Warning letter to Halol plant: Sun Pharma has announced that the FDA has issued a warning letter to its facility located at Halol, Gujarat. While the stock price was factoring in this risk, we think the timing is still a surprise given the remediation efforts that were still ongoing at the facility. Halol is one of Sun Pharma’s largest facilities for US sales with sales ~8-9% of overall top-line (~$380-400m) and has been in remediation since its last inspection in 2014. Post issuance of the warning letter, approvals from Halol will continue to be withheld, which will impact future launches from the facility.
Call highlights: The warning letter (WL) reiterates most of the issues raised in the ‘483 observation’ letter post inspection in Sep-14. While Sun Pharma said that the warning letter requires more detailed analysis for it to be able to guide on a timeline for possible resolution, some areas need additional remediation and a possible change of course post-discussion with external consultants. Management thinks the usual timeline for a WL of c15 months may not hold, as the remediation process has already been under way for almost 15 months. The company has not initiated a site transfer of products other than for gGleevec, which was recently approved from an alternative site at Cranbury. Sun reiterated that its immediate focus is to resolve the Halol plant rather than the site transfer of a few material opportunities. Product supplies to the US will continue post-WL, but may continue to be disrupted owing to remediation efforts. Halol has been inspected by other regulators and has passed inspection. The WL has not impacted FY16 sales guidance.
Downgrade to Hold, TP cut to R735 (from R932), revising earnings downwards: While we wait for further details, the Halol warning skews risk-reward negatively and could extend the timeline for a recovery in the US business. We reduce our estimates for US sales as we remove a few anticipated launches (gGlumetza, gCrestor) and build higher costs for a possible increase in remediation expenses. With two large companies— Sun and Dr Reddy’s under FDA warnings, we believe there is potential for further sector de-rating. We derive our new TP of Rs 735 (from Rs 932) using 21x our Dec-17 EPS of Rs 36.4 and add additional value for gGleevec and MK-3222, discounting this to get to our fair value TP (target price).
Chances of import alert, sensitivity to Halol
The escalation of the warning letter remains a risk, although the likelihood of such an event would be dependent on observations in the warning letter and Sun’s subsequent response to the FDA. In the worst case outcome of an import alert at Halol, we believe the impact would be limited to adjusted earnings now, as some products such as Doxil will be exempt due to existing shortage.
Valuation and risks
The warning letter at Halol has a negative impact on risk-reward and while we wait for further details, we believe any material change in the time-line for resolution could impact US growth further. We have already adjusted our estimates for new launches in FY17-18 and expect US sales to grow from current $2.2bn to $2.67bn by FY18 with material upside from Taro, non-Halol facilities and synergies from Ranbaxy in the US. We believe given a better growth outlook in India and Taro in US, the stock should find valuation support and not trade below the sector average of c20x. FY16 company guidance is intact and we expect financial impact to be minimal. Our net adjustment on the back of lower sales in US and higher costs is a c7% cut in FY17e earnings and c9% in FY18e.
