Sun's Eclipse

Six years ago, Dilip Shanghvi, the promoter and Managing Director of Sun Pharmaceutical Industries, was clear and confident when asked two questions that were key to the company's future - Is it risky to over-depend on the US market? And, is it possible to maintain the sky-high margins of more than 40 per cent?

"US is the biggest market, and is going to remain so in the future. Margins may go down as base increases, but we will try to maintain 'above industry average' growth and returns. We are looking at giving maximum shareholder returns every year," he had said.

This was the period when Sun was considered a miracle wrought by Shanghvi. In 2007/08, for instance, its net profits were over 44 per cent of sales. A year before that, the figure was 36 per cent (see Sliding Margins). The key was its ability to make complex high-value generic drugs with limited competition. Though Ranbaxy, Cipla and Dr. Reddy's were bigger in sales, Sun Pharma was, and still is, sitting on huge cash, despite the numerous acquisitions over the years.

Sun's big moment came in 2014, when it became India's largest drug company after acquiring the troubled Ranbaxy Laboratories from Daiichi Sankyo in an all-stock deal. It also became one of the top 10 Indian companies with sales of over Rs 27,000 crore as well as the world's fifth-largest specialty generics company. But this growth had come at a cost. In 2014/15, the merged entity's profit margins were only 16 per cent, mainly due to costs related to integrating the troubled Ranbaxy. A year before, they were 19.6 per cent, without Ranbaxy (in 2013/14, it had taken a huge hit due to a patent case settlement). In 2014/15, Lupin's margins were 19 per cent and Dr. Reddy's 14.9 per cent. Sun's profits were Rs 3,141 crore without Ranbaxy in 2013/14 and Rs 4,541 crore (including Ranbaxy) in 2014/15.

Since the past eight months the merged entity has been trading on the Bombay Stock Exchange, nervous investors have been asking two questions - is Shangvi's magic fading? Or, is the slump just a small hitch in Sun's glorious journey over the past one decade? Most experts that we talked to for the story agreed that though Sun faces an eclipse, at least for the next one-two years, as it grapples with integrating Ranbaxy and resolving old and fresh issues raised by the US Food and Drugs Administration, or USFDA, regarding manufacturing practices both at Ranbaxy and its own plants, it will, more likely than not, regain its shine.

Double Blow - 2015

"100 per cent compliance, enhancing R&D productivity and strong business growth are the key priorities for Sun Pharma as a combined entity," the company had said while announcing the completion of the merger on March 25, 2015. The markets also reacted positively to the merger. From Rs 891 on 25 February, the stock rose to Rs 1,168 on April 6, making Shanghvi India's richest businessman, overtaking Mukesh Ambani. But this was short-lived. From there, the stock fell to Rs 764.15 (as on December 22), taking the market capitalisation to Rs 1.83 lakh crore, eroding Rs 93,000 crore of investor wealth.

Of course, signs of trouble with Ranbaxy were clear even at the peak. For instance, while announcing the merger, Sun had said that the remedial action at Mohali, Dewas, Poanta Sahib and Toansa facilities of Ranbaxy, which were banned by the USFDA for violating manufacturing standards, was on track.

But when its own plants also got into trouble with the USFDA, it was really a bolt from the blue, and a big one at that. In May 2014, it was issued a warning letter and import alert for violations of current good manufacturing practice regulations for finished pharmaceuticals from its facility in Karkhadi in Baroda that makes cephalosporin drugs. Sun maintained that the plant's contribution to its overall revenues was negligible.

More trouble was brewing. In July, Sun said it was resolving manufacturing discrepancies found by the USFDA at its Halol facility in Gujarat, and that this was causing some supply constraints in the US for some products. It also warned that the situation would continue for some more time till the remedial steps were completed.

In spite of Sun's regular updates to the USFDA on remedial measures since the September 2014 inspection, it was issued a warning letter a little more than two weeks ago. Some analysts, though, maintain that the issues at Halol are not serious and may not lead to the USFDA ban.

"As far as Halol is concerned, there have been no new product approvals. While for the approved products, supplies from Halol continue, there has been some supply disruptions due to the ongoing remediation efforts," said a company spokesperson.

But investors are wary. "The worrisome factor is the warning letter even after the company said it had taken corrective action," says Sarabjit Kour Nangra, Vice President, Research (Pharma), Angel Broking.

The Halol plant is crucial as it contributes 7-9 per cent of Sun's overall revenues and 15 per cent of US revenues. Also, the company was planning to manufacture a host of injectable products at this facility by 2020. Even though Sun has acquired one more injectable facility in the US (Pharmalucence), not all products can be shifted to that facility. "The focus is on remediating Halol," said the spokesperson when asked if there were plans to move production of injectable products to other facilities.

Analysts, however, see hope in Sun's several USFDA-compliant plants (out of 48) that have been audited in the past 15 months without negative observations.

Diverse Issues

Experts say one of the biggest problems was that these manufacturing issues came up at a time the management was already grappling with integrating Ranbaxy. The integration had seen the exodus of several key Ranbaxy executives, many voluntarily and some as part of the merger process in which Sun's executives took over the key responsibilities, though the company spokesperson says that not all exits were a result of integration.

Sanjiv Kaul, Managing Director, ChrysCapital Investment Advisors, who was with Ranbaxy before 2004, says, "While there is little doubt that the Ranbaxy deal was a very astute move and a shrewd investment decision, the integration could have been better planned and managed."

An industry veteran, who has known Shanghvi for long, says his major problem today is the sheer diversity of challenges he is facing at the same time. "There are just too many priorities today. People who are running a company should not be actively involved in the integration as this makes them take eyes off the company," he says.

As part of the integration exercise, Sun is planning to divest some non-core strategic assets. For instance, it recently sold a plant in the US.

"We are going to implement synergies ahead of time and realise full value by 2017/18. While significant costs related to the integration have been incurred, and some costs will continue, the benefits will be visible going forward," Shanghvi recently said in a con-call with analysts. The company spokesperson said they were committed to $300 million synergies by year three of the merger.

Sun has already warned that consolidated revenues will remain flat or decline over 2014/15. It has also said that profits may also be adversely impacted due to certain expenses/charges arising out of integration as well as remedial actions.

Sunshine Ahead

The first two quarters of 2015/16 were bleak for the company. In the first quarter, sales were flat at Rs 6,522 crore, while the net profit was Rs 479 crore, due to a one-time Rs 685 -crore spend related to impairment of fixed assets and goodwill and other related costs as part of the integration. In the second quarter, net sales were Rs 6,803 crore, down 15 per cent over the same quarter last year, while the net profit was Rs 1,107 crore.

However, analysts say Sun has the potential to shine brighter in the coming years considering the high-value limited-competition products in the pipeline.

"Sun has multiple catalysts which could limit the damage. Low competition in the base business of Gleevec (blood cancer drug) and Xenazine (acne drug), coupled with faster-than-expected ramp-up of Keveyis (a drug for paralysis from Sun subsidiary Taro) and Ximino (acne drug of Ranbaxy) could surprise investors positively," say Kumar Saurabh and Amey Chalke, analysts with Motilal Oswal. The analysts are also betting big on a novel molecule from the company, MK 3222, now in the third phase of clinical trials.

Sun has also lined up quite a few products for the US market. Its 154 abbreviated new drug applications (ANDAs) are awaiting approval with the USFDA. The US market contributes 48 per cent to its overall revenues.

Analysts expect Sun to post a revenue of Rs 28,400 crore this year, Rs 33,690 crore in 2016/17 and Rs 36,540 crore in 2017/18, without acquisitions. Net profit is expected to be flat this year at Rs 4,390 crore, but jump to Rs 6,860 crore next year and to Rs 9,150 crore in 2017/18.

The future will be bright unless the USFDA issues become more complex and the integration with Ranbaxy fails. Still, the earlier profit margins are unlikely to be touched as global generic drug sales dynamics have changed due to rising competition from new players in high-value limited-competition product segments.