JM Financial: United Phosphorus: Competition, regulatory risks offset opportunity

United Phosphorus: Competition, regulatory risks offset opportunity
􀂄 Valuations reasonable in view of growth outlook and risks; initiate with
HOLD: We initiate coverage on United Phosphorus (UPL) with a HOLD rating,
as we think a 12.6x FY11E P/E adequately discounts its 8-10% organic growth
outlook that could be pressured by intense competition in overseas markets
and regulatory actions on certain important products. We also believe UPL’s
inorganic growth strategy of acquiring less profitable, out-of-favour assets
and engaging in cost-cutting to boost profitability carries execution and
growth sustainability risk, and therefore does not warrant a higher multiple.
􀂄 Inorganic growth strategy carries risks, is difficult to replicate: Herbicide
napropamide, a major product for UPL that was acquired in late 1990s and is
marketed under the name Devrinol, is at risk of getting banned in the EU after
Nov’10. We believe this serves as an example of the risks implicit in UPL’s
acquisition strategy, which focuses on acquiring older but more hazardous
molecules at low valuations with the aim of boosting near-term profits, but
which may compromise long-term growth prospects. Additionally,
restructuring the acquired entities may be a painstaking and difficult
exercise, as illustrated by the delay in shutting down Cerexagri’s European
plants due to labor union and local government pressures.
􀂄 Generics’ market is growing, but competition is stiff: Patents worth c.$4bn
are expiring during 2009-12, boosting the generics’ opportunity, but margins
have been under pressure at large manufacturers, including UPL and peers
Makhteshim Agan, Nufarm and Cheminova, due to intense price competition
from smaller generics companies and higher raw material prices. Acquisition
of Cerexagri has also hurt UPL’s margins, while its EPS growth has been
pressured by substantial equity dilution.
􀂄 Sept’11 TP of `200 based on 11.5x FY12E EPS; earnings upside is key risk:
Our target multiple is in-line with the peer group average and one-year
historical average. The shares could rise above our price target if near-term
quarterly earnings are better than expected, sparking estimate upgrades as
well as multiple expansion. However, risks tied to stiff competition,
regulatory pressures and large acquisitions keep us on the sidelines.