Macquarie : Orchid Pharmaceuticals- Visible growth

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Orchid Pharmaceuticals
Visible growth
Event
 We initiate coverage on Orchid Pharmaceuticals (OCP IN) with an Outperform
rating and a target price of Rs395, implying upside potential of 39%. We like
OCP for its earnings visibility provided by long-term bulk supply agreements at
attractive margins (eg, the one to Hospira; HSP). We believe that strengthened
front end in the US and expanding oral formulation franchise will further add value
going forward. In addition,, a significantly de-leveraged balance sheet gives us
further comfort.

Impact
 HSP bulk contract underappreciated: OCP has a 10-year exclusive
contract to supply APIs to its divested injectables business, which HSP
acquired (the transaction closed in March 2010, and the market perceived it
as a ‘crown jewel’ sell-off). However, we expect OCP to book US$100m in
bulk sales to HSP in FY11, making up for the entire ~US$90m revenue loss
on the sale of its injectables business. Given the limited competition for the
products under contract (carbapenem, Tazo Pip and ADD-Vantage), we
expect this to be a significant growth driver, with EBITDA margin above 30%.

 Strengthening front end and formulation franchise: OCP has a pipeline of
35 ANDAs pending approval in the US, of which eight are first to file (FTF), and
OCP has settled three with the innovator. To strengthen its front-end presence
in the US, OCP acquired generic marketing firm Karalex Pharma and tied up
with Alvogen for the distribution of eight specific products. FTF opportunities
would add to earnings momentum FY13 and beyond, in our view. We expect
finished formulation to contribute ~50% of the top line by FY13 vs ~30% today.

 Cash from asset sale helped deleverage: OCP used the US$400m cash
received to pay down Rs14bn of high-interest debt, thereby lowering the
debt/equity ratio to 1.4x from 4.6x. Aided by strong free cashflow generation
(~US$100m over the next three years), the balance sheet should further
strengthen. Contractual obligations in supply deals with MNCs require lower
receivable days driving net working capital to 40% of sales (~65% in FY10).

 OCP’s innovative pipeline: We do not expect a significant value discovery in
the near term and, hence, do not attribute any value at this stage. However,
we think positive news flow (likely in FY12/13) would provide option value.
Earnings and target price revision

 We value OCP at a target price of Rs395, based on 9x FY12E EBITDA (at a
discount of 35% to its peers).

Price catalyst
 12-month price target: Rs395.00 based on a EV/EBITDA methodology.
 Catalyst: Imipenem and Cilastatin approval; strong quarterly results.

Action and recommendation
 Valuations are attractive, in our view, with OCP trading at a PER of 13.2x
FY12E diluted EPS, despite our estimated 33% EPS CAGR for FY11–13.
 Risks: Lack of financial discipline and increased competition in key products
contrary to our expectations are the key risks to our investment thesis.