Strides Arcolab. CMP: INR717 TP: INR829 Buy

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1 BSE SENSEX S&P CNX 17,144 5,200 Bloomberg STR IN Equity Shares (m) Week Range (INR) 794/276 1,6,12 Rel. Perf. (%) -2/37/98 M.Cap. (INR b) 41.4 M.Cap. (USD b) July QCY12 Results Update Sector: Healthcare Strides Arcolab CMP: INR717 TP: INR829 Buy Strides Arcolab's (STR) 2QCY12 performance was below our expectations. Key highlights: Net revenue declined 12.6% YoY to INR5.1b v/s our estimate of INR5.7b. EBITDA grew 4.5% YoY to INR1.13b v/s our estimate of INR1.41b. Recurring PAT declined 83% YoY to INR117m v/s our estimate of INR801m, impacted by worse than anticipated operational performance, higher interest cost and forex loss of INR734m. Excluding the sale of Ascent Pharma, topline grew ~30% YoY, led by 39% YoY growth in sterile business revenue to INR3.1b v/s our estimate of INR4.1b. Pharma segment revenue grew 18% YoY to INR2.46b even on a high base, boosted by one-off sales in the tender business. EBITDA grew 4% YoY to INR1.13b v/s our estimate of INR1.41b, led by higher gross margin. EBITDA margin expanded 360bp YoY to 22.2% v/s our estimate of 24.7%. Margins were driven by improved product mix, YoY decline in manpower expense due to divestment of Ascent Pharma and reduced other expenditure. Adjusted PAT declined 83% YoY to INR117m (v/s our estimate of INR801m), impacted by by worse than anticipated operational performance, higher than estimated interest cost and forex loss of INR734m. However, reported PAT grew 31.3% YoY to INR905m, led by INR946m gain reported on the sale of Ascent Pharma. STR is set to emerge as a specialty products company, with revenue contribution from this segment increasing from 28% in CY09 to an estimated 67% in CY13. The company has an impressive specialty product pipeline. It has large manufacturing capacities in place to support revenue scale-up, coupled with best-in-class marketing partners like Pfizer and GSK. We expect STR to post 24% earnings CAGR over CY11-13, led by revenue ramp-up in the SI (sterile injectables) segment and substantial reduction in interest cost owing to debt repayment. Return ratios are set to improve over CY11-13 and debt-equity should decline from 1.9x in CY10 to 0.7x in CY13. The stock trades at 13.3x CY12E and 12.1x CY13E EPS. Buy with a revised target price of INR829 (14x CY13E EPS), an upside of 18.8%. Amit Shah (Amit.Shah@MotilalOswal.com) Nimish Desai (NimishDesai@MotilalOswal.com); Investors are advised to refer through disclosures made at the end of the Research Report.

2 Performance led by specialty business segments Strides' net revenues declined 12.6% YoY to INR5.1b (v/s est of INR5.7b), EBITDA grew 4.5% YoY to INR1.13b (v/s est of INR1.41b) while recurring PAT declined 83% YoY to INR117m (v/s est of INR801m) impacted by lower operational performance, higher than estimated interest cost and forex loss of INR734m. Excluding sale of Ascent Pharma, topline grew 30% YoY and the growth was led by a 39% YoY growth in sterile business revenue to INR3.1b (v/s estimates of INR4.1b). Specialty segment sales (excluding licensing income) grew by 71% YoY to INR2.5b on account of higher revenues from US market led by new product launches and shortages of sterile injectable products worldwide. However, Licensing income declined 23% YoY to INR570m Pharma business reported 38% YoY decline to INR2.46b primarily due to divestment of Ascent business. Adjusted for the same the growth was 18% led by day one launch of generic oral Vancomycin in US. STR gained ~30% market share in this product during the quarter on account of first entrant generic entrant in the product and limited competition. We expect the benefit from generic Vancomycin to continue for couple of quarters more. Revenue mix (INR m) 2QCY12 2QCY11 YoY (%) 1QCY12 QoQ (%) Specialty business 2,500 1, , % of Sales Pharma business 2,460 3, , % of Sales Licensing income % of Sales Revenues 5,530 6, , Source: Company EBITDA grew by 4% YoY to INR1.13b below our estimates EBITDA grew 4% YoY to INR1.13b (est of INR1.41b) led by improved Gross margins on the back of improved product mix, YoY decline in manpower expense due to divestment of Ascent Pharma and reduced other expenditure. EBITDA margins at 22.2% expanded 360bp YoY (v/s est of 24.7%). EBITDA was lower than estimate primarily due to lower than estimated revenue from specialty business and lower licensing income. Adjusted PAT declined 83% YoY to INR117m (est of INR801m) impacted by lower operational performance, higher than estimated interest cost and forex loss of INR734m. However, reported PAT grew 31.3% YoY to INR905m led by INR946m gain reported on sale of Ascent Pharma. 31 July

3 EBITDA trend (INR m) Source: Company/MOSL Key takeaways from conference call 2QCY12 Performance During 2QCY12, specialty revenues were stagnant QoQ because of lumpy nature of the contracts signed with the GPO. Since the injectables are not retail products, the off-take varies QoQ depending on product supplies to GPO under contractual obligations. However the company has indicated that 2HCY12 should see good ramp-up in sterile business as new product supplies will start under new contracts beginning 1st July and 1st October. The company has also started selling the products in Canada from its Poland facility as Canada is also facing shortages in sterile products. The company has indicated that its Brazilian operations will break-even by the year end and sees significant scale-up potential in Brazilian operations going forward led by supplies of penems to regulated markets. The company indicated that the oncology portfolio is ramping well as the company has 38 filings in this space out of which it has got approvals for 19 products out of which it has launched only 11 products so far. The remaining 6 products will be launched shortly in the market. Further the company successfully competed integration of acquired facility at Bengaluru and expects to start shipment from this facility in 4QCY12. The company reported net extraordinary gain during the quarter of INR946m related to profit on sale of Ascent Pharma. The company has debt of INR1.3b on the balance-sheet with D/E ratio of 0.65x as against 1.67x at the end of CY11. It has forward cover worth USD40m on books. CY12 guidance Management has declined to give any revenue guidance for CY12 as of now citing that many of its product launches for CY12E are linked to successful US FDA approvals and outcome of patent challenges. However, it has indicated that given the number of approvals expected in CY12 and healthy inflow of licensing income (USD50-60m), performance should be robust. We expect topline growth of 38.5% (excluding sales of Ascent Pharma) led by US specialty business. 31 July

4 The company has guided for EBITDA margin for sterile business at 23-30% for CY12. The company expects to improve profitability of Brazilian operations in CY12. Expect USD25m capex for CY12 while there will be reduction in the interest cost. The company expects to file 32 products in the US market in 2HCY12. Enters Canadian injectable market through JV; Will benefit from the drug shortages; No Significant upside in the short term STR's specialty business subsidiary, Agila, entered Canadian injectable market by setting up marketing joint venture with Jamp Pharma. Agila will be holding 70% stake in the subsidiary while the rest will be owned by Jamp Pharma. The JV will be launching 40 injectable products in the market over the next two years and some of these products have already been approved by the regulator, Health Canada. The approved products will be immediately launched in the market. The marketing of these products will be done by the sales force of Jamp Pharma. There won't be significant impact on the STR financials due to this JV over the next two years. There is no initial capex requirement for this JV since this is just a marketing partnership. All the product IPs are owned and registered by STR with Jamp Pharma being just a marketing partner. Though the company has not disclosed the revenue upside from this JV over next two years, it has indicated that, the upside won't be significant till the JV starts marketing all the 40 products. Also the management has indicated that the overall market size of injectable segment in Canada is not very large. In the long term STR will benefit from the injectable drug shortages in Canada Specialty business in US to see significant ramp-up led by new capacities, product approvals and low competition Specialty business in US will see significant ramp-up on the back of USFDA approval for company's new sterile injectable and oncology facilities at Bengaluru and Penems facility in Brazil. Strides is now in the process of shifting manufacturing of all the approved injectable products to new facility thereby eliminating the capacity constraints. The company has already shifted few key products to the new facility. Strides currently has 72 product approvals in sterile segment in US, of which it has launched 43 products versus only 33 products. STR plans to launch all approved products in CY12 which will boost revenues from the specialty business significantly. The company is expecting strong product approvals in this market even in CY12. Further, Strides also mentioned that currently 6 out of 8 major players in injectable segment have been facing production issues at its facility, which in turn is helping it to increase its revenue rapidly in the US market. STR is entering into long term contracts ranging from 2-5 years with GPOs to establish its strong credentials as reliable supplier of injectable products in the US market. Strides expects to garner 15-25% market share in the products it has launched in US over a period of time backed by strong marketing and distribution set-up of Pfizer and lower competition. Further, the management mentioned that for the first time it has started developing products for Para IV filings in the US market and plans to file 26 Para IV products in US over next couple of years. Further, it plans to file 14 products in ophthalmic segment in CY July

5 Downgrading CY12 and CY13 earnings estimates by 9.8% and 6% respectively Based on 2QCY12 performance, we are downgrading revenue estimates for CY12 and CY13 by 4% and 5.8% respectively given the below expected revenue in specialty segment and lower licensing income. Further, given the lower EBITDA and higher than estimated interest cost in 2QCY12, we are downgrading earnings estimate for CY12 and CY13 by 9.8% and 6% respectively. The downgrade in earnings is not substantial despite far below than estimated PAT in 2QCY12, due to forex gains expected in 2HCY12 and higher than estimated other operating income led by profit on oral Vancomycin in US. Valuation and view STR is set to emerge as a specialty products company with revenue contribution from this segment rising from 28% in CY09 to expected 75% in CY13. STR has an impressive specialty product pipeline. Large manufacturing capacities are in place to support revenue scale-up, coupled with best-in class marketing partners like Pfizer and GSK. We believe that the sale of Ascent Pharma at the attractive valuation will lead to significant improvement in financials for the company in the future. STR may unlock further value from the sale of remaining Pharma business in the future as the focus remains on specialty business. As per our revised estimates, we expect STR to post 24% earnings CAGR over CY11-13, led by revenue ramp-up from SI (sterile injectables) segment and substantial reduction in interest cost owning to repayment of debt. Core EBITDA margin will expand in line with changing product mix and higher capacity utilization. Return ratios are set to improve over CY11-13 and debt-equity will decline from 1.9x in CY10 to 0.7x in CY13. The stock trades at 13.3x CY12E and 12.1x CY13E EPS. Maintain Buy with revised target price of INR829 (14x CY13E EPS), an upside of 18.8%. 31 July

6 Strides Arcolab: an investment profile Company description Established in 1990, Strides is an integrated manufacturer and exporter of finished pharmaceutical dosage forms, both branded and generic with 14 manufacturing facilities in six countries. It has collaborations with five of the top 10 global pharmaceutical players and a presence in over 75 countries. Strides has reorganized its business into three divisions, specialties, pharmaceuticals and branded generics. Key investment arguments Strides is set to catapult into a specialty company with revenue contribution from this segment set to rise from 27% in CY09 to 75% by CY13. The company has an impressive product pipeline in the specialty segment with 73 product approvals. Besides, large manufacturing capacities are in place to support a revenue scale-up and strong marketing partners like Pfizer and GSK will lead to sustainable revenue growth. Key investment risks If Strides does not get timely approval for its large product pipeline, its revenue could be impacted. Strides does not have API manufacturing capacities and sources its API requirements from elsewhere. This leaves it exposed to risks like unavailability of raw material and price fluctuations. That is a reason for Strides' volatile margins. Recent developments Sold generic business in Australia & Southeast Asia to Watson for A$375m. Acquires new sterile manufacturing facility from STAR drugs and Research Ltd. Valuation and view We expect Strides to clock earnings CAGR of 24% over CY11-13, D/E will decline from 1.9x in CY11 to 0.7x in CY13. Based on our revised estimates, the stock trades at 13.3x CY12E and 12.1x CY13E EPS. We maintain Buy Sector view The Sterile injectable segment and branded generic segment are likely to enjoy better profitability and growth going forward. Comparative valuations Strides Arcolab Jubilant P/E (x) CY12E CY13E P/BV (x) CY12E CY13E EV/Sales (x) CY12E CY13E EV/EBITDA (x) CY12E CY13E EPS: MOSL forecast v/s consensus (INR) MOSL Consensus Variation Forecast Forecast (%) CY CY Target price and recommendation Current Target Upside Reco. Price (INR) Price (INR) (%) Buy Stock performance (1 year) Shareholding pattern (%) Jun-12 Mar-12 Jun-11 Promoter Domestic Inst Foreign Others July

7 Financial and valuations 31 July

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