Dolphin Investments

Initiation Report

Vinay Basavaraj
2/3/2012

Aurobindo Pharmaceutical
ceutical Limited (APL)
We initiate coverage of APL on 3rd February 2012 with a
target price of INR 103.

Stock price information as of 3-Feb-12

Close
P/E

115.35 Monthly H/L 120/86.9 52 Weekly H/L 244.5/80.35

20.00 Industry P/E

10.87 Industry

Pharmaceuticals

Scrip ID AUROBINDOP Index/Group BSE 200

Company profile
APL, founded in 1986, is one of the leading global pharmaceutical companies engaged in the
development, manufacturing
cturing and marketing of active pharmaceutical ingredients (APIs) and finished
f
dosage formulations for 25 years. In 1988, the company commenced operations with a single unit
manufacturing semi synthetic penicillin (SSPs) at Pondicherry. The company is the market leader in semisemi
synthetic penicillin drugs. It has a presence in key therapeutic segments like SSPs, cephalosporin,
antiviral drugs, CNS, cardio-vascular
vascular and gastroenterology. APL created a name for itself in the
manufacture of bulk actives, its area of core competence. The company has entered the high margin
specialty generic formulations segment, with a global marketing network. Lastly, the company
com
claims to
be amongst the largest 'Vertically Integrated' pharmaceutical companies in India
India.

Research and development (R&D)

APLs R&D strengths are in developing intellectual property in the area of non
non-infringing
infringing processes and
resolving complex chemistry challenges. In the process, APL is developing new drug delivery systems,
new dosage formulations, applying new technology for better p
processes. The company boasts of two
research centers, both located in Hyderabad. However, given the nature of the pharmaceutical industry,
R&D efforts are materialized only after stringent quality tests and adherence to compliance
requirements. Consequently,
y, there is considerable time lag in achieving desired results. As of Mar 11,
APL has filed for a total of 464 patent applications, including 46 applications filed in the year 2010-11.
2010
Lastly, expenditure on R&D has increased from 3% to 4.1% of total sale
saless turnover from Mar 10 to Mar
11 respectively.

Shareholding pattern
A majority of the shares (54%)
%) are held by the promoter and promoter group companies. The rest of the
shares held are fairly distributed amongst Mutual Funds (11%), FIIs (14%) and others.
others Summarily, the
shareholding pattern is fairly diversified in terms of its public shareholding pattern.

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Corporate governance
The composition of the Board is in conformity
with Clause 49 of the Listing Agreement. As of
Mar 11, the Board comprises of ten Directors;
four executive Directors and six non-executive
non
Directors. The Board also comprises of subcommittees in charge of effective corporate
governance are the Audit and Compensation
committees.

Industry evaluation
India's pharmaceutical industryy is no
now the 3rd largest in the world in terms of volume and ranks 14th in
terms of value. A highly organized sector, the In
Indian
dian pharmaceutical Industry is estimated to be
currently worth USD 4.5 billion,
llion, growing at about 88-9% annually. By 2015, Indian pharmaceutical market
is expected to establish itself among the world's leading 10 markets. Moreover, the
t
Indian drug
companies account for over 25% of the total gener
generic drug applications made to the US FDA.

Peer company comparison

We compare APL to 85 of its peers in the industry. Our comparison entails four key parameters, i.e. total
assets, net profit, sales and market capitalization. We find that APL is amongst the largest of its peers on
all parameters examined. As seen, the respective values corresponding to APL are positioned in the
fourth quartile signifying their relative size.

Quartile =
Market Cap
Sales
Net Profit
Total Assets

Peer company evaluation

1
2
3
4
87
445
1,900
56,662
201
494
1,155
6,124
5
45
143
12,897
195
512
1,517
11,985

APL
3,482
4,133
594
4,887

Investment highlights
Inelastic demand
Pharmaceutical products exhibit minimal correlation to macroeconomic variables. Therefore, earnings
are relatively safeguarded against macroeconomic fluctuations. Consequently, APL has displayed a
consistent rise in earnings and profits over the years.

Liquidity
APL boasts of a relatively high level of liquidity as compared to its peers. The greater liquidity can be
viewed
ewed as being an enabler of managerial flexibility in conducting day
day-to-day
day business as well as a cash
cushion.
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R&D
APLs strength lies in the successful outcome of its R&D efforts. The rise in R&D costs is indicative of
APLs commitment towards long-term
term value creation. Moreover, the pending 464 patent applications, if
successful, will add value to the bottom line and provide APL with a competitive advantage.

Financials
Earnings
We compare APLs net sales figures to that of its two of its peers, namely Lup
Lupin
in and Cadia. We find that
APLs net sales have grown at a compounded annualized growth rate (CAGR) of 21.8%, whereas those of
Lupin and Cadia are 22.6% and 10.7% respectively. Furthermore, we would like to ascertain APLs
earnings quality. We compare the accruals ratio a measure of earnings quality of APL to that of its
peers.
The interpretation of the ratio is as follows: higher the ratio, higher the managerial discretion in
reported earnings, and therefore, lower earnings quality. As seen in the figure
re on earnings quality, APLs
accruals ratio has increased significantly since Mar 10. The higher ratio implies higher managerial
discretion in reported earnings. As seen, APL exhibits the least amount of volatility of the accruals ratio
as evidenced by the lowest standard deviation of the ratio.

Profitability
We examine the trend in profitability by focusing on three key profitability indicators, i.e. operating
profit margin (OPM), gross profit margin (GPM) and net profit margin (NPM). Moreover, we compare
the latter figures of APL to those of its peers from Mar 07 to Mar 11.. The peers have been selected
based on comparable profit margins. We observe that APL does not outperform its peers on all three
parameters. The only positive trend observed is with the operating profit margin (OPM). With regards to
gross profit margin (GPM) and net profit margin (NPM), APL lags behind its peers and exhibits a negative
trend
d contrary to that exhibited by its peers. The trend in GPM can be attributed to lower pricing power
of APL. However, those of OPM and NPM are clearly relative inefficiencies.

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Liquidity and solvency

We employ two sets of ratios to evaluate APLs trend in liquidity and solvency. The first set comprises of
the current ratio and quick ratio whilst the second set comprises of the debt/equity ratio and leverage.
We compare the ratios to those of APLs peers and find that the company is maintaining a higher level of
liquidity as compared to its peers. However, the solvency position is not as commendable as is its
liquidity position. Nonetheless, APL seems to be following industry trends without any serious
aberrations in trends.

Cash flows
Our focus is on the cash flowss available to the providers of
capital, both equity and debt. The free cash flow to the
firm (FCFF) is one such measure that not only accounts for
the operational expenses but also the fixed capital
investments. As seen, free cash flows are currently
negative and trending downward.

Du Pont Decomposition
We employ the 3-stage
stage Du Pont decomposition model to analyze and identify the key drivers behind
APLs return on equity (ROE). The model decomposes ROE into three components, i.e. net profit margin
(NPM), asset turnover and leverage. As seen, leverage has played a significant role in achieving the ROE
over the period examined. Furthermore, the contribution of leverage towards ROE has increased in
recent years. Contrarily, profitability and its contribution towards ROE ha
have
ve remained at a relatively low
level. Asset turnover, too, has declined steadily.

Valuation
We employ the two-stage
stage Dividend Discount
Model (DDM) to ascertain the intrinsic value of a
stock of APL.. We assume a high growth rate of
dividends paid for the next five years and a
constant, albeit lower, growth rate thereafter for
the foreseeable future. To arrive at the latter we
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require two inputs, i.e. a required rate of return (Re) and a sustain
sustainable
able growth rate of dividends paid
(g). The Capital Asset Pricing Model (CAPM) helps us in ascertaining the former whereas the g is
computed as a function of ROE and the dividend payout ratio (DP). The assumptions are shown in the
respective tables below.

Period =
Dividend per share
Terminal value
Present value
Intrinsic value

0
Mar '11
2.02
103.03

CAPM
Rm
Rf
Beta
Re

0.14
0.08
1.70
0.19

Dividend Discount Model (DDM)

1
2
3
4
5
Mar '12E Mar '13E Mar '14E Mar '15E Mar '16E
2.36
2.76
3.23
3.77
4.41
223.09
1.98
1.95
1.91
1.88
95.31

Thereafter
Mar '17E
4.56

Quantitative analysis

The objective of our quantitative analysis is to analyze the

distribution of returns of APLs stock. The mean and variance of
returns may not adequately describe the returns of an investment.
For instance, APLs
s stock has a daily average return of 0.076% and a
Sustainable growth rate (g)
standard deviation of 3.89%. In the period examined, Apr 95 to
DP
0.30
Feb 12, the stock exhibits a large negative skew. This is evident
ROE
0.24
from the returns distribution graph, i.e. the longer end of the tail of
g
0.17
the
he distribution is towards the left. Moreover, the distribution can
be defined as being platykurtic. In other words, the tails of the distribution are flatter as compared to
that of a Normal distribution. The nature of the distribution implies a lower probability
obability of extreme
surprises.

Challenges, risks and concerns

The following is the managements perspective of the challenges, risks and concerns facing APL
extracted from the Management Discussion & An
Analysis
alysis (MD&A) section of the 2011 Annual Report.

Macroeconomic risks
APL derives approximately 49% and 22% of its
revenues from US and Europe respectively.
Therefore, an economic slowdown in the US or
Europe could adversely affect the company's
business.

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Competition
The marketplace for APLs products is highly crowded. Consequently, profit margins can be easily eroded
by competition. However, APL being a vertically-integrated company has some control over raw material
sourcing.

Regulatory risks
The pharmaceutical industry is highly regulated. Consequently, the tangible cost of compliance and the
intangible costs of non-compliance are significant.

Patent protection
The companys success will depend on its ability in the future to obtain patents, protect trade secrets
and other proprietary information and operate without infringing on the proprietary rights of others.

Foreign exchange risks

With a majority of its revenues derived from overseas markets, APL is exposed to significant foreign
exchange risks, i.e. adverse movements of the INR.

Personnel risks
APL operates in a highly knowledge-intensive industry. Therefore, the risk is that the company may be
unable to attract and retain talent to populate its R&D centers.

Conclusion
The current market price of APL stock implies that the stock is overvalued. However, we do not
recommend purchase of the stock because its relatively low earnings and negative free cash flows.

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