Macquarie Research:: Cipla 3Q FY11 -Underperformance continues

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Cipla
Underperformance continues
Event
 Cipla reported 3Q FY11 sales of Rs15.5bn (up 8% YoY) and a profit of
Rs2.3bn (down 20% YoY). Results were much below ours and consensus
estimates. EBITDA margin declined by ~600bps YoY to 20.5% primarily on
account of increased factory overhead at Indore SEZ and INR
appreciation(~4%) which led to lower exports realizations. We maintain our
Underperform rating and recommend switching to Dr Reddy’s Laboratories
(DRRD IN, Rs1,579.85, OP, TP: Rs1,840), which remains our preferred pick
in the Indian Pharma large cap space.

Impact
 Margins impacted due to increased overheads & INR appreciation:
Cipla’s EBITDA margin for the quarter came in at 20.5% (down 600bps YoY
and 220bps QoQ). The rupee appreciated ~4% YoY and weighed on Cipla’s
export sales and margin growth. Increased overhead from the new Indore
SEZ impacted margins negatively as sales began to Semi-Regulated markets.
For 9MFY11, the EBITDA margin declined 460bps YoY. Regulatory approval
from especially regulated markets (US, Europe) should help optimize
utilization, but we believe that would take 12–15 months to fructify.
 Volatile tech income: We have been highlighting tech income booked by Cipla
as being highly volatile and able to cause dramatic swings to EBITDA margins.
In 3Q FY11, tech income was Rs151m (down 79% YoY). Management is now
guiding to similar low levels of tech income/qtr going forward.
 Muted domestic growth: Domestic sales were weak this quarter (up 11%
YoY). While Cipla’s branded domestic formulations business grew ~15%,
generic formulations growth was muted. For 9MFY11, domestic sales grew by
11.5% YoY.
 Export sales grew 11.9% YoY driven by both formulation (up 11.7% YoY) and
API (up 12.8% YoY) sales. Inhalers for US and EU are keenly watched
opportunities; however, given the regulatory complexities involved for approval,
we believe any meaningful upside is still 18–24 months away.
Earnings and target price revision
 No change.
Price catalyst
 12-month price target: Rs290.00 based on a PER methodology.
 Catalyst: 1) Appreciation of INR, 2) lower tech income.
Action and recommendation
 Given volatile tech income, a declining ROCE, rupee appreciation risks and
an NPPA overhang, we believe Cipla should trade at discount to the sector
multiple. We value Cipla’s core business at Rs297, based on a PER of 18x
FY12E EPS and deduct Rs8 for the NPPA liability risk to arrive at our target
price of Rs290. However, the announcement of any supply pact with big
pharma companies for the emerging and developed markets (as the story is
being speculated about in the media) could be a risk to Underperform rating.