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Sweet Pill

Aurobindo Pharma is on a high growth trajectory & is also attractively valued…

Aurobindo Pharma Ltd. is a Hyderabad-based company that started operations in 1986. Initially it focused on manufacturing active pharmaceutical ingredients (APIs) and became the leader in segments such as semi-synthetic penicillin and cephalosporins. In 2001 the company entered into the manufacturing of formulations, a higher-margin business. The formulations business began to ramp up significantly from 2007.

Positives
Global formulations player: From being chiefly into APIs, Aurobindo Pharma has transformed itself into a global formulations player. Formulations accounted for only 16 per cent of its revenue in FY06, but their share is expected to rise to 62 per cent in FY11 (APIs will fetch 38 per cent). The main driver of growth in sale of formulations has been its entry into the US market and its supply agreements with two multinational pharmaceutical companies.
About $45 billion worth of drugs are expected to go off-patent in the US between CY10-14. Governments in the developed world are increasingly favouring generic medicines to reduce healthcare costs. Hence, Aurobindo Pharma’s revenue is expected to increase at 20 per cent annually in the US.
The company is also trying to expand its footprints in the European Union (EU), which at present accounts for only 7 per cent of its sales. Supplies to developing countries are also expected to gather momentum from FY12. Sale of branded generics in developing markets is expected to improve margins.
Backward integration: Up to 85 per cent of the formulations that Aurobindo Pharma exports are backed by its own APIs. This backward integration enables it to keep its costs low.
Strong regulatory pipeline: Aurobindo Pharma has applied for regulatory approval to sell its generic products in the US, EU, South Africa, and other geographies. In the US, for instance, it has filed 200 ANDAs (abbreviated new drug applications), the third-largest among Indian players. Of these it has received approvals for 128. In EU it has filed 1,175 MAAs (marketing authorisation applications). As it receives regulatory permissions, its position will get strengthened even further.
MNC alliances: The company has entered into licensing deals with multinationals such as Pfizer and Astra Zeneca, which means that it will manufacture and supply formulations to these companies. The supply agreements will enable the company to quickly commercialise the products for which it receives regulatory approval. These alliances have boosted its revenue visibility. Analysts at Bank of America-Merrill Lynch (BoA-ML) expect revenues from MNC supply contracts to increase five-fold from $47 million (Rs211.5 crore) in FY10 to $246 million (Rs1,107 crore) by FY13.
The initial ramp up in supplies is likely to happen in the US and the EU, but later sales are expected to grow in developing markets also. Pfizer, for instance, plans to sell generics in developing markets through its subsidiary called Greenstone using supplies from Aurobindo Pharma.
The deal with Astra Zeneca is for 30 products which will be sold in 40 emerging markets. Some of the key markets under this deal are Brazil and Mexico. In these markets the company will sell branded generics which enjoy higher margins. Commercial supplies to Astra Zeneca are expected to begin from the fourth quarter of FY12.
Having entered into supply agreements with two well-known multinationals, one can expect Aurobindo Pharma to bag more such deals in future.
Strong manufacturing capability: Over the last four years the company has invested Rs870 crore in augmenting its manufacturing capacity. It has 13 manufacturing facilities (10 in India, two in the US, and one in Brazil). In terms of manufacturing capability, it is at par with India’s large-cap generic manufacturers. Most of these manufacturing facilities have been approved by the major global regulators.
At present, the company utilises only 35 per cent of its total manufacturing capacity for formulations and about 70 per cent for APIs. As the volume supplied to its MNC partners increases, capacity utilisation will increase. This is expected to help the company expand its margins.
The company is now enhancing its capacity in niche areas such as oral contraceptives and injectible formulations. These areas witness less competition and will enable the company to earn higher margins. Some of these niche products are expected to be launched by the end of FY13.
Declining debt: The company incurred a lot of debt to fund its capacity expansion plans. From 1.1 currently its debt to equity ratio is expected to decline to 0.68 by FY13.

Negatives
US FDA import alert: Recently the US Food and Drugs Administration (FDA) issued an import alert on the Aurobindo Pharma’s cephalosporin facility. This essentially means that after examining the plant this regulatory body found it inadequate and will therefore not allow imports of products manufactured there. When this piece of news broke, the stock declined sharply.
However, analysts at BoA-ML are of the opinion that this sharp market reaction was unwarranted since the import alert is expected to affect revenues to the extent of 4 per cent and bottom-line to the extent of 6 per cent only. Supplies to its MNC partners are expected to be affected to the tune of $4.5 million (Rs20.25 crore). Moreover, the company will still be able to export formulations manufactured at this plant to other developing countries. Analysts expect that it will take at the most two years for the company to resolve US FDA’s concerns regarding this plant.
FCCB redemption: Aurobindo Pharma has to redeem foreign currency convertible bonds (FCCBs) worth $204 million (Rs918 crore) this year. Earlier, there were doubts about its ability to meet this liability. But owing to improved cash flow from its MNC licensing deals and the end of its capex programme, it is expected that the company will be able to meet this liability. It has already arranged for foreign currency denominated loans worth $100 million (Rs450 crore) and it has also bolstered its cash position by divesting its shareholding in a Chinese manufacturing facility.

Key risks
The company does face a few risks that could affect its earnings growth adversely. One, the recent import alert by US FDA could force it to spend more on good manufacturing practices. Two, the supply agreements with its current and future MNC partners may not scale up as expected. Three, the regulatory approvals in different geographies (US, EU and several developing markets) may not come through as quickly as expected. And finally, since 70 per cent of the company’s revenue comes from exports, appreciation of the rupee could adversely affect its earnings.

Valuation
The company is currently trading at a 12-month trailing PE of 8.19. This is lower than its five-year median PE of 11.26. Over the last five years, the company’s earnings per share has grown at a compounded annual rate of 52.41 per cent. This gives it a price-earnings to growth (PEG) ratio of 0.21. Given its current attractive valuation and strong growth prospects, you should purchase this stock with at least a three-year horizon.