Integration challenges: Sun Pharma's next hurdle

Recent correction is an opportunity to add a quality stock to your portfolio, even amid uncertainty

Sun Pharmaceutical Industries' stock fell 8.5 per cent on Tuesday after minority shareholder Daiichi Sankyo offloaded its entire 8.93 per cent. The increased supply of 214 million shares saw the stock come under pressure and at the current price is down 18 per cent from its all-time intra-day high in April.

The correction was primarily on the back of the share sale, with equity dilution, the integration challenges with Ranbaxy and valuations probably the other reasons. Analysts at ICICI Securities say the stock's premium to its peers is justified due to its robust financials, on the the back of value-accretive acquisitions and product launches, above-average margins and healthy return ratios, despite sitting on a high amount of cash. They believe this correction is a good opportunity to re-enter the stock.

However, not all agree. An analyst at a domestic brokerage believes the challenge of merging Ranbaxy into the company has not been factored in. “Be it salary differential, sales force productivity, restructuring of manufacturing facilities, treatment of Ranbaxy brands and improving margins, each is a huge challenge and the Street has not yet taken some of these issues into account,” he says.

The extent of the challenges the company faces will probably be known over the next three to four quarters. If acquisition and production issues in the recent large acquisitions such as of Taro (legal) and Caraco Pharma (regulatory issues on manufacturing) and the time taken to solve these are anything to go by, it will take a couple of years for things to settle.

The Sun Pharma management has indicated they will deliver synergies of $250 million by 2018 through various operational efficiencies. The major hurdles are on account of Ranbaxy’s key manufacturing facilities in the country which cannot cater to the US market. Sun will look at monetising some of the recent ANDA (abbreviated new drug applications) filings of Ranbaxy from the latter’s Ohm facility in the US.

This is the only facility that is not under a consent decree, the term for an agreement to make various changes after violation of good manufacturing practices. Further, a complete resolution of the US drug regulator, the FDA's observations on Sun’s Halol (in Gujarat) facility is a key monitorable.

Any increase in competitive pressure in the US market due to acquisition and mergers, such as the reported offer of Teva to acquire Mylan, could be detrimental to Sun Pharma’s fortunes, as it will create a formidable opponent. Unlike Teva, whose India operations are insignificant, Mylan has 12 facilities in the country, six of which are injectables.

If the combined entity is able to tap the low-cost manufacturing base here, there could be a price war in the US market, believes an analyst. And, this could impact the margins of many Indian companies, including Sun.

While there are uncertainties, most analysts continue to keep their faith in the stock, a star performer among large-cap pharma scrips in recent years. This is on the back of strong performance in the domestic market, which could improve, given the pole position (9.1 per cent share) it has occupied since the merger.

Also, after the merger, the company has a more diversified geographical profile, with Sun’s enhanced presence in emerging markets and in Europe. The company will be able to de-risk a bit, as the share of the US market comes down from 60 per cent to 50 per cent of revenue. However, the US, which has been the mainstay of its revenue and margins, will continue to be a key market -- the merged entity becomes the largest generic dermatology entity.

How well the company monetises its filings and cumulative approvals will be important, as a significant part of this includes high-margin complex generics and controlled substances.

At the current price of Rs 967, the stock is trading at 20.6 times its FY17 earnings estimates. This is reasonable, at the lower level of the valuation band for  large-cap generic peers, at 20-23 times. Most analysts peg the target price for the stock in the Rs 1,000-1,200 band.