Syngene: Premium valuations for outsized opportunity

Past record, management quality and forward integration are positives; long-term investors could subscribe

Syngene, Biocon’s contract research subsidiary, planning to raise Rs 550 crore from its Initial Public Offering, has plans of forward integration into commercial manufacturing. The company is planning a capex of $200 million over the next two-three years, most of which will be invested in setting up manufacturing capacity, and expanding existing facilities. This will mark its foray into the commercial manufacturing space as the company has so far been a contract research organisation (CRO). After the setting up, it will be a full-fledged contract research and manufacturing services player. However, given that it is an Offer for sale, where its parent Biocon is selling its stake, the proceeds will go to Biocon and Syngene and fund the expansion through internal accruals and debt.

The company, which is into discovery, development and clinical supply for both large molecules (biopharma) and small molecules, gets  revenues primarily from two areas — fee for service/full-time equivalent and dedicated centres. While the former forms 61 per cent of the revenues and is project-based short-term contracts, the latter are long-term contracts with dedicated resources and facility for the client. The company has three clients — Baxter, Abbott and Bristol-Myers Squibb — for the dedicated centre segment and these contribute 39 per cent of the revenues. The start of commercial manufacturing will expand as well as diversify this revenue base. While its cash flows are strong over the past few years, the capex is a large one and will mean more than doubling of its assets from the current level. However, the potential is huge.

  The custom research market is expected to grow at 11.5 per cent annually over the next four years from CY14 base of $43.4 billion. Moreover, of the total pharma research spend of $139 billion for CY14, about $105 billion can be outsourced. This means that only 41 per cent ($43.4 billion) has been outsourced so far, and there is huge scope for enhancing this number going ahead. While there is little doubt about the potential, any slowdown in research spends by pharma multinationals will have an adverse effect on the fortunes of service organisations such as Syngene. The dependence on three clients that form two-fifths of the revenues is also a risk, and can impact growth rates even if one of them pulls out partially or fully.

So far, however, the company’s performance has been robust with sales growing at 28 per cent annually over the last five years, with operating margins upwards of 30 per cent, return ratios exceeding 20 per cent over the past two years and low working capital requirements.

At the lower end of the price band and assuming net profit growth at 20 per cent for FY16, the company is asking for a valuation of 23 times its earnings. While there are no Indian peers (Divi’s, for example, is into outsourced manufacturing and not research), the nearest Asian peer is WuXi PharmaTech, which is trading at 22 times one-year forward earnings. While the valuations is in line with the Chinese major, WuXi’s sales ($700 million) and market cap ($3 billion) are 4.8 times and 3.6 times that of the Indian company. Even on an enterprise value-to-Ebitda basis, WuXi’s number comes to 15.86 times (CY14) while that of Syngene is pegged at 16.38 times (FY15), at a slight premium. Considering this, the valuations are a bit stiff. While the Biocon stock has underperformed its pharma peers, given the potential of the outsourcing market, which is increasingly shifting to Asia given cost advantages, Syngene has a lot going for it. Investors who have at least a three-year perspective should look at subscribing to the issue.