Cipla - Earnings lag estimates; Downgrade to Reduce : Emkay

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Cipla Ltd

Earnings lag estimates; Downgrade to Reduce

REDUCE

CMP: Rs 324                                       Target Price: Rs 310

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n     Cipla’s Q3FY11 result were disappointing with a) Revenues at Rs15.5bn (est. Rs16.1bn) b) EBITDA at Rs3.2bn (est. Rs3.9bn) and c) APAT at Rs2.3bn (est. Rs2.8bn)

n     OPM contracted 593bps YoY to 20.5%, led by 24% increase in overheads, largely due to the commissioning of the Indore SEZ plant

n     On account of earnings disappointment and optimal utilization at Indore SEZ still 2 years away, we cut our EPS estimates for FY11/12E by 12%/11% respectively

n     With EPS acceleration potentially an FY13 story; we downgrade the stock to Reduce with a target price of Rs310

 Subdued performance in the domestic business and lower tech income

dragged revenue growth

Lower than expected growth in the domestic formulation (11% vs. est. of 15%) and

lower technology income (Rs151mn versus expectations of Rs400mn) resulted in 8%

growth vs est. of 12% in the top line. In the domestic market, branded as well as the

generic business registered lower than expected growth of 16% and 12% respectively

on account of higher competitive intensity. Going ahead, we expect the domestic

business to grow at below than industry growth rates at 10-12% rate. Total export

business for the quarter grew by 12% YoY driven by 12% growth in formulation

business (est. 14%) and 13% growth in APIs. Decline in technology licensing income

from Rs703mn to Rs151mn this quarter (as most of the projects are in completion

stages and partly due to presence of one-time higher income in Q3FY10) also dragged

the overall growth.

In the exports business, Cipla launched Seroflo inhaler in the South African market

(US$15-20mn opportunity) and is looking to supply in Russian markets (market size

US$150mn) over the next 2 quarters. Management expects increased traction from

Seroflo opportunity given the limited competition in the market and has indicated that

they will start getting approval for combination inhalers in some of the EU markets from

FY12E onwards.

Increased overheads at Indore SEZ and lower Tech income impacted

margins

Operating income for the quarter was lower at Rs3.2bn (est. of R3.96bn). OPM for the

quarter contracted by 593bps to 20.5% because of a) Lower tech income b) Lower

realization on exports (4% negative impact due to currency fluctuation), c) 250bps increase

in employee cost due to increase in manpower at Indore facility, reclassification of

contracted staff at its Goa facility and annual increments, and d) Higher other expenditure

mainly due to increase in selling expenses and factory overheads at Indore SEZ. Total

operating cost at Indore facility is ~ Rs250-300mn per quarter, which is fixed in nature.

Excluding this cost, EBITDA margins stood at 22.1% in Q3FY11. We believe higher

overheads will continue to pressurize margins as it wil take atleast 2 years for the Indore

SEZ to reach optimal levels of utilisation. However, recent approvals from other regulators

such as UK MHRA, WHO and ANVISA will help to over-ride some of the cost overheads at

the plant. The company expects Indore SEZ to contribute ~10-12% of the total revenues by

Q4FY12, which in our view, is on the higher side.

Lower EBITDA and higher capital cost impacted APAT

Despite a) higher other income (up by 44%), b) lower interest cost (down by 33%), due to

repayment of short term working capital loans and c) lower tax provision (15.6% of PBT vs.

17.6% of PBT in Q3FY10), APAT de-grew by 24.6% to Rs2.3bn. The growth in the APAT

was further impacted due to 43% increase in depreciation cost due to addition to fixed

assets mainly on account of commissioning of Indore SEZ factory. The EPS for the quarter

and 9MFY11 stood at Rs2.9 and Rs9.5 respectively.

Owing to earnings disappointment and EPS acceleration potentially an FY13

story, we cut earning estimates and downgrade the stock to Reduce

Owing to earnings disappointment (sub-optimal performance in the domestic market, lower

tech income, higher overheads) and delay in ramp-up at the Indore SEZ facility, we cut our

EPS estimates for FY11/12E by 12%/10% to Rs12.6 (earlier Rs14.2) and Rs15.5 (Rs17.4

earlier). Further, with EPS acceleration potentially an FY13 story, we downgrade the stock

to Reduce (earlier Accumulate) with a revised target price of Rs Rs310 (earlier Rs350). We

believe Cipla to trade at discount to its peers, as huge capex incurred in the past is yet to

materialize in the near future. While management remains upbeat about the growth

prospects for the company, its time-frame for delivery of returns to shareholders may be

longer than current market expectations.

Key risk to our call:

§ Commencement of API supplies to Teva

§ Higher traction of products tied-up with Dr. Reddy

§ Earlier than expected launch of combination inhalers

§ Faster ramp-up in the domestic business

§ Higher traction from inhaler launch in CIS and South African markets

§ Supply agreements with MNC’s