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InterMarket Pulse

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18 June 2019

Pakistan Pharmaceuticals

SEARL: Negatives are in the price but growth is uncertain; Neutral

We resume coverage on SEARL with a Neutral rating and a Jun’20 TP of PKR188/sh.

Key changes include (i) lower sustainable volumetric growth at c. 12% (ii) higher API costs driven by sharp 11% PKR devaluation (Dec’18-to-date), (iii) price reversal on hardship cases, (iv) proposed changes to tax regime in Budget 2020 and (v) revised valuation assumptions.

While the sharp PKR devaluation should feed into inflation and may help support prices, this may not be enough to completely offset the impact of higher raw material costs, in our view. That said, some catalysts may support our growth outlook on the stock (e.g. SEARL has issued a notice today to potentially acquire OBS Pakistan Ltd).

SEARL has corrected 43% from its 12M high where further derating seems unlikely (FY20f P/E: 12.1x). Historically trading c. 2x of the broader market PE, we do not foresee the return of cyclical troughs for the pharma sector (PE of 10x in CY10-12 during price freeze). We remain Neutral on SEARL, as the acquisition of OBS Pakistan is still in feasibility stage and may take some time to materialize, if at all.

Several recent negatives incorporated- Neutral We resume coverage on SEARL with a Jun’20 TP of PKR188/sh, where our FY19/20f EPS expectations are PKR11.97/13.63 (down 16% from previous estimates). Bulk of the revision in earnings estimates comes on the back of (i) lower volumetric growth (FY19-23f: c. 12% vs. 16% earlier) accompanied with a 10% flat price hike (for drugs other than hardship), (ii) higher API costs driven by sharp 11% PKR devaluation (Dec’18-to-date), (iii) price reversal on some hardship cases, (iv) changes to tax regime for drugs imported in finished form in Federal Budget FY20 and (iv) changes to valuation including: TP rollover to Jun’20, higher Risk-free rate of 12% (from 11%) and a lower FY20f target P/E of 15x.

Slower volume growth may be partially offset by recent price hikes We lower our volumetric growth assumption for SEARL (FY19-23f: c. 12%) as guided by the management. This is much lower than historical average of 15%+. However, the difference is likely to be partly compensated by (i) recent price hikes (15% on drugs other than hardship cases) and (ii) upcoming CPI linked price hike in Jul’19, where SEARL’s revenue is expected to grow at a 20% 5-yr CAGR (vs. 25% previously). Moreover, confidence associated with the SEARL brand should help limit fallout on volumes, in our view (notwithstanding sentiments on product recall of Extor batches). SEARL has also reversed prices for some of its hardship case drugs (notice issued in Jan’19) however; we have not taken the full impact in our valuations, as some cases are sub judice. Therefore, we expect revenue growth to accelerate from 13% in FY19f to 19%yoy in FY20f. It is pertinent to mention that SEARL is now the 3rd largest pharmaceutical company in Pakistan by volume and 5th largest by value (please refer to charts on pg. 2).

Margins to see some pressure The PKR has devalued 32% since Dec’17, while further devaluation in the upcoming months may cannot be ruled out. Most pharmaceuticals had budgeted 150-160 to the dollar for raw material sourcing for 2019 and therefore margins for the sector have trimmed by 3-4ppt yoy so far in FY19f. With 2-3month inventory on hand, we expect impact of higher API costs to come with a lag. Recent allowance of 15% price hike on drugs (other than hardship cases) should however, help limit this to a great extent. We have conservatively assumed 10% pass on of this price hike by SEARL. While PKR devaluation should cause a spike in the upcoming CPI readings; this, in our view, is not enough to entirely offset the higher API costs. As a result, we see SEARL posting gross margins of 49%/47% in FY19/20f down from 49% earlier. Going forward, we expect margins to settle in the 46%-47% range.

The Searle Company Limited Price (PKR/sh) 165.54

TP (PKR/sh) 188.50 Stance Neutral

Upside 13.9%

Fwd D/Y 3.0% Total Return 16.9%

Bloomberg / Reuters SEARL PA / SEAR.KA

Mkt Cap (US$mn) 252.5 52wk Hi-Low (PKR/sh) 301.04/123.29

6m Avg. D. Vol ('000 shrs) 742

6m Avg. Td Val (US$mn) 1.09

Key Ratios FY17A FY18A FY19F FY20F FY21F

EPS (PKR) 11.09 12.65 11.97 13.63 14.93

EPS Gth (%) 14.1% 14.1% -5.4% 13.9% 9.5% PER (x) 14.93 13.09 13.83 12.14 11.09

DPS (PKR) 7.24 4.35 4.00 5.00 5.00

DY (%) 4.4% 2.6% 2.4% 3.0% 3.0% PBV (x) 3.78 3.26 2.96 2.67 2.39

ROE (%) 28% 27% 22% 23% 23%

P/S (x) 2.64 2.14 1.89 1.59 1.32 Source: IMS Research

Margins may drop further before normalizing

Source: IMS Research

5-year sales CAGR projected at 20%

Source: IMS Research

10%

12%

14%

16%

18%

20%

40%

42%

44%

46%

48%

50%

52%

54%

FY1

6

FY1

7

FY1

8

FY1

9

FY2

0f

FY2

1f

FY2

2f

FY2

3f

Net Margin - Rhs Gross Margin

0%

5%

10%

15%

20%

25%

-10%

10%

30%

50%

FY1

6

FY1

7

FY1

8

FY1

9f

FY2

0f

FY2

1f

FY2

2f

FY2

3f

Npat growth (%)-Lhs Sales growth (%)

Inflection point

Yusra Beg yusra.beg@imsecurities.com.pk 92-21-111-467-000 Ext: 305

Market Pulse

Budgetary changes may lead to higher taxation It has been proposed in the FY20 Federal Budget to reduce tax collection on pharmaceutical products imported in finished form, from 5.5% to 4.0%, if such goods are not manufactured in Pakistan as certified by DRAP. However, the rule has been altered to introduce this as minimum tax on the product to the extent that taxable income on these goods should be higher of 4% of import value or annual corporate tax rate applicable on PBT of those goods. This would imply a move towards minimum tax from final tax (at import stage previously) on the trading business. Historically, the difference between the import cost (less 5.5% tax) was much smaller than actual sale price, resulting in profits disproportionate to those being taxed otherwise. This move should help narrow that gap and is likely to impact players which run large trading businesses (Hep-C, anti-cancer drugs etc.). Currently, SEARL has c. 6% of sales which arise from trading which should raise SEARL’s effective tax rate by 1.5-2ppt per annum, in our view. We have incorporated this in our financial model.

Valuation assumptions revised Following the sharp 150bps rise in Discount Rate to 12.75% in the May’19 Monetary Policy (up 650bps since Dec’17), we raise our risk-free rate assumption by 1ppt to 12% and roll over our target price to June 2020. We have also reduced our Target PE multiple to 15x from 22x previously, given the KSE 100 forward. PE (for IMS Universe) has de-rated from 10.9x in 2017 to 6.6x now. Pakistan’s pharma sector has historically traded 2x of the market PE multiple over the last 10 years, with the exception of CY10-12, during which time a pricing moratorium was imposed on pharmaceuticals. We use a blended valuation for SEARL, where we have assigned equal weightage to PE and DCF. SEARL has corrected 43% from its 12M high, where further derating seems unlikely, particularly following today’s notification by SEARL to potentially acquire OBS Pakistan Ltd. However, we maintain our Neutral rating on SEARL, given this potential acquisition deal is still in early stages.

Pakistan pharmaceuticals trades at 2.0x of the market’ PE multiple

Source: IMS Research

0

5

10

15

20

25

30

CY0

8

CY0

9

CY1

0

CY1

1

CY1

2

CY1

3

CY1

4

CY1

5

CY1

6

CY1

7

CY1

8

CY1

9f

(x)

Pharma Sector Avg P/E KSE 100 Avg PE (Universe avg)

SEARL’s trades at a 34% discount to its previous 5yr PE

Source: IMS Research

SAPL, 14.63

HINOON, 8.97

SEARL, 13.83

AGP, 12.03

GLAXO, 19.03

ABOT, 40.13

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

20

19

F P

E (x

)

SEARL is now the 3rd largest by volumes…

Source: SEARL Investor briefing 2019

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

Barret

Atco

Bosch

GSKCH

Getz

Martin

Sami

SEARL

ABOT

GLAXO

Market Share- Volume wise

…and 5th largest by value

Source: SEARL Investor briefing 2019

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0%

SAPL

Obs

Hilton

High-Q

Martin

SEARL

Sami

ABOT

Getz

GLAXO

Market Share- Value wise

Market Pulse

SEARL is looking to acquire OBS Pakistan (Private) Ltd. SEARL issued a notification today that it is looking to indirectly/directly acquire OBS Pakistan (Private) Ltd. (formerly known as

MSD- Merck Sharp and Dohme Pakistan Ltd). OBS Pakistan is a subsidiary of OBS Group (9th largest pharma company in Pakistan by value) and is one of Pakistan’s leading corporations in the healthcare segment with a strong presence in Pakistan and Sri Lanka. The stake sale, by OBS Group, is aligned with the group’s restructuring strategy, having recently sold its holding in AGP

Pharmaceutical to AitkenStuart Pakistan (Private) Limited. It was previously intimated by SEARL’s management, that Mr. Munis Abdullah, who is part of the IBL Group (parent company of SEARL), was reportedly in advanced talks with OBS Group to acquire assets of OBS Pakistan unit, (including a Karachi manufacturing facility and portfolio of drug rights) via privately-owned firm Luna

Pakistan. Now following today’s notice, we understand that SEARL may be interested in acquiring these assets. However, given this acquisition is still in early stages, we will await further details before incorporating into our estimates.

Manufacturing rights for Reckitt Benckiser can also move the needle

SEARL has recently acquired distribution and marketing rights for several flagship brands of Reckitt Benckiser (Gaviscon, Disprin, Bonjela etc.). These are strong household names and should, initially, give a boost to sales. This builds upon the relationship SEARL has fostered with Reckitt via trading of its infant milk and GUMP brands -Enfamil and Enfagrow (Mead Johnson). To recall,

Reckitt (Global) acquired Mead Johnson Nutrition Company in Jun’17. While this should initially give a boost to sales by PKR1-2bn p.a., management expects manufacturing rights to be acquired soon, which should result in toll manufacturing fee and visibly improve earnings, in our view. Lastly, US FDA approval of Nextar Pharmaceuticals (70% owned subsidiary) will likely take another

two years. Management intimated that all activities at the plant are being monitored by the FDA. The Nextar plant is a biotech API manufacturing facility.

Price reversal on legacy brands is a key downside risk

SEARL is currently negotiating with DRAP on four key brands in its portfolio (Hydryllin, Gravinate, Peditral, Metodine) regarding a price hike taken in 2012 which has been asked to be reversed by officials in the Health Ministry. SEARL has managed to obtain a stay order and the matter is currently being contested in the Appellate Court of Pakistan. Management seems hopeful to win the

case, if not in the Appellate court then the High Court. We highlight this as a key downside risk to our investment thesis.

Market Pulse

I, Yusra Beg, certify that the views expressed in the report reflect my personal views about the subject securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly,

related to the specific recommendations made in this report. I further certify that I do not have any beneficial holding of the specific securities that I have recommendations on in this report.

Ratings Guide* Upside

Buy More than 15%

Neutral Between 0% - 15%

Sell Below 0%

*Based on 12 month horizon unless stated otherwise in the report. Upside is the percentage difference between the Target Price and Market Price.

Valuation Methodology: We use multiple valuation methodologies in arriving at a Target Price including, but not limited to, Discounted Cash Flow (DCF), Dividend Discount Model (DDM) and

relative multiples based valuations.

Risks: (i) Further PKR devaluation over PKR160 for CY19, (ii) price reversals on ongoing pending cases, (iii) lower than expected volumetric growth and (iv) delay in expansion projects.

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