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.