Sun Pharma is to buy Ranbaxy for $4 bn in an all share swap (16.2% dilution for Sun Pharma), valuing Ranbaxy at 2.2xLTM (last twelve months) sales. While the deal will be earnings dilutive in the near term (-4% in FY16), we see significant synergies over the next three-four years which we believe will lead to 10-12% incremental EPS (earnings per share) in year three from the acquisition.
Per management, acquisition will be cash EPS accretive in the first year. While our base case forecast today is unchanged, given Sun Pharmas previous track record in M&A, we would expect the market to factor in some of this upside prior to the deal closure. We have moved up our PE (price-to-earnings) multiple to 24x (times) to reflect the higher growth visibility, which was a key reason for our earlier downgrade.
Acquired entitypeak at regulatory issues; bottom of margins: We highlight that with all four US FDA approved plants under import alerts, Ranbaxy is at the peak of regulatory issues which has resulted sub optimal margins of 8% in CY13. We highlight that Ranbaxy spends 4% of its sales on consent decree. While it is difficult to ascertain the regulatory time line, we believe that there is significant scope for operational improvement and hence earnings upside.
Sun Pharma has a history of turning around distressed assets. Sun Pharma has a successful track record of turning around distressed assets with recent cases such as Taro and URL. While we acknowledge that Ranbaxy will likely have its own challenges, we highlight that Ranbaxys gross margins (63-64%) are largely in-line with other Indian peers (indicates that geography mix or product-mix is not an issue). Regulatory overhangs and high fixed costs have depressed Ranbaxys profitability, where Sun Pharma can bring its operational strength.
Price objective basis & risk: Our price objective of R680 is based on 24x FY15e EPS (20% premium to peers: in-line with historical multiple). We expect Sun to sustain its premium valuation to the large-cap peers on P/E multiples, given strong franchise, industry-leading margins, and strong execution track record. However, vulnerability to price competition and earnings volatility over the next two years pushes it down in our preference list.
The risks to our price objective are:
(i) higher-than-expected price erosion in Taro portfolio, (ii) longer than anticipated turn-around time for Ranbaxy, (iii) higher price erosion in Doxil portfolio, and (iv) the possibility that the Ranbaxy acquisition does not consummate.