipla remains confident of its position, we note the company hasn’t provisioned for any potential contingent liability and any adverse court ruling is likely to negatively impact our FY13 earnings estimate by 10%.

Currency risk

Cipla derives nearly 50% of its revenue from international markets and is substantially exposed to the risk of currency appreciation. This, however, is partially negated by its foreign receivables. As a policy, the company covers net export billing on a month-to-month basis and had outstanding hedge of ~US$200mn as on end-March 2011. On the other hand, its margins are relatively protected in case of currency depreciation because of the lack of front-end presence in international geographies.


65 Cipla


Y/E March (Rsmn) 1QFY11 4QFY11 1QFY12 YoY (%) QoQ (%)

Domestic 6,752 6,522 7,436 10.1 14.0

Exports

Formulation 6,257 7,428 6,589 5.3 (11.3)

API 1,402 2,322 1,713 22.2 (26.2)

Gross revenue 14,410 16,272 15,738 9.2 (3.3)

Less: Excise 137 120 235 72.0 96.3

% of domestic sales 2.0 1.8 3.2

Other operating income 524 540 411 (21.6) (23.9)

Net revenue 14,798 16,692 15,914 7.5 (4.7)

Total raw material costs 6,702 7,998 6,683 (0.3) (16.4)

% of revenue 45.3 47.9 42.0 - -

Staff costs 1,376 1,308 1,712 24.5 31.0

% of revenue 9.3 7.8 10.8 - -

Other expenses 3,341 4,365 3,824 14.5 (12.4)

% of revenue 22.6 26.2 24.0 - -

EBITDA 3,379 3,021 3,695 9.4 22.3

EBITDA margin (%) 22.8 18.1 23.2

Other income 295 204 249 (15.6) 22.1

Interest 1 18 43 3,763.6 134.8

Depreciation 548 697 703 28.1 0.8

PBT (before exceptional items) 3,124 2,510 3,199 2.4 27.4

Exceptional 0 0 0

PBT (after exceptional items) 3,124 2,510 3,199

Tax 550 370 666 21.0 79.9

Reported PAT 2,574 2,140 2,533 (1.6) 18.4

PAT margin (%) 17.4 12.8 15.9 - -



66 Cipla

Financials



Net sales 52,343 56,249 63,218 69,066 75,903

% growth 24.1 7.5 12.4 9.3 9.9


Staff costs (2,714) (3,191) (4,895) (6,746) (7,425)

Others (13,892) (15,198) (17,562) (17,082) (18,562)


EBITDA 12,263 13,330 13,291 15,894 17,248

% growth 42.4 8.7 (0.3) 19.6 8.5

EBITDA margin (%) 23.4 23.7 21.0 23.0 22.7

Other income (1,402) 881 1,049 1,038 1,462

Interest costs (329) (230) (173) (194) (207)

Profit before depn. and tax 10,531 13,982 14,166 16,738 18,503

% growth 8.7 32.8 1.3 18.1 10.6

Depreciation (1,518) (1,671) (2,542) (2,845) (3,145)


% growth 7.5 36.6 (5.6) 19.5 10.6

Tax (1,245) (2,435) (1,952) (2,779) (3,072)

Effective tax rate (%) (13.8) (19.8) (16.8) (20.0) (20.0)

Net profit 7,768 9,876 9,673 11,114 12,287

% growth 10.8 27.1 (2.1) 14.9 10.6

Extra-ordinary item (13) 950 223 278 307


% growth 10.6 39.6 (8.6) 15.1 10.6

EPS (Rs) 10.0 13.5 12.3 14.2 15.7

% growth 10.6 35.1 (8.6) 15.1 10.6

DPS (Rs) 2.0 2.0 2.8 2.0 2.0

Payout (%) 23.5 17.3 26.4 16.4 14.9




Equity 1,555 1,606 1,606 1,606 1,606

Reserves 41,923 57,500 65,056 74,577 85,300

Net worth 43,478 59,106 66,661 76,183 86,906

Short-term loans 8,640 47 4,346 5,092 5,539

Long-term loans 763 4 1,373 1,373 1,373

Total loans 9,402 51 5,719 6,465 6,912

Deferred tax liabilities/ (assets) 1,642 1,792 2,132 2,131 2,131

Liabilities 54,522 60,948 74,512 84,779 95,949

Gross block 26,933 28,973 42,411 47,411 52,411

Depreciation 7,008 8,861 11,465 14,310 17,455

Net block 19,925 20,112 30,946 33,101 34,956


Long-term investments 801 10 3,668 3,668 3,668

Inventories 13,983 15,126 19,062 21,167 23,297

Debtors 18,529 15,666 14,908 17,807 19,599

Cash 534 621 1,010 2,831 4,420

Liquid investments 0 2,454 2,236 2,936 6,536



Creditors 4,559 8,271 8,150 8,741 9,642




Total assets 54,522 60,948 74,512 84,779 95,949




EBIT 10,745 11,659 10,750 13,049 14,104

Inc./(dec.) in working capital (5,877) (2,244) (2,883) (5,595) (4,126)


Other income (1,402) 881 1,049 1,038 1,462

Depreciation 1,518 1,671 2,542 2,845 3,145

Interest paid (-) (329) (230) (173) (194) (207)

Tax paid (-) (1,245) (2,435) (1,952) (2,779) (3,072)

Dividends paid (-) (1,819) (1,873) (2,615) (1,871) (1,871)



Net cash after capex (4,657) 2,211 (2,733) 1,493 4,435

Inc./(dec.) in short-term borrowing 3,056 (8,593) 4,300 746 447

Inc./(dec.) in long-term borrowing 541 (759) 1,369 0 0

Inc./(dec.) in borrowings 3,597 (9,352) 5,668 746 447

Inc./(dec.) in investments 147 (1,664) (3,440) (700) (3,600)

Equity issue/(buyback) 0 6,691 0 0 0

Cash from financial activities 3,744 (4,324) 2,228 46 (3,153)

Others 654 2,200 895 282 307

Opening cash 793 534 621 1,010 2,831

Closing cash 534 621 1,010 2,831 4,420

Change in cash (259) 87 390 1,821 1,589




Per share (Rs)

Reported EPS 10.0 13.5 12.3 14.2 15.7

Adjusted EPS 10.0 13.5 12.3 14.2 15.7

DPS 2.0 2.0 2.8 2.0 2.0

BV/share 55.9 73.6 83.0 94.9 108.2

Dividend payout (%) 23.5 17.3 26.4 16.4 14.9


RoE 19.1 21.1 15.7 16.0 15.4

RoCE 21.6 20.2 15.9 16.4 15.6


P/E 29.5 21.8 23.9 20.8 18.8

P/BV 5.3 4.0 3.5 3.1 2.7

EV/net sales 4.7 4.2 3.8 3.5 3.1

EV/EBITDA 20.0 17.7 18.1 15.1 13.9

Efficiency ratios

Asset turnover (x) 0.8 0.8 0.8 0.7 0.7



Inventory days 103 103 113 115 115

Payable days 42 70 60 60 60



Initi

atin

g C

over

age

Reuters: CADI.BO; Bloomberg: CDH IN

1 November 2011

Valuation Stretched We believe Cadila Healthcare’s extended rally over the past two years led by 48% earnings CAGR and 928bps/723bps improvement in RoE/RoCE, respectively, is likely to pause as the current valuation fully discounts the strong earnings trajectory and further PE multiple expansion would be capped by the USFDA warning letter on its injectables facility. Moreover, a hazy roadmap for its US$3bn revenue target by 2015 is likely to keep investors on the sidelines. We assign a Sell rating to the stock with TP of Rs743, implying a 2% downside from the CMP.

We are 8% below consensus estimate on FY13 PAT: As against the consensus estimate of 20% earnings CAGR over FY11-13E, we expect Cadila’s PAT to show 15% CAGR as we factor in the delay in ramp-up of its wellness business, and its joint venture with Nycomed (as the latter gets integrated with Takeda) and also take into account higher interest costs and depreciation on integration of the recently acquired assets of Nesher Pharma.

All is not well at Zydus Wellness: Our channel checks indicate that the impact of 100bps distributor margin cut and hike in the prices of key products is likely to extend for another one or two quarters before stabilising. Moreover, the entry of Hindustan Unilever (HUL) and Johnson & Johnson (J&J) in the face wash and scrub category is likely to exert pressure on sales of EverYuth, as it is priced at a lower entry point.

Regulator’s warning letter may delay launch of injectables in US: While the USFDA’s warning letter has no immediate financial impact, we believe any prolonged resolution will delay Cadila’s injectables launch plan in the US, one of the key levers for its US$3bn revenue target by 2015. The company has indicated speedy resolution in nine months, but going by past instances we believe it may take much longer.

Domestic formulations, US market to drive growth: We forecast 15% CAGR in revenue as well as PAT over FY11-13E. We believe Cadila’s weak 1QFY12 results were an aberration and expect a recovery in the coming quarters led by a rebound in the domestic formulations business (field force addition, planned new launches, etc), benefits in the US (market share gains, integration of Nesher Assets with effect from 2HFY12) and from emerging markets (with Abbott partnership to start contributing from FY13). We have assumed lower contribution from its JVs owing to increased competition faced by Taxotere and delayed ramp-up at the JV with Nycomed, as the latter gets integrated with Takeda.

Valuation: We have valued Cadila at 16.2x FY13E EPS of Rs46 to arrive at a TP of Rs743. Our target multiple is at a 10% discount to our target sector multiple of 18x to factor in the impact of USFDA warning letter), and at a 15%/20% premium to its past five-year average and Sensex, respectively, which we feel is justified given its robust balance sheet, healthy return ratios, and strong positioning in the domestic market.

SELL


CMP: Rs758

Target Price: Rs743

Downside: 2%


Key Data



52 Wk H / L (Rs) 987/674



Promoter 74.8 74.8 74.8

FII 5.5 5.9 6.2

DII 13.3 12.6 11.6





1 M 6 M 1 Yr

Cadila 1.8 (10.8) 10.6

Nifty Index 7.8 (7.3) (11.4)

Source: Bloomberg


Revenue 29,275 36,868 46,207 52,007 61,477

YoY (%) 26.0 25.9 25.3 12.6 18.2

EBITDA 6,058 8,086 10,262 12,199 13,873

EBITDA (%) 20.7 21.9 22.2 23.5 22.6

Adj PAT 3,232 5,091 7,110 8,295 9,395

YoY (%) 20.7 57.5 39.6 16.7 13.3

Fully DEPS 23.7 37.3 34.7 40.5 45.9

RoE (%) 28.1 35.6 37.4 33.2 29.5

RoCE (%) 21.2 24.6 28.5 27.5 25.7

P/E (x) 34.1 20.5 21.8 18.7 16.5

EV/EBITDA (x) 27.3 20.2 15.9 13.4 11.6


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Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11

CADILA HEALTHCAR NSE S&P CNX NIFTY INDEX

Cadila Healthcare


68 Cadila Healthcare


We are 8% below consensus estimate on FY13 PAT, as we assume moderate growth in its wellness busines in view of increased competition from HUL and J&J and the absence of new launches planned in FY13. Impact on volumes due to distributor margin cut and 15% hike in the prices of key products like Nutralite may extend for another one or two quarters - as indicated by our channel checks - but should stabilise in FY12. We also expect a back-ended ramp-up in API supply for Nycomed JV, as the the latter gets integrated with Takeda. Lastly, we assume higher depreciation and interest costs as Cadila integrates Neshers assets from 2HFY12.

Exhibit 1: Our estimates versus consensus expectations

FY12E FY13E

(Rsmn) NBIE


Variation (%)

NBIE estimates

Bloomberg consensus

Variation (%)

Revenue 52,007 53,158 (2.2) 61,477 63,078 (2.5)

EBITDA 12,199 11595 5.2 13,873 14,215 (2.4)

EBITDA margin (%) 23.5 21.8 164bps 22.6 22.5 3bps

PAT 8,295 8167 1.6 9,395 10,223 (8.1)


Exhibit 2: Revenue estimates

(Rsmn) FY11 FY12E YoY(%) FY13E YoY(%)

Domestic formulations 17,145* 18,194 6.1 20,742 14.0

API-Domestic 352 334 (5.0) 351 5.0

Consumer business and others 4,827 5,507 14.1 6,283 14.1

North America 9,655 11,678 20.9 15,651 34.0

Europe 2,756 2,850 3.4 2,935 3.0

Latin America 2,251 2,592 15.1 2,933 13.2

Japan 422 563 33.3 728 29.3

Emerging markets 1,980 2,079 5.0 3,047 46.6

Joint ventures 2,707 4,427 63.6 5,053 14.1

API-Exports 3,116 2,952 (5.3) 3,247 10.0

Total 45,211 51,176 13.2 60,970 19.1

*Includes Bayer revenues, which is reclassified as JV revenue for FY12 and FY13

Source:Company, Nirmal Bang Institutional Equities Research

Exhibit 3: Bloomberg Consensus revenue trend Exhibit 4: Bloomberg Consensus earnings trend


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Jan-10 May-10 Oct-10 Feb-11 Jun-11 Oct-11


(Rsmn)



Upside factored in valuation

Cadila’s valuation multiple has sharply re-rated from 9x to 19x over the past two years, led by 48% earnings CAGR and consequent 928bps/723bps improvement in RoE/RoCE, respectively. The current multiple of 16.5x compares well with some of the larger peers, but leaves little scope for further expansion, especially due to the USFDA warning letter overhang on its injectables facility in Ahmedabad and a hazy roadmap to achieve US$3bn revenue target by 2015. Moreover, our lower-than-consensus forecast of 15% earnings CAGR over FY11-13E leads us to believe that the market is still discounting bullish assumption, even as the company is unlikely to maintain its historical growth momentum.

Exhibit 5: PE graph Exhibit 6: P/BV graph


PE multiple down from July 2011 high

The current PE multiple of 16.5x is off from July 2011 high, as weak 1QFY12 results and the USFDA warning letter overhang on its injectables facility hampered valuation, but is still at a 20% premium to its historical five-year average. We believe this may come down further, in accordance with 795bps/274bps decline in RoE/RoCE, respectively, over the next two years.

Based on our valuation framework, we value Cadila at 16.2xFY13E EPS of Rs46 to arrive at a target price of Rs743, implying a 2% downside from the CMP. Our target price is pegged at: a) 10% discount to our target sector multiple, b) At 10% premium to its five-year average owing to improved financial profile, and c) 20% premium to Sensex, given the stock’s strong defensive appeal and relatively higher return ratios.


Sector PE (x) 18.0

Premium to sector (%) (10)

Cadila's PE (x) 16.2

FY13E EPS 45.9


b) Para IV value 0



Exhibit 8: Premium/discount to Sensex Exhibit 9: Premium/discount to sector


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Rating Rationale

We assign a Sell rating to Cadila Healthcare with a target price of Rs743, implying a 2% downside from the current level. The stock’s protracted rally over the past two years led by 48% CAGR in earnings and 928bps/723bps improvement in RoE/RoCE, respectively, is likely to pause as the current valuation fully discounts the strong earnings trajectory and further PE multiple expansion would be capped by the USFDA warning letter related to its injectables plant. Moreover, a hazy roadmap for its US$3bn revenue target by 2015 is likely to keep investors on the sidelines.

All is not well in the wellness business

Cadila’s wellness business (7% of revenue) grew by a muted 5% in 1QFY12, led by a 100bps distributor margin cut (from 8% to 7%), as the company realigned itself closer to the industry norm of 6% for similar line of products. Also, a 15% price hike and a two-week breakdown at its Ahmedabad plant hurt Nutralite volumes. While the management indicated that its impact was largely over in 1QFY12, our channel checks suggest otherwise and we believe the lower inventory off-take is likely to extend for another one or two quarters before stabilising. Moreover, the entry of HUL and J&J in the face wash and scrub category is likely to exert pressure on the sales of EverYuth, as it is priced at a lower entry point. We forecast 15% revenue CAGR over FY11-13E, in line with the lower end of the company’s guidance of 15-20%, as against 39% CAGR registered over the past five years.

Exhibit 10: Rising competition to exert pressure on volume growth

Scrub Zydus Wellness Grams Rs J&J Grams Rs Himalaya Grams Rs

EverYuth (Cucumber) 30 30 Neutrogena (Clean & Clear) 20 27 Himalaya (Neem) 50 65

EverYuth (Ultra Mild) 60 55 Neutrogena (Clean & Clear) 50 50

EverYuth (Walnut) 60 55

Face wash Zydus Wellness Grams Rs HUL Grams Rs

EverYuth (Lemon) 72 40 Fair & Lovely (Multi-vitamin) 20 20

EverYuth (Neem) 72 40 Fair & Lovely (Multi-vitamin) 50 45

EverYuth (Fruit) 72 40 Pears (Oil Clear) 60 50

EverYuth (Light) 60 50 Pears (Pure & Gentle) 60 50

EverYuth (Poll Defense) 75 60 Pears (Fresh & Gentle) 60 50

EverYuth (Oxi Activ) 75 60 Pears (Intense Moisture) 50 60

Source: Industry

Exhibit 11: Wellness business revenue to moderate


0.0

88.7

26.3

26.5 37.4

25.415.0

15.0

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Consumer Wellness Growth

(Rsmn) (%)



Excluding wellness business, domestic revenue to trail industry growth

Excluding wellness business, we expect Cadila’s domestic revenue to trail industry growth and show a 13% CAGR over FY11-13E, moderating from 19% growth in FY11.

Strong domestic portfolio

With a market share of ~3.7% and leadership position in key therapies like cardiovascular, respiratory, gastro-intestinal and women’s healthcare (together contributing 60% to its domestic revenue), Cadila is an inherent beneficiary of strong domestic market growth. The company enjoys strong brand equity among doctors, with 17 of its brands featuring in top 300 brands. Historically, its revenue CAGR of 12% over FY06-11 has underperformed industry CAGR of 14%, but with a changing product mix (35% portfolio contributed by chronic therapies as per IMS) and renewed focus on key therapies like respiratory and cardiology, we expect its domestic business to recover and track industry growth.

Exhibit 12: Domestic revenue trend Exhibit 13: Growth break-up for key therapies


Shifting focus to tackle slow growth

Over the past three years, Cadila’s focus has shifted considerably in favour of increasing its market reach and improving market share through portfolio expansion, new product launch and increased market penetration. During FY08-11, the company more than doubled its field force (from 1,900 to 4,500) and consistently launched 55-60 products each year (including line extension). Further, it is realigning the focus on key therapies through creation of new divisions and restructuring of sales force. This has worked well so far; for e.g., in FY11, both respiratory and cardiology divisions outpaced industry growth after the company restructured these divisions in FY10. Similarly, Zydus Cardiva and Synovia divisions registered healthy growth rates of 30% and 35%, respectively, in FY10, after their launch in FY09.

Exhibit 14: Realigning focus on key therapies through creation of divisions, restructuring of sales force

Year Division Therapy area Comments

2011

Zydus Heptiza Hepatology Allocated task force to consolidate position in hepatology segment

Zydus Gynova Gynaecology Allocated task force to consolidate position in gynaecology segment

Bayer JV Women's healthcare, metabolic disorders, diagnostic imaging, CVS, anti-diabetes and oncology

Strategic move to strengthen its position in these therapy areas through its existing portfolio as well as new products from Bayer

2010 Zydus Cardiva Cardiology Reshuffled cardiology business between Zydus Cardiva and Zydus Medica (existing division). Zydus Cardiva was launched with a field force of 300 people and caters to the urban market with its range of anti-hypertensive and aspirin combinations

Respiratory Expanded field force in respiratory division by additional 100 people to tap the potential of anti-asthma inhalation therapy in mass markets.

2009 Zydus Nutriva Nutraceuticals Launched with 250 people to strengthen position in nutraceuticals market

Zydus Synovia Rheumatology Launched with 50 people to focus on high-end products for rheumatoid arthritis

Topcare Hospital segment To leverage strength of diagnostic product portfolio

- Chronic obstructive pulmonary disease Allocated task force to consolidate position in niche segments

2008 - Rural market Increase in field force by 150 people to further penetrate rural markets


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(Rsmn)

Hurt by resturcturing ofdistribution channels

(%)Aggressive sales push to achieve US$1bn revenue target

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Cardiovascular Female Healthcare

Gastro-Intestinal Respiratory Anti-Infective

FY07 FY08 FY09 FY10 FY11

(%)



Bayer JV – Shot in the arm

Earlier this year, Cadila entered into a 50:50 joint venture with Bayer Schering to jointly market products in female healthcare, metabolic disorder, CVS, anti-diabetic treatment, oncology and diagnostic imaging segments. As per the agreed terms, both partners will shift their existing products and sales force to the JV, as well as patented products from Bayer’s pipeline. Among the key brands, Bayer will shift its Glucobay, Xarelto, Nexavar and Yaz/Yasmin products to the JV, while Cadila will shift key products such as Euglim, Progynova and Ultravist. The JV became operational in May 2011 and currently has a field force of 500 Medical Representatives (MR’s), which is expected to touch 800 MR’s going forward. Based on 1QFY12 contribution of ~Rs160-180mn, we expect revenue of Rs1bn in FY12 and Rs1.15bn in FY13.

Strong track record in US, but maintaining past performance may be difficult

Despite being a late entrant, Cadila’s US revenue CAGR of 81% over FY06-11 has been exemplary and compares well with some of its larger peers, even in the absence of marketing exclusivity/Para IV opportunities. Judiciously selected portfolio of 41 products (half of them vertically integrated) and market share gains in key products (among the top 3 in 9 out of 10 products with over 20% share) has been the basis for this growth. With revenue now touching more than US$200mn, Cadila acknowledges that maintaining historical growth would be increasingly difficult and it is thus focusing on filing for delivery-based, difficult-to-make products in nasal and parenteral (transdermal, injectable) segments. The company has 64 ANDAs pending approval, of which 5 are for nasals and 18 are for parenterals (including 14 for contract manufacturing).

Exhibit 15: Cadila’s US performance exemplary


USFDA warning letter may delay launch of injectables in the US

Cadila’s injectables facility in Ahmedabad received a warning letter from the USFDA in June 2011, citing violation of current good manufacturing practices (GMP). Being a pre-approval inspection, this does not have any immediate financial impact, but is still relevant as a prolonged resolution of the issue may delay its plan to launch injectables in the US. The injectables segment has high entry barriers (top three players account for more than 60% of volumes) owing to stricter regulatory norms for manufacturing and a different distribution chain, and is therefore identified as a key lever by Cadila for its US$3bn revenue target by 2015. The company’s management has indicated speedy resolution of the issue in nine months, but going by the past instances we believe it may take much longer.

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Exhibit 16: USFDA warning letters to various drug majors

Warning letter Facility Date announced Date resolved Time lag

Aurobindo Unit III May-2011 -

Lupin Mandideep May-2009 Jan-2010 8 months

Dr Reddy’s Mexico Jun-2011 -

Sun Pharma Michigan (Caraco) Nov-2008 -

Sun Pharma Cranbury Aug-2010 Sep-2011 13 months

Ranbaxy Poanta Sahib Jun-2006 -

Ranbaxy Dewas Sep-2008 -

Ranbaxy Batamandi Sep-2008 -

Ranbaxy Ohm Laboratories Dec-2009 -

Source: Industry

Acquisition of Nesher Pharma assets is positive, but not EPS accretive

Cadila’s acquisition of the assets of Nesher Pharma - including its existing pipeline of eight ANDAs, future pipeline of five ANDAs, manufacturing and R&D facilities - for US$60mn, gives it a direct presence in the lucrative controlled substances market, valued at US$7bn. Nesher has considerable expertise in niche therapies which have development or production barriers such as controlled release medications or DEA-controlled substances. This is positive for Cadila, though not EPS accretive. Nesher’s parent company, KV Pharmaceuticals is under a consent decree since March 2009 with the USFDA - following a voluntary nationwide recall and suspension of shipment of all products on reports of over-sized morphine sulphate ER tablets – owing to which Nesher is currently making losses (not disclosed). Nesher currently has one product (Micro-K/Micro K-10) in the market, while Cadila’s management is expecting another USFDA approval next year. Nesher will get consolidated from September 2011 and our revenue assumption from Nesher in FY12 is in line with the management’s guidance of US$15mn, while we expect slightly higher revenue of US$40mn in FY13. The management has given revenue guidance of US$100mn by FY15.

Integration with Takeda may delay API ramp-up for Nycomed JV

We believe Nycomed’s integration with Takeda is likely to delay the additional API ramp-up at its JV with Cadila, owing to lack of clarity over future sourcing. Under the JV, Cadila currently supplies intermediates for Nycomed’s blockbuster drug Pantoprazole (Indication: anti-ulcerant; market size: US$1.8bn) on cost plus mark-up basis. The JV has been extremely profitable, contributing ~US$100mn to revenue and ~US$69mn to profits since FY06. While revenue from the JV started moderating since FY10 following at-risk launches by generic players, the moderation is likely to accelerate following the expiry of Pantoprazole patent in January 2011.

Exhibit 17: Nycomed JV revenue, PAT

Rsmn FY06 FY07 FY08 FY09 FY10 FY11

Revenue 653 837 669 999 758 556

PAT 460 663 479 682 465 334

PAT margin (%) 70.4 79.2 71.6 68.3 61.3 60.0

Source: Company

To offset this, Nycomed and Cadila extended their partnership to cover 14 additional APIs, thereby establishing the JV as key sourcing hub for Nycomed’s global API requirement. Cadila also commissioned a new API manufacturing facility at Navi Mumbai in FY11, where it plans to manufacture eight APIs, while the remaining six will be manufactured at Cadila’s plants. While the additional API supply was slated to start from 2QFY12, we believe it is likely to be delayed and expect a ramp-up only from 4QFY12 or 1QFY13. From US$12mn in FY11, we forecast Nycomed JV revenue to decline to US$9mn in FY12 and increase thereafter to US$11mn in FY13 as the supply of APIs begins.



Exhibit 18: Nycomed revenue to ramp up from FY13 on additional API supply


Taxotere to drive Hospira performance

To offset declining contribution from Nycomed JV, Cadila entered into a 50:50 joint venture with Hospira in 2006 to supply six oncology injectables for the US and European markets. The JV commenced operations in FY10 and since then has cumulatively garnered ~US$85mn in revenue with around 58% PAT margin in FY11. Currently, the JV supplies three products for the European markets and one product for the US, while the management expects all six products to be commercialised by the end FY13 in the US as well as in Europe.

Exhibit 19: Hospira JV revenue trend

*1Q12 is our estimate as Hospira revenues were not disclosed seperately


Bulk of the revenue currently is contributed by generic Docetaxel, Sanofi’s blockbuster oncology drug with annual revenue of US$1.2bn, for which Hospira has a shared marketing exclusivity in the US. Hospira launched generic Docetexal in March 2011 - almost two months earlier than the next generic player, Sun Pharma, and has a single vial formulation, similar to the innovator, unlike other competitors (Sun, Accord, Sandoz) who have a double vial formulation. Hospira, at its July 2011 conference call had informed that its market share in Taxotere was still 50% and price erosion was closer to 50% even with the entry of Sun and Accord. However, with the entry of Sandoz, the company anticipates higher price erosion going forward.

Of the remaining five products, we believe Gemcitabine and Oxaliplatin can be key opportunities. Hospira recently launched the solution version of generic Gemcitabine injections, Eli Lilly’s blockbuster oncology drug with US$750mn annual revenue, while we expect it to launch generic Oxaliplatin along with multiple players in August 2012, as per its settlement with Sanofi. Together, we expect revenue from the Hospira JV to scale up from US$48mn to US$67mn in FY12 and to US$76mn in FY13.

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Docetaxel launch



Exhibit 20: Market share of injectables in US Exhibit 21: Hospira JV to scale up on Taxotere, Gemzar launch

Source: Industry, Nirmal Bang Institutional Equities Research Source: Company, Nirmal Bang Institutional Equities Research

Brazil, other emerging markets to maintain growth traction; Europe to lag

We expect Cadila to maintain its growth trajectory in Brazil led by monetisation of its large pending pipeline of 40 products. The company is witnessing strong traction in its branded (75% of business; growing at over 15%) as well as generic business (25% of business; growing at over 25% on a low base). Over the past three years, its Brazilian revenue nearly doubled, growing from US$27mn in FY08 to US$50mn in FY11. The company has given guidance regarding launch of 8-10 products every year and also expects 20% growth in revenue, but factoring in the delay in product approvals, we forecast 14% revenue CAGR over FY11-13E. We also expect emerging markets’ revenue to show 24% CAGR over FY11-13E, led by favorable demographics and contribution from Abbott partnership in FY13. Europe, however, would lag owing to the ongoing price cuts and we expect a moderate 3% CAGR over the next two years.

Exhibit 22: Brazil to maintain growth traction Exhibit 23: ROW markets’ revenue to be propped up by Abbott


Exhibit 24: Europe revenue to moderate due to price cuts


Hospira, 37%

Baxter, 14%Fresenuis, 10%

Pfizer, 7%

Novartis, 4%

Others, 28%

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Earnings CAGR of 15% over FY11-13E

We expect Cadila to post 15% revenue CAGR over FY11-13E. Growth is likely to be broad-based, with India (13% CAGR), the US (27% CAGR), Hospira JV (26% CAGR) and emerging markets (24% CAGR) being the key contributors. We expect Europe to remain subdued due to ongoing price cuts, while we factor in delays in ramp-up of additional APIs in the JV with Nycomed, as the latter gets integrated with Takeda. We expect margins to expand by 125bps in FY12 because of higher Taxotere contribution to Hospira JV and dossier income of Rs446mn from Abbott which should get normalised in FY13. Also, higher contribution from the loss-making Nesher Pharma (US$40mn in FY13E) will lead to a 89bps decline in FY13 margins. Lastly, we assume higher interest costs and depreciation due to acquisition of Nesher Pharma assets, which combined with our lower-than-consensus revenue forecast, drives our PAT estimate 8% below consensus expectation.

Exhibit 25: Key financials


Strong cash flows; RoE/RoCE to decline

Led by strong operating performance, we expect Cadila to generate free cash flow of Rs5.3bn in FY13 even after factoring in Rs4.5bn of normalised capex in FY12 and FY13 and another Rs2.7bn (US$60mn) for acquisition of Nesher Pharma assets. Consequently, we expect its RoE to decline by 795bps – as the proportion of low-yield cash increases – while integration of the loss-making Nesher Pharma assets drag RoCE lower by 274bps over FY11-13E. We also expect its working capital cycle to reduce marginally, led by improvement in its receivable cycle, which saw a sharp increase in FY11 on account of higher contribution from Docetaxel.

Exhibit 26: Return ratios trend Exhibit 27: Strong FCF generation


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(Rsmn)



Downside risks

Currency risk: Cadila derives almost 50% of its revenue from international markets and is therefore significantly exposed to currency risk. At the same time, 50% of its outstanding debt of Rs10.9bn is denominated in foreign currency, which acts as a natural hedge. The company has partly hedged its receivables and debt position and has total outstanding hedge of US$126m currently. So far, the company has managed its forex exposure well, with forex gains/losses not exceeding 10% of PBT in a year.

Exhibit 28: Forex gain/loss as a percentage of PBT


Domestic market growth slower than expected: Domestic business constitutes a significant 50% of overall revenue and even higher to profits, and any slowdown is likely to impact earnings adversely, especially in view of an increased fixed cost base.

Lower off-take at Hospira JV: We have assumed higher traction in Hospira JV revenue in FY12 and FY13 owing to increased contribution from Taxotere and Gemzar, which will be negatively impacted in case of higher-than-expected competition in these products.

Upside risks

Better-than-expected ramp-up in wellness business and Nycomed JV: We have assumed moderate growth in Cadila’s wellness business owing to increased competition and extended impact of distributor margin cuts, based on our channel checks. Moreover, we have also assumed delay in API ramp-up in the JV with Nycomed, as the latter gets integrated with Takeda. Earlier-than-expected ramp-up in these businesses will be an upside risk to our stock call.

(6)

(4)

(2)

0

2

4

6

8

10

12


Forex Gains/Loss

(%)




Y/E March (Rsmn) 1Q11 4Q11 1Q12 YoY (%) QoQ (%)

Gross revenue 10,682 11,844 11,889 11.3 0.4

Less: Excise 131 157.3 153.9 17.5 -2.2

% of revenue 1.2 1.3 1.3

Other operating income 786.9 442 721.8 (8.3) 63.3

Net revenue 11,338 12,129 12,457 9.9 2.7

Total material costs 3,259 4,381 3,620 11.1 (17.4)

% of revenue 28.7 36.1 29.1 - -

Staff costs 1,302 1,952 1,615 24.0 (17.3)

% of revenue 11.5 16.1 13.0 - -

Other expenses 3,803 3,518 4,198 10.4 19.3

% of revenue 33.5 29.0 33.7 - -

EBITDA 2,974 2,278 3,024 1.7 32.8

EBITDA margin (%) 26.2 18.8 24.3

Other income 28.7 34.5 63.1 119.9 82.9

Interest 315.5 189.8 111.5 (64.7) (41.3)

Depreciation 313.9 317.4 347.2 10.6 9.4

PBT (before exceptional) 2,373 1,805 2,628 10.8 45.6

Exceptional 0 160.1 0

PBT (after exceptional) 2,373 1,965 2,628

Tax 337.7 104 285.4 (15.5) 174.4

Adj on consolidation (43.3) (71.9) (44.7)

Reported PAT 1,992 1,789 2,298 15.4 28.4

PAT margin (%) 17.6 14.8 18.4 - -




Financials



Net sales 29,275 36,868 46,207 52,007 61,477

% growth 26.0 25.9 25.3 12.6 18.2


Staff costs (3,109) (4,011) (5,493) (6,572) (7,532)

R&D expenses (1,564) (1,660) (2,502) (2,907) (3,314)

Others (8,978) (11,327) (13,196) (14,154) (16,872)


EBITDA 6,058 8,086 10,262 12,199 13,873

% growth 32.2 33.5 26.9 18.9 13.7

EBITDA margin (%) 20.7 21.9 22.2 23.5 22.6

Other income 204 159 131 152 183

Interest (1,205) (821) (699) (817) (882)

Depreciation (1,118) (1,339) (1,269) (1,421) (1,721)


% growth 19.3 54.5 38.5 20.0 13.3

Tax (666) (741) (1,064) (1,517) (1,718)


Net Profit (Before extraordinaries) 3,273 5,344 7,361 8,596 9,735

Extraordinary items (241) (46) - - -

Minority interest - (247) (251) (301) (341)


% growth 15.7 66.6 40.8 16.7 13.3


% growth 20.7 57.5 39.6 16.7 13.3

Reported EPS (Rs) 22.2 37.0 34.7 40.5 45.9

% growth 6.5 66.6 (6.2) 16.7 13.3

Adjusted EPS (Rs) 23.7 37.3 34.7 40.5 45.9

% growth 11.1 57.5 (6.9) 16.7 13.3

DPS (Rs) 4.5 7.5 6.3 7.3 8.3

Payout (%) 26.3 24.5 21.5 21.7 21.7




Equity 682 682 1,024 1,024 1,024

Reserves 11,670 15,603 20,691 27,183 34,535

Net worth 12,352 16,285 21,715 28,206 35,558

Short-term loans 1,445 724 1,309 1,309 1,309

Long-term loans 11,228 10,181 9,664 12,292 11,292

Total loans 12,673 10,905 10,973 13,601 12,601

Deferred tax liability 982 1,141 1,127 1,127 1,127

Minority interest 228 392 670 971 1,312

Liabilities 26,235 28,723 34,484 43,905 50,598

Gross block 22,870 25,578 28,320 35,520 40,020

Depreciation 7,572 8,734 9,994 11,415 13,136

Net block 15,298 16,844 18,326 24,105 26,884


Long-term investments 209 207 207 200 190

Inventories 6,012 7,504 8,119 9,192 10,957

Debtors 4,549 4,668 7,652 8,664 10,328

Cash 2,517 2,507 2,952 5,143 6,811

Liquid investments 40 - - - -



Creditors 5,256 6,196 8,306 9,199 11,000




Forex difference 438 102 - - 0

Total Assets 26,235 28,723 34,484 43,905 50,598




EBIT 4,940 6,747 8,993 10,778 12,153

Inc./(dec.) in working capital (1,090) (1,061) (2,066) (1,723) (2,494)


Other income 204 159 131 152 183

Depreciation 1,118 1,339 1,269 1,421 1,721

Interest paid (-) (1,205) (821) (699) (817) (882)

Tax paid (-) (666) (741) (1,064) (1,517) (1,718)

Dividends paid (-) (728) (796) (1,237) (1,539) (1,804)



Net cash after capex (1,440) 1,191 756 (444) 2,659

Inc./(dec.) in short-term borrowing 83 (721) 585 - -

Inc./(dec.) in long-term borrowing 4,213 (1,047) (517) 2,628 (1,000)

Inc./(dec.) in preference capital - - - - -

Inc./(dec.) in borrowings 4,296 (1,768) 68 2,628 (1,000)

Inc./(dec). in investments 5 (38) - 7 10

Equity issue/(buyback) 54 - 341 - -

Cash from financial activities 4,355 (1,806) 409 2,635 (990)

Others (1,324) 605 (721)

Opening cash 926 2,517 2,507 2,952 5,143

Closing cash 2,517 2,507 2,952 5,143 6,811

Change in cash 1,591 (10) 445 2,191 1,669


Exhibit 33:Key Ratios


Per share (Rs)

Reported EPS 22.2 37.0 34.7 40.5 45.9

Adjusted EPS 23.7 37.3 34.7 40.5 45.9

DPS 4.5 7.5 6.3 7.3 8.3

BV/share 90.5 119.3 106.1 137.8 173.7

Dividend Payout (%) 26.3 24.5 21.5 21.7 21.7


RoE 28.1 35.6 37.4 33.2 29.5

RoCE 21.2 24.6 28.5 27.5 25.7


P/E 34.1 20.5 21.8 18.7 16.5

P/BV 8.4 6.4 7.1 5.5 4.4

EV/Net sales 5.6 4.4 3.5 3.1 2.6

EV/EBITDA 27.3 20.2 15.9 13.4 11.6

Efficiency ratios (x)

Asset turnover 1.0 1.0 0.8 0.8 1.0

Working capital/sales 0.2 0.2 0.2 0.2 0.2



Payable days 83 79 84 84 84



80

Disclaimer Stock Ratings Absolute Returns

BUY > 15%

HOLD 0-15%

SELL < 0%

This report is published by Nirmal Bang’s Institutional Equities Research desk. Nirmal Bang has other business units with independent research teams separated by

Chinese walls, and therefore may, at times, have different or contrary views on stocks and markets. This report is for the personal information of the authorised

recipient and is not for public distribution. This should not be reproduced or redistributed to any other person or in any form. This report is for the general information

for the clients of Nirmal Bang Equities Pvt. Ltd., a division of Nirmal Bang, and should not be construed as an offer or solicitation of an offer to buy/sell any securities.

We have exercised due diligence in checking the correctness and authenticity of the information contained herein, so far as it relates to current and historical

information, but do not guarantee its accuracy or completeness. The opinions expressed are our current opinions as of the date appearing in the material and may be

subject to change from time to time without notice.

Nirmal Bang or any persons connected with it do not accept any liability arising from the use of this document or the information contained therein. The recipients of

this material should rely on their own judgment and take their own professional advice before acting on this information. Nirmal Bang or any of its connected persons

including its directors or subsidiaries or associates or employees or agents shall not be in any way responsible for any loss or damage that may arise to any person/s

from any inadvertent error in the information contained, views and opinions expressed in this publication.


81

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