Saturday, 24 March 2012

Piramal Healthcare: In The Territory of Unknown And Unknowable

Let me start with saying that the whole idea behind this post is not to arrive at any conclusion (as for me, analysis of PHL is still work in progress!). However, what prompted me to write this post is my reading of Dr. Richard Zeckhauser's very interesting paper  on "Investing in Unknown and Unknowable" and Prof Sanjay Bakshi's lecture notes connecting the above article with investment in Piramal Healthcare Limited (PHL). Dr.Richard Zeckhauser is a professor at Harvard Univesity and chairs the program on investment decision and behavioral finance. After reading the article, I could instantly connect PHL with what Dr.Zeckhauser was describing as investing in known and unknowable. 

First thing first! Central premise of Dr.Zeckhauser is that some of the greatest investors have earned extraordinary returns by investing in unknown and unknowable (reffered to as UU) and such decisions are made based on reasoned and sensible basis. The thesis contends that there are ample situations in real world investments where, even possibilities of future state, are not known, leading to "ignorance". This ignorance about future state of events/scenario keeps most of the people/investors away from investing in such situations. What happens is that many a times uncertainty is perceived as "risk" which it may or may not be. However, if one applies a sensible thought process involving probability and payoffs and evaluate expected payoffs, it is possible to gain disproportionately from this uncertainty without assuming disproportionate risk. He proposes that person who has a unique combination of various soft skills termed as complimentary skills (deal making, deep insight into an industry, sense of judgement etc) can take maximum advantage of UU situations. Since all of us can not possess such skills, one can invest along with people who have such complimentary skills to benefit most of UU situations. ( i know many of you must be yawning by now!)

Now let us look at PHL. When PHL sold its generics business to Abbott in 2010, it was 3rd largest pharmaceutical company in India with 4.5% market share. It sold its generic business to Abbott at mind boggling valuation 9X revenue and 36 times EBITDA. The deal was valued at USD3.72 billion where USD 2.12 billion was paid in 2010 while remaining USD1.6 billion was to be paid to PHL in 4 equal installments of USD 400 million beginning 2011. It also sold its diagnostic business to Super religare for consideration of 600 crores. So now, PHL was in a situation where company was flush with cash (10,500 crores  on hand and another 6,500 crores in receivables)
but without a large chunk of cash generating business! This is a unique situation where it becomes a problem of "excess" as it is not possible to deploy a large chunk of cash in short time of a few months. since PHL sold its cash generating business and remaining businesses are much smaller as compared to generics business(sold to Abbott), it is not possible to understand the future of PHL in next few years. 

Typical questions that can not be answered immediately are 

1) How is company going to deploy such large cash to earn good return on capital?

2) Which new businesses will PHL enter into to drive growth in future? 

3) Will management be able to handle new business as effectively as pharma business? Will they perform as good, better or worse?

3) What will be profitability profile of new businesses and how effectively value creation will happen in new businesses? 

4) In case if management is not able to identify suitable opportunites, will it distribute money to its minority shareholders?

Hence we enter the realms of unknown and unknowable! As described by Dr. Zeckhauser, most of the investors (including FIIs and DIIs) shunned PHL and stock prices plummeted below its cash level, presenting you, as Prof. Sanjay Bakshi puts it India's largest cash bargain! Shall one invest in this cash bargain or is PHL going to be a value trap? Let's try to look at this and try to understand positive and negative aspects of investing in PHL 

Negative Aspects:
  • Deal with Abbott was concluded in middle of 2010 and received cash about the same time. It is almost 2 years since then and PHL has still not invested large chunk of money in any of the operating businesses (11% stake in vodafone for 6000 crores is a financial investment as per Mr. Ajay Piramal). This money sitting on the books or deployed in liquid/short-term investment may earn lower return on capital than the past track record suggests.
  • PHL's core business was pharmaceuticals till 2010. Post Abbott deal  management wants to make investments in other areas of business such as NBFC, real estate and home land security in addition to pharma business. NBFC and real estate businesses are considered inherently risky by the market. 
  • It is perceived (and may be true also) that future success of PHL largely depends upon Mr.Ajay Piramal due to complimentary skills that he brings to the table and his ability to build scalable and sustainable business models thereby creating value for company's shareholders. This extremely high reliance on one person poses as a big risk as any untoward incident (impairment/death etc) to Mr.Piramal may put a big question marks on PHL's ability to create value.
  • PHL is currently is in investment mode to achieve its long term objectives and hence in the shorter term, margins of the company are going to be under pressure till it starts to earn returns on its investments in operating businesses. 
Positive Aspects:
  • PHL has an extremely good track record of value creation in the past. Since 1988, PHL has grown its sales CAGR 29%, EBITDA at CAGR 31% and PAT at CAGR 33%. This is nothing short of phenomenal considering 22 years of span! 
  • PHL has always believed in maximizing value for shareholders as evident from its actions at various stages. After Abbott deal, PHL bought back 20% of its shares at 19% premium to market price to reward its shareholders. Buy-Back is considered as the most tax-efficient way of rewarding share holders as compared to other options such as special dividends. This reflects the underlying thinking for preserving value for investors.
  • I have gone through ARs, analyst presentations, announcements and conference call transcripts and I gather an impression that PHL management has been very transparent in all its disclosures and announcements. It has been very open about its plan to deploy cash at various points of time in different businesses and has made an extra efforts to explain the nature of investment (strategic/financial/short-term investment) to give better understanding to shareholders.
  • Another thing that is strikingly clear is that PHL sets the long term targets and more often than not achieves it before time. A Case in point - when it bought Nicholas laboratories, it was ranked 48th in Indian pharma market. At the time of the deal, Ajay piramal told head of Nicholas Laboratories that he will make it one of India's top 5 pharma companies. In a decade he fulfilled his promise. In 2010, he made PHL no.3 in Indian market. According to PHL's analyst presentation in August 2011, PHL wants to clock revenues of 10,000 crores with EBIDTA margin of 18-20% by 2016. PHL aims to be one of the top-3 OTC players in india, one of the Top-3 custom research players, one of the top-2 in anesthetic drugs and commercialize 2 new molecules. 
  • Mr.Piramal's track record as deal maker is very impressive. His approach to acquisition is firmly rooted in value investing as evident from some of the deals and his interviews and publications. He almost always avoids transaction where there are too many companies chasing the deal. He looks for companies that have specific disadvantages/weakness which in his judgement can be corrected. Hence he is not likely to overpay for acquisitions and squander value (as happens in many of the companies flush with cash). 
  • As Prof.Bakshi points out, he has a contrarian bent of mind which helps him extract maximum value on sell while paying minimum value on buy. This contrarian approach is out of his conviction in his assessment of situations/opportunities. This is precisely one reason why he is not at all in hurry to invest money though market is killing its stock price.
  • PHL aims to be the first fully integrated pharma company from India who intends to develop a new molecule and commercialize it successfully. Piramal Healthcare Research (earlier known as piramal life-science limited) has been actively working towards this goal since many years. It has, in all, 24 new chemical entities (NCE) in pipeline at various stages of trials, many of which are as advance as Phase-2/Phase-3 trials. This activity has very high risk-reward ratio. From whatever little information I have, typically out of 100 compounds in the pre-clinical stage, roughly 20 of them get commercialized. If we take the same ratio, out of 24 new compounds, 5 of them can reach commercialization stage where rewards are extremely high. Some of the compounds that PHL is working on has market potential of USD 10 billion (diabetic type-2 drug). Thus it will bring lot of upside into the equation.
  • PHL is currently trading as cash bargain and below book value. This essentially means PHL's existing businesses such OTC, CRAMS, Critical care and new drug discovery along with real estate PE fund and NBFC business (though minuscule) are available for free.
So, what shall one make of it. Here is how I will try to come to some conclusion.

I would like to assign probabilities and payoff/loss to each of the key risk factors and upside potential to work out an expected value of each out come wherever I can. This will give me some idea about my odds of falling into a value trap!  

Another thing that I would gauge is margin of safety, cornerstone of value investing. I will try to assess my downside considering worst case scenario. If I find that my downside is limited while I am exposed to significant upside, Bingo!I will go and grab it with both hands...

Disclosure: I have not created any position in PHL and this article is not a recommendation for buy/sell.

9 comments:

  1. Hi Dhwanil,

    I'm a regular reader of your blog and love the quality of your posts.

    Keep it up!!

    Thanks,

    Vikas

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    Replies
    1. Thanks Vikas for your kind words.

      Best Regards
      Dhwanil Desai

      Delete
  2. Hi,
    Kudos for running nice blog. Enjoyed reading all the posts.
    My 2 cents on the post:
    1. "NBFC and real estate businesses are considered inherently risky by the market" - I feel it does not matter how the Mr.Market currently perceives NBFC and real estate venture. All we should be concerned is whether the management can create value out of these ventures over the long term??
    So far IndiaREIT (real estate fund) done fairly well by following a contrarian approach and it is one of the elite fund out of 46 funds which not only returned the capital but also gave good 17-20% return on capital. (http://forbesindia.com/article/big-bet/ramesh-jogani-the-value-builder/24002/0)
    Regarding NBFC, this answer from ajay piramal during concall gives good pointer on how they would like to build the business. Analyst: have a question on PHL Finance, you shared your vision
    that you expect to generate an RoE of about 15% to 16% on
    this business, I am just wondering is that a conservative
    estimate, because it seems a bit low even compared to the
    other businesses and also if you look at other NBFCs?
    Piramal: So we do want to build conservatism in this business
    because we believe that to get a NBFC, solid strong
    foundation if you set up very aggressive target it is easy to
    achieve them in the short-term, but one does not know what
    happens in the long term, so as we learn more and more
    about this business, we shall increase it, so the easiest way
    for us to do is actually increase leverage, but we have
    deliberately kept it at a lower level only because we want to
    be conservative as we start-of. I think we will update you as
    we go ahead in the future as to what we can do but this is a
    conservative estimate. (piramalhealthcare.com/fckeditor/editor/filemanager/connectors/aspx/fckeditor/userfiles/file/PHL - Q1 FY2012 Results Conference Call - Transcript.pdf)
    2. I think you are bit too optimistic in assuming that 20% of drug pipeline can be commercialized. Drug discovery is highly risky business and there is high chance that a promising drug target could turn out to be a dud even at fag end of Phase III clinical trials too, draining the resources pumped in. Most of the out-licensed deals by indian pharmas like glenmark, Dr.Reddy's, biocon etc. have fallen through without yielding any headroom. Indian pharmas are attempting drug discovery for past 10-12 years and they are yet to make a single drug to show for their effect from the combined pipeline of 100 lead molecules. Hence for a conservative value investors, it would be safe not to assume any potential from drug discovery in valuation process. My opinion is if any drug discovery materializes, let it be a positive surprise.
    3. I was intrigued how we can assign probabilities when the whole picture itself is not complete??
    As an investor in PHL, my main focal point would be on CRAMS and Inhalation anesthetics business which they projected to form 75% of group revenues in 2016. what kind of acquisitions they do? market potential? company's execution ability? etc.
    Would love to hear your thoughts

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  3. Thanks Jagadees for your compliments.

    here are my views point-wise.

    1) Yes, I completely agree with you that what matters is not market perception but whether PHL will be able to create value through real estate and NBFC businesses. My personal take on it is that Mr.Piramal is building both the businesses like a value investor (as evident from the approach of IndiaReit and the snippet of conversation that you sent). At the same time, it is important to keep in mind that risk profile of real-estate and NBFC is very different than that of pharma business. Both the businesses are inherently more risky than pharma business. However, if one takes a conservative approach as suggested by Mr.Piramal, it is possible to create good value through business.

    2)I have very limited knowledge of pharma drug discovery process, however while I was analyzing piramal's research business, I did a small research on drug discovery. And I found that one starts with hundreds of "lead" molecules in the intitial screening stage which are reduced to 30 in pre-clinical stage, 5 and 1-5 in phase-I. and one or two going to phase-2 and Phase-3. From whatever papers/articles that I read, I got and impression that success rate after preclinical (i.e. phase-1) is 18-20%. If I look at Piramal's research portfolio, more than 70% of the NCE are Phase-1 or above and hence I have assigned 10% probability. However, let me admit, I may be wrong and this success rate may be much lower in India due to very many reasons. And, I am approaching this as a pure upside potential as you suggested. Even though we assign a small probability to success, pay offs can be huge and hence expected profits (probability * pay off) can be substantial.

    3) Yes, I do agree that it is very difficult to assign probability to some of the outcomes. However, as it is said by many value investors that it is better to be approximately right than precisely wrong. I feel that if one understands the business drivers/economics/management thoroughly, it may be possible to assign probabilities (though it may be subjective)to various outcomes. I am currently in the process of doing that. I am not sure how far I will succeed, but I am giving it a shot. It will at least give me some way of quantifying risk of loss of capital versus expected gains.

    It is indeed good to receive such detailed comments having very high substance. I would love to receive more of it and engage in insightful discussions.

    Best Regards
    Dhwanil Desai

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  4. Glad to receive detailed reply.
    1. Yeah, i agree risk profile of real-estate and NBFC is very different from pharma business. Also management bandwidth going to be severely tested when a group runs several business that too most of them in start-up stage. One more thing to be aware is that these 2 business going to consume only 25% of cash surplus(75% planned to go in pharma business only) and investors while doing valuation should guard against giving more than warranted attention.
    2. True, potential pay-off could be huge. They are making right moves - they brought in 2 fellows to the board from prestigious Royal society of London, brought in research heads from big MNCs and above all big money to avoid funding headaches. But in drug discovery as in cricket parlance, Match is not won/lost until it is done :P
    3. Eagerly looking forward to the next post on it. (between this recent investor presentation by PHL may help u in your endeavor - http://piramalhealthcare.com/fckeditor/editor/filemanager/connectors/aspx/fckeditor/userfiles/file/PHL%20%20Investor%20Presentation%20-%20March%202012%281%29.pdf)

    Regards
    Jagadees

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    Replies
    1. Hi Jagadees,

      Sure. I will have a post on PHL as soon as I am done with my analysis of odds. I am working slightly differently on this now. I am analyzing each part of business separately and trying to understand a base case (as conservative as possible), worst case and best case scenario for them in terms of top line projections. I will take that as basis instead of going by management's guidance for valuing PHL.

      Let's see how credibly i am able to come out with these projections.

      Best Regards
      Dhwanil Desai

      Delete
  5. I had a look at this company and its business in late 2010.I knew very little about investing etc and that time and was reading bakshi blog on this business.Only one point made me not to invest on this business.The dependability on a single person. He might be great visionary and businessman etc..but what happens if he is gone?

    I did not even hear about second level management people of this company.which i thought a bad sign with no successor plan in place.

    They might do well ,,they might not but i am not gonna bet on a single person in a business.

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    1. Hi TheZion,

      I also share same concern as you and betting on capabilities of a single person is tough. However, I do not envisage that in case of Mr. Piramal not at the helm of PHL, company would come down like pack of cards. If one looks at top level management, Mrs. Swati Piramal is equally involved in business. Ms. Nandini piramal (daughter of Mr.Piramal) has been inducted on the board. In addition to that at operational level there are quite a few people like Mr.Vijay Shah (COO) and Mr. Rajesh Ladhha (CFO) have been with group for more than a decade. On the research side Mr.Sharma has been leading research efforts of PHL group for many years. Hence, all of this taken into account, I do not think there will be vacuum in case if Mr.Piramal is not there. Yes, I am not too sure about whether PHL will be able to grow at the same pace under leader other than Mr.Piramal.

      Delete
  6. hi

    by any chance do you have 'Investing in the Unknown and Unknowable' by Zeckhauser in soft copy!

    If you can send it to me @ achinj at gmail dot com

    ReplyDelete