The shape of things

What Sun’s buy of Ranbaxy foretells about the the pharma industry and M&As

By Mohan Sule

The acquisition of Ranbaxy Laboratories by Sun Pharma is another milestone on Deal Street. On the surface, it is seen as a vindication of the trend of fluidity in the pharmaceutical sector. In no other indsutry is there such mobility of companies and uncertainty about future earning. Giants have beaten hasty retreats and small players scaled up to large caps. MNCs have sold off to local investors as well as snapped up promising outfits. No one symbolizes this flux better than the Ajay Piramal group, which bought Indian as well as foreign drug producers and in 2010 divested its branded generics domestic business in favor of a large global producer at bumper valuation of 10 times sales. Copycat producers pushing prices down, the wait for regulatory approvals and changes in government policies keep the industry on the edge. For all the unpredictability, the market has welcomed the Sun-Ranbaxy merger for three reasons. First, promoter Dilip Shanghavi has the tenacity to make his purchases pay off. The battle to control struggling Taro was long-drawn. Despite the Israeli pharma maker’s minority shareholders foiling a merger with Sun, the acquisition is a jewel in Shanghavi’s crown: He added a producer with significant global presence to his portfolio and also lured its CEO to manage the group going global. Second, there was no cash outflow. The share-swap makes Ranbaxy’s owner Daiichi the second largest shareholder of Sun. This has raised concern about future flexibility of the group. But that is a small price to pay to conserve cash, which will be needed to revamp Ranbaxy’s manufacturing processes and to take care of liabilities arising from the US FDA’s crackdown going forward.

Third, Sun’s product portfolio will expand. It can leverage its leadership position in certain niches to position itself as a producer of generics accross spectrum, boosting bulk buying by healthcare giants. In fact, the presence of Daiichi could be taken as a confirmation of the continuing potential of Indian generics, which in the first place prompted the Japanese global maker to snap up Ranbaxy in 2008. This is in contrast to the pessimism about the local industry’s health due to its conversion into a low-margin business because of pricing controls, pushing it to seek outsourcing and exports. The deal is also notable for confirming certain assumptions as well as exploding myths about takeovers. First, companies with global ambitions require footprints in markets across the board. This includes presence in different geographics as well as in a range of products. The US market may consume drugs to counter lifestyle diseases, while the emerging markets need to thwart life-threatening ailments. Besides, patents are going off at a faster pace than new drugs being discovered. This makes the generics market crowded and cost-effective players have a better chance of survival. Second, at two times revenue, the buy was at the lowest valuation in the pharma space, signalling that the industry’s margin might have peaked, even after discounting the seller’s immediate problems, which are repairable in the short to medium term.

Third, the merger throws a light on the blurring of the caste system in the Indian drug industry. During the pre-reform era of controlled capacity and pricing, entrepreneurs could enter the segment by obtaining licences of big players on loan. Now small-scale players are getting back by concentrating on overseas markets and competing in the trading ring with older and established players. For instance, the shift in focus of Ranbaxy from being a local leader to a significant player in the US market. Thus, the deal confirms that Indian players have to look overseas to grow. The downside is the turning of the spotlight on quality issues at production facilities. Fourth, the conventional investing wisdom of ignoring distressed companies in favor of those making profit has been turned on its head as predators would prefer cheap buys rather than load their balance sheet with debt. The fifth lesson is that a brute controlling stake such as over 60% held by Daiichi in Ranbaxy need not be a barrier to change in management control. Instead of exiting through an open offer, minority shareholders of the target company would want to be part of a growth story. But if innovative financial engineering can be a boon it can also be a bane. Piramal Healthcare received cash from the sale of the generics business and later announced a 300% special dividend. But the ordinary shareholders were left with a company devoid of a divison contributing nearly 70% of revenue. Last, concern of dilution of equity (Sun’s by nearly 14%) can be addressed by the earning potential of the target’s (Ranbaxy’s) basket of products. The Sun-Ranbaxy merger, thus, could be a trigger for more cashless consolidation.