Will Sun Pharma be able to manage the merger with Ranbaxy without hurting itself?

Forget big profit days of the past and don't be surprised to hear about harsh decisions and gloomy outlook from the company in the next one to two years. This was the essence of what Dilip Shanghvi, Founder and Managing Director of India's largest drug company, Sun Pharmaceutical, told investors on July 20.

The Sun Pharma stock tanked 15 per cent the following day with Shanghvi saying that the 2015/16 consolidated revenues would remain flat, or may even decline. The profits, too, could be hit by expenses and charges arising out of the integration of Ranbaxy Laboratories, which it had acquired last year, as well as due to regulatory issues.

There are several reasons why investors are not happy. Before buying Ranbaxy, Sun clocked sales of Rs 16,200 crore (2013/14). Its net profit margins for five years to 2013/14 were 32-35 per cent, while that of its top 10 peers was between 9 per cent and 14 per cent. Sun's US formulation business, which contributes 60 per cent to its revenues, grew at a compounded annual growth rate of 45 per cent during the period. However, though its 2014/15 sales (after the merger) rose to Rs 27,600 crore, net profit margins were just 18 per cent. EBITDA (earnings before interest, taxes, depreciation and amortization) margins also fell from 45 per cent to 29 per cent. "Merger-related woes were evident after the fourth quarter of 2014/15, when revenues and operating profit margins (OPMs) were impacted. Adjusting for merger-related costs, OPMs were 26-27 per cent," says Sarabjit Kour Nangra, Vice President, Research (Pharma), Angel Broking.

"Sun's fourth-quarter earnings and 2015/16 revenue guidance have been disappointing, leading to earnings downgrades. However, the core investment arguments remain intact," say IDFC analysts Nitin Agarwal and Param Desai.

But the question is, how will Shanghvi bring back Sun Pharma's golden days, if at all?

"We are not a top line-driven company. Our focus will be high-value specialty generics and differentiated products," says Shanghvi. Broadly, his integration plan revolves around six points - cultural integration, cGMP compliance for all facilities, more product filings, productivity improvement, revenue synergy and ensuring a more efficient procurement and supply chain. cGMP refers to current good manufacturing practices.

Industry observers say this can only be achieved if some harsh decisions, such as closure of plants and trimming of workforce and product range, are taken. Unlike Sun, which is focused on the US, Ranbaxy's business is spread across continents. Many of its operations are either unprofitable or have low margins. Shanghvi has hinted at hiving off some of Ranbaxy's non-core businesses. Also, instead of trying to restore the quality of all four facilities of Ranbaxy under the US drug regulator's scanner - Mohali, Dewas, Poanta Sahib and Toansa - Sun will prioritise and ensure compliance at just one or two facilities. With the acquisition of Ranbaxy, Sun now has 45 manufacturing facilities and, therefore, moving products to other plants is an option.

Nangra of Angel Broking says 29-30 per cent margins from 2016/17 should not be a problem after Sun writes off all merger costs in 2015/16. If the integration goes off smoothly, Sun will get synergy benefits of $280 million to $300 million by 2017/18, says Shanghvi.

The other problem for Sun is about regulatory issues at its Halol facility in the US, which accounts for over Rs 4,000 crore revenues. Remedial measures at Halol continue to create supply constraints for various product lines, particularly injectables.

Sun is executing another plan to maintain profits. It is building a marketing team of 40-50 people in the US to sell its new ophthalmic products and in-licensed psoriasis drug MK-3222 (Tildrakizu-mab), which is in the final phase of trials. It is also planning to sell branded over-the-counter and private label products in the US.

If the plan works, what will Shanghvi's next move be? The purchase of Ranbaxy has already positioned Sun as the largest domestic and emerging market player, well-placed to pursue further transformational merger and acquisition deals, and evolve as a global specialty major, say IDFC analysts.

Sun is now the fifth-largest specialty generics company in the world with revenues of $5.1 billion. If it is able to acquire a company with revenues of over one billion dollars, it can overtake both Actavis and Mylan, which have revenues of close to $6.4 billion, each, to become the third-largest after the $9.8-billion Teva and the $8.5-billion Sandoz, as per the 2014 revenues.

However, any escalation of regulatory issues in the US will be a big negative, say analysts. "So far we have not come across anything drastic or surprising related to the integration," says Shanghvi.

But considering the business history and complexity of Ranbaxy's business, integrating the company with Sun will be tough for Shanghvi and his team, and big growth may take some time. For the present, the biggest challenge is to go back to the high profitability of pre-Ranbaxy days.