Cadila Healthcare: In bad shape - Sell

Cadila Healthcare appears to be in for some rocky times owing to a recent regulatory clampdown and increased competition for its high-margin products in the US market.

In April, the US drug regulator USFDA inspected Cadila’s key formulations plant at Moraiya, Ahmedabad. Post audit, the USFDA issued 14 ‘Form 483’ observations to the company. A few observations, relating to the contamination in the plant’s sterile unit, seem to be severe in nature, which are expected to be a major hurdle for the early clearance of the regulatory issue.

Reacting to this, the shares of Cadila hit a 52-week low over the following weeks. If the 483 observations issued to the Moraiya facility get escalated to a warning letter or an import alert, the stock can slip further. The stock is down 43 per cent from our last ‘Buy’ call in September 2018. While at the current price of ₹229, the stock trades at about 13 times its estimated FY21 earnings — compared with the 18-22 times its peers Biocon, Torrent Pharmaceuticals and Alkem Laboratories trade at — valuations can come under further pressure if there is any adverse development in the regulatory remediation process.

With the prospects of the company’s FY20 earnings looking bleak, investors can book profit and wait for better revenue and earnings visibility before considering the stock.

Muted near-term prospects

The stock has been on the backfoot over the past 9-12 months, despite the company reporting a stable set of numbers. Concerns over increased competition in its recently launched generic drugs in the US and lack of near-term blockbuster products have taken a toll.

The US market has been the key growth driver for Cadila as the region contributes nearly half of the company’s overall revenue. The Moraiya plant is the company’s largest facility, contributing more than 40 per cent to its US sales.

Considering the critical nature of the observations on contamination, the regulatory remediation process may take more than 12 months. This would impact Cadila’s US pipeline, as one-third of the pending US approvals are dependent on the Moraiya facility.

The sales in the recently launched key limited-competition generic drugs in the US — including Lialda, Asacol HD and Levorphanol — are expected to decline as new players are gaining approvals in the respective categories. Currently, these three drugs contribute almost 30-35 per cent of the firm’s US sales.

It is to be noted that when the USFDA had issued a warning letter to the Moraiya facility in December 2015, the company proactively addressed the situation. The plant then received a clear chit from the regulator in June 2017. However, the possibility of a new warning letter being issued to the facility is likely to weigh on the stock in the near term.

Over the past few years, Cadila’s US business has registered a significant growth thanks to niche and limited-competition product launches. Going ahead, there could be a slowdown in the US business as several lucrative products were filed from the Moraiya facility. However, the management expects around 35 new generic drug approvals (ANDA - Abbreviated New Drug Application) and 35-40 launches in FY20 (filed from facilities other than Moraiya). Such approvals should offset the erosion in the base business.

Currently, the cumulative US pipeline consists of 330 filed ANDAs; of these, 144 are pending for final approvals. The management has guided for low single-digit growth in US generics for FY20.

Modest domestic business

Cadila’s domestic formulations business, which contributes 28 per cent to the overall revenue, has also grown moderately by 6 per cent CAGR in the past five years. The company enjoys leadership position in the low-margin acute segments. Further, about one-fourth of Cadila’s domestic products are under the NLEM (National List of Essential Medicines) price control. However, the company is the fourth-largest player in the Indian branded formulation space with 3.9 per cent market share.

The company is in the process of restructuring its domestic portfolio to improve operational efficiency and focus on sales force efforts on large brands and high-growth segments. The firm is focussing to expand its growth in therapeutic areas including gynaecology, respiratory, pain management, cardiovascular, dermatology and gastrointestinal. It has till date discontinued around 158 low-revenue-generating tail-end brands. The company expects these initiatives to improve the margins of the India business, with a recovery in growth expected from FY20 onwards.

Long-term prospects

Near-term challenges aside, the company’s long-term prospects appear healthy, given the possibility of recovery in its domestic business, a growing pipeline in niche biologics and vaccines, traction in wellness business, and some meaningful launches in the US (apart from the Moraiya facility).

Cadila is one of the few companies making an entry into the highly expensive, complex, biosimilar products business. The firm owns a pipeline of 21 biosimilars and six novel biologics. Similarly, it owns 13 vaccines in different stages of development. The biosimilar sales are around ₹250 crore annually, largely from India. The company expects biosimilar sales to reach $200 million; vaccine and biosimilar sales are likely to reach $500 million over the next two years.

Cadila’s Zydus wellness segment, which contributes around 6 per cent to the overall revenue (consolidated), grew 16 per cent in the past five years. The company recently acquired Heinz, and thereby added Glucon-D, Complan, Nycil, and Sampriti ghee to its product basket.

This has helped it expand its existing product basket (Sugar Free, Everyuth, Nutralite) over a larger geographic footprint. However, this acquisition is expected to prop up revenue from only FY21.

Cadila’s R&D expenses remain around 7-8 per cent of its total sales. The company clocked revenues of about ₹13,166 crore and profit of about ₹1,849 crore in 2018-19. Its operating profit margin stood at a healthy 23 per cent during the period.