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Aurobindo Pharma - Recalibrating Itself

Recovering from a setback in 2012, Aurobindo Pharma has showed a decent performance in 2013. Shrikant Akolkar sheds some light on the company and its plans to focus on certain areas of growth in the near future.

Sentiments change quickly in the world of investments. Investors lose money as the stocks are sold when companies face issues on several fronts. Once shattered, an investor’s confidence takes a long time to return to such counters. The result is, investors ignore such companies until they see a sharp run up in the stock price and participate in the rally when it is just about to end. This is a perfect recipe for disaster. If there is no steam in the stock, all you will see is stagnation or wealth erosion. On the other hand, there is every possibility that you would catch up with some returns even if you enter such a counter at a later stage of the rally if the company is really worth its salt.

This happened in case of Wockhardt, which we had recommended some time ago and are glad that investors did make decent money out of that recommendation. But cases like these are rare. Here is another case where the stock has run up quite a bit until now, but there still seems to be enough steam left in it to give you some good returns going forward. We are talking about the pharmaceutical company Aurobindo Pharma. This is another pharma stock which will, in all probability, go the Wockhardt way.

Aurobindo Pharma put up a poor business performance in FY12 due to the import alert on its two facilities from the US FDA. It has now come back with a superior performance in FY13. Strikingly, the high debt levels of the company have been brought within the management’s control and therefore Aurobindo is now worth having a fresh look at. Here is how the company’s future looks like and the reasons why we are recommending this stock to you.

The Business

There are companies and then there are pharma companies. Operating in this sector calls for a tremendous wherewithal on the technological side and a will to invest in Research & Development. Aurobindo is a 25-year-old company which manufactures and markets Active Pharmaceutical Ingredients (APIs) and finished dosage formulations (generics). It has a total of 14 manufacturing facilities located in India, approved by regulatory bodies from countries like USA, UK, Australia, Brazil, South Africa, Canada and WHO as well. It operates in over 100 countries with a major focus on the USA, UK, Spain, Japan, Australia, Brazil and Russia.

Broadly, the company derives 56 per cent of its revenues from Formulations including its Anti-Retroviral (ARV) business and 44 per cent comes through APIs.

The Right Formulations

Formulations are the main growth engine of the company. It has two subsegments in this - the Anti-retroviral (ARV) business and the Formulations business (this again is divided into two parts; the US and the rest of the world). The US formulations business, RoW formulations and the ARV business bring in 27 per cent, 15 per cent and 14 per cent of its consolidated topline respectively.

Patent expiry in the US is the main driver of growth for the formulations business. It has augmented well for a host of companies in India which have utilised their capability of delivering cheaper copy cats of erstwhile patented drugs to the developed world. The four-year compounded annual growth rate of Aurobindo Pharma’s formulations business (ex-ARV) at the end of FY12 stood at 32 per cent. Over the years, its US revenues have played a key role in its overall financials as the contribution of its US revenues in its total revenues has increased from nine per cent in FY08 to 27 per cent as of 9MFY13.
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Revenues from RoW markets have shown some inconsistency due to the current crisis in the European countries. Pressure on government spending in that region has taken its toll on healthcare as well. According to the management, the pressure in Europe will remain for another year or so, after which it expects some improvement there. It is expecting a positive growth in the UK and Netherlands going ahead. It has recently entered Spain and Portugal, but the market conditions there remain subdued and the management feels it needs more time to perform in these markets. It is therefore too early to comment on the revenues from this segment. This gives you an idea of how well geographically diversified the revenue stream of Aurobindo Pharma is.

Revenues from ARVs, on the other hand, have grown at a four-year CAGR of 18 per cent up to FY12. Lately, however, revenues from this segment have shown a declining trend. These revenues come by winning tenders for supply of AIDS medicines to agencies like the President’s Emergency Plan for AIDS Relief (PEPFAR), Clinton Foundation, WHO, etc. The ARV business has become extremely competitive due to the entry of newer players into it. Currently this segment is profitable for the company, and the management has said that it is looking to participate in high value tenders. Therefore, one can expect more profits from this segment going forward.

The API Business

Aurobindo’s business earlier was hugely dependent on the APIs as it was deriving 61 per cent of its revenues from this segment until FY08. The increase in revenues from formulations has resulted in the share of APIs going down to 44 per cent towards the end of FY12 from what it used to be earlier. Though the contribution of APIs in percentage terms to the total revenues has come down, it does not mean that the segment is not performing well. The API business, in  absolute value terms, has shown a near two-fold growth over the last five years. According to the company management, earlier, regulated markets (US and UK) contributed quite less to this business. However, the same has started to increase in FY13 and therefore the company expects this segment to do well.

Aurobindo has recently commissioned a new API plant which will cater exclusively to the Japanese market. The Japanese Pharma market has started showing a good trajectory on the generics front and Aurobindo stands to gain in that market. Very few Indian companies like Lupin and Cadila have entered Japan and hence Aurobindo’s entry in Japan would add to its revenues in good meas- ure. The key of the API business is that, the utilisation rates in some of its API facilities remain about 75 per cent. This leaves enough headroom for the company for further growth in that segment.

Growing R&D Investments

Research is a very important aspect of the Pharma industry. It doesn't matter if you are a pure research company or a generic manufacture. R&D always throws more options open to the companies which help fuel growth by increasing the product's pipeline. Aurobindo has been increasing its R&D investments over the last four years. R&D costs, which remained between 3-3.5 per cent in FY09 - FY-10, have surged to 4.54 per cent as of FY12. The net impact of this can be seen on its products pipeline.

Product registrations across the markets have soared in case of Aurobindo. One of the very niche objectives of its R&D investments is to increase its pipeline in the sterile segment (injectable and Ophthalmic). In the Ophthalmic segment, it is yet to receive any product approval but has a total of four filings so far. It expects to file about 25 products in this segment in the next few years which sounds good from the revenue accretion point of view.
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Aurobindo has earmarked injectables as a key growth area in which it is expecting to file more drugs in the next three years. In fact, the recent sale of Stride Arcolab’s injectables unit to US-based Mylan, which was valued more than the overall firm, indicates that the injectables business has a huge growth potential. These drugs require a complex manufacturing technology since they enter the body through the intravenous route. Thus, not many companies in the generics space manufacture them. The ultimate impact is a huge shortage of injectables in the USA. 

These drugs also have higher EBITDA margins (30-35 per cent) compared to oral products which have margins of around 20-22 per cent. This clarifies the rationale of Aurobindo betting big on injectables. The company expects to file nearly 80 products in the segment which would give it sufficiently larger revenues and also increase its margins.

The 2012 Import Alert

The growth story of the company received a shock after an import alert was sounded on two of its units (IV and VI). The alert wiped off revenues of around USD 36 million in FY12 alone. While import alerts usually take more time for resolution from the US FDA end, Aurobindo had been quick to get its facilities back in production. By complying with the US FDA guidelines, it got back unit IV which is an injectable capacity. The company has started filing products there and therefore approval of drugs from this capacity will be very positive on its revenues.

Unit VI of the pharma company has been re-inspected by the US FDA and has received an Establishment Inspection Report (EIR). As per the EIR, the compliance of Aurobindo with US FDA has been satisfactory and the company can start filings from the unit. In simple terms, the unit has almost received the US FDA’s approval now. The company has said that it has not seen any major change in the market share of the products that it manufactured from this unit and hence, the revenue opportunity still remains with it. It intends regaining 70-80 per cent of the total revenues of USD 36 million that it lost in FY12. One can thus expect a better financial performance from the company FY14 onwards.

FY13: A Healthy Year

The company had a hard landing in FY12 due to the twin problems that it faced. As discussed earlier, the first one was an import alert on its facilities. The second was its FCCBs worth USD 139 million (about INR 740 crore), which were redeemed in FY12 at a premium of 146 per cent. This resulted in a loss of around INR 123 crore for FY12.

However, the company has recovered from both these shocks and has put up a robust performance up to 9MFY13. Its topline for this period has witnessed a good growth of 25 per cent to INR 4285 crore. The net profit stands at INR 185 crore against a loss of INR 232 crore reported in 9MFY12. The EBITDA margins have also increased by 148 basis points to 15.15 per cent, showing a relatively better operational performance.

The company carries a gross debt of INR 3250 crore on its balance sheet which mainly includes foreign currency borrowing of INR 1190 crore and short-term loans of INR 435 crore, the rest is majorly in the form of working capital requirements. The short-term loans will be paid in the June quarter of 2013. The foreign currency loans will be fully repaid over the next two to three years through internal accruals.

The management expects INR 800-900 crore of free cash flow generation from the next year onwards in order to help it reduce its debt further. Reduction of the long-term debt will further improve its returns ratio resulting in better net profit every year. The working capital loans are perpetual in nature and hence it will not become a fully debt-free company which implies that some interest cost will remain with the company.

Valuation

On the valuation front at CMP INR 165.10, the stock is trading at TTM P/E of 19x and EV/EBITDA of 11x which is in line with its peer companies. Considering the high growth rates it is witnessing as well as the expected reduction of debt over the next two years, we expect about 40 per cent price appreciation in the stock over the same period. We recommend a ‘buy’ on the scrip. It will certainly add value to an investor’s portfolio.

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