Lupin Limited (OTC:LUPNY) recently reported a disappointing set of 3Q FY20 numbers – sales declined 2.8% YoY to INR 37.2 billion, EBITDA margin contracted 480 bps YoY to 14.1% and net loss from continuing operations widened to INR 8.6 billion (after a one-off loss of INR 2.9 billion from the impairment of the Gavis portfolio and the divestiture of Japan generics business Kyowa, as well as the related tax charge of INR 7 billion) from a net loss of INR 1.6 billion in the year-ago comparable period.

Going forward, I believe the ramp-up of Levothyroxine and launch of Albuterol in 1H FY21 in the US, coupled with a possible clearance of the manufacturing sites under observation to allow for several product launches, will be the key margin drivers. Nonetheless, it is still some time until a few operational positives can be seen for the company, and I would rather stay on the sidelines for the near-term.

A Closer Look at the Results

Earnings: 3Q FY20 sales from continuing operations came in at INR 37.2 billion, down 2.8% YoY (up 1.1% QoQ). North America continued to be the company’s largest market with sales of INR 13.8 billion, down 2.9% YoY (up 4% QoQ) and accounting for 37% of total sales, while sales from the Indian formulations were INR 13 billion, up 9% YoY, accounting for 35% of total sales. India’s branded formulation sales grew by 10.6% YoY.

Source: Company Presentation

Profitability: EBITDA decreased 27.6% YoY to INR 5.2 billion, representing a margin of 14.1%, down 480 bps from 3Q FY19. Management indicated that the EBITDA number was impacted by higher sales promotion expenses, higher R&D investments (INR 4.2 billion or 11.5% of sales), and remediation spend to resolve the 5 USFDA Warning Letter/OAI affected plants in the network. For the full FY20, management expects EBITDA margin to come at the lower end of 18%-20%, certainly implying that adverse business mix – limited traction of key products like Solosec, Levothyroxine – and other factors affecting operations are also in play and weighing on the profitability and indicates 4Q 2020 to be soft as well.

Source: Company Presentation

From FY21, management aspires to improve margins by ~100-150 bps and expects India business growth initiatives, a meaningful contribution from US specialty products pipeline and savings from cost optimization to drive the margin improvement, though R&D expenditures are likely to continue at current run rates.

Exceptional items: Exceptional losses for the quarter stood at INR 2.9 billion (lower than the INR 3.4 billion exceptional loss in 3Q FY19) and pertained to pre-tax impairment of INR 15.8 billion million related to changes in the pipeline value of Gavis portfolio in the US due to slower ramp-up, offset partially by one-time pre-tax gain of INR 12.9 billion on divestment of the company’s entire stake in Kyowa Pharmaceutical, Japan. Net additional tax burden as a result of the one-time items was INR 7 billion during the quarter.

Source: Company Presentation

Update on standing on the compliance front: Management indicated they are not satisfied with regard to their standing on the compliance front. As such, they have strengthened the quality management team with addition of heads of compliance and investigation and plan on carrying out deep quality transformation across all the manufacturing facilities and have started with the Indore facility (good progress is seen) which is scheduled to be completed by March 2020, and expect the transformation program to start at the Goa facility in the mid of February 2020. Work is ongoing on remediation measures at the Goa and Somerset sites and is expected to take 2-3 months, after which the company plans to invite the USFDA for re-inspection. Increased regulatory issues are not expected to impact much and become company-wide problems by the management, as the opportunity loss due to regulatory issues is around $40-$50 million per year over the past two years.

Update on the pipeline: During 3Q FY20, Lupin received USFDA approval for 4 ANDAs and has 152 ANDAs pending review in the US. Over 15 product launches in the US are anticipated in FY21, without assuming any clearance of the adversely impacted sites. In case Lupin manages to get clearance for Goa and Somerset facilities, management seems confident of launching 30 new products in the US in the next fiscal year. Additionally, few FTF opportunities from Somerset are also expected over the next few years.

Regarding Levothyroxine, management indicated that they got approval against all RLDs in November 2019 and should see a ramp-up in 4Q FY20. With regard to Solosec, the initial response to the redesigned sales promotion strategy has been positive. The other possible launches to drive the US business include inhalation products (gAlbuterol expected approval in 1HFY21), biosimilars (pegfilgrastim), and Lupin’s first injectable (gSpiriva in FY22). Management also indicated ramp-up in Gavis’ GI product portfolio and development of the controlled substances portfolio.

Execution in the US is a key for accretion to earnings: Despite the marginal ramp-up of Levothyroxine in the quarter, the initial positive response to Solosec (+48% QoQ) and the market share gains, revenue growth from the US was flattish sequentially during 3Q FY20. A significant ramp-up and share gain are expected from Levothyroxine in 4Q FY20 (full impact is expected in FY21) and, along with the likely approval and launch of Albuterol in 1H FY21, will be one of the two key products driving Lupin’s performance in FY21. Further, as the management indicated, the launch of over 15 products (even without clearance of Goa and Somerset sites) should be able to support Lupin’s base business in FY21.

Source: Company Presentation

I assume that the ramp-up of Levothyroxine and launch of Albuterol should add ~$85-$90 million in incremental revenue in FY21, and improve margin by ~200 bps (ex-licensing income), with any delay in the approval or launch of Albuterol being a key risk to my estimates. Further, I believe the expansion of women’s health portfolio (in addition to Solosec) will likely be another key margin driver but is highly unlikely in the near-term.

Likely Near-Term Pressure on Operational Weakness amid Regulatory Challenges

Owing to the regulatory challenges at its manufacturing sites, there is a potential cap on the number of products Lupin can target launching in FY21. I believe Lupin’s management has to execute well on its quality transformation program to make sure the sites under regulatory observation are cleared by the USFDA in the next round of inspection, in addition to ramping up Levothyroxine sales in the US, and getting the gProAir inhaler (Albuterol) approved in the US and bEnbrel launched in Europe, to expect any recovery in margins.

Due to the overall sector de-rating amid regulatory challenges and Lupin’s company-specific regulatory setback at manufacturing sites and operationally weak results, I value the company at a significant 25% discount to its six-year historical average PE multiple of 28.4x. The company’s stock has already witnessed ~4% decline since the announcement of 3Q FY20 results, and any further observation from the USFDA or the failure on the part of management to execute on the transformation program or the product ramp-up/launches in the US will add further pressure on the stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2020-02-16