Sunday, May 30, 2010
Better-than-expected financial performance, promising outlook for its domestic and international formulations business and the possibility of resumption in manufacturing at Caraco's site by the end of this year make Sun Pharmaceuticals a reasonable long-term investment bet.
The company's fairly strong pipeline of drug applications also adds to its appeal. At the current market price of Rs 1630, the stock trades at about 23 its likely FY-11 per share earnings, which seems justified by its many growth triggers.
Investors nevertheless can accumulate the stock in lots given the broader market volatility.
For the quarter-ended March 2010, the company reported a 2 per cent fall in consolidated revenues. This was largely led by a 21 per cent dip in its Indian branded generics (domestic formulation) sales as export formulations (excluding that of Caraco, its US-based subsidiary) grew by over 33 per cent.
But, after adjusting for the one-off sales spurt of approximately Rs 200 crore in the fourth quarter of last year, the domestic formulation growth looks healthy at about 14 per cent.
Caraco's revenues also grew 8 per cent, while overall formulations exports grew by 11 per cent. Net profits remained flat while there was a three-percentage point improvement in operating margins to 33 per cent.
For the coming year, the management has guided for 18-20 per cent growth in revenues. While this may seem difficult in the absence of high sales opportunities from generic Protonix and Eloxatin this year, it might not be very ambitious.
The growth guidance appears plausible given the low base of domestic formulations and the likely resolution of the FDA issue at Caraco. Improving business outlook for its international formulation business too could pitch in.
Upside from the expected approval for its version of Effexor XR in the US may also present an additional growth avenue, though there isn't any specific timeline on when that may happen.
Domestic formulations, which contribute over 45 per cent of the total revenues, hold the key to its growth guidance.
The company appears to be at a fairly strong vantage here with an overall market share of 3.7 per cent and leading market shares in select therapeutic areas.
A favourable revenue mix between existing and new products also strengthens its hold in the highly fragmented domestic market. Sun derives close to 70 per cent of its revenues from older products (launched before 2006), with new launches making up for the rest. This provides it with a sustainable competitive advantage over peers.
The company also plans to add, albeit slowly, to its differentiated products count; this may help it improve on its market share in the IPR regime. Besides, with global pharmaceutical companies showing increased interest in the Indian market, Sun's strong reach (2500 sales agents) and brand presence makes it a strong contender for in-licensing deals too.
The likely resolution of the cGMP issues at Caraco Pharmaceuticals may also be strong growth trigger for the company. While Caraco has already received an approval from the US FDA for the remediation work plan it had submitted earlier — remedial activities are underway now — it would be able to resume manufacturing operations only on receiving a final nod from FDA. This, the management expects to get by end of the financial year.
That notwithstanding, Sun has also filed for site transfer for some of its key products.
While the management doesn't expect a dramatic increase in its market share in the US thereafter, site transfer or better still, final nod from the drug authority, would in itself be reason enough for a re-rating. Delays in approval, therefore, could present a risk to its earnings.
Between Sun Pharma and Caraco, over 84 ANDAs (abbreviated new drug applications) now stand approved, while 123 await US FDA approval.
Sun had filed 30 products in the US last year and plans to file a similar number this year too. This would help it seal a long-term growth potential in its US generic business.
In the controlled-substance segment, Sun presently has approvals for formulations of three such products. However, it is yet to capture a significant market share in them. Though the growth potential in this business remains attractive, the management expects the growth rates to remain modest given the quota system followed by Drug Enforcement Authority in the US (quotas are allotted depending on existing sales and not based on product approvals).
What to watch out for
While the company has stopped further shipment of Pantoprazole following the US Federal jury's verdict upholding the innovator's patent (Pfizer Inc.), the management is confident of the strength of its litigation. However, if the court were to uphold the patent, it may cost Sun heavily.
In such case, the company may have to cough up roughly over three times the sales loss suffered by the patent-holder (estimated at about Rs 1800-5,400 crore).
The court's verdict, therefore, will hold the key. Israel's Supreme Court ruling on the disputed Sun-Taro acquisition could be the other trigger; though there still is not enough clarity on if and when that could happen.
The Hindustan Unilever (HUL) stock has been the sole exception to the re-rating enjoyed by consumer companies over the past year.
The stock made no gains even as the BSE FMCG index soared by 41 per cent. This is a good opportunity for conservative investors to add this blue-chip to their portfolio.
Signs of better-than-market volume growth in HUL's recent numbers, strong pace of new launches and its ability to massively outspend rivals in defending market shares may help it accelerate sales growth in the year ahead.
Pessimism about HUL's sluggish sales and market share losses have also resulted in the stock's valuation slipping into a discount relative to its peers. At current market price (Rs 235), HUL trades at a one-year forward PE of 21, against Nestle India's 34 times and Dabur India's 27 times, offering room for re-rating.
HUL's financials for 2009-10 were not impressive, as its net profit remained flat while sales grew a tepid 6.3 per cent. However, this hides the big improvement in its growth trajectory in recent quarters.
The key concerns for HUL last year were its slow volume sales in categories such as soaps, laundry and tea, where rivals managed to gain market share through aggressive price cuts. Benign input costs also allowed regional brands to undercut HUL and capitalise on consumer down-trading.
However, HUL has managed to address most of these concerns over the past couple of quarters.
One, it has taken price corrections in segments such as laundry and advertised aggressively to fortify its presence across price points. The steady improvement in HUL's overall volume growth to a healthy 11 per cent for the March quarter (from 1 per cent in the September quarter), seems to indicate prevention of further market share losses.
Two, recent months also saw an exceptional pace of new product launches as it entered segments such as premium male grooming and rolled out new offerings in branded tea, skin care and ice creams.
Though this has required HUL to set aside a whopping 14.5 per cent of its sales towards adspend, it is likely to pay off through a better product mix.
The latest March quarter numbers in fact show that HUL managed to hold on to its gross margins despite taking deep price cuts in its laundry segment. Personal products, beverages and foods revved up to a 15-23 per cent sales growth and aided margins.
Finally, firming raw material prices and rising competitive pressure in FMCGs may also give HUL – with its massive scale – a sizeable edge over its rivals whether in procuring inputs, ramping up advertising budgets or garnering shelf space.
Over the medium term, HUL's strength in modern trade, plans to treble its rural reach and reduce distribution inefficiencies too could boost its size as well as competitive advantage.
Investors can consider holding on to steel major SAIL, whose massive size in terms of production capacity, raw materials and cash, coupled with low levels of debt and a robust domestic market for its products, makes for a compelling case to stay invested.
Despite SAIL's advantages within the steel space, in terms of a domestic market focus, low leverage and abundant raw material supplies, the stock trades at a valuation that is on a par with its peers at around 12.6 times FY10 earnings at Rs 206
SAIL currently produces 13.4 million tonnes of crude steel at eight locations led by units in Bhilai and Bokaro. The company's sales and profits have grown at an annual compounded rate of 10 and 13 per cent since FY06. The commodity price collapse had led most of the top ten steel producers to slip into red over the last year.
SAIL, however, was among the exceptions, managing a profit growth of 9.4 per cent with operating profit margins at 24.4 per cent for the last financial year.
It owes this to two factors: A robust business model that revolves around two production facilities in proximity to huge captive iron ore mines and a domestic market whose demand remained quite tight through the crisis.
Even by 2010, 75 per cent of SAIL's expanded capacity will be located in the mining belt of Chhattisgarh, Orissa and Jharkhand in close proximity to its various captive mines. The company's expansion plans include upping brownfield capacities by 70 per cent by FY13.
Factors that work strongly in favour of SAIL are the 20,000 acres of surplus land at its Bokaro facility and abundant quality captive iron ore mines rendering it self-sufficient on that front for the long term.
The land and the mines have been a major draw for steel majors, including Tata Steel, Posco and Arcelor Mittal, all of whom are seeking to collaborate with SAIL on facilities ranging from rolling mills to integrated steel production.
The upside for SAIL from such an alliance is quick access to value-added products in cold-rolled steel which would enable it move up the value and margin chain, in addition to access to technology such as FINEX which uses non-coking coal(readily available at a lower cost domestically).
The resulting reduction in dependence on coking coal(currently SAIL imports 70 per cent of its requirement) could reduce the cost structure for SAIL. Coking coal prices are up 55-60 per cent this quarter; the shift to quarterly contracts is a source of risk for SAIL, possibly denting operating margins. A good portion of the company's product mix is dominated by semi-steel, steel plates and hot rolled coils.
The company, through a combination of brownfield expansions and rolling facilities, hopes to eliminate the lower margin semis category in addition to doubling its capacities in higher margin categories such as structurals, cold rolled coils and coated products.
This will tilt the current 60:40 flat:long mix in favour of the more lucrative flat and value-added segment. This will augur well for margins over the medium term.
SAIL is nearly fully dependent on the Indian market for sales where the outlook is mixed. Volumes have remained buoyant through the downturn and recent evidence from indicators such as IIP numbers, construction activity indicate that volumes may hold up nicely over the next year.
Steel realisations, however, do not have the same sanguine outlook. After a four-month dream run where realisations and demand rose even as costs remained low, the converse situation may now pan out. Higher prices of coking coal and lower realisations now look set to moderate margins in the latter half of this fiscal.
With China applying the brakes on lending and construction activity in the last two months, global steel realisations may be hurt for the next few months. This could mean softer prices in the domestic markets too as Indian steel prices typically do follow global trends though with a lag.
Some growth risks
There are a few medium term risks to SAIL's volume growth too. China's capacity addition binge could cause a global overhang on steel capacity that can moderate prices.
A smaller but equally potent source of near-term annoyance is the European crisis leading to choppy commodities markets.
Domestically, long-term concerns relate to disruptions to SAIL's operations from local insurgencies.
The other is long term domestic over-capacity fears with scepticism over whether Indian infrastructure will be able to make the leap on investments.
On the leverage front, the company's capex plans are being funded through a mix of debt, cash and equity. The debt component has pushed its debt:equity figure from 0.27:1 at the end of FY09 to the current 0.5:1, a very manageable number considering the EBIT covers interest 26 times over! With cash balances of about Rs 22,000 crore as of March 2010, SAIL appears well placed to fund the capex.
Plans are also on to raise equity through dilution at the time of a government planned FPO which is likely to happen around the middle of the current financial year.
The expected equity dilution of 10 per cent, when viewed in context with the expanded business, does not pose a worry for investors who are in for the long haul.
Investors with a two-year horizon can consider taking exposure to the stock of NIIT, a training solutions provider for individuals and corporates, given the broad-based recovery in all its key segments of operations.
The revival in IT sector hiring leading to higher training enrolments, continuing deal wins from governments towards ensuring computer-led education in schools, and increased volumes in corporate training point to robust prospects for NIIT over the next couple of years.
At Rs 61, the share trades at 12 times its likely FY-11 per share earnings, which is the lowest among what companies under the education/training category enjoy. The valuation includes the 25 per cent stake that NIIT has in NIIT Technologies.
Over a four-year period, the company has seen its net sales increase at a compounded annual rate of 27.7 per cent to reach Rs 1,199.4 crore in FY-10, while net profits grew at 14.2 per cent to Rs 70.2 crore.
NIIT has managed a turbulent FY-10, marked by a 6 per cent increase in revenues and flat profits.
The company has a desirable geographic mix with 49 per cent of system-wide revenues coming from India, 27 per cent from the US and Europe and 24 per cent from the rest of world, from China. This creates a blend of growing and mature markets to which NIIT makes targeted offerings.
NIIT operates in three segments — individual IT training (57 per cent of system-wide revenues), corporate (34 per cent) and school learning solutions (8 per cent).
Training looks up
The company is partly a play on the economy, in general, and the slowdown, especially in the IT sector hiring, affecting enrolments for the company.
With the revival in IT hiring, seekers of careers in the sector have once again propped up enrolments.
Enrolments in FY-10 have risen 12 per cent, much of it supported by a spurt over the last couple of quarters. 17 per cent of revenues from this segment comes from China, which is still a nascent market as far as software training is concerned, providing an early mover advantage to companies such as NIIT.
Importantly, enrolments for courses such as infrastructure management services, an area of increasing focus and deal wins for IT majors, are up over 64 per cent.
This is in addition to its core “edgeineers” programme witnessing a spike in enrolments. This learning business is a high-margin one for the company (EBITDA of 23 per cent).
Placements after course completion are also up 25 per cent, suggesting an all-round revival that would enable margin expansion for NIIT.
New alliances and programs have been formed with companies and institutions such as IGNOU for innovative training programs.
Corporate training is another important area for the company, which was affected significantly during the slowdown.
However, volumes are looking up over the past few quarters, though pricing and currency appreciation may be risks to realisations.
NIIT has signed three multi-million dollar deals over FY-10 and has orders worth $90.3 million, 58 per cent of which is executable over 12 months, giving a reasonable revenue visibility.
More schools added
School learning solutions, mostly a domestic play, have seen a 45 per cent increase in revenues to Rs 200 crore. NIIT has added as many 2,812 schools over FY-10, taking the total number of schools in its portfolio to 15,000. That momentum has continued this fiscal too with a deal-win from the Maharashtra Government.
Though orders from the government are hardware-intensive (and commands lower margins), there have been several repeat orders for the company, thus assuring annuity revenues.
Significantly, the number of non-governmental schools, particularly private ones, has increased by 334, expected to bring in better realisations. With a healthy blend, margins in this segment would be at comfortable levels of around 15 per cent.
NIIT also has a new segment where training is imparted to students for careers in BPOs and in financial services (specifically banks).
This is still nascent and loss-making, though there has been significant increase in enrolments, making a case for growth over the next few years.
Operationally, key positives are increase in IP-led revenues, which accounted for 43 per cent of revenues in FY-10 and expansion in annuity-based order book, which now constitutes nearly 52 per cent.