Shasun Pharma: Buy

Improved financial performance, robust outlook and reasonable valuations make Shasun Pharma an interesting stock idea to reckon with from a medium-term perspective.

Predominant API manufacturer

Shasun is predominantly engaged in contract manufacturing of active pharmaceutical ingredients (API) and intermediates for the export markets. API (including contract manufacturing) accounts for 93 per cent of the company's revenue. Shasun is a leading producer of Ibuprofen and its derivatives such as Ibuprofen lysinate, Ibuprofen sodium.

The company has consciously shifted focus from low-margin Ibuprofen to high-margin derivatives and other APIs such as Ranitidine, Nizatidine, Gabapentin and Cycloserine.

As a result of this, the contribution from Ibuprofen and derivatives has declined by 4 percentage points to 24 per cent in FY12. Though the dependence on Ibuprofen is still significant, with increased contribution from other APIs and new products such as Sevelamer Hcl and Sevelamer carbonate, the product concentration risk is expected to wane gradually.

The company also has an interesting contract research and manufacturing services agreement (CRAMS) pipeline of novel molecules which are currently in various stages of clinical trials. Shasun is currently supplying API/intermediates for the clinical trials, and commercial supplies will commence once these products are approved.

Improved financial performance

Profits of Shasun's UK subsidiary, Shasun Pharma Solutions (SPSL), doubled in FY12 to Rs 53 crore driven by product launches. The company commenced supplies of 16 new products as part of its CRAMS last year.

The company has an impressive CRAMS pipeline of 17 more products, including API and intermediates, of which eight are in phase III and nine in phase II of clinical trials. The annual revenue potential from these products is expected to be £46-78 million (Rs 394 crore-668 crore). While the peak revenue is expected to flow in over the next four-five years, the earliest opportunity will likely commence by FY15 adding £25-50 million (Rs 214-428 crore) to revenues.

SPSL's operating margins, helped by new launches, particularly API/intermediate supply for patented products, expanded by 600 basis points to 21 per cent in FY12. The margin improvement is likely to sustain in the near term and improve gradually as launches kick in. Strong performance by SPSL, coupled with rupee depreciation, has helped Shasun better consolidated operating margins by 350 basis points to 13.7 per cent in FY12. This is expected to improve to 14-15 per cent in FY13. The average return on equity has zoomed from 26 per cent in FY11 to 33 per cent in FY12.

Expansion to spur growth

The company has planned investment of Rs 250 crore over the next two years in various expansion projects. This has the potential to contribute Rs 750 crore to the consolidated revenue over the next three years. In the first phase, Shasun has expanded the formulation capacity at its Puducherry facility from 3-5 billion tablets. In the second phase, the company aims to double its capacity to 10 billion tablets over the next 2 years.

In addition to this, the company is setting up a green-field API plant at Vizag, which is expected to come on stream by March 2013. This apart, Shasun has augmented the capacity of Ibuprofen, its flagship API, and other derivatives significantly.

Investments have also been made to improve process efficiency and minimise costs at the Cuddalore facility wherein other key API's such as Ranitidine and Nizatidine are manufactured. This will drive revenue growth as well improve operating margins. Management has guided for a 25 per cent compounded revenue growth over the next 3 years, on the back of these investments.

Rupee depreciation

Shasun exports bulk of its API production and, hence, 70 per cent of the company's revenue is denominated in foreign currency. Despite the steep depreciation in the rupee over the last few months, the entire benefit did not flow to the company due to outstanding forex hedge contracts locked in at Rs 41.5/dollar. However, these contracts are slated to expire in October 2012, post which the benefit from a weaker rupee is expected to accrue in full.

Reasonable valuations

At the current market price, the stock trades at 4.6 times its one-year forward earnings. This implies a 76 per cent discount to the leader Divi's Labs. While premium valuations for Divi's may be justified by its superior margin profile and stronger balance-sheet, Shasun's valuation discount to the leader seems substantial. Given the improvement in the fundamentals and positive growth triggers over the next three years, the valuation gap should narrow for the stock, thereby leading to a re-rating for the stock.

Interestingly, the institutional interest in the stock has increased over the last six months. With Caduceus Asia Mauritius Ltd, a private equity company, acquiring 11.93 per cent stake in the company in March 2012, the institutional holding in the stock has increased by 7.82 percentage points to 24.27 per cent compared to the previous quarter.

Though the stock has more than doubled in the last six months, the upside potential from a one-to-two year perspective remains attractive.

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