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Will Caraco's FDA issues hit Sun Pharma? - Views on News from Equitymaster
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Will Caraco's FDA issues hit Sun Pharma?
Jun 27, 2009

The last one year has been harsh for Indian pharma companies given the tough stance adopted by the US FDA (Food & Drug Administration). In its bid to become more stringent and vigilant, not only has the FDA been delaying in granting product approvals but has come down heavily on the manufacturing plants of domestic companies due to non compliance to quality manufacturing standards. The first to face the ire of the US FDA on a big scale has been Ranbaxy. The latest company to fall short of the US FDA standards has been Caraco, which is a 76% subsidiary of Sun Pharma. The current issue and its implications
Caraco had already come under the US FDA scanner in FY09 due to its failure to meet the regulator’s ‘current Good Manufacturing Practice’ (cGMP) requirements, which assure the quality of manufactured drugs. In fact, the FDA had last November sent a warning letter to Caraco on quality control issues at its Detroit manufacturing plant. During the fourth quarter of FY09, Caraco recalled some products manufactured in this facility as a result of which its sales and profits for the full year declined by 4% and 42% respectively.

In the latest development, the US FDA has seized more than 30 drugs manufactured at Caraco’s Detroit facility the value of which has been pegged at US$ 15-20 m by the company. What also needs to be noted is that Sun Pharma’s US business comprises of two revenue streams.

  • First, products manufactured by Caraco in the US and sold there. This accounted for US$ 112 m in FY09.

  • Second, products manufactured by Sun Pharma in its facilities in India and marketed by Caraco in the US. This accounted for US$ 225 m in FY09.

Thus, the US FDA has issues with the manufacturing facilities of Caraco and hence revenues from products manufactured by Sun Pharma in India for the US market will not get impacted. The company’s management, in its special conference call today, discussed this development and also stated that the US FDA had already recently inspected 4 of its manufacturing plants and found them to be compliant with its standards. Therefore, the damage will be limited to what Sun Pharma earns through Caraco in the US.

What to expect?
At the current price of Rs 1,140, Sun Pharma’s stock is trading at a multiple of 10.2 times our estimated FY12 earnings. Sun Pharma’s management has stated that it will be working closely with Caraco to resolve the issue with US FDA as soon as possible. But the timeline regarding the resolution of this matter remains uncertain, as the Ranbaxy issue as amply demonstrated. The management, however, is confident that while performance will be impacted in the short term, in the medium and long term the business will continue to do well.

Further, the management in its conference call post the FY09 results had given a guidance of a 13-15% growth in topline in FY10, which it will now be revising downwards. The capex plans of the company will, however, not be impacted. Investors should note that despite pressures faced by Caraco in FY09, the overall performance of Sun Pharma on both the topline and bottomline levels was considerably above our estimates compelling us to upgrade our numbers for FY09.

Going forward, we have not assumed any new product approvals from Caraco in FY10, as a result of which we expect revenues from Caraco’s business to decline by around 50% in FY10 and subsequently grow marginally in FY11. Sales should however pick up in FY12 on the assumption that the issue gets resolved by then and keeping in mind the fact that the number of drugs going off patent in that year is considerable.

Thus, we expect Sun Pharma’s consolidated (including Caraco) sales to decline by 3% YoY in FY10. We have also assumed a further reduction in operating margins as its costs to address the issue increase. Therefore, even after factoring in all of this, and after the 12% plunge in the stock price on Friday, we maintain our positive view on the stock from a long term perspective.

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