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Sunday, May 08, 2005

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Sun Pharma: Buy

Nath Balakrishnan

FRESH exposure can be considered in the Sun Pharma stock, which now trades at Rs 495. Though it has run up by over 50 per cent since our earlier `buy' recommendation, we continue to be confident about the company's prospects and rate it as our preferred pick among domestic large-cap pharma stocks. A strong presence in the domestic market in chronic therapy areas, a tight control over costs and a diversified revenue profile that does not depend excessively on the price-sensitive American generics market, underpin our current view.

Considering the gains that stocks have racked up in the recent past, appreciation from the current level is likely to be more modest. Any decline in the stock's price linked to trends in the overall market, may be used to step up exposure.

Unlike several companies that have a significant exposure to the domestic market, Sun's revenue profile that blends domestic and export sales in a 60:40 ratio has cushioned the impact of VAT-related issues on offtake. Domestic formulation (medicines in finished form) sales in the March quarter fell 6 per cent. Sun has also been affected by the controversy surrounding the stocking of psychotropic drugs by chemists, as psychiatry is a key therapy area for the company.

Sun's margins are among the best in the industry; however, the dynamics of the March quarter, when domestic sales fell and exports rose sharply (driven primarily by bulk exports), has resulted in a 15-percentage-point compression in operating margins at 33.6 per cent compared to the year-ago period.

Clearly, the pricing pressure in bulk exports appears to have played a critical role in depressing margins, given the extent of its contribution to revenues. Another element that has driven margins down is the raw material costs. As a percentage of sales, these costs have risen by over seven percentage points to 27.7 per cent compared to the corresponding previous period. However, domestic formulation sales are expected to be back on track as most of the VAT-related issues get resolved; moreover, the surge in bulk exports seen in the March quarter could be seen as transient in nature, considering that the demand for this product tends to get lumped at times. Once this happens, margins should move into an upward trajectory from the current levels.

Sun, along with its subsidiary in the US — Caraco Pharma — has 22 abbreviated new drug applications (ANDAs) pending approval with the US Food and Drug Administration. For those products for which Caraco receives approval, the supply of the bulk ingredient should be from Sun and that should yield the benefit of lower cost. Geographical expansion outside of the US market should enable Sun mitigate the impact of pricing pressures prevalent in that market currently.

Sun also has a cash chest of $440 million (about Rs 1,950 crore) that it intends to use for acquisitions in the American market that preferably complement Caraco's strengths. The cash, which has been deployed in bank deposits, chipped in with returns of Rs 22 crore for the March quarter. Expensive valuations in the American market is the single biggest deterrent to make an acquisition; it is now more a matter of the timing of the acquisition. Given Sun's ability to generate returns in excess of 30 per cent on its invested funds, a suitable acquisition could contribute significantly to the bottomline.

Sun has novel drug delivery systems projects that are slated to enter clinical trials shortly; also, the company intends to file for an investigational new drug application for its chemical entity that is undergoing phase I human studies in Europe. The outcomes of such research efforts is often defined by unpredictability; however, any positive news flow, either in terms of moving to the next stage of trials or possible outlicensing, could provide a significant booster to the stock.

At the current market price, the stock trades at a multiple of 19 times its expected per share consolidated earnings for FY-06. We reiterate a `Buy'.

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