Wockhardt Ltd - Stock Valuation and Financial Performance

Wockhardt has total debt of ~Rs 3,000 crore as on Sept 30, 2019, of which 300 Cr is maturing in Nov’20 and 1300 Cr in Dec’21. We believe that under current financial position Operating cash flows of < 200 Cr, Wockhardt faces refinancing risks.

We read in Media that Wockhardt will be selling out key divisions from its India business to raise money to pay off the debt. The proposed sale of these segments is expected to fetch a combined valuation of Rs 2,400-Rs 2,700 crore as per reports. We believe Wockhardt will use most of this money to repay all of its debt and use some amount to reward shareholders with a one-time special dividend (very usual management action post sell-off). This can lead to stock price appreciation. We do not believe that the company is getting acquired but only one segment of business will be sold out, so sustained rise in stock price is not warranted.

Our hypotheses on Wockhardt that it will be able launch new chemical entity in anti-biotic hasn’t materialized yet. If India business is sold, the remaining international business is not very valuable while the company continues to struggle even in international business as four of its plants are under USFDA ban. This stock can slip further. We thus, advice to sell Wockhardt on every rise over the next few weeks taking advantage of price movements on acquisition news. We will consider looking at Wockhardt after it successfully launches new molecules in US.

Previous Assumptions:

• Wockhardt’s formulation units at Chikalthana and Waluj have been under USFDA’s import alert since 2013. We were expecting the facilities to get clearance by 2015-2016 and the company to recapture significant market which it had lost in US, post import alert.
• With the recapture of US market and new fillings, the sales were expected to grow at compounding rate of 23% considering the low revenue base. On the account of improved product mix, the net margins were expected to improve. Based on normalized earnings, the earnings were grow at 19% CAGR.
• Assuming the turnaround to happen in our investment period and strong research driven business, PE of 16 was assigned.

What has changed?

• Clearance from USFDA is taking longer than what we had assumed previously. This is likely to hurt the market share given the longer waiting period and dampen the proportion of market share the company could recapture with extension of 2-3 years from expected time.
• Price erosion has been a part of generic space but recently it has been higher single to lower double digit. New launches used to offset such price erosion. Wockhardt’s facilities being under USFDA’s import alert are resulting in delay in its drug filings and competition in existing base business has hit its US base business and dampened the growth.

Current Assumptions:

• For US sales, we are assuming the major new filling to happen from third party. The company is likely to restart the manufacturing and supplying of drugs that had been restricted because of non clearance of facilities from USFDA from third party. The sales are expected to grow at 18% CAGR.
• Considering third party manufacturing the gross margin for US sales is likely to remain subdued unless manufacturing starts from Chikalthana, Waluj or any other facility as compared to previous years. The overall GPM are expected to be lower for next 1-2 years till its new dug launches kick in and improves the product mix improving the earning power.
• The earnings are expected to grow at 19% CAGR based on normalized EPS of 50.
• Our return ratio has decreased as compared to our earlier evaluation, so we are derating the earning multiple to 15.

What do we do now?

• With the new assumptions, the valuation has come down. However, we have not considered the clearance of the facilities and its impact. Neither have we taken the positive impact on financials with the QIDP drug launches that management is expecting to take place in 2020-2021. We are not saying that we do not see this happening in our investment period or so. But as investor, we should see Wockhardt as a research based start-up company assuming volatility in its business unlike the sustainability we can see for big four indian pharma companies. However, clearance from USFDA or QIDP launches would be optimistic scenario unfolding.
• Pharmaceuticals manufacturing is a good business to own. Within that, the companies having aggression to explore new opportunities are very lucrative.
• Wockhardt has good and research driven management. Though the existing business is fundamentals are not very great, they are likely to improve drastically.
• At the very start we have mentioned we are buying Wockhardt for high risk high opportunity bet. We did know the slippages in execution during turnaorunds hence have been recommending only 3% allocation to portfolio.

We had recommended investing 3% of portfolio at average price of around Rs. 1250/share.

Based on new facts, we expect Wockhardt’s stock price to rise to Rs. 1600/share after three years provided the above assumptions come true.

We do not feel it’s a big blow to portfolio since it was 3% of portfolio. For now we recommend hold since all of the negatives are priced in and we do not need to get out at such discounted price.

Do write to us before making a purchase. Don’t average down and maintain Max. Recommended allocation of 3%.

Like we had highlighted in note of pharmaceutical stocks, we are updating our new valuation and related advice in sometime.

For existing customers, continue to hold. Do not average down without our advise. For new customers, await our updated valuation and BUY signal before taking an action.

Three days back, India Ratings downgraded Wockhardt rating to AA- from AA with negative outlook.

One of our equity analysts is alumni of CRISIL Ltd. As per his knowledge, movements in rating are based on current financial standing of the company. As far as the company’s rating stands above BB+ rating, the company has sound rating and financial stability.

In our case, Wockhardt has AA- rating which is 7 notches above BB+ rating. [AA-, A+, A, A-, BBB+, BBB, BBB-, BB+]

The reason for rating change is in lines with our assessment of company’s standing as on date. We wish to re-iterate that the company has not been able to resolve regulatory concerns since 24+ months. We have also visited Aurangabad for its AGM to understand future course of action by the management.

Top-line: Because of this slow moving resolution, US revenues have taken a hit. Since US revenues have higher margin, profitability looks more subdued than revenues. We expect US revenues to start flowing in from FY18. Meanwhile, the management making an attempt to source drugs through third party facilities. Though margins will be lower in third party manufacturing but from time value of money concept, it makes sense to use this route. To lower the impact of subdued US revenues, the company is working hard in India, Middle East and LatAm markets. Sales growth from these geographical regions is quite encouraging.

Debt: We observe that debt to operating cash flow has been quite in comfortable range despite high R&D cost outgo. Operating cash flow is the cash available after all the expenses, funds held but not released by clients. This should be used to judge whether the company has debt servicing capacity. The management hinted that they have purposely kept debt in control to focus on sustainability of business rather than accelerated growth. One would remember that the company has seen its worst in 2008-2011 due to leverage and derivatives contract working against it. The company has come out of all the pains and the bankers are more than happy to help now. In addition to current debt levels, the bankers are willing to fund more than 1.5x of current debt based on financial viability.

Research: As we had mentioned previously, the company has strong pipeline including anti-infectives. One of the five drug is under abriged phase three trial and likely to get funding from Biomedical advanced research and Development authority. This will partially reduce the R&D costs and release pressure from operating margins. Rest of the drugs are likely to be monetized post FY20.

Succession planning:Dr. Habil Khorakiwala is old and we believe that Murtuza Khorakiwala will take over the reins of the company after him. Murtuza is a doctor from GS Medical and MBA from University of Illinois, USA. He is equally capable and passionate to take the business forward.

Valuation: We are assuming the company to grow its earnings by 19% on due to current low base. Our MRP implies Revenues of Rs. 6000 Cr and net margins of 20%. We have assigned a reasonable 16xEPS price multiple.

In worst case scenario, lets assume revenues to touch Rs. 5000-5500 Cr and margins returning to 16-18%. At our first purchase price of Rs. 1250/- (MCap 11,000 Cr),  the stock trades at PE 11-14x earnings. The stock has corrected 40% since then.

At current price of Rs. 693/share, the stock trades at PE 5.7-7x earnings. If we had known earlier that the stock would ever correct back to 5-7X EPS, we would have sat calm till that time. Since we saw value even at 1,250/share, we were happy to accumulate at 11-14xEPS.

 A wise person would ask, if its so lucrative why not average at every price correction?

In investing, risk control is equally important as the stock idea. We may find bargains frequently, but its important to assign probabilities to our estimates materializing. Since this business requires very high R&D and R&D can fail to commercialize or undergo failure during trail phase. Taking into consideration all those factors, we have capped the investment to 3% of portfolio. You may add just 1-2% of portfolio at current levels if you want but we do not advise to keep on averaging a stock which goes lower and lower. It defeats the purpose of assigning Max recommended % allocation for downside risk control. Future is always uncertain and things may pan out outside our expectations, hence we recommend holding 15-18 stocks in portfolio.

One has to be prepared to hold this investment for 12-18 months to see some gains. It is ok to hold a company which currently shows paper loss if potential gains are likely to outweigh temporary pains. Unless we see material changes in our valuation, we do not get influenced.

Please read this blog for understanding more. Avoid Noise in long term investing

Business standard reported, “The US Food and Drugs Administration (FDA) has issued an import alert on Wockhardt’s Ankleshwar plant for alleged violation of good manufacturing practices.

The US FDA had carried out an inspection at the Ankleshwar plant in November last year and issued adverse observations known as Form 483 for violating good manufacturing practices.

The Ankleshwar plant is used to make both formulations and active pharmaceutical ingredients and largely caters to domestic and European markets. However, it exports some formulations and active pharmaceutical ingredients (APIs) to Wockhardt’s US plant.”

We have highlighted that the company’s exports to US have happen through two Aurangabad based plants. Though financial impact will not be very high as the exports are halted except for two drugs.

To understand exact impact and time taken for resolution we will need to hear from the management. We will be emailing them our queries and get back to you once we get answers.

We believe our MRP for the stock remains the same. We will inform you if there is any major concern.

We always believed that USFDA import alert and resolution can take more than expected time. Till that time the stock is likely to be quite volatile. Since the stock forms 3% of portfolio allocation, we believe that it doesn’t affect volatility of portfolio in short run.

We are building a portfolio which should be held for the long term, which we define as at least 5-7 years. However, this does not mean every stock will perform in each year. Our performance should be judged on the basis of the overall portfolio over 2-3 years at least, not on the basis of short-term performance of individual stocks. Uninvested cash should be parked in money market/liquid funds/fixed deposits earning 5-6% post-tax returns.

Currently, the broader markets seem quite overvalued on basic metrics. Be extremely cautious. Don't rush to buy average or below average companies. Stay away from the euphoria. Keep some cash handy to buy stocks if markets correct. Don't be fully invested at these levels.

 Wockhardt 3Q 2016 Result

The company posted its 3Q16 result on 11 Feb, 2016. Sales during the quarter have come in lower by 22%. This is due to one-time opportunity from UK market in the corresponding quarter last financial year. Additionally, indicated high R&D spends has resulted in lower net profit margins (NPM%) on YoY/QoQ basis. However, gross margins remain more or less similar (~50 bps lower), which validates that business conditions remain unchanged. We believe increasing R&D costs are a positive, as this means higher chances of new drugs launch in future (read higher revenues). Again this was highlighted by management.

The results were as per our expectation and there is no surprise whatsoever. This result was factored in our valuation and our valuation remains unchanged.

Shendra facility update

Shendra facility received a Form 483 from the US FDA in Jan 2016. Shendra currently exports to UK and Ireland, both of which remain unaffected by this event. Also, though Wockhardt was planning to use Shendra facility for future exports to this US, this would have required capacity ramp-up, as the current capacity too small to serve this market. Also, the market size of the drugs filed through Shendra was very small.

The management is still working on achieving the US FDA compliance on Shendra.

Waluj and Chikalthana facilities update

Waluj and Chikalthana facilities had received US FDA alerts in 2013. The company has since then taken necessary actions, compliance has been completed and US FDA had been called for another inspection. The US FDA has completed its inspection inMay 15, but no approvals have been received yet.

The facility, however, received an unrestricted GMP certificatefrom the UK MHRA in Dec 15, giving us confidence on quality. Once the company starts exporting through these facilities we can expect the company regaining its previous revenue and profitability.

What should investors do?

We had suggested buying the stock at Rs. 1300. The stock is currently trading at Rs. 760. While we continue to believe in the business model, we ask clients not to enter the stock at this level to average your buy price.

Since the analyst coverage on this stock is low and it has very low institutitonal holdings, the stock is very volatile. Also, the liquidity of the stock is low as 75% (Max. allowed promoter holding) is held by promoters, which leads to large swings than expected in stock price. The widespread market panic may lead overreaction by investors to any news thereby giving us better risk reward scenario for us. (read we may get a lower price to average)

For now, hold the stock and wait for our recommendation on the follow up action on the stock. We will also update our users, in case of any new information contrary to our assumptions.