Sun reported weak Q4FY17 and guided to single digit revenue decline in FY18. Margins should also drop as it invests in specialty business. FY19 will see some recovery, but higher than expected US price erosion leads to 25/16% cut in FY18/19 EPS, leaving EPS broadly flat over FY17-19. The 20% fall in shares in last 2 months reflects some of these overhangs but with positive triggers also uncertain and valuations uncompelling at 19x FY19 P/E, we retain Hold.
Weak quarter led by pricing
Sun reported Q417 EPS of Rs 5.1/sh, down 14% y-o-y, coming 15% below estimates as revenue and margins (340 bps lower) both disappointed. US revenues fell 25% q-o-q with US ex Taro down a sharper 33% q-o-q. Part of this was due to delays in product supplies and lower exclusivity sales. US base revenues fell some 10%, too, in our estimates.
Besides weak Q4, Sun also guided to a single digit decline in FY18 revenues. It is also hiking its spend for its specialty business by ramping up R&D and building front end for FY19 innovative launches —Tildrakizumab and Seceria. This could offset the remaining $100m Ranbaxy synergy benefits expected in FY18.
Cut FY18/19 EPS by 25/16%
The overhang of lower revenues and rising spend could be exacerbated by a squeeze in Taro and higher and longer than expected pricing pressure in US business. Consequently we expect blended Ebitda margins to fall a sharper 450 bps in FY18 and recover gradually over FY19/20. We cut FY18/19 EPS by 25/16% to build these in.
The 20% fall in past 2 months reflects some of these uncertainties. Sun is also better placed than peers to overcome the pricing challenge and deliver strong growth post FY18 given its innovative pipeline. Nonetheless these remains somewhat distant while potential near term triggers like Halol resolution or Taro stabilisation are uncertain. With EPS flat over FY17-19 and valuations uncompelling at 19x FY19 PE (5% premium to peers), we retain Hold with lower Rs 535 TP preferring Cadila instead among large cap.
Specialty/complex generic and M&A will be key for pharma EPS growth going forward, where Sun is one of the best placed, in our view. Weak near term earnings and uncertain timing of positive triggers remain overhang. Retain Hold with revised DCF-based TP of Rs 535 implying 17.5x FY19 PE. Risks: Halol resolution (+), pricing pressure(-).
Results below expectation
Sun reported weak Q4FY17 results with revenues declining 7% y-o-y, 9% below JEFe, and margins declining 380 bps y-o-y, 340 bps below JEFe. The key disappointment was in the US business led by Taro and increased pricing pressure in base business. There were some one-off impacts, too, in the quarter —inventory write-off, lower exclusivity sales and order supply delays.
US business revenues declined 25% q-o-q, with US ex Taro revenues down 33% q-o-q. Management indicated that part of this was due to delays in product supplies and lower exclusivity sales, with Imatinib exclusivity being present in Q4FY16 but expiring by July 2016. We estimate base business to have declined 10%. There was a one-time charge of $45m for inventory write-off and certain other charges.
Guidance also muted
In addition to a muted Q4FY17, management also guided for weak FY18 led by increased pricing pressure in US and investment in speciality business. FY18 revenues could see single digit decline led by:
1. Increased pricing pressure from buyer consolidation and increased competition.
2. Lack of approvals as Halol resolution remains uncertain. Management is not factoring in any approvals from Halol for the FY18 sales guidance. However, delay of approvals from Dadra has not been assumed.
3. Increased R&D spend — R&D as a percent of sales is expected to be in the 9-10% range. The incremental increase in R&D spend will largely be in specialty vs 7% in FY17.
4. Increased investment in specialty for building front end for innovative launches—Tildrazumab and Seceria— in FY19.
Near term earnings risk is high
Near term earnings risk for Sun remains high led by increased pricing pressure in US business both Taro and ex-Taro. We expect sharp moderation in Taro with margins declining 1600 bps over FY17-19. US ex Taro will also remain muted in FY18 and see recovery only from FY19.
Taro outlook muted: Taro reported very weak Q4 results. Revenue was down 26% y-o-y and 11% q-o-q. Margins declined
670 bps q-o-q and 1680 bps y-o-y. Both revenues and margins are at the lowest levels since Q1FY15. Profit after tax declined 28% y-o-y. The decline was led entirely by price erosion. Volumes were up 3% y-o-y. Management stated that the generic pricing environment in US remains difficult. The risks to earnings for Taro remain high. We have seen multiple new entrants in the generic market over the past 12 months and multiple additional generic companies are working on Derma products. This, in addition to the ongoing channel consolidation, should keep pricing pressure elevated for Taro.