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Equity Research
Introducing our framework for regulatory action vs. valuations
Regulatory compliance critical for US opportunity over 2011/12
In our report “Deep dive into US opportunity; $3 bn opportunity for Indian
cos,” dated Feb. 18, 2011, we highlighted about 80 product opportunities in
the US for top 6 firms under our coverage. In our view, these launches will
be key drivers of stock performance in 2011/12, and therefore it is critical
for companies to maintain a good regulatory compliance record to ensure
these limited-period opportunities are capitalized upon. We introduce our
Regulatory Matrix to map how our covered stocks stack up currently.
No news is good news on FDA; valuations recover after 18 months
Case studies point to a 3-stage impact on valuations following regulatory
action: Near-term: Multiples compress by 10%-25% in the first 6 months.
Medium-term: Valuations remain stagnant for 12-18 months before the
market starts looking beyond the FDA issues. Longer-term: If there is no
further bad news multiples recover to pre-event levels (e.g., RBX, SUN)
after 18-24 months, assuming there is sufficient basis in the fundamentals.
In light of this, we believe there is limited scope for valuations to expand
for firms affected recently — DRL, Cadila & Aurobindo (all Neutral) — and
expect any upward stock performance to be driven by earnings upgrades.
Introducing our Regulatory Matrix; best placed – LUPN,JUBL,GLEN
Our Regulatory Matrix maps pharma companies on their past and current
regulatory record (483s/WLs/IAs, resolution speed, number of approved
facilities) vs. exposure to FDA (% of US sales/no. of facilities selling to the
US). We are cognizant of factors like nature and quantum of sales from
affected plants, quality of FDA observations (hygiene factors/GMP
violations/credibility factors) and broader market conditions. Re-enforcing
our stock picks, Lupin (Buy), Jubilant (Buy), Glenmark (Neutral) that screen
better than Aurobindo (Neutral), Ranbaxy (Neutral), Sun (Sell).
Rolling valuation forward to FY13; top picks – Lupin, Jubilant
We roll over valuations to FY13E from FY12E and raise our 12-m Director’s
Cut-based TPs by 11%-15% (except for Jubilant +34%, Aurobindo -10%, and
12-m SOTP-based TP for Piramal by -7%). We revise our FY12E-FY14E EPS by
+1% to -22%, except Ranbaxy by -62% for CY11E as we factor in a potential
US$300 mn payment to resolve FDA issues. Sector risks: Delayed product
approvals from the FDA, regulatory actions, currency volatility.
Regulatory compliance critical especially over the next two years
Regulatory record critical over 2011/2012 to capitalize on US opp
In our report titled Deep dive into US opportunity; $3 bn opportunity for Indian cos, dated
February 18, 2011, we highlighted about 80 product opportunities in the US for the top 6
firms under our coverage. In our view, these launches will be key drivers of stock
performance in 2011/12, and therefore it is critical for companies to maintain a good
regulatory compliance record to ensure these limited-period opportunities are capitalized
upon. We introduce our GS Regulatory Matrix for Indian Pharma as a framework to
interpret how companies are placed valuations vis-a-vis Regulatory Record’.
No news is good news on FDA; valuations recover in 12-18 month
The case studies we have discussed in this report point to a three-stage impact on
valuations following regulatory action on firms:
In the near-term: Multiples compress on an average by 10%-25% in the first 6-
mths (even after having factored in the earnings impact).
Over the medium-term: Valuations tend to remain stagnant for 12-18 months
before the market starts looking beyond the issues, (eg; DRL, Cadila, Aurobindo).
Over the longer-term: In our view, the market interprets no news as good news,
and hence multiples recover to pre-event levels (e.g., RBX, SUN) after 18-24
months or so, assuming there is sufficient basis in the fundamentals and with no
further negative news.
In light of this, we believe there is limited scope for valuations to expand for firms affected
in the recent past — like DRL, Cadila & Aurobindo — and expect any upward stock
performance to be driven by earnings upgrades. We retain Neutral on these stocks.
Introducing our Regulatory Matrix for Indian Pharma
Our Regulatory Matrix maps pharma companies on their past and current regulatory
record (their 483s/warning letters/Import Alert, resolution speed, number of approved
facilities) vs. their exposure to the FDA (% of US sales / No. of facilities selling to US).
We highlight that our Regulatory Matrix is not a comment on the Manufacturing Quality or
Quality compliance of the companies, but analyzes the extent of the current overhang (if
any) of regulatory agencies (primarily the FDA). We are also cognizant of variable factors
like nature and quantum of sales from affected plants, quality of FDA observations
(hygiene factors / GMP violations / credibility factors) and broader macro economic
conditions influencing stock performance. On current metrics, we believe that Lupin,
Jubilant and Glenmark are better placed on our matrix vs. Aurobindo, Ranbaxy, and Sun.
Rolling our target prices to FY13; top picks – Lupin, Jubilant
We roll over our valuations to FY13 from FY12 estimates. As a result, we raise our 12-m
TPs by 11%-15% (except for Jubilant +34%, Aurobindo -10%, and Piramal by -7%). We use
Director’s Cut methodology for all our coverage group, except Piramal for which we use
SOTP methodology. We revise our FY12E-FY14E EPS estimates by +1% to -22%, except
Ranbaxy by -62% for CY11E as we factor in a potential US$300 mn payment for a
comprehensive resolution with the FDA (Exhibits 20-21).
Impact of FDA actions on valuation: three stages in multiples
Most Indian pharma companies under our coverage that have exposure to US generic
markets have faced FDA action on violations of manufacturing guidelines over the last 4-5
years. The frequency of FDA inspections and subsequent issuance of observations (in the
form of 483s) and warning letters (WL) has increased significantly over the last 2-3 years —
with Ranbaxy, Sun, Aurobindo, Cipla, Cadila, Dr Reddy’s all facing some form of regulatory
action.
Based on our case studies for Lupin, Ranbaxy, Sun and Aurobindo, which we have
discussed in this note, we observe a 3-stage impact on how multiples tend to progress
after any regulator action:
In the near-term: Multiple compression of 10%-20%: Announcement of an FDA
action typically has led to multiple compression of 10%-20% in the first 1-6
months, depending on severity of issues raised by the FDA. We recognize though
there are other multiple factors which may have a bearing — like nature and
quantum of sales from affected plants, quality of FDA observations (hygiene
factors / GMP violations / credibility factors) as well as broader market conditions.
Over the medium-term: Valuation stagnates for 12-18 months: Stocks then
tend to have remained with an overhang from these regulatory issues and with
range-bound multiples for 12-18 months before the market starts looking beyond
the issues.
In our coverage, we view Dr Reddys, Aurobindo, Cadila to be in this stage
currently (Exhibit 3), and we expect their valuations to remain at current levels.
We expect their stock price performance to be closely tied to earnings upgrades,
rather than by any multiple expansion over the next 12 months.
Over the longer-term: Valuation recovery to pre-event levels: In most cases,
we observed a recovery in valuations between 18-24 months following the FDA
actions, especially when there were no incremental negative developments. We
believe that market interprets “no news as good news”, and that this is
particularly the case when accompanied by a relatively stable operational
performance, which helps the stock re-rate despite outstanding issues.
Case studies from our Indian Pharma coverage
Lupin: November 2008
No incremental negative developments and strong operational performance
mitigated multiple compressions beyond 6 months
Lupin received FDA-483s on its Mandideep facility in Madhya Pradesh in November 2008
(Economic Times) citing 15 manufacturing deficiencies. This resulted in immediate
valuation compression of the stock by 20%, with the stock trading at 8x on 1-yr forward P/E
multiple. In May 2009, Lupin announced it had received a Warning Letter on the facility and
was actively working towards its resolution. During this period stock remained rangebound at 8x-10x.
Following this, with no incremental development after the warning letter and strong
operational performances allaying concerns, its multiples re-rating over the next 12 months.
The company also managed to successfully close the letter with FDA within 8 months of
issuance.
Ranbaxy: June 2006
Significant de-rating during Warning Letter, Import Alert & Application Integrity
Policy (AIP) stage; multiples recovered in two years despite there being no visible
progress with the FDA
Ranbaxy received a Warning Letter for its Paonta Sahib facility in Himachal Pradesh in
June 2006 (Economic Times) citing deviations from US cGMP manufacturing guidelines.
(see Exhibit 45 for a detailed chronology of events). This resulted in valuations
compressing by about 40% (on price-to-sales multiples).
In September 2008, FDA followed up by issuing Warning Letters and an Import Alert for
drugs from two Ranbaxy plants in India (Dewas and Paonta Sahib) affecting over 30
different generic drugs, with total US sales of $145 mn over August 2007-July 2008. We
had estimated this to account for 37% of CY2007 US sales. The severity of the action
resulted in a 65% decline in the stock price within two months. Furthermore, in February
2009, FDA took new regulatory action against Ranbaxy’s Paonta Sahib Plant in India and
halted review of drug applications from plant due to evidence of falsified data and invoked
Application Integrity Policy (AIP).
Since then, despite there being no visible progress on the FDA issue, multiple drug
approvals over 2009-2010 from other plants, key one-off launches and Ranbaxy asking FDA
to re-inspect its Dewas facility in September 2009 has resulted in the stocks recovering to
their earlier (pre-FDA action) multiples. Hence, after a period of two years of material
underperformance, the stock has regained its historical valuations as its key one-off
product opportunities (Lipitor, Aricept) came closer to the launch.
Sun Pharma: November 2008
Average waiting time of 18 months has been sufficient for stocks to return to their
pre-WL multiples, in our view
Sun Pharma’s US subsidiary Caraco received a Warning Letter for its Detroit facility in
November 2008 (Economic Times) citing violations. This was followed by the FDA seizing
products at this facility in June 2009 following Caraco’s failure to meet the FDA's cGMP
requirements. Sun’s valuations were compressed by at least 20% during this period and
the stock traded at the lower end of its 5-years historical trading average. However, after
about 18 months of no incremental negative developments and Sun entering into a
Consent Decree with FDA for resolution of the issues, the stock has recovered its premium
valuations vs peers. In our view, this is also partially attributable to Sun’s operational
performance being helped by one-off products in US and acquisition of Taro.
Aurobindo Pharma: February 2011
FDA action on multiple facilities (Unit III, VI) could, in our view, prolong valuation
recovery
Aurobindo Pharma received an Import Alert on Unit VI in Feb 2011, followed by a Warning
Letter on Unit III in May 2011. Both these events resulted in a compression of multiples by
about 35% to 8X from 12X on 1-year forward P/E. Hence, despite the relatively limited
financial impact of the FDA action on current fundamentals, concerns over any potential
escalation of action by the FDA, either on the same plans or newer plants coming under the
FDA radar has led to significant multiple compression. We believe multiples will now be
compressed over a 12-18 month horizon, based on our case studies.
Based on our case studies, we it could take around 18-24 months for multiples to normalize
to previous levels, assuming there is no incremental negative developments on any other
plants, and that the operational performance of the company improves.
Dr Reddy’s/Cadila: June/July 2011
Stock performance following recent FDA actions demonstrates the need for earnings
upgrades
Dr Reddy’s recently received a warning letter for its Mexican API facility in June, which
was followed by an Import Alert. While the stock declined and multiples compressed, the
approval of Fondaparinux (1-yr revenue potential of US$64 mn as per our Feb 18, 2011
report), which DRL launched in July, has driven the stock performance. This supports our
thesis that earnings upgrades are required for stock performance, rather than just multiple
expansion due to the regulatory overhang on the stock.
Cadila received a warning letter for its penicillin facility in July, which saw the stock derate
significantly from its peak valuations of 22X to 19X. We do not expect a rebound in
multiples for the stock in the near-term, and any near-term stock performance would need
to be driven by earnings upgrades, in our view.
Introducing our Regulatory Matrix for Indian Pharma
Our Regulatory Matrix plots our Indian Pharma coverage on their current stage of
Regulatory Overhang vs. their exposure to the US market. We map the Regulatory
overhang on a relative score card (based on current and past 483s/WLs/IAs, speed of
resolution if any, number of approved facilities, corporate communication) vs. their
FDA exposure (% of US sales / No. of facilities selling to US).
We highlight that our Regulatory Matrix is not a comment on the Manufacturing Quality or
Quality compliance of the companies, but analyzes the extent of the current overhang (if
any) of regulatory agencies (primarily the FDA). We also recognize there are other factors
at play — the nature and quantum of sales from impacted plants, the quality of FDA
observations (hygiene factors vs. GMP violations vs. credibility factors) and broader market
conditions.
On current metrics, we believe that Lupin, Jubilant and Glenmark are better placed on our
Regulatory Matrix vs. Ranbaxy, Sun and Aurobindo. DRL and Cadila are in neutral territory,
as discussed earlier, as the FDA actions are quite recent and therefore as there remain
concerns around any potential escalation, we expect valuations to remain range bound for
these stocks
Case studies of firms with successful resolution to FDA action
With various issues with the FDA for multiple companies unresolved — including
Ranbaxy (Warning Letter/Import Alert), Sun Pharma’s Caraco (Consent Decree),
Aurobindo (Import Alert), Dr Reddy’s (Import Alert), Cadila (Warning Letter) — we
look at case studies for resolution under different types of FDA Actions. Our key
observations include:
Despite the varying types of regulatory actions, there are case studies of
successful resolutions to all actions. However, the time frame of resolution varies,
from a few months to a few years.
Consent Decrees have also been resolved successfully, with a few cases involving
penalties levied by the FDA, and also provisions for subsequent penalties in the
event of any non compliance. Sun Pharma entered into a Consent Decree, without
any upfront payment
Warning Letter and resolution – Lupin (May 2009-January 2010)
Lupin received FDA-483 on its Mandideep facility in Madhya Pradesh in November 2008
(Economic Times) citing 15 manufacturing deficiencies. After this, they reviewed the
responses from Lupin and found them to be inadequately addressing some concerns
relating to “maintaining production, control, or distribution records associated with a batch
of drugs”, along with other procedures relating to the manufacture of the drugs per CGMP
resulting in issuance of a warning letter on 7th May, 2009. Lupin announced in May 2009
that they have received the letter and were actively working towards its resolution. The
facility was re-inspected in November 2009 and FDA found the company had address all
concerns raised in the warning letter satisfactorily. On January 20, 2010, Lupin announced
the FDA had cleared the site.
GS view: We believe that the successful resolution of the warning letter by Lupin within
seven months of the issuance was reflected in the P/E multiple expansion that the stock
witnessed over the year, albeit helped by the strong operational performance.
Import Alert & resolution – Apotex (December 2008-May 2011)
Apotex received warning letters followed by Import Alerts on two of its facilities in Canada
during December 2008 to August 2009. The first facility located in Etobicoke, Ontario,
Canada was inspected by the FDA in December 2008, which revealed deviations from the
cGMPs. FDA reviewed the response to 483s and issued a warning letter for the same on the
June 25, 2009. After this incident, the second facility of Apotex located in Toronto, Canada
was inspected in July-August, 2009 and CGMP violations were found identical that found in
the Etobiocoke inspection. This resulted in an Import Alert on August 28, 2009 on products
manufactured from these plants which led to the recall of 659 batches of different drugs
manufactured at these sites. Later on, through taking appropriate corrective actions, the
warning letters for the two facilities were resolved by Apotex and the Import Alert was
lifted. Hence, it resumed shipping to the US from May 10, 2011, almost 2.5 years after they
first faced the FDA action on these plants.
GS view: Most of the companies in our coverage group which have received Import Alerts
from the US FDA have not been able to resolve the issue as yet. Based on the case study
above, however, we believe that it is possible for them to get the import ban lifted,
although it may be time consuming depending upon the severity of the violations.
Consent Decree and settlement thorough penalty payment –
Schering Plough (September 1999-May 2002)
During 1998-2001, FDA inspected four facilities of Schering Plough located in New Jersey
and Puerto Rico and during the 13 inspections done over this period, they found significant
violations related to “facilities, manufacturing, quality assurance, equipment, laboratories
and labeling”. Those deficiencies led the FDA to delay for nearly a year, the approval of
Clarinex, the successor drug to Claritin, the blockbuster allergy drug that at the time
brought in one-third of Schering-Plough's revenues. The four plants — in Kenilworth and
Union, NJ, and in Manati and Las Piedras, Puerto Rico — produced about 90 percent of the
company's products at the time. The company settled the issue with FDA by entering into a
consent decree with the USFDA (May 17, 2002).
Under the terms of Consent Decree:
SGP was required to hire and retain qualified outside experts for compliance with the
then current GMP in manufacturing, procedures and controls at production facilities.
Additionally, SGP was also required to a total of $500 mn to the US govt. in two equal
installments of $250mn each. In the event agreed-upon actions not completed on time,
the consent decree provided for daily payments of $15,000 for each deadline missed.
These payments cannot exceed $50 million incurred in any calendar year and have an
overall cap of $175 million incurred through 2005. A royalty payment of 24.6% of net
US sales could be assessed for each product for which revalidation had not been
successfully completed within the timelines of the consent decree.
The company was also scheduled to complete its revalidation plans by December 31,
2005. The company would expense any such payments if and when incurred.
SGP also terminated sales of certain product from these facilities the aggregate sale of
these products was $ 50 mn (mostly veterinary medicines products).
GS view: We believe that although the Application Integration Policy (AIP) is the most
severe form of action taken by the FDA, it is still possible for companies to resolve the
same with the regulators by entering into a Consent Decree with the FDA. This may result
in a settlement through paying penalty for the damages caused due to the violations and
other terms and conditions being fulfilled. Our case study of Schering Plough suggest that
similar steps could be taken by Ranbaxy to resolve its outstanding issues with the regulator
and make a settlement which may result in a penalty payment being made to the regulator.
Another similarity between these two cases is the approval of a blockbuster drug, which
were a material portion of the companies’ revenue/profit outlook, delayed due to the issues
with the FDA and violations of guidelines
Stocks in focus; implications of our Scorecard
Ranbaxy (Neutral) – Introducing a disgorgement payment of
US$300mn for a comprehensive resolution with the US FDA
Our base case for Ranbaxy currently factors the launch of generic Lipitor and other FTF
opportunities (Diovan, Actos, Provigil) for Ranbaxy in 2011-2013. However, we are
balancing our assumptions with the view that this would involve a simultaneous
settlement with FDA on the AIP issue. In our view, this could be a pre-requisite for
Ranbaxy to launch Lipitor and other products in the US.
We have discussed multiple case studies where companies have been able to get a goahead from the FDA, after paying a disgorgement amount (Exhibit 13). One of the case
studies we have discussed is of Schering Plough, which also faced an AIP during 1999-
2002 and was later able to reach a settlement with the FDA after paying about $500mn
penalty and other conditions. Based on some of the case studies we discussed earlier,
regarding the amount of the settlement, we observe a range of 20%-30% of operating
profits from the products/period under dispute.
However, while estimating this amount for Ranbaxy- we do not have visibility if such a
percentage might apply only to past one-off launches, or include future one-off
launches (Exhibit 14), or might even apply to overall sales generated in the US from
2006 to now (Exhibit 15). Therefore, estimating the value of the operating profits from
2006-2010 as $465mn and from 2011-2014 as $1938mn (incl. Nexium launch in 2014),
we arrive at a range of $93–$481 mn, and we use the midpoint of this range US$287.
As a check, we also triangulate it with a different case study based on the sales
generated, and assuming 10% of sales from 2006-2010 – to arrive at a potential amount
of US$231mn. Hence, we incorporate an average of $300 mn in our base case as the
disgorgement amount, which implies Rs32 per share of settlement amount in our
target price for Ranbaxy.
In light of this, we cut our CY2011 EPS by 62%. We also tweak 2012/2013 estimates on
low interest income received on lower cash balance. With these revised forecasts, we
arrive at our valuation for the core business as Rs466 (12-month Director’s Cut-based
target price) and coupled with the NPV of Rs58 for Lipitor and other one-offs, our
revised SOTP 12-month target price is Rs524 (up from Rs471), yielding only 1%
potential upside. With limited upside, we maintain our Neutral rating on Ranbaxy.
Key risks: early FDA resolution (upside), delay in generic Lipitor launch (downside).
Aurobindo (Neutral)– Increasing discount vs. peers owing to
multiple facilities impacted; maintain Neutral despite compelling
valuations
We maintain our Neutral rating on Aurobindo with our new 12-month Director’s Cutbased target price of Rs192 (down from Rs213), implying 22% potential upside.
Our target price implies a P/E of 8.9X on FY13E EPS vs. the sector average of 15.4X.
Despite this reasonable upside we retain our Neutral rating based on our view that
there will be an overhang on the stock from the FDA action on its facilities, and fear of
FDA issues spreading to its other plants.
Hence, despite factoring in the financial impact of the FDA action on Unit VI (refer our
note dtd 24
th
Feb, 2011, “USFDA import alert poses medium term overhang, move to
Neutral”), we believe that it could take a further 12-18 months for the stock to recover
its multiples, assuming that there are no incremental negative developments. Hence,
we expect the stock to trade at a greater discount to its peers and raise our discount
applied on Aurobindo from 30% (its historical discount to peers) to 40%.
We provide a sensitivity table below applying different ranges on the discount applied
to the stock.
We also lower our FY12E-FY14E EPS estimates for Aurobindo by 6.5%-16%,
incorporating recent quarterly results reported by the company, and largely owing to
margin reduction due to: 1) Adverse business mix; 2) Rising input cost; 3) US$8mn lost
revenue opportunity along with absorbing the fixed overheads cost and costs of
compliance, as well as higher finance charges post redemption of FCCBs in 1QFY12
(including F/X losses due to restatement of FCCB).
Key risks: resolution of import alert, closure of the FDA issues vis-a-vis Unit III and
Unit VI (upside); escalation of FDA issues, lower capacity utilization (downside).
Dr Reddy’s (Neutral) – Incorporating financial impact of FDA Import
Alert; 1Q results, maintain Neutral on valuation
We maintain our Neutral rating on Dr Reddy’s with a new 12-month Director’s Cutbased target price of Rs1718 (ADR: US$38.20), implying 11% potential upside.
We incorporate recent quarterly results into our forecasts and lower our margin
assumptions by 1.2%-2.0% over FY12-14E. Coupled with the cost of compliance of
bring the Mexican facility back into cGMP compliance, we also believe that increasing
competitive pressure and higher costs in the high margin domestic markets and
slightly prolonged approvals (and hence launches) in the US are impacting the
operating margins negatively.
We incorporate the financial impact of the import alert on DRL’s Mexico facility (sales
of $30mn p.a. as guided by management). We are not factoring in any near-term
resolution of the Import Alert and lower our revenue forecasts by 2.6%-6.0% over
FY2012E-14E. As such, we reduce our FY12E-FY14E EPS estimates by 17%-22%.
Our revised target price of Rs1,718/ADR US$38.20 (from Rs1507/ADR US$33.50)
implies a one-year fwd P/E multiple of 18.5X on FY13E estimates. We maintain our
Neutral rating on the stock.
Key risks: Increase in the number of one-off/exclusive launches (upside); increasing
competitive pressures in domestic market, escalation of the regulatory action
(downside).
Cadila (Neutral) – Premium valuations at risk on regulatory
overhang (following the Warning Letter) and risk to FY13 growth
We maintain our Neutral rating on Cadila with a new 12-month Director’s Cut-based
target price of Rs801 (rolled over from Rs706 previously), implying 4% potential
downside.
We believe that although the revenue and earning CAGR for Cadila (at 17%/18% for
FY11-FY14E) are better than the sector (at 15%/16%), current valuations for the stock
already reflect the stable outlook as it is trading at 17.6X on FY13E P/E, which is a 22%
premium to the sector average.
Furthermore, although the pre-approval warning letter to Cadila’s Zyfine facility does
not have an impact on the current fundamentals, it could impact future growth
prospects for the company from its penicillin portfolio launching out of the same
facility.
Hence, we believe that it is difficult to justify a premium for the stock vs. the sector and
maintain a Neutral on valuation. We fine tune our FY12E-FY14E EPS by -3% to -4% to
account for the lower than expected revenue growth in 1QFY12 earnings.
Key risks: earlier than expected product approvals and launches (upside); escalation of
the regulatory action (downside).
Sun Pharma (Sell): Expensive valuations are tough to justify
We maintain our Sell rating on Sun Pharma with a new 12-month Director’s Cut-based
target price of Rs376 (rolled over from Rs327 previously), implying 24% potential
downside.
In our view, Sun’s recovery of its valuations to the levels before the FDA action (on
Caraco’s facilities) is a function of both: (1) no incremental negative developments over
Caraco; and (2) strong one-off driven revenue and profit growth in FY2011.
However, our thesis is based on our views that: (a) domestic revenue share to decline
to 42% in FY12E vs. 47% in FY10; it typically commands a higher multiple, in our view;
(b) Exports, while boosted by Taro consolidation, face headwinds for critical product
opportunities like Docetaxel (Sun’s double vial injection faces a challenging single-vial
market in US), Eloxatin (with an injunction against it); (c) Weaker pipeline opportunity
vs. peers in the US market, lagging Ranbaxy, Lupin, and Dr Reddy’s.
Furthermore, we maintain our margin decline forecast on Sun, and forecast 190bp
decline in FY12E (vs. +130bp in FY11). We fine-tune our FY12E-FY14E EPS for Sun by
less than half a percent.
Key risks: resolution of FDA issue for Caraco, re-launch of Eloxatin, favorable verdicts
in ongoing litigations.
Piramal (Neutral): Increasing discount as company enters multiple
sectors
Residual business continues to be in flux: We note that the residual businesses (post
Abbott deal and Pathlabs divestiture) consisting of CRAMS, critical care and OTC,
continues to be in flux as the management focused on the closure of the Abbott deal
and the upcoming share buyback program. While margins have taken a hit in this
transition period, we expect margins to recover to normalized levels over the medium
term.
Increase discount to cash value in our SOTP methodology: Piramal has cash per share
of Rs440 on its balance sheet, on which we had previously applied a discount of 20% to
arrive at Rs350 per share. With the company's announcement of a range of
acquisitions outside the core healthcare business over the past 6-7 months ( REIT fund,
Real Estate Advisory, plans in Life Insurance and the latest announcement of a stake in
Vodafone Essar), we increase the discount applied to 30% as these plans increase the
transition period for the company.
We finetune our FY12E/FY13E/FY14E EPS to Rs16.17/Rs21.17/Rs26.06 and lower our 12-
month SOTP-based target price to Rs445 (from Rs480 previously), implying 20%
potential upside, to reflect our lower cash per share value of Rs308 and our P/E-based
value for the residual business—where we use a multiple of 11X (from 12X previously
to reflect the increased transition period) FY13E core business EPS of Rs12.5 to arrive
at a value of Rs137 (from Rs130 previously).
Key risks: Earlier than expected turnaround/prolonged slowdown in global CRAMS
business.
Biocon (Neutral): Incorporating divestment of Axicorp
Biocon has divested Axicorp from this quarter. We are incorporating this into our
models and hence, lower our revenue estimates by 35%-40% and EPS by 11%-20%
over FY12E-FY14E as Axicorp was a low margin business thereby improving the
margin profile of the business post divestiture.
We roll forward our valuation basis to FY13E and hence raise our 12-month Director's
Cut-based TP to Rs366 (from Rs318 previously), yielding a potential upside of 5%. Our
TP implies a 1-yr fwd P/E of 18.3X vs. the sector’s implied P/E of 15.6X.
Key risks: Lower than expected margins following divestment; outlicensing deals.
Lupin, Jubilant, Glenmark: Well-placed on regulatory scorecard
Under our regulatory scorecard, Lupin, Jubilant, and Glenmark are well placed, in our view:
Lupin has resolved its warning letter within 7 months, Cipla has cleared its 483s with no
escalation; and Glenmark has not received any major observations in the past for their
facilities. Jubilant has not faced any regulatory action in the recent past.
Lupin (LUPN. BO; Buy): We lower our FY12E-FY14E EPS by 2%-5% to reflect recent 1QFY12
results. However, we raise our 12-m Director’s Cut-based TP to Rs518 (from Rs463
previously) as we roll forward our valuation basis to FY13E. Key risks include delayed
product launches in the US.
Jubilant (JULS. BO; Buy): We raise our 12-m Director’s Cut-based TP to Rs286 (from Rs214
previously) as we roll forward our valuation basis to FY13E. We expect FY12E-FY13E to be
a recovery phase for the company (for details, refer to our report titled Gradual recovery
ahead post a tough transition year; maintain Buy, dated June 15, 2011). Key risks include
Slower than expected revival in CRAMS business, forex volatility.
Cipla (CIPL. BO; CL-Sell): We raise our 12-m Director’s Cut-based TP to Rs272 (from Rs244
previously) as we roll forward our valuation basis to FY13E. Key risks include better than
expected operating margins.
Glenmark (GLEN. BO; Neutral): We finetune our FY12E-FY14E EPS. We raise our 12-m
Director’s Cut-based TP to Rs348 (from Rs312 previously) as we roll forward our valuation
basis to FY13E. Key risks include delayed product launches in the US, outlicensing deals.
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Introducing our framework for regulatory action vs. valuations
Regulatory compliance critical for US opportunity over 2011/12
In our report “Deep dive into US opportunity; $3 bn opportunity for Indian
cos,” dated Feb. 18, 2011, we highlighted about 80 product opportunities in
the US for top 6 firms under our coverage. In our view, these launches will
be key drivers of stock performance in 2011/12, and therefore it is critical
for companies to maintain a good regulatory compliance record to ensure
these limited-period opportunities are capitalized upon. We introduce our
Regulatory Matrix to map how our covered stocks stack up currently.
No news is good news on FDA; valuations recover after 18 months
Case studies point to a 3-stage impact on valuations following regulatory
action: Near-term: Multiples compress by 10%-25% in the first 6 months.
Medium-term: Valuations remain stagnant for 12-18 months before the
market starts looking beyond the FDA issues. Longer-term: If there is no
further bad news multiples recover to pre-event levels (e.g., RBX, SUN)
after 18-24 months, assuming there is sufficient basis in the fundamentals.
In light of this, we believe there is limited scope for valuations to expand
for firms affected recently — DRL, Cadila & Aurobindo (all Neutral) — and
expect any upward stock performance to be driven by earnings upgrades.
Introducing our Regulatory Matrix; best placed – LUPN,JUBL,GLEN
Our Regulatory Matrix maps pharma companies on their past and current
regulatory record (483s/WLs/IAs, resolution speed, number of approved
facilities) vs. exposure to FDA (% of US sales/no. of facilities selling to the
US). We are cognizant of factors like nature and quantum of sales from
affected plants, quality of FDA observations (hygiene factors/GMP
violations/credibility factors) and broader market conditions. Re-enforcing
our stock picks, Lupin (Buy), Jubilant (Buy), Glenmark (Neutral) that screen
better than Aurobindo (Neutral), Ranbaxy (Neutral), Sun (Sell).
Rolling valuation forward to FY13; top picks – Lupin, Jubilant
We roll over valuations to FY13E from FY12E and raise our 12-m Director’s
Cut-based TPs by 11%-15% (except for Jubilant +34%, Aurobindo -10%, and
12-m SOTP-based TP for Piramal by -7%). We revise our FY12E-FY14E EPS by
+1% to -22%, except Ranbaxy by -62% for CY11E as we factor in a potential
US$300 mn payment to resolve FDA issues. Sector risks: Delayed product
approvals from the FDA, regulatory actions, currency volatility.
Regulatory compliance critical especially over the next two years
Regulatory record critical over 2011/2012 to capitalize on US opp
In our report titled Deep dive into US opportunity; $3 bn opportunity for Indian cos, dated
February 18, 2011, we highlighted about 80 product opportunities in the US for the top 6
firms under our coverage. In our view, these launches will be key drivers of stock
performance in 2011/12, and therefore it is critical for companies to maintain a good
regulatory compliance record to ensure these limited-period opportunities are capitalized
upon. We introduce our GS Regulatory Matrix for Indian Pharma as a framework to
interpret how companies are placed valuations vis-a-vis Regulatory Record’.
No news is good news on FDA; valuations recover in 12-18 month
The case studies we have discussed in this report point to a three-stage impact on
valuations following regulatory action on firms:
In the near-term: Multiples compress on an average by 10%-25% in the first 6-
mths (even after having factored in the earnings impact).
Over the medium-term: Valuations tend to remain stagnant for 12-18 months
before the market starts looking beyond the issues, (eg; DRL, Cadila, Aurobindo).
Over the longer-term: In our view, the market interprets no news as good news,
and hence multiples recover to pre-event levels (e.g., RBX, SUN) after 18-24
months or so, assuming there is sufficient basis in the fundamentals and with no
further negative news.
In light of this, we believe there is limited scope for valuations to expand for firms affected
in the recent past — like DRL, Cadila & Aurobindo — and expect any upward stock
performance to be driven by earnings upgrades. We retain Neutral on these stocks.
Introducing our Regulatory Matrix for Indian Pharma
Our Regulatory Matrix maps pharma companies on their past and current regulatory
record (their 483s/warning letters/Import Alert, resolution speed, number of approved
facilities) vs. their exposure to the FDA (% of US sales / No. of facilities selling to US).
We highlight that our Regulatory Matrix is not a comment on the Manufacturing Quality or
Quality compliance of the companies, but analyzes the extent of the current overhang (if
any) of regulatory agencies (primarily the FDA). We are also cognizant of variable factors
like nature and quantum of sales from affected plants, quality of FDA observations
(hygiene factors / GMP violations / credibility factors) and broader macro economic
conditions influencing stock performance. On current metrics, we believe that Lupin,
Jubilant and Glenmark are better placed on our matrix vs. Aurobindo, Ranbaxy, and Sun.
Rolling our target prices to FY13; top picks – Lupin, Jubilant
We roll over our valuations to FY13 from FY12 estimates. As a result, we raise our 12-m
TPs by 11%-15% (except for Jubilant +34%, Aurobindo -10%, and Piramal by -7%). We use
Director’s Cut methodology for all our coverage group, except Piramal for which we use
SOTP methodology. We revise our FY12E-FY14E EPS estimates by +1% to -22%, except
Ranbaxy by -62% for CY11E as we factor in a potential US$300 mn payment for a
comprehensive resolution with the FDA (Exhibits 20-21).
Impact of FDA actions on valuation: three stages in multiples
Most Indian pharma companies under our coverage that have exposure to US generic
markets have faced FDA action on violations of manufacturing guidelines over the last 4-5
years. The frequency of FDA inspections and subsequent issuance of observations (in the
form of 483s) and warning letters (WL) has increased significantly over the last 2-3 years —
with Ranbaxy, Sun, Aurobindo, Cipla, Cadila, Dr Reddy’s all facing some form of regulatory
action.
Based on our case studies for Lupin, Ranbaxy, Sun and Aurobindo, which we have
discussed in this note, we observe a 3-stage impact on how multiples tend to progress
after any regulator action:
In the near-term: Multiple compression of 10%-20%: Announcement of an FDA
action typically has led to multiple compression of 10%-20% in the first 1-6
months, depending on severity of issues raised by the FDA. We recognize though
there are other multiple factors which may have a bearing — like nature and
quantum of sales from affected plants, quality of FDA observations (hygiene
factors / GMP violations / credibility factors) as well as broader market conditions.
Over the medium-term: Valuation stagnates for 12-18 months: Stocks then
tend to have remained with an overhang from these regulatory issues and with
range-bound multiples for 12-18 months before the market starts looking beyond
the issues.
In our coverage, we view Dr Reddys, Aurobindo, Cadila to be in this stage
currently (Exhibit 3), and we expect their valuations to remain at current levels.
We expect their stock price performance to be closely tied to earnings upgrades,
rather than by any multiple expansion over the next 12 months.
Over the longer-term: Valuation recovery to pre-event levels: In most cases,
we observed a recovery in valuations between 18-24 months following the FDA
actions, especially when there were no incremental negative developments. We
believe that market interprets “no news as good news”, and that this is
particularly the case when accompanied by a relatively stable operational
performance, which helps the stock re-rate despite outstanding issues.
Case studies from our Indian Pharma coverage
Lupin: November 2008
No incremental negative developments and strong operational performance
mitigated multiple compressions beyond 6 months
Lupin received FDA-483s on its Mandideep facility in Madhya Pradesh in November 2008
(Economic Times) citing 15 manufacturing deficiencies. This resulted in immediate
valuation compression of the stock by 20%, with the stock trading at 8x on 1-yr forward P/E
multiple. In May 2009, Lupin announced it had received a Warning Letter on the facility and
was actively working towards its resolution. During this period stock remained rangebound at 8x-10x.
Following this, with no incremental development after the warning letter and strong
operational performances allaying concerns, its multiples re-rating over the next 12 months.
The company also managed to successfully close the letter with FDA within 8 months of
issuance.
Ranbaxy: June 2006
Significant de-rating during Warning Letter, Import Alert & Application Integrity
Policy (AIP) stage; multiples recovered in two years despite there being no visible
progress with the FDA
Ranbaxy received a Warning Letter for its Paonta Sahib facility in Himachal Pradesh in
June 2006 (Economic Times) citing deviations from US cGMP manufacturing guidelines.
(see Exhibit 45 for a detailed chronology of events). This resulted in valuations
compressing by about 40% (on price-to-sales multiples).
In September 2008, FDA followed up by issuing Warning Letters and an Import Alert for
drugs from two Ranbaxy plants in India (Dewas and Paonta Sahib) affecting over 30
different generic drugs, with total US sales of $145 mn over August 2007-July 2008. We
had estimated this to account for 37% of CY2007 US sales. The severity of the action
resulted in a 65% decline in the stock price within two months. Furthermore, in February
2009, FDA took new regulatory action against Ranbaxy’s Paonta Sahib Plant in India and
halted review of drug applications from plant due to evidence of falsified data and invoked
Application Integrity Policy (AIP).
Since then, despite there being no visible progress on the FDA issue, multiple drug
approvals over 2009-2010 from other plants, key one-off launches and Ranbaxy asking FDA
to re-inspect its Dewas facility in September 2009 has resulted in the stocks recovering to
their earlier (pre-FDA action) multiples. Hence, after a period of two years of material
underperformance, the stock has regained its historical valuations as its key one-off
product opportunities (Lipitor, Aricept) came closer to the launch.
Sun Pharma: November 2008
Average waiting time of 18 months has been sufficient for stocks to return to their
pre-WL multiples, in our view
Sun Pharma’s US subsidiary Caraco received a Warning Letter for its Detroit facility in
November 2008 (Economic Times) citing violations. This was followed by the FDA seizing
products at this facility in June 2009 following Caraco’s failure to meet the FDA's cGMP
requirements. Sun’s valuations were compressed by at least 20% during this period and
the stock traded at the lower end of its 5-years historical trading average. However, after
about 18 months of no incremental negative developments and Sun entering into a
Consent Decree with FDA for resolution of the issues, the stock has recovered its premium
valuations vs peers. In our view, this is also partially attributable to Sun’s operational
performance being helped by one-off products in US and acquisition of Taro.
Aurobindo Pharma: February 2011
FDA action on multiple facilities (Unit III, VI) could, in our view, prolong valuation
recovery
Aurobindo Pharma received an Import Alert on Unit VI in Feb 2011, followed by a Warning
Letter on Unit III in May 2011. Both these events resulted in a compression of multiples by
about 35% to 8X from 12X on 1-year forward P/E. Hence, despite the relatively limited
financial impact of the FDA action on current fundamentals, concerns over any potential
escalation of action by the FDA, either on the same plans or newer plants coming under the
FDA radar has led to significant multiple compression. We believe multiples will now be
compressed over a 12-18 month horizon, based on our case studies.
Based on our case studies, we it could take around 18-24 months for multiples to normalize
to previous levels, assuming there is no incremental negative developments on any other
plants, and that the operational performance of the company improves.
Dr Reddy’s/Cadila: June/July 2011
Stock performance following recent FDA actions demonstrates the need for earnings
upgrades
Dr Reddy’s recently received a warning letter for its Mexican API facility in June, which
was followed by an Import Alert. While the stock declined and multiples compressed, the
approval of Fondaparinux (1-yr revenue potential of US$64 mn as per our Feb 18, 2011
report), which DRL launched in July, has driven the stock performance. This supports our
thesis that earnings upgrades are required for stock performance, rather than just multiple
expansion due to the regulatory overhang on the stock.
Cadila received a warning letter for its penicillin facility in July, which saw the stock derate
significantly from its peak valuations of 22X to 19X. We do not expect a rebound in
multiples for the stock in the near-term, and any near-term stock performance would need
to be driven by earnings upgrades, in our view.
Introducing our Regulatory Matrix for Indian Pharma
Our Regulatory Matrix plots our Indian Pharma coverage on their current stage of
Regulatory Overhang vs. their exposure to the US market. We map the Regulatory
overhang on a relative score card (based on current and past 483s/WLs/IAs, speed of
resolution if any, number of approved facilities, corporate communication) vs. their
FDA exposure (% of US sales / No. of facilities selling to US).
We highlight that our Regulatory Matrix is not a comment on the Manufacturing Quality or
Quality compliance of the companies, but analyzes the extent of the current overhang (if
any) of regulatory agencies (primarily the FDA). We also recognize there are other factors
at play — the nature and quantum of sales from impacted plants, the quality of FDA
observations (hygiene factors vs. GMP violations vs. credibility factors) and broader market
conditions.
On current metrics, we believe that Lupin, Jubilant and Glenmark are better placed on our
Regulatory Matrix vs. Ranbaxy, Sun and Aurobindo. DRL and Cadila are in neutral territory,
as discussed earlier, as the FDA actions are quite recent and therefore as there remain
concerns around any potential escalation, we expect valuations to remain range bound for
these stocks
Case studies of firms with successful resolution to FDA action
With various issues with the FDA for multiple companies unresolved — including
Ranbaxy (Warning Letter/Import Alert), Sun Pharma’s Caraco (Consent Decree),
Aurobindo (Import Alert), Dr Reddy’s (Import Alert), Cadila (Warning Letter) — we
look at case studies for resolution under different types of FDA Actions. Our key
observations include:
Despite the varying types of regulatory actions, there are case studies of
successful resolutions to all actions. However, the time frame of resolution varies,
from a few months to a few years.
Consent Decrees have also been resolved successfully, with a few cases involving
penalties levied by the FDA, and also provisions for subsequent penalties in the
event of any non compliance. Sun Pharma entered into a Consent Decree, without
any upfront payment
Warning Letter and resolution – Lupin (May 2009-January 2010)
Lupin received FDA-483 on its Mandideep facility in Madhya Pradesh in November 2008
(Economic Times) citing 15 manufacturing deficiencies. After this, they reviewed the
responses from Lupin and found them to be inadequately addressing some concerns
relating to “maintaining production, control, or distribution records associated with a batch
of drugs”, along with other procedures relating to the manufacture of the drugs per CGMP
resulting in issuance of a warning letter on 7th May, 2009. Lupin announced in May 2009
that they have received the letter and were actively working towards its resolution. The
facility was re-inspected in November 2009 and FDA found the company had address all
concerns raised in the warning letter satisfactorily. On January 20, 2010, Lupin announced
the FDA had cleared the site.
GS view: We believe that the successful resolution of the warning letter by Lupin within
seven months of the issuance was reflected in the P/E multiple expansion that the stock
witnessed over the year, albeit helped by the strong operational performance.
Import Alert & resolution – Apotex (December 2008-May 2011)
Apotex received warning letters followed by Import Alerts on two of its facilities in Canada
during December 2008 to August 2009. The first facility located in Etobicoke, Ontario,
Canada was inspected by the FDA in December 2008, which revealed deviations from the
cGMPs. FDA reviewed the response to 483s and issued a warning letter for the same on the
June 25, 2009. After this incident, the second facility of Apotex located in Toronto, Canada
was inspected in July-August, 2009 and CGMP violations were found identical that found in
the Etobiocoke inspection. This resulted in an Import Alert on August 28, 2009 on products
manufactured from these plants which led to the recall of 659 batches of different drugs
manufactured at these sites. Later on, through taking appropriate corrective actions, the
warning letters for the two facilities were resolved by Apotex and the Import Alert was
lifted. Hence, it resumed shipping to the US from May 10, 2011, almost 2.5 years after they
first faced the FDA action on these plants.
GS view: Most of the companies in our coverage group which have received Import Alerts
from the US FDA have not been able to resolve the issue as yet. Based on the case study
above, however, we believe that it is possible for them to get the import ban lifted,
although it may be time consuming depending upon the severity of the violations.
Consent Decree and settlement thorough penalty payment –
Schering Plough (September 1999-May 2002)
During 1998-2001, FDA inspected four facilities of Schering Plough located in New Jersey
and Puerto Rico and during the 13 inspections done over this period, they found significant
violations related to “facilities, manufacturing, quality assurance, equipment, laboratories
and labeling”. Those deficiencies led the FDA to delay for nearly a year, the approval of
Clarinex, the successor drug to Claritin, the blockbuster allergy drug that at the time
brought in one-third of Schering-Plough's revenues. The four plants — in Kenilworth and
Union, NJ, and in Manati and Las Piedras, Puerto Rico — produced about 90 percent of the
company's products at the time. The company settled the issue with FDA by entering into a
consent decree with the USFDA (May 17, 2002).
Under the terms of Consent Decree:
SGP was required to hire and retain qualified outside experts for compliance with the
then current GMP in manufacturing, procedures and controls at production facilities.
Additionally, SGP was also required to a total of $500 mn to the US govt. in two equal
installments of $250mn each. In the event agreed-upon actions not completed on time,
the consent decree provided for daily payments of $15,000 for each deadline missed.
These payments cannot exceed $50 million incurred in any calendar year and have an
overall cap of $175 million incurred through 2005. A royalty payment of 24.6% of net
US sales could be assessed for each product for which revalidation had not been
successfully completed within the timelines of the consent decree.
The company was also scheduled to complete its revalidation plans by December 31,
2005. The company would expense any such payments if and when incurred.
SGP also terminated sales of certain product from these facilities the aggregate sale of
these products was $ 50 mn (mostly veterinary medicines products).
GS view: We believe that although the Application Integration Policy (AIP) is the most
severe form of action taken by the FDA, it is still possible for companies to resolve the
same with the regulators by entering into a Consent Decree with the FDA. This may result
in a settlement through paying penalty for the damages caused due to the violations and
other terms and conditions being fulfilled. Our case study of Schering Plough suggest that
similar steps could be taken by Ranbaxy to resolve its outstanding issues with the regulator
and make a settlement which may result in a penalty payment being made to the regulator.
Another similarity between these two cases is the approval of a blockbuster drug, which
were a material portion of the companies’ revenue/profit outlook, delayed due to the issues
with the FDA and violations of guidelines
Stocks in focus; implications of our Scorecard
Ranbaxy (Neutral) – Introducing a disgorgement payment of
US$300mn for a comprehensive resolution with the US FDA
Our base case for Ranbaxy currently factors the launch of generic Lipitor and other FTF
opportunities (Diovan, Actos, Provigil) for Ranbaxy in 2011-2013. However, we are
balancing our assumptions with the view that this would involve a simultaneous
settlement with FDA on the AIP issue. In our view, this could be a pre-requisite for
Ranbaxy to launch Lipitor and other products in the US.
We have discussed multiple case studies where companies have been able to get a goahead from the FDA, after paying a disgorgement amount (Exhibit 13). One of the case
studies we have discussed is of Schering Plough, which also faced an AIP during 1999-
2002 and was later able to reach a settlement with the FDA after paying about $500mn
penalty and other conditions. Based on some of the case studies we discussed earlier,
regarding the amount of the settlement, we observe a range of 20%-30% of operating
profits from the products/period under dispute.
However, while estimating this amount for Ranbaxy- we do not have visibility if such a
percentage might apply only to past one-off launches, or include future one-off
launches (Exhibit 14), or might even apply to overall sales generated in the US from
2006 to now (Exhibit 15). Therefore, estimating the value of the operating profits from
2006-2010 as $465mn and from 2011-2014 as $1938mn (incl. Nexium launch in 2014),
we arrive at a range of $93–$481 mn, and we use the midpoint of this range US$287.
As a check, we also triangulate it with a different case study based on the sales
generated, and assuming 10% of sales from 2006-2010 – to arrive at a potential amount
of US$231mn. Hence, we incorporate an average of $300 mn in our base case as the
disgorgement amount, which implies Rs32 per share of settlement amount in our
target price for Ranbaxy.
In light of this, we cut our CY2011 EPS by 62%. We also tweak 2012/2013 estimates on
low interest income received on lower cash balance. With these revised forecasts, we
arrive at our valuation for the core business as Rs466 (12-month Director’s Cut-based
target price) and coupled with the NPV of Rs58 for Lipitor and other one-offs, our
revised SOTP 12-month target price is Rs524 (up from Rs471), yielding only 1%
potential upside. With limited upside, we maintain our Neutral rating on Ranbaxy.
Key risks: early FDA resolution (upside), delay in generic Lipitor launch (downside).
Aurobindo (Neutral)– Increasing discount vs. peers owing to
multiple facilities impacted; maintain Neutral despite compelling
valuations
We maintain our Neutral rating on Aurobindo with our new 12-month Director’s Cutbased target price of Rs192 (down from Rs213), implying 22% potential upside.
Our target price implies a P/E of 8.9X on FY13E EPS vs. the sector average of 15.4X.
Despite this reasonable upside we retain our Neutral rating based on our view that
there will be an overhang on the stock from the FDA action on its facilities, and fear of
FDA issues spreading to its other plants.
Hence, despite factoring in the financial impact of the FDA action on Unit VI (refer our
note dtd 24
th
Feb, 2011, “USFDA import alert poses medium term overhang, move to
Neutral”), we believe that it could take a further 12-18 months for the stock to recover
its multiples, assuming that there are no incremental negative developments. Hence,
we expect the stock to trade at a greater discount to its peers and raise our discount
applied on Aurobindo from 30% (its historical discount to peers) to 40%.
We provide a sensitivity table below applying different ranges on the discount applied
to the stock.
We also lower our FY12E-FY14E EPS estimates for Aurobindo by 6.5%-16%,
incorporating recent quarterly results reported by the company, and largely owing to
margin reduction due to: 1) Adverse business mix; 2) Rising input cost; 3) US$8mn lost
revenue opportunity along with absorbing the fixed overheads cost and costs of
compliance, as well as higher finance charges post redemption of FCCBs in 1QFY12
(including F/X losses due to restatement of FCCB).
Key risks: resolution of import alert, closure of the FDA issues vis-a-vis Unit III and
Unit VI (upside); escalation of FDA issues, lower capacity utilization (downside).
Dr Reddy’s (Neutral) – Incorporating financial impact of FDA Import
Alert; 1Q results, maintain Neutral on valuation
We maintain our Neutral rating on Dr Reddy’s with a new 12-month Director’s Cutbased target price of Rs1718 (ADR: US$38.20), implying 11% potential upside.
We incorporate recent quarterly results into our forecasts and lower our margin
assumptions by 1.2%-2.0% over FY12-14E. Coupled with the cost of compliance of
bring the Mexican facility back into cGMP compliance, we also believe that increasing
competitive pressure and higher costs in the high margin domestic markets and
slightly prolonged approvals (and hence launches) in the US are impacting the
operating margins negatively.
We incorporate the financial impact of the import alert on DRL’s Mexico facility (sales
of $30mn p.a. as guided by management). We are not factoring in any near-term
resolution of the Import Alert and lower our revenue forecasts by 2.6%-6.0% over
FY2012E-14E. As such, we reduce our FY12E-FY14E EPS estimates by 17%-22%.
Our revised target price of Rs1,718/ADR US$38.20 (from Rs1507/ADR US$33.50)
implies a one-year fwd P/E multiple of 18.5X on FY13E estimates. We maintain our
Neutral rating on the stock.
Key risks: Increase in the number of one-off/exclusive launches (upside); increasing
competitive pressures in domestic market, escalation of the regulatory action
(downside).
Cadila (Neutral) – Premium valuations at risk on regulatory
overhang (following the Warning Letter) and risk to FY13 growth
We maintain our Neutral rating on Cadila with a new 12-month Director’s Cut-based
target price of Rs801 (rolled over from Rs706 previously), implying 4% potential
downside.
We believe that although the revenue and earning CAGR for Cadila (at 17%/18% for
FY11-FY14E) are better than the sector (at 15%/16%), current valuations for the stock
already reflect the stable outlook as it is trading at 17.6X on FY13E P/E, which is a 22%
premium to the sector average.
Furthermore, although the pre-approval warning letter to Cadila’s Zyfine facility does
not have an impact on the current fundamentals, it could impact future growth
prospects for the company from its penicillin portfolio launching out of the same
facility.
Hence, we believe that it is difficult to justify a premium for the stock vs. the sector and
maintain a Neutral on valuation. We fine tune our FY12E-FY14E EPS by -3% to -4% to
account for the lower than expected revenue growth in 1QFY12 earnings.
Key risks: earlier than expected product approvals and launches (upside); escalation of
the regulatory action (downside).
Sun Pharma (Sell): Expensive valuations are tough to justify
We maintain our Sell rating on Sun Pharma with a new 12-month Director’s Cut-based
target price of Rs376 (rolled over from Rs327 previously), implying 24% potential
downside.
In our view, Sun’s recovery of its valuations to the levels before the FDA action (on
Caraco’s facilities) is a function of both: (1) no incremental negative developments over
Caraco; and (2) strong one-off driven revenue and profit growth in FY2011.
However, our thesis is based on our views that: (a) domestic revenue share to decline
to 42% in FY12E vs. 47% in FY10; it typically commands a higher multiple, in our view;
(b) Exports, while boosted by Taro consolidation, face headwinds for critical product
opportunities like Docetaxel (Sun’s double vial injection faces a challenging single-vial
market in US), Eloxatin (with an injunction against it); (c) Weaker pipeline opportunity
vs. peers in the US market, lagging Ranbaxy, Lupin, and Dr Reddy’s.
Furthermore, we maintain our margin decline forecast on Sun, and forecast 190bp
decline in FY12E (vs. +130bp in FY11). We fine-tune our FY12E-FY14E EPS for Sun by
less than half a percent.
Key risks: resolution of FDA issue for Caraco, re-launch of Eloxatin, favorable verdicts
in ongoing litigations.
Piramal (Neutral): Increasing discount as company enters multiple
sectors
Residual business continues to be in flux: We note that the residual businesses (post
Abbott deal and Pathlabs divestiture) consisting of CRAMS, critical care and OTC,
continues to be in flux as the management focused on the closure of the Abbott deal
and the upcoming share buyback program. While margins have taken a hit in this
transition period, we expect margins to recover to normalized levels over the medium
term.
Increase discount to cash value in our SOTP methodology: Piramal has cash per share
of Rs440 on its balance sheet, on which we had previously applied a discount of 20% to
arrive at Rs350 per share. With the company's announcement of a range of
acquisitions outside the core healthcare business over the past 6-7 months ( REIT fund,
Real Estate Advisory, plans in Life Insurance and the latest announcement of a stake in
Vodafone Essar), we increase the discount applied to 30% as these plans increase the
transition period for the company.
We finetune our FY12E/FY13E/FY14E EPS to Rs16.17/Rs21.17/Rs26.06 and lower our 12-
month SOTP-based target price to Rs445 (from Rs480 previously), implying 20%
potential upside, to reflect our lower cash per share value of Rs308 and our P/E-based
value for the residual business—where we use a multiple of 11X (from 12X previously
to reflect the increased transition period) FY13E core business EPS of Rs12.5 to arrive
at a value of Rs137 (from Rs130 previously).
Key risks: Earlier than expected turnaround/prolonged slowdown in global CRAMS
business.
Biocon (Neutral): Incorporating divestment of Axicorp
Biocon has divested Axicorp from this quarter. We are incorporating this into our
models and hence, lower our revenue estimates by 35%-40% and EPS by 11%-20%
over FY12E-FY14E as Axicorp was a low margin business thereby improving the
margin profile of the business post divestiture.
We roll forward our valuation basis to FY13E and hence raise our 12-month Director's
Cut-based TP to Rs366 (from Rs318 previously), yielding a potential upside of 5%. Our
TP implies a 1-yr fwd P/E of 18.3X vs. the sector’s implied P/E of 15.6X.
Key risks: Lower than expected margins following divestment; outlicensing deals.
Lupin, Jubilant, Glenmark: Well-placed on regulatory scorecard
Under our regulatory scorecard, Lupin, Jubilant, and Glenmark are well placed, in our view:
Lupin has resolved its warning letter within 7 months, Cipla has cleared its 483s with no
escalation; and Glenmark has not received any major observations in the past for their
facilities. Jubilant has not faced any regulatory action in the recent past.
Lupin (LUPN. BO; Buy): We lower our FY12E-FY14E EPS by 2%-5% to reflect recent 1QFY12
results. However, we raise our 12-m Director’s Cut-based TP to Rs518 (from Rs463
previously) as we roll forward our valuation basis to FY13E. Key risks include delayed
product launches in the US.
Jubilant (JULS. BO; Buy): We raise our 12-m Director’s Cut-based TP to Rs286 (from Rs214
previously) as we roll forward our valuation basis to FY13E. We expect FY12E-FY13E to be
a recovery phase for the company (for details, refer to our report titled Gradual recovery
ahead post a tough transition year; maintain Buy, dated June 15, 2011). Key risks include
Slower than expected revival in CRAMS business, forex volatility.
Cipla (CIPL. BO; CL-Sell): We raise our 12-m Director’s Cut-based TP to Rs272 (from Rs244
previously) as we roll forward our valuation basis to FY13E. Key risks include better than
expected operating margins.
Glenmark (GLEN. BO; Neutral): We finetune our FY12E-FY14E EPS. We raise our 12-m
Director’s Cut-based TP to Rs348 (from Rs312 previously) as we roll forward our valuation
basis to FY13E. Key risks include delayed product launches in the US, outlicensing deals.
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