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Biocon
Questioning accounting practices
BIOS’ shares have had an uninspiring run post the termination of the
PFE deal, which dealt a body blow to its biosimilar insulin aspirations.
Whilst the deal is now terminated, it will continue to throw its shadow
over future earnings, thanks to an aggressive accounting policy that
will see BIOS shift biosimilar insulin R&D costs off the P&L. This, along
with use of a creative transaction structure for AxiCorp, leaves us
frustrated with corporate governance standards at the company, and
we downgrade our accounting and corporate governance rating from
AMBER to RED. Stripping out biosimilar insulin (90% valuation
haircut) and Dificid, BIOS is currently trading at ~12x FY13E EPS. We
cut our FV by 47% to Rs. 186 (from Rs.350 earlier) and switch to SELL.
PFE deal termination was a body blow
Earlier in the year, BIOS’ biosimilar insulin aspirations were dealt a body blow
following the termination of its global development and commercialization deal with
PFE. This sent the shares down by ~10% on the day, with shares continuing to drift
post Q4’FY12 results earlier in the month. Post the deal’s termination, the focus now
shifts to BIOS’ internal progress on the biosimilar insulin program.
Another incidence of aggressive accounting policies
There has been considerable confusion over the timing and accounting treatment of
PFE milestones through the P&L, as BIOS currently has deferred revenues of
~Rs.4930m on the balance sheet. In our experience, globally, post a deal termination,
the balance of deferred revenues lying on the balance sheet is typically recognised in
year-1 as a one-off revenue item. This is in line with matching principle as the
revenues from a terminated deal should not ideally be matched against costs of
another deal (internal or external). Based on the guidance provided by the
management, we believe that the company is likely to recognize the deferred
revenue in line with R&D costs associated with biosimilar insulin program in a
particular year. We see this accounting policy as aggressive (the auditors have drawn
an emphasis in this regards). This marks the third instance of aggressive accounting
with regards to recognition of income/costs for biosimilar insulin. We believe it will
lead to consistent over-reporting of EPS (and potentially over-valuation) to the
tune of 20% every year during FY13-15 while also leaving investors blind-sided with
the clinical spend and progress in biosimilar insulin development.
Concerned with AxiCorp “circular” transaction
In April ’11, BIOS sold its 77% stake in AxiCorp to existing minority investors for a
~EUR40m valuation, ~33% higher that its acquisition cost of EUR30m, and implying a
P/E of ~7.4x. However, the nature and structure of the transaction raises eyebrows as
BIOS used a creative deal structure at the time of acquisition that allowed it to pay
~EUR16m cash for AxiCorp but required it to transfer the rights to biosimilar human
insulin and glargine for Germany to AxiCorp for EUR14m. Our analysis indicates that
BIOS received only ~EUR5m in cash for the divestment, which is surprising given that
AxiCorp had a net profit of ~EUR5m in FY11. Moreover, while it seems that BIOS made
a profit of ~EUR10m on the transaction, in reality, there was a cash loss of ~EUR10m
and a notional loss of ~EUR21m in buying back the IP rights. Despite this, the deal
structure ensured that BIOS was not required to report any loss on sale in the P&L.
Cash drain not reflected in EPS – Valuing BIOS on SOTP
With the PFE deal terminated, we see little reason to own BIOS shares in the wake of
only modest growth prospects for the base business. We expect the FCF generation
to be further pushed out by 2-3 years resulting in a haircut of ~90% on rNPV of insulin
deal from Rs.40 to
R&D costs and Dificid, BIOS is currently trading at ~12x FY13E earnings. We value
Biocon’s base business at Rs.172 or (v. Rs.265 earlier), as we reduce the target P/E
multiple to ~10x FY13E EPS (v. 15x earlier), a 30% discount to mid-cap Indian pharma
peers, which we see as justified given the modest growth prospects for the base
business, and persistent accounting and corporate governance issues. A combination
of lower base business valuation and substantial haircut on biosimilar insulin means
that our FV now stands reduced by 47% to Rs.186 (from Rs.350 earlier). We
downgrade to SELL, 14% downside. Our EBIT and EPS estimates stand reduced by
16%/28% and 10%/25% for FY13/14 respectively.
