by Aakash Athawasya
Granules India continues to be on a strong yet sustainable growth track, albeit with a few hiccups. For the September quarter, the Hyderabad-based pharmaceutical giant recorded a stellar set of numbers. Even with the pharmaceutical industry’s COVID-19 tailwinds easing relative to the rest of the market, Granules India looks strong heading into H2.
The company has a portfolio comprising of over 35 active pharmaceutical ingredients (APIs), which include Ibuprofen, Paracetamol, Metformin, Guaifenesin, and Methocarbamol, pharmaceutical formulation intermediates (PFIs), and finished dosages (FDs), across Granules India and its wholly-owned subsidiaries, Granules USA, Granules Pharmaceuticals Inc (GPI), and Granules Europe. It operates its API facilities out of Bonthapally and Jeedimetla in the outskirts of Hyderabad, Vizag, which also has an intermediate facility, and Jingmen in China.
September 2020 numbers
For the second quarter in a row, Granules’ earnings held strong. Back in June 2020, the company saw record-breaking revenues, with EBITDA margins and net profit at its highest in the company’s history. However, this was not without caution. Priyanka Chigurupati, the executive director of the company highlighted last quarter that gross margins could be eaten up by increasing raw materials costs and geopolitical risks, involving China.
Continuing from the success of the July quarter, September didn’t disappoint. Granules’ revenue for Q2 stood at Rs. 858 crores, up from the record-breaking revenue of Rs. 736 crores last quarter. Gross margins moved down marginally from 59.5% to 57.9% despite new launches in the finished dosage segment and increased sales in the same. EBITDA jumped from 25% in Q1 to 30% in Q2, higher than the 23% guidance given by Krishna Chigurupati, the company’s MD last quarter.
Profit after tax (PAT) for the company stood at Rs. 164 crores, a jump of 47% sequentially, and 74% on a year-on-year basis. It should be noted that the PAT includes a reversal of a provision for a recall of one of the company’s top API’s Metformin, of Rs. 7.5 crores.
In the revenue mix, the company’s APIs wing account for 29.7% of revenue, which is down from a 31.1% share it took last fiscal year. The PFI and FD share stands at 20.2% and 50.1% respectively. On the geographical front, North America continues to account for the majority of revenue at 54.9% followed by Europe (17.9%), LATAM (7.6%), and India (13.7%).
Beyond the headline numbers, the company’s financials and conference call had a lot more talking points concerning decreasing operational leverage, improving R&D, generating free cash flow, easing geopolitical tensions curtailing supply, and preventing losses or provisions for the same eating away the company’s optimistic margins going forward.
One of the biggest talking points was the developments from last quarter’s recall of Metformin ER 750 mg dosage, a type 2 diabetes medication, from the US market due to NDMA levels higher than mandated FDA-levels. Metformin is one of three core products in the US generics market, with Paracetamol and Ibuprofen, and the collective US markets (GPI and Granules USA) account for 70% of overall revenues.
In July, the management stated that it had recalled the product and placed a provision of Rs 15.4 crores included in the quarterly PAT. However, the recall itself is unlikely to affect its bottom line, as the 750 mg dosage contributed to 0.3% of its FY20 revenue, but its immediate cost was stated to be shifted to the September quarter.
For Q2, the management stated that out of this Rs. 15.4 crores provision, half of it has seen recalled to the books as it estimated the cost of the total recall not to exceed $1 million (Rs. 7.4 lakhs). The estimated date for the relaunch of Metformin 750 mg dosage is between 1 to 3 quarters, based on discussions with the FDA. For the time being, the company is pushing to improve the market share of the 500 mg dosages.
Within the September numbers, first, there’s the question of capital expenditure. In July, the management stated that a new formulation site would be constructed at Gagillapur which would require a net spend of Rs. 250 crores for the next 6 quarters, and would be ready by Q3FY22, paying back 24-36 months later. This site would be funded through internal accruals, MD Chirugapati said,
“This would need some additional capex during the current and next year to keep our growth momentum, but this will all be funded through internal accruals only and not through debt.”
However, in the September quarter, the company incurred Rs. 60 crores in overall CAPEX, taking the total for the first six months to Rs. 105 crores. The guidance given for the entire fiscal’s CAPEX spend is in the Rs. 350 crores to Rs. 450 crores range.
The CAPEX numbers over the next few quarters will be key, especially because it will need to balance out key financials including free cash flow, net debt, and have to contend with geopolitical tensions preventing investment in alternative technology.
Free-cash flow and inventories
Last quarter, the management unequivocally said that “free cash flow continues to be our focus,” hence the bottom line attracted the most attention by analysts and investors alike. For the June quarter, Granules’ free cash flow stood at Rs. 37.3 crores, which was a drop from the previous quarter because of an increase in inventory and hence receivables owing to logistics issues induced by COVID-19 lockdowns. In Q4FY21, the closing inventory for the company stood at Rs. 200 crores and increased by Rs. 60 crores in Q1FY21.
Questioned on the inventories piling up, which amounted to Rs. 158 crores on receivables and Rs. 184 crores as blocked in inventory, Krishna Chirugapati said, “This will not be a continuing thing at this level.” He stated that the extra stocks piled up in the company’s US subsidiary due to the pandemic and upcoming launches, adding that inventory for 3 to 5 months is accumulated, and this will persist going forward.
Free cash flow for the quarter in question will be pulled back due to piling inventories and receivables, and will only add to the next quarter’s numbers. This was seen between the June and September quarter when the free cash flow increased by 39.9% to Rs. 52.2 crores. However, from this, Rs. 33 crores was used to pay the buyback tax, the interim dividend paid was Rs. 12 crores and long term borrowing repaid amounted to Rs. 52 crores. Going forward, the company expects to generate free cash flow from 12 new products to be approved and 6 approved and to be launched in the US market.
Further, the company incurred an expense of Rs. 9.9 crores for supply-side problems, adding on to the previous quarter’s expenses of Rs. 9.3 crores. This has also forced the company to delay the launch of certain products, focusing on soft launches in H2FY21.
One of the main worries for the pharmaceutical industry currently is geopolitical tensions, involving China. Granules looks to survive this tide despite its Jingamen site. In December last year, it sold its entire stake in its Chinese joint venture Granules - Biocause Pharmaceuticals Co. to its Chinese partner Hubei Biocause Heilen Pharmaceutical Co for RMB 109 million (~ Rs. 120.1 crores). Interestingly, the company, at the time, said that the sale proceeds would strengthen its cash position and reduce net debt.
For the company, three products, all key starting materials (KSMs), are sourced from China. Out of these, the company imports a large amount of 1 KSM, Para-aminophenol (PAP) for paracetamol, whereas the remaining two KSMs have alternate sources. PAP doesn’t have a sourcing problem in China, but its prices are volatile, forcing the company to use technology to backward integrate it, which it has been working on for the last 8 years.
The management stated they have “restrained” themselves from investing in this technology because this quarter’s and fiscal’s CAPEX spend is high. To balance the China-tensions with the need to import PAP, Krishna Chirugapati said that they are in “final stages of agreements with two companies who make the product for us exclusively with a buyback arrangement,” providing no details on the same.
In June, consignments worth Rs. 200 crores from China were stuck at ports and airports, causing a shortage for the collective pharmaceutical industry. On this stoppage potentially affecting his company, Krishna Chigurupati, in an interview with CNBC-TV18 stated,
“For paracetamol, the main raw material PAP comes from China, so that is effected. I think our sales to the effect of 30% to 35% will be affected.”
Another potential pain-point for the margins, especially so in the pharmaceutical space, is R&D. The company signaled that R&D expenses would increase for the subsidiary GPI, and would decrease for the core business, Granules India. Between the two quarters of this fiscal year, the R&D expense has increased by 11.5% to Rs. 22.2 crores, but has dropped from 2.7% of sales to 2.6%.
Data source: Investor Presentation Q2FY21, Granules India
Prioritizing away from R&D, the company stated back in July that it will focus on and invest in products that have a strong value proposition, hence limiting abbreviated new drug applications (ANDAs). The focus will be on increasing the Drug Master File (DMF) filings in the US. The expenses marked for R&D will be re-routed for CAPEX. However, the R&D guidance remains the same at Rs. 250 crores per year.
In the quarter gone by, the company invested Rs. 22 crores in R&D, made four DMF filings, and received approvals for four products. In H2, the total number of launches will be at least 3, divided between one EU product, expected to launch in Q4, and two products acquired. These products will be launched via the core business and the US-subsidiary, and are in the medium to high volume range.
Debt and pledged-equity
Even with large current and forward expenses, leverage will be avoided for the CAPEX, but not operations. At the beginning of Q2, the company had gross debt of Rs. 870 crores, down from Rs. 884 crores three months prior. Out of this Rs. 870 crores, long term debt stood at Rs. 552 crores versus short term debt at Rs. 348 crores. The goal before the start of the quarter was to reduce more than half the debt to Rs. 430 crores, by the close of the fiscal year, which is looking unlikely.
Debt for the September quarter stood at Rs. 861 crores, down by just 1% in three months. Long term debt dropped by 8%, while short term debt rose by 9.4%, as working capital requirements tightened, owing to the inventory-flux mentioned above, and an independent marketing route employed. The company stated that they have switched from marketing in the US with partners, and instead have begun “aggressively operating” through their franchise beginning last year. This required short-term borrowing but could result in extra margins, previously shared with the company’s partners. However, this is not a one-off expense, and will continue to reflect on the financials, the MD said,
“So as a very conscious decision we have started our own front end and this would definitely need extra working capital to our receivables and also inventories. So this is not a onetime affair.”
In terms of the debt-numbers, for the second half of the year, the company has to reduce its debt by over 50% or by Rs. 431 crores to meet its target, a tall order especially in light of the continued franchise investment, planned CAPEX, and free cash flow focus.
Data source: Earnings call, Granules India
Last quarter, the company’s pledged shares dropped by 12.9% to 3.5% of the total equity of the company and 8.5% of the equity held by promoters, by the end of Q1, with the hope of extinguishing it completely by the end of the fiscal. However, in the first week of September, Krishna Chirugapati himself created two pledges with 72 lakh shares and 17.7 lakh shares of the company respectively, representing a total of 3.6% of the company. The company did not allude to the pledged shareholding in the September call.
Since the broad numbers held strong and then some from the first quarter, analysts maintained their positive outlook on Granules. However, The company received one recommendation downgrade from Geojit BNP Paribas, albeit with a higher target price, while Sharekhan, KR Choksey, Motilal Oswal, BP Wealth, and ICICI Securities maintained a ‘Buy’ each with a higher target.
On both fronts, individual brokers, and overall market estimates, the revenue, and PAT numbers were higher. The ICICI Securities report on the company stated,
“We like Granules’ clear vision to play on its strength of economies of scale and gradually expand into more complex products/forms to improve margins. Sustained margin expansion is likely to support FCF generation despite brownfield capex lined up till FY23E.”
With a focus on CAPEX, in investment and expected demand, rising revenues, and ramping up of filings and products in the US market, BP Wealth expects FY21 to FY23 to be stronger still in terms of revenue. Its report increased the estimated earnings for FY21 and FY22 by 17% and 19% respectively, reasoning,
“Considering the expected strong growth in profitability, a healthy balance sheet, and improving return ratios, we remain optimistic about the long-term growth prospects of the company. In light of better growth visibility.”
The company is focusing on both reducing debt directly and pledged equity, while also improving free cash flow despite its recent corporate actions, in the form of dividend payouts and a buyback. These positive operational margins as well as strong revenues and margin growth have been cited as key positives in Sharekhan’s report, placing a target at a 24.3% premium against the company’s trading price.
On the valuations front, Granules at the time of its earnings release was trading at Rs. 384 giving it a P/E multiple of 32 times, based on its FY20 numbers. In its report, Geojit BNP Paribas stated that Granules’ price, at a 20x multiple of its estimated FY22 EPS, and above its 5-year average P/E multiple of 13x has “factored in the positive outlook for the company.” Based on its price at an inflated valuation, the broker downgraded it from a “Buy” to an “Accumulate.”