By Geetanjali Kedia

Laurus Labs is entering the primary market on Tuesday 6th December 2016, to raise upto Rs. 300 crore via fresh issue of equity shares of Rs. 10 each and an offer for sale (OFS) of upto 2.41 crore equity shares by PE investors, both in the price band of Rs. 426 to Rs. 428 per share. At the upper end, issue represents 29.42% of the post issue paid-up share capital and will raise Rs. 1,332 crore, of which, OFS portion is Rs. 1,032 crore. Issue closes on Thursday, 8th December.

Laurus Labs manufactures active pharmaceutical ingredients (APIs), which account for ~90% of revenue, finished dosage formulations, synthesis (contract development and manufacturing services) and specialty ingredients used in nutraceutical/cosmeceutical sector. 61% of APIs serve the therapeutic area of anti-retrovirals (ARV), others key areas being Hepatitis C and onclogy. Thus, product concentration risk is high. In addition, client concentration is also high, as top five customers - Aspen Pharmacare, Aurobindo Pharma, Mylan Laboratories, Natco Pharma and Strides Shasun - contributed nearly 59% of H1FY17 income.

Company has strong R&D focus, having spent 5.6% of H1FY17 revenue on R&D and employing 24% of its over 2,500 employees at 2 R&D centers, located in Hyderabad and US. As of 30-9-16, company owned 34 patents and had 152 patent applications pending. It has 5 manufacturing facilities at Visakhapatnam and Hyderabad, 2 of which are USFDA approved and 3^rd undergoing inspection. 4^th and 5^th facilities have been acquired in June 2016 (pursuant to 73% stake purchase in Sriam Labs for Rs. 21 crore, 27% stake held previously). Company is establishing 2 additional facilities, one for potent APIs (to commence operations in FY16) and other for APIs and intermediates (to commence operations in FY17).

FY16 consolidated revenue rose 35% YoY Rs. 1,784 crore, of which, exports constituted a third. EBITDA rose 62% YoY in FY16 to Rs. 380 crore (EBITDA margin expanding to 21.3%) as material costs as a percentage to sales declined 590 bps from 62.4% in FY15 to 56.5% in FY16. In the past too, material costs have swung very widely – FY13 material costs stood at 57.4% of sales, which shot up to 62.6% in FY14. In a span of 4 years, company’s material costs have swayed between 56% to 63% of sales - such wild swings are quite unheard of in the pharma business and surprising they were not passed on!

Thus, FY16 show sharp growth on account of FY15’s low base / poor show. FY15 PAT margin dropped to a low of 5.2% (down from FY14’s 8.4%) which moved higher in FY16, to 7.4%, on PAT of Rs. 133 crore. FY16 diluted EPS stood at Rs. 13.48. For H1FY17, company achieved consolidated revenue of Rs. 930 crore, EBITDA of Rs. 209 crore and PAT of Rs. 75 crore, translating into diluted EPS of Rs. 7.59, on equity of Rs. 98.75 crore, adjusted for 3:1 bonus issue made in July 2016.

As of 30-9-16, consolidated networth was Rs. 929 crore and total debt at Rs. 1,127 crore. Excluding cash and equivalents of Rs. 14 crore, net debt to equity ratio is 1.2:1, which will contract to 0.7:1 post IPO, as close to Rs. 225 crore from fresh issue proceeds will go towards debt repayment, while balance will be used for general corporate purposes.

Promoters held 32.82% stake as on date of RHP, which will reduce to 30.64% post IPO. Company has 3 investors – Warburg Pincus’s Bluewater, FIL Capital Management (erstwhile Fidelity Growth Partners) and Aptuit - collectively holding 58.14% stake, and all 3 are participating in the OFS. While Aptuit (invested since 2010) is exiting completely, other 2 are making a partial exit, and will continue to hold 31.42% stake in company, post IPO.

At the upper end of the price band of Rs. 428, Laurus will have a market cap of Rs. 4,526 crore and EV Rs. 5,415 crore, which translates into EV/EBITDA multiple of 14.3x and 13.0x for FY16 and FY17E respectively. On PE multiple basis, the IPO is demanding valuation of 32x for FY16 and 27x on estimated FY17 EPS of Rs. 15.7. These multiples are quite stretched, considering company’s current financial position as well as somber mood of the secondary markets. It seems that the IPO is factoring in 2 year forward prospects at current discount multiples!

In the RHP, company has compared itself with Aurobindo and Divi’s. Aurobindo Pharma, having market cap of 42,000 crore, annual topline of Rs. 15,000 crore plus, stronger net margins of 15%, diversified product profile spread over 7 therapeutic areas and 21 manufacturing facilities, is currently trading at PE multiple of 18x, on FY17E earnings. Divis’s Labs, with market cap of Rs. 30,000 crore and annual topline of 4,000 crore, clocking high net margins of close to 30% and debt free status, is trading at PE multiple of 27x, on FY17E. Thus, these peers are not only larger in size but also stronger in earnings which can justifying their high valuation multiple.

Since Laurus has a very high share of APIs, its net margins are very low (have been 8% or lower in past 5 years). Once formulations business, in which close to Rs. 300 crore has been invested, picks up, margins may expand, but that is still a few quarters away. Besides high product risk (90% revenue from API), single therapeutic focus (over 50% from ARVs) and high client concentration, on such a large base (Rs. 2,000 crore topline), debt levels of Rs. 900 crore post repayment is also not small.

API maker Aarti Drugs, with annual topline of Rs. 1,250 crore, net margins similar to Laurus with high debt (debt equity ratio of 1:1) and 63% promoter holding is trading at PE multiple of 23 times, based on annualised H1FY17 earnings). Thus, at PE of 27x, valuation of Laurus is atleast 15-20% higher. On the contrary, being a primary market offering, some money needs to be left on the table, to incentivize prospective investors, which is clearly absent in this issue.

On macro front too, things are not looking too hunky dory – existing bluechips and fancied mid-caps are ruling anywhere between 20-25% lower from their monthly highs, and pharma space in particular is completely out of flavor - despite robust earnings. Adding fuel to the fire, neither is the IPO market booming - grey market activity is very low, Greensignal Bio IPO was called off, Sheela Foam IPO saw retail portion remaining undersubscribed (0.44x) while recent listings Varun Beverages, HPL Electric and ICICI Prudential Life are ruling below issue price. 

In a nutshell, single digit margins, client and product concentration risk, rich valuations, dull secondary market conditions may lead to muted demand to the issue. Thus, the IPO is an avoid, despite growth and experienced management / marque investors. 

Disclosure: No Interest.