Angel Broking recommends Buy on Sun Pharmaceuticals with a 12 months Target Price of Rs 661

Merger with Ranbaxy Labs

Sun Pharmaceutical Industries (Sun Pharma) and Ranbaxy Laboratories (Ranbaxy) announced that they have entered into definitive agreements pursuant to which Sun Pharmaceuticals will acquire 100% of Ranbaxy in an all-stock transaction. The deal value for the transaction at ~ US$4bn, puts the valuation of Ranbaxy at 1.6xFY2015E EV/sales, which is at a discount to its peers, which trade at 2.0-2.5x. Thus, every shareholder of Ranbaxy would get 0.8 shares of Sun Pharmaceuticals. This exchange ratio represents an implied value of Rs. 457 for each Ranbaxy share (18% and 24% premium to Ranbaxy's 30-day and 60-day volume-weighted average share price, respectively). The transaction has a total equity value of approximately US$3.2bn. Subject to pending shareholders and regulatory approvals, Sun Pharma anticipates that the transaction will close by the end of CY2014.

The key highlights of the merged entity:

Merger with Ranbaxy to aid diversification: The combined entity's revenues are estimated at US$4.2bn (pro forma CY2013 sales). Ranbaxy has a significant presence in the Indian pharmaceutical market (21% of Ranbaxy's sales) and in the US as well (29% of Ranbaxy's sales) where it offers a broad portfolio of abbreviated new drug applications (ANDAs) and first-to-file opportunities. In high-growth emerging markets (50% of Ranbaxy's sales), it provides a strong platform which is highly complementary to Sun Pharma's strengths. Sun Pharma on the other hand has a strong presence in the US (60% of sales), India (23% of its sales), and the ROW (17% of sales). Thus, the combined entity would be more diversified with US, ROW and India contributing 47%, 31% and 22% of sales respectively.

Combined entity to be much stronger: In terms of market share, the combination of Sun Pharma and Ranbaxy creates the fifth-largest specialty generics company in the world (just behind Teva, Sandoz, Activas and Mylan), the largest pharmaceutical company in India with a market share of 9.2% with a sales of US $1.1bn, and ahead of Abbott which has a market share of 6.5% (which is huge gap in the highly fragmented Indian market. In terms of asset base, the combined entity will have operations in 65 countries, 47 manufacturing facilities across 5 continents, and a significant platform of specialty and generic products marketed globally, including 629 ANDAs.

Profitability to remain higher than the Industry: On the profitability front, the company is estimated to have a combined pro forma EBDITA of US$1.2bn, and an OPM of 28.6%, which is still very healthy, given that Ranbaxy is currently operating at a low OPM. The company is confident of turning around the same, given its history of turning around its acquisitions (Caraco, Taro, DUSA and URL) in the past.

Sun Pharma is confident of turning around the acquisition. It expects synergies worth US$250mn by the third year of acquisition (i.e. mostly by FY2019). However, in the near term, the acquisition will dilute the reported ROE from 25.4% to 25.1% in FY2016, which is healthy, given the low profitability of the acquired company and it would be at the higher end of its peers, which have an ROE of 17-25%. The operating ROE, which excludes the cash component, will still be higher at around 41%.

Outlook and Valuation: The acquisition is likely to get completed by the end of CY2014 and thus will fully reflect in Sun Pharma's FY2016 financials. Thus, in FY2016, Ranbaxy will contribute around 37% to the sales (estimated to be around Rs. 31,223cr) of the combined entity. On the operating front, the company is likely to have an OPM of 29.3%, with a combined net profit of Rs. 6,639cr. The EPS of the combined entity would now stand at Rs. 27.6 for FY2016, lower form Rs. 28.8 estimated earlier, on back of equity dilution of 16%. The acquisition will dilute Sun Pharma's reported ROE from an estimated 25.4% to 25.1% in FY2016, which is healthy, given the low profitability of the acquired company and would be higher end of most of its peers which have an ROE of 17-25%. However, the operating ROE, which excludes the cash component, will still be higher at around 41%.

Also, in connection with the transaction, Daiichi Sankyo has agreed to indemnify Sun Pharmaceuticals and Ranbaxy for, among other things, certain costs and expenses that may arise from the recent subpoena which Ranbaxy has received from the United States Attorney for the Toansa facility. Thus there could be some expenses, if any, to be borne by Sun Pharma, which should not be a problem, given the strong cash on the books of the combined entity (estimated to be around Rs. 20,000cr in FY2016).

Thus, we don't see any significant de-rating in the stock and hence believe that given the growth opportunities and its market share, the company will continue to trade at a premium to sector valuations. Thus, we maintain our Buy recommendation on Sun Pharma with a price target of Rs. 661. As regards shareholders of Ranbaxy, we believe that they should hold on to their investments, given the synergies and the positives emanating from the deal.

Source : Equity Bulls

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