Piramal Healthcare-: CRAMS: Recovery Signals?; Margins Disappoint :: Citi

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Piramal Healthcare (PIRA.BO) 
Alert:  CRAMS: Recovery Signals?; Margins Disappoint 
Piramal Healthcare’s (PIRA) 3Q results indicate a pick-up in CRAMS but margins
surprised negatively. While the EBITDA loss in 3Q appears to be an aberration, the
guidance for 4Q of c14% margin implies normalized annual EBITDA margins
around c10% vs. c13-15% in our model. Net cash of cRs70bn (cRs335/sh) & the
proposed buyback (20% of equity) at Rs600/sh should support valuations in the
near term. The longer-term outlook would, however, depend on how the cash is
put to use & a clearer picture on the businesses left in PIRA.

 Robust revenue growth: Good signs in CRAMS – Revenues (adjusted for
hived-off businesses) grew 26% YoY, with good traction in all key areas. Pharma
Solutions (CRAMS) grew 24%: sales from Indian assets up 40%, overseas up 7%.
While the low base did help, this is the first time in 8 quarters that sales grew YoY.
OTC (+32%) and Critical Care (+28%) sales also clocked healthy growth. The
management expects growth rates to remain healthy going forward.
 Margins disappoint – EBITDA margins (adjusted for forex gains) stood at -4.5%
& -9.8% for 3Q & 9M respectively. The management indicated that these numbers
are not representative, given the transition (sale of two large businesses) during
the year. It expects EBITDA margin to improve to c14% in 4Q, as topline picks up.
We however do not think transition-related issues had much to do with the lower
margins in 3Q (appears much weaker seasonally than expected). The 4Q
guidance implies normalized annual margins around c10% levels.
 Significant cash on hand – Net cash is at cRs70bn (cRs335/sh) & generated
treasury income of cRs1.3bn – leading to recurring net profit of Rs731m. Even
post the proposed buyback (20% of equity), the company will be left with net cash
of Rs45bn (cRs270/sh). Besides, it will be receiving further cash flows (Rs75bn)
from Abbott & SRL over the next four years. PIRA did not provide any added colour
on use of cash.
 Other earnings call takeaways – 1) Bought a small company called Oxigen
Health to enhance offerings in the research services domain; 2) Sevoflurane
received approvals in 3 more countries; 3) Investing in vaporizers to enhance
Sevoflurane capacity; 4) Proposed buyback of shares to be completed before end
of FY11; 5) Desflurance case hearing scheduled for July 2011.
Piramal Healthcare (PIRA.BO; Rs419.80; 2M)


Piramal Healthcare
Valuation
Our target price for Piramal of Rs560 is based on 18x June 11E earnings. This is
at a premium to our target multiple for mid-sized Indian pharma companies and in
line with our target multiple for sector leaders. We believe Piramal deserves a
higher multiple than other mid-sized Indian pharma companies given its leadership
in innovator CRAMS and superior return ratios. Revenue visibility and
sustainability are high in the CRAMS business: these are long-term exclusive
contracts with innovators with no risk of litigation-related delays and competitive
pressures - these would continue to boost valuations in an environment where
outsourcing as a theme is gaining traction.
Risks
We rate Piramal Medium Risk, as suggested by our quantitative risk-rating system.
The main downside risks to our target price are: 1) While custom manufacturing
should drive Piramal's revenues and profitability, any slip-up in executing the
contracts would be a big negative. 2) A break-up of any major association could
have a short-term impact on revenues and earnings. 3) Any unfavorable trend in
growth or pricing could have an adverse impact on the company's financials. Key
upside risks to our target price are: 1) Faster than expected recovery in the
CRAMS business; 2) A victory in the patent litigation with Baxter on Desflurane; 3)
Better than anticipated performance in the critical care business.