CMP: INR788 TP: INR875 (+11%) Buy Halol facility receives warning letter

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1 21 December 2015 Update Sector: Healthcare Sun Pharma BSE SENSEX S&P CNX 25,519 7,762 Stock Info Bloomberg SUNP IN Equity Shares (m) 2, Week Range (INR) 1,201/706 1, 6, 12 Rel. Per (%) 6/0/3 M.Cap. (INR b) 1,862.0 M.Cap. (USD b) 27.8 Avg Val ( INRm)/Vol / 0.3 Free float (%) 45.3 Financials Snapshot (INR b) Y/E MARCH 2016E 2017E 2018E Net Sales EBITDA (Rs b) Net Profit EPS EPSGr. (%) BV/Share (Rs) P/E (x) P/BV (x) RoE (%) RoCE (%) Shareholding pattern (%) As On Sep-15 Jun-15 Sep-14 Promoter DII FII Others FII Includes depository receipts Stock Performance (1-year) CMP: INR788 TP: INR875 (+11%) Buy Halol facility receives warning letter Early resolution is critical given that Halol remains one of the key facilities for SUNP with high single digit contribution to total sales and >15% to US sales. Even though corrective plans were already getting implemented since more than a year ago; a warning letter means additional efforts are required. Management expects resolutions to happen in less than months from now. US FDA inspected facilities in the past 15 months (post Halol inspection) with no major observations. This provides comfort regarding business outlook for Ex-Halol US business. Warning letter status leads to ~6% and 3% cut in FY17/18E EPS, respectively. We estimate ~15% earnings cut if warning letter converts into import alert (low probability event in our sense). Early resolution is critical- expect resolution by 1H CY17 Halol is already under quasi warning letter state as it received zero approvals over the last 15 months (since USFDA inspection in Sep-14), and corrective action plan started at this facility more than a year back. Though SUNP will have to augment its corrective measures to provide additional comfort to US FDA, we believe remediation measures taken over last few months will help the company expedite the resolution process. Management remains focused on resolving issues at this facility than looking for site transfers for key products. Having said that, since the facility has got OAI status so a reinspection will be required which could lead to some delay before it getting cleared by US FDA. Accordingly, we have built warning letter resolution at Halol by 1H CY17. Earnings impact to be limited if situation does not worsens We have cut our FY17/18E EPS by 6% and 3%, respectively as we build a delay of 3-6 months in resolution of Halol facility. Though earnings impact would be limited (as the facility was already in the quasi warning letter state since last 15 months), we expect multiples to remain range bound in the near term. We maintain our Buy rating on SUNP but with lower TP of 23x FY18E PER (vs 27x 1H FY17E PER earlier). Multiple triggers over the next months- could limit the damage Though in the near term, we expect the stock to react negatively on the back of issuance of this warning letter; SUNP has multiple catalysts ahead which (if played out well) could help limit the damage. Low competition in base business of Gleevec and Xenazine coupled with faster than expected ramp-up of Keveyis, and Ximino could surprise investors positively. Apart from this, positive MK-3222 phase -3 data would be a key data point to watch in near term. Key Risk: Warning letter converting into import alert (low probability event in our sense) Given that it has been 15 months since the time of USFDA inspection at Halol, probability of an import alert is lower in our view. However, in case of an import alert, EPS cut could be in the range of 13-15%. Kumar Saurabh (Kumar.Saurabh@MotilalOswal.com); Amey Chalke (amey.chalke@motilaloswal.com); Investors are advised to refer through important disclosures made at the last page of the Research Report. Motilal Oswal research is available on Bloomberg, Thomson Reuters, Factset and S&P Capital.

2 Key takeaways from the conference call Warning letters: The company s Halol facility which was inspected in September 2014, has received warning letter from US FDA for unsatisfactory replies. The inspection had culminated into several 483 observations in OAI categories related to sterility and computer system validation. The company will respond to the US FDA warning letter within next 15 days. The company s response is likely to highlight the remediation steps already taken since the inspections. Warning letter doesn t include any need of system wide assessment from the third party consultant for all the facilities. The company also indicated that it may not see voluntary supply disruption due to remediation activities and Incremental remediation may not take months. (Indicating warning letter resolution could be faster). Priorities post warning letters: The management has clearly notified that first priority remains bringing Halol facility under US FDA compliance. Site transfer of future approvals and existing products won t be a priority for the company. However, SUNP has already site transferred Gleevec to US based facility and received final approval for the same. The company is expected to launch this product in Feb 16. Revenue exposure: Halol facility contributes 7-9% (higher single digit) of overall SUNP s sales in FY15/16. It is not likely to impact SUNP s US sales in near term as it can supply to US market. However, future approvals will be withheld for Halol facility till it comes back into compliance. Halol warning letter doesn t change SUNP s FY16 revenue guidance. Impact on Injectables: Almost all pending approvals for injectable products are filed from Halol facility. Even though SUNP had acquired one more injectable facility in the US (Pharmalucence), not all products could be shifted to that facility. So resolution of Halol plant remains a key for SUNP. Other inspections: The management also highlighted that most of the other US approved facilities of SUNP have been inspected by US FDA over last 15 months and they have not received any major observations from US FDA. SPARC approvals: SUNP doesn t expect to get product approvals for SPARC products till the Halol facility comes under compliance. The company also not likely to shift these products due to time consuming and cumbersome procedures for site transfers that involves stability period and validation from new facility. 21 December

3 Multiple triggers over the next months- could limit the damage Though in the near term, we expect the stock to react negatively on the back of issuance of this warning letter; SUNP has multiple catalysts ahead which (if played out well) could help limit the damage. Low competition in base business of Gleevec and Xenazine coupled with faster than expected ramp-up of Keveyis, and Ximino could surprise investors positively. Apart from this, positive MK-3222 phase -3 data would be a key data point to watch in near term. Exhibit 1: Multiple filings in specialty and novel areas Triggers Status Near term triggers Gleevec To be launched in Feb'16 Xenazine Launched in 2QFY16 Medium term triggers Ximino Launched in 2QFY16 Keveyis Launched in 2QFY16 Azasite Launched Xelpros To be launched Elepsia XR To be launched Long term triggers MK-3222 To be launched in FY19/20 21 December

4 Exhibit 2: Past US FDA enforcement action on Indian companies Nature of Date of Date of Resolution in Company FDA Action Unit facility action resolution (months) Dr. Reddy's Warning Letter Srikakulam, AP API 6-Nov-15 x NA Dr. Reddy's Warning Letter Miryalaguda, TL API 6-Nov-15 x NA Dr. Reddy's Warning Letter Visakhapatnam, AP Formulations 6-Nov-15 x NA IPCA Labs Import Alert Silvassa, Gujrat Formulations 25-Mar-15 x NA IPCA Labs Import Alert Pithampur, MP Formulations 25-Mar-15 x NA Sun Pharma Import Alert Karkhadi, Gujarat API 13-Mar-14 x NA IPCA Labs Import Alert Ratlam, MP API 23-Jan-15 x NA Ranbaxy Ban Taonsa API 24-Jan-14 x NA Ranbaxy Import Alert Mohali Formulations 13-Sep-13 x NA Strides Arcolab Warning Letter Bangalore Injectable formulations 11-Sep-13 x NA Wockhardt Import Alert Waluj, India Formulations 24-May-13 x NA Jubilant Life Sciences Warning Letter Canada Formulations 27-Feb-13 x NA Dr. Reddy's Import Alert Mexico API 6-Jul Jul Cadila Warning Letter Moraiya Formulations 6-Jun Jul Aurobindo Warning Letter Unit III Formulations 23-May-11 4-Jun Aurobindo Import Alert Unit VI Formulations 27-Feb Mar Sun Pharma Warning Letter Able Labs 31-Aug Sep Ranbaxy Warning Letter Ohm Labs Formulations 24-Dec-09 x NA Sun Pharma Product Seizure Michigan, Caraco Formulations 26-Jun Aug Lupin Warning Letter Mandideep Formulations 14-May Jan Cipla Form '483 Bangalore API 20-Apr Aug Ranbaxy AIP Paonta Sahib Formulations 26-Feb-09 x NA Taro Brampton, Warning Letter Formulations 5-Feb Apr Pharma Canada Ranbaxy Warning Letter Batamandi API 17-Sep-08 x NA Ranbaxy Import Alert Dewas Formulations 17-Sep-08 x NA Exhibit 3: SUNP s US FDA approved facilities Company Plant Locations Type Last Inspected US FDA action Dadra, India Formulations 1/30/2015 Y Panoli, India API 6/14/2012 Y Sun Pharma (IND) Karkhadi, India API 11/16/2013 Import Alert Tandalja, Vadodara, India 5/8/2015 Y Halol, India Formulations 9/16/2014 Warning letter Ahmednagar, India API 6/19/2015 Y Sun pharma (USA) Chattanooga, US API N/A Caraco Cranbury, US Formulations 8/27/2015 Y URL (USA) URL, Philadelphia Formulations 7/17/2015 Y URL, Aurora IL, US Formulations N/A Taro Taro, Brampton, Canada Formulations 2/28/2014 Y Haifa Bay, Israel Formulations/API 5/21/2015 Y Ohm Labs Formulations 3/19/2014 Y Dewas, India Formulations/API 2/12/2008 Import Alert Ranbaxy Toansa, India API 1/11/2014 Import Alert Paonta Sahib, India Formulations N/A Import Alert Mohali, India Formulations 12/12/2012 Import Alert 21 December

5 Story in charts Exhibit 1: Revenue to grow at 10% CAGR Exhibit 2: EBITDA CAGR at 19% Formulations (INR b) API (INR b) EBITDA (INR b) EBITDA growth (%) Exhibit 3: Ranbaxy synergies to drive margins Exhibit 4: R&D expense to increase to 9% of sales Gross Margin (%) EBITDA Margin (%) R&D expense (INR b) % of sales Exhibit 5: Rich ANDA pipeline Exhibit 6: Fixed asset turnover (x) ANDA filed ANDA pending Gross assets (INR b) Fixed asset turnover (x) FY09 FY10 FY11 FY12 FY13 FY14 YTD Exhibit 7: EPS to grow at 25%CAGR Exhibit 8: Leading return ratios RoE (%) RoCE (%) FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E 21 December

6 Financials and valuations Income Statement (INR Million) Y/E March E 2017E 2018E Net Sales 57,214 80, , , , , , ,387 Change (%) EBITDA 19,566 31,947 49,063 69,257 78,075 80, , ,931 Margin (%) Depreciation 2,049 2,912 3,362 4,092 11,947 10,750 11,750 12,500 EBIT 17,518 29,035 45,701 65,165 66,128 69,928 99, ,431 Int. and Finance Charges ,790 5,000 3,000 2,000 Other Income - Rec. 3,611 4,856 3,727 6,282 6,069 7,050 10,950 13,450 Extra-ordinary Exp ,836 25,174 2,378 6, PBT 20,357 33,598 43,148 45,831 64,029 65, , ,881 Tax 1,286 3,826 8,456 7,022 9,147 11,876 19,231 26,048 Tax Rate (%) Profit after Tax 19,072 29,772 34,693 38,809 54,882 53,250 88, ,834 Change (%) Margin (%) Less: Mionrity Interest Reported PAT 18,158 25,917 29,830 31,434 45,394 43,201 77,357 91,534 Adjusted PAT (excl. Ex. Items) 18,158 25,917 29,830 31,434 47,415 43,906 68,563 91,534 Balance Sheet (INR Million) Y/E March E 2017E 2018E Equity Share Capital 1,036 1,036 1,036 2,071 2,406 2,406 2,406 2,406 Total Reserves 93, , , , , , , ,313 Net Worth 94, , , , , , , ,719 Minority Interest 8,472 11,616 16,351 19,212 28,661 38,710 49,560 61,860 Deferred Liabilities Total Loans 3,717 2,739 2,072 24,982 77,827 64,585 47,308 34,795 Capital Employed 103, , , , , , , ,857 Gross Block 39,128 46,542 56,026 63, , , , ,369 Less: Accum. Deprn. 16,794 20,406 24,421 28,904 60,617 71,314 83,493 96,452 Net Fixed Assets 22,334 26,136 31,604 34,982 69, , , ,917 Capital WIP 2,355 3,447 5,626 8,415 20,386 22,425 24,667 27,134 Goodwill 10,599 13,378 24,870 33,191 57,073 57,073 57,073 57,073 Investments 22,297 22,129 24,116 27,860 27,163 27,163 27,163 27,163 Curr. Assets 61,146 90, , , , , , ,835 Inventory 14,895 20,870 25,778 31,230 56,680 55,873 63,029 65,949 Account Receivables 11,049 19,261 27,108 22,004 53,123 52,289 57,385 62,227 Cash and Bank Balance 22,046 33,672 40,587 75, , , , ,771 L & A and Others 13,156 16,878 19,948 48,257 77,619 80,196 90,689 98,887 Curr. Liability & Prov. 15,361 24,950 38,439 61, , , , ,266 Account Payables 10,078 14,410 15,752 15,887 59,198 59,979 67,661 70,795 Provisions 5,283 10,541 22,687 45,622 67,376 77,483 89, ,471 Net Current Assets 45,785 65,730 74, , , , , ,569 Appl. of Funds 103, , , , , , , ,856 E: MOSL Estimates 21 December

7 Financials and valuations Ratios Y/E March E 2017E 2018E Reported EPS Adjusted EPS Cash EPS BV/Share DPS Payout (%) Valuation (x) P/E P/BV EV/Sales EV/EBITDA Dividend Yield (%) Return Ratios (%) RoE RoCE Working Capital Ratios Fixed Asset Turnover (x) Debtor (Days) Inventory (Days) Working Capital T/O (Days) Leverage Ratio Interest Cover Ratio Debt/Equity (x) Cash Flow Statement Y/E March E 2017E 2018E OP/(Loss) bef. Tax 19,534 31,935 43,227 44,083 75,697 73, , ,931 Int./Dividends Recd. 3,611 4,856 3,727 6,282 6,069 7,050 10,950 13,450 Direct Taxes Paid -4,048-5,373-10,379-9,010-17,553-11,876-19,231-26,048 (Inc)/Dec in WC ,319-2,336-5,589-20,865 9,952-3, CF from Operations 18,811 23,099 34,239 35,767 43,348 78,951 99, ,874 (inc)/dec in FA -16,500-10,585-22,501-18,580-82,570-47,091-13,813-14,008 Free Cash Flow 2,311 12,515 11,737 17,187-39,223 31,860 85, ,866 (Pur)/Sale of Invest. 9, ,987-3, CF from investments -7,134-10,416-24,488-22,324-81,872-47,091-13,813-14,008 Change in networth 8,225 5,318 4,334 6,674 37, (Inc)/Dec in Debt 2, ,910 52,845-13,242-17,276-12,513 Interest Paid ,790-5,000-3,000-2,000 Dividend Paid -4,213-5,115-6,058-7,270-11,964-14,075-16,890-16,890 CF from Fin. Activity 5,280-1,058-2,835 21,872 72,605-33,067-37,166-31,403 Inc/Dec of Cash 16,957 11,626 6,915 35,315 34,080-1,207 48,535 73,463 Add: Beginning Balance 5,089 22,046 33,672 40,587 75, , , ,308 Closing Balance 22,046 33,672 40,587 75, , , , ,771 Note: Cashflows do not tally due to acquisition 21 December

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