Piramal Healthcare- Gazing Through Crystal ball- Part 2

In the Part-1 of this post, we reviewed three different businesses of PHL namely CRAMS, critical care and research division. As described in the earlier post, I have tried to be as conservative as possible while trying not to be projecting doomsday scenario at the same time. So let's do a small recap of revenue and investment projection for three businesses discussed in Part-1

Custom Research & Manufacturing: Assuming PHL is able to grow business at least as well as industry (historical data suggests that they have out performed industry), in 2016-17, one can expect revenue of INR 3500 crore with investment of roughly 1300 crores. 

Critical Care: One of the leading players having entire range of product portfolio and sales and distribution network, PHL shall be able to clock revenue of around  1500 crores with estimated investment of 1000 crores. 

Research Division: A business which is exposed to positive black swan. However, while counting for revenue, I have tried to derive expected value  based on actual receivable benefits in immediate future only (e.g. only upfront payment for out-licensing deal is considered, rest of the elements are not considered). Based on this, I arrive at revenue estimation of around 2100 crores with investment of 800 crores. 

So now moving on let's analyze rest of the three business namely OTC, NBFC and real estate private equity. 

OTC Business: PHL's OTC business comprises of 7 brands such as i-pill (emergency contraceptive pill), Lacto Calamine (skin care), Saridon (headache), Superactiv complete (nutrition supplement), itchmosol ( itching), Triactiv (nutrition suppliment) and Polycrol (acidity). Some of these products such as lacto calamine, Saridon and i-pill are household names. OTC business in India is expected to grow at 16-18% in next few years and will reach size of around USD 10 billion  from current size of roughly USD 2 billion. 

OTC business is driven by two things, building brands and distribution network. Both these activities will require substantial investment. Once the brands are well established and availability of the product is ensured, sales will be driven by "pull" rather than "push". In my opinion, PHL's portfolio of  brands can be categorized as follows 

Strong brands: LC, i-pill, Saridon and Superactiv 

Moderately strong brand : Polycrol 

Weak brand: Itchmosol and Triactiv  

So if we consider that PHL has 4 strong and 1 moderately strong brand out of 7 brands and financial capacity to make large investment in brand building and distribution network, it can grow at probably 25% CAGR in terms of revenue (OTC business is likely to grow at 16-18%). This will mean annual revenue of around 700 crores (taking 225 crores as base in FY 12). PHL has indicated investment of around 2500 crores in OTC considering inorganic growth. Even though, I have not considered inorganic growth in CAGR projections, to be on the conservative side, I will keep investment number at 2500 crore. 

NBFC Business: PHL has entered into NBFC business and started lending money. According to PHL, they would like to attain asset under management of around 6000 crores in next 5 years. As we do not have any benchmark in terms of past performance in this business for PHL, i would like to take management's guidance on its face value. Moreover, the target set by the management seems to be achievable compared to market potential of NBFC and niche area that they want to target such as real estate, education and hospitals. All these sector are currently not served by existing NBFC players (to the best of my knowledge)

In order to derive at revenue generation for NBFC, I have tried to look at other NBFCs such as IDFC and Shriram Transport to understand the ratio of revenue to AUM. In case of IDFC, 5 year average revenue/AUM is around 25% while that of STFC is around 14.5%. I will take lesser of the two and assume 15% revenue/AUM ratio which will mean revenue stream of around 1000 crores   from NBFC operations. Management has guided that investment required will be around 1000 crores. I will stick with management's number. 

Real Estate PE business:  Let me be candid here and admit that I do not know how to value (or predict revenue) for real estate PE firm. I believe that typical valuation of a PE firm is around 4-5% of Fund Value, however I do not know either the methodology or has grasp of the business to give any insight. Management has guided that they will invest roughly 1000 crores and manage funds of around 13,000 crores. So how should I value this business? After pondering over this, I decided to not put any revenue number and assume that by not valuing this business I am providing for "margin for error" in my estimates for other businesses. What I will do is, I will not count revenue from this business while will consider investment of 1000 crores in this business in the investment section. 

So at the end of the whole exercise, my conservative scenario, following are revenue and investment numbers. 

Revenue (in Crore): 3500 (CRAM) + 1500 (critical care) + 2100 crore(research) 

                            + 700 (OTC) + 1000 (NBFC) = 8800 Crores

Investment (in crore): 1300 (CRAMS) + 1000 (critical care) + 800 (research) + 

                               + 2500 (OTC) + 1000 (NBFC) + 1000 (real estate PE)

                              = 7,600 crores

PAT Estimates: 10 year average PAT for PHL's pharma business was 10.4%. However, in next 5 years, PHL is going to have tax shield of loss making research division which is going to bring down PHL's tax rate to 7-8%, less than average tax rate for last 10 years. Reduced tax burden shall translate into higher profit margin however, I am not accounting for that as I believe lower margin in initial years in OTC business may counter the upside.

For NBFC business, 5 year average net profit margin for STFC and IDFC is 18.7% and 25%  respectively. 

So I am assuming combined PAT as 10% of revenue (which in my opinion is fairly conservative). this will bring PAT to roughly 900 crores. 

Number of shares outstanding: 

After buyback, as on date, number of shares outstanding are 16.72 crores. 

PHL has total cash equivalent of 

Vodafone investment = 6600 crores (10% return on investment post tax which is much lower than management guidance)

Abbott Deal receivables: NPV of receivables is around 5000 crores 

Hence total cash available for deployment is roughly 11600 crores. Out of this, investment requirement will be around 7600 crores. 

This will leave 4000 crores of cash surplus plus free cash flows generated from 2012-2016. PHL may decide to partially retire debt out of this proceed. PHL management has clearly indicated their preference for buy back over dividend payout due to tax advantage. Hence, I see very high chances of second round of buy back by PHL. In my opinion PHL will buy back when the price of the stock is subdued. Hence let me assume PHL offers to buy back shares at Rs. 600 and allocates roughly 2000 crores for the same. This will mean extinguishing 3.33 crores shares. After second buy back, total shares outstanding around 13.39 crores. 

Thus, estimated EPS for PHL in 2017 will be PAT/outstanding shares = 900 crores/13.39 crores  = 67.2 

Valuation: Let me confess! This is the toughest part for me. I do not know how market will look at PHL five years down the line and what valuation it will assign to the company. The inference that I derive from my above analysis is: 

PHL's revenue will likely to have grown at CAGR 34% in 5 years and PAT (barring one time profit) at much higher rate. I think, if PHL is able to come near to expected numbers, considering valuations of peers (most of them have traded at 20-25 P/E), PHL's historical P/E (around 20-25) and clean balance sheet, P/E multiple of 15 seems reasonable. In my opinion, if PHL trades at P/E of 15, it will mean market is still circumspect about PHL's management ability or future growth prospect. However, I will  go with P/E of 15. 

If I apply P/E of 15 to EPS of 67, it will will give value of share around 1008. Thus from current price of 455, it will be return of CAGR 17%. 

To me, 17% is a base case, conservative and quantifiable estimate for return. In addition to this, Investor is exposed to following upsides. 

• PHL is able to successfully complete phase-3 trials for its lead molecule P-276 which will open up a new vista for the company. If they are successfully able to commercialize this molecule, as intended by management, PHL will be in a different league altogether. 
• PHL's molecules for Merck and Eli Lily moves forward in trials and if any one of them gets commercialized,  value of royalty, milestone payments and marketing rights will be substantial.
• PHL is able to move some of the current molecule till phase-2 end. They will represent significant out-licensing value. (P1446 (likely to move to phase-2 in 3-6 months) and P2745 (phase-1 likely to be completed by end 2012)) 
• As per management's guidance (management has track record of meeting their targets by and large) PHL is able to grow inorganically and achieve much higher growth rate than estimated in my analysis. 
• PHL's margins improve due to increased income for R&D which is a high margin business. 
• Last but not the least, market values PHL at least in line with their peers. 

On the downside following risks

• It is not able to run NBFC business properly and is not able to achieve profitability as projected.
• I have assumed complete loss of capital for PHL (i.e. investment of 1000 crores) 

In all if I am getting a chance to partner is a business where the management is flush with money, has excellent track record, top management is transparent, ethical and competent, I am able to see at least 17% compounded return in 5 years and exposed to large positive black swans, I would grab it with both the hands.

Update: PHL has received approval for BST-cargel in EU countries. It has also applied for approval in Canada and will approach authority in India post EU approval.

Disclosure: I have position in PHL. Views expressed in this post shall not be construed as investment advice. Readers must do their own due diligence before taking investment decision

Piramal Healthcare: Gazing Through Crystal Ball - Part I

In value investing, gazing through crystal ball is highly injurious and rather considered to be poles apart from the basic tenets of value investing. However, in certain situations such as unknown and unknowable events (UU events), it is important to not be bogged down by the sheer scale of uncertainty and think simple and straight to make sense of the fluid situations. It is very much possible that some of the outcomes may vary considerably from assumptions, however, at least the whole exercise leads to a structured thought process that may give some "sense" on the probable outcomes.

Success of the whole process will depend on focusing on conservative outlook rather than going gung-ho about the growth or taking management's estimates (which, many a times are very aggressive) on its face value. As described in my earlier article "Piramal Healthcare: In the territory of unknown and unknowable", PHL is surrounded with a lots of uncertainty about how future will pan out for the company. This post is a modest attempt to wade through numerous uncertainty to derive some "feel" on how future might look like 5 years down the road. 

Even though I have tried my best to derive numbers based on some of the published information on industry growth rate, past track record and some of the activities happening in the same space/sector, at some places, I have put numbers based on my "hunch", which inherently is subjective. Again numbers that are arrived at are not sacrosanct and are just very broadly indicative. The core principle still remains that it is better to be approximately right than precisely wrong.

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)

When to Sell Stock: Decision Making Based on Value Investing Approach

I have always felt that decision on when to sell a stock is much harder to make then making a decision about when to buy. Once you have already bought an investment, you are prone to cling on to your decision due to number of psychological biases such as endowment bias where you tend to overvalue your possessions most of times and confirmation bias where you look for confirming evidences to support your initial hypothesis. 

Even though when to sell stock is as critical and complex question as that of when to buy stock, there is relatively very little information available in literature of value investing on detailed methodology or framework regarding the selling decision. one school of thought suggest a "buy and hold forever"strategy. However, the underlying assumption for this approach is that one has followed the central premise of value investing thoroughly and has made investment in an enterprise that is able to increase its intrinsic value consistently over a long period of time.Though it sounds simple and elegant, putting this into practice consistently in all investment decision is very difficult except for some exceptional and legendary investors. Hence, I feel one needs to develop a clear understanding on how one should go about making a decision to sell. The approach/framework shall be as much rational  as one would expect in a decision to buy an investment. 

I can conceive three situation in which you shall exit an investment.

Updates on Oriental Carbon Chemicals Limited

I am writing this post with respect to my earlier post on OCCL Oriental Carbon and Chemicals: Keeping a close eye. I was circumspect about the sustainability of NPM in the longer run and hence advised caution before taking a plunge. Today I have come across announcement from Schrader Duncan, a company promoted by Duncan group (promoters of OCCL) and Schrader Bridgeport International Inc. OCCL had 12.58% shares in Schrader Duncan. Now, OCCL is going to acquire 50% share from Schrader Bridgeport for roughly 14 crores (as per OCCL announcement on March 05). This will mean that Schrader Duncan will become subsidiary of OCCL.

Schrader Duncan has two divisions namely Tyre/tube valves and accessories and pneumatic products. Schrader Duncan is currently in shambles due to very many reasons but primarily due to lack of pricing power and cut-throat competition. The situation is so bad that company is not able to pass on increase in raw material and operating cost and is incurring operating losses for last 2 years. Company had a plant located in Mulund which has been shut down and land is sold in March 2011 for 42 crore. Company has received 20 crore proceeds from this sale till December 2011 while remaining 22 Crore  is yet to be received. Schrader Duncan incurred extraordinary expense of 15 crore for VRS of its employees at mulund plant which has eroded company's networth substantially. Moreover, in its AR in 2011, management specifically talks about intense competitive pressure and lack of pricing power for its products. Thus management does not expect substantial improvement in business economics.

I am not able to understand the rationale behind management's move.This move raises doubts about management's ability to protect interests of OCCL shareholders.

Applying Capital Allocation Framework: Part 2

In the part 1, I discussed the two building blocks of capital allocation framework  i.e. conviction rating and valuation rating and then drilled down to constituents of conviction rating i.e. business quality, fundamentals, growth prospects and management quality. I illustrated the process with the example of Cera Sanitaryware. For reading Part 1 click here. 

Following is the overall score rating on Cera on business quality and fundamentals. 

Business Quality: 1.64

Fundamentals: 2.06

Now moving on from there, let's look at other two attributes of conviction rating i.e. growth prospects and management quality. 

Growth Prospects (weightage -30%):

Opportunity Size: This is one the most crucial parameter in the longer term as it determines the outer limit of scalability potential of a company. To give an example, Gillette has opportunity size of selling more than 3 billion razors, considering population of men around the world and hence if caught in early stage, such company can easily grow 100x . In terms of opportunity size, Cera can be considered to have a very large opportunity size considering more than 300 million households (and growing) and replacement demand that can be generated for their products. Hence Cera scores very well on this count Score:9

Applying Capital Allocation Framework: Part I - Conviction Rating

First two months of 2012 have been stupendous for the market. Many of the investors(including me) have had the feeling of being left out. At the same time I am reasonably confident that in time to come, market will again create lots of interesting opportunities for value investors. How can we remain prepared to take maximum advantage of such opportunities? I have always struggled in deciding as to what criteria one should adopt while allocating capital to existing stocks or new stocks. Should one buy more of some of the existing stocks in one's portfolio, or reduce positions in existing ones to allocate money to new opportunities that have better risk-reward ratios? Even though most of the investment I have made are based on careful study of business and valuation, relative merit of each stock in my portfolio was elusive and was doing capital allocation on "gut feel" basis rather than  a systematic process. When I come across the forum initiated by veteran value blogger Mr.Donald on capital allocation framework, I was thrilled to find a perfect answers to my quandary. Mr. Donald and fellow forum members have engaged in a very insightful discussion to deliver a fairly robust and methodical approach to capital allocation within one's portfolio and new opportunities.  

Here is the link to this discussion 

http://www.valuepickr.com/forum/valuepickr-scorecard-aug-2011/399834292

What I have tried to do here is take the capital allocation framework suggested by Mr.Donald and try to illustrate the whole process step by step by applying those parameters to one of the stocks in my portfolio Cera Sanitaryware (once again!). This may  be helpful in understanding outlined methodology slightly better. 

In order to keep the post interesting and readable, I have decided to write it in 2 parts. 

Part I- Discussion of basic idea of Mr. Donald's framework and two attributes of "conviction rating" i.e. Business Quality and Fundamentals

Part II - Remaining two attributes of "Conviction Rating" i.e. Growth Prospects  and Management Quality. I will also cover "Value Rating" and arrive at a composite rating for Cera in the second part. 

Before starting the illustration, let me first discuss the basic premise proposed by Mr.Donald. He has suggested that one can broadly rate a stock based on "conviction" and "valuation" on the scale of 1 to 10. As name suggests, conviction rating is based on how convinced one feels about the business attributes of one's investments. It is measured through business quality, management quality, fundamentals and growth prospects.