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Wockhardt: Debt dilemma

Feb 11, 2009

We had a research meeting with Wockhardt to discuss the company’s growth prospects and concerns regarding its high debt levels. Here are the key takeaways. Key business drivers: Wockhardt’s operating performance over the years has been reasonably good. The company derives revenues from India, US, Europe and ROW with Europe accounting for a larger chunk of the revenue pie.

India: As far as the domestic market is concerned, the company’s focus is largely on anti-infectives, pain management, biotechnology and nutraceuticals. The latter accounts for 28% of the revenues from India after the acquisition of Dumex with its strong brands ‘Protinex’ and ‘Farex’. The company has also been focusing on in-licensing products (with focus on dermatology; a niche area) from Europe, US and Japan and 6 products have already been launched in the Indian market. Revenues from in-licensing, which are Rs 300 m currently, are expected to touch Rs 1 bn within 2 years. As far as biotechnology is concerned, the company plans to launch ‘Glargine’, long-acting insulin during 1QCY09. Its insulin product ‘Wosulin’ had faced problems with the regulatory authorities due to quality issues but this has been resolved and the company has reiterated that the sales of this product are back on track.

Europe: Before acquiring Pinewood and Negma, Wockhardt’s presence in Europe was restricted to UK and Germany. The UK is a highly competitive generics market and Wockhardt has been growing at 14% in this market with a focus on OTC products, generics, branded generics and contract manufacturing. The latter is especially a major growth driver with the company having bagged a contract with Amylin for the latter’s anti-diabetic drug ‘Byetta’. The company had also signed three more contracts, revenues from which started accruing this year. Thus, given that contract manufacturing accounts for 30% of revenues from the UK, it will be the key growth driver in the highly competitive UK market. Germany accounts for a smaller chunk of the revenues from Europe and the management is contemplating on the strategy to be followed to grow the business further.

As far as Pinewood is concerned, the company is the largest generics company in Ireland with 40% of revenues coming from the UK. The company has been growing at 20% with a focus on liquids, ointments and creams and is expected to maintain this growth going forward. Negma, on the other hand, has branded products in its portfolio, the patents of which are set to expire in 2014. Negma largely caters to the osteoarthritis market, which is mature. As a result, sales have been growing at 8%. Wockhardt is looking to also set up a generics business in France given that the generic penetration in France is low giving ample room to grow. As far as biotech is concerned, if all goes well, Wockhardt is looking to get an approval for its biosimilar ‘insulin’ in Europe in 2011.

US: While US accounts for 11% of Wockhardt’s overall revenues, this business has been growing at a scorching pace due to a lower base and ramp up in ANDA approvals and subsequent product launches especially in the injectables space, which is a niche area. The company’s acquisition of Morton Grove is also expected to segment sales as between the two companies, they now have 63 products launched in the US market. At the time of acquisition, Morton Grove was growing at 15% and was loss making at the EBIDTA level. Wockhardt managed to turn it around within six months of acquiring it. Morton Grove is expected to record profits at the net level CY09 onwards.

Rest of World: In the ROW markets, the focus was largely on selling biotech products namely insulin and EPO. Sales from these markets have been erratic in the past due to ‘Wosulin’ having being pulled off due to quality issues. With this being resolved, the company has been re-registering the products and consequently sales from these markets are expected to pick up going forward.

Operating margin outlook: Wockhardt’s operating margins in CY07 stood at 24% and there is not expected to be any significant change in the same going forward. The growth drivers for any margin expansion would be the strong growth in the US and growth in volumes of the biotech business.

So much of debt, so little cash: Since Wockhardt acquired Pinewood and Negma in Europe and Morton Grove in the US, this entailed huge debt to be loaded onto its books including foreign convertible bonds (FCCBs) to the tune of US$ 110 m. The redemption of these bonds is now due in 2009.

And therein lies the hitch.

The company’s current stock price is way below the conversion price (Rs 486) of these bonds, which means conversion into equity shares seems highly unlikely. The company cannot take on any more debt to redeem these bonds as the debt equity ratio was as high as 2.3 in CY07; considerably higher than the debt levels of its domestic peers making it obvious that it is most likely to have problems repaying this debt in the future.

Stake sale to private equity funds seems to have hit a roadblock as valuations turned out to be a problem. The company, therefore, is planning to sell off some of its non operating assets and raise preference share capital to the tune of Rs 5 bn to redeem the FCCBs. If these initiatives are successful then the company might contemplate raising further capital through an equity issue.

Capex: Given that the company is strapped for cash, the capex that has been envisaged for the next two to three years is Rs 1.2 bn, which will largely be towards maintenance. The company’s injectables plant in the SEZ at Aurangabad is expected to come on stream in 2009.

What to expect?
At the current price of Rs 102, the stock is trading at a price to earnings multiple of 3.4 times its trailing 12-months earnings. As far as the business is concerned, while the US and Indian businesses have been doing well, the real test will be whether these acquisitions provide significant value to the overall business. The last two years saw the topline growing at a scorching pace precisely due to the revenue contribution from the acquired businesses. Therefore, CY09 will really test the mettle of the company. The company’s operational performance so far has not really been poor. But taking into account the high debt levels, inadequate cash flows and lack of management quality, the cons outweigh the pros.

The troubles that Wockhardt is facing, especially on the balance sheet front, have made projections for the future very tricky. While the company is doing reasonably on the operating front, we are concerned on the way the company is handling its external obligations like debt and FCCBs. Valuations of the stock at the current levels appear very cheap probably because they deserve to be where they are. Thus, given the uncertainty surrounding the company, we are substantially downgrading our view on the stock. At these levels, we maintain caution on the same.

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