Company Research- Granules India Ltd [23/11/2017]

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1 Summary Company Research- Granules India Ltd [23/11/2017] Company Overview- Granules is one of the large drug manufacturers in India. In last decade, the company has successfully moved up the pharma value chain, from manufacturing API to manufacture and sells finished Dosage (Over the counter products). Granules revenue has grown by CAGR by 17% and Profit after tab (PAT) has increased by CAGR 41% in last five years. The company is undergoing significant expansion at it s manufacturing plant. Some of the development is already complete and the remaining part will likely to be finished by Q1 FY19. The capacity increase will help the company deliver increasing profit in next year. The company is on the cusp of improved profitability going ahead and present an exciting opportunity for short to medium term. Business and Company Overview The company classifies its business into three business operations: Core Business- It involves the development, manufacture and distribution of key molecules, primarily targeted at international markets. They commenced operations with the production of large volume API products such as Paracetamol, and subsequently expanded the core business to include other key molecules such as Ibuprofen, Metformin, Guaifenesin and Methocarbamol. Emerging Business- It is focused on the development, production and distribution of generic FDFs through a vertically integrated business model, primarily targeted at the U.S. generics formulations market. The company has stepped up efforts for ANDA filing. CRAMS Business. The company has entered the CRAMS business through the joint venture Granules Omnichem Private Limited ( Granules- Omnichem ) set up in Fiscal 2012 with the joint venture partner S.A. Ajinomoto OmniChem N.V. ( Ajinomoto OmniChem ). The CRAMS business currently involves contract manufacturing of API intermediates for further processing through Ajinomoto OmniChem to innovator pharmaceutical companies. Key Products Active Pharmaceutical Ingredients (API) - APIs are the chemically active components of a drug product and the principal ingredients for pharmaceutical formulations. APIs possess the actual medicinal value attributable to the drug and are also known as bulk active substances or bulk drugs.

2 Pharmaceutical Formulation Intermediates (PFI)- PFIs are granulated APIs that are directly compressible into tablets. This is Granula s innovation that has traction in the marketplaces in recent time. An API requires further processing, like the addition of excipient (e.g sugar) to palatable to, human consumption before packing into a tablet or capsule. PFI does the work of further processing of API and addition of excipient and provides ready produce for the customer directly blend these into the final packages, removing the need for intermediate processing. If you want to find further information, please visit below links. Finished Dosage Formulations (FDF)- FDFs are finished pharmaceutical products ready for consumption by the patient. FDF products are based on various combination formulations of the core molecules including Paracetamol, Ibuprofen, Metformin, and Methocarbamol. These products typically include coated, uncoated and rapid release gel capsules. Research and Development The USA is a significant market for Granules, and the US market for generic pharmaceutical companies is facing intense pressure from competitive as well as regulatory sides. On the one hand, the consolidation is happening on the wholesale buyer, and on the other hand, USFDA is keen to bring in more competition in generic drugs by fast-track approval to from multiple players. Consequently, the generic drug makers are facing intense pricing pressure. To combat the threat of competitive pressure, Granules has been increasingly focusing on value-added products and moving up in the value by investing in R&D. They have a research staff or around 140 people spread over geographies in US and India. Moreover, they are increasing focus on R&D as shown by the R&D investment over the last three years Year FY17 FY16 FY15 R&D Investments (Cr) Granules R& expenditure. The acquisition in 2015, has helped the company acquire US facility in Virginia. The company has upgraded the facility recently to carry out state of the art research at and file ANDA, along with company s existing R&D centres in Hyderabad, Visakhapatnam and Pune. Granules is stepping up ANDA filling, for instance, in FY17, they filed 4 ANDA, and in FY18, the company is targeting to file 10 ANDA. US FDA takes around 2 to 3 years to approve ANDA, and only after approval, the company may be able to sell products. Sometimes, the company may need few years (to get approval for the manufacturing plant or wait for the patents to expire) before the final product is sold in the market. Granules is mainly operating in the first line of defense products, so I presume most of the ANDA

3 will be in a similar area. So, even if they get an ANDA approval on time- 2 to 3 years down the line- the revenue contribution won t be material in short to medium term ( 1 to 3 year). Thus, R&D will help the company on a long-term; but, it will be a drag on financially for some time to come. However, the global pharma industry is getting extremely competitive and having robust R&D capabilities is essential if Granules has to strengthen its position in the market. CRAMS- The Contract Research & Manufacturing Services industry (CRAMS) estimated at US$ 8 billion in 2015, is expected to reach has a huge potential for investments. (Source: Sector presentation by IBEF available at Granules has already working Joint Venture (Granule OmniCom) to cater this segment. The CRAMS business, operated through the joint venture Granules-Omnichem, was profitable in its first full year of operations and it generated 25cr of PAT in FF17. The company is expected to pursue additional opportunities in this area. It seems that the company has a client at an advanced stage for using this business as evident from this line from QIP document Potential customers of the CRAMS business have applied for relevant U.S. FDA approvals for such facility as part of obtaining approvals for their own formulations. (QIP document page 141). Capacity Expansion Granules business model relies on setting up new manufacturing facilities, making them regulator compliant (e.g. USFDA), and then manufacture API to sell directly to the customer or creating PFI or create finished dosage by using these API. To increase business, Granules has to build new capacities or expand existing capacity continuously. Granules is currently undergoing major capacity expansion and (to the tune of 600 to 800 cr) for following product categories. Year 2017 Capacities New Capacity API 21,560 TPA TPA kilo liters per annum PFI 18,400 TPA 6000 TPA FDF billion units per annum Source- QIP document Some part of the expansion is already complete and currently undergoing testing, and the management is hoping that they would be able to start selling by December The management is confident to complete the CAPEX by the end of March 2018 (source-q2 Con call).

4 Financial Analysis The company has shown consistent growth in revenue and profit over the year. Source= Screener.in Although, the company revenue has grown by CAGR 21% over the last ten years, the growth is funded by mainly by, either borrowing or equity dilution. Source= Screener.in Key Points about Financial Analysis 1. Granules revenues has grown by 21% over the last ten year. During this time, their borrowing as well as the fixed asset both have grown by CAGR of 17%. It suggests that the company has funded new fixed asset mainly by borrowing money. It also highlights the capitalintensive nature of the business, as, without an increase in fixed asset, the company would have struggled to achieve even 10% revenue growth over the last ten year.

5 2. In last few years, company has frequently diluted the shareholding by raising money either through QIP or warrants. Granules has raised another 300 cr at a price of Rs 121 from the secondary market on Sept As on Sept 2017, total borrowing stood at 816 cr, and it is expected to increase by another 150 to 200 cr in next 6 month. (source-q2 con call). 4. Addition of QIP money has kept a Debt to equity ration around 1, which is not ideal, but within control given company s profitability going forward. 5. Granules Fixed Asset Turnover over the last five year is between 2.2 to 2.6. In the current year, the company will complete major CAPEX. Management has indicated that they will not do any new CAPEX in next 4 year. The increased capacity will allow the company to generate increasing revenue in next three-four years. The company has already incurred the majority of the cost, and it will enable the company to generate more revenue and hopefully better profit without having to investment more in capacity creation.

6 Revenue Analysis Granules sell their products in more than 60 countries, but the majority of the revenue is derived from selling products in the USA. Source= QIP Document In term of product, API contributes to the most followed by PFI and FD. Total income has increased by 139 cr in absolute term between ; however, the USA sales have increased by 216cr. It is clear from the above table that Granules revenue growth has happened on the back of the US business.

7 Product contribution- Following table depict the product contribution to overall sales. Source= QIP Document Above table depicts the contribution from different segment. It is evident from the above table API revenue has been more or less constant in absolute term, and income from FD has shown YOY decrease from 412 cr to 342 cr in FY17. However, the PFI has demonstrated massive increase from 310 cr to 542 cr in FY17. In my view, the improved profitability of Granules (127 cr to 205 cr) between can be attributed to increased sales from the USA as well as a sharp uptick in sales of profitable product -PFI. Of course, other factors must have also contributed to it like lower raw material cost (API products are derivatives of speciality chemicals, which themselves are derivative of oil. Lower oil prices must have helped to lower raw material cost for the company in the last 2 year in my view). Key Concerns US FDA Compliance- US FDA has recently increased the number of plant visit to regularly check if the plants are consistently adhering to the quality norms require for a company to sell their products in the US. Due to increasing frequency along with stricter compliance norms, major pharma companies like Dr Reddy s, Sun Pharma, Lupin are under various import alerts. Granules have already received 483 observation and alerts for their production facilities at Gagillapur in Fiscal 2013 and Jeedimetla in Fiscal 2014 and Granules still has an import alert for one of its plants in for Granules-Omni hem JV. Although they have successfully carried out necessary remediation measure to address notification, they have not yet received the clearance from USFDA (I think they have received the EIR report on Sept Hopefully, Granules has learned the lesson from these alerts and implemented required procedures and process in places as mandated by the USFDA. However, the possibility of additional 483 observations cannot be ruled out in future.

8 Any notification and observation for the current as well as new plant may have a significant impact on company s performance. Pricing Pressure- Then generic drug industry has in recent years been facing increasing competition and price pressures in the US resulting from high capacity build-up and an increase in the number of ANDA and DMF filings. The pricing pressure is more pronounced in drug going off patent. However, Granules is operating in areas, which has been already competitive and mature so that pricing pressure may have little or no impact. Moreover, by leveraging integrated API, PFI and FDF product portfolio and large-scale manufacturing capacities, together with their competencies in filing patents and applications for DMFs and ANDAs, Granules is better prepared to meet the challenges faced by increased competition. Commodity Nature of the business API manufacturing is a very competitive industry. The commodity nature of the business is evident from following statement in QIP document we currently do not have long term contractual arrangements with most of our customers. Our customers also participate in competitive bid process for supply to government entities, private agencies and institutions. Any inability on the part of our customers to successfully win tenders will result in a lower demand for our products from them. We do not have exclusive arrangements with our customers, and our customers may source similar products from other manufacturers as well. Further, some of our customers currently manufacture or may start manufacturing their own APIs and may discontinue purchasing APIs from us. Management Compensation Promoters are not allowed to take more than 10% of PAT as compensation for their efforts, and Granules' promoters have seems to have made the most of this rule. Source= QIP Document The promoters are taking the maximum allowed salary for last few year (and based on the pattern, I would assume that they would have received similar compensation in the past). However, further drill down of compensation details reveal interesting thing.

9 Source= 2017 Annual Report In the case of Krishna Prasad Chigurupat, 82% of yearly compensation, and 98% of Uma Devi Chigurupat is compensation is in the form of commission (I would assume that it would be meeting the specific sales or profit target). Last few years, they are reaping the reward for hard work they are steering the company through the competitive environment. Another point to note is the management has not awarded stop option or sweat equity, which is good thing. In summary, key management person has received higher compensation in line with company s growth. Any slowdown in meeting company s number may have an impact on commission, which is far better than having a significant portion of compensation as gross fix salary. Hence, I am not too concern with compensation level, even though they look at a first glance. Investment rationale and thought on Valuation 1. The company is on the cusp of major operational improvement due to the completion of huge CAPEX the company has been doing for last few quarters. They are finishing major CAPEX to the tune of 600/900 cr, in next couple of quarters. By March 2018, all CAPEX except on the oncology would not only be complete but will become operational, too. The oncology-related expansions would likely to be finished by June 2018 and company is hoping to start sales in the next year. 2. Granules have incurred most of the cost associated with the expansion, and, increase in sales will likely to help company report better profitability going forward.

10 3. Granules is planning to enter into new areas like Oncology. This will enable the company to develop their expertise in the new area and as well as acquire a new customer and cross-sell other products. 4. CRAMS is a profitable opportunity and Granules has been operating an joint venture with Omnicom since However, the JV reported a first profit of Rs 25cr last year. The client is facing some issues on their side as a result, Granules is unlikely to report meaningful profit from this JV. However, the management is confident of achieving CAGR 25 in next five year from this venture. It seems that Granules is in advance stage for initiating a project with another client as per a statement from Potential customers of the CRAMS business have applied for relevant U.S. FDA approvals for such facility as part of obtaining approvals for their own formulations. (QIP document page 141). We accordingly intend to enter into strategic tie-ups with major pharmaceutical companies for exclusive supply arrangements through the CRAMS business. Any strategic tie-up, in the CRAMS space, has a potential to generate lucrative business opportunity and better profitability. Thoughts on valuations Due to the highly competitive nature of the business in which Granules is operating, I would prefer to split my view in term of short term and long term. On a long-term basis, the company has to overcome a lot of hurdles. The company is in the commodity business. Coupled this with the low bargaining power with a supplier as well as with customer and a capital-intensive business model, will constrain the ability of the company to grow at a sustainable rate going ahead, without raising additional debt or equity dilution. Although, they have successfully demonstrated moving up the value chain, the extent to which this migration happens in a coming year, likely to determine long-term valuation. However, on a short to medium term (1 to 3 years), the company future looks promising. Granules is trading at 19PE (price as on 23 Nov 2017 is 123), which is not a cheap valuation, however, it is not on the expensive side either. Taking into account, the major capacities build is coming to an end and immediate or near-term increase in sales, bode well for the stock. By the end of FY18, the company would have incurred raised all debt required to complete ongoing capacity expansion. Increase in sales in next few years is likely to improve profitability. Market is a slave to numbers, so an increase in profitability will be more or less reflected in the stock price returns, all things being equal. Completion of major CAPEX and a potential increase in CRAM business bode well for the company to deliver CAGR 20-25% return in next few (two to three in my opinion) years.

11 Reference and useful information. 1. QIP Document ( 7GRANULES_PD.pdf) 2. Q2 Con Call Money Control Interview on 10 Nov Annual Report ( 7.pdf) 5. Discussion on Pharma Sector ( vmgiwcbtw) 6. Pharma sector presentationhttps:// Disclaimer: I have invested in the Granules. This is not a recommendation to Buy, Sell, or Hold. I am not a SEBI registered analyst. I wrote this document to organize my thoughts and deepen my understanding about the company and industry. I am sharing it so that you can learn something from this.