The Hindu Business Line : Cadila Healthcare: Buy

Scaling up of operations in the US and a turnaround of its French subsidiary next year are two key events that could bolster Cadila's bottomline in the medium term

Quarterly earnings up 70 per cent year-on-year
Altana JV contributed 30 per cent to earnings
New drug policy could be a key risk

Investors can consider adding the Cadila Healthcare stock to their portfolio. At the current price of Rs 560, the stock has the potential for a meaningful upside. The 30 per cent drop from the highs reached in May has enhanced the stock's attractiveness. The multiple earnings drivers are in place for the stock — the scaling up of the US business, the turnaround of the venture in France (though still some time away), a stable domestic franchise and a ramp up in contract manufacturing deals. Cadila, along with Glenmark, would be the preferred picks within the mid-cap pharma space.

US operations

The ongoing fiscal will capture the complete effect of the US subsidiary's operations and should play a key role from the earnings standpoint. Cadila reported sales of Rs 27 crore (an improvement on a sequential basis) and earnings of Rs 3.4 crore from the US foray for the quarter ended June 2006. The management guidance for revenues of $30 million for the current fiscal from the US outfit is achievable.

Though the company may not be present across a swathe of products, it intends ramping up its filings with the US Food and Drug Administration (USFDA), with a targeted rate of about 20 abbreviated new drug applications (ANDAs) per year. Cadila also has a distribution agreement with Mallinckrodt, which should help in containing front-end costs. Additionally, considering that most ANDA filings would rely on Cadila's own bulk drugs, margins from this business should be reasonably protected.

The Altana JV

This has clearly been the star of all Cadila's businesses, responsible for bringing in close to 30 per cent of earnings for the year-ended March 2006. The JV makes Pantoprazole intermediates for Altana's Protonix, which is under patent protection. The net profit margin of close to 80 per cent underscores the importance of this business.

A significant risk that this venture is exposed to is the overturning of patents on Protonix, leading to the entry of generic players. A gradually declining contribution from this venture is likely as patent expiration approaches.

To de-risk its business model, Cadila has also stitched up other similar deals in the contract manufacturing space. Of these, the one with Mayne of Australia for manufacturing oncology injectibles is most promising with a peak revenue potential of $50 million. The other deals are expected to generate maximum revenues of $20 million. As the bottomline impact of the Altana JV tapers off, the other deals are expected to make up. Cadila is pursuing more such deals in this space.

The French connection

Cadila's subsidiary reported a loss, which could have been higher but for the sale of brands acquired from Alpharma. Cadila would want to capitalise on the attractive potential for generics in the French market. Two initiatives could help Cadila turnaround its operations: Its tie-up with Evolupharm for distribution, which should play a crucial role in reining-in costs; and a gradual shifting of product manufacturing to India, giving Cadila another cost lever. The key earnings trigger to watch for would be when the French operation moves into the black.

Domestic business

Cadila's domestic business focuses on chronic therapy areas and the company has been aggressive in plugging gaps in its portfolio by sewing up in-licensing deals. The growth in the first quarter was muted on account of the high base-effect of the previous quarter (spillover sales due to VAT) and the restructuring of its field staff. Growth is expected to pick up in the quarters ahead.

Cadila is also making steady progress on the drug development front and any news on a possible out-licensing deal for one of its lead molecules could propel the stock's valuation. However, the recommendation does not factor-in any upside on this score.

Valuation and view

At the current price, Cadila trades at 16-17 times its expected consolidated per-share earnings for 2006-07. The lower multiple the street is according to the stock can be attributed partly to the earnings risk associated with a dependence on the Altana JV.

However, we do not see valuation levels stretched and see room for expansion, as multiple triggers are in place.

The principal risk to the `Buy' recommendation would be if patents on Protonix were to get overturned and generics rushed into the market. Other key risks include a delay in securing product approvals from the USFDA and a widening of the scope of price control under the to-be-announced drug policy.

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