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Initiation Report
Vinay Basavaraj
2/3/2012
Aurobindo Pharmaceutical
ceutical Limited (APL)
We initiate coverage of APL on 3rd February 2012 with a
target price of INR 103.
10.87 Industry
Pharmaceuticals
Company profile
APL, founded in 1986, is one of the leading global pharmaceutical companies engaged in the
development, manufacturing
cturing and marketing of active pharmaceutical ingredients (APIs) and finished
f
dosage formulations for 25 years. In 1988, the company commenced operations with a single unit
manufacturing semi synthetic penicillin (SSPs) at Pondicherry. The company is the market leader in semisemi
synthetic penicillin drugs. It has a presence in key therapeutic segments like SSPs, cephalosporin,
antiviral drugs, CNS, cardio-vascular
vascular and gastroenterology. APL created a name for itself in the
manufacture of bulk actives, its area of core competence. The company has entered the high margin
specialty generic formulations segment, with a global marketing network. Lastly, the company
com
claims to
be amongst the largest 'Vertically Integrated' pharmaceutical companies in India
India.
Shareholding pattern
A majority of the shares (54%)
%) are held by the promoter and promoter group companies. The rest of the
shares held are fairly distributed amongst Mutual Funds (11%), FIIs (14%) and others.
others Summarily, the
shareholding pattern is fairly diversified in terms of its public shareholding pattern.
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Corporate governance
The composition of the Board is in conformity
with Clause 49 of the Listing Agreement. As of
Mar 11, the Board comprises of ten Directors;
four executive Directors and six non-executive
non
Directors. The Board also comprises of subcommittees in charge of effective corporate
governance are the Audit and Compensation
committees.
Industry evaluation
India's pharmaceutical industryy is no
now the 3rd largest in the world in terms of volume and ranks 14th in
terms of value. A highly organized sector, the In
Indian
dian pharmaceutical Industry is estimated to be
currently worth USD 4.5 billion,
llion, growing at about 88-9% annually. By 2015, Indian pharmaceutical market
is expected to establish itself among the world's leading 10 markets. Moreover, the
t
Indian drug
companies account for over 25% of the total gener
generic drug applications made to the US FDA.
Quartile =
Market Cap
Sales
Net Profit
Total Assets
APL
3,482
4,133
594
4,887
Investment highlights
Inelastic demand
Pharmaceutical products exhibit minimal correlation to macroeconomic variables. Therefore, earnings
are relatively safeguarded against macroeconomic fluctuations. Consequently, APL has displayed a
consistent rise in earnings and profits over the years.
Liquidity
APL boasts of a relatively high level of liquidity as compared to its peers. The greater liquidity can be
viewed
ewed as being an enabler of managerial flexibility in conducting day
day-to-day
day business as well as a cash
cushion.
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R&D
APLs strength lies in the successful outcome of its R&D efforts. The rise in R&D costs is indicative of
APLs commitment towards long-term
term value creation. Moreover, the pending 464 patent applications, if
successful, will add value to the bottom line and provide APL with a competitive advantage.
Financials
Earnings
We compare APLs net sales figures to that of its two of its peers, namely Lup
Lupin
in and Cadia. We find that
APLs net sales have grown at a compounded annualized growth rate (CAGR) of 21.8%, whereas those of
Lupin and Cadia are 22.6% and 10.7% respectively. Furthermore, we would like to ascertain APLs
earnings quality. We compare the accruals ratio a measure of earnings quality of APL to that of its
peers.
The interpretation of the ratio is as follows: higher the ratio, higher the managerial discretion in
reported earnings, and therefore, lower earnings quality. As seen in the figure
re on earnings quality, APLs
accruals ratio has increased significantly since Mar 10. The higher ratio implies higher managerial
discretion in reported earnings. As seen, APL exhibits the least amount of volatility of the accruals ratio
as evidenced by the lowest standard deviation of the ratio.
Profitability
We examine the trend in profitability by focusing on three key profitability indicators, i.e. operating
profit margin (OPM), gross profit margin (GPM) and net profit margin (NPM). Moreover, we compare
the latter figures of APL to those of its peers from Mar 07 to Mar 11.. The peers have been selected
based on comparable profit margins. We observe that APL does not outperform its peers on all three
parameters. The only positive trend observed is with the operating profit margin (OPM). With regards to
gross profit margin (GPM) and net profit margin (NPM), APL lags behind its peers and exhibits a negative
trend
d contrary to that exhibited by its peers. The trend in GPM can be attributed to lower pricing power
of APL. However, those of OPM and NPM are clearly relative inefficiencies.
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Cash flows
Our focus is on the cash flowss available to the providers of
capital, both equity and debt. The free cash flow to the
firm (FCFF) is one such measure that not only accounts for
the operational expenses but also the fixed capital
investments. As seen, free cash flows are currently
negative and trending downward.
Du Pont Decomposition
We employ the 3-stage
stage Du Pont decomposition model to analyze and identify the key drivers behind
APLs return on equity (ROE). The model decomposes ROE into three components, i.e. net profit margin
(NPM), asset turnover and leverage. As seen, leverage has played a significant role in achieving the ROE
over the period examined. Furthermore, the contribution of leverage towards ROE has increased in
recent years. Contrarily, profitability and its contribution towards ROE ha
have
ve remained at a relatively low
level. Asset turnover, too, has declined steadily.
Valuation
We employ the two-stage
stage Dividend Discount
Model (DDM) to ascertain the intrinsic value of a
stock of APL.. We assume a high growth rate of
dividends paid for the next five years and a
constant, albeit lower, growth rate thereafter for
the foreseeable future. To arrive at the latter we
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require two inputs, i.e. a required rate of return (Re) and a sustain
sustainable
able growth rate of dividends paid
(g). The Capital Asset Pricing Model (CAPM) helps us in ascertaining the former whereas the g is
computed as a function of ROE and the dividend payout ratio (DP). The assumptions are shown in the
respective tables below.
Period =
Dividend per share
Terminal value
Present value
Intrinsic value
0
Mar '11
2.02
103.03
CAPM
Rm
Rf
Beta
Re
0.14
0.08
1.70
0.19
Thereafter
Mar '17E
4.56
Quantitative analysis
Macroeconomic risks
APL derives approximately 49% and 22% of its
revenues from US and Europe respectively.
Therefore, an economic slowdown in the US or
Europe could adversely affect the company's
business.
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Competition
The marketplace for APLs products is highly crowded. Consequently, profit margins can be easily eroded
by competition. However, APL being a vertically-integrated company has some control over raw material
sourcing.
Regulatory risks
The pharmaceutical industry is highly regulated. Consequently, the tangible cost of compliance and the
intangible costs of non-compliance are significant.
Patent protection
The companys success will depend on its ability in the future to obtain patents, protect trade secrets
and other proprietary information and operate without infringing on the proprietary rights of others.
Personnel risks
APL operates in a highly knowledge-intensive industry. Therefore, the risk is that the company may be
unable to attract and retain talent to populate its R&D centers.
Conclusion
The current market price of APL stock implies that the stock is overvalued. However, we do not
recommend purchase of the stock because its relatively low earnings and negative free cash flows.
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