Is Aurobindo A Value Trap?

Aurobindo has corporate governance issues such as inferior financial reporting, less than ideal disclosures and taxation issues relating to promoters. Moreover, the company also faces structural issues around absence of ‘moated’ revenue/profit streams and long-term growth drivers. Also, it faces potential revenue/margin erosion as incumbents return and regain market share post FY18 through competitive pricing in complex injectables, controlled substances and cephalosporin. 

Accounting quality  

Low cash flow generation and high loans and advances as a percentage of net worth Corporate governance  Opaque tie-ups with relatively unknown companies  Capital allocation   Vertical integration and improvement in product mix is a positive; gross block turnover in line with peers.

IBAS  

Lack of investment in innovation and no moats around its business; revenues exposed to return of competition Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on. Accounting quality – Poor cash flow generation Aurobindo has poor cash flow generation (CFO/EBITDA of 56% vs peer average of 85%) led by an extended working capital cycle (93 days vs peer average of 65 days).

Its accounting practices have raised issues before, leading to undisclosed income of `300mn during raids by income tax authorities in 2012 (click here).  Capital allocation – Improvement in product mix and vertical integration Aurobindo moved up the value chain from an API manufacturer to a formulation manufacturer. Its acquisition track record is yet to be established; though the Actavis acquisition looks promising, we would wait before giving too much credit as pharma companies have struggled with profitability in Western Europe. Corporate governance – Distribution agreement impairs upsides Mr. Nithyanand Reddy (Chairman, ex-MD) appears to be a connected person.

Aurobindo Pharma was named in a charge-sheet filed on a disproportionate asset case for which court proceedings are underway. Also, Aurobindo’s distribution agreement with Citron Pharma and Celon Labs for the US market is opaque and impairs upsides from product-specific opportunities.  IBAS – Lack of spending on innovation; no moats in its business  Aurobindo incurs 4.4% of R&D as a percentage of sales vs peer average of 6.3%. 

Out of these, some/none of the investments are longer-term growth drivers like NCEs, biosimilars and NDDS-based products. Also, the company has a limited presence in the branded business (moats), which provides sustainable revenue as compared to the lumpy business from US generics.  Expect discount to front-line peers to expand as earnings growth abates Aurobindo’s earnings deserve a lower multiple vs peers due to corporate governance issues and lack of moats. 

Valuations of 16.3x FY17E EPS are expensive vs being optically cheap and may begin to de-rate, as incumbents return to the US, and revenue/margins/RoCE starts declining from FY18E