This post is an application/case study on an Indian business, of the lessons learned from the O’Glove’s wonderful book- Quality of Earnings. This is the third post in the series, where I ruminate and try to apply the lessons in an Indian context. For the first and second post in the ‘Reflections” series, peruse this and this respectively.
If you would like to peruse the lessons from O’Glove’s book, I highly encourage you to read the sister series called “Understanding Quality of Earnings”.
Analyzing Letters to Shareholders: A Tour Through the Letters
The act of interpretation is an intensely personal act. Very silent, very subjective. One man’s surprise is another man’s expectation. Showing the act of “interpretation” in action is a difficult job. Hence any act of “teaching” how to interpret is an exercise fraught with risks and allegations of post-facto justification.
Be that as it may, I will still venture out to read, analyze and subsequently walk you through my conclusions and findings after reading individual letters to shareholders written by Chairmen of different companies. Readers will also blame me for post-facto bias if I attempt to analyze historical annual reports. But readers will have to take my word for granted and have faith in my intellectual honesty here. Any claim seeks evidence, and I will try to justify this. I will upload snapshots of my notes onto this blog to allow judgment of my honesty. Later, I will also try to conduct this tea-leaf reading (I definitely won’t blame you, if this is called so) with the latest annual reports.
Tea Leaf Reading or Method to Madness
Interpreting Letters to Shareholders in a gamut of rules
I have followed three rules in my exercises when perusing these letters. These three rules stem partially from human psychology but mostly from cynicism.
- Management is always wildly optimistic. Do not get sucked into this
- Pay attention to the choice of words and question their use
- Validate each subjective claim with numbers
These three rules will guide you towards an understanding of the industry, in general, the business in specific, but most importantly will help to make an informed guess about the growth rate in the coming years.
Sometimes, and very rarely they can also divulge about strategy. I have not come across them much. An expectation setting is much needed here: – being able to read these letters will not impart some immediate material secret knowledge about the businesses, but they will help an investor in asking the right questions and making informed guesses about a business’s future potential.
A Study in Unichem
The conclusion from reading AR 2013-14: Unichem Laboratories is an Indian generic drug manufacturer with the main focus on bulk drug manufacturing and their formulations. It has a strong R&D presence but focussed primarily on process innovations (attempting to build APIs with an easier and more efficient process “pathways”- yield and purity are important metrics here). Main focus on India, US, EU. Segment wise focusses on Chronic and Acute Therapies.
The following section picks statements from the letters and is immediately followed by my interpretations/questions and my ideas about those statements. I will also upload a snapshot of my notes if you would like a more “real-time” picture.
Excerpts from Letters to Shareholders in AR 2013-14
“last few years have been difficult years for Indian pharma industry”
Slowing growth? Regulatory Challenges (FDA observations)?
“In this environment, our growth rate also has been sluggish. Our prices also has been affected”
I read it as “Don’t diss us for our lackluster growth.” It was surprisingly forthright in my opinion for management to discuss their challenges so openly.
“restructured our domestic formulation business”
Streamlining/Building production efficiency? We should expect a PAT margin improvement?
“Acute therapy segment has begun to show higher growth rate well above the industry average”
Possibly a small area of the overall business. Possibly a low base effect playing in.
“Chronic therapy segment. We expect that in the coming years we will be able to accelerate growth rate there too”
Stagnating market? Efficiency wins will seldom win the growth war(Post-note note: Why did I write this sentence?)
“Our international business has already crossed 40% of our consolidated turnover driven by our consistent push in US market and our contract manufacturing business”
No comments made
“After prolonged and sustained efforts our subsidiaries have begun to turn corner”
You mean, “they have started turning profitable?”. Were they bad acquisitions to start with?
Niche Gen Ltd (UK) has improved its profitability and Unichem Pharmaceuticals (US) has posted a robust sales growth of over 45%
Low base effect?
“To exploit the foundation laid by the US Subsidiary, we are accelerating filings of our ANDAs”
Options of growth for the next 2-3 years?
“I can say with confidence that after a long and patient journey in these international markets we are about to see major turning points”
Too optimistic? A “sense of relief”?
“Several cost reduction & productivity optimization measures”
Boy, the times must be really tough!
“Special interim dividend out of the proceeds of plan sale”
Why pay the dividend, when you are optimistic about growth?
Unichem Laboratories is facing a tough time. Its core warhorse/cash cows/growth engines have slowed down to sputter and the management has gone down to the bunkers to streamline and make things more efficient. It has made multiple claims of “turning corner” and “accelerating growth”, but they largely conflict with the overall tone and tenor of the letter. So it must be concluded that these instances are small entities and have very little effect on the larger financials.
Times are tough!
Unichem Industry indeed faced a very lackluster growth year of 4.7 %, partially inferred by the verbiage of the letter. The restructuring of operations was primarily marked by a sale of its MP plant of bulk manufacturing (reasons unknown) and centralization of all its R&D facilities in a center of excellence in Goa. This will help it to cut overheads by reducing fixed assets. The growth aspect of “Acute” business is overplayed as it is not the main driver of the business, Chronic therapy business is. Among its subsidiaries, only one has turned profitable i.e. Niche Generics Ltd (UK). The growth in its subsidiaries being high is purely optics as it indeed is a growth from a low base.
Excerpts from Letters to Shareholders in AR 2014-15
“Unichem focusses on improving the quality of medicines available, and to make the medicine available to a large section of society at reasonable prices”
Boy, O Boy, are you in the crosshairs of “regulators”? Are you fending off, serious attention of sub-par quality medicines/ production during this time? Or is it because you have made peace with the government’s populist policies of medicine price control?
“… we had realigned our acute business and this led to acute business showing consistent growth”
“consistent growth” term is a stretch. It has shown growth only beginning last year after restructuring/streamlining and also contributes about 41% to the business.
“Similar realignment to our chronic divisions- CNS have started showing encouraging results”
Read it as: “be patient”: our efforts will bear fruit in the coming years. This was not done as easily as acute business perhaps because it is more complex and widespread than acute business.
“In the last leg, we have undertaken this similar exercise in our cardiac divisions”
Why are divisions being taken up one at a time? A hint of complexity?
“I am happy to share with you that our performance in the key market of U.S. remains robust, where we have reported over 100% growth in topline”
(This bit is an apriori knowledge, gleaned from reading previous years AR) Low Base Effect!
“We continue to invest significant portion of R&D for the regulated markets, especially U.S”
Why? What kind of R&D? Is it a red queen effect?
Belief in “Quality & Reliability”, “…right side of stringent regulatory audits”
Read it as “don’t be afraid dear shareholders, your company will not face FDA censure”.Around this time, there must have been a lot of license cancellations in the industry
“4 manufacturing plants which have various accreditations including USFDA… extremely happy to share 3 plants were recently inspected by USFDA and …. no critical observations”
Further placating and assuaging shareholders.
“We expect more and more molecules and their combinations to come under price control in the near future as the government has made its objective clear by stating that more chronic/ lifestyle diseases drugs, antibiotics, etc., may come under the price control net.”
Posted right at the fag end of the letter. This is a serious development and very adverse news for the shareholders. If I am an analyst, this will force me to revisit, revise and re-align my growth forecasts for the India formulations business.
Alternatively, if I am a strategy guy, I will have to develop a completely new strategy to generate growth.
“Aggressive capex program covering all areas of businesses like formulation & API”
Increasing expenses generally is a positive sign, but the question is, what is the growth strategy on which the management is betting? Is it the US push that the management is still betting on? All actions point to that.
Some further quotable quotes from Management Discussion & Analysis
“In the International business, regulated markets like the US remain the key focus areas for your Company as it searches for its next leg of growth. The growth so far in the USA region has been significant.”
Your Company’s strategy is to scale-up operations for sustained growth over time. The revenue from the US market showed a robust growth of over 100%
as compared to the previous year. Going forward, we expect this business to grow at a robust pace despite bleak approval outlook.
The business is facing severe constraints on growth. On one hand, the Indian side of the business is seeing price controls and subdued growth, on the other hand, there is a renewed focus of FDA authorities on India based production plants. Post selling of the previous bulk manufacturing plant and acquisition of the new plant in Kolhapur (not mentioned here, but mentioned in the AR), the management is trying to make a renewed and last-ditch push to break into American subcontinent.
There are some very fine points made in the annual reports of 2015-16 and 2016-17 in the Letters to the Shareholders section as well as Management Discussion and Analysis. I happened to read through them and pleasantly I must say, I wasn’t surprised to see the management decide the actions that it decided in FY 2017-18.
The Status 3 years down the lane: FY 18
- Unichem sold its India business to Torrent Pharmaceuticals along with all the formulations, people, assets, production lines etc.
- It retained the right to market its formulations in off-shore geographies
- It also generated some revenue by in-licensing other formulations in India business. How much this will continue post-sale, is hard to decide but a reasonable guess will be zero.
- The management renewed its push in U.S markets and in the process incurring some losses after the sale of its Indian business, which took the lion’s share of its revenues.
Keys to Valuation
The growth profile of this business will have to be modelled like any new business, with a “portfolio” of real options. Its profit and revenue pattern will also behave like one, where its “accounting profits” will be negative for some time (a few years at least), as it tries to set up its business by making high investments.
Its revenues will see high growth (J-shaped). Shareholders and management should start building the expectation of dividend being cut down to zero. We can have either growth or income.
Some Further Notes for Valuation
Owing to my myopic nature of reading annual reports with an outsized focus on determining the valuation assumptions, I found that an analyst trying to value this company will not have to make many quality adjustments.
The accounting quality looks good(save for one item line), reporting quality feels high and communication quality feels assuring.
A good accounting quality helps us in predicting our line items with a higher degree of confidence. A higher reporting quality helps us build and test our valuation models with a higher degree of confidence. Finally, the communication quality helps us in setting expectations about growth and future strategy, which in turn helps us to form expectations about the balance sheet.
The Snapshots of My Notes are here:
Tomorrow, we will be analyzing the annual reports of Mindtree for the years from 2014 to 2018. The second part of the series is here.