SURYA PHARMA

Company Details
BSE Price: 139.00 NSE Price: 138.20 Industry: Pharm-Ind-BD&For
BSE Code: 532516 NSE code: SURYAPHARM Free float: 17.12%


Company details
Price target: Rs205
Market cap: Rs154 cr
52 week high/low: Rs177/53
NSE volume: 56,290

(No of shares)
 BSE code: 532516
 NSE code: SURYAPHARM
 Sharekhan code: SURYAPHARM
 Free float: 84 lakh
(No of shares)
Key points
 Surya Pharmaceuticals is moving up the product value chain in the anti-infective segment from being a manufacturer of betalactum antibiotics (a low-margin product) to a maker of third- and fourth-generation cephalosporins (a high-margin product).
 The company is expanding its production capacity to tap the growing contract manufacturing market. These capacity expansions will raise its cephalosporin capacity by 154% and formulation capacity by 567%. The expansions are backed by contract manufacturing deals worth over Rs350 crore that include a Rs220 crore-deal with a British pharmaceutical firm and a Rs36 crore-per-year deal with an Iranian firm.
 The company has refinanced its debts at lower rates, reducing its interest burden to an expected 7.1% in FY2007. Its plants in Baddi and Jammu will enjoy income tax and excise exemption. These cost reduction efforts will contribute to improvement in the net profit margin from 5.2% in FY2005 to 9.2% in FY2007.
 We expect a 106% compounded annual growth in the net profit on the back of a 52% compounded annual growth in the sales over FY2005-07. For FY2007 the company is estimated to record gross revenues of Rs418 crore, yielding earnings per share (EPS) of Rs25.5.
 At the current market price of Rs139 Surya Pharmaceuticals is trading at 5.4x its FY2007E earnings, clearly at a discount to its peers. We believe that assigning Surya Pharmaceuticals a price/earnings (PE) multiple of 8x its FY2007E earnings is a fair valuation. Hence we initiate a Buy recommendation on Surya Pharmaceuticals with a price target of Rs205.
Shareholding pattern


Price performance
(%) 1m 3m 6m 12m
Absolute 5.0 -12.5 -1.8 148.1
Relative to Sensex -8.3 -26.2 -36.4 102.1

Company background
Surya Pharmaceuticals, a Chandigarh-based pharmaceutical company, manufactures bulk drugs (primarily anti-infectives) and also produces formulations in smaller quantities. Started as a manufacturer of penicillin derivatives in 1993, the company now concentrates on contract manufacturing for global pharmaceutical majors. It is setting up bulk drug and formulation manufacturing capacities in Jammu and expanding its formulation facility in Baddi.
The management is headed by Rajeev Goyal (managing director) and the promoters hold close to 24.5% stake in the company while corporates hold a substantial 48% stake.

Key financials Rs (cr)
Year ended 31st March FY2004 FY2005 FY2006E FY2007E
Net profit 6.2 8.6 16.6 36.9
EPS 4.3 6.0 11.5 25.5
PER (x) 32.7 23.3 12.0 5.4
Book value/ share (BV) 38.2 47.1 75.4 101.2
P/BV 3.6 3.0 1.8 1.4
Cash EPS 7.6 9.8 17.6 35.5
P/cash EPS 18.3 14.2 7.9 3.9
EV/EBIDTA 10.5 8.7 8.0 5.3
RONW (%) 10.8 12.4 15.1 25.1
ROCE (%) 15.9 16.7 11.4 15.7
Business model
Surya Pharmaceuticals has changed its business model from the one that involved just manufacturing bulk drugs and intermediates to the one that involves being the partner of choice in the contract manufacturing space while maintaining the earlier businesses. The company has tied up with the other pharmaceutical companies, both Indian and foreign, and carries out contract manufacturing of bulk drugs and formulations. It is also involved in technology development related contracts but the major chunk of its revenues comes from the contract manufacturing business.
The anti-infectives segment
Of all the therapy segments in the pharmaceutical industry, anti-infective is the third largest in the world and largest in India having a share of over 22% of the Indian pharmaceutical industry. Three types of drugs—cephalosporins, fluroquinones and betalactum antibiotics—dominate the global anti-infective segment. Cephalosporins are the new (high-margin) drugs having the widest usage while betalactum antibiotics are the older (lower-margin) drugs.
Indian pharmaceutical industry break-up


Investment arguments
Moving up the product value chain
Till last year Surya Pharmaceuticals was amongst the top Indian players in the betalactum antibiotic manufacturing segment. Now it has expanded its operations to manufacture bulk cephalosporins and with increasing capacities is set to become one amongst the five leading manufacturers of cephalosporins in the country.
It already manufactures second- and third-generation cephalosporins, such as cephaclor and cephixime, which are high-margin products. It is increasing its cephalosporin manufacturing capacity by 154% of the earlier capacity, thereby boosting not only the sales but also the margins. This change in the product mix is partly responsible for the improvement in its margins, as can be seen from the results of the recent quarters.
Operating margin
FY2006 (%) FY2005 (%) Improvement (basis points)
First quarter 19.4 14.0 540.0
Second quarter 19.4 15.0 440.0
The company is also diversifying into high-margin lifestyle segments like anti-histamines and cardio vascular drugs, and increasing its focus on exports for the long term. The improved product mix will be one of the key growth drivers and lead to good profit margins in the future.
Massive scaling up of capacity—another key growth driver
The company is carrying out capacity expansions at its existing facilities at Baddi and Banur. It is also coming up with a greenfield project at Jammu. The bulk drug facility at Panchkula has been completely revamped to produce 24 tonne of anti-histamine bulk products like loratidine and fexofenadine per year. At Baddi the de-bottlenecking of operations is expected to be complete by April 2006, resulting in the tripling of the utilisable capacity from the current 33%.


Capacities: Present and future
Location Product lines Units Capacities Growth (%)
FY2005 FY2007
Banur & Jammu Cephalosporins Tpa 177.6 451.6 154
Panchkula Anti histamine and Lifestyle Tpa 12.0 62.0 417
Baddi & Jammu Formulations tablets+capsules crore 36.0 240.0 567
Baddi Betalactum Antibiotics Tpa 1200.0 1200.0 0
Baddi & Banur Intermediates Tpa 82.0 82.0 0
The greenfield project at Jammu is expected to provide a big boost to its sales. It will be set up in two phases. The phase 1, which would involve the setting up of a plant to manufacture sterile cephalosporins and high-value bulk drugs, is expected to be completed by September 2006. In the phase 2, a facility to manufacture formulations will be set up. Bumper revenues from the utilisation of these capacities are expected in FY2007.
Debt refinancing deals to decrease the interest rate
The capacity expansion exercise is expected to cost about Rs136 crore and will be funded by the 40 lakh zero coupon warrants issued by the company (last date of conversion into shares is 6thAugust2006), the proceeds of the foreign currency convertible bond (FCCB) issue and long-term loans raised at reduced rates.
Figures in Rs crore FY2006 FY2007 Total
40 lakh zero coupon warrants of Rs70 each 28.0 0.0 28.0
12000 FCCBs of 1000$ each 52.8 0.0 52.8
Bank loans 60.0 50.0 110.0
Total 140.8 50.0 190.8
In the past the company had financed its debts at very high interest rates. It has now refinanced these and new debts at lower rates. Due to the new deal, term loans will be raised at a reduced cost of 8.25% (interest rate for term loans was 15.7% in FY2005) while working capital will cost 10.5% (for FY2005 and working capital loan rate was 19.3%). Also the company issued 12,000 FCCBs (due conversion in FY2009) at a rate of 1%. The cumulative effect of these financing deals will be that in FY2007 the effective interest rate for term loans (including the FCCBs) is estimated at 6.4% while the effective loan rate for working capital is estimated at 10.5%. This reduction in the financing cost will reflect in the bottom line.
Effective interest rate

Source: Sharekhan Research
Tax benefits to provide an additional edge
The company''s major expansion plans include the de-bottlenecking of the formulation facility at Baddi, and the installation of bulk drug and formulation capacities at Jammu. Baddi is a tax haven and the formulation plant will enjoy a ten-year excise holiday and a five-year income tax exemption here. Also at Jammu the company will enjoy a five-year income tax exemption on both formulations and bulk drugs and a ten-year excise refund policy. As a result although the company''s gross sales are expected to increase by 67% from FY2006 to FY2007, yet the excise duty during the same period is expected to increase by merely 4.2% while the income tax is expected to increase by 34.8%. The net effect of these exemptions will manifest itself in an improvement in the net profit margins in FY2007.
Cost cutting mantra expected to work well
The company has taken up cost cutting and process optimisation measures. These include improving the solvent recovery process, optimising the temperature requirements and reducing the fuel, power and refrigeration costs. The company is also setting up a 2-megawatt captive power plant, which is expected to be operational by April 2006 and would further decrease its power and fuel costs per unit consumption. These measures are expected to reduce the company''s manufacturing costs by over 20%. However keeping in mind the gestation period for these changes, we are estimating an improvement of 10% in Surya Pharmaceuticals'' manufacturing efficiency in FY2007.

Comparative increments


Source: Sharekhan Research
Strong deal flow to provide the foundation for healthy growth
The company has tied up with pharmaceutical firms both in India and abroad to supply bulk drugs and formulations. It has made a deal with a British pharmaceutical major to supply six bulk drugs. This deal is valued at Rs44 crore per year, aggregating to Rs220 crore over the next five years. The company has also signed another deal with an Iranian firm to supply advanced cephalosporins at pre-determined prices. This deal is expected to generate revenues of Rs36 crore a year. In addition the company is also manufacturing cephalosporins for Indian pharmaceutical majors. As a result it has a healthy flow of orders. Since the major orders in the coming years are expected from foreign firms, the contribution of the high-margin export business is bound to increase to 60% of the total sales by FY2008.
Portfolio break-up

Source: Sharekhan Research
Surprise acquisition could be in the offing
Surya Pharmaceuticals is sourcing one of its raw materials from a company in China. It is in negotiations to acquire this company. If the acquisition does occur in the second half of FY2006 or early FY2007, we expect the deal to materialise at close to Rs17.5 crore. Surya Pharmaceuticals has plans to convert the Chinese plant into a formulation manufacturing facility and this could prove to be a significant revenue source. Although we have not discounted the revenues from this possible acquisition in our FY2007 estimates, we remain bullish about the acquisition.
Sales to increase at a CAGR of 52.01% from FY2005 to FY2007
The increase in the capacities and the deal flow are expected to result in increased sales in FY2006 and FY2007. The company has in the first half of FY2006 notched up net sales worth 71% of its FY2005 sales and surpassed the FY2005 net profits by 30%. On a year-on-year basis, the H1FY2006 net sales have increased by 68% as compared with that of H1FY2005. This is an indicator of the measure of increment expected in the sales in the coming years.
Gross sales

Source: Sharekhan Research
Profit margins to zoom, PAT to surge over the next two years
The expected increase in the sales will provide the initial momentum. A better product mix and lower interest rates along with manufacturing efficiency will result in higher net profit margins. The tax savings will further improve the margins as we expect the net profit to increase at a CAGR of 106.7% from FY2005 to FY2007. The net profit would rise on the back of a 52% compounded annual growth expected in the sales during the same period and a 209-basis-point increase in the net profit margins from FY2006 to FY2007. This would improve the return on net worth from 12.4% in FY2005 to 25.1% in FY2007.
Margins

Source: Sharekhan Research
Valuation
Surya Pharmaceuticals has shown a good growth over the previous quarters and its future growth prospects look even brighter. For FY2007 we estimate it to record gross revenues of Rs418 crore, yielding earnings per share (EPS) of Rs25.5 and cash EPS of Rs35.5. In our estimates we have not considered the revenues from the possible Chinese acquisition. At the current market price of Rs139 Surya Pharmaceuticals is trading at 5.4x its FY2007 estimated earnings and 3.9x its FY2007 estimated cash earnings.
PE Surya Pharma Shasun Drugs Dishman Pharma
FY2006E 12.1 10.1 17.0
FY2007E 5.4 9.1 11.4
In comparison with its peers, like Shasun Drugs (trading at 9.1x its FY2007E earnings) and Dishman Pharmaceuticals (trading at 11.4x its FY2007E earnings), Surya Pharmaceuticals is clearly trading at a big discount at 5.4x its FY2007E earnings. Moreover the bulk drug industry has an average price/earnings (PE) of 8x FY2007E earnings.
Surya Pharmaceuticals has all the pre-requisites for growth: it is increasing its capacities, has a healthy order book, is in the right business segment and has increasing efficiency. Considering this unique combination that adds to its sound business model, we believe that assigning Surya Pharmaceuticals a PE multiple of 8x FY2007E earnings is a fair valuation. This translates into an 18-month forward fair price of Rs205.
Keeping in mind the good growth prospects, new product stream, major capacity expansion plans and signing of major deals to support the revenue flow, we believe that Surya Pharmaceuticals shall definitely perform brilliantly in the coming years. Hence we initiate a Buy recommendation on Surya Pharmaceuticals with a price target of Rs205.
Valuations
Particulars FY2004 FY2005 FY2006E FY2007E
EPS 4.3 6.0 11.5 25.5
PER (x) 32.7 23.3 12.0 5.4
Book value/ share (BV) 38.2 47.1 75.4 101.2
P/BV 3.6 3.0 1.8 1.4
Cash EPS 7.6 9.8 17.6 35.5
P/cash EPS 18.3 14.2 7.9 3.9
EV/EBIDTA 10.5 8.7 8.0 5.3
M Cap/Sales 0.9 1.1 0.9 0.5
Financials
Profit and loss statement Rs (cr)
Particulars FY2004 FY2005 FY2006E FY2007E
Gross sales 172.5 180.9 249.9 418.1
Excise duty 11.0 12.2 15.6 16.3
Net sales 161.4 168.7 234.3 401.8
Other income 0.5 0.2 1.3 1.1
Total income 161.9 168.9 235.6 402.9
Total expenditure 138.7 138.7 191.9 326.1
Operating profit 22.6 29.9 42.3 75.7
Interest 9.6 11.7 11.7 16.5
Depreciation 4.8 5.5 8.7 14.5
Profit before tax 8.8 12.9 23.2 45.8
Total tax 2.6 4.3 6.6 8.9
Profit after tax 6.1 8.6 16.6 36.9

Balance sheet Rs (cr)
Particulars FY2004 FY2005 FY2006E FY2007E
Sources of Funds
Share Capital 10.4 13.3 14.5 14.5
Reserves & Surplus 46.4 56.1 95.5 132.4
Secured Loans 49.0 63.9 179.4 229.4
Unsecured Loans 1.8 3.5 3.5 3.7
Deferred Tax Liabilities 8.2 10.7 14.4 19.4
Total 116.1 147.6 307.4 399.5
Application of Funds
Gross Block 65.2 75.9 75.9 200.8
Less: Depreciation 19.5 25.0 33.8 48.3
Net Block 45.7 50.8 42.0 152.4
Capital Work-in-Progress 0.0 0.0 124.9 0.0
Investments 0.1 0.7 0.7 0.7
Current assets
Inventories 43.9 60.3 71.5 129.5
Sundry Debtors 32.0 44.1 52.9 122.5
Cash & Bank Balances 8.2 6.1 33.0 28.3
Loans & Advances 16.1 19.6 25.7 38.9
Total 100.4 130.2 183.2 316.2
Liabilities 31.8 35.6 44.3 73.3
Net Current Assets 68.6 94.6 138.8 248.3
Miscellaneous Expenditure 1.6 1.4 0.9 0.4
Total 116.0 147.5 307.4 399.5

Key ratios
Particulars FY2004 FY2005 FY2006E FY2007E
Debt: Equity 0.9 1.0 1.7 1.6
Operating Margin (%) 14.1 17.8 18.1 18.8
Net Profit Margin (%) 3.8 5.1 7.1 9.2
RONW (%) 10.8 12.4 15.1 25.1
ROCE (%) 15.9 16.7 11.4 15.7