The note

Aurobindo Pharma is majorly a play on US generics space (patent cliff , huge potential market ). The company has a healthy mix of Formulations and APIs(57% formulations and 43-44% API).

The company has shown good R&D capabilities and mantained a good pipeline of drugs and approvals ..

The company had a bad financial year a year ago as it received sanctions on one of its unit (UNIT VI in February 2011by USFDA (losing around 35 million dollars of sales from that unit’s products ) and a huge forex loss(on restatement of fair value of liabilities and redeeming of Fccbs ).

The company is back on the recovery track with resuming of operations in the previously shutdown unit and better hedging policy, healthy cash flows .

A thing to be noted here is although the company is highly leveraged( outstanding long and short term loans of around 3400 crs with a D/E ratio of 1.3) .But with more than 90% of debt in foreign currency ,its net foreign receipts are adequate enough to cover the debt repayment over various maturity dates. Over the coming year , company has to pay back around 50 million dollars of loans, and management is confident enough of paying it out of internal accruals.

Business 

The generic pharma industry in US is highly commoditized  , many players , short product life cycles.

A company has to keep introducing new drugs to sustain as well as grow its revenue.

Introduction of generic form of a medicine usually involves high price erosion of 80-90% in comparison to the patented drugs price and there is more subsequent price erosion with more players getting the approval for same drug.

Moat

The company has a narrow moat in the form of R&D capabilities of complex molecules and cost arbitrage with India as a manufacturing base.

Other Indian pharma majors like Cipla ,Lupin, Sun , Dr reddys have a wider moat but not by a huge margin  in the form of highly integrated structure of Sales & Distribution, Manufacturing and R&D capabilities .

Pricing power is very low in generic space but still companies try to find some niche pockets; like Aurobindo has shown higher margins in the injectables space .

The company envisions to have CRAMS as 15-20% of it sales  in the longer horizon of 3-5 years . These contracts provide good revenue stability by being very long term in nature , but exact terms of these contracts are usually confidential.

With the current pipeline of drugs management seems confident of achieving 20% compounded growth in sales.

Financials

-margins over the years

Historically, the company has a EBIDTA margin of 17-18%; currently with Ebidta margins at around 15%; management expects a 200-300 basis points improvement over the coming 4-5 quarters

Ebitda margins are expected to improve with op. leverage accruing with capacity addition and better sales mix with increasing formulations and injectables .

The UNIT-Vi which was issued an import alert by USFDA had to be kept running for quality management , inspection checks etc and now with reinstatement of production , these costs will be absorbed and aid in a better EBITDA margin .

Management

The promoters have shown good managerial capabilities in scaling up the business across various geographies , and now company has hired experienced executives for its US operations as well.

Dangerous cocktail of  promoter shares pledged and huge debt

As of March 2013, 23.46% of promoter shareholding is pledged  (around 12% of total shares outstanding is pledged ) and the total debt is around 600 million dollars.

Valuation

Probabilistic scenarios

Good ( growth keeps momentum , more launches , margin expansion due to op. leverage and favorbale sales mix towards formulations and the cashflow improves reducing debt  )

Base case( launches continue , forex fluctuations, ,no margin expansion due to significant inventory rampups , significant investments towards sales force and other things)

Bearish case (Delay in ANDA approvals hence ramping up sales will hurt the debt repayment schedule ,USFDA alerts to any other units.)

With sales growth , better margins and deleveraging of bal. sheet over coming 2-3 years ,there is a good potential upside from EPS growth and rerating.

Risks

Business slowdown

The biggest nightmare for any highly leveraged company is slowdown in business as it adds to interest costs and company may have to refinance loans on unfavorable terms.

Usfda

Dollar denominated debt

the company has to restate the fair value of liabilities every quarter and with rupee depreciating , it may prove to be a dampener for EPS .

US macro environment