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Red flags – Aftek infosys

By Rohit Chauhan
In Rejected investment ideas, Uncategorized
May 24, 2007
3 Min read
15 comments
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Aftek infosys appeared on my stock screens a few days back. I also had a comment from prem sagar on the company. The company seems to be extremely undervalued. It seems to have almost 400 Crs of cash on the books with a market cap of just around 650-700 Crs. With the last year profits of 98 crs, the company seems to be selling at a PE of 2-3. On the face of it the company seems to be an investors wish come true. My initial scan showed nothing wrong, so I decided to dig deeper and came up with a can of worms.

– the company’s management was penalized by SEBI for participating with Ketan parekh in various behind the scene deals during the 2000 bull market (see here)

– The company had an investment of almost 46 Crs in a company called Arexera. They have accquired this company this year (the balance portion) for a sum of 56 crs. One would consider this accquisition to be significant. The positives of the acquisition are mentioned all over the report. However the valuation of the deal is not mentioned. The company had a net profit of 1 Crs last year (see page 100 of the annual report). The company was acquired at a valuation of 100 Crs ( PE = 100 !!!). The management has not discussed the valuation anywhere in the report and why they paid so much for it. Finally surprise , surprise – this company was accquired from the promoters !!! . See the cash flow statement on page 83. There is an entry for 54.8 Crs which was paid to promoters to acquire this company. So the management accquires this company and has a related party transaction and does not mention this in the complete report??

– The company has issued 3.96 lac warrants to the promoters. They have received 10% of the price now and the rest can paid by the promoters within 18 months. Why have these warrants been issued if the company is swimming in cash, had some FCCB still open and is making almost 100 Crs per year ?

– Promoter holding is only 12%.

– FCCB issue in the last few years to raise capital. This capital is being used to accquire companies like Arexera from promoters.

The stock may do well (had a jump of 10 % recently). However I have bad feel of the whole thing. All the red flags I have pointed above don’t give me any confidence in the management. I still think the business will do well and the company should make money. But I am not sure if the shareholders will benefit or the promoters would. Their past and current actions don’t give me any confidence. I am definitely giving the stock a pass although there could be some trading gains to be made.

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Analysis of Novartis india

By Rohit Chauhan
In Investment ideas, Uncategorized
May 21, 2007
3 Min read
4 comments
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Novartis india is the Indian subsidiary of Novartis AG. The company has the following business segments – Pharmaceuticals, Generics, OTC and Animal care.

The company is in various therapeutic areas such as Immunology and Transplantation, Oncology, Gynaecology, Central Nervous System, Respiratory, Pain and Inflammation, Ophthalmics and Orthopaedics. In the OTC space the company has some strong brands such as Sandoz.

Financials

The company has just tread water in the last few years. The topline growth has been more or less flat and is currently at around 520 Crs. The bottom line is now at around 88 Crs. Both the topline and bottomline have growth a low single digit growth rates and I expect the same to continue.

The Global parent has a local unlisted subsidiary and has made comments of introducing products through the unlisted subsidiary. As a result the topline and bottomline growth for novartis could be at best 5-7% per annum for the next few years. The poor growth in the last few years has mainly been due to poor performance of generics, sale of the Rifampicin (anti-TB) business and due to price control on some of its brands.

Valuation

At the current profit of 88 Crs and EPS of around 27.5, the company sells for around 12-13 times PE. In addition the ROE and ROCE is actually very high. The 2006 AR shows that the company as just 10 Crs in fixed assets and negative working capital. As a result the Return on capital is very high (>100%). All the assets are in cash or inter corporate deposits and other liquid investment.
It seems the company has become complete asset free and is outsourcing almost its entire production.
In addition in one of the earlier AGM, the company has mentioned that the excess profits would be returned via generous dividends. The dividends for the last few years have been 200%+ giving a dividend yield of almost 3-4%.

On a comparable valuation basis, the other pharma MNC with similar business model sell at around 20-30 times PE.

Thus the stock appears undervalued with intrinsic value between 600-650 Rs

Risk

Poor topline and bottom line growth or even de-growth. In absence of few product launches in the Pharma segment and continued competition and price pressure the company could have a drop in net profits. The OTC and animal care business seem to be growing, but do not have very high margins
In addition the parent could increase the focus on the unlisted subsidiary and milk the listed one for profits.

Conclusion

The company is selling at a 4 year low. I feel that all the negatives seems to be priced in. Net of cash, the company sells at almost 8-9 times earnings or cash flow. This seems to be fairly low for a stable and profitable pharma business.

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Business models of Pharma industry

By Rohit Chauhan
In Competitive advantage, Industry analysis, Uncategorized
May 17, 2007
4 Min read
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I have written (see here) earlier on the pharma industry in 2005. A few high profile patent challenge losses in 2005 and 2006, brought down the valuations for several companies. My basic thoughts about the industry have not changed

I have been analysing the industry further recently and can see two different business models.

The Domestic market focussed model

Most MNC’s like novartis, merck, pfizer come under this model. The key characterisitics of the model are

1. Subsidiary of a global MNC operating in india for the last few decades
2. The subsidiary operates as an extension of the global company and due to the patent law in the past, has introduced mostly the off-patent drugs.
3. Strong brands, marketing network and good return on capital and strong competitive advantage.
4. Possibility of introducing the drugs from global portfolio. However in some cases the parent company has an unlisted subsidiary and hence treats the listed one as a cash cow. In such cases the market is rightly giving a lower PE multiple due to the poor corporate governance attitude of the parent.
5. Strong cash flows due to minimal R&D and very low assets in the business as most of the manufacturing is sub-contracted.
6. Low growth in domestic market, marked by constant price controls (DPCO and new pharma policy) by the government on various essential drugs. This has resulted in poor topline and bottomline growth for several companies solely dependent on the domestic market.

The International market focussed model

1. This model is followed by the indian pharma companies such as ranbaxy, dr reddy’s, nicholas pharma etc
2. These companies are in the process of globalizing. Their approach to it has been through the drugs which are coming off patent (generics strategy). These companies have built a strong R&D infrastructure in india to develop these drugs coming off patents. They also have a marketing and legal infrastructure in foreign markets to file ANDA and other applications for these drugs as soon as they come off patents. If these companies win these cases, then they get a 180 day exclusive marketing period for these drugs. Post the exclusive period too, these companies are able to maintain good market shares. Thus these companies have created a value chain of R&D labs in india, and a distribution, marketing and legal infrastructure abroad to funnel these new drugs coming off patents.
3. These companies are following riskier strategy as these legal challenges are costly and if the company loses one, the entire money is down the drain.
4. The market was pricing earlier as if each of these ‘bets’ would pay off. However due to some high profile failures in the past, the market has started pricing the risk of the strategy now.
5. Some companies are also acting as outsourcers for the global pharma companies. This is the contract or custom manufacturing business. There a large no. of FDA approved facilities in india ( second largest in the world). Several indian companies now provide advanced manufacturing facitility to global pharma companies and are now doing accquisitions in this space to accquire complementary assets abroad.
6. The third segment of this model is the R&D segment where some of the top companies are now investing heavily in R&D to develop NCE and NDDS. Some of the molecules are now in the stage I and Stage II trials. Some companies such as DRL have licensed these molecules to other companies and they get royalties based on milestones. This is a high risk, high return startegy. However it is likely the larger pharma companies in india could go down this path and emulate their global counterparts.

It is easier to predict the cash flow and valuation of the domestic model as the overall business risk is lower in that model. The international business model has a higher upside, however the valuation seems to reflect that upside in several instances. All these international market focussed model has ‘real options’ embedded in it. However I do not have the skill to do the valuation of these options. It is often difficult to predict which Patent challenges would be successful and which ones will fail

For additional detail on the pharma industry see here. The article is dated, but useful to understand the various terms such as ANDA, Para I,II etc.

There are several good stocks in the pharma industry available at reasonable valuations. I have discussed about merck earlier. In addition I am looking at novartis and alembic too.

Caution : Stocks which i look at generally perform poorly in the short term as they are undervalued. Please do your own research before investing in them.

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How to be a better investor – evaluating performance

By Rohit Chauhan
In Investing Philosophy, Uncategorized
May 14, 2007
3 Min read
3 comments
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One of the most important aspects of becoming a better investor is to evaluate one’s performance. However I do not think an absolute performance is the right way to do it.

For ex: If one’s stock portfolio returned 2% during the period 2000- 2003, I would consider it to be a superior performance than a 30% increase from 2003-2006. The reason is that during the period 2000-2003 , the market lost more than 30%, whereas during the period 2003-2006 the market almost doubled.

I evaluate my own performance as follows

I use the following formulae to evaluate the performance on my stock portfolio. I am not referring to a single stock, but for the entire stock portfolio.

Return = End portfolio amount – starting portfolio amount – cash added (or removed)/ starting portfolio amount

The period for the above formulae can be a month, quarter or a year. I prefer to evaluate the performance annually.

I compare this performance with the following three benchmarks. You can look at these benchmarks as three rising levels of hurdles to be crossed.

Level 1 – No risk FD return – This is the return I get from investing in bank FD. The stock portfolio has to cross this level. Otherwise I am way better off investing in FD’s and going off to sleep.

Level 2 – Index fund return – This is the return one can get by investing in the index (NSE or BSE) via ETF’s or index funds. The stock portfolio has to outperform this level, other wise I am better off investing in an index fund.

Level 3 – Mutual fund return – I referred to it in my previous post. My stock portfolio return should exceed the return I get from my portfolio of mutual funds (post expenses). If not, then I am again better off handing my money to the fund managers and doing something better with my time.

A caveat – One should not make a decision based on a single year’s return. In a single year, the stock portfolio returns can be volatile and even be below level 1 benchmark . I prefer to look at rolling 3 year returns to reach some tentative conclusion. I would prefer to look at the results of atleast 5 years before reaching a conclusion that I have crossed each of the above benchmarks. For a 5 year period, one should look at the cumulative returns from the stock portfolio and compare it with the above 3 benchmarks. Only if one has done substantially better than the three benchmarks, can one conclude that he or she ‘may’ be a superior stock picker.

The above may sound harsh and pompish. But I think if one has to be better investor, honest appraisal of one’s performance is important. If I have five duds and my portfolio returns less than what I could get in an FD, then there is not much to be gained from a stock pick which doubled in 15 days. I may have bragging rights and may feel smart, but I am not being honest and objective about my performance.

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