HEALTHCARE

September 2014

Product Sales selection execution

Event specific risk Base business Drivers of growth growth N ewer Associated avenues risk to for growth growth Regulatory risk

Therapeutic coverage

Sales force Geographical productivity coverage

Thematic: Mid-size pharma - DNA for growth

Analysts: Aditya Khemka [email protected] Tel: +91 22 3043 3272 Paresh Dave [email protected] Tel: +91 22 3043 3212 Healthcare

CONTENTS

SECTOR

Healthcare: Mid-sized pharma: DNA for growth………………………………………….. 3

Mid-sized pharma: Apples or Oranges……………………………………………………… 4

Introduction to Indian pharmaceuticals……………………………………………………...8

Deep dive into IPM’s evolution; regulation says ‘innovate’! …………………………….10

Challenges ahead for mid-sized pharma…………………………………………………. 14

Analysing sustainability: Business DNA……………………………………………………. 15

Valuations not in sync with DNA…………………………………………………………….28

Suggest switching from Aurobindo (SELL) to Cadila (BUY)……………………………… 31

Case studies…………………………………………………………………………………… 33

COMPANIES

Cadila Healthcare (BUY): Multiple levers for growth………………………………37 - Snapshot of company financials………………………………………………………… 38 - Cadila – Diversified revenue streams………………………………………………….. 39 - Gaining lost ground………………………………………………………………………. 40 - Mapping competitive advantage – The 5 ’R’s………………………………………… 43 - Cadila has multiple levers for growth………………………………………………….. 48 - Valuation discount to large-caps to narrow…………………………………………… 56 - Accounting analysis – No concerns…………………………………………………….. 61

Aurobindo Pharma (SELL): Structural issues galore………………………………. 67 - Snapshot of company financials………………………………………………………… 68 - Aurobindo – Opportunistic and fragile………………………………………………….69 - Snowballing of a most humble beginning…………………………………………….. 70 - Low rank in our competitive framework – the 5 ’R’s…………………………………. 71 - US formulations the only growth driver but a ‘no moated’ business……………… 77 - Base business EBITDA margins and RoCE to improve till……………………………. 85 FY17E but decline thereafter - Valuation – Deserves a deep discount to large-caps………………………………… 88 - Accounting analysis – some RED flags…………………………………………………. 94

September 16, 2014 Ambit Capital Pvt. Ltd. Page 2

Healthcare

POSITIVE

THEMATIC September 16, 2014

Mid-sized pharma - DNA for growth Key Recommendations Lupin Mid-sized pharma companies have been able to establish themselves in BUY domestic formulations. Whilst the growth in India would continue, these Target Price: 1,387 Upside 2% companies are considering exports to broaden their growth horizon. As ` traction in the US market is unlikely in the absence of a compelling IPCA BUY proposition, we favour mid-sized companies with a commensurate EM focus and a track record of creating a strong branded business. Our Target Price: `949 Upside: 16% business DNA framework serves as a valid proxy for probable success in Cadila BUY EMs. Ajanta, IPCA, Torrent and Glenmark are best placed on our framework. We initiate coverage on Cadila (BUY) and prefer it over Target Price: `1,510 Upside: 19% Aurobindo (SELL), due to Cadila’s: (a) better score on our competitive ‘5’ Aurobindo R framework; (b) significantly stronger presence in branded markets like SELL India; and (c) higher investments in innovative pursuits like biosimilars Target Price: `828 Downside: 8% and NCEs. Mid-sized pharma names have established domestic market presence We prefer Cadila over Aurobindo The domestic market share for the top-10 Indian pharma companies in FY08-14 despite higher valuations due to has increased 966bps to 38.1% and that for the next 30 companies has higher ranking on 5R and RoCE increased by 277bps to 44.5%. Whilst stalwarts like Sun and Lupin have recorded 21 a CAGR of >20%, mid-sized companies like IPCA, Glenmark, Torrent, Indoco 19 Sun and Ajanta have beaten the Indian pharma market (IPM) consistently. However, 17 Pharma the quality of growth across companies varies, with growth being driven by all or 15 Cadila Cipla 13 some of the levers at the companies’ disposal. Dr. Lupin 11 Reddy's Glenmark 9 IPCA Mapping the sustainability of growth in India Aurobind 7 o We map the strength of the domestic franchise by creating a Business DNA 5 framework. We analyse: (a) the current Drivers for growth that would help (FY16E) EV/EBITDA 10 20 30 40 sustain the growth momentum (product selection, sales execution and brand RoCE (FY14) equity); (b) Newer avenues for growth (therapeutic coverage, geographical

coverage and sales force productivity); and (c) Associated risks (structural and event-specific risks). DNA of the domestic franchise is a good proxy for EM export prospects Most of the mid-sized pharma companies have started tapping exports to broaden their growth horizon. However, with consolidation of the buy and supply side in regulated markets like the US, we believe mid-sized companies may face challenges unless they have compelling propositions. Hence, mid-sized companies with a commensurate EM focus are likely to perform better. Ajanta, IPCA, Torrent and Glenmark are best placed on our framework. Initiate coverage on Cadila (BUY) and prefer it over Aurobindo (SELL) Analyst Details Whilst both Cadila and Aurobindo trade at similar market-caps and are set to Aditya Khemka benefit from a large ANDA pipeline in the US, we prefer Cadila over Aurobindo, +91-22-3043 3272 due to Cadila’s: (a) better score on our competitive ‘5’ R framework; (b) [email protected] significantly stronger presence in branded markets like India; (c) higher investments in innovative pursuits. Our DCF fair multiple of 19.0x one-year Paresh Dave forward P/E for Cadila vs 10.0x for Aurobindo reflects terminal RoCEs of 17% +91-22-3043 3212 and 12% respectively. [email protected] Our coverage summary CMP Mcap P/E P/E Upside / Implied P/E Implied P/E EPS CAGR EPS CAGR Company Rating TP (`) RoCE (FY14) (`) (US$mn) (FY15E) (FY16E) Downside (FY15E) (FY16E) (FY08-14) (FY15E-17E) Sun Pharma BUY 806 27,495 32 25 730 -9% 28.5 24.8 9% 21% 38% Lupin Ltd BUY 1,359 10,042 25 22 1,387 2% 25.6 22.7 33% 17% 26% Dr. Reddy's BUY 2,959 8,296 22 20 3,149 6% 23.8 20.8 22% 19% 16% Cadila Health BUY 1,273 4,292 26 19 1,510 19% 31.1 22.2 11% 31% 17% Ipca BUY 820 1,703 20 16 949 16% 22.9 18.2 23% 21% 31% Aurobindo SELL 896 4,302 17 13 828 -8% 14.2 11.3 29% 31% 24% Source: Company, Ambit Capital research Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision. Healthcare

Mid-sized pharma: Apples or Oranges

Mid-sized pharma companies have been able to establish themselves in domestic formulations over the years using various means of market penetration. Whilst some companies have resorted to being present across the market, others have been able to grow by gaining more market share in a few segments. Whilst the growth in the Indian pharma market would continue, the mid-sized pharma companies are looking towards exports to broaden their growth horizon. As traction in the US market is unlikely in the We favour companies with an EM absence of a compelling proposition, we favour mid-sized companies with a focus and track record of creating commensurate emerging market (EM) focus and a track record of creating a strong branded businesses strong branded business. Our business DNA framework serves as a valid proxy for probable success in EMs and sustainability of profits from the domestic business. Mid-sized pharma companies have established themselves in India The market share for the top-10 pharma companies in India has increased 966bps to 38.1% and that for the next 30 companies has increased by 277bps to 44.5% over FY08-14. Whilst stalwarts like Sun Pharma and Lupin have expanded at a CAGR of more than 20%, mid-sized companies like IPCA, Glenmark, Torrent Pharma, Indoco and Ajanta have beaten the broader market consistently. However, the quality of The quality of domestic growth growth across companies varies. We strive to distinguish the companies that have across companies varies exhibited a superior quality of growth (rather than the quantum) as compared to their peers.

Exhibit 1: Sales CAGR over FY08-14 reflects strong growth by mid-sized pharma companies

30% 24% 24% 25% 19% 20% 14% 15% 15% 13% 10% 11% 10% 7% 8% 6% 6% 4% 5% 5% 5% 0% FDC IPCA Claris Natco Cadila Ajanta Strides Biocon Indoco Torrent Alembic Ranbaxy Unichem Glenmark Wockhardt Source: AIOCD data, Ambit Capital research Current market wisdom seems to suggest buying companies headed/expected to ramp up towards US/regulated markets

The recent ramp up in valuations of many Indian mid-caps seems to suggest Companies with growth prospects premium valuations for companies with growth prospects in the US market. Stocks in the US have premium valuations such as Indoco Remedies, Cadila, and Aurobindo have re-rated due to their visible growth prospects in the US market.

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Exhibit 2: Indoco plans to foray into the US market, whilst Aurobindo is likely to ramp up its US operations (stock price indexed to 100 and adjusted for dividends)

500

400 300

200 100

0 Jul-14 Jan-14 Jan-14 Apr-14 Apr-14 Jun-14 Jun-14 Oct-13 Feb-14 Sep-13 Sep-13 Dec-13 Mar-14 Aug-13 Nov-13 Nov-13 Aug-14 Aug-14 May-14 Strides Indoco Aurobindo Glenmark Cadila

Source: Bloomberg, Ambit Capital research; Note: We have adjusted Strides’ performance for the special dividend of Rs500/share paid in December 2013 Regulated markets’ generics growth sustainability cannot be taken for granted

The US and other regulated markets are low-gestation markets and we agree that Sustainability of profits in regulated these markets present an opportunity for these mid-sized companies to grow; markets cannot be taken for however, we would like to remind investors that the sustainability of profits from granted in the absence of a selling generics in these markets cannot be taken for granted. We illustrate our point compelling proposition by taking the example of generic Protonix sold by Sun Pharma (Brand Pantocid) in India and the US.

Exhibit 3: Brand Pantocid continues to provide a steady Exhibit 4: After the initial revenue flows from generic revenue stream for Sun Pharma in India Protonix, Sun withdrew from the US market

Pantocid-India Protonix-US 150 1,200 1,071 160 1,040 135 140 130 1,000 892 120 720 800 100 613 80 600 478 80 361 60 In ` mn `In 400 In US$ mn US$In 40 200 20 0 0 0 0 0 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Source: AIOCD data, Ambit Capital research Source: Walter-Kluwer data, Ambit Capital research

Larger companies like Sun Pharma, Dr. Reddy’s and Lupin have exhibited the capability of sustaining and growing profits in regulated markets consistently. The sustained growth momentum has been a result of investments in R&D (scaling up the value chain), excellence in execution (gaining market share and logistics excellence) and scale (large basket of product offering) amongst other things. Mid-sized companies are yet to fully establish themselves in However, mid-sized pharma companies are unlikely to repeat the performance of the regulated markets larger pharma companies. Barring IPCA, Cadila and Aurobindo, we believe other mid-sized firms are yet to fully establish themselves in the US and other regulated markets and the jury is still out on the sustainability of their growth prospects.

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Exhibit 5: Mid-sized pharma companies like Ajanta, FDC and Biocon have no US revenues % of Total Revenue

mn Domestic US ` FDC 82.0% 0.0% 18.0% Biocon 37.0% 0.0% 63.0% Ajanta 32.5% 0.0% 67.5% IPCA 36.7% 7.0% 56.3% Natco 75.6% 13.3% 11.1% Torrent 28.0% 18.6% 53.4% Unichem 60.0% 18.9% 21.1% Cipla 38.8% 19.0% 42.2% Alembic 52.0% 25.0% 23.0% Indoco 65.0% 28.8% 6.2% Cadila 34.2% 30.1% 35.7% Ranbaxy 17.7% 32.2% 50.1% Glenmark 26.6% 32.2% 41.2% Strides 7.3% 36.8% 55.9% Dr. Reddy 11.9% 41.8% 46.3% Lupin 25.1% 42.4% 32.5% Wockhardt 21.0% 44.0% 35.0% Claris 50.0% 50.0% 0.0% Sun Pharma 22.1% 60.4% 17.5% Source: Company, Ambit Capital research Several challenges to growth in US/regulated markets for mid-sized pharma We believe that to earn initial revenues in the regulated markets of Europe and the US is a relatively simple task once the manufacturing and product registration hurdles are overcome. Moreover, these revenues generally carry higher than consolidated margins due to better realisations and thus look attractive to the entrepreneur and analyst alike. Consolidation in the buy and However, with the ongoing consolidation of the buy and supply side in the US, we supply side to favour scale believe the regulated markets would increasingly start favouring scale, and life will be difficult for mid- to small-sized companies with no significant value proposition. For example, IPCA and Aurobindo offer a low-cost value proposition whilst Cadila offers a technology advantage which keeps its prospects in these markets strong; however, not all mid-sized companies have similar propositions. Branded generic exports offer sustainable growth for mid-sized companies

We believe mid-sized pharma companies are better off exploring the branded generic Lower upfront investments and export markets, given their relevant experience in the Indian pharma market. Even as sustainability make RoW a viable these markets offer lower margins and RoCEs as compared to the US initially and avenue for growth have higher gestation periods, we believe that lower upfront investments and the sustainability of revenues and profits from these geographies makes them the most viable avenue for growth.

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Exhibit 6: Teva and Actavis have shown that the RoW market has provided better growth than overall revenue growth

Five-year revenue CAGR over CY08-13 35.0% 32.4% 30.0% 27.9% 25.0% 20.0% 17.9% 15.0% 12.9% 10.0% 5.0% 0.0% Teva Actavis RoW Overall

Source: Company, Ambit Capital research The branded generic markets, excluding some minor details, largely mirror the Indian Branded generic markets largely market, and hence, we believe that a successful track record in India can be taken as mirror the Indian market a valid proxy for probable success in these markets. Let’s not forget that the India business itself is of prime importance for mid- sized pharma Whilst the broadening growth horizon is a positive, we do not want to lose sight of the fact that the quality of growth in India also determines the sustainability of profits Quality of growth in India from the domestic business as well. Hence, we take a deep dive into the evolution of determines the sustainability of the Indian market and the quality of growth exhibited by mid-sized Indian companies profits from the domestic business using our business DNA framework. The exercise helps us in: (a) projecting the sustainability of revenues in India and (b) extrapolating the success of the Indian business to other branded generic exports.

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Introduction to Indian pharmaceuticals Industry structure The Indian pharma market (IPM) represents a secular growth opportunity amidst Brand equity drives a certain intense competition. However, the branded nature of the market ensures that once portion of growth the brand is established, brand equity drives a certain portion of growth. Owing to low regulatory hurdles and reasonable margins, the market offers RoCEs ranging from 15% for small players to 30% for the larger ones. Secular growth The IPM is experiencing secular growth characterised by: (a) rising income levels, ensuring affordability; (b) higher health awareness, leading to higher diagnosis; (c) better penetration of diagnostic clinics, leading to better patient access; (d) increasing insurance penetration, ensuring affordability, and (e) worsening lifestyle in urban centres, causing high incidence of chronic diseases like diabetes, psychiatric diseases and neurological disorders. Historically, the IPM has grown at 12-15% per annum, comprising: (a) Volume growth (7-8%); (b) New introductions (3-5%) and (c) price increases (1-2%).

Exhibit 7: The IPM has registered higher CAGR of 13.1% over FY05-14 as compared to Historically, the IPM has grown at real GDP (7.4%) and disposable income (4.2%) 12-15% per annum India Pharma Market Growth > Indian GDP growth

800 705 730 700 630 600 544 477 500 418 400 363 315 276 300 240 in ` billion `in 200 100

- FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Source: AIOCD, CIEC data, Ambit Capital research Organic consolidation

The IPM is amongst the most competitive markets globally. The Herfindahl-Hirschman Indian pharma market is the most Index (HHI) for the market is at 229 (for FY14) as compared to the US market’s 593 competitive globally (monopoly would have an index value of 10,000 and perfect competition would tend to 0). However, despite intense competition, the market is experiencing organic consolidation.

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Exhibit 8: Herfindahl-Hirschman Index (HHI) indicates organic consolidation 235 HHI 230 228 229 227 225 223 220 217 215 213 210 212 210 205 200 Mar-07 Mar-08 Mar-09

Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: AIOCD, Ambit Capital research We believe that the factors contributing to consolidation despite intense competition are: (a) Branded nature of the IPM: Companies can establish their branded generic product in a given therapy area and leverage upon it to expand to more Branded nature of IPM, higher products in the same therapy or a different therapy with the same audience (doctors). incentives to sales force and (b) Incentives to sales force generally higher for larger companies: The larger alliances to drive market the organisation, the more it can spend on incentivising its sales force and other consolidation stakeholders (distributors, retailers and doctors). Higher incentives lead to higher sales and make up for the expenditure in promotion costs through operating leverage. (c) Partnerships and alliances: Larger companies have been the preferred partners for those companies that do not have a local distribution and sales network in India. This adds to the portfolio basket of the larger companies and bundled with higher R&D capability and bandwidth again results in organic consolidation. Market share for MNCs declined post 1970 The market share for MNCs has declined from more than 70% before the 1970s to less than 25% in FY14. The rise of several domestic companies with low-cost advantages and brand equity built over time has caused the erosion in market share for MNCs.

Exhibit 9: Indigenous companies have increased market share by leveraging their low-cost advantage

1970 2014

22% 32%

68% 78%

MNC Indigenous MNC Indigenous

Source: AIOCD, Ambit Capital research MNCs being innovators are excluded from our consideration set We exclude local subsidiaries of multinational corporations (MNCs) from our analysis, as: (a) the local subsidiaries are trading entities with negligible exports and (b) the parent entities are innovators with high brand equity globally due to R&D.

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Deep dive into IPM’s evolution; regulation says ‘innovate’!

A deep dive into the Indian pharmaceutical market’s history suggests that the regulations post-independence were aimed at importing expertise, technology and capital through MNC participation. Whilst import was enabled by various regulations, affordability and local participation in manufacturing were also ensured. The re-introduction of product patent, tax breaks on R&D spend and higher span of price regulation in recent times seems to be aimed at ensuring affordability and pushing the new-age entrepreneurs towards innovation, which we believe is the end-game.

Phase I (pre-1947): The age of MNCs/no direction for a domestic industry Low presence of domestic manufacturers The British Government introduced the allopathic form of medicine in India. Drugs MNCs had 87% share in the were imported by foreign companies and marketed in India. The indigenous industry, domestic market consisting of very few entrepreneurs, contributed little to the total demand (13% of demand met by Indian companies).

World War II provided the opportunity for indigenous players However, during World War II (1939-1945), foreign companies were unable to WW II led to short supply from supply drugs to India. This resulted in the establishment of Indian companies such as MNCs; domestic companies met Unichem, Cipla, Zandu Pharmaceuticals, and Calcutta Chemicals. Gradually, 70% of domestic demand domestic contribution to total demand in the Indian market rose to 70%. The key highlight of this period was focus on production-related activities rather than R&D activities.

Phase II (1947-1970): Regulatory push helps in the rise of domestic bulk manufacturing Domestic companies failed to participate in global R&D revolution Even as pharma companies globally started making sizable investments in R&D The Industrial Policy (1948) failed during this period, the Indian industry could not participate due to lack of knowledge, to import technology, as MNCs experience and capital. Whilst through the Industrial Policy Statement (1948), the assembled imported drugs Government of India (GOI) allowed MNCs to establish a manufacturing base in India, MNCs imported bulk drugs and assembled/marketed the product locally.

Industrial Licensing Policy 1956 succeeded in importing technology The Government of India in its Industrial Licensing Policy, 1956, made it compulsory PSUs established by the GoI played for foreign companies to establish production units in India and produce an important role in shaping up drugs from the basic stage. At the same time, the Government, on its own, set up new-age entrepreneurs like Anji Hindustan Antibiotics (1954) and Indian Drugs and Pharmaceuticals Ltd (1961) to Reddy start the production of important drugs. These public sector units have played an important role in shaping up new-age entrepreneurs like Anji Reddy, who was an ex-employee of a Government entity. Also, the research impetus by the Government through the establishment of sponsored research institutes helped in fostering the technological environment for all the current top domestic pharmaceuticals companies. This resulted in domestic companies capturing a significant share in the bulk drug segment. MNCs continued to sell formulation However, MNCs continued to have monopoly in high-payoff formulation products at high prices products, resulting in prices that were as high as in developed nations.

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Phase III (1970-1991): The regulatory troika; the emergence of Indian generics Patent Act, Foreign Exchange Regulation Act (FERA) and New Drug Policy The Patent Act 1970 abolished In order to bring the prices to normalised levels and make it affordable to everyone, product patents and recognised the Government of India amended the Patent Act 1970 and enacted the Foreign only process patents Exchange Regulation Act (FERA) 1973 and New Drug Policy 1978. . Patent Act, 1970: The Patent Act abolished product patents and recognised only process patents. The Indian companies could now patent their own processes and compete with MNCs in the formulations market. . FERA, 1973: FERA was implemented to compel MNCs to manufacture high- technology bulk drugs through restrictions on equity holdings (<40% FERA (1973) compelled MNCs to stake allowed for commoditised bulk drugs vs 74% for high tech). Further, manufacture high-tech drugs in 50% of bulk drugs manufactured by MNCs were to be sold to non- India associated companies. . New Drug Policy (NDP), 1979: In order to bring prices under control, the NDP was revised in 1979 to restrict the prices of 349 drugs on a cost-plus basis (DPCO 1978).

Phase IV (1991-2005): MNCs edged out Due to the competence gained by the domestic companies in process re-engineering, the Indian companies emerged as major players in the domestic market. New Drug Policy, 1994: Welcoming FDI; reduction in span of price control The New Drug Policy of 1994 and 2002 abolished the licensing requirement for entry Having established domestic and expansion of firms. Further, 100% inward foreign direct investment was allowed. manufacturing, the GoI invited Even as India had emerged as one of the cheapest producers of drugs, prices MNCs to invest in India through continue to be controlled on the basis of cost of production, but only for ‘essential FDI; the span of price control was drugs’. As per the NLEM (National List of Essential Medicines), 74 drugs were brought reduced under price control.

Phase V (2005 onwards): Balancing act on regulation/impetus now on innovation and self- sustenance Effects of Amendments to Patent Act, 1970: Reincarnation of product patents The 2005 amendment led to the re-introduction of 20-year product patents. Re-introduction of 20-year product Product patents make reverse engineering illegal. However, Section 84 (compulsory patents and implementation of licensing) and Section 3(d) (patentability criteria) safeguards public interest. compulsory license and In an unprecedented act in 2012, compulsory license was awarded for Nexavar patentability criteria (Bayer) to Natco Pharma. Whilst the innovator stands to lose out on profits, compulsory licensing helps in affordability and the generic companies still make profits, as they do not have to incur R&D costs. Further, Novartis was denied a patent, as the Indian courts felt that it failed the patentability criteria under Section 3(d).

National Pharmaceuticals Pricing Policy (2012): Higher span of price control (a) The scope of NPPP 2013 is much broader than 1995, which thus maintains Broader span of price control, affordability beyond products under NLEM (b) Market-based pricing instead of cost-based pricing, which protects industry interests This policy has expanded beyond NLEM (order passed in July 2014 on non-essential diabetic and cardio drugs). This order is now being contested in court.

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Foray into NCEs and NDDS: Large domestic companies have ramped up R&D Many of the large domestic pharma companies have evolved from being generic drug Large domestic companies focus manufacturers to consciously investing in R&D activities to produce novel molecules on NCEs and NDDS by ramping up (small and large) and drug delivery systems (targeted and passive). We believe this to R&D; example, Lipaglyn (Zydus) be the next leg of growth for the large domestic manufactures. Companies like Dr. Reddy’s, Zydus, Lupin and Glenmark have many products in the pipeline in various stages of development. In 2013, Zydus received an approval for its first NCE, anti- diabetic drug, Lipaglyn. Dr. Reddy’s markets biosimilars in India and EMs and Smaller Indian generic companies Glenmark has out-licensed many novel candidates under-development. However, are yet to invest in such initiatives the relatively smaller Indian generic companies are yet to invest in such initiatives.

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Exhibit 10: The ramp up in the number of pharma manufacturing units in India was driven by the introduction of process patents in 1970

(a) Industrial Licensing Policy, 1956 - Compulsory establishment of New Drug Policy, 1994 - production units by foreign companies 25,000 74 drugs based on NLEM, reducing span of (b) Setting up of PSU pharma companies control (a) Ammendment of Patent Act, 1970 - 20,000 (a) Pre- Moved from 5-year process patent to independence (a) Patent Act , 1970 - Introduction of process patent 20-year product patent (b) NPPP 2012 - 348 drugs included IPM dominated (b) FERA, 1973 - Compels MNCs to manufacture high tech drugs 15,000 by MNCs (c) NDP, 1979 - Restricts prices of 349 critical drugs under price control (b) WW II (c) Compulsory licensing, 2012 - GOI provided to award compulsory licence to ensure 10,000 opportunity to availability of drugs

Production Units Production domestic cos. 5,000

0 1952-53 1960-61 1969-70 1977-78 1979-80 1980-81 1982-83 1983-84 1984-85 1985-86 1989-90 2000-01 2012-13 2013-14 Pre 1947 Pre (a) Domestic cos hit as product patent (a) Domestic companies made reverse engineering illegal started reverse (b) Stringent price controls result in (a) Import of technology engineering products lower profitability (b) Breeding ground of (b) Affordability of Opportunity to price (c) Compulsory licensing hurt new-age entreprenuers critical medicines drugs at higher rates which are not under innovators and benefit generics cos NLEM (d) NCEs and NDDS provides the Key events Its Impact next leg of growth for domestic cos

Source: Ambit Capital research

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Challenges ahead for mid-sized pharma Organic consolidation despite increasing competition Intensifying competition in the domestic market is a threat to the existing market players. Attracted by the high RoCEs offered by the domestic branded formulations business, small domestic pharmaceutical companies have mushroomed. The number HHI suggests organic consolidation of companies earning more than `500mn from the domestic formulations market has increased from 108 in FY08 to 122 in FY14, as per AIOCD data. However, competition has not yet proven detrimental for incumbents and the domestic formulations market is experiencing organic consolidation.

Exhibit 11: Market share of top-10 companies has increased over FY07-14 Competition has not yet proven detrimental for incumbents Market share of top-10 companies 30% 23.4% 24.1% 22.2% 25% 21.0% 20% 17.7% 16.1% 14.5% 15%

10%

5%

0% Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14

Source: AIOCD data, Ambit Capital research We believe, other than the incumbents, a number of mid-sized companies have Other than the incumbents, a exhibited sustainable growth. We list below a number of challenges that are possibly number of companies have making life difficult for the smaller Indian players as compared to the incumbents. exhibited sustainable growth Attrition rate in marketing representatives (MRs) The industry has seen high attrition rates in past decade. Our primary data checks suggest that the industry average attrition amongst sales representatives is 30%. Due to the high attrition rates, the productivity of the sales force has grown at a mere 3% CAGR over FY05-14. Whilst productivity has remained low, salary increments at 10- 15% have been higher than inflation. This is due to the high attrition rate, as 15% of the workforce remains either on a notice period or is undergoing training. In such a scenario, for smaller companies to retain MRs and showcase good productivity is a challenge.

Exhibit 12: Sales force productivity in the industry has grown at 3% CAGR Whilst sales force productivity has recorded a CAGR of 3% Sales force productivity only, wage inflation has been 10-15% 6 CAGR 3% 5.01 4.46 4.58 4.59 5 4.01 4.02 4.46 4.21 4.09 4.18 4 3 2 1 - FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Source: Company, Ambit Capital research; * Note: Companies that we have aggregated for arriving at industry numbers are Glenmark, Sun Pharma, Torrent Pharma, IPCA, Cadila, Lupin, Dr. Reddy’s, Ranbaxy, Cipla and GSK

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Healthcare

Exhibit 13: Sales force productivity of the top companies, as Exhibit 14: Sales force productivity of bottom companies as per our framework per our framework (Decreasing to Stable) 10% 8.9% 3% 2.7% 8.2% Sales force productivity Sales force productivity 9% 2% 8% 6.8% 6.5% 1% 14 14 7% - - 6% 4.6% 0% 5% 3.7% 4% -1% -1.0% 3% -2% -1.5% 2% CAGR FY05 CAGR CAGR FY05 CAGR 1% -3% 0% -4% -3.1% Ipca GSK Cipla Lupin Cadila Torrent Ranbaxy Dr. Reddy Dr. Glenmark

Sun Pharma Sun Source: Company, Ambit Capital research Source: Company, Ambit Capital research Converging to unbranded generics In a democratic country like India, the fact that the Government is striving for populist ‘Jan aushadi’, the ‘SMS’ policies to ensure affordability for the poor is no surprise. The Government of India programme and mandating (GoI) has set up schemes like Jan aushadi stores, a government pharmacy chain, generic names suggest within government hospitals which provide medicines at subsidised rates. Further, the convergence to the unbranded GoI in association with certain agencies is working on an SMS programme where market the patient could ‘SMS’ a brand name prescribed by the doctor and in return the patient would receive a reply with the lowest-cost brands of the same drug available in the market. Moreover, there have been demands from the Medical Council of India to make it mandatory for doctors to prescribe the generic name of medicines instead of the brands. Increasing span of price regulations The GoI in its DPCO Order 2013 had expanded the scope of price controls and The increasing span of price extended it beyond the National List of Essential Medicines (NLEM) 2011. However, in regulations would continue to be a July 2014, the National Pharmaceutical Pricing Authority (NPPA), exercising its right threat to profitability of the Indian to fix ceiling prices for any drug it deems necessary, announced ceiling prices for 108 business non-scheduled formulations (50 molecules). Out of these 50 molecules, 33 are not a part of the National List of Medicines (NLEM) 2011. The increasing span of price regulations would continue to be a threat to the profitability of the Indian business. Whilst such price regulations are reasonably tolerated by the larger domestic players Price regulations could move the due to their wide and diversified product baskets, such events could move the needle needle for smaller participants for smaller participants. Regulatory hurdles to new introductions In order to curb malpractices and patient deaths during clinical trials, the Ministry of Stringent norms for clinical trials Health has put in place stringent reforms and increased scrutiny. Whilst the reforms and additional layer of are essential for curbing negligent professional behaviour, they are double-edged administration in new approvals is sword. The reforms have resulted in not only lower clinical trial approvals but slowing the pace of new also reduced the number of trials actually undertaken. At the same time, the introductions costs associated with these clinical trials have gone up substantially, as companies have to comply with stricter norms. Also, the approval process has been lengthened, with pharma companies required to take approval from the Drug Controller General of India (DGC (I)) committee. The documentation requirements are also more elaborate. These measures by the regulator have increased the time taken for new introductions Regulatory changes may affect and also increased the cost for companies to launch products. Whilst the larger firms smaller companies more can continue to feed on the cash generated by the large base business, such significantly regulatory changes may affect smaller companies more significantly.

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Analysing sustainability: Business DNA

Whilst the organic consolidation and challenges cited above are definite hurdles for Indian mid-caps to grow, smaller companies have exhibited resilient growth.

Exhibit 15: Domestic sales CAGR over FY07-14 reflects strong growth by smaller companies We suspect that the growth for some of the Indian mid-cap 30% pharma companies is more 24% 24% 25% sustainable than others w.r.t. 19% Indian formulations 20% 14% 15% 15% 13% 10% 11% 10% 7% 8% 6% 6% 4% 5% 5% 5% 0% FDC IPCA Claris Natco Cadila Ajanta Strides Biocon Indoco Torrent Alembic Ranbaxy Unichem Glenmark Wockhardt Source: AIOCD data, Ambit Capital Research However, we suspect that the growth for some of these companies is more sustainable than others. Various factors need to be assessed when judging the quality, sustainability and risks to reported sales growth for the Indian business.

Exhibit 16: Key levers to assess Business DNA Components Measures Weights Ability to select product segments which can grow higher than IPM (Molecule sales growth Product selection 20% > IPM sales growth)

Ability to outperform peer sales growth (Company sales growth in molecule > Drivers of Growth Sales execution 20% Molecule sales growth) (50% weightage)

Gauging higher brand equity (Higher base business growth). Lower weightage as brand Base business growth equity is a derivative of the many factors 10% including product selection and execution.

Smaller therapeutic presence indicates higher scope for product portfolio expansion (Lower Therapeutic coverage 10% current coverage of product portfolio)

Smaller geographical presence indicates higher scope for expansion (Lower current Newer Avenues for Geographical coverage 10% geographical reach of product portfolio) Growth

(25% weightage) Indicates push vs pull dynamics underlying the business (Higher sales per marketing representative). Lower weightage as sales Sales force productivity 5% productivity could be lower due to a fragmented target audience.

Broader brand base reduces event specific risk (Top-50 products’ contribution to total sales). Higher weightage as event specific risks in the Event specific risk past have been more detrimental for 15% Associated Risk to companies than regulatory risk (example Growth Losar franchise for Unichem) (25% weightage) Higher contribution from base business growth to overall growth mitigates impact of Regulatory risk 10% regulatory risk (Contribution of base business growth to total growth) Source: Ambit Capital research

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Exhibit 17: Business DNA decides which path the company takes

Newer avenues

Drivers

Associated risk Sales growth Sales

Time Drivers Scope Risk

Source: Ambit Capital research Is Indian mid-cap pharma investible?

Whilst we do see challenges for the domestic players, we believe that the Indian The domestic market remains a domestic market remains a lucrative opportunity for participants of all sizes and age lucrative opportunity for due to its scope and structure. The market is experiencing secular growth driven by participants of all sizes and age better affordability, higher diagnosis, rising insurance penetration and more awareness. Whilst the branded nature of the market provides an opportunity to build brand equity, the competition makes it a non-auto pilot business. Only those participants that exhibit execution through constant rigour are likely to benefit in the long run. We also need to appreciate that the GoI has always been providing an impetus to the domestic players through various regulations. Be it Industrial Licensing in 1956 or key regulations in 1970-1990, the Government continues to push the domestic companies towards uncharted territories. The recent examples of regulations providing direction are price regulations (2013- 2014) and product patents (2005). Whilst the Government is curbing the prices of plain-vanilla products, it is also providing opportunities for domestic companies to increase R&D spend and innovate. Given these market dynamics we advise investors to be selective and invest in Investors need to be selective and companies which have the ability to sustain growth momentum. invest in sustainable growth

Which companies were selected and why?

For the purpose of this exercise we select companies based on three categories:

. Market capitalisation of more than `10bn – to ensure that the opportunity has an investible size and enough liquidity.

. Sizeable domestic business (>10% of total EBITDA) – we retain our thesis that smaller companies will find it difficult to sustain growth momentum in regulated markets like Europe and the US.

. Exclude MNCs i.e. companies having origin outside India and have set up subsidiaries in India to run Indian operations – MNC subsidiaries are prone to lack of management access and multiple sister concerns in India which are unlisted but engaged in the same business. Based on the above filters, we analyse 19 companies ranging from large capitalisation names like Sun Pharma, Lupin and Dr. Reddy’s to medium market capitalisation names like Claris Life Sciences, Unichem Labs and Indoco Remedies. Note that 14 out of the selected 19 companies fall under the top-40 in the Indian pharma market (by sales in FY14).

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I. Drivers of growth We believe that the key for domestic companies to maintain their growth trajectory is to have strong product portfolios and have the ability to execute sales in a manner where they are able to create a strong brand which is sustainable over time and resilient in the face of incremental competition. Product selection: Ability to select therapeutic segments which can grow higher than the IPM We believe a key driver of growth for companies is the ability to select therapeutic segments which can provide impetus to growth which would be higher than the growth of the Indian Pharmaceutical Market (IPM).

We evaluate this parameter by assessing the presence of companies in different Ability to select therapeutic therapeutic segments and comparing the YoY growth of therapeutic segments, in segments can provide impetus to which the companies are present, with the growth of IPM over FY09-14. growth

Exhibit 18: Growth of therapeutic segments (in which companies are present) as compared to IPM growth on a YoY basis Growth YoY (%) FY09 FY10 FY11 FY12 FY13 FY14 Rank Ajanta 16.9% 14.9% 21.8% 15.4% 14.6% 7.8% 1 Biocon 19.8% 16.8% 31.7% 21.2% 13.8% 6.9% 1 Glenmark 16.3% 15.2% 20.0% 16.2% 11.8% 6.2% 3 Unichem 16.3% 14.5% 17.9% 15.4% 12.5% 4.7% 3 Torrent 18.9% 17.5% 17.7% 16.6% 11.6% 5.2% 5 Sun Pharma 17.9% 15.3% 18.9% 15.2% 11.7% 5.7% 6 Lupin 16.5% 14.0% 18.9% 15.1% 11.4% 5.2% 6 IPCA 18.2% 16.5% 16.1% 14.7% 10.9% 5.1% 6 Indoco 18.4% 15.8% 18.9% 14.9% 11.1% 3.4% 6 Strides 18.1% 15.1% 19.6% 14.9% 11.7% 4.7% 6 FDC 19.5% 16.1% 14.1% 15.3% 10.6% 4.0% 6 Ranbaxy 16.3% 14.3% 18.4% 14.9% 10.9% 4.8% 6 Cadila 15.4% 13.5% 16.9% 15.0% 11.4% 4.9% 13 Dr. Reddy 19.3% 16.2% 15.0% 15.2% 11.6% 4.6% 13 Wockhardt 15.7% 13.6% 16.4% 13.8% 10.0% 3.5% 13 Cipla 14.8% 13.5% 15.3% 13.5% 10.5% 4.2% 16 Alembic 16.6% 12.9% 15.0% 13.9% 10.0% 3.7% 16 Natco 8.8% 9.2% 10.8% 9.7% 6.8% 0.1% 18 Claris 12.7% 8.4% 10.4% 12.8% 6.4% 1.5% 18 IPM 14.8% 13.6% 15.3% 15.3% 11.7% 6.2%

Source: AIOCD, Ambit Capital research

Based on the above data, Ajanta and Biocon have displayed superior capability to Ajanta and Biocon have displayed select the therapeutic segments which can deliver above-market sales growth over superior capability to select FY09-14. At the same time, Natco and Claris have consistently had poor therapeutic therapeutic segments selection and are ranked the lowest amongst their peers. However, note that secondary sales data does not capture hospital sales, which are the bread and butter for both Natco and Claris. To that extent our analysis is distorted for these two companies. Sales execution: Ability to outperform peer sales growth Whilst product selection is a key determinant for future growth, however accurate Product selection is a futile exercise product selection may be, it is a futile exercise unless the company is able to unless the company is able to capitalise on it and report superior sales performance. Therefore, we analyse capitalize on it companies with the yardstick of sales execution. The ability to execute sales efficiently and report growth better than the therapeutic segment growth is the parameter that we have used to assess the companies.

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Exhibit 19: Domestic sales growth as compared to the respective therapeutic segment growth Growth YoY (%) FY09 FY10 FY11 FY12 FY13 FY14 Rank Sun Pharma 26.5% 22.2% 23.2% 24.2% 20.4% 16.2% 1 Therapeutic segment growth 17.9% 15.3% 18.9% 15.2% 11.7% 5.7%

Lupin 24.3% 18.3% 28.1% 17.3% 14.0% 12.3% 1 Therapeutic segment growth 16.5% 14.0% 18.9% 15.1% 11.4% 5.2%

Glenmark 20.3% 16.7% 16.3% 23.0% 19.6% 16.1% 3 Therapeutic segment growth 16.3% 15.2% 20.0% 16.2% 11.8% 6.2%

IPCA 31.2% 26.6% 13.9% 18.6% 15.0% 18.7% 3 Therapeutic segment growth 18.2% 16.5% 16.1% 14.7% 10.9% 5.1%

Ajanta 7.4% 18.6% 21.4% 27.8% 21.7% 28.8% 5 Therapeutic segment growth 16.9% 14.9% 21.8% 15.4% 14.6% 7.8%

Indoco 26.5% 16.1% 22.1% 11.6% 9.3% 4.3% 5 Therapeutic segment growth 18.4% 15.8% 18.9% 14.9% 11.1% 3.4%

Cadila 8.7% 14.1% 2.2% 15.2% 20.0% 8.4% 5 Therapeutic segment growth 15.4% 13.5% 16.9% 15.0% 11.4% 4.9%

Biocon 17.2% 42.0% -11.5% 66.3% 9.9% 39.8% 8 Therapeutic segment growth 19.8% 16.8% 31.7% 21.2% 13.8% 6.9%

Cipla 15.3% 14.9% 5.3% 13.3% 8.3% 9.1% 8 Therapeutic segment growth 14.8% 13.5% 15.3% 13.5% 10.5% 4.2%

Alembic 6.1% 21.5% 4.1% 16.9% 7.6% 10.5% 8 Therapeutic segment growth 16.6% 12.9% 15.0% 13.9% 10.0% 3.7%

Natco -9.8% 80.5% 5.7% 51.2% 16.6% -34.8% 8 Therapeutic segment growth 8.8% 9.2% 10.8% 9.7% 6.8% 0.1%

Unichem 21.0% 9.1% 9.2% 2.7% 7.9% 6.9% 12 Therapeutic segment growth 16.3% 14.5% 17.9% 15.4% 12.5% 4.7%

Torrent 16.0% 13.4% 9.5% 9.9% 16.1% 14.6% 12 Therapeutic segment growth 18.9% 17.5% 17.7% 16.6% 11.6% 5.2%

Strides 118.6% -15.8% 19.6% -11.8% -7.8% -14.6% 12 Therapeutic segment growth 18.1% 15.1% 19.6% 14.9% 11.7% 4.7%

Claris -18.0% 68.2% -19.9% 117.9% 3.0% -24.4% 12 Therapeutic segment growth 12.7% 8.4% 10.4% 12.8% 6.4% 1.5%

Wockhardt 3.5% 3.9% 19.2% 12.3% 5.1% 0.5% 16 Therapeutic segment growth 15.7% 13.6% 16.4% 13.8% 10.0% 3.5%

FDC 10.1% 10.2% -10.7% 4.0% 5.0% 2.9% 17 Therapeutic segment growth 19.5% 16.1% 14.1% 15.3% 10.6% 4.0%

Ranbaxy 0.6% 4.7% -6.3% 12.5% 6.1% -1.0% 17 Therapeutic segment growth 16.3% 14.3% 18.4% 14.9% 10.9% 4.8%

Dr. Reddy 5.7% 13.1% 3.0% 8.6% 10.4% 4.6% 17 Therapeutic segment growth 19.3% 16.2% 15.0% 15.2% 11.6% 4.6%

Source: AIOCD, Ambit Capital research

The above table clearly reflects the importance of having efficient execution Amongst the midcaps, IPCA, capabilities over and above the product selection expertise. Sun Pharma and Lupin, Ajanta, Indoco and Cadila have which ranked lower on the product selection scale, have displayed superior execution executed better than their peers capabilities by growing higher than their respective therapeutic segment growth on a consistent basis. Dr. Reddy’s and Ranbaxy despite having fairly reasonable product portfolios have not been able to capitalise and implement superior execution skills and thus they rank the lowest in the sales execution criteria. Amongst the midcaps, IPCA, Ajanta, Indoco and Cadila have executed better than their peers.

Base business growth: Gauging higher brand equity In the above two sections we discussed the necessity of smart product selection and The ability to establish brands sharp sales execution. The third criteria we look at to maintain the current drivers of successfully and create brand growth is the ability to establish brands successfully and create brand equity for the equity for the product portfolio product portfolio. Brand equity is critical to create consumer perception not just for determines longevity of growth one product but leveraging brand equity of one product to the entire portfolio.

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To determine brand equity, we analyse the base business revenue CAGR over FY09- 14. Companies delivering consistent base business growth at higher levels are considered to have stronger brand equity. We define the base business as all the products launched two years prior to the year in question. For example, in FY11, the base business would include all the products launched in the FY minus 2 year i.e. FY09.

Exhibit 20: High base business CAGR over FY09-14 portrays brand equity 30 25 26.6 20 22.7 15 20.5 18.1 16.8 10 18.2 11.2 17.4 17.3 12.4 10.0 5 11.9 10.9 7.5 6.8 6.4 3.2 1.7 0 -5 -10 -6.5 FDC IPCA Cipla Lupin Claris Natco Ajanta Cadila Biocon Indoco Strides Torrent Alembic Ranbaxy Unichem Dr. Reddy Dr. Glenmark Wockhardt Sun Pharma Sun Source: AIOCD, Ambit Capital research Amongst midcaps, Biocon, Ajanta and Claris have developed strong brand equity for Amongst mid-caps, Biocon, Ajanta their portfolio products by growing the domestic base business by a CAGR of 26.6% and Claris have developed strong over FY09-14. Strides has reported negative CAGR over the same period, displaying brand equity a lower ability to position itself as a strong brand and capitalise on the products launched. Overall, Ajanta, Glenmark, Biocon, IPCA and Indoco have better quality of growth than their peers Aside from the usual suspects like Sun Pharma and Lupin, amongst the mid-caps, Ajanta, Glenmark, Biocon, IPCA and Indoco have exhibited a better quality of growth and are more likely to sustain growth in the face of the aforementioned challenges.

Exhibit 21: Ajanta has the best ‘drivers of growth’ placed in its business Ajanta, Glenmark, Biocon, IPCA Product Sales Base business Overall Company / Score and Indoco have better quality of selection execution growth Rank growth Weights 40% 40% 20% 100% Ajanta 1 5 2 1 Glenmark 3 3 7 2 Biocon 1 8 1 3 Sun Pharma 6 1 3 4 Lupin 6 1 8 5 IPCA 6 3 5 6 Indoco 6 5 10 7 Torrent 5 12 9 8 Unichem 3 12 15 9 Cadila 13 5 12 10 Natco 18 8 6 11 Alembic 16 8 11 12 Cipla 16 8 13 13 Claris 18 12 4 14 Strides 6 12 19 15 Wockhardt 13 16 16 16 Ranbaxy 6 17 17 17 FDC 6 17 18 18 Dr. Reddy 13 17 14 19 Source: Ambit Capital research; Note: We derive the weighted average overall rank by scoring each company (with a maximum score of 20) on the basis of the individual rank. For example, rank 1 in the individual rank would score 20 and rank 19 would score 1.

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II. Newer avenues for growth In this section, we assess the ability of companies to foster newer avenues of growth. We analyse the companies based on three factors:

. Therapeutic coverage - Smaller therapeutic presence indicates higher scope for product portfolio expansion (Lower current coverage of product portfolio)

. Geographic coverage - Smaller geographical presence indicates higher scope for expansion (Lower current geographical reach of product portfolio)

. Sales force productivity - Indicates push vs pull dynamics underlying the business (Higher sales per sales representative)

Therapeutic coverage: Smaller therapeutic presence indicates higher scope for product portfolio expansion Most of the companies analysed have a presence in limited therapeutic segments and Expanding the therapeutic segment have followed a focussed approach to capitalise on these segments. We believe an presence may help in cultivating absence in some therapeutic segments presents an opportunity for companies to new avenues for sales growth expand scope and bring about new avenues for sales growth. We do agree that a foray into new therapeutic segments requires significant investment and capabilities and is more a medium- to long-term growth story rather than a short-term phenomenon. Therapeutic coverage is defined as the sales of therapeutic segments in which the company is present as a percentage of total IPM sales. Lower coverage provides an opportunity to the company to expand its product portfolio into non-covered therapeutic segments.

Exhibit 22: Low therapeutic coverage provides an opportunity to expand scope (% of market covered)

80 67.5

70 67.8 64.9 60 63.4 53.6 48.5 49.4 48.1

50 46.1 42.9 40 39.6 35.0 36.1 34.8

30 29.0 21.3 20 18.9 14.1

10 8.5 0 FDC IPCA Cipla Lupin Claris Natco Ajanta Cadila Biocon Strides Indoco Torrent Alembic Ranbaxy Unichem Dr. Reddy Dr. Glenmark Wockhardt

Sun Pharma Sun Source: AIOCD, Ambit Capital research Claris Life Sciences, Natco, Ajanta and Biocon have the lowest coverage in the Claris, Natco, Ajanta and Biocon universe, and thus they have an opportunity to grow sales by foraying into uncharted have the lowest therapy presence therapeutic segments. This provides inorganic growth for the company, keeping the and hence the largest opportunity current business constant. On the other hand, Cipla and Cadila have the highest therapeutic coverage. They have a presence in most therapies, thus implying less scope for inorganic expansion of sales. Geographic coverage: Smaller geographical presence indicates higher scope Expansion of geographic presence for expansion also represents opportunity for Apart from growth in therapeutic segments, another avenue for companies to grow is sales growth to expand their geographic coverage to regions in India which have not been tapped. For example, Strides has a focus in the southern states of India. Through its acquisition of the branded generic business of Bafna Pharmaceuticals, Strides can

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Healthcare now expand its geographical coverage to the northern states, where Bafna has strong infrastructure and sales execution capabilities through its distributor channels.

As per AIOCD data, sales are divided into 24 regions. We assess geographical We assess geographical coverage coverage by analysing the concentration of sales in different regions. Higher sales by analysing concentration of sales from the top-10 regions signify geographic concentration. in different regions

Exhibit 23: Geographic concentration of sales (as a percentage of total sales) is the least for Strides

100 3 19 24 25 26 80 24 26 30 32 32 33 33 33 35 36 37 38 39 41 43

60 27 76 71 43 47 42 41 35 33 41 41 39 40 40 36 36 40 40 55 37 35 20 32 32 31 31 29 28 28 27 27 27 27 27 22 22 0 22 22 FDC IPCA Cipla Lupin Claris Natco Cadila Ajanta Biocon Strides Indoco Torrent Alembic Ranbaxy Unichem Dr. Reddy Dr. Glenmark Wockhardt Top 4 regions 4th to 10th region Pharma Sun 11th to 24th region

Source: AIOCD data, Ambit Capital research Strides ranks the highest, as it has a high concentration in southern India. However, with the acquisition of Bafna’s branded generic business, it now will be able to increase its presence in other regions and provide impetus to its sales.

Other mid-caps which could tap similar opportunities are Natco, Claris, FDC, Indoco Strides, Natco and Claris have high and Biocon. geographic concentration Cadila and Alembic, on the other hand, have a diversified presence across India and the scope for increasing the footprint to new regions is limited, and thus they have a lower ability to increase sales through geographic expansion. Sales force productivity: Indicates push vs pull dynamics underlying the business The capabilities of the sales force are crucial to broaden scope for higher sales growth. As we had mentioned earlier, the industry faces a challenge in retaining its sales force due to the high attrition rate of Marketing Representatives (MRs).

MR productivity helps understand whether the company follows a push model of sales Efficient MR productivity signifies or a pull model. Efficient MR productivity signifies constructive efforts by the sales higher prescription share and force to establish the brand in front of the doctor and get a higher prescription share brand loyalty (pull mechanism). Low productivity indicates a push mechanism where the prescription may be largely driven by the frequency of doctor calls without really capturing a significant mind share. We evaluate companies based on sales per marketing representative. Higher sales per MR represent better MR quality and focus on a pull model as compared to lower Companies with general physicians sales per MR which represents more focus on a push sales model. We accept that this as their primary audience are likely matrix has an inherent lacuna under which it does not reward companies which to see low productivity follow a pull model but experience lower productivity purely due to the higher number of doctors that the MR has to address. Such issues are largely noticed with companies which rely on general physicians for prescriptions as compared to say a Sun Pharma which relies on a lower number of doctors due to its presence in specialty segments. Hence, we assign lower weightage to sales force productivity in our overall framework but we believe that better sales per MR provides the requisite understanding of companies’ ability to capitalise their sales force through better training and efficient reward systems.

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Exhibit 24: Sun Pharma has excellent sales reps productivity

10 9.3 FDC and Biocon also rank amongst 7.6 8 Revenue per sales reps per annum (FY14), ` mn the top-5, performing much better 6.6 6.4 than their other mid-cap peers 5.6 5.3 6 5.0 5.0 4.7 4.1 4.0 3.8 4 3.1 2.9 2.7 2.4 2.4 1.8 1.5 2

0 Sun… FDC IPCA Cipla Lupin Claris Natco Ajanta Cadila Biocon Strides Indoco Torrent Alembic Ranbaxy Unichem Dr. Reddy Dr. Glenmark Wockhardt Source: AIOCD data, Company, Ambit Capital research Whilst Sun Pharma gets an expected pole position, FDC and Biocon also rank amongst the top-5, performing much better than other mid-cap peers. IPCA, Indoco and Ajanta rank the lowest presumably due to their general physician exposure, as discussed above. Overall, Claris, Natco, FDC, Biocon and Indoco have higher scope of growth than mid-cap peers Smaller companies have the maximum opportunity to grow. Claris, Natco and FDC have the maximum scope to increase their product and geographical coverage. Whilst FDC has an efficient sales force, Claris and Natco can leverage their sales force through newer product introductions.

Exhibit 25: Claris has the maximum scope to grow Therapeutic Geographical Sales force Company / Score Overall Rank coverage coverage productivity Weights 40% 40% 20% 100% Claris 1 3 11 1 Natco 2 2 12 2 FDC 6 4 2 3 Biocon 4 6 3 4 Strides 5 1 14 5 Indoco 8 5 18 6 Sun Pharma 10 12 1 7 Ajanta 3 11 19 8 Glenmark 12 9 7 9 Ranbaxy 16 7 6 10 Dr. Reddy 9 14 10 11 Torrent 11 10 15 12 IPCA 7 13 17 12 Cipla 19 8 8 14 Wockhardt 15 15 5 15 Unichem 13 16 13 16 Cadila 18 19 4 17 Alembic 14 17 16 17 Lupin 17 18 9 19 Source: Ambit Capital research; Note: We derive the weighted average overall rank by scoring each company (with a maximum score of 20) on the basis of the individual rank. For example, rank 1 in the individual rank would score 20 and rank 19 would score 1.

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III. Associated risks to growth We have addressed the avenues and scope of growth above, but it is also meaningful to assess the risk facing the domestic sales of the companies and the ability and preparedness of these companies to mitigate this risk.

To evaluate the risk attached to the domestic business, we analyse companies under Whilst some risk is inherent to the two categories: (a) Event-specific risk and (b) Regulatory risk business, our motive is to identify Event-specific risk: Broader brand base reduces event-specific risk the companies which are more vulnerable than their peers The domestic market faces several event-specific risks such as price regulation, adverse events reported and therapeutic substitution. The resultant price cuts, decline in market size and decline in volumes pose a serious risk to the companies, as their margins are likely to shrink. We believe companies which have a broader product portfolio are less susceptible to event-specific risk. To assess the event-specific risk, we evaluate companies based on their brand concentration. Companies with higher brand concentration are at risk in terms of their revenue. Therefore, on a relative basis, companies deriving a higher percentage of sales from the top-50 products rank lower in the population.

Exhibit 26: Sun Pharma ranks first, with a diversified product portfolio; Natco is at risk

100

80

60

40

20

0 FDC IPCA Cipla Lupin Claris Natco Cadila Ajanta Biocon Strides Indoco Torrent Alembic Ranbaxy Unichem Dr. Reddy Dr. Glenmark Top 10 brands Top 11-25 brands Top 26-50 50Wockhardt and above Sun Pharma Sun Source: AIOCD data, Ambit Capital research From the exhibit above, we infer that Sun Pharma has excellent product Barring the larger caps, IPCA, diversification and faces the least event-specific risk. It derives 51% of its sales from Ajanta and FDC show considerable the top-50 products. On the contrary, Strides, Claris and Natco derive almost 100% diversification of product portfolios of their sales from the top-50 products, thus posing event-specific risk to their revenue. The analysis represents an obvious bias towards larger companies. But, we assert that larger companies indeed are less prone to needle-swinging events as compared to the smaller ones and hence are relatively safe from event-specific events. Regulatory risk: Higher contribution from base business growth to overall growth mitigates regulatory risk Whilst lower brand concentration helps reduce event-specific risk, the industry continues to faces regulatory issues which cannot be mitigated. However, through efficient product positioning coupled with strong brand recognition, companies can minimise the impact of regulatory risk.

For example, as discussed above, the industry currently faces a challenge in new Low number of new approvals product introductions due to stricter regulations and increase in the cost of clinical might dent the growth for trials. The changes in regulations have resulted in lower approvals by the regulator companies that rely heavily on new and also lower new product filings by companies. This could dent new product products for growth introductions and thereby companies run the risk of lower sales growth. However, this risk can be mitigated if companies have strong base business growth.

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Therefore, we evaluate companies on the basis of their ability to derive and sustain/grow revenue from the base business. We assess the contribution of base business growth to the total revenue growth for the company. Higher contribution from the base business implies that despite challenges arising out of regulatory risk (such as lower new product introductions), companies are able to sustain the current growth in revenue through the base business.

Exhibit 27: Strides has the highest contribution, whereas Cadila earns most of its Strides, Claris and Indoco have the revenues from new product introductions highest contribution from the base business in terms of growth 120 Base business contribution to total growth, Avg FY09-14 100 80 97.7 97.7

60 92.1 78.3 78.3 77.5 77.5 76.2 76.2 75.8 74.6 74.6 73.8 73.8 73.3 73.3

40 68.7 66.8 66.8 66.5 66.5 64.4 64.4 62.9 62.9 61.5 61.5 59.4 59.4 56.3 56.3 20 55.8 47.4 47.4 0 FDC IPCA Cipla Lupin Claris Natco Ajanta Cadila Strides Biocon Indoco Torrent Alembic Ranbaxy Unichem Dr. Reddy Dr. Glenmark Wockhardt

Sun Pharma Sun Source: AIOCD data, Ambit Capital research Amongst the mid-caps, Torrent, IPCA, Glenmark, Indoco and FDC have the lowest risk to growth than mid-cap peers Whilst larger companies score higher on risk mitigation, amongst Whilst larger companies score higher on risk mitigation, amongst mid-caps, Torrent, mid-caps, Torrent, IPCA, IPCA, Glenmark, Indoco and FDC have the lowest risk to growth. Glenmark, Indoco and FDC have the lowest risk to growth Exhibit 28: Cipla is the most efficient in risk mitigation Company / Score Regulatory risk Event-specific risk Overall Rank Weights 60% 40% 100% Cipla 3 5 1 Sun Pharma 1 9 2 Torrent 6 4 3 Lupin 2 13 4 IPCA 10 6 5 Ranbaxy 5 14 6 Glenmark 8 10 7 Indoco 14 3 8 FDC 12 7 9 Cadila 4 19 9 Strides 17 1 11 Dr. Reddy 7 17 12 Claris 18 2 13 Alembic 9 16 14 Biocon 16 8 15 Wockhardt 15 12 16 Unichem 13 15 16 Ajanta 11 18 18 Natco 19 11 19 Source: Ambit Capital research; Note: We derive the weighted average overall rank by scoring each company (with a maximum score of 20) on the basis of the individual rank. For example, rank 1 in the individual rank would score 20 and rank 19 would score 1

September 16, 2014 Ambit Capital Pvt. Ltd. Page 25

Healthcare

Companies best placed in domestic formulations are… In the above sections, we evaluated the competencies of companies on each of the Business DNA components. In this section we try to view the complete picture and assess the overall capabilities of companies.

Exhibit 29: Overall ranking as per our DNA framework Business DNA Drivers of growth Newer avenues for growth Associated risk to growth Base Product Sales Therapeutic Geographical Sales force Regulatory Event specific Overall Rank Rank business selection execution coverage coverage productivity risk risk growth Weights 20% 20% 10% 10% 10% 5% 15% 10% 100% Sun Pharma 6 1 3 10 12 1 1 9 1 Glenmark 3 3 7 12 9 7 8 10 2 Biocon 1 8 1 4 6 3 16 8 3 Ajanta 1 5 2 3 11 19 11 18 4 IPCA 6 3 5 7 13 17 10 6 5 Torrent 5 12 9 11 10 15 6 4 6 Lupin 6 1 8 17 18 9 2 13 7 Indoco 6 5 10 8 5 18 14 3 8 Cipla 16 8 13 19 8 8 3 5 9 Claris 18 12 4 1 3 11 18 2 10 Strides 6 12 19 5 1 14 17 1 11 Natco 18 8 6 2 2 12 19 11 12 FDC 6 17 18 6 4 2 12 7 13 Cadila 13 5 12 18 19 4 4 19 14 Unichem 3 12 15 13 16 13 13 15 15 Ranbaxy 6 17 17 16 7 6 5 14 16 Alembic 16 8 11 14 17 16 9 16 17 Dr. Reddy 13 17 14 9 14 10 7 17 18 Wockhardt 13 16 16 15 15 5 15 12 19 Source: Ambit Capital research; Note: We derive the weighted average overall rank by scoring each company (with a maximum score of 20) on the basis of the individual rank. For example, rank 1 in the individual rank would score 20 and rank 19 would score 1. Whilst Sun Pharma and Lupin unsurprisingly feature amongst the top-10 companies on our framework, amongst mid-caps, we highlight Glenmark, Biocon, Ajanta, IPCA, Glenmark, Biocon, Ajanta, IPCA, Torrent and Indoco as companies that are better placed than their peers in terms of Torrent and Indoco are better business DNA and hence sustainability of growth. placed than other mid-caps Glenmark: Whilst the company ranks low on therapeutic coverage (high number of segments already covered by product portfolio) and event specific risk (moderate diversification beyond top 25 brands), it scores high on product selection (high presence in fast growing therapy areas) and sales execution (company’s revenue growth higher than therapeutic areas present in). Overall Glenmark secures the 2nd rank on our DNA framework. Biocon: Biocon has exhibited best-in-class product selection and brand equity (base business growth). The company also boasts of low therapeutic and geographic coverage (implying high scope for growth) and high sales force productivity (concentrated audience and large basket of products offered to target audience). However, Biocon’s business entails higher than average regulatory risk. Overall, Biocon scores the 3rd position on our DNA framework. Ajanta: Ajanta has exhibited best-in-class product selection and brand equity (base business growth). The company also boasts of low therapeutic and geographic coverage (implying high scope for growth). However, low sales force productivity (fragmented audience and small basket of products offered to target audience) and higher regulatory and event specific risk drag the company’s overall rank. Overall, Ajanta scores the 4th position on our DNA framework.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 26

Healthcare

IPCA: IPCA ranks high on product selection, sales execution, base business growth, therapeutic coverage and event specific risk. The company’s presence in few niche segments like malaria, pain and dermatology has driven past performance. However, low sale force productivity (target audience of consulting and general physicians is highly fragmented and low number of products offered) and high regulatory risk exposure are challenges. Overall, the company secures the 6th position on our DNA framework. Torrent: Torrent’s business has exhibited best-in-class risk management (low event specific and regulatory risks) and product selection (high chronic therapy exposure). However, the company has been plagued by patchy sales execution (changes in business heads) and limited scope for growth (high therapy and geography coverage and low sales force productivity). Overall, Torrent scores the 7th position on our framework. Indoco: Indoco ranks high on product selection, sales execution, low event specific risk and low geographical coverage. However, low base business growth, sales force productivity and high regulatory risk exposure drag the overall competitive positioning to 9th amongst the 19 companies analysed.

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Healthcare

Valuations not in sync with DNA

Indian pharma valuations are still reasonable in global context, but… In our ‘Hunting for sustainability’ report dated 5 May 2014, we had highlighted that the Indian pharma valuations were lower than the historical premiums that they have commanded over international pharma (represented by the BWPHRM Index) and international generic pharma (represented by the BIGNRCGP Index) despite visibility of higher growth and RoCE and no deterioration in competitive advantage. The valuations of Indian pharma companies have reverted closer to the longer-term average since. We believe that the reversion has been a product of better visibility of commitment of Indian pharma companies to longer-term growth drivers like NCEs, NDDS based products, biosimilars and complex products like vaccines, inhalers, and insulin. However, the mix of reversion in valuation has been slightly different than what we had envisaged.

Exhibit 30: BSETHC’s P/E premium has reverted to its 10- Exhibit 31: BSETHC’s P/E premium has reverted to 30% vis- year average vis-a-vis the BWPHRM Index a-vis the BIGNRCGP Index

100% BSETHC premium to BWPHRM Average 70% BSETHC premium to BIGNRCGP Average 60% 80% 50% 60% 40% 30% 40% 20% 10% 20% 0% 0% -10% -20% -20% -30%

Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Source: Bloomberg, Ambit Capital research Source: Bloomberg, Ambit Capital research

We illustrate below that the valuations for Indian pharma companies which are expected to derive a larger proportion of growth from the US have re-rated more than the valuations for those which derive a higher proportion of growth from EMs. We believe that the prevailing market wisdom favours companies headed West (towards the US), as: (a) the US market offers a low gestation period and (b) the US market also offers higher RoCEs and margins on similar products sold in other markets.

We question the prevailing wisdom of investing in companies headed to US

Whilst we agree that the US market offers better realisations/higher margins and The ability of mid-sized Indian higher RoCEs (after gaining scale) in the near term, we argue that the effort required companies to establish themselves for a mid-sized Indian company to establish itself in the US cannot be taken for in the US cannot be taken for granted. We believe companies like IPCA (offering cost advantage due to vertical granted integration) and Natco and Indoco (entering with niche products with manufacturing complexity) have better chances of scaling up in the US than others, which are just entering with ‘me-too’ products and/or leveraging upon the currently prevailing shortages. The consolidation on the buy and supply side in the US is also likely to make life difficult for the marginal players in the absence of a compelling proposition. However, the street has given the benefit of doubt to these players, as is reflected in the stock performance of the US-bound mid-sized companies.

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Healthcare

Exhibit 32: US-bound mid-cap pharma's valuation gap with large-cap pharma has narrowed substantially (one-year forward EV/EBITDA)

18.0

16.0

14.0

12.0

10.0

8.0

6.0 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Large size pharma US bound mid size pharma EM bound mid size pharma Source: Company, Bloomberg, Ambit Capital research; Note: Large caps include Sun Pharma, Lupin, Dr. Reddy’s and Cipla; US-bound mid-size include Wockhardt, IPCA, Strides, Ranbaxy, Cadila, Alembic, Natco, and Indoco; and EM-bound midsize include Torrent, Glenmark, Biocon, Claris, FDC, Unichem and Ajanta We suggest using the domestic business DNA as a proxy for success in export markets for mid-caps

For the mid-sized pharma companies, the fate of the export market remains unclear. Most mid-caps are too small in Most mid-caps are too small in the export markets and hence they could largely be export markets and hence could growing on a small base vs a sustainable and profitable business model. The Indian largely be grow due to a small business growth is likely to fuel cash flows and RoCEs in the near term for these base companies and could be used as a proxy for judging the fate of branded export markets. Companies with a high score are available at reasonable valuations We believe companies, which score higher than average on our framework, offer higher RoCEs and are available at reasonable valuations, are the best bets.

Exhibit 33: Amongst the mid-caps, Ajanta, IPCA, Torrent and Glenmark appear better placed than peers 30

25

Ranbaxy Natco 20 Sun Pharma Cipla Cadila 15 Glenmark Torrent Lupin Alembic Indoco Dr. Reddy Strides Wockhardt Ajanta 10 FY16 EV/EBITDAFY16 IPCA FDC Biocon 5 Unichem Claris

- 0 5 10 15 20 25 30 35 40 45 50 ROCE (%)

Source: Company, Ambit Capital research. Note: (a) Bubble size indicates rank on DNA framework (larger the better). (b) – Large-cap companies (presence across markets), – EM-bound companies, – US-bound companies

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Healthcare

IPCA and Glenmark are already making investments in innovative avenues for growth whilst Torrent and Ajanta have not made any significant moves on this front. However, given that all these companies appear in the bottom right quadrant of the exhibit above and are all available at valuations of 10.0x-13.0x FY16E EV/EBITDA (as compared to an average of 12.5x), we believe there are upsides to these stocks.

Exhibit 34: Ajanta, IPCA, Torrent and Glenmark are the best bets among mid-caps Score on RoCE (%) EV/EBITDA MCap Business Market focus (FY14) (FY16) (US$ Mn) DNA Sun Pharma 37.5 19 18.2 29,381 Presence across markets Glenmark 20.8 18 12.9 3,483 EM-bound Biocon 12.7 17 10 1,655 EM-bound Ajanta 46.7 16 11.5 948 EM-bound IPCA 30.6 15 10.1 1,668 US-bound Torrent 30.4 14 10.8 2,417 EM-bound Lupin 26.3 13 12.4 9,973 Presence across markets Indoco 17 12 12.3 473 US-bound Cipla 18.9 11 15 7,611 Presence across markets Claris 17.8 10 3.5 159 EM-bound Strides 12.1 9 10.7 699 US-bound Natco 17.5 8 20.9 811 US-bound FDC 24.8 7 8.4 470 EM-bound Cadila 17.5 6 13.8 4,398 US-bound Unichem 20.8 5 7.7 349 EM-bound Ranbaxy 7.1 4 21.2 4,562 US-bound Alembic 37.7 3 13.7 1,254 US-bound Dr. Reddy 15.5 2 12.3 8,445 Presence across markets Wockhardt 26.6 1 11.9 1,532 US-bound Source: Company, Bloomberg, AIOCD data, Ambit Capital research Based on our analysis above, we highlight that Ajanta, IPCA, Torrent and Glenmark appear to be the best bets amongst the Indian mid-caps. Biocon and Indoco miss the cut due to depressed RoCEs.

Exhibit 35: Our key recommendations CMP Mcap P/E P/E EPS CAGR RoCE Comments Company Rating (`) (US$mn) (FY15E) (FY16E) (FY15E-17E) (FY14) We highlight that Sun Pharma’s acquisition of Ranbaxy is a Sun key positive; synergies are likely to be US$400mn-500m by BUY 806 29,381 32 25 21% 38% Pharmaceuticals Year 3 as opposed to the management guidance of US$250m. Lupin’s expertise in evolving profitably would keep the Lupin Ltd BUY 1,359 9,973 25 22 17% 26% company on the growth track as it moves up the pharma value chain. Higher visibility on longer-term growth drivers keep us Dr. Reddy's Labs BUY 2,959 8,445 22 20 19% 16% bullish on Dr. Reddy’s prospects in India/RoW and regulated markets. High investments in longer-term growth drivers, high Cadila Healthcare BUY 1,273 4,398 26 19 27% 17% presence in India and a large US ANDA pipeline are likely to fuel growth over the next 3-5 years. Whilst IPCA is facing near-term headwinds from regulatory issues with the FDA, we keep sight of the fact that the IPCA BUY 820 1,668 20 16 21% 31% company has a credible Indian and branded exports business with an inclination towards innovation. Lack of investments in longer-term growth drivers, past Aurobindo SELL 896 4,302 17 13 31% 24% legal issues with the promoter, and absence of moated revenue streams keep us cautious on Aurobindo. Source: Company, Ambit Capital research

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Healthcare

Suggest switching from Aurobindo (SELL) to Cadila (BUY)

We suggest switching from Aurobindo to Cadila despite Aurobindo trading at a 35% discount to Cadila (on one-year forward EV/EBITDA), due to:

. Management issues: Cadila faces some management issues like an ineffective acquisition track record in the recent past and multiple business interests. However, Aurobindo faces much severe issues like involvement of promoter in illegal issues, poor accounting practices leading to undisclosed income in the past, and less than ideal disclosure practices.

. Higher presence in branded markets: Cadila sources 59% of its revenues (FY14) from branded businesses (moated) and Aurobindo sources a negligible portion of its revenues from branded business. Branded businesses lend the opportunity to build brand equity and product differentiation. These levers provide ‘moats’ to revenues and profits and in turn offer opportunity to scale up. Lack of branded businesses makes us cautious on Aurobindo medium term growth prospects and profitability.

. Absence of incumbents from US product segments: Cadila sources a negligible portion of revenues from those product segments in US where incumbents are temporarily off-market due to FDA issues. Similarly, Cadila’s pipeline in the US is targeted towards more complex products (transdermals, inhalers, oncology, etc). However, Aurobindo sources a significant portion of revenues from cephalosporins and general injectables, whilst a significant portion of its pipeline is targeted towards general injectables, penems and controlled substances. All these segments have large players like Teva, Hospira, and Ranbaxy which are currently off-market due to FDA issues. Whilst the absence of the incumbents does present a near-term opportunity to gain market share, we believe when the incumbents eventually return, Aurobindo is likely to face market share and price erosion.

. Long term investments / R&D spend: Despite similar market capitalisations, Cadila’s R&D spend is almost 2x of Aurobindo’s. Lack of investments in longer term growth drivers such as NCEs, NDDS and biosimilars are likely to hurt Aurobindo’s long-term growth prospects.

. Regional mismatch in revenue and costs: Cadila sources 44% of FY14 revenues from India. Hence, the company’s income statement is hedged against higher cost inflation in India. However, Aurobindo has 53% of operating costs in India with no commensurate revenue. This exposes Aurobindo to cost inflation in India which may not be passed on to consumers in developed markets.

. Aurobindo deserves a deep discount: Our DCF-based target prices suggest a 50% discount to Cadila and other large-cap peers. The stock currently trades at a 35% discount. We expect Cadila to maintain a 10-15% discount to its large-cap peers. Our TP for Aurobindo implies an 8% downside from current levels and that for Cadila implies a 17% upside.

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Healthcare

Exhibit 36: Aurobindo’s discount to Cadila’s 1 year forward Exhibit 37: Revenue growth contribution for Cadila is EV/EBITDA has narrowed higher from stable branded business as compared to Aurobindo

40% EV/EBITDA premium/discount % 300 120% Cadila Mcap, RHS Contribution to total revenue growth 20% Aurobindo Mcap, RHS 250 100% API, 2.4% 0% 200 API, 24.1% 80% Branded, -20% 150 48.2% 60% `. Bn `. -40% 100 40% Unbranded , 75.9% -60% 50 Unbranded 20% , 49.4% -80% 0 0% Cadila Aurobindo

Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: Company, Ambit Capital research Source: Company, Ambit Capital research; Note: Unbranded includes US, Europe, ARV, and RoW (For Aurobindo). Branded includes India formulations, RoW (For Cadila) and Consumer business (For Cadila)

Exhibit 38: Aurobindo’s EBITDA and RoCE have recently Exhibit 39: R&D spend of Cadila is almost double that of overtaken Cadila’s given Cymbalta launch in US and lack Aurobindo of traction for Cadila

40% 5000 4,669 Cadila Aurobindo 4,563 25% 30% 4000 3,628

20% 3000 2,502 2,551 15% 2,085 `. Mn`. 10% 2000 1,564 1,660 1,593 1,394 952 973 5% 0% 1000 FY09 FY10 FY11 FY12 FY13 FY14 CDH, EBITDA margin ARBP, EBITDA margin 0 CDH, RoCE (RHS) ARBP, RoCE (RHS) FY09 FY10 FY11 FY12 FY13 FY14 Source: Company, Ambit Capital research Source: Company, Ambit Capital research

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Case studies

We highlight a case study exhibiting how a mid-sized pharma company has been able to re-rate, as it extended its capabilities and strength of the Indian business in other geographies and another case study of a company that does not have a strong franchise in India and has hence failed to create a strong business in the export markets. Case study 1: IPCA Labs (Rank 5 out of 19 in our DNA framework) IPCA’s RoCE has been ramping up led by operating leverage and product mix

Exhibit 40: IPCA has built a robust, cost-effective and capital-efficient pharma franchise in India

35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY09 FY10 FY11 FY12 FY13 FY14

RoCE (%) Revenue growth (%)

Source: Company, Ambit Capital research

Historical stock price chart for IPCA

Exhibit 41: IPCA has delivered consistent returns for stockholders led by rational capital allocation

1000 Production halt in API USFDA approved plant facility in Ratlam due to 900 expected to fuel growth issue of Form 483 over next 2-3 years. The 800 plant has been commercialised in 700 4QFY14

600

500 Exports and Institutional malaria business in Exports starting to Africa lead net profit 400 Malaria dominated ramp up in semi growth sales in India; Exports regulated markets 300 to semi regulated

200

100

0 No… No… No… Ma… Ma… Ma… Jun… Jan… Jun… Jan… Jun… Jan… Apr… Oct… Apr… Oct… Apr… Feb… Sep… Feb… Sep… Feb… Sep… Dec… Dec… Dec… Aug… Mar… Aug… Mar… Aug… Mar… Jul-95 Jul-02 Jul-09 Source: Company, Ambit Capital research

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Healthcare

Exhibit 42: IPCA’s re-rating as a sustainable business has been reflected in its P/E multiples 25 IPCA - one-year forward P/E chart 20

15

10

5

0 Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 Sep-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 May-10 May-11 May-12 May-13 May-14 Source: Company, Bloomberg, Ambit Capital research Case study 2: Unichem Labs (Rank 14 out of 19 in our DNA framework) Unichem’s RoCE has been volatile due to inconsistent revenue growth in India and exports

Exhibit 15: Unichem’s domestic business suffered from therapeutic substitution of losartan by Telmisartan

30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY09 FY10 FY11 FY12 FY13 FY14

RoCE (%) Revenue growth (%)

Source: Company, Ambit Capital research Historical stock price chart for Unichem

Exhibit 43: Unichem has not been able to deliver consistent returns due to its inconsistent performance in the India and export markets 300 Under-performance of US sales vs market expectations 250 and therapeutic substitution of leading brand Losar in India 200

150

100 Margin expansion led 50 API facility at Pithampur Gradual ramp-up in by operating leverage receives FDA approval exports in exports 0 Jul-14 Jul-13 Jul-12 Jul-11 Jul-10 Jan-14 Jan-13 Jan-12 Jan-11 Jan-10 Sep-14 Sep-13 Sep-12 Sep-11 Sep-10 Sep-09 Mar-14 Mar-13 Mar-12 Mar-11 Mar-10 Nov-13 Nov-12 Nov-11 Nov-10 Nov-09 May-14 May-13 May-12 May-11 May-10 Source: Company, Ambit Capital research

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Exhibit 44: Unichem’s P/E multiples have not re-rated due to lack of confidence in the future of the business

35 Unichem - one-year forward P/E chart 30 25 20 15 10 5 0 Sep-09 Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 Nov-09 Aug-10 Nov-10 Aug-11 Nov-11 Aug-12 Nov-12 Aug-13 Nov-13 Aug-14 May-10 May-11 May-12 May-13 May-14 Source: Company, Bloomberg, Ambit Capital research

Exhibit 45: Relative valuation summary CMP Mcap EV/EBITDA (x) P/E (x) EV/Sales (x) CAGR (FY14-16) ROE (%) US$ mn FY15 FY16 FY15 FY16 FY15 FY16 EBITDA EPS FY14 FY15 FY16 Large caps Sun Pharma* 806 27,495 23.6 18.2 31.7 24.6 9.3 5.6 25 22 15 28 29 Lupin* 1,359 10,042 14.4 12.4 25.1 22.3 4.1 3.4 21 22 0 0 0 Dr. Reddy's* 2,959 8,296 14.3 12.3 22.4 19.5 3.5 3.0 12 11 26 23 21 Cipla 613 8,103 20.6 16.6 32.9 25.4 4.3 3.7 18 18 15 14 16 GSK Pharma 2,505 3,494 27.2 22.2 35.2 31.5 6.3 5.7 NA NA 29 32 Aurobindo Pharma* 896 4,302 11.8 9.3 16.6 13.2 2.5 2.1 16 24 37 35 32 Cadila* 1,273 4,292 17.9 13.5 26.3 18.7 3.4 2.7 30 30 25 26 29 Ranbaxy 610 4,259 14.3 20.1 20.6 33.3 2.3 2.4 NA NA 32 14 Divi's Laboratories 1,756 3,839 18.6 15.5 25.7 21.3 7.5 6.3 20 19 28 28 28 Glenmark 770 3,441 15.2 12.9 24.2 19.6 3.4 2.9 29 40 19 25 24 Average 17.8 15.3 26.1 22.9 4.7 3.8 Mid-caps Torrent Pharma 870 2,425 12.2 10.6 20.0 17.6 3.0 2.6 15 12 40 33 30 IPCA Laboratories* 820 1,703 12.5 10.1 19.8 15.7 2.9 2.4 11 17 27 24 25 Biocon 498 1,642 12.3 10.3 21.6 17.9 2.9 2.5 14 15 14 14 15 Bayer Cropscience 2,592 1,563 19.0 16.3 28.7 24.0 2.6 2.2 17 20 16 18 17 Wockhardt 852 1,543 18.7 14.3 27.8 18.9 2.3 2.1 (16) (23) 28 11 13 Alembic Pharma 431 1,337 18.2 14.3 26.9 21.0 3.7 3.1 26 28 40 37 35 Ajanta Pharma 1,746 1,011 14.5 12.4 22.5 19.3 4.4 3.7 16 17 47 36 31 Pfizer Ltd 1,548 761 12.1 10.5 21.3 18.6 3.0 2.7 28 6 19 30 28 Abbott India 3,339 1,169 22.8 19.7 36.2 31.1 3.1 2.8 NA 7.3 25 23 23 Jubilant Life Sciences 174 456 7.0 5.5 9.0 5.7 1.1 1.0 6 111 4 11 16 Strides Arcolab 730 716 15.7 11.6 22.5 16.0 3.1 2.5 NA NA 19 21 Natco Pharma 1,495 814 25.1 21.8 41.4 34.7 6.3 5.5 15 16 16 16 17 Average 15.8 13.1 24.8 20.0 3.2 2.7 Small caps FDC Ltd 159 466 NA NA NA NA NA NA NA NA 17 Unichem Labs 242 361 10.0 8.2 15.6 12.6 1.7 1.4 22 1 22 16 18 Indoco Remedies 302 458 17.5 13.1 28.7 20.1 3.2 2.6 34 55 13 19 22 Claris LifeSciences 183 165 NA NA Average 11.2 8.9 18.1 13.5 2.1 1.8 Source: Company, Bloomberg, Ambit Capital research; Note: * indicates Ambit Capital estimates

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September 16, 2014 Ambit Capital Pvt. Ltd. Page 36

Cadila Healthcare

BUY

INITIATING COVERAGE CDH IN EQUITY September 16, 2014

Multiple levers for growth Pharmaceuticals

Cadila scores average on our ‘5R’ and below average on our ‘DNA’ Recommendation frameworks. However, Cadila has established itself in India (4% market Mcap (bn): `222/US$3.7 share in FY14) and the US (US$360mn sales in FY14); continued spending 6M ADV (mn): `127/US$2.1 on complex and innovative products (35% of total R&D) should add to CMP: `1273 sustainable revenue streams. Whilst Indian market growth would likely TP (12 mths): `1510 normalise, as systemic issues are resolved, US sales growth would be Upside (%): 19 driven by new approvals. Cadila seems to be in the gestation period in RoW, but given its poor ranking on DNA, it does not deserve the benefit Flags of doubt. We estimate 20% sales CAGR and 28% net profit CAGR over Accounting: GREEN FY14-17E, largely led by niche opportunities in the US. Our implied Predictability: AMBER multiple of 20.0x FY16/17 EPS is at a 20% discount to large-caps. Key Earnings Momentum: GREEN risks: Delay in EM profits and failure in innovation. Competitive position: MODERATE Changes to this position: STABLE Catalysts Other business interests and recent ineffective acquisitions a concern . Niche approvals in the US Whilst Cadila ranks highly on rational capital allocation, investment risk . Sustained growth momentum in management and R&D productivity, the company loses ground on other business domestic formulations interests and ineffective acquisitions in the recent past. It has scope for Ramp up of new launches in the improvement on our ‘DNA’ framework, if it exhibits better growth and . Wellness business profitability in India along with the Nesher, Biochem and RoW acquisitions

Plenty of levers for growth; we do not give the benefit of doubt yet Performance Whilst we do not pencil in any material ramp up in growth in Wellness/RoW/JV 28,000 1200 businesses given its poor ranking on our DNA framework, the US business is 26,000 1100 likely to ramp up (37% CAGR in FY14-17E) with 158 ANDAs pending approval vs 24,000 1000 68 marketed products. The India formulations business is likely to grow in line 22,000 900 with the broader market (12% CAGR in FY14-17E). We credit Cadila for the 20,000 800 launch of the first NCE in India and are upbeat about the prospects of other 18,000 700 innovations, such as vaccines, NCEs and biosimilars. 16,000 600 US/ EMs and differentiated products to drive near / medium term RoCE Jun-14

Better margins from niche launches (transdermals and nasal sprays) in the US Oct-13 Apr-14 Feb-14 Dec-13 Aug-13 Aug-14 are likely to increase EBITDA margin to 20.4% in FY17E from 17% in FY14 and Sensex Cadila Healthcare, RHS expand RoCE to 24.4% in FY17E (from 17.5% in FY14). Cadila has invested in its Source: Bloomberg, Ambit Capital research ground presence in several geographies through bolt-on acquisitions and in biosimilars, vaccines and NCEs (35% of R&D as of FY14). Whilst bolt-on acquisitions seem to be in the gestation period as of now, innovative products have started contributing to revenues in India recently.

Stock performance to be lower than earnings growth Continued earnings momentum (25% in FY14-17E) and RoCE expansion drive our valuation; we expect P/E to normalise—our DCF implies 20.0x one-year forward P/E vs the current 22.0x. We prefer Cadila to Aurobindo on better prospects in EMs and investments in innovation and model 23% FCFF CAGR in FY17-27E vs 8% for Aurobindo. Key risks: Delay in EM profits (-10% EBITDA); failure in innovation.

Key financials

Year to March FY13 FY14 FY15E FY16E FY17E Analyst Details Net Revenues (` mn) 61,552 70,600 82,389 101,257 122,902 Operating Profits (` mn) 11,251 12,001 15,522 20,280 25,048 Aditya Khemka Net Profits (` mn) 6,536 8,036 9,928 13,916 16,968 +91-22-30433272 [email protected] Diluted EPS (`) 31.9 40.1 48.5 68.0 82.9 RoE (%) 23.7 25.2 26.0 29.1 27.8 Paresh Dave P/E (x) 40.4 32.2 26.6 19.0 15.6 +91-22-30433212 P/B (x) 4.5 3.8 3.1 2.5 1.9 [email protected]

Source: Company, Ambit Capital research

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Cadila Healthcare

Snapshot of company financials

Profit and Loss Revenue Mix Year to Mar ( mn) FY15E FY16E FY17E ` Year to Mar (` mn) FY15E FY16E FY17E Net revenues 82,389 101,257 122,902 Domestic Formulations 27,131 30,821 34,884 EBITDA 15,522 20,280 25,048 Depreciation 2,841 3,119 4,536 API (Domestic and Exports) 3,824 4,160 4,506 Interest expense 1,115 1,115 1,115 Consumer 4,511 4,872 5,261 Adjusted PBT 12,064 16,756 20,345 Tax 1,810 2,513 3,052 Animal Health 3,198 3,569 3,983 Adjusted net profit 9,928 13,916 16,968 Export Formulations 40,469 54,359 70,658 Reported net profit Profit and Loss Ratios 18.8 20.0 20.4 North America (US) 29,096 41,350 55,910 EBITDA Margin (%) 12.1 13.7 13.8 Ex North America 11,373 13,009 14,748 Net profit margin (%) 18.2 13.7 10.7 EV/ EBITDA (x) 26.6 19.0 15.6 JV Revenues 4,882 5,308 5,669 P/E on adjusted basis (x) 3.4 2.7 2.2 EV/Sales (x) 82,389 101,257 122,902 Total Gross Sales 84,014 103,088 124,962

Balance Sheet Cash flow

Year to Mar (` mn) FY15E FY16EE FY17E Year to March (` mn) FY15E FY16E FY17E Total Assets 71,460 83,110 97,811 PBT 12,064 16,756 20,345 Fixed Assets 41,812 44,193 46,157 Depreciation 2,841 3,119 4,536 Current Assets 46,517 58,400 74,134 Tax 1,810 2,513 3,052 Investments 866 866 866 Net Working Capital (2,505) (4,005) (4,593) Total Liabilities 71,460 83,110 97,811 CFO 10,264 13,030 16,910 Total networth 84,103 107,404 136,807 Capital Expenditure (4,500) (5,500) (6,500) Total debt 27,004 27,004 27,004 Investment - - - Current liabilities 17,736 20,349 23,346 CFI - - - Deferred tax liability 961 961 961 Issuance of Equity (4,500) (5,500) (6,500) Balance Sheet ratios Inc/Dec in Borrowings - - - RoCE 20.2 23.9 24.4 Net Dividends - - - RoE 26.0 29.1 27.8 Interest paid (2,232) (2,266) (2,266) Gross Debt/Equity (x) 0.3 0.3 0.2 CFF - - - Net debt (cash)/ Eq (x) 0.2 0.1 0.0 Net change in cash (2,232) (2,266) (2,266) P/B (x) 3.1 2.5 1.9 Closing cash balance 3,532 5,264 8,144

Operating leverage in EMs/Europe yet to play out… Cadila a key beneficiary of improvement in approval timelines EBITDA Contribution to In mn (FY14) Revenue EBITDA ` margin % reported EBITDA 70 60 Zydus Wellness 4,027 1,084 26.9% 9.0% 60 54 50 40 40 Joint Ventures 4,499 2,017 44.8% 16.8% 40 24 25 30 20 20 18 18 15 India Business 24,644 6,161 25.0% 51.3% 20 14 1412 13 11 8 11 10 10 3 US Business 21,704 4,341 20.0% 36.2% - FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Others 15,726 (1,602) -10.2% -13.3%

Filings Approvals Reported 70,600 12,001 17.0%

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Cadila Healthcare

Cadila – Diversified revenue streams

Cadila sells prescription drugs in India (32% of FY15E revenues) and North America (35% of FY15E revenues) and other export markets (14% of FY15E revenues). The company also sells consumer products (5% of FY15E revenues) and animal healthcare products (4% of FY15E revenues) in India. Cadila has JVs with Hospira (oncology products for export markets), Takeda (APIs and intermediates for exports) and Bayer (prescription drugs for India). These JVs would jointly contribute to ~6% of FY15E revenues.

Exhibit 1: Presence in multiple segments (` Bn) Exhibit 2: Decline in RoCE and EBITDA margins due to lack of approvals in US and slowdown in other segments (%)

80 35% 3 7 30.5% 60 3 4 6 30% 3 5 11 26.5% 3 5 10 40 5 4 25% 21.6% Bn 3 4 8 ` 25 4 7 2 23 22.6% 23.0% 6 19 20% 24.1% 18.3% 20 16 17.5% 14 22 15 18.2% 17.0% 7 10 12 15% 0 FY10 FY11 FY12 FY13 FY14 FY10 FY11 FY12 FY13 FY14 US India formulations RoW JV Consumers API CDH, EBITDA margin CDH, RoCE

Source: Company, Ambit Capital research Source: Company, Ambit Capital research

Within India, Cadila has had an acute heavy presence which drags down the company’s score on our DNA framework. However, off late, the company has increased its presence in chronic therapies and has also commercialised biosimilars and NCE (Lipaglyn) in India. We are upbeat about the prospects of other innovative projects that Cadila has undertaken like biosimilars, NCEs, vaccines and NBEs.

Exhibit 3: Cadila’s therapy split in India (FY14) Exhibit 4: Cadila sources a higher portion of its EBITDA from India when compared to large caps

80.0 Domestic EBITDA as % of Total Revenue 68.8 70.0 60.0 53.7 Cardiac, 48.2 50.0 42.9 17% Others, 40.0 % 23% Gastro 30.0 Intes, Derma, 7% 20.0 14% Pain 10.0 0.0 , 7% 0.0 Anti- Infectives,

13% IPCA Cadila Gynaecolog Respiratory, Biocon ical, 10%

10% Glenmark Aurobindo Source: Company, Ambit Capital research Source: Company, Ambit Capital research

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Cadila Healthcare

Gaining lost ground Cadila’s evolution Cadila’s history suggests that the company has foregone opportunities that were leveraged by its peers to create value for stakeholders. However, if we discount the initial 43 years of its relatively passive existence, Cadila seems to be a budding newbie. A deep dive into Cadila’s history suggests that the company has been proactive in acquiring capabilities and product-related assets through alliances, JVs and acquisitions. However, its financials suggest that the company is yet to extend these acquired assets beyond the domestic market. We believe that the extension of these assets and capabilities beyond the home market would be a key trigger for value creation and revaluation of Cadila’s long-term growth prospects.

Phase 1 – (1952 – 1994): The dark age Cadila was established in 1952 by the Modi and Patel families. This period was a dark age for Cadila in more than one way. Firstly, there is not much known about the company’s activities in this era apart from the fact that the company produced anti-TB medicines and vitamins for the Indian Little progress in early years of formation except the flagship market. And secondly, the company clocked revenues of only `2bn by 1995, indicating that very little progress was made in the early years of formation. Sugar Free brand The most significant legacy of this era was ‘Sugar Free,’ the company’s flagship brand in the wellness business which was launched during the latter part of this period (1988).

Phase 2 – (1995 – 2002): The building blocks of domestic business In 1995, Cadila was split into Cadila Pharmaceuticals (headed by the late Indravadan Modi) and Zydus Cadila (headed by the late Ramanbhai Patel). With the new management in place, Cadila went on an in-licensing spree to ramp up its revenues by leveraging the established domestic platform. To our knowledge, the company Post the split of the Patel family engaged in a total of 27 acquisitions/alliances/JVs in this period to expand their and Modi family, Cadila engaged product offerings. Amongst these alliances, the most notable was Byk JV (now Takeda in in-licensing to ramp up JV) which was formed in 1998 for the manufacturing of pantoprazole intermediates. revenues Post listing on the BSE in 2000, Cadila acquired German Remedies (2001) and Recon (2000) to expand its product basket and distribution reach in the Indian formulations business. The company received the rights to the blockbuster brand, Aten, through the German Remedies acquisition.

In FY03, Cadila reported revenues of `10.4bn, implying a CAGR of 25% since the takeover by Ramanbhai in 1995. The growth was led by in-licensed products/acquisitions and organic expansion.

Phase 3 – (2003 onwards): Exploring the export opportunity; focus on innovation Cadila entered the US market through the acquisition of Banyan Chemicals in 2002. Banyan had a USFDA-approved API facility which enabled Cadila to produce pharmaceuticals for clients who were marketing in the US. Cadila’s Moraiya Entry in the US market through formulations facility received UK MHRA approval in 2002. The company established acquisition and approval by US two subsidiaries in FY03 (in Brazil and the US). The establishment of a US front-end FDA for the Moraiya facility, and was aimed at starting its own ANDA filings in the US. In 2003, Cadila filed its first front-ending to start its own ANDA in the US and it received a USFDA approval for its formulation facility at ANDA filings Moraiya in 2004. Cadila launched its first product in the US in 2005 in collaboration with Mallinckrodt.

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Cadila Healthcare

Exhibit 5: RoCE has reduced over FY05-14 due to lack of new launches in US and pricing regulation in India

Incremental competition in Launch of Depakote ER Taxotere and import alert at marginally offsets US and EU exports ramped Moraiya facility hurt adverse impact of up leading to expansion in profitability and RoCE pricing in India and low RoCE owing to higher margins in JVs and margins Wellness Launch of new products Launch of generic in US ramped up Taxotere with limited revenues and RoCEs competition led to Lack of new spike in RoCEs meaningful launches in 35.0% US, pricing regulation 80 in India and losses in foreign subsidiaries 70 30.0% 60 30.5% 24.1% 25.0% 22.7% 23.0% 50 20.1% 26.5% 40 24.1% 20.0% 17.8% 18.2% 30 20 15.0% 10 17.5% 10.0% 0

FY05 FY06 FY07 FY08 RoCE FY09 Revenue, RHSFY10 (Rs. Bn) FY11 FY12 FY13 FY14

Source: Company, Ambit Capital research

Exhibit 6: Major milestones with stock price performance

1200 Generic Taxotere FDA clears the Listed on Started its front-end in approved by USFDA Moraiya facility the NSE the US and started Launched first 1000 and BSE filing ANDAs; entered product in the US the French market Tentative approval 800 for generic Taxotere Acquired 600 companies FDA approved Hospira JV files USFDA Recon and GRL Launch of Moraiya facility for Taxotere issues and brand Aten 400 US Court warning Depakote ER invalidates letter to in US drives revenues and 200 Taxotere Moraiya patents facility profitability 0 Jul-01 Jul-06 Jul-11 Jan-04 Jun-04 Jan-09 Jun-09 Jan-14 Jun-14 Apr-00 Oct-02 Apr-05 Oct-07 Apr-10 Oct-12 Sep-00 Feb-01 Sep-05 Feb-06 Sep-10 Feb-11 Dec-01 Dec-06 Dec-11 Mar-03 Mar-08 Mar-13 Aug-03 Nov-04 Aug-08 Nov-09 Aug-13 May-02 May-07 May-12 CDH stock price Source: Company, Bloomberg, Ambit Capital research

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Cadila Healthcare

Active strategic partnerships/acquisitions approach In FY05, Cadila entered into JVs with Mayne Pharma (now Hospira) for cytotoxic injectables for the regulated markets and with BSV to develop, manufacture and market a non-infringing and proprietary Novel Drug Delivery System (NDDS). These JVs catapulted Cadila’s profits in FY10-14.

Exhibit 7: Active strategic partnerships by Cadila from 2003 onwards Name of Joint venture Nature Year Geography Particulars / Acquisition

Acquired US-based Alpharma Inc's French subsidiary, Alpharma SAS France for a consideration of Alpharma SAS France Acquisition 2003 France Euro5.5 million. This acquisition will provide access to the French generics markets.

Signed a pact with Schering AG, Germany, which allows Zydus to market Schering's eight patented - Alliance 2003 India products in India. The agreement also covers transfer of technology and manufacturing of Schering AG's products in India. The products are in the women’s healthcare segment.

Fermenta Biotech Ltd (FBL), a subsidiary of Duphar Interfran, signed an agreement with Cadila Ltd for the sale of FBL's global patents and process technology for the manufacture of Lisinopril and - Alliance 2003 - Benazepril. The objective of this alliance is to strengthen the presence in CVS and anti-hypertensive segments.

Long-term strategic pact with Boehringer Ingelheim India, a wholly-owned subsidiary of Boehringer - Alliance 2004 India Ingelheim of Germany, for manufacturing and marketing the latter's products in India for a period of 10 years and to set up a joint venture to fortify their co-marketing efforts in India.

Agreement with Tyco's Mallinckrodt Pharmaceuticals under which Mallinckrodt would market - Alliance 2005 US generics produced by Cadila. This alliance provided Cadila with access to the US markets

Joint Cadila Healthcare and Mayne signed an agreement to set up an API manufacturing facility in India Mayne JV 2005 - Venture to manufacture specialty oncology products.

Acquisition of Nippon Universal Pharmaceutical Ltd., Japan. The acquisition provided access to Nippon Universal Acquisition 2006 Japan ready manufacturing facilities, marketing base and the distribution network of Nippon in Japan. In Pharmaceutical Ltd. 2014, Cadila announced its decision to exit the Japanese market.

Quimica e Farmaceutica Acquisition of Quimica e Farmaceutica Nikkho do Brasil Ltda for US$25mn. The objective of this Acquisition 2006 Brazil Nikkho do Brasil Ltda acquisition is to foray into Brazil's branded generics business.

Entered into a three-year collaboration with Sweden’s Karo Bio for developing new drugs for the - Alliance 2008 - treatment of inflammatory diseases.

Acquired stake in Combix Laboratorious, Spain. Combix has a pure generic focus and strong Combix Laboratorious Acquisition 2008 Spain product pipeline in Spain.

Zydus Cadila acquired Etna Biotech, a subsidiary of Crucell N.V. The deal helped Cadila foray into Etna Biotech Acquisition 2008 - innovative vaccine research and development.

Simayla Pharma Acquisition 2010 South Africa Acquired Simayla Pharma, South Africa, to strengthen its presence in South Africa.

Joint Agreement with Bayer HealthCare to set up 50:50 joint venture company in the name of Bayer Bayer Zydus Pharma 2011 India Venture Zydus Pharma for sales and marketing of pharmaceutical products in India.

Acquired Nesher Pharma which has expertise in niche therapies such as controlled release Nesher Pharma Acquisition 2011 US medications.

Acquired Bremer Pharma GmbH from ICICI Ventures to expand its animal health business to gain Bremer Pharma GmbH Acquisition 2011 RoW strategic access in markets across Europe, South America, Asia and Africa.

Biochem Acquisition 2011 India Acquired Biochem to strengthen its anti-infective segment in the domestic market.

Agreement with Microbix Biosystems, Canada, for re-commercialising and marketing of certain - Alliance 2012 US drugs in the US markets. Source: Company, Ambit Capital research

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Cadila Healthcare

Mapping competitive advantage – The 5 ’R’s

Cadila receives the fourth rank in our competitive advantage framework (amongst Cadila ranks fourth in our seven companies analysed in the Indian large-cap pharmaceutical space). Whilst the competitive advantage company scores high on risk management, robustness of business model and capital framework allocation parameters, it lags on parameters like R&D productivity (largely due to delays in product approvals) and quality of management (high other business interests and no significant competitive advantage). Please refer to our thematic report for further details on the competitive framework.

Exhibit 8: Cadila ranks average largely due to rational capital allocation Rank out of seven Competitive advantage Components Measures Remarks companies analysed Vision and mission focus on: (a) being a research-led company by Strategy Stated intent and vision 2020; (b) global aspirations; (c) innovation and quality excellence; (d) commitment to partners.

Recent hire of Dr. Sharad Govil as CEO of Zydus Noveltech Recent hires, expands technical capability. JVs with various other healthcare management transition, organisations give us comfort on management width and depth. depth and width Stable top management since 1995. Third generation of promoter Quality is well entrenched. No transition in sight. Other business interests Average number of other business interests. Ambit's Forensic Our forensic accounting analysis raises no significant concerns. Reputed management, accounting 6 (Worse than strategy and execution average)

Cadila has consistently beaten the broader market growth, Growth rate in India indicating good quality of execution. Cadila is second to only Lupin in gaining market share in the US. Market share in US The company has won many accolades for excellent service levels in the US. Execution Cadila has an average performance in earnings delivery and Earnings visibility and visibility. However, over the recent past, the company has over- delivery promised and under-delivered. Cadila has been an active acquirer. The recent acquisitions of Inorganic strategy success Biochem and Nesher Pharma have left much to be desired. Cadila has average R&D productivity. The company's productivity Productivity Revenues generated per R&D productivity has been depressed in our view largely due to lack of interesting 4 (Average) index R&D spend approvals in the US because of the warning letter at Moraiya. Greatness Ambit's proprietary Cadila comes second to only Sun Pharma and IPCA in rational Rational capital allocation 2 (Excellent) framework framework capital allocation. Bargaining Higher than average bargaining power with buyers, as indicated by power with Average debtor days debtor days of 58 days. buyers Bargaining Average bargaining power with suppliers, as indicated by average Robustness of the business power with Average creditor days 3 (Better than creditor days. model suppliers average) Significant portion of revenues sourced from competitive segments Revenues from niche with no sustainable barriers to entry; ~15% of revenues from Barriers to entry segments limited competition segments (India consumer business, animal health and niche products in the US). Diversity of manufacturing base Average number of USFDA-approved facilities (formulations + API) Operational risk encountered by a high 483 issue rate make Cadila prone to Incidence of Form 483s operational risk. Risk entailed in operations from USFDA 4 (Average)

JVs, alliances and Best-in-class diversification of investment risk with JVs and alliances Investment risk partnerships for multiple product segments and geographies. Cadila obtains an average position as compared to large- Overall rank 4 (Average) cap peers. Source: Company, Ambit Capital research

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Cadila Healthcare

Reputed management, strategy and execution – Scope for improvement

Positives – High-quality execution in US and India; no transition in sight The management is focussed on sustainable competitive . The vision and intent of the management are in sync with our thoughts on the longer-term prospects of the industry. We believe innovation is the only advantage over the longer term sustainable competitive advantage over the longer horizon.

. Well-entrenched third generation of promoters gives us comfort on the transition risk. Multiple JVs with various partners also bodes well for management bandwidth and depth.

. The company’s execution in India and the US has been high quality. Despite an inferior product mix in India and lack of support from the base business in terms of growth contribution, the company has been able to consistently beat the broader market growth led by new product introductions and consistent execution.

Negatives – Recent acquisitions have not added value Despite being an active acquirer, Cadila has thus far been unable to replicate its . It was unable to replicate its success with German Remedies in other acquisitions. This is a cause for concern, success with German Remedies in as the company remains acquisitive and may not be taking impairment charges other acquisitions despite incurring losses on past investments.

. The company underwent a restructuring in 1995 when the Modi family split from the Patel family. Until then, after 43 years of existence, the company had clocked revenues of only `2bn (1995). . The multiple business interests of the promoters and kin are also a cause for concern. The promoter and immediate kin had 25 other directorships other than Cadila and its subsidiaries.

Exhibit 9: Risk of divergence in management focus

60 Other directorships of immediate family of promoters 48 50 47

40

30 25 Average 20 15 16 18

10 4

0 Glenmark Lupin Cipla Ipca Cadila Sun Dr. Reddy's Healthcare Pharma

Source: Ambit Capital research

. The continued losses at several foreign subsidiaries may be indicative of the lack of scalability of the company’s strategy in these markets.

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Cadila Healthcare

R&D productivity – Heading northwards

Positives – R&D productivity healthy due to high market share Scores average on the R&D productivity index . Despite Cadila’s US revenues being depressed due to delay in USFDA approvals, the company has been able to register decent R&D productivity.

Exhibit 10: Cadila registered decent R&D productivity despite delay in USFDA approvals and high innovative avenues spend

10.0% Dr. Reddy's Glenmark 9.0%

8.0% Lupin 7.0% Cadila 6.0% Sun Pharma (FY14) 5.0% 4.0% Ipca 3.0% R&D spend as % of sales sales of as % spend R&D 2.0% 0 1 2 3 4 5

R&D productivity index Source: Ambit Capital research

. R&D spend on innovative pursuits like biosimilars, vaccines and NCEs bodes well for longer-term prospects. Negatives – Innovation entails its own risks

. High R&D spend in innovative pursuits (35% of R&D in FY14) may lead to High R&D spend led to depression in RoCE until such endeavours yield results. depressed RoCE . The company has capitalised its R&D spend on transdermals in the Zydus Noveltech JV with Sharad Govil. Whilst the principle of capitalising the R&D spend in a JV is appropriate per accounting standards, the profits stand exaggerated due to such a practice. We credit the management for disclosures on this front.

Rational capital allocation – Best-in-class allocation but… Positives – JVs and Wellness business exhibit high RoCE

. Cadila ranks high on our rational capital allocation measures (Ambit’s proprietary ‘greatness’ framework). Amongst pharma companies, Cadila ranks second only to Sun Pharma and IPCA. Higher RoCE in the Wellness and . The company’s investments in JVs and the Wellness business are yielding high JV business RoCEs (30.9% and 49.3% as of FY14 respectively as compared to 12.8% for the rest of the business).

Negatives – Biochem and Nesher value-dilutive as of now

. The company’s investments in bolt-on acquisitions in 2005-2010 and in Biochem and Nesher in 2011-2012 seem to be RoCE-dilutive.

. Whilst the company still remains acquisitive, there is a credible threat of a ‘great mistake’ as indicated by the less-than-ideal track record in acquisitions.

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Cadila Healthcare

Robustness of business model - All is well Positives – High proportion of ‘moated’ revenue streams vs peers Less than average debtor days are a positive for bargaining power against . Diversified revenue portfolio buyers. augurs well for sustainability . High proportion of revenues sourced from differentiated segments like consumer business, animal business and niche products in the US augurs well for sustainability. Cadila sources ~45% of its revenues from the domestic market as compared to ~30% for most large-cap peers. High proportion of domestic revenues (branded market) is a key positive. Negatives – Working capital cycle may expand Less than average creditor days indicate low bargaining power with suppliers. Working capital cycle to expand . as exports outpace domestic . Since Cadila has lower exposure to export markets, the working capital cycle revenues might expand as and when exports outpace domestic revenues.

Risk entailed in operations – Excellent investment risk management Positives – Alliances and partnerships reduce investment needs

. Cadila’s approach to expansion in various product segments and markets illustrates measured investment risk undertaking. Although partnerships pare near-term upside due to payments to partners, the high gestation period and low Measured investment risk risk of failure make such deals prudent, in our view. undertaking through partnerships Negatives – High 483 issue rate and expanding capacity by adding more USFDA facilities . Cadila has exhibited a high 483 issue rate in the past. However, with the company now expanding capacity by adding more USFDA-approved facilities, we believe the operational risk will reduce.

Cadila’s standing on our five ‘R’s framework

Cadila ranks fourth in our competitive advantage framework (amongst seven Cadila ranks fourth in our companies analysed in the Indian large-cap pharmaceutical space). Whilst the competitive advantage company scores high on robustness of business model and capital allocation framework parameters, it lags on quality of management (high other business interests and no significant competitive advantage). We see a material improvement in R&D productivity ahead and also anticipate that the management would improve on earnings delivery and visibility. With new capacities coming online for the US market, the operational risk is also likely to decline. These improvements are likely to cause a material jump in Cadila’s ranking in our universe.

Exhibit 11: Cadila scores average on our five ‘R’s framework; improvement in management and risk could lead to a material jump in rankings Reputation, strategy and Rational capital Robustness of the Risk entailed in Overall Company R&D productivity execution of management allocation business model operations rank Lupin 1 2 4 1 5 1 Sun Pharma 4 5 2 1 2 2 IPCA 2 7 1 6 2 3 Cadila 6 4 2 3 4 4 Healthcare Dr. Reddy's 7 2 6 3 1 4 Glenmark 5 1 7 5 6 6 Cipla 3 6 5 7 7 7 Source: Ambit Capital research

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Cadila Healthcare

Exhibit 12: SWOT analysis Strengths Weaknesses

. Promoter-led management keeps agency costs low. Promoter stake in . Multiple business segments have proven difficult to manage (for example, the company is currently at ~75%. the lacklustre growth in the India wellness and emerging markets despite enormous scope for growth). . Robust business model with a reasonable portion of revenues (~15% of sales in FY14 from consumer business in India, animal health and . Inorganic strategy has not proven successful. As opposed to the value- niche products in the US) sourced from limited competition segments. accretive German Remedies acquisition (2001), the latest acquisitions of Biochem and Nesher Pharma (2011-2012) are yielding negative RoCEs. . High R&D productivity going ahead and investment risk management to aid ramp up in RoCE levels. High investments on long-term growth . The company’s presence in many export markets through bolt-on drivers (35% of R&D spend in FY14) a positive. acquisitions is also yielding negative RoCE (Brazil, Mexico, Spain, and France); investments may be impaired. . Depth and width of management to ensure stability; no transition in sight. Third generation of promoter well entrenched in the business. . Highest percentage of revenues sourced from the Indian market (44%) as compared to its peers (average of 30%) ensures higher sustainability of revenue streams over the longer term. . Efficient capital structure compared to peers (net debt:equity of 63% as of FY14) beneficial for stakeholders.

Opportunities Threats

. Small business in RoW markets (US$175m revenues; 15% of total . The lack of growth in certain geographies could be a signal of lack of sales in FY14) offer scope for long-term sustainable growth. scalability of the business.

. The company already markets biosimilars in India and is ahead of its . High investments in innovative pursuits may keep RoCE depressed in the peers (except Dr. Reddy’s) in development of NBE/MBEs. This is a long- near term if these pursuits do not bear fruit in the near term. term growth driver which could play out over the next few years. . Innovative projects undertaken in India like Lipaglyn (NCE) exemplify the company’s R&D capabilities. Geographical expansion of such projects can lead to a re-rating of the entire business. . Large ANDA pipeline (158 ANDAs pending approval) in the US as compared to a smaller currently marketed portfolio (68 products marketed) bodes well for growth prospects. . Meaningful additions in wellness product portfolio and geographical expansion of the product basket to emerging countries may add significant value. Source: Company, Ambit Capital research

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Cadila Healthcare

Cadila has multiple levers for growth

With most of Cadila’s businesses, other than the foreign subsidiaries (ex-US), running at base-business profitability with no one-offs, we see minimal risk to current profits. In the past, the Takeda JV (JV formed with BYK in 1999 for manufacture of pantoprazole intermediates) had seen extraordinary profits due to pantoprazole Uptick in profitability of the US exclusive sales, whereas the Hospira JV (formed in 2005 for oncology products) had business led by niche launches seen high profitability from limited competition in generic Taxotere. In the near term, Cadila is likely to see an uptick in profitability of the US business led by niche launches like transdermal and nasal sprays. We do not expect any material change in the growth trends of the Indian consumer business, animal health business and foreign subsidiaries largely owing to lack of visibility. We believe that Cadila’s investments in NCEs, biosimilars and vaccines are key positives. Revenue mix – Spread across verticals

Exhibit 13: RoW and other business’s earn negative EBITDA margins Implied EBITDA FY13 FY14 FY15E FY16E FY17E Comments margins (FY14) Domestic Formulations 23,232 24,644 27,131 30,821 34,884 25.0% The most profitable business segment for Cadila Legacy business, growing slower due to higher captive API (Domestic and Exports) 3,098 3,497 3,824 4,160 4,506 -10.0%* consumption Business struggling for growth after larger brands have Consumer 4,100 4,296 4,511 4,872 5,261 26.9% matured Animal Health 2,462 2,865 3,198 3,569 3,983 -10.0%* Small business as of now Export Formulations 24,886 32,282 40,469 54,359 70,658 10.2%

Largest and fastest growing business; profitability North America (US) 15,068 21,704 29,096 41,350 55,910 20.0% suppressed due to authorized generics and lack of FDA approvals Ex North America 9,818 10,578 11,373 13,009 14,748 -10.0%* Loss making business; scale to provide margins overtime New product launches to fuel growth; low visibility on JV Revenues 5,070 4,499 4,882 5,308 5,669 44.8% interesting products Total Gross Sales 62,848 72,083 84,014 103,088 124,962 17.0%

Source: Company, Ambit Capital research Note: Aggregate EBITDA margin for all other business is implied -10% India formulations business: Acute-dependent

As compared to other larger peers, Cadila's India business is sub-par in terms of Cadila has a presence in the therapy area presence and growth potential. The company has significant presence in lower-growth acute therapy areas acute therapies like anti-infectives, pain, and gynaecology, which are slower-growing segments with intense competition.

Exhibit 14: Higher presence in acute segment like anti-infective, pain and gynaecology

Cardiac, 17% Others, 23% Gastro Intes, Derma, 7% 14%

Pain, 7% Anti-Infectives, Gynaecological, 13% 10% Respiratory, 10%

Source: AIOCD, Ambit Capital research

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Cadila Healthcare

Amongst chronic therapies, the company has a credible presence in the cardiac and chronic respiratory segment. The company has limited presence in the faster-growing areas of anti-diabetes and neurology. However, in the past, the company has beaten the broader market growth by better execution (better selling and marketing) and plethora of new introductions.

Exhibit 15: Contribution of new product sales to total Exhibit 16: Cadila’s product selection has been sub-par growth has improved over FY10-14 with CAGR of 130% as (IPM sales > Sub group sales) but it has exhibited strong compared to 15% total sales CAGR execution capabilities (Cadila sales > Sub group sales) 22% 33% 25% 36% 100% 25.0% Growth YoY % 147% 80% 20.0% 60% 15.0% 40% 78% 75% 67% 64% 20% 10.0% 0% 5.0% -47% -20% 0.0% -40% FY09 FY10 FY11 FY12 FY13 FY14 FY10 FY11 FY12 FY13 FY14 Cadila Cadila - Sub Group Sales IPM sales Base business New Product sales

Source: AIOCD, Ambit Capital research Source: AIOCD, Ambit Capital research

We expect the business to sustain its growth in line with the broader market, as the Domestic business to grow in line product mix improves. We maintain that with higher data requirements on clinical with the broader market trials and longer timeframe for new product approvals, the Indian Pharma Market (IPM) is likely to experience a slow down by a couple of percentage points.

Exhibit 17: Domestic business to grow in line with broader market

40,000 35,000 CAGR 13% 30,000 25,000 CAGR 14% 20,000 mn

` 15,000 10,000 5,000 - FY10 FY11 FY12 FY13 FY14 FY15e FY16e FY17e

Source: Company, Ambit Capital research

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US business: Large pipeline to unfold

Cadila's US business, excluding Nesher Pharmaceuticals, has been facing pricing Resolution of warning letter at the pressure. The business has not seen any material new launches in the recent past Moraiya facility to provide niche other than Depakote ER (AG and own ANDA), Trilipix (AG) and Tricor (AG). However, approvals over the next 12 with the resolution of the warning letter to the Moraiya facility, the company is likely months to obtain some niche approvals over the next 12 months.

Exhibit 18: Withdrawal of warning letter at Moraiya facility to help obtain niche approvals

1,000 US$ mn 900 800 CAGR 39% 700 600 500 400 CAGR 26% 300 200 100 - FY10 FY11 FY12 FY13 FY14 FY15e FY16e FY17e

Source: Company, Ambit Capital research The company has ~158 ANDAs pending approval, including filings for niche controlled release products like Toprol XL (US$250mn) and Transdermals (6-7 ANDAs filed), which may include interesting opportunities like Clonidine (USD200m), Estradiol Weekly (US$150mn), Fentanyl (US$1bn) and Lidocaine (US$1.2bn). Acceleration in approvals by FDA It has also filed more than 20 injectables (12 for partners and 8 for itself), 4 to benefit Cadila’s158 products ointments and 5 nasal products, for which approvals are pending. Cadila currently pending approval markets only 68 products in the US as compared to a pending pipeline of 158 products. Given that the FDA is going to accelerate approvals under GDUFA, Cadila could be a key beneficiary in terms of growth and launch opportunities.

Exhibit 19: Cadila could get 40-60 approvals from USFDA in FY16E and FY17E

70 60 60 54 50 40 40 40

30 24 25 18 18 20 20 20 14 14 15 11 12 11 13 8 10 10 3 - FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Filings Approvals

Source: Company, Ambit Capital research We expect the US business to scale up on approvals of niche opportunities and We explicitly build in known launch of controlled substance products from the Nesher stable. We follow a mix of opportunities in the pipeline and top-down and bottom-up approach whilst projecting revenues. We explicitly build in take a revenue run rate of known opportunities in the pipeline and take a revenue run rate of US$6mn for US$6mn for unknown products unknown products.

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India consumer business: Steady growth ahead

Growth in the Indian consumer business has not been consistent on annual basis in Intensifying competition in niche the past. The patchy performance is due to intensifying competition in niches that business Zydus Wellness has created for itself. Although the product basket (Sugar Free and Nutralite) is mature with high market share, the consumer business still has a long way to go in terms of new product launches, brand extensions, and expanding geographical reach within India.

Exhibit 20: We expect continued competition in the India consumer business 6,000 ` mn CAGR 8% 5,000

CAGR 13% 4,000

3,000

2,000

1,000

- FY10 FY11 FY12 FY13 FY14 FY15e FY16e FY17e

Source: Company, Ambit Capital research We expect the business to grow in single digits in the foreseeable future. We see Expect business to grow in single upside risk to these estimates if the recent launch of ActiLife and re-launch of digits in the foreseeable future EverYuth brands (with extensions) were to perform better than our expectations and the company were to materially expand its geographical reach. Zydus Wellness brands currently penetrate only 30% of the total target market in terms of distribution, as per the management.

JVs: Growth expectations low due to lack of visibility The JV business generated RoCE of 49% for Cadila in FY14. Taking the JV route has JV business faces stiff competition helped Cadila manage investments, expand its geographical reach, and generate and lack of visibility of pipeline phenomenal returns. However, the business seems to have peaked in FY12, with the Hospira JV facing stiff competition in Docetaxel. Our expectations from the Nycomed Takeda) and Bayer JV also remain low due to lack of visibility of the pipeline.

Exhibit 21: The JV business has stiff competition and low Exhibit 22: The JV business has generated phenomenal visibility in product pipeline; any unexpected upsides to returns as investments have been limited whilst products the JV business can materially ramp up consolidated RoCEs have yielded margins mn 6,000 ` CAGR 8% RoCE - JV business

5,000 CAGR 30% 120.0% 95.7% 4,000 100.0% 87.0%

3,000 80.0% 60.0% 49.3% 2,000 48.4% 40.0% 1,000 20.0% - 0.0% FY11 FY12 FY13 FY14 FY10 FY11 FY12 FY13 FY14 FY15e FY16e FY17e Source: Company, Ambit Capital research Source: Company, Ambit Capital research

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We expect the business to grow in single-digits and see upside risk to our estimates in case any significant and niche opportunities (such as docetaxel and pantoprazole in the past) were to materialise. We expect the JVs to ramp up post FY16E led by the Hospira JV. Hospira in its 2013 10K mentioned that 2014 and 2015 are likely to be peak years in terms of manufacturing start-up, validation (facility and product- related), registration costs, and unabsorbed production costs w.r.t. the Zydus-Hospira JV. RoW markets: Is there an operating leverage play? Cadila entered Brazil in 2006, South Africa in 2010, Spain in 2008, France in 2001 and Japan in 2006 mostly through bolt-on acquisitions.

Exhibit 23: Partnerships by Cadila in the last decade Name of Joint venture / Nature Year Geography Particulars Acquisition Acquired US-based Alpharma Inc's French subsidiary, Alpharma SAS France for a Alpharma SAS France Acquisition 2003 France consideration of Euro5.5 million. This acquisition provides access to the French generics markets. Fermenta Biotech Ltd (FBL), a subsidiary of Duphar Interfran, signed an agreement with Cadila Ltd for the sale of FBL's global patents and process technology for the - Alliance 2003 Global manufacture of Lisinopril and Benazepril. The objective of this alliance is to strengthen the presence in the CVS and anti-hypertensive segments. Acquisition of Nippon Universal Pharmaceutical Ltd, Japan. The acquisition provides Nippon Universal Acquisition 2006 Japan access to ready manufacturing facilities, marketing base and the distribution network of Pharmaceutical Ltd. Nippon in Japan. In 2014, Cadila announced its decision to exit the Japanese market. Quimica e Acquisition of Quimica e Farmaceutica Nikkho do Brasil Ltda for US$25mn. The objective Farmaceutica Nikkho Acquisition 2006 Brazil of this acquisition is to foray into Brazil's branded generics business. do Brasil Ltda Acquired stake in Combix Laboratorious, Spain. Combix has a pure generic focus and Combix Laboratorious Acquisition 2008 Spain strong product pipeline in Spain. Simayla Pharma Acquisition 2010 South Africa Acquired Simayla Pharma, South Africa, to strengthen its presence in South Africa. Acquired Bremer Pharma GmbH from ICICI Ventures to expand its animal health Bremer Pharma Acquisition 2011 RoW business to gain strategic access in markets across Europe, South America, Asia and GmbH Africa. Source: Company, Ambit Capital research Although we agree with the strategy in terms of the need to diversify from an Improvement in profitability may India/US concentration, profitable integration of these operations may take a long potentially result in margin time. We concede that visibility in the pricing of products/services to these markets expansion remains low, but any improvement in profitability of the larger subsidiaries (through turnaround of operations or rationalisation), especially in Latin America, Spain, the US (Nesher) and Mexico may potentially result in margin expansion.

Exhibit 24: EBITDA contribution from other business (FY14) EBITDA Contribution to In Mn Revenue EBITDA ` margin % reported EBITDA Zydus Wellness 4,027 1,084 26.9% 9.0% Joint Ventures 4,499 2,017 44.8% 16.8% India Business 24,644 6,161 25.0% 51.3% US Business 21,704 4,341 20.0% 36.2% Others 15,726 (1,602) -10.2% -13.3% Reported 70,600 12,001 17.0%

Source: Company, Ambit Capital research However, we are not building in any margin expansion from these markets in our estimates for the explicit forecast period owing to the poor ranking for Cadila in our DNA framework.

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Exhibit 25: Sales in EU and emerging markets to increase

16,000 ` mn 14,000 CAGR 14% 12,000 10,000 CAGR 11% 8,000 6,000 4,000 2,000 - FY10 FY11 FY12 FY13 FY14

FY15e FY16e FY17e Source: Company, Ambit Capital research Further, Cadila's partnership with Abbott for ~18 emerging markets provides a longer-term growth prospect. Innovation: Working on moving up the value chain The company has launched six biosimilar products in India which primarily include complex proteins. The company has 17 biosimilar and 3 novel biologic projects in the pipeline for indications like oncology, rheumatoid arthritis, gynaecology and nephrology. Cadila has commissioned a large-scale MAB manufacturing unit in India. It also has seven NCE programmes. One of these, Lipaglyn (Saroglitazar) indicated for dyslipidaemia has already been launched in India. We remain positive on its longer- We remain positive on its longer-term growth prospects and believe that moving up term growth prospects and the value chain is the end-game for all Indian companies. Cadila spends 35% of its believe that it is moving up the R&D spend on innovative pursuits. Our confidence is derived from commercialisation value chain of biosimilars and Lipaglyn (NCE) in India.

Expect margin expansion led by US business ramp-up We expect EBITDA margin expansion of 340bps over FY14-17E to be largely led by operating leverage on overheads and R&D expenses. The company has guided towards R&D spend growing lesser than revenues over the foreseeable future. Given that Cadila is expected to register a revenue CAGR of 20% over FY14-17E, we have pencilled in R&D spend growing at CAGR of 10%.

Exhibit 26: Common size statement – Margin expansion through operating leverage FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Material Cost 31.9% 31.9% 36.5% 37.6% 37.2% 37.9% 39.0% General Expenses 40.6% 40.3% 38.5% 39.5% 39.0% 37.4% 36.1% R&D Expenses 5.4% 6.9% 7.3% 6.3% 5.4% 5.1% 4.8% Total Expenditure 77.8% 79.1% 82.3% 83.4% 81.6% 80.4% 80.0% EBITDA 22.2% 20.9% 17.7% 16.6% 18.4% 19.6% 20.0% Source: Company, Ambit Capital research

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RoCE to peak in FY18 and then gradually decline

Cadila had RoCE of 17.5% in FY14 and is likely to close FY15E with an RoCE of RoCE will peak out in FY18 at 20.2%. As per our estimates, RoCE will peak out in FY18 at 27.9% till the 27.9% till ramp up in USFDA aforementioned ramp up in the USFDA approvals fuels growth. Post FY18E, we approvals fuels growth expect RoCEs to gradually decline to 17% in FY29E. We expect RoCEs to decline overtime due to a) as the company moves up the value chain, the cost arbitrage with Western generic companies would narrow resulting in lower asset turnover; b) High proportion (44%) of revenues coming from India in FY14 (high RoCE business due to high asset turnover and margins). As the EMs presence in built out and revenues are geographically diversified, the RoCE would be adversely impacted (other geographies are relatively lower RoCE markets).

Exhibit 27: We expect RoCEs to be above WACC and stabilise at 17% in the terminal year

35.0% WACC 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E FY23E FY24E FY25E FY26E FY27E FY28E FY29E ROCE

Source: Company, Ambit Capital research Financial assumptions

Exhibit 28: Detailed financial assumptions (` mn unless otherwise mentioned) Particulars Assumptions YoY change (%) Comments FY15E FY16E FY17E FY15E FY16E FY17E

Sales assumptions

Expect growth to be back on track post a disruptive FY15 owing to challenges in pricing. Cadila is likely to grow the India formulations 27,131 30,821 34,884 10% 14% 13% domestic formulations business in line with the broader market. Expect strong growth momentum in US generics led by high NA generics 29,096 41,350 55,910 34% 42% 35% number of ANDAs pending approval when compared to currently commercialised products and better product mix. Expect India consumer business to accelerate marginally India Consumer and animal health 7,708 8,440 9,245 8% 9% 10% under the new leadership. Expect Europe and EM exports growth momentum to Europe and EM exports 11,373 13,009 14,748 8% 14% 13% continue on a small base. Profitability in these segments is sub-par as of now owing to lack of scale. Overall revenue growth likely to be in the high teens for our Total 84,014 103,088 124,962 17% 23% 21% explicit forecast period. We do not expect any material change in gross margins. Ramp up in the US business is likely to fuel margin growth Gross profit 52,877 64,133 76,296 17% 21% 19% which would be offset by pricing pressure in India and AG launches in the US. With better directed R&D expenditure and operating Overhead costs 37,355 43,853 51,247 13% 17% 17% leverage playing out in several export businesses, we expect slower growth in overheads as compared to revenues. We expect ~340bps expansion in EBITDA margins over EBITDA 15,522 20,280 25,048 29% 31% 24% FY14-17E largely led by operating leverage in the US and other export businesses. EBITDA margins (%) 18.84% 20.03% 20.38%

Higher depreciation and tax rate impact net profit growth. PAT (adj for forex loss) 10,254 14,242 17,294 23% 39% 21% We expect a net profit CAGR of 27% over FY14-17E. Source: Ambit Capital research

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Ambit vs consensus Our revenue projections are 3-8% higher than consensus estimates for FY16/17E, largely due to our expectations of higher number of launches in US led by improvement in USFDA timelines. Our EBITDA and net profit estimates are 7-9% and 7-8% ahead of consensus for FY16E andFY17E presumably due to higher operating leverage assumptions.

Exhibit 29: Our net profit estimates are broadly in line with consensus Particulars (` mn) Ambit Consensus Divergence (%) Sales

FY15E 82,389 83,911 -1.8% FY16E 101,257 98,119 3.2% FY17E 122,902 113,530 8.3% EBITDA

FY15E 15,522 15,344 1.2% FY16E 20,280 18,913 7.2% FY17E 25,048 23,004 8.9% Net Profit

FY15E 9,928 10,293 -3.5% FY16E 13,916 12,996 7.1% FY17E 16,968 15,765 7.6% Source: Bloomberg, Ambit Capital research

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Valuation discount to large-caps to narrow Cadila is trading at a ~15-20% discount to the which peer average one-year forward Cadila is trading at a ~15-20% P/E multiple. Whilst well-entrenched promoters, high R&D productivity and excellence discount to the peer average one- in execution lend comfort on valuations, earnings momentum is also likely to sustain year forward P/E (led by the unfolding of the ANDA pipeline in the US). We use a DCF methodology to value Cadila with a terminal RoCE of 17% and discount rate of 13%. This leads to a target price of `1,510/share.

Valuation methodology We value Cadila using a DCF methodology wherein EBITDA margin, medium-term revenue growth rate and terminal revenue growth rate are the key variables controlling the valuation. Furthermore, we use a free cash flow to equity methodology. Cadila would have incremental EBITDA margin: We build in a gradual expansion in EBITDA margins from 17% in margin tailwinds in the US and FY14E to 27.2% in FY29E (terminal year). Cadila would have incremental margin Indian markets over the longer tailwinds in the US and Indian markets over the longer term, as it ramps up its term product basket. Please note that our model does not account for any material improvement in the product mix (ex-India), as we do not assume any success in innovative endeavours like biosimilars, NCEs, NBEs and vaccines.

Medium-term and terminal revenue CAGR: We pencil in medium-term (FY18- FY27E) revenue CAGR of 9% largely led by continued growth momentum in the India and US markets. We expect the US revenues to slowdown post FY19E, as the tailwinds on faster approvals subside.

Exhibit 30: We pencil in medium-term revenue growth of 12% and terminal rate of 4% Medium-term revenue CAGR Terminal revenue growth (FY18-27E) rate (FY28E onwards) Domestic Formulations 8.6% 5.0% Domestic API 5.5% 0.0% Consumer & Others 8.2% 5.0% Export Formulations 10.8% 3.1% North America (US) 11.0% 3.0% Europe 8.9% 3.0% Latin America 14.2% 5.0% Emerging Markets 8.7% 3.0% Animal Health & Others 10.0% 5.0% Exports API 5.2% 0.0% All JVs 5.6% 3.6% Total gross sales 9.8% 3.6% Source: Ambit Capital research

Our DCF model suggests a fair value of `1,510/share (our 12-month forward target price), which implies ~20.0x FY16/17E EPS as compared to the current trading multiple of 23.0x FY15/16E EPS.

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Exhibit 31: Valuation multiples do not reflect competitive positioning 28 26 Sun Pharma 24 Lupin 22 20 Cadila 18 Cipla Glenmark

P/E (FY15E) P/E 16 IPCA 14 Dr. Reddy's 12 10 10 15 20 25 30 35 40 RoCE (FY14E)

Source: Bloomberg, Ambit Capital research; Note: Bubble size indicates competitive positioning (larger bubble = higher position) As seen in the exhibit above, Cadila is trading at a deep discount to Sun Pharma and Lupin largely due to depressed RoCEs despite comparable competitive positioning. We believe that the discount is justified given the suppressed profitability and RoCE and no visible catalysts to turn around the foreign loss-making subsidiaries. At our target P/E multiple of 20x one-year forward EPS, Cadila would still be trading at a discount of 10-15% to these companies. In our DCF model, we do not assume any significant success in innovative pursuits and would expect the discount to narrow further in case Cadila’s innovative pursuits show signs of paying off.

Exhibit 32: Terminal value contributes 47% to total fair enterprise value Key assumptions Value Remarks Discount rate 13.1% Cost of equity Terminal growth rate 3.7% Population growth rate + increasing penetration + medical insurance penetration + pricing RoW business is on a very small base; India growth in line with broader market; expect moderation of Medium-term growth rate 9.0% growth in US in absence of visibility on longer term growth drivers Expect margin expansion led by revenue ramp up in the US, revival in growth in India and operating EBITDA margins (FY15e) 18.8% leverage US margins to ramp up due to niche segment presence; India and other businesses margins to EBITDA margins (FY29e) 27.6% increase due to operating leverage Total Enterprise Value 327,149 ` mn Terminal Value 152,476 ` mn Terminal value as % of total 47% Source: Ambit Capital research We expect Cadila’s EBITDA margin to improve over the next 15 years and RoCE to expand from the current ~17% to 27% in the terminal year (FY29E).

Exhibit 33: Our 12-month forward target price is `1,510/share Particulars In mn ` Total EV 327,149

Net debt (FY15E) (17,985)

Equity Value 309,165

No. of shares outstanding (mn) 205

Value / share ( ) 1,510 ` CMP ( ) 1,273 ` Upside / Downside (%) 19.0%

FY15E FY16E FY17E Implied adj. PE (x) 31.1 22.2 18.2 Current adj. PE (x) 26.3 18.7 15.4 Source: Ambit Capital research

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Cross-cycle valuation

Cadila is currently trading at 26.0x FY15/16E EPS i.e. a ~15-20% discount to its Cadila has re-rated in the past larger peers like Lupin and Sun Pharma. Whilst the company has re-rated led by the management’s significantly over the recent past largely led by the management’s guidance towards guidance towards margin margin expansion and revenue growth in the US, we believe that sustained earnings expansion and revenue growth growth may drive valuations higher. The US generics business is about to ramp up led by approvals of niche products. Historically, the company’s re-rating has been driven by scaling up the value chain. At the current valuations, we see little room for further re-rating of the business and believe that niche opportunities like transdermals and nasal sprays in the US are largely accounted for. Hence, we expect the stock performance to be largely in line with earnings growth. We expect earnings CAGR of 27% over FY14-17E.

Exhibit 34: Cadila has re-rated led by higher expectations Exhibit 35: The stock has traded in a EV/EBITDA average of from US exports and revival in India formulations growth 13.3x over the last 12 months

1800 CDH Price Band chart 20.00 1600 30x 18.00 16.00 One yr EV/EBITDA avrage of 1400 13.3x 1200 14.00 12.00 1000 20x 10.00 800 Price 8.00 600 6.00 400 4.00 10x 200 2.00 0 0.00 Jul-06 Jul-08 Jul-10 Jul-12 Jul-14 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 Nov-05 Nov-07 Nov-09 Nov-11 Nov-13 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: Bloomberg, Ambit Capital research Source: Bloomberg, Ambit Capital research

Exhibit 36: Earnings growth and RoE increased in FY10-11 Exhibit 37: EBITDA growth and RoCE have been declining to due to launch of interesting products like Taxotere in US; competition in generic Taxotere and lack of new approvals post FY11 no other interesting product has been launched for niche products from USFDA

80% 40% 40% 35% 70% 35% 60% 35% 30% 30% 25% 50% 30% 40% 20% 25% 30% 25% 15% 20% 10% 20% 10% 20% 5% 0% 15% 0% 15% -10% -5% -10% 10% -20% 10% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

PAT growth (LHS) RoE (RHS) EBITDA growth (LHS) RoCE (RHS)

Source: Bloomberg, Ambit Capital research Source: Bloomberg, Ambit Capital research

We believe that the next round of re-rating would require the longer-term growth Re-rating will require longer-term opportunities to come to the fore and the US business to ramp up. The investments opportunities to come to the fore made in innovative projects like NCEs, biosimilars, NBEs, vaccines and emerging markets have suppressed RoCEs despite the growing profitability of the US business and operating leverage in India. Given that the long-term growth drivers come to the fore, especially in emerging markets, over the next 3-5 years, we would expect the P/E multiple to re-rate. Turnaround in profitability of EMs could be another trigger for a re-rating.

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Key risks to our BUY thesis

. Failure in innovation: Innovative ventures like biosimilars, NCEs, NBEs and vaccines development carry the risk of failure with lesser hits than misses. If Cadila is unable to monetise its innovation R&D (35% of R&D spend in FY14), margins may decline. Although we are not building in any significant revenues from innovative projects into our projections, we believe any failure in innovation may impact margins by adversely impacting costs like R&D.

. Delay in EMs profits: We deduce RoW business EBITDA margins of -10% for FY14. If the company is unable to rationalise/turnaround EM operations, RoCE may remain depressed. Due to below average ranking in our DNA framework, we do not build a turnaround in emerging market profitability into our forecasts.

. Worse-than-expected pricing environment in the US: We assume a moderate decline in the base business pricing in the US. This assumption is led by market expectations of high approvals for competitors in the base business partly offset by increased FDA vigilance, keeping very small players out of the market.

. INR appreciation against USD: Cadila has not been a beneficiary of the INR depreciation against the USD largely due to hedges taken at lower rates. However, the company now has negligible hedges and in the event of a reversal in trend, we assess that the company’s profits could decline by 1.5% for every 1% appreciation in the INR beyond `60/USD levels.

Catalysts

. Quicker-than-anticipated improvement in FDA approval rate: Whilst we have assumed a growing rate of improvement in FDA approval timelines, the improvement may be uniform or even front-ended over the next four years. If so, then the revenue ramp up in the US could be higher than our expectations. We are building in a parabolic improvement in FDA timelines in FY16E and FY17E.

. Faster-than-anticipated growth in India: The management expects to beat the broader market growth by a wide margin which is growing at 13%. However, we are pencilling in a growth (13%) in line with the broader market led by our assumptions of a lower number of new launches in India in the future. Higher- than-estimated growth in India is likely to be a key catalyst.

. Unknown large filings in the US: We have taken a top-down approach for the unknown filings in the US at an average revenue rate of US$5mn per ANDA. However, as seen in the past, there is always an upside risk to such assumptions, as more complex and already off-patent products do not come under our radar.

. Progress on innovative projects and other differentiated filings: Cadila expects to market Lipaglyn in export geographies in 2-3 years. We have not pencilled in any material upside from such ventures in our estimates.

Sensitivity of fair enterprise value to our assumptions

Exhibit 38: Sensitivity of TP to discount and terminal growth rates Terminal growth rate

1.7% 2.7% 3.7% 4.7% 5.7%

11.1% 1,858 1,981 2,138 2,344 2,627

12.1% 1,586 1,674 1,783 1,922 2,104 13.1% 1,367 1,432 1,510 1,607 1,730 14.1% 1,189 1,237 1,295 1,364 1,450

Discount rate Discount 15.1% 1,042 1,079 1,121 1,172 1,234 Source: Ambit Capital research

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Exhibit 39: Sensitivity of TP to US business medium-term growth rate and EBITDA margins Medium-term EBITDA margins

22.6% 23.1% 23.6% 24.1% 24.6%

8.0% 1,373 1,391 1,409 1,426 1,444

9.0% 1,422 1,440 1,458 1,476 1,494 term term - 10.0% 1,474 1,492 1,510 1,528 1,546 11.0% 1,528 1,547 1,565 1,584 1,602 growth rate growth

medium 12.0% 1,587 1,605 1,624 1,643 1,662 US formulations formulations US Source: Ambit Capital research

Our INR assumption and sensitivity of earnings

We have pencilled in `60/USD for FY15E and beyond. Our sensitivity analysis suggests that for every percentage point appreciation/depreciation in the INR/USD, Cadila’s net profit decreases/increases by 1.5%.

Exhibit 40: Explanation for the flags on the cover page Field Score Comments In our forensic analysis of 360 companies, Cadila scores in line with the pharma industry average (comprising 26 companies). Cadila scores high on ratios of: (a) gross block conversion; (b) change in depreciation rates; Accounting GREEN (c) audit fees and (d) non-operating expenses. However, Cadila has weaker scores on: (a) cash yield; and (b) volatility in sales and distribution costs. Overall, the management has made timely announcements in its earnings calls, meetings and interviews Predictability AMBER regarding product filings, acquisitions and business outlook. However, the unpredictability of emerging markets and innovative projects makes us assign an AMBER flag on predictability. Consensus FY15 EBITDA and EPS estimates have been upgraded by 4-5% and FY16 EBITDA and EPS Earnings momentum GREEN estimates have been upgraded by 2-5% over the past three months. Source: Bloomberg, Ambit Capital research

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Accounting analysis – No concerns

. Revenue recognition: Cadila’s pre-tax CFO as a percentage of EBITDA has Stable CFO as a percentage of been stable over the years, with a blip in FY12. The reason for the decrease in EBITDA revenue recognition from 81% in FY11 to 64% in FY12 was due to higher working capital investment. Working capital days increased from 95 days in FY11 to 142 days in FY12. Excluding FY12, Cadila’s revenue recognition has been similar or better than its peers. Also, Cadila’s revenue recognition has been less volatile than its peers. We assign a GREEN FLAG.

Exhibit 41: Revenue recognition YoY change in CFO Company/Metric Pre-tax CFO as a % of EBITDA as a % of EBITDA Volatility (bps) (measured by SD) FY09 FY10 FY11 FY12 FY13 FY14 FY13 FY14 Cadila 98% 96% 81% 64% 82% 98% 1,806 1,590 13% Aurobindo 62% 70% 55% 65% 46% 46% 1,072 (1,963) 10% Glenmark NA NA 60% 131% 80% 102% 7,165 (5,114) 31% IPCA 93% 71% 66% 94% 86% 90% 2,806 (841) 12% Biocon 35% 101% 152% 123% 104% 103% (2,840) (1,924) 39% Average(ex-Cadila) 63% 81% 83% 104% 79% 86% 2,051 (2,461) 23% Divergence 35% 15% -2% -40% 3% 12% (244) 4,050 -9% Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity

. Working capital days: Cadila’s debtor days and inventory days have been consistently lower than the peer average due to its Zydus Wellness business in which it sells relatively fast-moving goods such as sugar substitutes and EverYuth scrubs and peel-offs in the skin-care range. Zydus Wellness contributes 12% to consolidated PBT. Cadila has a large presence in the non-US and non-EU market. Cadila earns 66% of its revenues from the emerging market and animal health Lower working capital days due business. Businesses in these geographies usually require higher working capital to the Wellness business investment, as the debtor cycle is usually longer. Despite having a substantial presence in emerging markets, Cadila has been able to manage its debtor days at significantly lower levels than its peers. GREEN FLAG. Cadila’s inventory days have been stable over FY09-14 and better than its peers. As stated above, despite having a considerable presence in emerging markets, the company has managed its inventory well. We take comfort from the fact that Cadila has stable and below average inventory days and hence we assign a GREEN FLAG. Cadila’s creditor day has been higher than the peer set in FY09-FY11but have lowered in FY12-14. We believe this may be due to acquisition of Nesher pharma and Biochem pharma in FY12. However, this needs further investigation and hence we assign AMBER FLAG.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 61

Cadila Healthcare

Exhibit 42: Working capital days Company/Metric Average Debtor days Average Inventory days Average Creditor days Working Capital days FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14 Cadila 49 58 54 53 62 66 66 65 57 48 35 40 53 77 85 78 Aurobindo 91 97 88 95 107 118 108 97 57 56 51 52 141 160 146 140 Glenmark 140 108 105 115 100 72 59 54 81 66 66 73 158 115 98 96 IPCA 83 63 49 48 82 104 96 94 24 32 33 34 141 134 113 109 Biocon 63 88 74 70 52 69 57 49 35 57 51 44 80 100 80 76 Average(ex-Cadila) 94 89 79 82 85 91 80 74 49 53 50 51 130 127 109 105 Divergence (46) (30) (25) (30) (23) (25) (14) (8) 8 (5) (16) (11) (77) (50) (24) (27) Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity.

. Expense manipulation: The average depreciation rate for Cadila was almost constant across FY11-14. However, as compared to its peers, the average deprecation rate has been significantly lower by 1.5-2.3%. This is primarily due to higher proportion of intangibles in the books of Cadila as compared to its peers. As shown in Exhibit 42, Cadila has 36% of its total gross assets as intangibles, as Lower depreciation rate due to compared to 4-9% for its peers. Majority of these intangibles consist of goodwill higher intangibles on the books arising out of acquisitions. Whilst goodwill is reviewed frequently and decision on impairment is taken on a periodic basis, amortisation is not done every year on intangibles. We see similar trends in Glenmark which has a higher percentage of intangibles in its total gross assets. Cadila’s numbers are mostly in line with Glenmark’s, with a marginally higher depreciation rate. We have no significant concerns over the depreciation rate and hence we assign a GREEN FLAG.

Exhibit 43: Expense manipulation - depreciation YoY change in Company/Metric Average Depreciation rate depreciation rate (bps) FY11 FY12 FY13 FY14 FY13 FY14 Cadila 4.8% 4.8% 4.6% 4.6% (21) 6 Aurobindo 7.1% 7.3% 7.3% 7.9% 0 60 Glenmark 3.8% 3.7% 4.1% 6.1% 45 199 IPCA 6.0% 6.3% 6.0% 6.0% (28) (7) Biocon 8.1% 8.4% 7.6% 7.6% (81) (3) Average(ex-Cadila) 6.2% 6.4% 6.3% 6.9% (16) 62 Divergence -1.5% -1.7% -1.7% -2.3% (5) (56) Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity.

Exhibit 44: Cadila and Glenmark have a high proportion of intangible assets Cadila Aurobindo Glenmark IPCA Biocon Tangible assets (%) 64% 91% 59% 91% 96% Intangible assets (%) 36% 9% 41% 9% 4% Source: Company, Ambit Capital research

. Cash manipulation: Cadila’s loans and advances have remained higher than its peer’s average consistently. Also, loans and advances have grown over the years from 20.9% in FY11 to 24.3% in FY14. However, majority of these loans and advances consist of advances paid to government authorities and hence we do not see this as a major concern. Hence, we assign a GREEN FLAG.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 62

Cadila Healthcare

Exhibit 45: Cash manipulation checks Company/Metric Loans and advances as a % of net worth FY10 FY11 FY12 FY13 FY14 Cadila 19.2% 20.9% 22.4% 25.3% 24.3% Aurobindo 20.3% 21.8% 18.1% 21.9% 31.1% Glenmark NA 9.8% 13.4% 12.8% 17.6% IPCA 14.6% 11.2% 18.2% 15.9% 15.8% Biocon 7.6% 9.6% 14.4% 15.8% 15.7% Average(ex-Cadila) 14.2% 13.1% 16.0% 16.6% 20.0% Divergence 5.0% 7.8% 6.4% 8.7% 4.2% Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity; we have excluded capital advances from loans and advances to calculate the above ratio.

. Investment income analysis: Cadila’s investment income as a percentage of Higher investment income as a cash has been high as compared to its peers. It has also been volatile, with FY12 percentage of cash reporting higher investment income due to profit from sale of investments. Whilst we take comfort from the fact that interest income accounted for negligible percentage of PBT over FY11-14, leaving little incentive for manipulation of this line item, but the higher investment income as percentage of cash is a cause of concern. We assign an AMBER FLAG.

Exhibit 46: Investment income analysis Change in investment Investment income as a % of cash and income as a % of cash and Company/Metric marketable investments marketable investments (bps) FY10 FY11 FY12 FY13 FY14 FY13 FY14 Cadila 4.8% 4.1% 8.7% 4.8% 5.5% (394) 74 Aurobindo 0.9% 0.3% 2.9% 0.3% 0.4% (260) 10 Glenmark NA 5.1% 3.6% 1.4% 0.7% (220) (71) IPCA 2.1% 3.5% 10.5% 8.7% 4.6% (179) (410) Biocon 3.1% 4.6% 4.7% 3.7% 4.0% (99) 30 Average(ex-Cadila) 2.0% 3.4% 5.4% 3.5% 2.4% (166) (150) Divergence 2.8% 0.7% 3.3% 1.3% 3.1% (95) 161 Source: Company, Ambit Capital research. Note: (a) All financials pertain to the consolidated entity; (b) Investment income comprises interest income, dividend income and profit on sale of current investments Contingent liabilities and provisions

. Cadila’s contingent liabilities as a percentage of net worth declined by 300bps in Higher contingent liabilities as a FY14. Cadila’s disputed liabilities as a proportion of net worth is significant as at percentage to net worth is a end-FY14 and mainly consisting of liabilities of Income tax matters. As compared cause of concern to its peers, contingent liabilities not provided for by Cadila is at the peer average. Contingent liabilities of more than 5% as percentage of net worth is a large number for our comfort and hence we assign an AMBER FLAG.

Exhibit 47: Contingent liabilities not provided for by Cadila is at peer average Contingent liabilities Contingent liabilities Net Worth FY14 as % of net worth (` Mn) (` Mn) Cadila 6.9% 2,383 34,390 Aurobindo 3.3% 1,253 37,502 Glenmark 4.3% 1,294 29,966 IPCA 12.9% 2,529 19,597 Biocon 7.7% 2,322 30,267 Average(ex-Cadila) 7.06% Divergence -0.13% Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 63

Cadila Healthcare

Provisions for debtors: Cadila’s debtors outstanding for more than six months Adequate provisioning of debtors (which have a high probability of turning bad) as a percentage of gross debtors have as compared to its peers been constant across FY11-14. At the same time, the provision for the same has dropped to 40% in FY14 from 51% in FY13. However, the company has consistently been providing for more than its peers. Cadila has lower debtors aging six months or more, which is due to its lower debtor days as compared to its peers. We assign a GREEN FLAG.

Exhibit 48: Provision for debtors Company\Metric Provision for doubtful debts as Provision for doubtful debts as Debtors over 6 months as a % of debtors over six months % of gross debtors % of gross debtors FY12 FY13 FY14 FY12 FY13 FY14 FY12 FY13 FY14 Cadila 50.9% 51.0% 40.4% 1.2% 1.3% 0.8% 2.3% 2.5% 2.1% Aurobindo 40.2% 42.7% 41.1% 2.3% 1.7% 1.2% 5.7% 4.0% 2.9% Glenmark 18.8% 10.0% 9.4% 2.2% 1.7% 1.2% 11.5% 16.6% 13.0% IPCA 3.7% 0.0% 4.8% 0.1% 0.0% 0.1% 2.4% 2.7% 3.0% Biocon 53.1% 27.1% 53.7% 1.4% 0.6% 0.8% 2.6% 2.1% 1.6% Average(ex-Cadila) 28.9% 19.9% 27.3% 1.5% 1.0% 0.9% 5.6% 6.3% 5.1% Divergence 22.0% 31.1% 13.2% -0.3% 0.3% 0.0% -3.3% -3.9% -3.1% Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity Auditors The company’s accounts are audited by M/s Mukesh M. Shah & Co., and the auditors have not been changed since FY08. We assign an AMBER FLAG. The Audit Committee, as on 31 March 2014, comprises three members (all of whom Auditors have not been changed are non-executive independent directors of the company). Mr. Mukesh M Patel is the since FY08 Chairman of the committee. The attendance of members has been healthy and composition revolving, and hence we assign a GREEN FLAG. Cadila’s audit fees as a percentage of sales are in line with the peer group average and we do not have any significant concerns on its audit fees. As compared to net sales, there was no significant growth in audit fees. GREEN FLAG Corporate governance

. Board composition and promoter background: Mr. Pankaj R. Patel is the Chairman of Cadila Healthcare. He founded the company in 1995 post the split from Mr. Indravadan Modi. Apart from Mr. Pankaj R. Patel, Mr. Shravil Patel (the son of Mr. Pankaj R. Patel) has been the Deputy Managing Director since July 27, 2007. The board comprises five non-executive independent directors out of the total seven board members, which implies a good mix. Rotation of independent directors: The Best Practices Code suggests that the . 3 out of 5 independent directors maximum tenure for an independent director should be five years. Three of the have been associated with Cadila five independent directors have been associated with the company for more than for more than 10 years 10 years. This is a cause of concern and hence we assign an AMBER FLAG.

. Attendance of the board: The attendance of the board members has remained reasonable for the Board meetings held in FY11-14.

. Insider trading: Insider transaction tracking indicates some trading activities in the company’s shares by the promoters/senior management. There have been no significant instances of insider trading, and hence, we assign a GREEN FLAG.

. Managerial remuneration: Cadila’s managerial remuneration as a percentage of PBT is high as compared to its peers. Growth in managerial remuneration has been in line with the growth in PBT. Remuneration declined by 42% in FY12 and 1% in FY13 as compared to PBT decline of 6% in FY12 and marginal increase of 2% in FY13. Though managerial remuneration has remained consistent from FY11 to FY14, the divergence from its peers is high. We assign an AMBER FLAG.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 64

Cadila Healthcare

Revenue Mix

Year ended 31 Mar (` mn) FY13 FY14 FY15E FY16E FY17E Domestic Formulations 23,232 24,644 27,131 30,821 34,884 API (Domestic and Exports) 3,098 3,497 3,824 4,160 4,506 Consumer 4,100 4,296 4,511 4,872 5,261 Animal Health 2,462 2,865 3,198 3,569 3,983 Export Formulations 24,886 32,282 40,469 54,359 70,658 North America (US) 15,068 21,704 29,096 41,350 55,910 Ex North America 9,818 10,578 11,373 13,009 14,748 JV Revenues 5,070 4,499 4,882 5,308 5,669 Total Gross Sales 62,848 72,083 84,014 103,088 124,962 Source: Company, Ambit Capital research

Income statement

Year to March (` mn) FY13 FY14 FY15E FY16E FY17E Net revenues 61,552 70,600 82,389 101,257 122,902 Material Cost 23,202 27,136 31,310 39,120 48,826 General Expenses 24,455 28,540 32,792 38,605 45,213 R&D Expenses 4,669 4,563 4,563 5,247 6,035 Core EBITDA 11,251 12,001 15,522 20,280 25,048 Depreciation 1,847 2,012 2,841 3,119 4,536 Interest expense 1,687 902 1,115 1,115 1,115 Adjusted PBT 8,088 9,422 12,064 16,756 20,345 Tax 1,188 1,060 1,810 2,513 3,052 Reported net profit 6,536 8,036 9,928 13,916 16,968 Source: Company, Ambit Capital research

Balance sheet

Year to Mar (` mn) FY13 FY14 FY15E FY16E FY17E Total Assets 60,859 63,798 71,460 83,110 97,811 Fixed Assets 37,612 40,153 41,812 44,193 46,157 Current Assets 34,965 38,846 46,517 58,400 74,134 Investments 1,145 866 866 866 866 Total Liabilities 60,859 63,798 71,460 83,110 97,811 Shareholders' equity 1,024 1,024 1,024 1,024 1,024 Reserves & surplus 28,459 33,366 41,028 52,678 67,379 Total net worth 29,483 34,390 42,052 53,702 68,403 Total debt 29,178 27,004 27,004 27,004 27,004 Current liabilities 12,901 16,067 17,736 20,349 23,346 Deferred tax liability 1,005 961 961 961 961 Source: Company, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 65

Cadila Healthcare

Cash flow statement

Year to March (` mn) FY13 FY14 FY15E FY16E FY17E PBT 8,088 9,422 12,064 16,756 20,345 Depreciation 1,847 2,012 2,841 3,119 4,536 Tax 1,188 1,060 1,810 2,513 3,052 Net Working Capital (1,996) (359) (2,505) (4,005) (4,593) CFO 4,272 8,870 10,264 13,030 16,910 Capital Expenditure (7,031) (4,576) (4,500) (5,500) (6,500) Investment (564) 354 - - - Other investments - - - - - CFI (7,595) (4,222) (4,500) (5,500) (6,500) Issuance of Equity - - - - - Inc/Dec in Borrowings 6,285 (3,095) - - - Net Dividends (1,790) (2,192) (2,232) (2,266) (2,266) Other Financing activities - - - - - CFF 4,495 (5,287) (2,232) (2,266) (2,266) Net change in cash 1,172 (639) 3,532 5,264 8,144 Closing cash balance 5,838 5,488 9,019 14,283 22,428 Source: Company, Ambit Capital research

Valuation Parameters Year to March FY13 FY14 FY15E FY16E FY17E EPS 31.9 40.1 48.5 68.0 82.9 Book Value ( per share) 288.0 335.9 410.8 524.6 668.2 P/E (x) 40.8 32.5 26.9 19.2 15.7 P/BV (x) 4.5 3.9 3.2 2.5 1.9 EV/EBITDA(x) 25.8 24.0 18.3 13.8 10.8 EV/Sales (x) 4.7 4.1 3.5 2.8 2.2 EV/EBIT (x) 30.8 28.9 22.5 16.3 13.2 Source: Company, Ambit Capital research

Ratios Year to March FY13 FY14 FY15E FY16E FY17E Revenue growth 20.9 14.7 16.7 22.9 21.4 Core EBITDA growth 2.4 6.7 29.3 30.7 23.5 APAT growth 0.1 23.0 23.5 40.2 21.9 EPS growth 0.1 25.6 21.0 40.2 21.9 Core EBITDA margin 18.3 17.0 18.8 20.0 20.4 EBIT margin 15.3 14.1 15.4 16.9 16.7 Net profit margin 10.6 11.4 12.1 13.7 13.8 ROCE (%) 18.2 17.5 20.2 23.9 24.4 Reported RoE (%) 23.7 25.2 26.0 29.1 27.8 Debt Equity ratio (X) 1.0 0.8 0.6 0.5 0.4 CFO/EBITDA (x) 0.4 0.7 0.7 0.6 0.7 Gross Block turnover (x) 1.7 1.8 2.0 2.4 2.7 Working Capital Turnover (x) 3.1 3.1 3.2 3.0 2.8 Current Ratio 2.7 2.4 2.6 2.9 3.2 Source: Company, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 66

Aurobindo Pharma

SELL

INITIATING COVERAGE ARBP IN EQUITY September 16, 2014

Pharmaceuticals Structural issues galore

Aurobindo not only faces governance issues (inferior financial reporting, Recommendation less than ideal disclosure, taxation issues of promoters) but also Mcap (bn): `252/US$4.2 structural issues—absence of ‘moated’ revenue/profit streams and long- 6M ADV (mn): `1621/US$26.6 term growth drivers, no commensurate Indian revenues to its domestic CMP: `896 operating costs and high likelihood of incumbents reviving in the US TP (12 mths): `828 market (35% of Aurobindo’s revenues). Valuations of 14.5x one-year Downside (%): 8 forward EPS may begin to de-rate, as incumbents return to the US, new products (injectables, OTC, controlled substances, penems) fail to gain Flags market share and RoCE starts declining from FY18E; our TP of 828 ` Accounting: RED implies 10.5x one-year forward P/E. Catalysts: Return of an incumbent Predictability: AMBER like Hospira in general injectables; large expensive acquisitions. Earnings Momentum: GREEN Competitive position: WEAK Changes to this position: STABLE Aurobindo ranks low on our competitive framework Catalysts Whilst the company scores high on risk management and R&D productivity, it . Return of incumbents in the US in segments such as general injectable, lags on parameters like rational capital allocation, robustness of business model controlled substance and oral solids and reputation and quality of management (hence, no significant competitive Slowdown in growth in US advantage). Issues in accounting, promoter history, active insider trading and . formulation sales less-than-ideal disclosures make us uncomfortable with its governance. . Large expensive acquisitions to make No ‘moats’ in current revenues; incumbents’ absence a transient boost up for lack of sustainable growth

A majority of Aurobindo’s revenues are sourced from generic generic segments. The company’s attempt to establish an India formulation business failed in 2006 Performance due to lack of scale. Its presence in EMs is negligible (~6% of FY14 sales) with 26,000 1150 no display of capabilities to scale up the business. The absence of incumbents in 24,000 950 the US segment has been a tailwind which may reverse anytime, which could 22,000 750 expose 35% of its revenues (FY15E) to both growth and margin risks. 20,000 550 EBITDA margin, RoCE to expand in near term, but to decline thereafter 18,000 350 16,000 150 Improvement in product mix towards injectables and other limited competition segments in the US and operating leverage are likely to lead to EBITDA margin Jul-14 Jan-14 expansion to 21% from 13% and RoCE expansion to 33% from 24% over FY14- Oct-13 Feb-14 Apr-14 Aug-13 Aug-14 Nov-13 May-14 17E. However, with 53% of costs based in India and lack of commensurate Sensex Aurobindo, RHS revenues and investments in long-term growth drivers (such as NCEs and NDDS), we expect RoCE to decline thereafter (peak at 33% in FY17E; FY29E Source: Bloomberg, Ambit Capital research estimate of 13%).

Expect discount to front-line peers to expand as earnings growth abates At a ~35% discount on FY16E EV/EBITDA to large-cap peers, valuations are not attractive and we expect it to widen to ~50% led by concerns around growth over medium term and governance issues. We forecast a FCFF CAGR of 6.5% over the medium term (FY18-27E). Our DCF-based TP implies 10.5x FY16/17 E EPS vs 18-24x for large-cap pharma. Key risks: Delay in return of incumbents; better pricing in the US; INR depreciation. Key financials Analyst Details Year to March ( mn) FY13 FY14 FY15E FY16E FY17E ` Aditya Khemka Net Revenues 58,553 80,998 119,928 136,808 161,507 Operating Profits 8,891 21,328 25,052 30,499 40,098 +91-22-3043 3272 Net Profits 3,501 11,737 15,770 19,733 27,268 [email protected] Diluted EPS 12.0 40.3 54.1 67.7 93.5 Paresh Dave RoE (%) 14.2 36.9 34.9 31.9 32.7 +91-22-3043 3212 P/E (x) 72.4 21.6 16.1 12.9 9.3 [email protected] P/B (x) 9.7 6.8 4.8 3.6 2.6 Source: Company, Ambit Capital research Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision. Aurobindo Pharma

Snapshot of company financials

Profit and Loss Revenue mix

Year to March (` mn) FY15E FY16E FY17E Year to March (` mn) FY15E FY16E FY17E Net revenues 119,928 136,808 161,507 Formulations

Core EBITDA 25,052 30,499 40,098 USA 42,416 55,495 74,175 Depreciation 3,701 4,226 4,264 ARV 9,591 11,029 12,132 Interest expense 1,071 846 621 Europe 33,745 34,060 37,204 Adjusted PBT 20,480 25,627 35,413 ROW 5,060 5,566 6,122 Tax 4,710 5,894 8,145 Total formulations 90,812 106,149 129,633 Reported net profit 15,770 19,733 27,268 API

Profit and Loss Ratios SSP 10,676 11,210 11,770

EBITDA Margin (%) 21.1 22.4 25.0 Cephs 10,200 10,500 10,500 Net profit margin (%) 13.1 14.4 16.9 ARVs and others 10,537 11,591 12,750 EV/ EBITDA (x) 11.5 9.1 6.7 Total API 31,413 33,301 35,020 P/E on adjusted basis (x) 16.1 12.9 9.3 Dossier Income 150 150 150 EV/Sales (x) 2.4 2.0 1.7 Total 122,375 139,600 164,803

Balance Sheet Cash flow

Year to March (in ` mn) FY15E FY16E FY17E Year to March (` mn) FY15E FY16E FY17E Total Assets 90,949 101,450 118,826 PBT 20,480 25,627 35,413 Fixed Assets 32,613 35,887 41,623 Depreciation 3,701 4,226 4,264 Current Assets 82,027 92,070 107,830 Tax (4,710) (5,894) (8,145) Investments 198 198 198 Net Working Capital (10,662) (4,207) (10,002) Total Liabilities 90,949 101,450 118,826 CFO 10,731 20,398 21,952 Total networth 52,946 70,948 95,823 Capital Expenditure (6,000) (7,500) (10,000) Total debt 35,691 28,191 20,691 Investment - - - Current liabilities 22,531 25,347 29,467 Other investments 200 200 200 Deferred tax liability 2,054 2,054 2,054 CFI (5,800) (7,300) (9,800) Balance Sheet ratios Issuance of Equity - - - RoCE 26.3 28.2 33.4 Inc/Dec in Borrowings (3,071) (8,346) (8,121) RoE 34.9 31.9 32.7 Net Dividends (1,384) (1,732) (2,393) Gross Debt/Equity (x) 0.7 0.4 0.2 Other Financing activities - - - Net debt (cash)/ Eq (x) 0.6 0.3 0.1 CFF (4,455) (10,077) (10,514) P/B (x) 4.8 3.6 2.6 Net change in cash 476 3,021 1,638 Closing cash balance 2,270 5,291 6,929

Consistently lower than average CFO/EBITDA concern Current valuation discount partially reflects structural issues (bubble size indicates competitive positioning on ‘5R’)

21 20 Company/Metric Pre-tax CFO as a % of EBITDA 19 Sun 18 Pharma FY10 FY11 FY12 FY13 FY14 17 16 Aurobindo 70% 55% 65% 46% 46% 15 Cadila Cipla Cadila 96% 81% 64% 82% 98% 14 13 Lupin 12 Glenmark NA 60% 131% 80% 102% Dr. Reddy's 11 Glenmark IPCA 71% 66% 94% 86% 90% 10 IPCA 9 Biocon 101% 152% 123% 104% 103% 8 Aurobindo EV/EBITDA (FY16E) EV/EBITDA 7 Average(ex-Aurobindo) 89% 90% 103% 88% 98% 6 Divergence -19% -35% -38% -42% -52% 5 10 20 30 40

RoCE (FY14)

September 16, 2014 Ambit Capital Pvt. Ltd. Page 68 Aurobindo Pharma

Aurobindo – Opportunistic and fragile

Aurobindo sells prescription drugs (formulations) in the US (35% of FY15E revenues), Europe (28% of FY15E revenues) and other export markets (12% of FY15E revenues). The company also sells APIs in India and other export markets (26% of FY15E revenues).

Exhibit 1: Presence highly concentrated in US and API sales Exhibit 2: Pickup in RoCE and EBITDA margins due to (US$ bn) Cymbalta launch in US and resolution of FDA issues at Unit VI (%)

30% 1,400 26.3% 1,200 25% 23.0% 474 22.0% 1,000 20% 24.2% 21.7% 13.2% 15.2% 800 466 77 19.5% 395 431 111 15% 600 139 338 77 10% US $ Mn US 53 58 79 86 400 65 138 9.8% 5044 148 164 5% 104 563 6.0% 200 322 192 261 247 0% - FY10 FY11 FY12 FY13 FY14 FY10 FY11 FY12 FY13 FY14 USA ARV Europe ROW API ARBP, EBITDA margin ARBP, RoCE

Source: Company, Ambit Capital research Source: Company, Ambit Capital research

Within US, Aurobindo has high concentration of revenues in oral solids (~59% of FY14 US sales excluding Cymbalta). During FY14, the company launched Cymbalta under 180 day shared exclusivity in the US which yielded US$94mn in revenues and high margins, in our assessment. Aurobindo has not invested in innovative projects like biosimilars, NCEs, vaccines and NBEs.

Exhibit 3: Aurobindo’s formulation split in the US (in US$ Exhibit 4: Aurobindo sources a negligible portion of its mn) (FY14) EBITDA from India when compared to peers (FY14)

80.0 Controlled 68.8 70.0 Substance One offs, 60.0 53.7 (Aurolife), 48.2 94 74 50.0 42.9 40.0 Cephalosp 30.0 orins, 28 20.0 10.0 0.0 Orals, Injectables 0.0 330 (Auromedi cs), 37 IPCA Cadila Biocon Glenmark Aurobindo Source: Company, Ambit Capital research Source: Company, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 69 Aurobindo Pharma

Snowballing of a most humble beginning

Aurobindo earns 26% of its revenues (FY15E) from API sales (including domestic and exports). Within formulations, the company earns 35% from the US, 28% from Europe (including Actavis’ business), 8% from ARV sales (8%) and 4% from EM sales.

Aurobindo’s history suggests that the company had a humble beginning in 1986 In 1988, the company started when Ramprasad Reddy, Nithyanand Reddy, and Dr. M Sivakumaran founded the manufacturing and marketing on company. Aurobindo started with locally trading anti-biotic molecules. In 1988, the its own in India and began company started manufacturing and marketing on its own in India and began exporting API in 1992 exporting API in 1992. The company began manufacturing formulations in 2002 and discontinued its Indian formulation business (50/50 JV with Citadel Fine Pharmaceuticals) in February 2006 due to continued losses. The company entered the US formulations market in 2003 when it filed its first ANDA and it has been investing heavily in manufacturing and R&D capabilities ever since. The business appears to be snowballing in the US with a strong pipeline of 208 ANDAs pending final approval, with an approved portfolio of 168 products currently. The company harbors ambitions of being a large generic player in the US and regulated markets of Western Europe.

Exhibit 5: RoCE has been lower than peer average and volatile due to one-off events

Rampup in US sales and In March 2013, US FDA lifts ban on Unit VI Lower capacity utilisation to get manufacturing associated operating resulting in higher revenues in the US market facilities ready for inspection by international leverage results in higher coupled with launch of Duloxetine (generic authorities resulting in lower profits due to RoCE Cymbalta) which provided super-normal profits sustained fixed cost due to shared exclusivity 30.0% 90 Challenges in profitability in overseas branches in Normalisation of Feb 2011: receives import alert in Unit 80 25.0% VI leading to US$36 million erosion in particular ventures in RoCE as capacity 70 China resulting in lower utlisation increases US sales and resultant lower depressed 20.0% 17.4% profitability profits due to operating leverage 24.2% 60 14.1% 12.7% 50 15.0% 11.4% 12.2% Improvement in product mix 21.7% 40 19.5% in API and continued ramp up 10.0% 6.9% in sales of oral solids and 30 Increase in capital employed 6.0% injectables in the US 20 5.0% through preferential allotment and increase in 10 4.1% 9.8% 0.0% debt led to lower RoCE 0 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 RoCE (%) Revenue, RHS (Rs. Bn)

Source: Company, Ambit Capital research

Exhibit 6: Recent stock price performance led by withdrawal of import alert on Unit VI and launch of Duloxetine

900 US FDA import Acquired operations in 7 Acquired Milpharm (UK), Purchased fully integrated alert for European countries from 800 Capacity engaged in generic R&D, formulation products from its Actavis and launch of expansion formulation manufacturing, manufacturing and Unit VI which Duloxetine (generic 700 through set up mainly in the UK market. distribution facility from manufacture Cymbalta) which of new facilities Milpharm had over 100 Sandoz in US; acquired cephs provided super-normal Pharmacin International 600 and listing at products approved from the profits due to shared stock exchange UK regulator and helped BV to help reduce exclusivity Aurobindo to tap the UK Aurobindo's time to market Commenced 500 and build portfolio in the Setting up two generic market marketing speciality generic value chain Commenced wholly owned injectables products 400 Lower capacity operations of SEZ subsidiaries in in US through Auro utilisation to get UNIT VII and US and Hong Medics manufacturing Aurolife USA 300 Kong to increase facilities ready facilities presence in the for inspection by 200 international international markets authorities 100 US FDA lifts import alert on Unit VI 0

Apr-95 Oct-95 Apr-96 Oct-96 Apr-97 Oct-97 Apr-98 Oct-98 Apr-99 Oct-99 Apr-00 Oct-00 Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Source: Company, Bloomberg, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 70 Aurobindo Pharma

Low rank in our competitive framework – the 5 ’R’s

Aurobindo receives an average position in our competitive advantage framework. Aurobindo ranks average in our Whilst the company scores high on risk management and R&D productivity, it lags on competitive advantage framework parameters like strategy and execution, rational capital allocation and robustness of business model. Please refer to our thematic report for further details on the competitive framework.

Exhibit 7: Aurobindo’s competitive position lags due to inferior capital allocation, strategy, execution and balance sheet Position as Competitive Components Measures Remarks compared to advantage larger listed peers Vision and mission focus on: (a) being among the top- 15 generic companies in the world by 2015; (b) Strategy Stated intent and vision developing wide range of products; (c) becoming the most-valued pharma partner. Recent hires, Key management personnel hired in the past 5 years management transition, to improve management bandwidth. depth and width Quality Lower than average other business interests. However, Other business interests Reputed legal issues in the past are a dampener. management, Ambit's Forensic Below average quality of financial reporting due to red Below average strategy and accounting flag on revenue recognition. execution Growth rate in India Aurobindo has no formulations business in India. The company has been able to gain greater than fair Market share in US share of market share in most products. Earnings visibility and Execution Low visibility on earnings; high variation in delivery. delivery Limited visibility of inorganic success. Recently Inorganic strategy acquired Europe business of Actavis is loss-making. success The management expects to break-even by FY16. Best-in-class R&D productivity of spend due to lower Revenues generated per R&D productivity Productivity index R&D spend as less complex products launched in the Above average R&D spend US (low margins). Rational capital Greatness Ambit's proprietary Below average score in capital allocation; earnings Below average allocation framework framework increase incommensurate with cash flows, a concern. Bargaining Lower than average bargaining power with buyers as power with Average debtor days indicated by debtor days of 119 days (FY14) as buyers compared to average of 88 days. Bargaining Robustness of the Higher than average bargaining power with suppliers power with Average creditor days Below average business model as indicated by higher than average creditor days. suppliers Significant portion of revenues sourced from Revenues from niche Barriers to entry competitive segments with no significant barriers to segments entry (general injectables, cephalosporin in the US). Diversity of High number of USFDA-approved facilities manufacturing base (formulations + API) encountered by a 39% 483 issue Operational risk Incidence of Form 483s rate make Aurobindo rank above average with low Risk entailed in from USFDA operational risk. Above average operations Average investment risk with a mix of JVs, alliances and Investment risk alliances/partnerships and own investments in partnerships subsidiaries and business verticals. Aurobindo obtains a below average position as Overall rank Below Average compared to its larger peers Source: Company, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 71 Aurobindo Pharma

Reputed management, strategy and execution – Scope for improvement Positives – Increased bandwidth with new professional hires The company’s execution in US has been high quality led by cost Over the past 5 years, the management has transitioned from being promoter- . advantage on vertically integrated driven to a team of professionals. The induction of Mr Govindrajan (ex Shasun), products as MD, Robert Cunard (ex Teva) as Head of US business and Arvind Vasudeva (ex Glenmark) as Head of International business also increases the management bandwidth.

. The company’s execution in the US has been high quality. Despite an inferior product mix in the US (largely ‘me-too’ products), the company has been able to consistently garner a higher than fair share of market share in most marketed products led by a cost advantage derived from vertical integration.

. Other business interests of the promoter family and immediate kin are lower than average. We believe this indicates lower risk of diversion in focus.

Exhibit 8: Aurobindo has lower other business interest as compared to its peers

60 Other directorships of immediate family of promoter 47 48 50 40 25 30 18 Average 20 12 15 16 10 4 0 Ipca Cipla Lupin Cadila Glenmark Aurobindo Healthcare Dr. Reddy's Dr.

Sun Pharma Sun Source: Company, Ambit Capital research Negatives – Structural, accounting and past legal issues

. Aurobindo also scores below average on our forensic accounting framework. The Aurobindo scores below average company’s scores lag due to concerns on consistently lower-than-peer on our forensic accounting CFO/EBITDA for the last 5 years and higher loans and advances. framework . The company also has the highest volatility amongst peers for reported vs expected EBITDA over the past 5 years. We believe that the trend suggests that the company’s earnings have largely been influenced by variables that were either unanticipated or undisclosed by the management.

. Aurobindo Pharma’s acquisition track record is yet to be established. The company’s acquisition of Actavis looks promising, but given that most pharma companies have struggled with profitability in Western Europe, we would wait and watch before giving much credit to the company. The management has guided towards a 12-month timeframe before any integration benefits are visible.

Exhibit 9: History of clustered acquisitions by Aurobindo Name of Joint venture / Nature Year Geography Particulars Acquisition Acquired Milpharm (UK), engaged in generic formulation manufacturing, mainly in the UK Milpharm Acquisition 2006 UK market. Milpharm had over 100 products approved from the UK regulator and it helped Aurobindo to tap the UK generic market. Sandoz manufacturing, R&D Purchased fully integrated R&D, formulation manufacturing and distribution facility from Acquisition 2007 US and distribution facility Sandoz in the US. Acquired Pharmacin International BV to help reduce Aurobindo's time to market and build Pharmacin International BV Acquisition 2007 Netherlands portfolio in the generic value chain. Acquired majority stake in group company, Trident Life Sciences, which provides Trident Life Sciences Acquisition 2009 India Aurobindo with additional capacity in non-oncological and non-infective injectables. Acquired Hyacinths Pharma, an API manufacturer; strategic location of land ideal and Hyacinths Pharma Acquisition 2013 India convenient for expansion plans for the company. Acquired Actavis's operations in 7 European nations, which includes personnel, Actavis's Europe operations Acquisition 2014 Europe commercial infrastructure, products, marketing authorisations and dossier license rights. Source: Company, Ambit Capital research

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. Promoter has been involved in legal issues: Aurobindo Pharma has also Political connectivity and been haunted by legal issues in the past due to alleged political connectivity. The declaration of undisclosed Central Bureau of Investigation in n India (equivalent of the FBI in the US) had agreement lead to significant charge-sheeted the former MD and current Board member, Nithyanand Reddy, in corporate governance issues a case involving disproportionate asset claims. However, the company did disclose that investments were made by promoters (if any) and the listed entity had nothing to do with the case. The charges were also later dropped by the CBI. Click here for media reports regarding this issue.

. Accounting practices of the company have failed in the past: Media reports also suggest that the company had declared `300mn of undisclosed income for FY12 post an Income Tax raid on its premises in February 2012.

. Upsides from interesting products impaired due to partnerships: Aurobindo’s distribution agreement with Citron Pharma on at least 39 oral products and 12 injectables for the US (possibly other emerging markets as well) would impair the upside for Aurobindo from these products, as it would have to pay distribution margins. Further, Aurobindo’s agreement with Celon Labs for hormones and oncology product manufacturing for the US (60:40 JV called Eugia) would also impair the potential upside from these ventures. Further, less than ideal disclosures on ownership and management of Citron Pharma make us uncomfortable with governance. R&D productivity – Highest owing to execution in US Positives – Vertical integration helping in market share gains in ‘me-too’ products

. Despite Aurobindo’s R&D spend being considerably lower than its peers, the Scores high on R&D productivity company’s productivity has been higher than most peers. We believe this is index due to no spend on long- a function of: (a) no spend on longer-term growth drivers like biosimilars, NCEs, term growth drivers and NDDS-based products and other complex products; (b) investments largely in less investments in less complex complex products like oral solids, general injectables, controlled substances, and products cephalosporins which have yielded significant revenues owing to excellent execution in the US driven by vertical integration.

. Low R&D spend is healthy for near-term (FY15E-18E) RoCE, as there is little revenue-cost mismatch on the income statement; however, over longer-term low R&D spend will keep avenues of growth poor.

. As per the management, there is no capitalisation of R&D spend. Even the R&D spend on hormones and oncology products in Eugia JV have been expended through the income statement. Cadila has capitalised its R&D spend in the JV for transdermals.

Exhibit 10: Aurobindo has high R&D productivity due to low R&D spend and excellent execution in the US to gain market share driven by vertical integration on oral solids 10.0%

9.0% Dr. Reddy's Glenmark 8.0% Lupin 7.0% Cadila Sun Pharma 6.0% Aurobindo

(FY14) 5.0% 4.0% Ipca 3.0% R&D spend as % of sales of % asspend R&D 2.0% - 1.0 2.0 3.0 4.0 5.0 6.0 7.0 R&D productivity index Source: Ambit Capital research; Note: Bubble size represents the ratio for pipeline of ANDAs to currently approved ANDAs

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Negatives – Lack of innovative investments may dampen long-term prospects

. Low R&D spend on innovative pursuits like biosimilars, vaccines and NCEs does not bode well for longer-term prospects. Low R&D spend on innovative products and lack of differentiation . The company’s revenues from oral solids, cephalosporins, controlled substances in currently marketed products and general injectables could be low-margin revenues. Lack of differentiation in the currently marketed portfolio makes Aurobindo more vulnerable to incremental competition from incumbents like Hospira (general injectables), Ranbaxy (cephalosporins) and Nesher (controlled substances) which have been out of the market due to FDA-related issues. Rational capital allocation – Not up to the mark; below average Positives – Improvement in product mix and vertical integration

. Aurobindo scores high on sales improvement and pricing discipline under our ‘greatness’ framework. Whilst improvement in product mix (move from API to formulations) has helped the score in pricing discipline, gaining traction in oral solids due to vertical integration has helped the score on sales improvement. We Improvement in product mix has highlight that both these advantages seem temporary, as the decline in helped score in pricing discipline contribution from API sales would be more gradual and Aurobindo is not vertically integrated in injectables which form a large chunk of its pipeline. The management may have to rethink its portfolio strategy once scale becomes an obstacle to growth.

. We have to credit the company for achieving sales growth in a short span of time Excellent sales execution post the resolution of issues with the FDA at Unit VI. Whilst Cymbalta has been a capabilities major contributor to sales and EBITDA in FY14, the resumption of cephalosporin sales and controlled substances along with general injectables have been within a very short span of time, exhibiting excellent execution.

Exhibit 11: Aurobindo scores high on pricing discipline and sales improvement, but lags in cash flow increase, balance sheet discipline and investments Scores out of 0.17 for each measure

Sales Pricing EPS and BS Ratios Total Score-using Company Investment Rank Improve discipline CFO increase Discipline improve Adj PAT IPCA 0.17 0.17 0.17 0.17 0.17 0.17 1.00 1 Sun Pharma 0.17 0.17 0.17 0.17 0.08 0.17 0.92 2 Cadila 0.17 0.17 0.17 0.17 0.17 0.08 0.92 2 Lupin 0.17 0.08 0.17 0.17 0.17 0.08 0.83 4 Strides 0.17 0.08 0.17 0.17 0.08 0.17 0.83 4 Torrent 0.08 0.17 0.17 0.13 0.13 0.17 0.83 4 Cipla 0.17 0.04 0.17 0.17 0.17 - 0.71 7 Dr Reddy's 0.08 0.08 0.17 0.17 - 0.17 0.67 8 Aurobindo 0.08 0.13 0.17 - 0.08 0.08 0.54 9 Glenmark - 0.08 - 0.08 0.08 - 0.25 10 Source: Ambit Capital research; Note: Bubble size represents the ratio for pipeline of ANDAs to currently approved ANDAs

Negatives – Working capital dampens cash flows

. The ever-expanding working capital cycle for Aurobindo has had an adverse impact on balance sheet improvement and cash flows amongst our framework. (Please refer Page 28 and Exhibit 43) Expanding working capital cycle . Whilst the company has guided to decreasing debt levels meaningfully going has an adverse impact on balance ahead, we would wait and watch for the improvement in the balance sheet sheet and cash flows before giving credit given the patchy track record on this front.

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Robustness of business model – Threat from return of incumbents in the US; below average Positives

. Higher-than-average creditor days signals are positive for bargaining power against suppliers. Negatives

. Higher than average debtor days indicates low bargaining power with customers. Vulnerable to incremental . The company’s revenues from oral solids, cephalosporins, controlled substances competition due undifferentiated and general injectables could be low-margin revenues. Lack of differentiation in product portfolio currently marketed portfolio makes Aurobindo more vulnerable to incremental competition from incumbents like Hospira (general injectables), Ranbaxy (cephalosporins) and Nesher (controlled substances) which have been out of the market due to FDA-related issues.

Risk entailed in operations – Excellent risk management; above average Positives – Diversified manufacturing base and low 483 issue rate

. Aurobindo has five API units and six formulation units that are commercialised in the US. With a diverse manufacturing base, we see low operational risk exposure for the company. Aurobindo also has a low 483 issue rate. Diversified risk through wide manufacturing base and low 483 Exhibit 12: Aurobindo has the second lowest Form 483 issue rate issue rate

80% Form 483 issue rate 67% 67% 70% 61% 57% 60% 50% 46% 50% 43% 39% 40% 32% 30% 20% 10% 0% Ipca Cipla Lupin Sun Cadila Torrent Pharma Glenmark Aurobindo Dr. Reddy's Dr. Source: FDAzilla.com, Ambit Capital research

. Aurobindo has engaged in a JV with Celon Labs for hormones and oncology injectables for the US. The JV diversifies manufacturing operations requirement and hence limits investment risk. Negatives – May face barriers to scalability Partnership model in the US and emerging markets represent barrier Aurobindo’s distribution partnership with Citron is likely to impair profitability in . to scalability of business certain products in the US as the company will have to pay 30-50% distribution margins without sharing any risk or cost.

. As seen with Cadila, the partnership model represents a barrier to scalability of business in emerging markets. Despite Aurobindo’s small base in these markets, we remain cautious of the potential growth that the company may see from such avenues.

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Aurobindo’s standing on our five ‘R’s framework Aurobindo receives a below average rank in our competitive advantage framework. Whilst the company scores high on risk management and R&D It lags on parameters like rational productivity (largely due to plain-vanilla products), it lags on parameters like rational capital allocation, robustness of capital allocation, robustness of business model and reputation and quality of business model and reputation and management (no significant competitive advantage). quality of management (no significant competitive advantage) We see a material improvement in R&D productivity ahead led by further monetisation of the strong pipeline of 208 ANDAs in the US. However, lack of (a) investments in long-term growth drivers, (b) no evidence of scalability in the RoW business, and (c) a well-established domestic formulations business should keep investors at bay. Promoters’ involvement in legal investigations, undisclosed income from Aurobindo coupled with less-than-ideal disclosures on partnership, management and ownership of Citron makes us cautious.

Exhibit 13: SWOT analysis of Aurobindo Strengths Weaknesses

. Promoter-led management keeps agency costs low. Promoter stake in . Lack of an established domestic formulations business. The domestic the company is currently at ~54%. business is a sustainable stream of profits and generates cash. . High R&D productivity led by vertical integration benefits coupled with . Lack of investments in sustainable long-term growth drivers. With the US R&D spend on less complex generics has been accretive to RoCE. formulations business experiencing exponential growth (29% CAGR over FY14-17E), the company may face a base effect in FY19E. . Depth and width of management to ensure stability; no transition in sight. The sons of Ramprasad Reddy (65 years old) are not involved. . Issues in corporate governance due to less than ideal disclosure practices and political interests of promoters are an inherent weakness. . Efficient capital structure as compared to peers (debt:equity of 100% as of FY14) beneficial for stakeholders. . High exposure to API business (35% of revenues as of FY14) is also a weakness. The company has registered API sales CAGR of 6% (in USD). . A large ANDA pipeline in the US (208 ANDAs pending final approval) is likely to drive 29% CAGR in US sales over FY14-17E and EBITDA . Lack of end-to-end capabilities in complex products would force the margin and RoCE expansion of 730bps and 920bps over FY14-FY17E. company to share the upsides from such opportunities in the future. . The company has avoided ‘great mistakes’ in its past acquisition . Aurobindo’s RoCE is lower than peers due to: (a) inferior product mix, (b) strategy. The recent acquisition of Actavis’ European business seems high investments in vertical integration of oral solids and (c) delay in RoCE-accretive. monetising US pipeline due to USFDA issues in the past.

Opportunities Threats

. Small business in RoW markets offer scope for long-term sustainable . The return of incumbents’ segments like cephalosporins, controlled growth (US$77mn sales in FY14). Given the lack of a track record for substances and general injectables is a matter of time. scaling up emerging market business, we do not give much credit to it. . We believe that the RoCE and margins of Aurobindo may come under . Large ANDA pipeline (208 ANDAs pending final approval) in the US as pressure if the company’s US business faces competition from incumbents compared to a smaller currently marketed portfolio (168 products that have withdrawn from the market due to FDA issues. marketed) bodes well for growth prospects. . Aurobindo’s revenues are largely forex-denominated and the foreign . The company is beginning to make investments in comparatively more debt is being wound down in the next 2-3 years; the company’s profits complex products like oncology and hormones injectables, complex could be highly sensitive to forex movements in the future. injectables, and OTC business in the US (Aurohealth). Source: Company, Ambit Capital research

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US formulations the only growth driver but a ‘no moated’ business

We believe Aurobindo is still evolving from an API-led player to a formulations player. Whilst API sales contributed 70% of FY07 sales and 35% of FY14 sales, we expect the contribution to steadily decline to 15% by FY29E, as formulations see higher growth in sales. However, within formulations, the company’s presence in the US appears to be the only bright spot. We highlight that the company has only 4% of its revenues sourced from emerging markets and only a portion of its ARV sales are in India (unbranded). Hence, there are no ‘moated’ revenue streams that can sustain growth over the medium to longer term.

Exhibit 14: Revenue mix – US formulations to dominate growth US$ mn FY14 FY15E FY16E FY17E CAGR FY14-17E Comments Formulations

30% CAGR represents reduction of FDA approval USA 563 707 925 1,236 30% timelines form current 36 months to 10 months as stipulated by GDUFA 2012. Growth in oral solids to remain muted as low number of -Orals 330 330 363 453 11% ANDAs pending approval and no ‘moats’ -One offs 94 80 40 38 -26% We expect Cymbalta to have a reasonably fat tail Controlled substances would be a key growth driver. -Controlled Substance (Aurolife) 74 131 204 322 63% Piperacillin Tazobactam contributed 50% of the segments revenue in FY14 Cephalosporins re-launched in FY14. Aurobindo likely to -Cephalosporins 28 31 34 37 10% benefit from absence of incumbents like Ranbaxy in the near term. Injectables are the key growth driver in US with a large -Injectables (Auromedics) 37 102 194 262 92% ANDA pipeline awaiting approval. ARV sales are likely to see moderate growth largely led ARV 139 160 184 202 13% by tender business through US President’s PEPFAR programme Actavis acquisition to fuel revenue growth in FY15E. Europe 111 562 568 620 77% However, post FY15E, we forecast single digit revenue growth -Legacy 111 133 160 192 20% -Actavis - 429 408 428 NA Despite a low base in RoW markets like Brazil, we ROW 77 84 93 102 10% forecast low double digit growth as the company has no India business and hence no experience in this area. Total formulations 890 1,514 1,769 2,161 34% API

SSP 162 178 187 196 7% Cephs 145 170 175 175 7% ARVs and others 167 176 193 212 8% We expect APIs to grow in single digits given company’s Total API 474 524 555 584 7% focus on maintaining margins. Total Revenues in US$ terms 1,364 2,037 2,324 2,744 26% Source: Company, Ambit Capital research

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US formulation sales – Key growth driver/no ‘moats’ Aurobindo has the largest ANDA pipeline amongst Indian generics in We expect a significant absolute numbers. However, the company’s FY14 revenue/ANDA was much lower improvement in the product mix in at US$3.4mn per annum when compared with stalwarts like Lupin and Dr. Reddy’s the US led by incremental launches (US$7mn-11mn p.a.). We believe that the subdued revenue per ANDA reflects the in niche areas like injectables, low complexity and high competitive intensity of its currently marketed products. controlled substances, OTC and However, in the future, we expect a significant improvement in the product mix in the penems US led by incremental launches in niche areas like injectables, controlled substances, OTC and penems.

Exhibit 15: Unit-wise filings, approved and pending approval as of 1QFY15 Unit-wise filings 1QFY15 Comments Aurobindo has a legacy business of oral non Betalactam products. Unit 3 - Oral Non-Betalactam products With only 5 ANDAs pending from Unit 3, we don’t expect significant

growth from the Unit. - Products filed 119 - Approved 114 - Pending 5 Unit 7 has 97 ANDAs pending approval in the oral non Betalactam Unit 7 - Oral Non-Betalactam products segment and likely to be the growth engine for the segment. We

expect revenues of US$4m/ANDA per annum from this segment. - Products filed 133 - Approved 36 - Pending 97 General injectables and ophthalmic products are likely to be the key Unit 4 - General Injectable and Ophthalmic products growth driver for Aurobindo’s US business. We expect revenues of

US$4m/ANDA from this segment going forward. - Products filed 66 - Approved 8 - Pending 58 Unit 12 is not a significant growth driver given only 1 ANDA from Unit 12 - Injectable Cephalosporin and Semi-synthetic penicillin the facility is pending approval. - Products filed 20 - Approved 19 - Pending 1 Unit 6 is not a significant growth driver given only 1 ANDA from the Unit 6 - Cephalosporin and Semi-synthetic penicillin facility is pending approval - Products filed 11 - Approved 10 - Pending 1 Controlled substances are a key growth driver given high margins Auro Life - Oral Non-Betalactam products (CS) and revenue potential per ANDA in the segment. We pencil in

US$20m / ANDA from the segment going ahead. - Products filed 25 - Approved 7 - Pending 18 Auro Next - Penem Injectable products Penem opportunity is too small in the overall scheme of things.

- Products filed 2 - Approved 0 - Pending 2 Total

- Products filed 376 - Approved 194 - Pending 182 Source: Company, Ambit Capital research

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Legacy oral solid products – Vertical integration driving market share We assess that sales from legacy oral products in the US were at US$330mn in FY14 vs US$121mn in FY09 (CAGR of 22% in USD terms). The growth in sales was largely driven by market share gains in these products owing to vertical integration benefits and incremental launches of ‘me too’ products and day 1 launches over the same period. We exclude generic Cymbalta from this segment due to its one-off contributions in FY14 and higher than normal pricing post exclusivity.

Exhibit 16: We expect Aurobindo’s Oral Solids CAGR at 11% over FY14-17E 500 Oral Solids CAGR 11% 400

300

CAGR 38% 453 200 363 312 330 330 100 233 213 Revenue in US$ mn US$ in Revenue 192 121 35 59 - FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Source: Company, Ambit Capital research Going forward, we expect the segment to register a revenue CAGR of 20% (in USD terms) over FY14-17E, led by incremental launches. Out of the 208 ANDAs currently pending approval from the USFDA, at least 102 products fall under this segment. These filings would likely unravel over the next 3-4 years and result in revenue growth. Aurobindo has also guided to filing ~40 ANDAs per year going forward. A majority of these would be general injectables in FY16E, but FY15E and FY17E are likely to see some more oral solid filings.

Exhibit 17: We expect the recent filings to unravel in the next 3-4 years Unit-wise filings 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 Unit 3 - Oral Non-Betalactam products

- Products filed 123 120 120 120 116 117 118 119 - Approved 114 115 116 117 114 114 114 114 - Pending 9 5 4 3 2 3 4 5 Unit 7 - Oral Non-Betalactam products

- Products filed 59 63 66 71 83 89 111 133 - Approved 18 19 23 28 29 30 33 36 - Pending 41 44 43 43 54 59 78 97 Source: Company, Ambit Capital research

One-off products – don’t expect a repeat of the ‘Cymbalta situation’ Cymbalta presented a one-off opportunity for Aurobindo wherein despite multiple FTFs only 5 generic companies launched the product on day 1 under exclusivity and this resulted in a shortage of inventory and better than normal pricing (~80% price erosion as compared to the normal 95% under similar competition). We believe Aurobindo clocked revenues of ~US$130mn under the exclusivity spread Aurobindo’s realisations from over 3QFY14-1QFY15 from the product, with an average market share of 25% as compared to Torrent Pharma clocking ~US$65mn over the same period with 8% Cymbalta have been impaired by market share and Lupin clocking ~US$110mn with 15% market share. We believe distribution margins paid to Citron that Aurobindo’s realisations from the product have been impaired by distribution which could be at 30-40% of sales margins paid to Citron which could be at 30-40% of sales.

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Exhibit 18: We estimate that Aurobindo paid 30-40% distribution margins to Citron In US$ mn Lupin Torrent Revenues over 3QFY14-1QFY15 (A) 110 65 Market share of Lupin (B) 15% 8% Total generic Cymbalta Market size (A/B) (C) 733 813 Market share of Aurobindo (D) 25% 25% Aurobindo's revenue from Cymbalta(C*D) (E) 183 203 Less: distribution margins to Citron (1-F/E) 29% 36% Revenue booked by Aurobindo (F) 130 130 Source: Company, Ambit Capital research Post exclusivity, even as incremental competition has stepped in and pricing has eroded further (~90% erosion now as per industry sources), the product still remains relatively more profitable as compared to other similar products. Aurobindo continues to sustain ~25% market share in the product, as per Wolter Kluwer’s audit data. We expect the product to have a fatter tail than normal in the near term.

Aurolife (controlled substances) – Poised for ramp up from new launches Aurolife has a local manufacturing facility in the US which was acquired from Sandoz in 2006. The company launched three products from Aurolife in 3QFY14 and has another 3-4 products with final approval which would be launched in FY15. Further, the company has filed for another 10 controlled substance products which Competitive intensity is not are yet to gain approval. The controlled substance market is ~US$10bn-15bn in extremely low and pricing in terms of annual sales in the US (contractpharma estimates). We believe that controlled substance is high approximately half the market is still under patent protection (Vyvanse, Adderall XR, and Oxycontin abuse resistant formulation are the largest-selling products) whilst the remaining are already generic, with ~4-8 players in each product segment. Even though the competitive intensity is not extremely low, the pricing in the controlled substance space is high given the high regulatory hurdles and ask for a local manufacturing unit in the US.

Exhibit 19: Expect Aurolife revenues to report CAGR of 63% Exhibit 20: Incremental revenues from new launches over FY14-17E 350 Controlled Substance (Aurolife) 30 Auro Life - Oral Non-Betalactam products 300 25

250 CAGR 63% 20 15 18 200 15 13 13 22 19 17 10 18 150 322 5 7 7 7 4 6 100 204 0 1 2 2

Revenue in US$ mn US$ in Revenue 131 50 74 - Q2FY13 Q3FY13 Q4FY13 Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 - Approved - Pending FY14 FY15E FY16E FY17E Source: Company, Ambit Capital research Source: Company, Ambit Capital research We estimate Aurolife would record a revenue CAGR of 63% over FY14-17E led by new launches in FY15 of already approved products and incremental launches in FY16/17E from new approvals from USFDA.

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Cephalosporins – Not a needle mover despite vertically integration benefits Aurobindo received an import alert on its cephalosporin manufacturing unit (Unit VI) from the USFDA in February 2011. The company was clocking revenues of ~US$33mn from cephalosporin sales in the US prior to the import alert. However, the sales dropped to zero in FY13 due to stoppage of exports. The import alert was lifted by the FDA in March 2013 and the company resumed supplies in April 2014.

Exhibit 21: Import alert in Unit VI led to zero sales in FY13 Exhibit 22: One product pending approval as on 1QFY15 40 Cephalosporins 30 CAGR 10% Unit 6 - Cephalosporin and Semi-synthetic 35 25 penicillin 30 20 9 2 2 1 25 15 20 10 1 1 1 1 16 16 16 17 15 5 10 10 10 10 10 0 Revenue in US$ mn US$ in Revenue 5

- Q2FY13 Q3FY13 Q4FY13 Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 FY11 FY12 FY13 FY14 FY15E FY16E FY17E - Approved - Pending

Source: Company, Ambit Capital research Source: Company, Ambit Capital research Post resumption of supplies, the company earned revenues of US$28mn from the Regain in market share driven by segment in FY14. We highlight that the regain in market share was driven by vertical vertical integration benefits and integration benefits and supply chain improvement, as most of the market share in supply chain improvement the interim was lost to players like Lupin. Going ahead, we expect the company to clock a CAGR of 10% over FY14-17E from the segment given no incremental launches.

Auromedics (general & specialty injectables) – Key growth driver Aurobindo has 66 ANDAs filed from Unit IV for general injectables, out of the entire gamut of 120 ANDAs. The remaining 50+ products would be filed over the next 3-4 years. The company currently has approvals for only 8 ANDAs from Unit IV and overall markets only 10 injectables in the US. The management expects to gain approvals and launch most of its general injectable ANDAs over the next 12-24 months. The company has also filed for two penem products which is a small but limited competition market.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 81 Aurobindo Pharma

Exhibit 23: 92% CAGR over FY14-17E due to product Exhibit 24: Revenue unlocking through higher product approvals approvals 300 Injectables (Auromedics) 70 Unit 4 - General Injectable and Ophthalmic products 250 60 50 CAGR 92% 200 40 58 30 42 47 150 36 262 20 24 19 19 100 10 18 194 8 8 8 0 0 2 5 6 6

Revenue in US$ mn US$ in Revenue 50 102 1 10 37 - Q2FY13 Q3FY13 Q4FY13 Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 FY12 FY13 FY14 FY15E FY16E FY17E - Approved - Pending

Source: Company, Ambit Capital research Source: Company, Ambit Capital research We pencil in revenue CAGR of 92% for injectable sales in the US from Auromedics over FY14-17E. We assume 15-20 product launches each year from the segment with average revenue per ANDA of US$4mn.

US sales CAGR of 29% over FY14-17E Overall, we estimate a 29% CAGR for US sales (in USD terms) over FY14-17E. The Absence of incumbents to support company has initiated development of complex injectables (fondaparinux filed with US revenue growth USFDA), OTC products (Aurohealth), ophthalmic and penem products in the US. These product portfolios are likely to drive medium-term growth in US revenues despite return of incumbents in current segments of significant presence. Incumbents that are currently not present in the segments discussed above are Teva and Hospira (injectables), Caraco (Sun) and Nesher (Cadila) (controlled substances), and Ranbaxy (Sun) and Apotex (cephalosporins). We pencil in 9% revenue CAGR in the US over the medium term (FY18-27E).

Exhibit 25: Split of US revenues in various segments US$ mn FY14 FY15E FY16E FY17E CAGR FY14-17E Formulations

USA 563 707 925 1,236 30% -Orals 330 330 363 453 11% -One offs 94 80 40 38 -26% -Controlled Substance (Aurolife) 74 131 204 322 63% -Cephalosporins 28 31 34 37 10% -Injectables (Auromedics) 37 102 194 262 92% Source: Company, Ambit Capital research Europe formulations sales – Actavis portfolio to drive profitability but not growth Aurobindo acquired Actavis’ generic operations in seven Western European The management expects to countries in 2014. The sales from the acquired business have been consolidated narrow Europe business losses in since April 2014. The acquisition was virtually self-financed by the working capital FY15 and break even in FY16 that the operations brought with itself, as the business was incurring a loss of EUR20mn p.a. on sales of EUR330mn. Aurobindo expects to narrow down the losses of the operations to EUR10mn in FY15E and break even in FY16E by integrating the operations with its own business in Western Europe, site transferring several products to lower cost manufacturing base in India and discontinuing loss-making products/segments where there are no synergies.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 82 Aurobindo Pharma

Exhibit 26: Contribution from Actavis portfolio to increase

700 Europe revenue in US$ mn 600 500 400 428 CAGR 77% 408 300 200 429 100 192 111 133 160 - FY14 FY15E FY16E FY17E

-Legacy -Actavis

Source: Company, Ambit Capital research Whilst we believe that the acquisition will be RoCE-accretive when the profitability is Acquisition will be RoCE-accretive turned around, it will also be margin-dilutive as Western European markets offer high but margin-dilutive single to low double-digit EBITDA margins for generic operations. We estimate revenue CAGR of 5% over FY15-17E. ARV and RoW formulations sales – No evidence of further scalability Aurobindo has registered revenue CAGR of 6.6% (in USD terms) in ARV formulations Africa is intensely competitive and sales. The company sells ARV formulations in India (through institutions) and also hence no evidence of scalability exports to various countries including Africa through the US President’s PEPFAR programme. The ARV business in Africa is intensely competitive, with multiple players rooting for tenders from global agencies like WHO, the Bill & Melinda Gates Foundation and the US President’s PEPFAR programme.

Exhibit 27: Aurobindo to witness competition in the ARV Exhibit 28: Cautious in the ROW business due to lack of business evidence on scalability

250 ARV revenue in US$ mn 120 ROW revenue in US$ mn

200 CAGR 13% 100 CAGR 10% 80 150 60 102 100 184 202 93 160 40 77 84 139 50 20

- - FY14 FY15E FY16E FY17E FY14 FY15E FY16E FY17E ARV ROW Source: Company, Ambit Capital research Source: Company, Ambit Capital research We pencil in 13% CAGR from ARV formulation sales largely driven by new introductions. We also believe that the margins in the African business have shown signs of improvement based on our primary data checks which suggest increased rationality in pricing for contracts. Aurobindo also has a small presence in certain emerging markets like South Africa, Canada, Australia and Brazil. It further plans to enter geographies like Mexico and South East Asian countries. Due to lack of evidence on the scalability of Aurobindo’s business in these markets, we remain cautious.

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API sales – Improvement in product mix to drive margins; revenue growth muted Aurobindo has been realigning its API portfolio to derive a better product mix and expand margins. However, in this endeavour, the company has registered a CAGR of only 6% over FY09-14 for its API sales. We pencil in a CAGR of 7.2% over FY14-17E.

Exhibit 29: Expect revenue growth to be muted and change in product mix to drive margins

700 API revenue in US$ mn 600 CAGR 7% 500 212 176 193 400 167 300 170 175 175 200 145 100 162 178 187 196 - FY14 FY15E FY16E FY17E

SSP Cephs ARVs and others

Source: Company, Ambit Capital research

No investments visible in long-term growth drivers Whilst Aurobindo has made medium-term investments in OTC products, ophthalmics, The company’s business in its complex injectables and penems, we are yet to see any credible investments in the current shape and five years from long-term growth drivers (NCEs, NDDS, biosimilars) which could yield sustainable, today, is likely to be highly sensitive annuity-like revenue and profit streams. Hence, the company’s business in its current to incremental competition shape and five years from today is likely to be highly sensitive to incremental competition. Lack of investments in long-term growth drivers (NCEs, NDDS, biosimilars) has also resulted in high R&D productivity in the near term and also aids reported RoCE and EBITDA margins.

Exhibit 30: Aurobindo has the lowest R&D spend as a percentage of sales

10% R&D cost as % of Sales - FY14 8%

6% 9.1% 4% 8.0% 8.9% 7.0% 5.4% 4.1% 4.3% 2% 3.1% 0% Cipla Lupin Cadila Ranbaxy Glenmark Aurobindo Dr. Reddy's Dr.

Sun Pharma Sun Source: Company, Ambit Capital research

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Base business EBITDA margins and RoCE to improve till FY17E but decline thereafter

We expect base business margins (ex Cymbalta and Actavis’ EU sales) to improve by 730bps over FY14-17E led by better product mix in the US and operating leverage on overheads and manufacturing. Whilst the company has clocked revenue/ANDA of ~US$3.4mn in FY14 (ex-Cymbalta), we build in US$4mn/ANDA for general injectable and oral solids and US$20mn/ANDA for controlled substances. We expect margins to decline post FY18E, once the tailwind from improving USFDA approval timeline subsides. Our assumption of lower margins is led by: (a) our assumptions on return of incumbents like Ranbaxy in cephalosporins, Hospira in injectables and penems, and Nesher and Caraco in controlled substances which is likely to result in market share and pricing erosion; and (b) lack of NCEs, NDDS and biosimilars to offset the decline in margins in the base business.

Exhibit 31: Base business margins to improve till FY17E led by product mix and operating leverage

31.0% 28.5% 29.0% 27.0% 26.3% 25.8% 24.8% 25.0% 24.1% 23.0% 22.3% 21.2% 20.9% 21.0% 19.0% 17.0% 15.0% FY14 FY15E FY16E FY17E Conslidated margins Base Business margins

Source: Company, Ambit Capital research

RoCE to expand by 920bps to 33.4% over FY14-17E, and then gradually decline We expect Aurobindo’s RoCE to ramp up to 33.4% in FY17E from 24.2% in FY14 led RoCE expansion led by improving by improvement in USFDA-approval timelines and monetisation of general approvals injectables, complex injectables, controlled substances and Para IV ANDAs. However, the company’s business in its current shape and five years from today, is likely to be highly sensitive to incremental competition. Post FY17E, we expect the RoCE to start gradually declining, as:

(a) incumbents like Hospira, Ranbaxy, and Nesher return and establish themselves in the respective segments resulting in market share and pricing erosion. (b) lack of longer-term growth drivers (NCEs, NDDS and biosimilars) start to reflect in terms of lower asset turnover. We pencil in decline in gross block turnover from 4.2X in FY17E to 3.0X (peer average) in FY27E. (c) Lack of scalability in RoW and ARV formulation sales begin to drag growth and operating leverage.

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Exhibit 32: We expect RoCEs to stabilise at 12.8% in the terminal year

40.0% 35.0% 30.0% 25.0% 20.0% WACC 15.0% 10.0% 5.0% 0.0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

FY15E FY16E FY17E FY18E FY19E FY20E FY21E FY22E FY23E FY24E FY25E FY26E FY27E FY28E FY29E Source: Company, Ambit Capital research Financial assumptions

Exhibit 33: Detailed financial assumptions (` mn unless otherwise mentioned) Assumptions YoY change (%)

Particulars FY14 FY15E FY16E FY17E FY15E FY16E FY17E Comments Sales assumptions

Growth in the US to be led by unfolding of the 208 ANDA USA 34,028 42,416 55,495 74,175 24.7% 30.8% 33.7% strong pipeline ARV 8,402 9,591 11,029 12,132 14.1% 15.0% 10.0% ARV sales growth muted, as opportunity is limited Post Actavis acquisition, we expect some rationalisation in Europe 6,721 33,745 34,060 37,204 402.1% 0.9% 9.2% product portfolio; we expect high single-digit growth on a consolidated basis for Europe Lack of evidence on scalability drives our low double-digit ROW 4,634 5,060 5,566 6,122 9.2% 10.0% 10.0% growth assumption Contribution to internal consumption to increase, API 28,643 31,413 33,301 35,020 9.7% 6.0% 5.2% pressurising growth for external sales Total 82,593 122,375 139,600 164,803 48.2% 14.1% 18.1% Mid- to high-teen growth in revenues for FY16/17E Expect expansion in gross margins, as product mix Gross profit 44,938 61,535 74,570 92,650 36.9% 21.2% 24.2% improves in US and API Limited operating leverage expected, as costs are based Overheads cost 23,610 36,483 44,070 52,552 54.5% 20.8% 19.2% out of India Expansion in EBITDA margins largely led by gross margin EBITDA 21,328 25,052 30,499 40,098 17.5% 21.7% 31.5% expansion EBITDA margins (%) 24.1% 21.1% 22.4% 25.0%

PAT (adj for forex Financial leverage fuels PAT growth higher than EBITDA 11,737 15,770 19,733 27,268 34.4% 25.1% 38.2% loss) growth Source: Company, Ambit Capital research Ambit vs consensus

Exhibit 34: Our estimates are higher than consensus on FY16/17E EBITDA margins Particulars (` mn) Ambit Consensus Divergence (%) Sales

FY15E 119,928 118,624 1.1% FY16E 136,808 135,198 1.2% FY17E 161,507 156,745 3.0% EBITDA

FY15E 25,052 23,665 5.9% FY16E 30,499 27,530 10.8% FY17E 40,098 32,342 24.0% Net Profit

FY15E 15,770 14,533 8.5% FY16E 19,733 17,224 14.6% FY17E 27,268 20,820 31.0% Source: Bloomberg, Ambit Capital research

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Our estimates are 1.1-1.2% ahead of consensus FY15/16 revenue and 6-11% ahead Our estimates are ahead of of consensus FY15/16 EBITDA estimates, as we expect a faster ramp up in US sales consensus, as we expect faster led by improvement in USFDA timelines. Our FY15E net profit estimate of `15.8bn is ramp up in US sales lower than management guidance of more than `16bn. Further, we believe that the street is yet to upgrade its estimates post the fantastic results in 1QFY15. We are penciling in higher margins for FY16/17E vs consensus led by our expectations of launch of all interesting products like penems, controlled substances etc over the period which are likely to result in higher EBITDA margins.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 87 Aurobindo Pharma

Valuation – Deserves a deep discount to large-caps

Issues with management, absence Aurobindo is trading at a 35% discount to the peer average one-year forward of longer-term growth drivers and EV/EBITDA multiple. Whilst well-entrenched promoters, high R&D productivity, low R&D spend deserve valuation excellence in execution, and near-term earnings momentum lend support to discount to large-caps valuations, we do not find the valuations attractive due to the following reasons: a) Given the absence of incumbents in the US, the market share and pricing for Aurobindo’s cephalosporins, general injectables and controlled substances may be inflated. Injectables and controlled substances account for more than 70% revenue and profit growth for Aurobindo over FY14-17E. We expect pressure on the base business to translate to decline in RoCE over the medium term (fy18- 27E). b) Aurobindo is vertically integrated in most of its oral products but not so in injectables. Hence, the company is unlikely to make similar margins and RoCEs from the anticipated growth in the US and market share gains cannot be taken for granted. c) Aurobindo sources 35% of its revenues (FY14) from API sales which are unlikely to grow significantly from hereon as the company rationalizes low margin revenues and increases captive consumption. Low consolidated growth beyond FY18E would result in lower multiples.

We use a DCF methodology to value Aurobindo with a terminal RoCE of 13% and discount rate of 13%. This leads to a target price of `828/share.

Valuation methodology

We value Aurobindo using a DCF methodology wherein EBITDA margin, medium- term revenue growth rate and terminal revenue growth rate are the key variables controlling the valuation. Furthermore, we use a free cash flow to equity methodology.

EBITDA margin: We build in a gradual expansion in EBITDA margins from 21% in FY14 (base business) to 29% in FY18E and then a gradual decline to 21% in FY29E (terminal year). Aurobindo would have incremental margin tailwinds in the US over the near term, as it ramps up its product basket. However, we believe it will face pricing and market share erosion, as incumbents in various segments return to market and establish themselves.

Medium-term and terminal revenue CAGR: We pencil in medium-term (FY18- FY27E) revenue CAGR of 7% largely led by continued growth momentum in the US market but no material growth in the API and Europe Actavis business. We expect the US revenues to slow down post FY18E, as the tailwinds on faster approvals subside.

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Exhibit 35: We pencil in medium-term revenue growth of 6.5% and terminal rate of 2.5% Medium-term Terminal revenue Growth rate assumptions (in constant currency terms) revenue CAGR growth rate (FY18-27E) (FY28E onwards) Formulations

USA 9.0% 3.0% -Orals (including upsides from Aurohealth) 9.0% 3.0% -One offs 0.0% 0.0% -Controlled Substance (Aurolife) 9.0% 3.0% -Cephalosporins 9.0% 3.0% -Injectables (Auromedics) (including upsides from Celon JV) 9.0% 3.0% ARV 5.0% 3.0% Europe 5.0% 2.0% -Legacy 5.0% 2.0% -Actavis 5.0% 2.0% ROW 10.0% 5.0% Total formulations 7.1% 2.9% SSP 5.0% 0.0% Cephs 0.0% 0.0% ARVs and others 5.0% 0.0% Total API 3.8% 0.0% Total Gross Sales 7.1% 3.0% Source: Ambit Capital research

Our DCF model suggests a fair value of `828/share (our 12-month forward target price), which implies ~10.5x FY16/17E EPS as compared to the current trading multiple of 14.5x FY15/16E EPS.

Exhibit 36: Aurobindo’s valuation discount does not fully reflect the competitive disadvantage and lower RoCE

21 19 Sun Pharma 17 Cipla 15 Cadila Glenmark 13 Lupin 11 Dr. Reddy's IPCA 9 Aurobindo 7 EV/EBITDA (FY16E) EV/EBITDA 5 10 15 20 25 30 35 40 RoCE (FY14)

Source: Bloomberg, Ambit Capital research; Note: Bubble size indicates competitive positioning (larger bubble = higher position); Aurobindo’s FY14 RoCE estimated at 16% excludes Cymbalta exclusivity profits As seen in the exhibit above, Aurobindo is trading at a discount to Sun Pharma and Lupin largely due to inferior competitive positioning and lower RoCE. We believe that the discount should expand given the lack of investments in longer-term growth drivers and the vulnerability of revenues and profits to incremental competition. At our target P/E multiple of 10.5x one-year forward EPS, Aurobindo would be trading at a 50% discount to these companies, which we feel is justified.

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Exhibit 37: Terminal value contributes 40% to total fair enterprise value Key assumptions Value Comments Discount rate 13.1% Same taken for other large caps Terminal growth rate 3% Lower than peers due to lack of India formulations, a credible RoW business and long term growth drivers Medium term growth rate 7.1% Driven largely by revenue growth in US and Europe formulation sales EBITDA margins (FY14) 26.3% Margins inflated due to Cymbalta; ex Cymbalta we estimate base business margins at 21.2% EBITDA margins (FY29E) 21.2% We expect margins excluding Cymbalta and Actavis acquisition to remain stable over the longer term Total Enterprise value 255,173

Terminal value 101,127

Terminal value as % of Total 40%

Source: Ambit Capital research

We expect Aurobindo’s EBITDA margin (excluding one-offs and Actavis’ acquired business) to remain stable over the next 15 years. Whilst the product mix is likely to improve in the near term, the operating leverage would play against Aurobindo in the medium term (FY18E-27E) as most costs (53% in FY14) are India-based whereas ~80% of revenues are from exports. Whilst these costs would continue to grow in the low double digits, we model revenue growth from exports in mid-to-high single digits.

Exhibit 38: Our 12-month forward target price is `828/share Particulars in mn ` Total EV 255,173

Net Debt (FY17) 13,762

Equity value 241,411

Number of shares outstanding (mn) 291.50

Value / share ( .) 828 ` CMP ( .) 896 ` Upside / Downside (%) -8%

FY15E FY16E FY17E

Implied adj. P/E (x) 15.3 12.2 8.9 Current adj. P/E (x) 16.6 13.2 9.6 Source: Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 90 Aurobindo Pharma

Cross-cycle valuation Aurobindo is currently trading at 14.5x FY15/16E EPS i.e. a ~35% discount to its Valuations fail to reflect the larger peers like Cadila, Lupin and Sun Pharma. Whilst the company has re-rated fragility of current profits and significantly over the recent past largely led by the management’s guidance towards growth prospects margin expansion and revenue growth in the US, we believe that the valuations fail to reflect the fragility of the current profits and growth prospects. At the current valuations, we see room for a de-rating of the business and believe that segments like controlled substances, oral solids and general injectables in the US are likely to see incremental competition from former incumbents in the medium term. Hence, we expect the price performance to be negative despite strong earnings growth.

Exhibit 39: The stock has traded in a P/E band of 6.0x-15.0x Exhibit 40: Aurobindo has re-rated owing to higher over the last 12 months expectation from US formulations sales growth

1200 ARBP Price Band Chart EV/EBITDA 18x 1000 20

800 12x 15 600 Price 10 400 6x

200 5

0 0 Jul-08 Jun-11 Jan-12 Oct-06 Apr-10 Oct-13 Feb-09 Sep-09 Dec-07 Mar-06 Mar-13 Nov-10 Aug-12 May-07 May-14 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: Bloomberg, Ambit Capital research Source: Bloomberg, Ambit Capital research

The spike in FY11 in EV/EBITDA and P/E ratios reflects the impact of FDA ban on Unit VI on earnings.

Exhibit 41: Earnings growth and RoE have been volatile Exhibit 42: EBITDA growth and RoCE in FY12 and FY13 due to forex losses, FDA ban and redemption of FCCB impacted due to import alert at Unit VI 300% 40% 150% 30% 250% 35% 25% 200% 30% 100% 150% 25% 20% 20% 50% 100% 15% 15% 50% 10% 0% 0% 5% 10% -50% 0% -50% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 5%

-100% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 -5% -150% -10% -100% 0%

PAT growth (LHS) RoE (RHS) EBITDA growth (LHS) RoCE (RHS)

Source: Bloomberg, Ambit Capital research Source: Bloomberg, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 91 Aurobindo Pharma

Catalysts We believe that the trigger/catalyst for de-rating could be: (a) Return of an incumbent like Hospira in general injectables which are likely to contribute 13.4% to the overall revenue growth over FY18E-27E. (b) Large expensive acquisitions to establish longer-term growth drivers but at an exorbitant cost; Aurobindo has no track record of large acquisitions, but we suspect that the company will have to look for one when the growth dries up over the medium term. (c) Slowdown in US formulations sales due to inability in gaining market share in injectables, as they are not vertically integrated.

Key risks to our SELL thesis (a) Value-accretive acquisitions: Value-accretive acquisitions (like Actavis’ European business) on the innovative products side (such as NCEs, NDDS and biosimilars) could lead us to change our view on the long-term prospects of the company. (b) Better-than-expected pricing environment in the US: We assume a moderate decline (3-5%) in the base business pricing in the US. This assumption is led by our expectations of high approvals for competitors in the base business partly offset by increased FDA vigilance, keeping very small players out of the market. (c) INR depreciation against USD: Aurobindo has been a beneficiary of the INR depreciation against the USD largely due to high exports. We assess that the company’s profits could increase by 2.5% for every 1% depreciation in INR beyond `60/USD levels.

Sensitivity of fair enterprise value to our assumptions

Exhibit 43: Sensitivity of TP to discount and terminal growth rates Terminal growth rate

828 1% 2% 3% 4% 5%

11% 984 1,036 1,102 1,186 1,297

12% 863 902 949 1,007 1,082 13% 765 794 828 870 922 14% 683 705 731 762 799

Discount rate Discount 15% 615 632 651 674 702 Source: Ambit Capital research

Exhibit 44: Sensitivity of TP to medium-term US growth rate and EBITDA margins Medium term EBITDA margins

21% 22% 23% 24% 25%

7% 646 674 701 728 755

term term 8% 707 734 762 790 818 - 9% 771 800 828 856 885 10% 841 870 899 927 956 medium growth rate growth 11% 915 945 974 1,004 1,033 US US Source: Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 92 Aurobindo Pharma

Our INR assumption and sensitivity of earnings

We have penciled in `60/USD for FY15E and beyond. Our sensitivity analysis suggests that for every percentage point appreciation/depreciation in the INR/USD, Aurobindo’s net profit decreases/increases by 2.5%.

Exhibit 45: Explanation for the flags on the cover page Field Score Comments Aurobindo accounting analysis raises RED flags on: (a) admission of undisclosed income in the past; (b) Accounting RED continuation of the same auditor despite undisclosed income issue; (c) lower than peer EBITDA/CFO ratios; and (d) higher than peer working capital cycle. Overall, the management has made timely announcements in its earnings calls, meetings and interviews Predictability AMBER regarding product filings, acquisitions and business outlook. However, the unpredictability of segments like ARV sales, RoW formulation sales and API sales make us assign an AMBER flag on predictability. Consensus FY15 EBITDA and EPS estimates have been upgraded by 5-8% and FY16 EBITDA and EPS Earnings momentum GREEN estimates have been upgraded by 4-5% over the past three months. Source: Bloomberg, Ambit Capital research

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Accounting analysis – some RED flags

. Revenue recognition: Aurobindo’s pre-tax CFO/EBITDA ratio has consistently been significantly lower than the peer average over the past few years mainly on account of higher working capital requirements. Aurobindo’s working capital days have deteriorated from 186 days in FY10 to 217 days in FY14. Given its lack of material exposure to branded generic markets, where terms of trade are more Low CFO to EBITDA ratio as benign, its working capital days remain ahead of its peers. compared to its peers Even in years when EBITDA has posted healthy growth, CFO/EBITDA has deteriorated, as working capital needs have expanded. For instance, in FY11, whilst EBITDA improved by 17%, CFO declined 9% owing to higher working capital (205 days in FY11 vs 186 days in FY10). Note that inventories and debtors increased significantly during the year (32% and 29% respectively). In FY13, pre-tax CFO/EBITDA deteriorated significantly again due to higher working capital. We highlight that the increase in working capital in FY13 was 49% of EBITDA vis-à-vis 23% in FY12. Not only is FY13 cash conversion lower than peers but it is also at a 7-year low. We assign a RED FLAG.

Exhibit 46: Revenue recognition YoY change in Company/Metric Pre-tax CFO as a % of EBITDA CFO as a % of Volatility EBITDA (bps) (measured by SD) FY10 FY11 FY12 FY13 FY14 FY13 FY14 Aurobindo 70% 55% 65% 46% 46% 1,072 (1,963) 9% Cadila 96% 81% 64% 82% 98% 1,806 1,590 16% Glenmark NA 60% 131% 80% 102% 7,165 (5,114) 37% IPCA 71% 66% 94% 86% 90% 2,806 (841) 15% Biocon 101% 152% 123% 104% 103% (2,840) (1,924) 39% Average(ex-Aurobindo) 89% 90% 103% 88% 98% 2,377 (2,626) 30% Divergence -19% -35% -38% -42% -52% (1,305) 663 -21% Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity Higher working capital days due to . Working capital days: Aurobindo’s high debtor and inventory levels is only partly explained by its business model, which is predominantly that of a generic business of generic drug supply drug supplier with a relatively lower negotiating power (hence longer payment cycles). This is in comparison with its peers that have a mix of generic as well as branded drug businesses. Both API and generic finished dosages in the Western markets are highly competitive. Whilst the higher debtor days can also be justified for new entrants trying to break into the business, Aurobindo has had a presence in the generic business for nearly a decade. Hence, we raise a RED FLAG on Aurobindo’s overall cash conversion cycle.

Exhibit 47: Working capital days Company/Metric Average Debtor days Average Inventory days Average Creditor days Working Capital days FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14 Aurobindo 91 97 88 95 107 118 108 97 57 56 51 52 141 160 146 140 Cadila 49 58 54 53 62 66 66 65 57 48 35 40 53 77 85 78 Glenmark 140 108 105 115 100 72 59 54 81 66 66 73 158 115 98 96 IPCA 83 63 49 48 82 104 96 94 24 32 33 34 141 134 113 109 Biocon 63 88 74 70 52 69 57 49 35 57 51 44 80 100 80 76 Average(ex- 85 83 74 76 80 86 77 72 51 52 47 49 108 106 94 90 Aurobindo) Divergence (37) (24) (20) (24) (19) (20) (11) (7) 6 (4) (13) (9) 33 53 52 50 Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 94 Aurobindo Pharma

. Cash manipulation: Aurobindo’s loans and advances as a percentage of net worth have been increasing for the years under consideration, except for a brief dip in FY12. The increase in FY14 was on account of: (a) Export rebate claims High loans and advances as a receivable at 1.4bn as compared to 0.9bn in FY12 and 1.2bn in FY13 ` ` ` percentage of net worth as (accounting for 12% of FY14 loans and advances) and (b) MAT credit entitlement compared to its peers amounting to `2.5bn as compared to `.1.3bn in FY13. Apart from these, the loans and advances schedule includes advances recoverable in cash or kind. Whilst the proportion of such loans has decreased substantially from 36% in FY11 to 10% in FY14, no disclosures have been provided with regard to these advances. We believe these require further probing and hence we assign an AMBER FLAG.

Exhibit 48: Cash manipulation checks Company/Metric Loans and adv as a % of networth FY10 FY11 FY12 FY13 FY14 Aurobindo 20.3% 21.8% 18.1% 21.9% 31.1% Cadila 19.2% 20.9% 22.4% 25.3% 24.3% Glenmark NA 9.8% 13.4% 12.8% 17.6% IPCA 14.6% 11.2% 18.2% 15.9% 15.8% Biocon 7.6% 9.6% 14.4% 15.8% 15.7% Average(ex-Aurobindo) 15.4% 14.7% 17.3% 18.3% 18.3% Divergence 4.9% 7.1% 0.8% 3.5% 12.8% Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity; we have excluded capital advances from loans and advances to calculate the above ratio.

Auditors The fact that the company acknowledged undisclosed income during tax raids in February 2012 calls into question the independence/ capabilities of both the statutory auditors (S R Batliboi and Associates) as well as the internal auditors (KPMG). This issue itself makes us raise a RED FLAG.

The statutory auditors of Aurobindo Pharma are S R Batliboi & Associates who were Undisclosed income not identified appointed in 2008-2009 replacing Batliboi & Company who had been auditors of by auditors but the auditors are not Aurobindo at least since FY01. Both the statutory auditors are essentially a part of changed Ernst & Young auditors and effectively the auditors have remained unchanged for more than 11 years now. S R Batliboi and Associates are statutory auditors of 46 companies including Adani Ports, Bharti Airtel, Biocon, Cairn India, GMR Infra, GVK Power, Lanco Group, Sobha Developers, Spice Jet, and Sun TV among others. The signing partner Mr Vikas Kumar Pansari (Membership Number 93649) is also a signatory to the accounts of ILFS Engineering, GVK Power, and Hyderabad Industries. The internal auditors of Aurobindo Pharma are currently KPMG who were appointed only in FY10-11. Prior to KPMG, M/s K Nagaraju & Associates were the internal auditors of Aurobindo Pharma. M/s K Nagaraju also happens to be the statutory auditors of Axis Clinicals and Trident Chemphar, which are the holding companies of the promoters in Aurobindo Pharma.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 95 Aurobindo Pharma

Corporate governance – AMBER FLAG for the Board

. Board composition: The Board currently comprises ten directors, out of which four are independent directors and four are executive directors. Although the percentage of independent directors is higher than Indian company laws’ prescribed 30%, it is lower than global best practice of 50%. AMBER FLAG In the past, ex-employees have been classified as independent directors and have Ex-employees have been classified occupied positions on critical board committees such as the Audit Committee. Mr as independent directors and Srinivas Lanka who was on the company’s board between 2002 and 2007 was occupied positions in critical board classified as an independent director; he had overseen the company’s operations committees in manufacturing and marketing up to early 2002 till he resigned from his executive duties and was inducted as a non-executive independent director on the board. Moreover, Mr Lanka was also a member of the all-important Audit committee until his resignation in 2007. We believe that the purpose of the independent directors on board is to safeguard minority interest. An ex-employee holding an ‘independent’ director designation on board is not an ideal practice, in our opinion. AMBER FLAG

. Rotation of independent directors: Over the past 10 years, Aurobindo’s board has seen significant churn amongst the independent directors. The Best Practices Code suggests that the maximum tenure for an independent director should be five years. We note that there was significant churn amongst independent directors during 2006-2008 when Aurobindo Pharma’s financial performance was poor and it also had a stretched balance sheet and poor cash flows. We highlight that the reason why a number of independent directors resigned from the Board in FY06-08 was not articulated either in the media or in the company releases. AMBER FLAG

. Insider trading: There are several stock transactions by insiders that raise Significant insider transaction prior questions over corporate governance practices. For instance, towards the end of to key events CY10 and early CY11 there was selling by insiders. This was shortly followed by issues relating to US FDA strictures against an injectable facility becoming public which led to significant correction in valuations. Similarly towards the end of CY11, there was heavy insider buying which was followed by news flow on regulatory issues gradually getting resolved. We assign an AMBER FLAG.

September 16, 2014 Ambit Capital Pvt. Ltd. Page 96 Aurobindo Pharma

Revenue Mix

Year ended 31 Mar (` mn) FY13 FY14 FY15E FY16E FY17E Formulations

USA 17,526 34,028 42,416 55,495 74,175 ARV 7,503 8,402 9,591 11,029 12,132 Europe 4,679 6,721 33,745 34,060 37,204 ROW 4,164 4,634 5,060 5,566 6,122 Total formulations 33,872 53,785 90,812 106,149 129,633 API

SSP 7,652 9,778 10,676 11,210 11,770 Cephs 9,373 8,755 10,200 10,500 10,500 ARVs and others 8,337 10,110 10,537 11,591 12,750 Total API 25,362 28,643 31,413 33,301 35,020 Dossier Income 760 165 150 150 150 Total 59,994 82,593 122,375 139,600 164,803 Source: Company, Ambit Capital research

Income statement

Year to March (in ` mn) FY13 FY14 FY15E FY16E FY17E Net revenues 58,553 80,998 119,928 136,808 161,507 Material Cost 29,908 36,060 58,393 62,238 68,857 General Expenses 17,670 21,059 31,086 37,914 45,284 R&D Expenses 2,085 2,551 5,397 6,156 7,268 Core EBITDA 8,891 21,328 25,052 30,499 40,098 Depreciation 2,487 3,125 3,701 4,226 4,264 Interest expense 1,316 1,087 1,071 846 621 Adjusted PBT 4,303 15,334 20,480 25,627 35,413 Tax 827 3,635 4,710 5,894 8,145 Reported net profit 3,501 11,737 15,770 19,733 27,268 Source: Company, Ambit Capital research

Balance sheet

Year to Mar (in ` mn) FY13 FY14 FY15E FY16E FY17E Total Assets 61,202 77,503 90,949 101,450 118,826 Fixed Assets 28,574 30,314 32,613 35,887 41,623 Current Assets 43,982 64,386 82,027 92,070 107,830 Investments 223 198 198 198 198 Total Liabilities 61,202 77,504 90,949 101,450 118,826 Shareholders' equity 291 292 292 292 292 Reserves & surplus 25,766 37,210 52,655 70,656 95,532 Total networth 26,058 37,502 52,946 70,948 95,823 Total debt 34,355 37,691 35,691 28,191 20,691 Current liabilities 10,685 16,037 22,531 25,347 29,467 Deferred tax liability 680 2,054 2,054 2,054 2,054 Source: Company, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 97 Aurobindo Pharma

Cash flow statement

Year to March (In ` mn) FY13 FY14 FY15E FY16E FY17E PBT 4,303 15,334 20,480 25,627 35,413 Depreciation 2,487 3,125 3,701 4,226 4,264 Tax (1,192) (3,440) (4,710) (5,894) (8,145) Net Working Capital (4,216) (10,591) (10,662) (4,207) (10,002) CFO 3,311 6,471 10,731 20,398 21,952 Capital Expenditure (2,676) (3,741) (6,000) (7,500) (10,000) Investment 233 (236) - - - Other investments (21) (4,211) 200 200 200 CFI (2,463) (8,187) (5,800) (7,300) (9,800) Issuance of Equity 8 35 - - - Inc/Dec in Borrowings 1,747 1,737 (3,071) (8,346) (8,121) Net Dividends (674) (596) (1,384) (1,732) (2,393) Other Financing activities - - - - - CFF 1,081 1,176 (4,455) (10,077) (10,514) Net change in cash 1,928 (540) 476 3,021 1,638 Closing cash balance 2,085 1,786 2,270 5,291 6,929 Source: Company, Ambit Capital research

Valuation Parameters Year to March FY13 FY14 FY15E FY16E FY17E EPS 12.0 40.3 54.1 67.7 93.5 Book Value ( per share) 89.5 128.7 181.6 243.4 328.7 P/E (x) 72.4 21.6 16.1 12.9 9.3 P/BV (x) 9.7 6.8 4.8 3.6 2.6 EV/EBITDA(x) 32.1 13.6 11.5 9.1 6.7 EV/Sales (x) 4.9 3.6 2.4 2.0 1.7 EV/EBIT (x) 50.8 17.6 13.3 10.4 7.4 CFO/EBITDA (x) 0.4 0.3 0.4 0.7 0.5 Gross Block turnover (x) 2.1 2.8 3.8 4.0 4.2 Working Capital Turnover (x) 1.3 1.3 1.5 1.4 1.5 Source: Company, Ambit Capital research

Ratios Year to March FY13 FY14 FY15E FY16E FY17E Revenue growth 26.5 38.3 48.1 14.1 18.1 Core EBITDA growth 45.7 139.9 17.5 21.7 31.5 APAT growth NA 236.5 34.8 25.1 38.2 EPS growth NA 234.9 34.4 25.1 38.2 Core EBITDA margin 22.0 13.2 15.2 26.3 20.9 EBIT margin 9.6 20.3 18.0 19.4 22.3 Net profit margin 5.9 14.4 13.1 14.4 16.9 ROCE (%) 9.8 24.2 26.3 28.2 33.4 Reported RoE (%) 14.2 36.9 34.9 31.9 32.7 Debt Equity ratio (X) 1.3 1.0 0.7 0.4 0.2 Current Ratio 4.1 4.0 3.6 3.6 3.7 Source: Company, Ambit Capital research

September 16, 2014 Ambit Capital Pvt. Ltd. Page 98 Aurobindo Pharma

Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected] Research Analysts Industry Sectors Desk-Phone E-mail Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected] Aadesh Mehta Banking / Financial Services (022) 30433239 [email protected] Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected] Aditya Khemka Healthcare (022) 30433272 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected] Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected] Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected] Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected] Karan Khanna Strategy (022) 30433251 [email protected] Krishnan ASV Real Estate (022) 30433205 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected] Paresh Dave Healthcare (022) 30433212 [email protected] Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected] Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected] Ravi Singh Banking / Financial Services (022) 30433181 [email protected] Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 [email protected] Ritesh Vaidya Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected] Ritu Modi Automobile (022) 30433292 [email protected] Sagar Rastogi Technology (022) 30433291 [email protected] Sumit Shekhar Economy / Strategy (022) 30433229 [email protected] Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 [email protected] Utsav Mehta Technology (022) 30433209 [email protected] Sales Name Regions Desk-Phone E-mail Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected] Deepak Sawhney India / Asia (022) 30433295 [email protected] Dharmen Shah India / Asia (022) 30433289 [email protected] Dipti Mehta India / USA (022) 30433053 [email protected] Hitakshi Mehra India (022) 30433204 [email protected] Nityam Shah, CFA USA / Europe (022) 30433259 [email protected] Parees Purohit, CFA UK / USA (022) 30433169 [email protected] Praveena Pattabiraman India / Asia (022) 30433268 [email protected] Production Sajid Merchant Production (022) 30433247 [email protected] Sharoz G Hussain Production (022) 30433183 [email protected] Joel Pereira Editor (022) 30433284 [email protected] Nikhil Pillai Database (022) 30433265 [email protected] E&C = Engineering & Construction

September 16, 2014 Ambit Capital Pvt. Ltd. Page 99 Aurobindo Pharma

Explanation of Investment Rating

Investment Rating Expected return (over 12-month period from date of initial rating) Buy >5%

Sell <5%

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