Financial Analysis of Pharmaceuticals

Section C Group 7Management Accounting 1Financial Analysis of PharmaceuticalsDr Reddy, Cipla, LupinAbhilash P Tom (14P123)Atul Prakash Mishra (14P136)Mohit Maheshwari (14P149)Namrata Kashyap (14P151)Sahil Garg (14P161)Utkarsh Patel (14P175)

ContentsAcknowledgment4Introduction5Pharmaceuticals Sector Outlook6Companies taken for Analysis7Dr Reddy Laboratories7Cipla8Lupin9Category of Analysis10Investments11Short Term Investments11Earnings Per Share (EPS)12P/E (Price to Earning)12PEG Ratio13Beta Value13Long term investment:14Interest Coverage Ratio15Debt to Equity Ratio16Dividend Per Share (DPS)17Dividend Yield18Return on Investment (ROE)18Lending19Short Term Lending19Current Ratio20Quick ratio21Inventory days22Receivable days23Payable days24Working capital cycle25Long Term Lending26Debt Equity Ratio26Interest Coverage Ratio27Gross Block28Fixed Asset Turnover Ratio29Return on Capital Employed30Altman Z-Score31Strategy32Overview of Pharmaceutical Industry32Domestic Markets32International Markets33Recent Budget Impact34Key Growth Drivers34Company Analysis37Dr Reddy Laboratories Ltd37Cipla38Lupin39Appendix40Dr Reddy Laboratories Ltd40Cipla Ltd41Lupin Ltd42Bibliography43

Acknowledgment

We would like to take this opportunity to thanks all the faculty members at Management Development Institute, Gurgaon This project would not have been possible without our basic understanding of Managerial Accounting and towards this end the indelible efforts of Prof. S.K.Rai. We are also grateful towards the Institute for providing us with excellent infrastructural support in the forms of the Computer Centre and the Central Library.

IntroductionFinancial statement analysis is the process of reviewing and evaluating a companys financial statements thereby gaining an understanding the financial health of the company and enabling effective decision making for owners and managers, prospective and present investors, financial institutions, government entities etc. It involves analysis of past, current and projected performance of the company.

Financial Statements are released by companies not only for acceding to the norms set up by the exchanges on which they are listed and to follow the rules put down by the regulator of that country but also to provide prospective investors and financial institutions a brief insight into the company. It helps them take decision to make investment or give loan, both long term and short term to the company.

Financial statements are normally available in companys website, prospectus as also the annual and the quarterly results declared by the company. These statements by themselves contain a lot of numbers which are in comprehensible unless a proper analysis of such documents is carried out to arrive at a conclusion on the company's financial health. The pages that follow, aim to provide a simplified explanation of some of the basic analysis company for different objectives of the investor/lender. The objectives include Short term and long term investment, short term and long term lending and future strategy.

Pharmaceuticals Sector OutlookThe industry has remained largely unaffected by the economic slowdown, especially critical pharmaceutical therapies. Various players have diversified its global presence across regulated and emerging economies, making it possible to sustain growth despite short-term slowdowns in any geography.

The global spending on generics accounts for 25% of the global pharmaceuticals spending (US$242 billion in CY11), growing rapidly in the last few years (~12% CAGR over CY06-11). The share of the top 10 Indian players is merely 1.1% of the total spending (~US$11 billion) and 3.3% of the generics spending (US$7.4 billion; ex-India), indicating attractive room for growth. Globally competitive business models with a mere 3.3% share of the addressable market combine to provide a large and sustainable opportunity for Indian pharma companies.

With the increasing contribution of India in US pharmaceuticals market, USFDA has ramped up its quality checks in India and many Indian companies has been found wanting in this regard which is substantiated by various discrepancies found in the facilities of Ranbaxy, Wockhardt, IPCA and others. Managing USFDA risk would increase compliance cost but is essential for sustaining growth over longer period of times. The companies which can manage the regulatory risk well over next few years would be sitting at a great opportunity as the competition would be limited due to entry barriers in US market and huge set-up cost for USFDA compliant plants.

The opportunity size is high for Indian generic manufacturers due to lot of drugs going off-patent in next 3 years. Developing R&D capability and streamlining operations to international standards is critical for Indian pharmaceutical companies to take advantages of increasing number of off-patent drugs.

The depreciated rupee will augur well for the pharmaceutical companies as many of them have exports forming a major part of revenue. However companies need to hedge against large foreign loans. The increasing litigations for instance, against Indian companies (like Ranbaxy, Aurobindo Pharma, Wockhardt) also seems to be a matter of concern as import alerts cause a major loss of revenue causing large aberrations.

Overall, the future looks optimistic due to huge and increasing opportunity size.

Companies taken for AnalysisDr Reddy LaboratoriesMarket Cap (As on 31-08-14): 50,267.57 crSales (FY14): 13,359.10 crEstablished in 1984, Dr Reddys Laboratories (DRL) is one of Indias pedigreed players having a firm footing in the US and other export markets with deep rooted product and market knowledge across therapies. Like Cipla, DRL also recognised the importance of having goodmanufacturing practices (GMP) accreditation in the eighties and eventually got USFDA approval (first of its kind approval for a formulation facility in India) in 1987. The company owns 22 manufacturing facilities and four developing centres across the globe. The facilities have been approved by various agencies such as the USFDA, WHO-Geneva, UKMHRA, TGA-Australia, MCC-South Africa, DMA Denmark, Brail ANVISA, among others. Over the years, along with generics, the company also established itself in the field of discovery of new chemical entities (NCEs) but with little success.DRLs business can be classified into three broad segments- 1) global generics (GG), 2) pharmaceutical services and active ingredients (PSAI) and 3) proprietary products (PP).

Global generics (76% of revenues) includes branded and unbranded prescription and over-the-counter (OTC) products business. It also includes operations of the biologics business.This segment comprises formulation sales to regulated markets of the US, Europe and emerging markets such as Russia/CIS, India and RoW. Pharmaceutical services and active ingredients (21% of revenues) consist of the active pharmaceutical ingredients (API) business and custom pharmaceutical services (CPS) business. Proprietary products (PP, 1% of revenues) consist of NCEs, differentiated formulations and dermatology focused specialty business operated through Promius Pharma.

DRL is one of the few Indian companies to foray into new drug discovery & development (NDDS) and new chemical entity (NCE) research. The company started research operations in 1992 through a non profit organisation, Dr Reddys Research Foundation, which was later merged into the company. Despite being an early entrant, the company is yet to taste success in it. DRL is also the first Indian company to out-license molecules to big pharma companies. DRL has spent around 7-8% of the turnover on R&D in the last four yearsbut this figure is likely to touch 10-11%, going ahead.

REVENUE BREAKUP

Source: Companys Annual Report FY14CiplaMarket Cap (As on 31-08-14): 44,305.20 crSales (FY14): 10,100.39 cr

Formed by Dr KA Hamied way back in 1935, Cipla is one of the oldest ventures set up by an Indian in the pre-independence era. With 34 manufacturing facilities spread over seven different locations, Cipla has a gamut of therapeutic offerings ranging from simple anti-infectives to complex oncology products. The product basket includes ~2000+ products encompassing almost all therapies and over 40 dosage forms.

The facilities have been approved by various agencies such as the USFDA, WHO-Geneva, MHRA-UK, TGA-Australia, SUKL-Slovak Republic, APVMA-Australia, MCC-South Africa, PIC-Germany, Danish Medical Agency, ANVISA-Brazil, INVIMAColombia, NDA-Uganda, Department of Health-Canada and MOH-Saudi Arabia, among others. So far, the company has not faced any cGMP issues or import alerts from any regulatory authorities.

Ciplas business model focuses on having marketing partnerships with local companies across the globe. Most partners are large generic players in developed countries. The company has partnership deals with ~22 partners in the US and ~65 in Europe. Cipla has also formed strategic alliances for product development, registration and distribution of itsproducts. For the non-regulated markets, the company has maintained long-standing relationships with non-government organisations and institutions globally. However, going ahead, we may witness launches via front-end model rather than partnership model especially in the US.

REVENUE BREAKUP

Source: Companys Annual Report FY14

LupinMarket Cap (As on 31-08-14): 57,746.08 crSales (FY14): 8,939.38 cr

From being a global leader in anti-tuberculosis (TB) and other infectious diseases to one of the fastest growing prescription companies in the US, Lupin has come a long way to emerge as a leading Indian generic exporter.

Established in 1968, the company has adapted well as per the changed industry dynamics like other peers such as Sun, Dr Reddys Laboratories, Ranbaxy and Cipla. During this journey, it has changed focus in therapies- from acute to chronic and also geographies, fromdomestic driven to export oriented. It has received USFDA approvals for two facilities - Ankaleshwar and Mandideep way back in 1989.

Besides this, the company has been fairly active in the global M&A front. It has acquired companies in Japan (significant acquisitions), Australia, Philippines and South Africa. Africa. Similarly, the company also acquired small ticket but lucrative brands in the US (Suprax, Antara, Locoid lotion and Alinia). Its latest acquisition, however, has been a complex injectable technology based company (Nanomi) in the Netherlands. Infrastructure-11 manufacturing facilities including two in Japan seven formulations (three USFDA approved) and four APIs (two USFDA approved).

REVENUE BREAKUP

Source: Companys Annual Report FY14

Category of Analysis

Investments1) Short Term Investment2) Long Term InvestmentLending1) Short Term Lending2) Long Term LendingStrategy

InvestmentsShort Term InvestmentsShort Term investment means investment for less than 1 year where aim is to book profits in short term by finding undervalued shares.Following parameters are considered in short term1. EPS2. P/E3. PEG4. Beta

Earnings Per Share (EPS)EPS for Cipla is not consistent while EPS for other 2 companies (DR Reddy and Lupin is consistently increasing). EPS for Lupin has increased by over 100 % from FY12 to FY 14.Earnings per Share for last 5 years .P/E (Price to Earning)The P/E ratio expresses the relationship between the price per share and the amount of Earnings attributable to a single share. i.e., the P/E ratio tells us how much an investor in Common stock pays per rupee of current earnings.

PE Ratio = Market Value per share / Earning per shareSector PE ratio = 27.53Investors compare a companys PE ratio with historic and sector PE ratio. A low PE ratio is considered to be a undervalued share but high PE ratio doesnt always imply a overvalued share. All 3 shares have PE ratio less than sectors so growth is important. PEG ratio should be looked at instead of PE.PEG RatioPEG ratio of Lupin is less than Dr Reddy lab and cipla which implies than Lupin is undervalued.Beta ValueDescribe correlated volatility of an asset compared to benchmark Negative beta, is a rare condition where the price of the stock moves in reverse direction to the market movement. Zero beta, is another rarity, where the price of stock stays same over time irrespective of market movement. A beta of less than 1 means that the security will be less volatile than the market. A beta of 1 indicates that the security's price will move with the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market

Overall View : Lupin seems to be the most viable option as its the least volatile stock with beta value of 0.37 and at the same time it looks to be most undervalued with PEG ratio of 1.14. EPS for Lupin has increased by more than 100 % in last 2 years. So Lupin looks like a low risk high return stock and is worth a try for short term.

Long term investment:Long term investments can be viewed as investments for 3-10 years. We taken into account risk and return to analyze stocks for long termRisk FactorsReturn Factors

Interest Coverage RatioDPS

Debt Equity ratioDividend yield

ROE

RISK FACTORS

Interest Coverage RatioA ratio used to determine how easily a company can pay interest on outstanding debt. TheInterest coverage ratio is calculated by dividing a companys EBIT of one period by the company's interest expenses of the same period:

There is an alarming decrease in interest coverage ratio of cipla from 61.61 to 13.89. Lupin is very comfortable in this front with coverage ratio of 107.25

Debt to Equity RatioIt defines the financial leverage of a company.A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. Also this signifies high risk as the company does not have enough funds to pay off its debt.

Lupin and Cipla are comfortably placed as far with debt to equity ratio of .08 and .12 respectively but Dr Reddy lab has significantly high ratio of .53

RETURN FACTORS

Dividend Per Share (DPS)DPS is the dividend given to shareholders per share. High dividend implies company is making profits and is willing to share it with shareholders.

DPS is highest for Dr. Reddy Labs while it is consistently 2 Rs. for Cipla. DPS is consistently increasing for Lupin. Though DPS for DR. Reddy is highest share price for it is also high compared to other 2 shares so dividend yield is better measure of companys dividend performance

Dividend YieldDividend yield is defined as dividend paid/Price of stock. A financial ratio that shows how much a company pays out in dividends each year relative to its share priceDividend Yield = Dividend Paid/Price of ShareAmong 3 companies dividend yield is highest for Dr. Reddy lab

Return on Investment (ROE)It is the amount of net income as a percentage of shareholders equity. Return on equity measures a stocks profitability by revealing how much profit a company generates with the money shareholders have invested. So higher the ROE, better is the performance of the company.Return on Equity = Net Income/Shareholder's Equity

ROE is lowest for cipla which is an area of concern. It is constant for Dr. Reddy lab while its consistently increasing for Lupin after 2012.Final Verdict :Lupin looks to be a favorite bet for long term looking at both risk and return factor. Dr Reddy looks to be close 2nd while presently Cipla doesnt look like a right company to invest in for long term.

LendingShort Term LendingThe short term lending is to provide capital to the company for short duration usually less than a year. These loans are generally used by the company to meet working capital needs but in some cases can be used for other purposes as well. The analysis of short term lending is aimed at finding how much return on investment can be realized in short run. A bank will thus lend money only to those companies which are running their business efficiently and are in a position to give good returns. It is imperative to analyze why the company is borrowing money and what will be the application of funds. We must find out whether the company will apply the funds to pay back loans (principal or interest) or to raise fixed assets or to increase current assets. The parameters taken into consideration are:- 1. Current Ratio 2. Quick ratio3. Inventory days 4. Receivable days5. Payable days6. Working Capital CycleCompanyFY 10FY 11FY 12FY 13FY 14

Current RatioCipla3.713.983.093.703.32

Dr Reddys 2.22 2.36 2.722.693.07

Lupin2.452.572.322.542.93

Quick RatioCipla2.432.351.821.981.65

Dr Reddys 1.46 1.60 1.962.012.30

Lupin1.611.711.471.651.95

Inventory days

Cipla98.15110.0296.18105.24104.63

Dr Reddys 69.95 77.86 72.2766.6066.09

Lupin73.5175.7789.2973.7868.86

Receivable daysCipla101.6686.0580.7773.5759.22

Dr Reddys 60.58 85.74 94.3497.5990.85

Lupin85.2479.29 89.2482.7979.69

Payable daysCipla76.3867.6075.6261.2762.61

Dr Reddys 18.29 21.52 19.7122.2623.82

Lupin 86.94 87.35105.0983.5970.38

Working CapitalCycleCipla123.43128.47101.33117.54101.24

Dr Reddys 112.24 142.08 146.90141.93133.12

Lupin 71.80 67.71 73.4472.9978.17

Current Ratio The formula is: Current ratio = current assets/current liabilitiesThe higher the current ratio, the more capable the company is of paying its obligations. A ratio less than 1 suggests that the current assets are less than current liabilities and hence the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt.

AnalysisHere the current ratio for all companies is high which signifies that current assets are not properly utilized. Cipla has highest while Lupin has lowest. All the companies have more currents assets than obligations which is a positive sign. However, low utilization of resources could be a matter of concern

Quick ratioThe formula is: Quick ratio = Current assets inventories/ current liabilitiesIdeally, quick ratio should be 1:1. A quick ratio higher than 1:1 indicates that the business can meet its current financial obligations with the available quick funds on hand. A quick ratio which is lower than 1:1 may indicate that the company relies too much on inventory or other assets to pay its short-term liabilities. Many lenders are interested in this ratio because it does not include inventory, which may or may not be easily converted into cash.

AnalysisHigher quick ratio is also not desirable because it indicates that company needs to employ high current assets in the business. However, high quick ratio is generally good for business if one takes into perspective the short term borrowing capability of the business. Here all the three companies have quick ratio above 1 but lupin amongst the three is the only one which is maintaining the stable while other Ciplas has declined from 2.43 to 1.65 and Dr Reddys has gone up from 1.46 to 2.3 .

Inventory daysInventory Days is an efficiency ratio that measures the average number ofdaysthe company holds itsinventorybefore selling it. Lower Inventory days is desirable.

AnalysisInventory days of Cipla has increased which indicates that the sales growth is financed by credit and better terms to the customer rather than product pull. But the increase in days is not very high and is in reasonable range.Dr. Reddy has seen marginal improvement in inventory days due to better working capital management.There has been drastic improvement in inventory days in last three years for Lupin which indicates that sales growth has come from product pull rather than push strategy which indicates stronger visibility.

Receivable daysA measure of theaveragetime acompany'scustomerstaketo pay forpurchases, equal toaccounts receivabledivided byannualsalesoncredittimes 365.

AnalysisReceivable days indicate the credit terms provided by the company to push sales. On this count, Cipla is the best company as it has been proficient in getting the money quickly from the debtors.However, all 3 companies are improving their receivables which are a good sign for a company financing their operations.

Payable daysA company's averagepayable period.Days payableoutstanding tells how long it takes a company to pay its invoices from trade creditors, such as suppliers

AnalysisHigher payable days are good for a company as this reduces the amount of capital to be employed in the business and improves the overall return ratios of the business.Lupin has higher payable days indicating better terms with its creditors as compared to the other two.

Working capital cycleAverage number of days a firm takes to convert working capital into sales revenue. Less the number of days, more efficient is the use of working capital. Working capital Cycle = Average working capital x 365 sales revenue. The easiest way to explain it is in terms of the number of day difference between when you pay for things and when you get paid.

AnalysisFor Dr Reddys the no of days in working capital cycle is high. Though it has been decreasing but still it needs improvement. Cipla is having very fluctuating working capital cycle and after a sharp increase in FY 13, it has been brought down to Previous levels in FY 14. Lupin is having a stable trend and is having the lowest working cycle among all of them.Overall AnalysisOn the basis of Working Capital Cycle, Lupin is the best as the cash conversion cycle is the lowest among all the 3 peers. So as a financier, if one has option to chose one amongst the 3, one will select Lupin Ltd for short term lending.

Long Term LendingThe purpose of long term lending is to analyze the company for steady gains over longer period of time. The main aim in analyzing is to minimize the risk and maximize the profits over the longer period of time. Following ratios are considered for this: Debt Equity Ratio Interest Coverage Ratio Gross Block Fixed Asset Turnover Ratio ROCE

Debt Equity Ratio It is a measure of a company's financial leverage. It indicates what proportion of equity and debt the company is using to finance its assets. D/E = Total Liabilities/ Net worthA low debt-equity ratio implies that a company needs to be more aggressive with its growth debt. It further suggests that the company is not leveraging itself optimally to achieve growth in return on equity funds. A high debt-equity ratio means that although the company is following aggressive growth path through debt funds, its bottom-line will be affected due to the interest expense accrued because of the debts.

AnalysisLupin has lowest Debt/Equity ratio which indicates it to be best company to finance for the long term on this parameter. Cipla is also having low but it is increasing year by year which is not good.

Interest Coverage Ratio

Interest Coverage Ratio = EBIT/Interest Expense

It is used to infer how easily a company can cover its debt expenses. The lower the ratio, the company has a higher debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable.Interest Coverage Ratio for all the three companies

AnalysisInterest Coverage ratio is highest for Lupin indicating it is very safe to finance Lupin with debt indicating Cash flow from operations are more than enough to finance interest costs. Even Dr. Reddy and Cipla has high coverage ratio and are good for long-term financing but Lupin seems to be the best bet.

Gross BlockGross block gives us the total value of all of the assets that a company owns without accounting for depreciation.

Gross Block for all three companies

AnalysisGross Block of all the 3 companies has increased and Cipla has followed aggressive approach in increasing the Gross Block compared to others which can affect its asset turnover ratio.

Fixed Asset Turnover Ratio

Fixed Asset Turnover = Sales/ Fixed Asset

It is a measure of a companys efficiency to generate net sales from fixed assets investmentsFor all three companies

AnalysisFixed assets turnover of Lupin is very high which indicates Asset light business model. Dr.Reddy also has high ratio indicating good economics of the business as a whole. Cipla reduced its fixed asset turnover ratio indicating that the increase in gross and net block has not yet reflected in sales of the company.

Return on Capital Employed ROCE = PAT/ Debt+Equity+Reserve

It is a ratio that indicates the efficiency and profitability of a company's capital investmentsAnalysisHigh ROCE of Lupin indicates better capital efficiency in the business. Also RoCE of Dr. Reddy and Cipla are high indicating enough returns to finance long term debt.

Overall AnalysisLending profile of the Lupin is the best as the Future Cash Flows are expected to be higher per unit of Capital employed. Even in case of Lupin and Cipla, Cash Flows are enough to finance the debt, so all the 3 companies are credit-worthy.

Altman Z-Score

Altman Z-Score is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy. The Altman Z-score, is based on five financial ratios that can be calculated from data found on a company's annual 10K report. The Altman Z-score is calculated as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0EWhere:A = Working Capital/Total AssetsB = Retained Earnings/Total AssetsC = Earnings Before Interest & Tax/Total AssetsD = Market Value of Equity/Total LiabilitiesE = Sales/Total Assets

A score below 1.8 means the company is probably headed for bankruptcy, while companies with scores above 3.0 are not likely to go bankrupt. The lower/higher the score, the lower/higher the likelihood of bankruptcy.Company Altman Z-Score (FY14)

Dr Reddy Laboratories Ltd6.28

Cipla10.64

Lupin14.74

AnalysisAll the 3 companies have Altman Z-score higher than 3 which suggest that all the 3 companies are good for lending as they are not likely to go bankrupt.

StrategyOverview of Pharmaceutical IndustryThe Indian pharmaceutical industry, sized at USD 34 billion (including exports) in 2013-14, has remained on a strong growth trajectory, over the past few years. The industry is marked with high fragmentation and relatively low drug prices, as compared with the regulated markets.The Pharmaceutical companies in India are one of the major exporters in the international markets. So we segment it into the domestic and international markets to better understand critical value drivers.Domestic MarketsThe domestic market is about $10.9 billion (or Rs 660.7 billion) and constituted around 1.1% of the global pharmaceutical market in value terms. This is because of lower drug prices and lesser penetration of healthcare, vis-a-vis developed markets, such as US and Europe. Over 100,000 drugs,across various therapeutic categories, are produced annually in India. The domestic formulations industry is highly fragmented in terms of both, number of manufacturers and variety of products. There are 300-400 organised players and about 15,000 unorganised players. However, organised players dominate the formulations market, in terms of sales. In 2013-14, the top 10 formulations companies accounted for 42.2 per cent of total formulation sales. Share of top 10 MNC pharmaceutical companies has reached close to20 per cent as onMarch 2014. India is primarily a retail-based branded generic market with 80% dispensed through pharmaceutical outlets. By 2020, it is expected that the retail segment will continue to dominate but the consumption in hospital settings will rise to 25-30% of the market share due to growth in medical infrastructure.A growing population, increasing healthcare awareness, and rising per capita income enabled the domestic formulations market to post a 13.3 % CAGR over the lastfive years. Domestic formulation sales grew by 6 % (YoY) in 2013-14. Due to poor sanitation conditions, infectious (acute) diseases are predominant in India. Mass therapies such as anti-infectives and gastrointestinals will continue to grow at a steady pace, due to the increasing penetration of such drugs in rural areas, which lack proper sanitation facilities and are thus more prone to acute ailments.The incidence of chronic ailments, characterised by prolonged exposure, has been increasing with the emergence of lifestyle diseases in India, due to changing work pattern of the working population, higher stress levels, and unhealthy eating habits.

Mckinseys analysis shows that the Indian pharmaceuticals market will grow to USD 55 billion by 2020 driven by a steady increase in affordability and a steep jump in market access. At the projected scale, this market will be comparable to all developed markets other than the US, Japan and China. In terms of volumes, India will be at the top, a close second only to the US market. With the chronic segment growing significantly, domestic industry is expected to generate even higher value growth over the next few years which provide an interesting opportunity for the industry.International MarketsExports, which contribute about 60 % to the Indian pharmaceutical industry, have been the key growth driver for revenues of Indian formulation and bulk drugs players. Over the past few years, Indian pharmaceutical players have been increasingly tapping opportunities in global generics markets, especially the US and Europe. Meanwhile, mid-sized and small-sized players have targeted semi-regulated markets of Africa, Asia and Latin America to enhance their distribution network before exporting to regulated markets. The improving penetration in pharmerging markets is also a huge opportunity where 63% of the expenses are likely to be filed under the head of generic products.For bulk drugs manufacturers, a burgeoning generic market and cost reduction measures by global pharmaceutical companies present a huge opportunity in regulated markets. Backed by cost-competitiveness, well-developed process chemistry skills and the largest number of drug master filings globally, India is well-placed to tap export opportunities in regulated markets. Significant exposure to international markets also exposes these players to risks, such as volatility in currency rates, overall market performance and outsourcing plans of key players in the target destinations, regulatory risketc. In terms of capital expenditure too, large players score over smaller formulation and bulk drugs firms, as the latter have a fewer number of US FDA-approved plants, which significantly reduces their capex requirements but this is well compensated by better realisations for bigger players. Large players, which garner larger proportion of sales from regulated markets, accordingly enjoy better profitability and returns.Recently, there has been increased scrutiny by USFDA. Managing USFDA risk would increase compliance cost but is essential for sustaining growth over longer period of times. The company which can manage the regulatory risk well over next few years would be sitting at a great opportunity as the competition would be limited due to entry barriers in US market and huge set-up cost for USFDA compliant plants. India has 2nd highest number of USFDA compliant plants after USA, hence it is well equipped to take advantage in future.Even after considering the high risks entailed with compliance, US and other regulated markets remain a key area of growth due to the sheer size of the market. With increasing number of drugs going off-patent in the next few years, there is enough opportunity for Indian generic manufacturers to capture market share and grow in their niche segments.

Recent Budget Impact Bringing technical testing of newly developed drugs on human participants, under the services tax gamut, would only have a marginally negative impact. Costs of human clinical trials may rise slightly; however, large pharmaceutical companies, which typically spend 6-8 per cent of revenues on R&D activities, may not see a significant impact on their overall bottom-line. This is because most players are majorly into abbreviated new drug applications (ANDAs), which only require bio-availability and bio-equivalence (BA/BE) studies as opposed to human drug trials The budgetary announcement to create new drug testing laboratories and strengthen 31 existing state labs, is a key policy move, aimed at further supporting state and food regulatory labs. As such, large pharma companies are already making efforts to meet regulatory compliance, both at international and domestic plants, especially in light of the recent US FDA scrutiny. The government move could now possibly usher a more stringent domestic regulatory environment for smaller manufacturers Exempting anti-retroviral drugs from customs and excise duties, under the National Aids Control Programme, is expected to help lower cost of these drugs, used in HIV treatment. However, this is not going to impact Indian manufacturers significantly as these drugs account for less than 1 per cent of the overall pharmaceutical market, estimated at Rs 660 billion as of 2013-14Key Growth DriversRising incomes of the middle class 1. Growing middle class with higher purchasing power Domestic demand will be driven by rising middle class population. Indias population is currently 1.2 billion and is projected to rise to 1.6 billion by 2050 a 45.5% increase. Besides, India has a huge middle class population which has grown rapidly. If the economy continues to grow fast and literacy rates keep rising, around a third of the population (34%) is expected to join the middle class in the near future. The middle class population is rapidly acquiring the purchasing power necessary to afford quality western medicine due to an increase in disposable income. The Indian population spent 7% of its disposable income on healthcare in 2005; this number is expected to nearly double, to 13%, by 2025. By 2020, 34% of Indian population is forecasted to be in the middle class which will further drive demand.2. Changing Lifestyle and disease profileThere is a trending change in the disease profile with the changing lifestyle. Traditionally, the acute disease segment held a significant share of the Indian pharmaceutical market. Due to issues relating to public hygiene and sanitation, this segment will continue to grow at a steady rate especially in semi- urban and rural areas. Due to changes in lifestyle there is an onset of lifestyle related conditions, there is a growth in the chronic diseases segment. India has the largest pool of diabetic patients in the world, with more than 41 million people suffering from the disease. With increase in affluence, life expectancy has risen and the growing size of the Indian geriatric population will be a key driver in the growth of chronic segment.3. Increase in Health Care Insurance Around 80% of Indias healthcare expenditure is financed out of pocket. This limits the propensity of Indians to spend on healthcare, particularly in lower and middle income groups which comprise around 95% of population. The government runs a health insurance scheme called Rashtriya Swasthya Bima Yojna (RSBY) that provides insurance cover for workers. Increased health insurance coverage will benefit generic drug manufacturers by increasing the markets affordability for medicines. 4. Portfolio diversification Besides plain-vanilla oral generics, many large cap Indian pharmaceutical companies are also expanding their capabilities in niche areas like parenterals (injectables), nasal, ophthalmics and trans-dermal delivery systems which offer growth opportunities. While they cover perhaps only 20% of the market, they offer higher margins and limited competition for an extended time, and hence are catalysts for sustainable growth.Investment in drug delivery systems has so far not had a big impact on growth levels, largely because the segment represents a minority share of global pharma sales. However, with blockbuster expiries in oral formulations in regulated markets, increasing emphasis on biologics (most of which are injectables) this missing link in some companies could prove costly for future sustainable growth in generics. The generic market in injectables should increase going forward. The growth in injectables is expected to outpace that in oral preparations as a result of: Increasing emphasis on shift towards specialty segments like oncology, hormones and blood-related disorders Growth in segments like biologics, therapeutic proteins and vaccines, all of which are injectable Limited pricing pressure in injectable generics as against plain-vanilla oralsInjectable oncology patents will start expiring post 2015, just when the opportunity in orals may register a huge decline. The US and EU together account for 90% of the regulated markets in injectables and the US represents nearly half the share in non-biologics injectables. A limited number of players will compete in this market, which should improve margins. Entry barriers are high as the segment involves building a large and complex product portfolio across various therapeutics, based on multiple technology platforms and delivery mechanisms. Recent acquisition of Orchid from Hospira and deals by Pfizer with Aurobindo and Claris LifeSciences indicate scarcity value in injectables. Generic opportunities in smaller share delivery systems like nasal, topical (dermal), otic and ophthalmics are expected to grow. Despite their low numbers in terms of sales, they can offer significant competitive advantage in terms of establishing a niche portfolio. Some of these systems, like nasal sprays, are not new to generics although they have started gaining prominence owing to significant opportunities in generic inhalers. Also the quality of pipeline of top Indian companies is gradually strengthening, comprising of higher Para IV filings, specialty products and niche complex chemistry molecules.

Company AnalysisDr Reddy Laboratories Ltd

Operational Strategy 1) Short Term

Current Ratio has been pretty steady over the last 3 years increasing incrementally. Current Ratio in FY14 stood at 1.96 which means that current assets are high compared to current liabilities. Inventory Management cycle has also been steadily decreasing which is a good sign. Debtors turnover has been high over years. Overall Working Capital Cycle has decreased from 146.9 to 133.1 which indicates company has got better terms with increase in sales and efficient working capital management.

2) Long Term

Fixed Asset Turnover has been high and steady over the past 3 years indicating company has been using the capital efficiently. Interest coverage ratio is higher than 20, indicating their is enough headroom for the company to grow inorganically as well as organically through Greenfield expansion.

Financial Strategy

Company can afford to undertake debt financing for growth and distribute profits as dividends to further improve the return ratios. Currently, the company has high interest coverage ratio and manageable Leverage ratio suggesting good credit worthiness for near term. Dr Reddy Laboratories has shown strong revenue growth over the last decade. Also its capital efficiency (RoCE) and profitability (PAT% to Sales) have steadily improved over the last 5 years. Its business has grown due to its limited competition products maintaining their market share. Therefore it should remain focused on building this steady pipeline of limited competition products which would help them in ensuring base revenue. Its business has grown in other countries like Russia while maintaining consistent growth in OTC business. Pharmerging markets should be an area of focus since it is expected to account for the majority of the absolute growth.

Cipla

Operational Strategy

1) Short term

Current ratio for Cipla is greater than 3. It has come down to 3.32 in FY14 from 3.7 in FY13. It understands that it needs to utilize its assets in a better way. Inventory days is also much higher than it peers and measures have to be taken to reduce it. Overall working capital cycle is fluctuating and has come down to previous levels after a high in FY13. It needs improvement since it is higher than its peers.

2) Long term

A look at the Fixed Asset turnover tells us that Cipla needs improvement on that front as well. It has decreased in Fy14 to less than half of its peers. The company needs to devise a strategy for asset utilization to drive sales growth. Fixed asset investment has to be efficient as this would help in achieveing the desirable long term sustainable growth rate.

Financial Strategy

Cipla has been managing debt well. From zero D/E ratio in FY12 it has been able to control its debt to a very manageable level in Fy14 signifying management focus towards efficient and leverage free based approach to growth. Cipla has significantly increased the gross block through debt financing but the utilisation has not yet reached peak levels. Cipla should wait for normalisation and consolidation of the business before going for next wave of expansion.

Cipla should formulate strategy that revolve around the risks that it could encounter in the future like1. Fluctuations in currency and hurdles due to excessive government regulation2. Implementation of the new drug pricing policy in India

LupinOperational Strategy

1) Short term

Current Ratio has been pretty steady over the last 3 years increasing incrementally. Current Ratio in FY14 stood at 2.92 which means that current assets are high compared to current liabilities. Inventory Management cycle has also been steadily decreasing which is a good sign. Debtors turnover has been high over years. Working Capital cycle has returned to a low level after a high in FY13.

2) Long term

Fixed Asset turnover has increased significantly over the last three years signifying that the company is utilizing its asset well. Net Profit has increased in sync with its sales thereby giving the impression that the company has been able to manage its expenses well over the period.

Financial Strategy

The company has low D/E ratio. Its almost debt free resulting in very high interest coverage ratio with respect to its peers. Lupin can follow a strategy of debt fuelled growth and use leverage to make significant investments in intellectual property such return on capital employed is maintained at the current levels.

Lupin believes it is witnessing a phase of a shift in margin profile. This is due to a shift in product mix and operating leverage. LPC is looking at acquisitions to a) strengthen presence in the US branded space, b) new technology platforms and c) enter new geographies

AppendixDr Reddy Laboratories Ltd

Cipla Ltd

Lupin Ltd

Bibliography

1) www.moneycontrol.com2) www.capitaline.com3) www.equitymaster.com4) http://www.drreddys.com/investors/pdf/annualreport2014.pdf5) http://www.lupinworld.com/pdf/14/Lupin-Annual-Report-2014.pdf6) http://www.cipla.com/getattachment/ba09f62d-ef87-4acf-93b5-442c81adb589/Annual-Report-2013-14.pdf.aspx?ext=.pdf7) www.investopedia.com