The following are excerpts from the recently-issued Stock Analyst Report on Sun Pharmaceuticals Industries, published by Morningstar Analyst Suruchi Jain. Registered Morningstar Members gain exclusive access to our full Sun Pharma Analyst Report (PDF), including fair value estimates, consider buying/selling prices, bull and bear breakdowns, financial and company overviews, and risk analyses. Not a Registered member? Get these reports immediately when you sign up with Morningstar for free.
We believe the strength of Sun’s low-cost generic portfolio, brand recognition in emerging markets, successful add-on acquisitions, and the capability to manufacture complex products will result in sustainable long-term profitability for the firm.
We believe the company has a narrow economic moat primarily due to its low-cost advantage, which includes low manufacturing, employee, and tax costs at its primary manufacturing base in India. Furthermore, in addition to its low-cost advantage, the firm’s vertically integrated operations through its API segment, and Sun’s focus on niche generic drug segments (including topicals and injectables), help the company earn profitability far above most of its peers.
We think Sun’s expertise in relatively more complex generic pharmaceuticals will help sustain the company’s growth and profitability, thereby stabilizing the company’s economic moat.
Most of Sun’s products are off-patent generic drugs that generally have numerous competitors and low-profitability. However, Sun earns industry leading profitability by combining its low-cost operations with unique drug categories within the generic space where greater product complexity produces more pricing power than typically seen with conventional generic pills.
It has also been able to focus on geographies where generic drugs can be marketed and sold under a brand name for a higher price than its competitors. In emerging markets such as India, doctors influence drug prescriptions among specific brands, which is unlike developed markets like the U.S. where pharmacists make automatic substitutions among generic products.
Sun’s 4,000 sales representatives maintain strong ties with doctors and pharmacies to ensure the company's lead among lesser-known branded generic competitors. Sun's niche drug and emerging market focus combined with its low-cost advantages allow the firm to earn robust operating margins (averaging near 37% over the last five years).
In the heavily commoditized US generics market, Sun’s products are able to undercut comparable US peers on price given its low-cost advantage, but Sun has been able to build out a portfolio of products beyond generics through select acquisitions.
For example, Sun's 66.3% stake in Taro Pharmaceuticals, a topical cream manufacturer, has given it access to a niche product segment with stronger pricing power. Thanks to more difficult manufacturing and regulatory approval processes for these more complex generics, fewer competitors participate in these market segments, which generally leads to better pricing and higher profitability.
During fiscal 2013, Taro contributed nearly 32% to Sun’s consolidated revenues and 48% to its profits for the year. Thanks in part to the upcoming patent cliff in the U.S. when small molecule generic launch opportunities decline, we think Sun’s markets, including Taro’s dermatology segment, could face greater competitive pressures as generic firms look for new growth drivers, but management will likely continue to utilize acquisitions to maintain a stronghold in its key generic drug markets, however.
Sun’s recent acquisitions of US firms DUSA and URL have allowed the company to expand its product offerings and manufacturing capabilities, and should uphold future growth opportunities for the firm. Although Sun has a few key products that are likely significant contributors to the company’s top- and bottom-line, we are confident that Sun will continue to take market share in the U.S. generics market thanks to its low-cost advantage.
Sun has not matched its peers ability to win highly profitable first-to-file drug launches in the U.S., such as Dr. Reddy’s Laboratories, but Sun’s ability to enter key limited-competition segments have offered compelling opportunities for Sun.
For example, Sun is the only manufacturer currently approved for a generic version of Doxil, Johnson & Johnson’s injection for ovarian cancer, in the US after manufacturing concerns created a supply shortage. Since Sun currently faces no other major competition, we estimate this has been a highly profitable drug launch for the company, which could face future pressure if other competitors eventually enter the market or the supply shortage diminishes.
Regardless, we think Sun’s ongoing participation in less competitive segments of the U.S. generic drug market remains an attractive opportunity for the company.
Valuation, Growth and Profitability
Our fair value estimate of INR 1,073 per share for Sun Pharmaceuticals implies a forward fiscal-year 2014 price/adjusted earnings ratio of 34 times, an enterprise value/adjusted EBITDA of 21 times, and a free cash flow yield of 2.3%.
We forecast that the company's revenues will grow at an average of 19.3% over the coming five years through add-on acquisitions, market share gains in developed markets, and increased volumes in developing markets as more patients can afford branded drugs.
We also assume Sun will be able to maintain a gross margin of 75.5% and an operating margin of 36.7%, both of which are comparable to the firm's five year historic average, through the 2018 fiscal year. We believe the company will continue spending an average 5.2% of its revenues on research and development in the coming five years.
Thanks to its low-cost advantage, its portfolio width across complex products, and its ability to find niche high-profit drug opportunities (such as Doxil and Taro's topical creams), we believe Sun Pharmaceuticals will continue to generate returns on invested capital in excess of our 10.5% cost of capital estimate (and 11% cost of equity), supporting our take that the company maintains a narrow economic moat.
Risk
In our opinion, the threat of competition from other low-cost rivals is Sun's biggest risk. While Sun has built up a very attractive business, it plays in the generic, off-patent market where the barriers to entry are generally low. Over time, other players may enter Sun's drug markets and gradually the company's beneficial pricing and profitability. Sun also faces the risk of changing global regulations that affect drug manufacturing, approval processes, product pricing, and taxation.
For example, the Indian government's May 2013 possible cap on the maximum price charged for numerous common drugs in the Indian market could cause an immediate cut to Sun's profitability. We believe the firm is also exposed to significant foreign currency fluctuations. As an exporter of pharmaceutical products manufactured in India, Sun's profitability could decline on adverse currency movements.
