JBCPL and Dr. Reddy’s call off the Prescription deal  Reliance Sec

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JBCPL and Dr. Reddy’s call off the Prescription deal
 Event: JB Chemicals (JBCPL) and Dr. Reddy's have called off the proposed
prescription deal in their overall business interests. However, both the
companies have indicated that they will continue to pursue their Russia-CIS
business aggressively. Russia and CIS contributed ~14.6% and ~47% of the
total sales for Dr. Reddy’s and JBCPL respectively in FY2011.
 The deal: In July 2011, Dr. Reddy’s had acquired the prescription portfolio of
JBCPL in Russia & CIS market for ~US$34.85mn. The deal comprised a total of
20 products with Metrogyl (a ~US$10mn brand) and Jocet being the key brands.
Dr. Reddy’s also received an access to several hospital products in the pipeline,
of which a few are expected to be first-time generic launches. The acquired
prescription business had annual sales of US$24mn, catering to prescriptions,
OTC & hospital segments.
 Potential reasons of deal fall-out: Both the company’s refused to divulge any
details pertaining to the deal cancellation. As per the media, the deal was called
off due to certain unsettled issues over the supply agreement. However, despite
Russia being an important part of Dr. Reddy’s expansion strategy, we believe
that the deal was called off due to the following reasons:
 Acquisition of Jocet gives Dr. Reddy’s an entry in the USD$256mn cough and
cold segment but it will have to spend a lot in terms of promotional and marketing
expenses in order to stay competitive against the bigger brands in this space.
 All the brands are in prescription category from which Dr. Reddy’s generates
almost 60% of its Russian revenue which come under reference pricing system
in Russia. Hence, we believe that margins in these brands will be lower than in
the OTC space.
 JBCPL will continue to manufacture these brands for Dr. Reddy’s for the next 3-4
years time, which will again drag down the margins in the medium term.
Outlook and Valuation
At ~1.5x sales, we believe the deal valuation was attractive for JBCPL given the
turmoil in the Russian geography. The Russian market currently faces headwinds in
the form of high working capital requirements and long-term pricing pressures as the
Russian legislation focuses on locally produced drugs. This was also the reason why
the JBCPL promoters sold the well set OTC business to J&J earlier this year. We
view this as a primary reason for the deal fall out. We believe that while it is still not
clear how the Russian pharma market will evolve over the next few years, investors
should no longer take sustainability of high growth and high margins in Russia to be
sacrosanct going forward.
Further, we reiterate that the company would take a few years to recoup the loss
from the sale of its Russian OTC business. Moreover, the low margins of the residual
business would keep the profitability under pressure, thereby depressing the return
ratios in the near term. Hence, we recommend investors to exit from JBCPL at the
current juncture and wait for signs of improvement in the business fundamentals. In
the meanwhile, investors looking for exposure in the pharma sector in the similar
space as JBCPL (strong focus on domestic market) can consider investing in stocks
like Sun Pharma (Accumulate, Target Price Rs562) and Glenmark (Buy, Target Price
Rs414), where the business growth prospects are relatively much clear.