Sun Pharmaceuticals- A classic spin off play.

Sun Pharmaceuticals (CMP Rs 923) is one of the best plays in the Indian pharmaceutical space. While the company has lined up a slew of R&D Products it has not let these developments disturb its over all profitability. Over the past couple of years Sun has focused on niche and chronic therapies and has tried to put down a controlled cost structure. Recently it did US acquisitions which has fared out quite well.

The company has announced the spin off the R&D division as a separately listed company with some cash and assets from the parent. Shareholders of Sun Pharma will be issued shares in the R&D company on pro rata basis..

Sun has a pipeline of more then 50 ANDAs pending approval, including Para IV filings, injectibles and complex products. This pipeline is equivalent to those of Ranbaxy and Dr. Reddy’s Sun plans to file about 30 ANDAs each year in the future.

The company has increased its sale by 23.33% CAGR over the last 4 years to Rs 1742.92 crores from Rs 753.10 crores. Net profit during the same period has grown by 28.11% CAGR to Rs 461.29 crores from Rs 171.20 crores. During the same period the operating profit margin has expanded to 31.02% from 27.66%

The stock trades at a current year PE of about 32 times which is high. But PE is surely not the best way to analyze Pharmaceutical companies The R&D hive off should increase margins and net profit by an additional 20%.

The management recently said that the first phase of its Project at Sikkim first phase will be operational by March 2007 and the second phase should be up by 2009. This 300 crore units capacity should increase overall capacity by 20 per cent

Over the next few years SUN Pharma should expand its global operations and bring it upto 50 per cent of total sales.

The demerger of the R&D division will create spin off benefits and shall lead to a rerating of the stock.

What should investors do post the demerger?

1)      Post demerger the R&D company stock could be hammered down. This is because it would have no earnings and investors would look at PE and EPS thus forgetting the long term viability of the stock.

2)      The main business will see a rerating. The incremental profit that would arise because of the decrease in R&D spending will ensure that the EPS grows at a higher level then what is generally expected.

3)     The fact that the company is hiving off its R&D business into a separate entity means that the company expects revenues to flow into its R&D business very soon.

Generally it would make sense to look at valuations and in case the market gives the R&D Company a thumbs down smart investors should move in and buy this focused research play for the long term. If the market values this R&D on expected lines then also it deserves to be held because the real kicker would come in from the R&D Company rather then the main business. At present the stock does look fairly valued and but the value unlocking could come from the spin off only.

Sun Pharma is the excellent pick in the Pharma space. It is constantly showing a CAGR of 35% for the last 4 years. It has a simultaneous focus in two main areas.

In Domestic sector it has a clear focus on the chronic disease segment and speciality products.

In International sector it is a aggressive player with a number of ANDA (Abbreviated New Drug Applications) filing in US. Sun has filed 27 products in US already they have a lot of products in the pipeline and they hope to have 100 products by 2009. They operate independently as well as through Caraco, its 100% Subsidiary in US. In the International scene they have complex products like Nasal Sprays, Injectibles which will be difficult to imitate immly. It has also exports in niche segments such as anti cancer, seroids, hormones et, which are very complex products and will wardoff competition to some extent.

Recently they have also acquired facilities in Ohio, Hungary and New Jersy where entry barriers are also quite high.and there will be substantial revenue contributions from these acquisitions.

As it is already known, they are demerging the R&D business which will unlock values.The proposed demerger may happen in March 2007.

Apart from the domestic and international sales they expect growth also from non-US formulations and bulk exports.

As regards the financials , it shows a constant increase in sales. The ROE and ROCE also is very comfortable. Constant increase in sales is a very healthy sign for any company.

Year                         Sales in Cr             ROE                  ROCE         PAT margin

Fy-2005                      1143.3                 40.5                     16.6           34.7

Fy-2006                      1594.5                41.4                     12.5            36.0

FY-2007 Estimated    2040.4                37.6                     15.2             35.3

It has not liquidated its equity in the last two years. The promoters shareholding is 71%. FII holding is 16%. Shares with Public is only  7%.

Since 15% of my portfolio is having pharmaceutical shares, I constantly keep a watch on the developments

In Pharmaceutical Industry.  In my opinion out of the four leading players in the Indian Pharmaceutical scene, (Cipla, DRL,Ranbaxy and Sun), Sun Pharma is best placed among all. Though in the upside

Ranbaxy may go to a  higher level percentage wise over Sun Pharma, the latter is the best one to go for in Pharmaceutical sector.