Cipla - Attractive Valuation; Upgrade To Buy - Nirmal Bang

Following a 9% fall in stock price over the past three months, Cipla now trades at 16xFY15E EPS, a 10% discount to its two-year average. We think the earnings related disappointment is overdone and believe Cipla's renewed focus on profitability growth (moving away from low-margin businesses and non-profitable geographies) and the change in strategic thinking (induction of professionals in its core team, setting up own front-ends in regulated markets) would lead to a re-rating of the stock in the long run. Further, with strong earnings visibility (10% earnings CAGR over FY13-FY15E; 17% CAGR excluding Lexapro exclusivity), we believe the stock offers good upside potential. We have upgraded our rating on the stock to Buy from Hold with a target price of Rs463, implying an upside of 19% from the current market price.

Structural changes: Over the past two years, Cipla has considerably changed its business strategy by inducting professionals (Mr. Frank Pieters - head of European operations and Mr. Tim Crew - head of US operations, both ex-Teva; Mr. Subhanu Saxena - CEO, ex-Novartis) and setting-up of own front ends in specific markets (recent offer to acquire Cipla Medpro, its joint venture partner in South Africa, reinforces our view). Further, renewed focus on profitability growth - changes to product mix, selective price increase/rationalisation have started reflecting in the numbers with gross margin up nearly 500bps in the 9MFY13 period (~400bps excluding Lexapro opportunity) from FY12.

Domestic growth, marketing exclusivity opportunities lend support to exports: From a muted 12% growth in FY11, Cipla's domestic formulations growth has recovered with 14% growth in FY12 and 17% in the 9MFY13 period. We expect the company to grow in line with the industry, as productivity from the recently added field force improves. Further, with the Indore SEZ expected to gain traction - on receipt of US Food and Drug Administration's approval in 3QFY13 - and gradual pick-up in Dymista (anti-allergic drug launched in 3QFY13), we expect the company to post a 10% earnings CAGR (despite a high base on account of Lexapro 180-day marketing exclusivity in the US in 1HFY13) over FY13-FY15E (17% excluding Lexapro exclusivity).

Capex scaling down, free cash flow to improve: With a major part of the capex phase nearing its end and improvement in margins, we expect Cipla to generate Rs9.0bn free cash flow in FY15E, from Rs1.2bn in FY12. Further, with higher capacity utilisation at Indore SEZ (post USFDA approval in 3QFY13, we also expect an improvement in its RoE/RoCE by ~130bps/170bps, respectively, over FY12-FY15E. We thus believe that Cipla's steep discount (trading 20% below peers growing at 12-15% CAGR and ~10% below its two-year average) is unwarranted and expect the discount gap to narrow. We have valued Cipla at 19xFY15E EPS of Rs24 to arrive at a target price of Rs463. Undisclosed 180-day marketing exclusivity opportunities (the management stated at least a couple in the next two years) are upside risks to our estimates.

Source : Equity Bulls

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