Friday, April 11, 2014

Sun Pharma Ranbaxy Part #2: Ranbaxy and the merger

Ranbaxy is an Indian pharma company founded in 1961. In the 90s it was widely respected and revered. Exports to 125 countries, has operations in 43 and plants in 8. In 2008 it was sold by the founding family to Japanese firm Daiichi Sankyo. 2 employees since 2005 had complained to the FDA about irregularities and quality concerns with the medicines produced by the company. The company since has had terrible financial performance and I cannot understand why it still trades at a market cap of 19K Crores!

I know I said I will cover this in 3 parts but I think the merger can be covered right here in Part #2.

1. How good is the moat?

Grade C moat

  • The company hasn't really been able to come out of the FDA action issues so far. Seems to me that it was not so independent of the founding family as was seen by the acquirer.
  • Brand - there is negative brand value at the moment
  • Product replication - as the company is selling generics product replication is not much of a big deal
  • Employees - I doubt the employee relations given the whistle blower issue. Maybe after the acquisition things may have improved
  • Performance during recessions - the demand for drugs is fairly inelastic so this point should not be much of a concern
  • Pricing - Ranbaxy has been growing revenue with Raw material costs at 33% of revenues whereas Sun Pharma only as 22% of the cost as revenue. That is a margin difference of 11% just on the raw materials.

2. Risks

  • Tainted by FDA notices - the company may never come out of this situation
  • Debt - There is 5800 Crores of debt on the balance sheet. EBITDA for 12 months ended Dec 2013 stands at 443 Crores giving us a Debt to EBTIDA of over 13 times. Given this Sun Pharma has offered 57 times EV to EBTIDA. I don't understand how that can create value.
  • Even if Sun Pharma was able to bring Ranbaxy back to its pre acquisition margins (which would be one of the greatest turnarounds in Indian history if it were to happen) the bottom line would be about 1200 Crores giving you a P/E of over 17 times and a Debt to EBITDA of 2.59 times which is still on the edge.

3. Financials

  • Given the state of Ranbaxy I think it best not to go into too much detail here as it might be fairly irrelevant
  • Inventory % of sales stands at 22% which is similar to Sun Pharma
  • Debtors % of sales stands at 16% or so which is significantly better than Sun Pharma

4. Soft factors

  • Daiichi Sankyo holds 63.4% of the equity in Ranbaxy
  • Given the fact that Sun Pharma is doing an all stock deal shows that they also think their stock is overvalued, because if they didn't there would be some cash component to it.

5. Pricing

  • Given the 13 times debt to EBITDA I would not buy the business. Now we need to figure out what Sun Pharma sees in Ranbaxy.
  • Sun Pharma is probably looking at 
    • the 50% sales from countries other than India and US that Ranbaxy has
    • Better rankings in various drug categories
    • Scale improvement for the combined entity
  • Sun pharma is already saying they want the Ranbaxy brand reduced and replaced with the Sun pharma brand confirming the negative brand value of Ranbaxy.
  • These things sound very nice from a investor presentation point of view but unfortunately for me I cannot see the earnings enhancement and think that the deal (like most M&A deals) will be not so great for Sun Pharma but excellent for Ranbaxy shareholders.
  • Merger arbitrage trade - I think not. The downside is much higher than the upside in this case. The stock was trading at around 360 in late march after which is has rallied 28%. If for some obscure reason the deal does not go through you stand to loose this 28%. Although I agree the stock fairly values the deal probability.

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