Aurobindo Pharma

Company Update | Pharma | ARBP IN

Institution Equity Research | India

Inst'l Equity
WL: Limited earnings risk but overhang to remain June 24, 2019

 US FDA issues a warning letter (WL) to Aurobindo’s Unit 11 API facility

after the Feb’19 inspection for ‘sartan’ recall
 Earnings downside limited to future growth as only 12 ANDAs to be
impacted; seven in FY20 and five in FY21
 Regulatory challenges to cast a shadow on stock performance in the
near term; maintain BUY but lower TP to Rs830
Unit 11 gets a warning letter: US FDA has issued a warning letter (WL) to
Aurobindo‟s API manufacturing facility Unit 11 after the inspection it carried out in
Feb‟19. The inspection was related to the „sartan‟ recall and US FDA issued a Form
483 with three observations. One of those observations was the most cited
observation among the 34 warning letters we analyzed. Other companies such as
Zhejiang, Mylan, Hetero, and Jubilant Life sciences also had their “sartan” API
facilities inspected post the recall (link to our report: Analysis of 34 WLs points to low
escalation risk) (Exhibits 1-2).
Earnings downside limited to future growth: Our analysis of 34 WLs and
interactions with the company suggest that the facility will be allowed to continue
supplying existing molecules. However, future approvals will be withheld until the
issues are resolved. There are 12 ANDAs, including one injectable, pending from Unit
11, of which seven approvals were expected in FY20 and five in FY21. While a
majority of these filings are „me too‟ products, there are a few that represent an
US$10mn+ opportunity annually. Based on these, we estimate that delays in such
approvals pending resolution of the WL could lead to earnings downside of 1-2% for
FY20/FY21. We update our FY20/FY21 numbers to reflect the same (Exhibits 3-4).
Chances of escalation to import alert slim but represent a sizeable downside: Source: Bloomberg, SSLe
We believe chances of the warning letter escalating to an import alert for Unit 11 are
slim based on evaluation of Zhejiang Pharma and Aurobindo‟s Form 483 and warning
letter. Zhejiang‟s Linhai facility, which is currently under import alert, had been issued
a Form 483 with 11 observations, which also included data integrity related
observations. On the other hand, Aurobindo‟s observations seem procedural in
nature. In the worst-case scenario, if it escalates to an import alert, we estimate 15-
20% earnings downside for FY20 (Exhibits 5-6).
The company remains committed to immediate resolution: The company has
shown utmost sincerity in submitting its response to US FDA in a timely manner. The
first response to the Form 483 was submitted within 15 working days and
correspondence was submitted on May 20. However, escalation to warning letter
suggests that US FDA has not viewed the company‟s CAPA favorably. Hence, to
better understand the regulator‟s perspective, the management is expected to meet
the US FDA in the next 10 days.
Overhang on the stock to continue: We continue to be positive on the company but
believe that regulatory headwinds will remain an overhang. Historically, US FDA-
related regulatory issues at the company have led to P/E derating of ~20%. However,
at current scale, there are multiple growth drivers and, hence, we value the
standalone business at P/E of 12x, which is ~10% discount to the last 3-year average.
Hence, our TP has been revised to Rs830, which includes upside of Rs100 related to
the Sandoz acquisition. Catalysts: Resolution of regulatory headwinds, Sandoz
acquisition closure, synergy realization from Sandoz acquisition. Downside risk:
Escalation to import alert, regulatory challenges at other plants (Exhibits 7-8)
Financial summary
Y/E Mar (Rs m n) FY18 FY19 FY20e FY21e
Net sales 164,998 195,636 224,996 242,763
EBITDA margin (%) 22.9 20.2 21.6 21.8
Adjusted net profit 24,232 24,528 30,592 34,374
vs. consensus (%) 3 2
Free cash flow (21) (25,238) 15,160 26,826
Adj. EPS (Rs) 41 42 52 59
growth (%) 5 1 25 12
P/E (x) 15 14 12 10
P/B (x) 3 3 2 2
EV/EBITDA (x) 10 10 8 7
Net D/E (x) 0.2 0.2 0.1 0.0
RoE (%) 23.0 19.2 20.0 18.7 Kunal Dhamesha
RoCE (%) 21.7 17.8 18.1 17.1 Analyst - Pharmaceuticals
+91 22 4348 7238
Dividend yield (%) 0.4 0.4 0.4 0.4
[email protected]
Source: Company, SSLe
SBICAP Research on Bloomberg SBICAP <GO>, www.emis.com Please refer to our disclaimer given at the last page.
Aurobindo Pharma SBICAP Securities Ltd

Exhibit 1: Unit 11 warning letter was expected as one of the Form-483 observation…
Aurobindo Form -483 observations

Concluded 1) Lab controls failed to include establishm ent of scientifically sound and appropriate
in the 1st specifications
Aurobindo Unit-11 (API)
w eek of 2) Investigation inadequate in that potential root causes not evaluated
Feb 3) Master production batch record w ere inadequate for manufacture of API

Source: FDA; SSL research

Exhibit 2: …is the most cited observation among the 34 warning letters issued to API manufacturing facilities in the last
two years
Most cited observations in w arning letters issued to API facilities in last tw o years (34 w arning letters) Citations
Failure to have laboratory control records to ensure your API com plies w ith established specifications and standards 19
Failure of your quality unit to ensure that quality-related complaints are investigated and resolved. 17
Failure to adequately investigate and document out-of-specification results according to a procedure. 9
Failure to prevent unauthorized access or changes to data, and failure to provide adequate controls to prevent omission of data. 7
Failure to implement a system for managing quality encompassing the organizational structure, procedures, processes and resources 6
Failure to have adequate cleaning procedures to prevent contamination or carry-over material that w ould alter API quality 6
Failure to ensure all production deviations are reported and evaluated, and that critical deviations are investigated and conclusions are
5
recorded.
Failure to have adequate w ritten procedures for the receipt, identification, quarantine, storage, sampling, testing, handling, and approval or
4
rejection of raw materials
Failure to prepare adequate batch production records and record the activities at the time they are performed 4
Failure to control the API repackaging, relabeling, and holding operations in order to avoid mix ups and loss of API identity 4
Failure to demonstrate that your manufacturing process can reproducibly manufacture an API meeting its predetermined quality attributes. 3
Failure to transfer all quality or regulatory information received from the API manufacturer to your customers 3
Failure to properly maintain equipment and to keep complete records of major equipment maintenance. 2
Failure to properly maintain buildings and facilities used in the manufacture of intermediates and API. 2
Failure to verify the suitability of analytical methods. 2
Failure to validate and monitor the w ater purification system to ensure that w ater is of appropriate quality and suitable for its intended 2
Failure to completely report test results on certificates of analysis. 1
Failure to provide personnel w ith adequate clean w ashing and toilet facilities. 1
Failure to establish a sampling plan based on scientifically-sound sampling practices. 1
Source: FDA; SSL research

Exhibit 3: Limited earnings downside from warning letter on Unit 11

FY20 FY21
Total ANDAs impacted 10 15
Unit 1 3 3
Unit 11 7 12
Potential revenue impacted (US$mn) 44 57
EBITDA impact @20% margin (US$mn) 9 11
Earnings impact (US$mn) 6 8
EPS impact (Rs) 0.76 0.99
EPS impact as % of consensus estimate 1% 2%
Source: Company; SSLe

Exhibit 4: Lower our earnings estimates to reflect delay in approvals from Unit 11
Change in estim ates Revised Old Change (%)
(Rs m n) FY20e FY21e FY20e FY21e FY20e FY21e
Total Income 2,24,996 2,42,763 2,26,798 2,45,634 (0.8) (1.2)
EBITDA 48,637 52,922 49,314 54,040 (1.4) (2.1)
EBITDA Margin (%) 21.6 21.8 21.7 22.0
Adjusted PAT 30,592 34,374 31,034 35,062 (1.4) (2.0)
Adj. EPS (Rs) 52.2 58.7 53.0 59.8 (1.4) (2.0)
Source: SSL Research

[email protected] June 24, 2019 | 2

Aurobindo Pharma SBICAP Securities Ltd
Exhibit 5: Chance of escalation to import alert is slim as Zhejiang’s observations significantly different than that of
Aurobindo’s
No Zhejiang Form 483 Observations
The change control system to evaluate all changes that may affect the production and control of intermediates or Active pharmaceutical
1
ingredients (APIs) is not adequate.
Validation of production processes, cleaning procedures, analytical methods, and in-process control test procedures are not alw ays
2
adequate
The system for managing quality to ensure confidence that the API w ill meet its intended specifications for quality and purity is not
3 adequate in that your quality unit lacks w ritten procedures and the authority and responsibility to ensure all critical deviations are
thoroughly investigated.
4 The quality unit does not alw ays fulfil the responsibilities of the quality unit to release or reject all APIs
Cleaning procedures do not contain sufficient details to enable operators to clean each type of equipment in reproducible and effective
5
manner
Equipment used in the manufacture of intermediates and APIs should be or appropriate design and adequate size, and suitably located
6
for its intended use, cleaning and maintenance.
7 Schedules and procedures for preventive maintenance of equipment are not adequate or do not exist
Substances associated w ith the operation of equipment, such as lubricants, heating fluids or coolants are not alw ays food grade
8
lubricants and oils.
Sampling plants, and test procedures are not alw ays scientifically sound and appropriate to ensure raw materials, intermediates and
9
APIs conform to established standard of quality
Your on-going testing program to monitor the stability characteristics of APIs to confirm appropriate storage conditions and retest dates
10
is not adequate
Production deviations are nor alw ays reported and evaluated and critical deviations are not alw ays investigates and the conclusions
11
recorded
Source: FDA; SSL research

Exhibit 6: Worst case scenario of Import alert represents sizeable downside

Worst case scenario - Im port alert on Unit 11
Unit 11 estimated reveune contribution (US$mn) 455
Estimated EBITDA impact @22% margin (US$mn) 100
EPS impact (Rs) 9
EPS impact as % of FY20 consensus 18%
Source: FDA

Exhibit 7: Sandoz acquisition represents EPS upside of Rs100 in base case scenario
assuming no synergies
(Rs m n) Sandoz
Revenue ($900mn revenue for Sandoz) 63,000
EBITDA (22% for Sandoz) 13,860
Synergies 0
D&A 6,300
Interest expense (incl. interest @3.5% on Transaction debt) 2,205
PBT 5,355
PAT 4,230
EPS 7.2
Share price upside @14x P/E assum ing steady state grow th rate @5% 101
Source: SSLe

[email protected] June 24, 2019 | 3

Aurobindo Pharma SBICAP Securities Ltd
Exhibit 8: Regulatory challenges lead to significant multiple derating

24x
Import alert on Unit 6 Resolution of Import
and followed by alert on Unit 6
warning letter on Unit
18x 3 and Unit 6
(FY2 P/E)

12x

6x

0x
Jul-09

Jul-10

Dec-12

Dec-16

Jun-19
Jan-10

Dec-10
Jun-11
Dec-11
Jun-12

Jun-13
Dec-13
Jun-14
Dec-14
Jun-15
Dec-15
Jun-16

Jun-17
Dec-17
Jun-18
Dec-18
FY2 P/E Mean Mean + 1SD Mean - 1SD

Source: Bloomberg

[email protected] June 24, 2019 | 4

Aurobindo Pharma SBICAP Securities Ltd

Financials
Income statement Balance sheet
Y/E Mar (Rs m n) FY18 FY19 FY20e FY21e Y/E Mar (Rs m n) FY18 FY19 FY20e FY21e
Revenue 164,998 195,636 224,996 242,763 Cash & bank balance 12,616 19,572 40,135 70,249
growth (%) 9 19 15 8 Other current assets 109,262 134,073 152,997 162,651
Operating expenses 127,281 156,116 176,359 189,841
EBITDA 37,718 39,520 48,637 52,922
growth (%) 10 5 23 9 Net fixed assets 47,366 70,356 99,199 101,552
Depreciation & amortisation 5,580 6,680 7,909 8,147 Goodw ill and intangible assets 19,676 31,077 8,325 8,325
EBIT 32,138 32,840 40,728 44,775 Other non-current assets 22,132 9,466 9,466 9,466
Other income (net) 1,020 554 1,370 2,809 Total assets 211,052 264,544 310,122 352,243
Interest expenses 777 1,627 2,161 2,416
Current liabilities 46,493 54,697 63,489 68,343
PBT 32,381 31,767 39,937 45,169 Borrow ings 44,825 67,532 75,489 80,145
Tax 8,183 7,269 9,385 10,841 Other non-current liabilities 2,911 3,392 3,392 3,392
Effective tax rate (%) 25 23 24 24 Total liabilities 94,230 125,620 142,369 151,880
Profit after tax 24,198 24,499 30,552 34,328
Minority interest 34 29 40 45
Adjusted net profit 24,232 24,528 30,592 34,374
Non-recurring items - (881) - - Shareholders' funds 116,804 138,908 167,777 200,433
Reported net profit 24,232 23,647 30,592 34,374 Minority interest 18 16 (24) (69)
growth (%) 5 (2) 29 12 Total equity & liabilities 211,052 264,544 310,122 352,243

Financial ratios Cash flow statement

Y/E Mar FY18 FY19e FY20e FY21e Y/E Mar (Rs m n) FY18 FY19e FY20e FY21e
Profitability and return ratio (%) PBT / PAT 32,412 23,647 30,592 34,374
EBITDAM 22.9 20.2 21.6 21.8 Depreciation & amortisation 5,580 6,680 7,909 8,147
EBITM 19.5 16.8 18.1 18.4 Chg in w orking capital (10,358) (16,607) (10,132) (4,801)
NPM 14.7 12.5 13.6 14.2
RoE 23.0 19.2 20.0 18.7 Other operating activities (8,086) 1,953 791 (394)
RoCE 21.7 17.8 18.1 17.1 Operating CF 19,548 15,673 29,160 37,326
RoIC 23.7 19.6 20.9 21.7
Capital expenditure (12,406) (25,191) (14,000) (10,500)
Per share data (Rs) Acquisitions / divestiture (6,659) (15,720) - -
O/s shares (mn) 586 586 586 586 Investing CF (19,065) (40,911) (14,000) (10,500)
Adj. EPS 41.4 41.9 52.2 58.7 FCF 483 (25,238) 15,160 26,826
FDEPS 41.4 41.9 52.2 58.7
CEPS 50.9 53.3 65.7 72.6 Equity raised/(repaid) 2 - - -
BV 199.4 237.1 286.4 342.1 Debt raised/(repaid) 12,022 22,706 7,957 4,657
DPS 2.5 2.5 2.5 2.5 Dividend (incl. tax) (2,641) (1,763) (1,763) (1,763)
Other financing activities (9,457) (1,953) (791) 394
Valuation ratios (x) Financing CF (74) 18,990 5,403 3,288
PE 14.6 14.4 11.5 10.3
P/BV 3.0 2.5 2.1 1.8 Inc/(dec) in cash & bank bal. 409 (6,248) 20,563 30,114
EV/EBITDA 10.2 9.7 7.9 7.3 Closing cash & bank bal. 12,616 19,572 40,135 70,249
EV/Sales 2.3 2.0 1.7 1.6

Other ratios
Net D/E (x) 0.2 0.2 0.1 0.0
DSO (days) 68 64 66 66

Du Pont Analysis - RoE

NPM (%) 14.7 12.5 13.6 14.2
Asset turnover (x) 0.8 0.7 0.7 0.7
Equity Multiplier (x) 1.0 1.0 1.0 1.0
RoE (%) 23.0 19.2 20.0 18.7
Source: Company, SSLe

[email protected] June 24, 2019 | 5

Aurobindo Pharma SBICAP Securities Ltd

Recommendation History
Date Stock Price TP Rec.
BUY HOLD SELL
3-Mar-17 668 811 BUY
Stock Price Target Price
1050 29-May-17 512 696 BUY
950 18-Jul-17 734 886 BUY

850 9-Aug-17 684 820 BUY

(Rs)

750
9-Nov-17 789 945 BUY
7-Feb-18 616 900 BUY
650
29-May-18 579 744 BUY
550
29-May-18 579 744 BUY
450 10-Aug-18 610 745 BUY
Jul-17

Jun-18

Jun-19
Oct-17
Nov-17
Jan-18

Nov-18
Jan-19
Aug-17

Apr-18

Aug-18
Sep-18

Apr-19
Feb-17
Mar-17
May-17

Mar-18

Feb-19
6-Sep-18 759 845 BUY
30-Oct-18 769 950 BUY

Source: Bloomberg, SSLe

12-Nov-18 796 950 BUY
20-Dec-18 726 950 BUY
7-Feb-19 778 950 BUY
25-Mar-19 775 950 BUY
27-May-19 679 950 BUY
29-May-19 685 950 BUY
21-Jun-19 602 830 BUY

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