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Sun Pharma: Acquisition pressure - Views on News from Equitymaster
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Sun Pharma: Acquisition pressure
Jan 31, 2006

Performance summary
Sun Pharma announced strong results for the third quarter and nine months ended December 2005. Topline has grown at a healthy double-digit pace backed by the strong performance of both its domestic and exports businesses. Operating margins were, however, under pressure due to increased costs on the back of acquisitions made. Despite this and an increase in depreciation charges, a considerable rise in other income coupled with the absence of any interest expense led to the bottomline outpacing topline growth.

Consolidated snapshot
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net sales 3,138 4,236 35.0% 8,798 12,207 38.7%
Expenditure 1,862 2,761 48.3% 5,337 7,961 49.2%
Operating profit (EBIDTA) 1,276 1,476 15.7% 3,461 4,247 22.7%
Operating profit margin (%) 40.7% 34.8%   39.3% 34.8%  
Other income 2 268   45 670 1382.7%
Interest 45 -   69 -  
Depreciation 101 177 74.8% 287 426 48.2%
Profit before tax 1,131 1,567 38.6% 3,150 4,491 42.6%
Tax 48 70 47.4% 116 126 8.8%
Minority interest 14 33   106 62 -41.7%
Profit after tax/ (loss) 1,070 1,464 36.9% 2,928 4,303 47.0%
Net profit margin (%) 34.1% 34.6%   33.3% 35.3%  
No. of shares (m) 185.5 185.5   185.5 185.5  
Diluted earnings per share (Rs)*         29.6  
P/E ratio (x)*         23.2  
(* trailing twelve months)            

What is the company’s business?
Sun Pharma is a leading domestic pharma company with a 3.27% market share (as per Nov 2005 ORG IMS MAT data) and a strong presence in the lifestyle therapeutic segment such as cardiology, neurology and diabetology. It started focusing on the exports market by acquiring Caraco Pharma in the US in FY02. Further, it increased its stake in the latter in FY05 to 73%, thus taking over the majority control. Exports contributed to around 38% to the company’s revenues in 9mFY06. With the help of Caraco, the company has been able to grow its US business, which brings in synergies with Sun's business by backward integration in both manufacturing and R&D.

What has driven performance in 3QFY06?
Revenues grow at a strong pace: Sun Pharma’s topline clocked an impressive 35% YoY growth during the quarter led by both its domestic and exports business. Domestic formulations recorded a 34% YoY growth due to a strong performance by its core therapeutic segments of psychiatry, neurology, cardiology, diabetology and gastroenterology. These segments contributed 70% to the domestic formulations sales. During the quarter, formulations exports grew by a robust 35% YoY, which was basically due to a strong 24% YoY growth shown by Sun Pharma's US based subsidiary, Caraco Pharma. It must be noted that during the quarter, Caraco received US FDA approval for the generic version of ‘Ultracet’, which the company launched during 3QFY06. Caraco had made a Para IV filing for the same and had won a court ruling in its favour. International business now accounts for 38% of total sales. The domestic bulk drugs segment (4% of revenues) declined by 2% YoY. It must be noted that the company does not regard this business as a priority area and is aiming to focus more on formulations. However, bulk drugs exports grew by 71% YoY (on a small base) on account of higher sales to the regulated markets.

Revenue break-up
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Domestic            
Formulations 1,847 2,476 34.1% 5,395 7,464 38.4%
Bulk 190 187 -1.5% 734 671 -8.5%
Others 1 -   8 0  
Total (A) 2,037 2,662 30.7% 6,137 8,136 32.6%
Exports            
Formulations 961 1,302 35.4% 2,648 3,510 32.6%
Bulk 307 525 71.1% 850 1,424 67.5%
Others 1 0   1 0  
Total (B) 1,269 1,827 44.0% 3,499 4,935 41.0%
Grand Total ((A)+(B)) 3,306 4,489 35.8% 9,636 13,071 35.6%

Contraction in margins: Operating margins declined by 590 basis points YoY driven by a rise in expenses on all fronts. During the quarter, Sun Pharma had acquired the assets of the New Jersey based Able Labs, which included large formulation facilities. Also, earlier during the year, the company had acquired two manufacturing facilities – one in Hungary and the other in Ohio, USA. This led to an increase in raw material costs as a percentage of sales as these facilities have a different cost structure and the company is in the process of integrating the same with itself. Pricing pressure in the US generic market also contributed to the margins decline.

Cost break-up
(% of sales) 3QFY05 3QFY06 9mFY05 9mFY06
Raw material costs 22.9% 26.8% 27.3% 30.1%
Staff cost 9.8% 11.5% 9.9% 10.6%
Other expenditure 26.7% 26.9% 23.5% 24.5%

Bottomline outpaces topline: Sun Pharma had raised zero coupon FCCBs in FY05 to the tune of US$ 350 m to fund acquisitions. These funds are currently parked with banks and have led to the sharp spurt in other income during the quarter. This also fuelled the 37% YoY growth in the bottomline despite a significant rise in depreciation charges.

Quarterly trend
(%) 3QFY05 4QFY05 1QFY06 2QFY06 3QFY06
Net sales growth 33.9% 24.9% 38.3% 41.5% 35.0%
Operating profit margin 43.6% 35.6% 35.0% 33.5% 34.8%
Net profit margin 33.3% 36.9% 35.3% 35.0% 34.6%

What to expect?
At the current price of Rs 688, the stock is trading at a price to earnings multiple of 23.2 times its trailing twelve months earnings. Sun Pharma’s domestic formulations business is likely to witness strong growth going forward due to the company’s focus on the lifestyle segment and technological complex products. In the international arena, branded formulation sales to the CIS countries, China, South East Asia, South Africa and the Middle East are expected to pick up momentum.

As far as the US markets are concerned, Sun Pharma is in a position to leverage its cost advantage in manufacturing and R&D by launching new drugs through Caraco Pharma. However, the pricing pressure in the US is likely to be an area of concern going forward. We shall soon be initiating coverage on the company.

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