Sunny days ahead

SPECIAL REPORT

The Taro buy has not only come cheap, but also bolstered Sun Pharma's positioning in the US generic market.

T he Sun Pharmaceutical Industries takeover of Israels' Taro Pharmaceutical Industries announced on Monday in a $454 million all cash deal appears to have got the thumbs up atleast from the investors.

The scrip rose by nearly 2.5 per cent on that day. Overall the strong potential synergies and the modest deal pricing seem to support the confidence reposed by the markets in what seems a win-win deal for both companies. 
 

DEAL DETAILS
	USD million
Deal Size:	454
Equity component	230
Debt taken	224
Interim financing	45
EV/sales*	1.5
Note: CY05 sales

To say that the global generics market, estimated at around $ 70 billion, is brimming with opportunities would be repetitive. And much of the battle to tap this huge goldmine would be centred around the continent of North America especially the United States, representing about 47 per cent of the total global generics market.

While 63 per cent of all prescriptions in the US are generic in nature, estimates suggest that the market represents a $40 billion opportunity in the next 3-4 years as several drugs go off patent. Fierce competition and new entrants have already exerted severe pricing pressure hitting the margins of all major players.

"In this scenario, two key elements remain significant for a company to maintain its profitability - a wide basket of products and ability to cut costs," says an analyst from a domestic broking firm. And it is here that the Taro acquisition makes immense sense for Sun Pharma. 
 

SUN PROFITS
	FY08	FY09
EPS	43.63	53.8
P/E	24.3	19.7
Source: Bloomberg

The tale of two companies
While Sun is on a strong footing in the domestic market with a 3.3 per cent market share, it is still quite an underling in the United States. Its primary front-end - the Detroit based subsidiary, Caraco - had sales of about USD 117 million in FY07. And till March 2007, both Sun and Caraco together had 34 ANDA approvals, while 77 were awaiting approvals.

In sharp contrast, Taro had revenues about three times as much accruing from the United States, which incidentally accounts for about 85 per cent of its sales. Moreover the company has over 100 ANDA approvals in the US alone and a product portfolio that indicates potential synergies.

For example, while Caraco has a strong footing in the diabetes, cardiovascular, muscle-relaxant, psycho-neurological and anti-inflammatory space; Taro, while adding significantly to some of these areas, also brings along its strong franchise in the dermatology and paediatrics arena.

As Uday Baldota, Vice President, Investor relations puts it, "This deal can be viewed by the product as also capability reach it extends to our company." Moreover, Taro's recent forays in the proprietary formulations space like Ovide (head and hair related problems) and T-2000 hold promise too.

At the same time, Taro has faced significant problems due to its inability to sustain its costs as also its modest pipeline of products - only 26 ANDAs and one NDA are awaiting approvals. The financial fundamentals of the company have also been open to question.

For example, between 2003 and 2005, the Israeli drug maker saw its net income collapse from $ 61.16 million to about $5.7 million. While the figures for 2006 are not yet determinable, Taro is expected to have made substantial losses during the year.

Moreover, while selling, general and administrative expenses, accounting for 36 per cent of CY05 revenues have been rising in recent times due to the company's foray into the OTC segment, this has not yielded expected results.

The company's proprietary line-up have involved significant R&D spend but a majority are as yet in the trial stage. Consequently, debt levels have risen and currently stand at $224 million.

Sun Pharma, on the other hand has been a study in contrast. "One of the reasons why Sun commands premium valuations in the market is its strong showing on the profitability front as also its strong product pipeline," says an analyst.

For example, in FY07 while its net sales increased by a robust 30.3 per cent to Rs 2132.1 crore, its operating profit margins rose by about 190 basis points to 32.7 per cent, one of the highest in the pharmaceutical space. In fact the company's turnover has doubled and net profit tripled in the last four years.

One of the primary reasons behind the success of Sun has been its strong positioning in the speciality therapeutic space pertaining to chronic diseases, which typically depend on doctor's prescription and contribute about 85 per cent of its revenues.

Within this space, Sun has the leading position in the neurology, psychiatry, cardiology, ophthalmology and diabetology space; all of which remain high growth segments both domestically as also abroad. Moreover the company's near debt free status has meant a huge build up of liquid reserves.

While its FCCB issue in 2004 had resulted in a cash flow of $350 million, its internal accruals at about Rs 700-800 crore also give it much room to manoeuvre. "In fact the FCCB issue and comfortable accrual situation would mean that financing the deal wouldn't really be much of a problem with negligible impact on the company's debt-equity ratio," says a research analyst tracking the sector.

Much of the benefits of the acquisition would however hinge on Sun's ability to not only turnaround Taro's financials but also its ability to cut costs at Taro's manufacturing facilities spread over Canada, USA and Israel.

The supply of APIs (constituting 15 per cent of Sun's revenues) from Sun's low cost manufacturing facilities in India could thus be a key positive as the Caraco experience has shown.

Since 1997, Sun has followed a two-pronged approach of inorganic expansion to boost its presence in the US market with a mix of outright entity acquisitions as in the case of Caraco in 1997 as also brand purchases in selected niche segments as in the case of Midrin and Ortho from the San Diego based Women's first Healthcare.

Its association with Caraco has, despite the net margin pressure witnessed in recent times, strengthened the financial fundamentals of the company as indicated by the total debt falling from $33.6 million in FY02 to near zero by FY04. The topline has also grown by a CAGR of about 69 per cent in the last five years. 
 

ACQUIRER AND ACQUIRED
(USD million)	Sun Pharma FY06	Sun Pharma FY07	Taro CY05
Net sales	400	520	298
Net profit	140	189	5.7
NPM (%)	35	36.3	1.9

The valuation tangle
A chief upside of the Taro-agreement remains its extremely moderate pricing. While the deal valued Taro's equity at $ 230 million or USD 7.75 per share which was at a premium of 27 per cent to its previous closing price, it is also about 49 per cent less than its 52 week high of $14.15. Overall while generally similar Indian cross border deals have hovered around the 2-3 times sales mark, this deal seems to be in the range of 1.3-1.6 times Taro's estimated CY06 sales.

Given the strong product portfolio and access to complementary capabilities, this does seem quite a modest price even after considering the 12-18 month time-frame it may take to make the company earnings accretive.

For shareholders awaiting a significant value unlocking when SPARC, the subsidiary housing Sun Pharma's innovative R&D division, gets listed in the next one-two months, the renewed strength in the generics business should only add to the good news.

While Sun's stock without considering the takeover, trades at over 19 times estimated FY09 earnings and may seem expensive at first glance, given its credible business model, the stock appears a quality investment.