Buy Lupin Ltd.

Target Price Rs.2,015
CM Price Rs.1,443.90

Evolving to higher realms

Lupin is a fully-integrated, top-quality Indian pharma company, poised to advance into the next growth orbit. The company has created a unique, best-in-class, rapidly-growing US business encompassing Branded and Generics, which has total revenues of ~US$260mn over FY04-09. Coupled with this and high growth in key markets such as Japan, European Union (EU) and India as well as strong intellectual property rights (IPR) capability, we expect Lupin to excel quantitatively (PAT CAGR of 23% during FY09-12E) as well as qualitatively (a niche pipeline and IPR & management capabilities) in the next three years. We initiate coverage on the stock with BUY rating and 18-month fair value of Rs2,015/share.

• Unique and balanced business model. Lupin differentiates itself from peers by virtue of its successful & rapidly growing US branded business, which is on course to touch ~US$125mn in FY10E. While scaling-up the US branded business is daunting (where Dr Reddy’s and Ranbaxy have been unsuccessful), we believe Lupin has all the ingredients for achieving the lofty revenue target of ~US$300mn by FY12E. Strong US business (32% of total revenues; ninth-largest), profitable & rapidly growing (~2x industry rate) domestic branded business (30%; #5), Japanese business (12%; #7), and a globally competitive API business (20%; RoCE of 33%) are other key pillars of Lupin’s well-diversified revenue base. Strong IPR capability (cumulative income of ~US$80mn) along with revamped new chemical entity (NCE) model provides broader dimensions to Lupin’s business model.

• Well positioned for Orbit II, with potential 25% revenue CAGR. The past five years have seen Lupin achieve revenue CAGR of ~25% to an impressive US$830mn in FY09. Management remains confident of maintaining revenue growth (I-Sec: 22% CAGR) for the next five years on the back of strong performance in the US, Japan, India and RoW markets. Potentially, acquisitions would help attain the FY14 aspirational goal of US$3bn, implying 29% CAGR.

• Initiate with BUY and 18-month fair value of Rs2,015. Buoyed by commercialisation of a rich ANDA & branded-products pipeline in the US as well as exploitation of synergies from the acquired businesses, we expect Lupin to step into the next growth orbit. Despite 114% run-up in its stock price in the past nine months, the stock trades at an attractive FY11E P/E of 14.9x, implying 23% discount to peer average. Besides, positive newsflow and earnings upgrade potential would give additional boost. We position Lupin as our top BUY in the sector (followed by Ranbaxy and Glenmark), with potential upside of 48% in the next 18 months.

Investment summary

Unique business model
Lupin’s business model differentiates from that of peers as regards strong US branded business, which has achieved critical mass of ~US$75mn revenues in FY09. While branded business is difficult to scale, Lupin has all the requisite ingredients – A distinct strategy of in-licensing and/or acquiring brands, smart marketing and ability to build customer franchise. Based on this, Lupin is set to clock-in 23% revenue CAGR through FY09-12E. The growth will be powered by US Branded (~56% CAGR), US Generics (~20%), Japan (~25%) and India-branded (~18%) businesses. Lupin’s robust dosage-form business is well supported by a globally competitive API business. Strong IPR capability (especially in new drug delivery system-NDDS; ~US$80mn income, as on date) coupled with revamped NCE model provides wider dimension to Lupin’s business model.

US generics business at inflection
We are fairly impressed by Lupin’s success in the US generics market, which is most lucrative and the largest globally. In only less than six years of its first product launch (Cefuroxime Axetil) in the US generics market, Lupin stands at #9 (in terms of number of prescriptions) with ~US$190mn revenues in FY09, up 90% YoY. The growth momentum is likely to sustain, with revenue CAGR of 20% to ~US$330mn through FY09-12E, mainly driven by an impressive pipeline of 65 ANDAs pending approval, of which 8-10 are para IVs and 15-17 are niche, such as hormones, extended release (ER) delivery system, complex chemistry and ophthalmics.

Lucrative monetisation of IPR
On account of smart product selection backed by innovation, Lupin has been considerably successful in commercialising generics research. Beginning with launch of Cefuroxime Axetil in July ’03 followed by Ceftriaxone, Perindopril and Ramipril, Lupin is likely to have registered estimated cumulative profit of ~US$80mn from R&D, which is the highest amongst Indian peers. Of this, a major portion (Rs2.2bn or €40mn) has come from monetisation of Lupin’s strong IPR for Perindopril. In October ’09, Lupin out-licensed its proprietary bio-adhesive technology to Salix Pharma’s Xifaxan (rifaximin). Lupin received US$5mn upfront milestone and is entitled to additional success-based milestone payments along with royalties that could be 5-10% of revenues, in our view.

Value-accretive acquisitions
Lupin made six strategic and value-accretive acquisitions over FY08-09 for Rs4.5bn, as a step to fill the geographic gap on its global footprint. The acquisitions have payback period of around three years, given inexpensive price/sales of ~1x. Further, the company has plans for acquisitions in key markets such as Latin America.

Initiate coverage with BUY; fair value of Rs2,015
Supported by strong management and prudent business strategy & model, Lupin is poised for a big leap over the next five years, with potential revenue & PAT CAGRs of 22-25% each. Besides, we find consensus EPS estimate to be conservative and expect earnings upgrade and strong positive newsflow to drive stock price to our 18- month fair value of Rs2,015/share, implying potential upside of 48%.

Risks
US FDA’s warning letter
The US FDA team visited Lupin’s Mandideep manufacturing plant (dosage-form and sterile APIs) in Q4CY08 and issued 15 observations in Form-483. Following this, Lupin sent its response in four letters during December ’08-March ‘09. However, the US FDA found these inadequate and issued a warning letter on May 7, ’09. This has led to suspension of new ANDA approvals mainly for Cephalosporins.

Management expects the issue to be resolved by mid-CY10. Assuming worst-case scenario (though unlikely) of imposition of ban by the US FDA, Lupin’s EPS could take a knock-off of ~7%.

EU inquiry on patent settlements
In July ’09, the European Commission (EC) decided to open a formal anti-trust investigation against Perindopril innovator Les Laboratories Servier (Servier) for suspected breach of rules of the EC Treaty on restrictive business practices and abuse of a dominant market position.

The probe found that direct payment was involved in over 20 settlements with total payment exceeding €200mn. Lupin has received €40mn or Rs2.2bn as part patent settlement with Servier. Lupin believes that since it has not delayed the generics launch, there would be no anti-competitive activity. Timeline for EC’s final decision is difficult to ascertain.

IPR impact on local market
With India coming under the IPR regime since January 1, ’05, the domestic dosageform business of all home-grown companies will be impacted going forward; Lupin derives 30% of its total product revenues from this market. We expect impact of the regime from ’11-12. Significant ramp-up in revenues from international business, domestic revenues are slated to decline to 27% of total revenues in FY12E, thereby reducing negative effect of the IPR regime on Lupin’s business.

Potential genericisation risk to Suprax
Reportedly, Orchid Pharma has filed ANDA for Suprax 100mg/5ml, which has estimated revenues of ~US$25mn. On October 22, ’09, Lupin filed a citizen’s petition with the US FDA, requesting the agency that all ANDAs for Suprax must meet the same standards as Lupin’s Suprax. Lupin is confident about its strong position and expects to keep any potential generic versions at bay for about two years. However, in the event of entry of a new player with all dosage-forms of Suprax, Lupin’s EPS could get dented 6-7% in FY10E and FY11E, assuming 50% reduction in revenues.

Promoters have pledged 10% stake
In February ’09, the promoter family pledged 12.4% equity stake (of their total stake of 50.65%) in Lupin. It reduced the pledged amount to 10.4% in September ’09, which is a positive. We expect the remaining pledge to be paid in due course.

Compelling valuations
Significant rerating in past five years
Powered by stellar business transformation and EPS CAGR of 29% in the past five years coupled with the ’03-07 bull-run and 114% spike since March’09, Lupin’s stock touched an all-time high of Rs1,400 (on closing basis is Rs1,377) recently. Until mid- CY03, the stock was trading at 6-8x one-year forward P/E. During the 18-month period ending December ’04, the stock traded at 20-35x P/E, mainly owing to firsttime significant newsflow pertaining to the US business. However, such high valuations are evidently unsustainable and unjustified. Since then, and till the financial meltdown, the stock traded at a more reasonable 10-15x P/E; it has doubled since March ’09, boosted by strong positive fundamental newsflow, investors’ heightened interest for the sector and sharp pullback of 93% in the Sensex over the same period.The five-year average P/E for the company stood at 7.7x, which has now almost doubled to 13.9x.

Lupin’s stock is up 29x or 52% CAGR since the past eight years vis-à-vis only 5x or 23% CAGR for BSE Sensex and 9x or 31% CAGR for CNX Midcap Index. With EPS rising 8x or 30% CAGR, the stock has rerated at 22% CAGR during the period on the back of improving quality of the business and underlying growth momentum.

Valuation framework

Segment-based approach
Given Lupin’s unique business model amongst Indian peers, as regards US branded business, which is at inflection point, we think it prudent to assign value to each key business segment. DCF-based valuation Lupin’s weighted average cost of capital (WACC) is 11%, which we have used to discount its next 10-year cashflow from operations. We have assumed long-term sustainable growth rate of 4% for the business. Consequently, we derive DCF-based value of Rs2,098/share. We have not assigned any value to Lupin’s NCE research at this stage, given the company’s inability to monetise any compound in the past decade as well as our view that the first licensing deal may take at least three years. 18-month fair value pegged at Rs2,015/share Our 18-month fair value of Rs2,015/share is based on the average of two values – Segment-based and DCF-based. This implies FY11E P/E of 14.9x, which compares well with that of Sun Pharma and Cipla.

Comparative valuations
It is evident (Table 2) that Lupin is trading at a very high 23% discount to peer average P/E of 19.5x (Sun Pharma, Ranbaxy, Cipla and Dr Reddy’s). Thus, among aforementioned peers, Lupin is the most inexpensive, in terms of FY11 P/E. Besides, the company enjoys the highest RoCE of 21% amongst Indian peers. This combined with strong EPS CAGR of 23% through FY09-12E and unique business model, we expect the stock to get rerated further.

Report card

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