Slower growth and full valuations prompt a downgrade

Written by Morgan Stanley | Updated: Aug 19 2013, 17:22pm hrs
We are downgrading Cipla shares to underweight from equal-weight on what we view as slowing growth prospects, limitations of business model, and full valuations. The downgrade also reflects our relative preference within the industry. We are overweight on Sun, Lupin and Dr Reddys Labs among the large caps and Glenmark and Biocon among the mid-caps. We are EW on Ranbaxy and UW on Glaxo.

* Earnings slowdown

ahead: We estimate a F14-15 EPS CAGR of 7% versus 28% over the past two years (FY12-13). Excluding Lexapro upside in FY13, we estimate the above growth rates to be 20% and 13%, respectively, implying a slowdown in the base business. This is being driven by midteen sales growth potential of the business, a flat margin outlook (ex currency benefits less NLEM hit) and a higher effective tax rate (21% in F12 moving to 24-25% in F13/14).

* Limitations of business model: Cipla has historically been risk averse and, therefore, embraced a partnership driven model in a few key geographies, including the US. Due to this, the company has higher dependence on its partner to succeed in international markets and, also, has to share economics with them. We appreciate Ciplas efforts to improve its capabilities by building a front-end in the US & EU, but we believe that this will yield results only in the longer term. Ciplas pipeline for the US also lacks depth versus other Indian peers.

* Valuations appear full: Based on our revised estimates, Ciplas P/Es (price-to-earnings ratio) are 19.5x for FY14e and 18.9x for FY15e, respectively. This is at a marginal discount to its longer-term average multiple and a discount of approximately 5-7% to the Indian large-cap pharma average. Lack of big product optionality in the near term could make breaking out of the 18-20x valuation band difficult for the stock price, we believe.

* Trailing outperformance: Cipla is up 16% over the past one year (versus +7% for the Sensex) and up 32% over the past 24 months (versus +6% for the Sensex). This was driven by strong earnings growth, commercialisation of the Indore facility, and a couple of niche launches in the US (eg, Lexapro, olanzapine).

Model changes:

* FY14e up 4.2%: This is largely driven by resetting our forex assumption to R57/$ (vs R52/$ earlier) and other operating income reported in F1Q14.

* FY15e down 4.1%: This is largely driven by resetting our forex assumption to R57/$ (vs R51/$ earlier), offset by higher operating expenses driven by front-ending efforts.

Our new price target is R386 (vs R414): We apply a 17.5x P/E multiple (marginal 5% discount to India largecap industry average) to our F2015e EPS of R22.03. The price target change is driven by: (i) FY15 earnings estimate cut by 4.1%, and (ii) marginally lower P/E multiple (to 17.5x from 18x to account for slower growth).

Upside risks to our estimates and price target include: Stronger earnings growth driven by weak rupee, especially if the company doesnt have to share it with its customers; surprise niche launch in US; value-accretive M&A and sharp ramp-up in international sales; and earlier-than-expected re-rating of the stock, driven by EU inhaler platform.