Sun Pharmaceutical : Best Getting Better:: Morgan Stanley

Sun is transforming its top-quality generic business
into a specialty company. We believe it can unlock
meaningful value from URL, DUSA, SPARC and its
own portfolio in the next few years. We expect 21%
EPS CAGR for F13-15, raise our PT to Rs1,159 (25x
F15e EPS) and stay OW. Added to Asia Best Ideas.
Deep dive analysis of new growth drivers in this
report: We address the current pressing issues with
Sun – SPARC products, unlocking value in URL and
DUSA, plus our view on Taro pricing. Net net, we believe
these new growth drivers can incrementally contribute
US$200mn to sales in the next 2 years (30% of growth).
We conducted an AlphaWise survey of 200
neurologists in the US for levetiracetam XR (1000/1500
mg, lead SPARC NDDS product), which may be launched
in 2013/14 (subject to FDA approval). The findings were
encouraging – 81% of patients are on a dose of 1000mg or
more per day, 70% of neurologists appeared amenable to
switch 30% of their patients to the SPARC product with the
possibility of a therapeutic switch (4% of the overall
market). We estimate US$75mn of sales.
Taro pricing outlook: Overall portfolio vulnerability to
new competition may be limited in view of revenue
diversification and entry barriers. However, nystatin/trim
(25% of Taro sales) poses a material risk. We have
assumed a 10% Taro sales decline in F14 (vs. F3Q13).
URL offers multiple product opportunities to grow
based on our competitive analysis of current and
discontinued portfolios. DUSA holds promise given its
underpenetration in the AK market. URL/DUSA can add
US$80-90mn sales by F15.

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Why Overweight?
 Robust medium- to longer-term
fundamentals and earnings
momentum.
 The company is developing a product
pipeline, part of which has high entry
barriers.
 Globally aging population, pressure to
contain costs, regular patent expiries,
and new markets (e.g., Japan) are
defining global opportunities.
 Global competitive advantages –
strong chemistry, low cost, and global
distribution capabilities.
Key Value Drivers
 Momentum in the base business,
driven by several geographies
 Unlocking value from market share
gains/ re-launch of URL’s portfolio
 Successful integration of DUSA
 Progression of technically complex
products on the regulatory pathway.
 Commercialization of monopolistic
opportunities, such as modified
release products, nasal sprays, etc.,
 Commercialization of products from
SPARC’s portfolio
Potential Catalysts
 Market share gain for generic Doxil,
 New approvals – Prandin,
auto-injectors, nasal sprays
 Approval of products from SPARC’s
portfolio
 Market share gains/ re-launch of
URL’s portfolio
 Regulatory filings of technically
difficult products, such as luprolide
depot


We Reiterate Our Overweight Rating on Sun
Summary & Conclusions
We have explored the multiple growth levers that Sun’s
business model carries in this in-depth report. These include
lead drug products from SPARC’s pipeline (levetiracetam XR
and venlafaxine XR), recent acquisitions (URL and DUSA),
Taro pricing risk, and doxycycline.
In the overall analysis, we believe that Sun has built growth
platforms to deliver a 21% earnings CAGR over the next two
years (F14-15). This is leveraged to:
1) Unlocking value in URL’s large product basket (129
products);
2) Market expansion of DUSA;
3) Prescription switches in levetiracetam and venlafaxine
XR forms (subject to FDA approval);
4) 1-2 new approvals of niche opportunities in Sun’s own
pipeline;
5) Sustaining pricing for Taro products (esp. nystatin/trim);
6) Continuing growth momentum in the domestic business.
We estimate that these drivers are likely to incrementally add
US$200mn to Sun’s sales in F15 – US$110mn SPARC
products (Sun should see some upside) and US$80-90mn from
URL/DUSA. On Levetiracetam NDA, the USFDA is satisfied
with the drug in fast conditions, but requires more details on fed
conditions, which will delay the approval by a few months.
Investment thesis – In view of the growth visibility detailed
above, the potential to unlock value in the balance sheet
(US$1.2bn net cash) and the company’s capability to manage
complex technologies, we reiterate our OW rating on the
stock. We raise the price target to Rs1,159 (25x F15e EPS),
implying 20% upside to the current market price. We argue for
premium valuations for Sun in view of its sustainable
competitive advantages (i.e., technical capabilities and an
end-to-end business model), global generic opportunities and
proven track record of high growth/ROE.
Changes to the model – We update our model to include
upside from SPARC’s pipeline, URL, DUSA, Taro and Doxil.
Consequently, we raise our F14 and F15 EPS estimates by
7.3% and 15.3%, respectively. The key drivers of the upgrade
are detailed in Exhibit 1 below. We are now 6.6% and 12.7%
ahead of the Street, which we believe is due to the Street's
underestimation of value-unlocking potential in URL/DUSA
and the SPARC pipeline. In the last 3-4 years, consensus has
underestimated Sun’s ability to grow (Exhibit 2).
What’s in the price? We believe that the base business
(domestic, Sun’s current US portfolio, Taro) is priced into the
stock. However, the new growth levers – SPARC, URL,
DUSA, niche opportunities, and balance sheet – are not well
understood by the markets and offer upside potential to the
stock. In view of sparse, not easily available information on
URL/ DUSA/ SPARC, we believe that their earnings are not
yet adequately reflected in the consensus estimates. We
expect greater clarity on value unlocking as the company
reports earnings in ensuing quarters. Plus, excess cash
(US$1.2bn) is yielding a 5% return, which, if productively used
for M&A, could unlock significant value.

Stock catalysts: 1) New approvals in the US including
venlafaxine XR, levetiracetam XR, Prandin, niche formulation
(such as nasal spray and auto injector); 2) market share
trends for Doxil, the URL portfolio, Levulan; 3) remediation of
the Caraco facility; and 4) monthly performance in the
domestic market.

Key risks to our thesis: 1) High competitive intensity in Taro
portfolio (especially nystatin/trim); 2) set backs in the domestic
market (new pricing policy and government free drug
initiative); 3) fruition of pending Protonix liability
(US$250-300mn – MSe) in excess of market estimates;
4) delays unlocking value in URL/DUSA; 5) adverse/no
economics in SPARC pipeline; and 6) strengthening rupee.
Positioning in our coverage universe – Sun is one of the
selected stocks in our two Morgan Stanley franchise portfolios
– ‘50 by 2015’ and ‘Asia’s Best Business Models’. We believe
that Sun has the most robust business model in the Indian
pharma space. It is our favorite stock in the sector for the
mid-longer term.
Valuation and Price Target
The stock trades at 24.7x/ 20.5x our F2014 and F2015 EPS
estimates, implying about a 17-20% premium to industry
large-cap average valuations.
We are raising our price target to Rs1,159 (from Rs845), by
applying a target multiple 25x (a 20% premium to the industry)
to our FY15 EPS of Rs46.37. The increase in our price target
is driven by 1) our F15 EPS upgrade, and 2) a 20% higher
target multiple (25x versus 21x earlier). We are raising our
target P/E multiple in view of new growth levers (URL/DUSA,
SPARC pipeline), a proven track record of consistent growth
and potential upside from its balance sheet (US$1.2bn net
cash).
We believe that comparing the forward P/E multiple for Sun
with P/E based on historical earnings doesn't correctly reflect
the valuation comps. This is because of significant earnings
revisions during the course of the year. To overcome this
anomaly in P/E chart, we have shown the historical P/E trends
using one year forward EPS estimates (Exhibit 4). Using this
metric, we believe that the current 24-25x P/E multiple is not
excessive and is sustainable. Our estimates do not capture
the potential to unlock value in B/S – US$1.2bn cash plus
room to raise external capital – through value accretive M&A.
Sun has been active on the M&A front, which is eminent from
recent acquisitions of URL and DUSA. Following the
acquisition of Taro, it now has more management bandwidth
and a richer balance sheet, and has demonstrated success
with Taro.
We argue for a 20% premium to the domestic large-cap
peer average valuation. We cite the following positives:
 Solid base business, especially its domestic market
leadership in chronic ailment therapies. This is being
replicated in other emerging markets.
 Stabilizing US base business, driven by breadth in the
portfolio of niche products, including generic Doxil,
azelastine nasal spray, Imitrex auto-injector, buproprion
XR form, Optivar and Keppra injectable. It has a deep
pipeline for the US market, with 142 ANDAs pending FDA
approval.
 New growth levers – SPARC, URL and DUSA.
 Its sizable and growing net cash on the balance sheet,
which could unlock value via inorganic means.
 Deepening leadership team (Israel Makov, Kal
Sundaram), which underlines Sun’s aspirations to
continue to grow globally and profitably.
 These positives contrast with: 1) the potentially large
Protonix liability. The company has made a provision of
Rs5.8bn in F2Q13 quarter. And 2) Taro pricing risk.

Bull and Bear case scenarios
We have applied a sum-of-the parts methodology to arrive at
our bull-bear case scenarios.
Bull case – Stronger base business (Rs1,378): Key drivers
for this scenario include:
 Niche US launches and Caraco come out from USFDA
seizure driving strong earnings by 8% (Rs93 per share).
 Re-rating on filing of complex generics (e.g., luprolide
depot; by 7-8% implies Rs87 per share).
 Value-accretive acquisition of about US$800mn (Rs39
per share).
Bear case – Deterioration in base business (Rs788): Key
drivers for this scenario include:
 Setback in core business driven by delays in resolution
of FDA issues, currency headwinds and an inability to
monetize on niche opportunities, driving an earnings cut
of about 15% (Rs174 per share).
 Higher-than-expected pantoprazole litigation liability in
the US of about US$450mn (Rs23 per share).
 Delay in IPR monetization, and core business loses
growth momentum leading to a de-rating by 12-15%
(Rs174 per share).

Investment Debates Summary
# 1. Levetiracetam XR
– Sizing market
opportunity
How big could
levetiracetam XR
(1000mg/1500mg)
opportunity be and what
would it imply for Sun?
Market view – This is one of the first
NDDS launches from India therefore the
product and the opportunity are less
understood by the market. Moreover,
the gains for Sun are uncertain since
this product is from the SPARC pipeline.
Our view – Based on our AlphaWise survey of 200
neurologists in the US, we believe that this could be a
reasonable sized opportunity (US$75-80mn sales). Given that
SPARC will depend on a third party (including Sun) for
manufacturing and marketing, we believe that Sun can derive
meaningful upside from this product.
Where we could be wrong: Doctors/patients may not find
using this product convenient resulting in poor Rx conversion.
Sun/SPARC may price this too high to hurt the Rx conversion.
2. What is the pricing
outlook for Taro
portfolio?
With a 66% rise in Taro
sales over last two
years (largely due to
price increases), how
sustainable is current
pricing?
Market view: The market has been
skeptical on Taro’s ability to hold onto its
pricing. Since the product by product
risk is far less understood, the market
lacks insights into the risk.
Our view: Based on our in depth analysis of the portfolio, we
believe that Taro’s pricing risk is credible but limited in view of
the multitude of products with pricing power, reasonable
market share and active competition. However, its largest
product – nystatin/trim (25% of Taro revenues) – presents a
clear risk (steep price increase and negligible competition).
We have assumed 10% overall portfolio decline in growth in
F14.
Where we could be wrong: We could be wrong in both the
upside (Taro may continue to increase prices steadily if the
competitive landscape stays unchanged) or the downside (a
much more severe competitive outcome).
3. URL Acquisition –
How can Sun unlock
value?
Market view: These are early days for
the acquisition and the potential for
value unlocking is unclear due to limited
information on the portfolio.
Our view: Based on our extensive analysis of URL’s portfolio
and the competitive landscape, we believe that Sun may have
multiple product opportunities to grow overall sales. We
believe that the company can double URL sales in 3-4 years.
Where we could be wrong: Strong competitive backlash
and/or challenges in scaling up the portfolio may prolong or
diminish value unlocking.
4. DUSA Acquisition –
How can sun unlock
value here?
With DUSA being a one
product company, how
can Sun unlock value in
this US$230mn
acquisition?
Market view: The market has limited
understanding of the business drivers of
DUSA’s specialty product – Levulan.
And, therefore, it is unsure of the value
creation in this acquisition.
Our view: We believe that Sun can potentially unlock
significant value in DUSA over the next three years based on:
1) under penetration of Levulan, and 2) reasonable positioning
of this product in photodynamic therapy (PDT) treatment of
non-hyperkeratotic actinic keratoses (AK).
Where we could be wrong: Lower acceptability of Levulan
with other dermatologists and surprise competition that limits
growth prospects.