Ranbaxy ban: Outsourcing an option, negative EBIDTA seen

Chirag Talati, pharma analyst at Espirito Santo Securities adds with outsourcing vendors coming into the picture, Ranbaxy will have to give up a big slug of its profit.

Talati and Pal advise investors to stay away from the stock in near term.

Below is the verbatim transcript of Surajit Pal and Chirag Talati's  interview with Sonia Shenoy and Latha Venkatesh on CNBC-TV18.

Latha: First thoughts, do you think this stock is now going to get into even negative EBITDA terrain as some people seem to tell us in early morning?

Pal: Yes, because the only two big contributors to their profit currently are India and the US. Plus the ban on other three plants - the expenditure on the resolution, which they have been doing for the three plants, definitely will have an impact on the margin. That has already been discounted. Now this additional thing has come as a big negative surprise.

I think 8-10 percent of core business margin will easily slip into negative zone because the rest of the other territory business is either negative or breakeven or marginally negative kind of thing. As a result, I believe the EBITDA margin will be negative and this is a huge negative for the company.

Sonia: What could the damage be on the stock itself this morning, how much lower do you think the stock could head?

Pal: Currently, their run rate is around USD 125-130 million from the US market per quarter. 70 percent of their total API requirements for the formulation manufactured in Ohm Laboratories comes from the Toansa plant. That is the only plant supplying formulation for the company in the US. So 70 percent of that plant’s requirement of API is supplied by Toansa. So if this plant is banned that means they have to immediately go for outsourcing of plant. That means that the initial cost will be huge.

Latha: Have you made the calculations, what might be the impact in terms of actual loss in the EBITDA?

Talati: I think it is too early to comment on that because there are two parts that we need to look at. One is the immediate EBITDA loss that is going to come out from delays in site transfers but two is there is going to be a permanent damage until the facility comes up because you move on to outsourcing vendors and you have to give up a big slug of your profit that goes to them which was historically Ranbaxy’s key point. They were extremely cost competitive.

So with benefits of vertical integration going away there could be points or question marks on their restoring ability to take up huge market share in the US, which could have a further impact on their margins as well. So at this point, it is a bit early to comment in terms of how this exactly would play out but given the state of affairs, I don’t expect a significant improvement anytime in the near term for this company.

Sonia: Would you downgrade the stock then and would you scale down your EPS estimates? If yes, to what extent and what would your target price look like now?

Talati: Obviously I cannot comment in terms of what we would be doing with regards to our recommendation but if you look at this stock, it has been holding up to Rs 410 levels and that is on hopes that there will be Diovon launch coming out at certain point in time. That could materialize if the FDA agrees to somebody else manufacturing the API, there could be profit share scenario like what we saw in Lipitor, there are various possibilities but I think fundamentally there is a big question mark that is now being raised on Ranbaxy’s overall ability to get in control of its quality issues.

So we would completely stay away from this stock. I don’t think that there are enough control systems within the management to take care of these issues. So I don’t see any reason why you would want to get involved with such a stock at this point.

Latha: You said 70 percent of the API comes from the Toansa plant, now what are the margins in that facility and if it is jobbed out, if it is outsourced how much will the margins be impacted?

Pal: I think roughly around 40 percent of margin they get from that business. Second, if you now go to any third party outsourcing company, the first thing which comes to mind is that you don’t have any other option to fall back on. So they will definitely wrench out the best possible margin from there which means that you will lead to the big soup and that ultimately will lead to your operating margin going into negative.

Latha: Are you also off the stock now as Chirag Talati just said or you have a price target, at some price you are a buyer?

Pal: Yes. I believe definitely for near-term to medium-term I don’t see any light at the end of the tunnel but definitely if you say one year beyond, I would say anything between Rs 200 and Rs 250, I will be a buyer.