Integration challenges holding back Strides Shasun

Management expects margins to recover in the second half of FY17

Strides Shasun was the second biggest loser in the BSE 200 Index, shedding around 3.5 per cent on Thursday (12 per cent in the last three sessions). Brokerages downgraded the stock because of integration and restructuring challenges that impacted numbers in the quarter ended June. Revenues in the quarter (Rs 875 crore) were eight per cent lower than consensus estimates because of lower sales in institutional and API business, while operating profit at Rs 133 crore missed estimates by 25 per cent. Margins at 15.2 per cent were 350 basis points lower.

Lower margins in two of its four segments, pharmaceutical services and active ingredients (PSAI; includes API or active pharmaceutical ingredients) and emerging markets (EM), were key disappointments. PSAI margins, which ranged between 13-15 per cent a few quarters ago, came in single digits. Higher costs because of quality control and R&D led to the margin fall, but Strides expects this to recover over the next two years.

Meanwhile, it is planning to spin off its API manufacturing unit into a fully-owned subsidiary. The management believes the business requires a separate leadership team and strategy to achieve its objective of being a global pharma supplier. The business (turnover of Rs 712 crore in FY16) is expected to be hived off by the December quarter. A large part of PSAI business was from Shasun Pharma, which merged with Strides and added to the US product pipeline. Once margins rebound, it could monetise this business.

In the EM segment, Strides has made some acquisitions including seven brands from Johnson & Johnson in October 2015 and two central nervous system divisions from Sun Pharma in September 2015, which led to its margins falling from over 20 per cent a couple of years ago. In the June quarter, lower Africa sales and integration challenges with acquisitions saw margins decline to single digits. Strides, however, expects margins of this segment to recover in the second half of FY17.

In the regulated markets business (43 per cent of revenues), Strides expects seven abbreviated new drug application approvals in FY17. How it will scale up US revenues and keep costs down will be critical.

Analysts at Credit Suisse and Macquarie maintain their outperform rating, but have cut earnings estimates and target prices because of the muted results and delay in synergies. Progress of integration would be key, according to analysts at Religare Institutional Equities, given that PE valuations of 19 times FY18 earnings leave little room for upside.