Investor's Eye: Stock Idea - Persistent Systems (Persistently innovating); Update - Pharmaceuticals (New drug pricing policy-less severe than anticipated)

 

Investor's Eye [September 28, 2012]  Sharekhan www.sharekhan.com

Summary of Contents   STOCK IDEA Persistent Systems Cluster: Emerging Star Recommendation: Buy Price target: Rs552 Current market price: Rs414 Persistently innovating Key points Well placed in the under-penetrated OPD space: Persistent Systems Ltd (PSL) is a niche player in the highly under-penetrated outsourced product development (OPD) market. According to industry reports, the OPD market was worth close to $8 billion in 2009 and is expected to grow at 19.1% CAGR over 2009-13. The addressable worldwide R&D/product engineering services market was worth approximately $35.4 billion in 2009 and is expected to reach $65.7 billion by 2013, growing at a CAGR of 16.7%. PSL has helped its customers develop over 3,000 products over the last five years. With strong domain expertise and years of experience in the OPD business, PSL is well placed to garner the incremental spending taking place in the global R&D space.  Investing for the future growth augurs well for deeper client mining: Over the last four years, PSL has consistently invested in the areas of innovative technologies (cloud computing, analytics, collaboration and mobility) to penetrate deeper into clients' wallet and the expertise that it has built in these areas over the years has started reflecting in its numbers. In the last two years, these four areas have contributed close to 40% of the total revenues and their combined contribution is poised to increase in the coming years with the increasing size of the funnel of orders in these segments. On the other hand, the proactive efforts to invest in the newer technologies would help the company to offer a better value proposition to its clients, get a bigger share of their R&D spending and diversify its offerings further. PSL is amongst the few Indian IT companies with considerable expertise in the area of innovative technologies with niche offerings in the OPD space.  Higher IP-led revenues = Margin improvement: With expertise in the OPD business and confidence of its clients, PSL continues to invest in acquiring and building intellectual property (IP) to gain a foothold in the non-linear side of the business. Its IP-led revenues have grown from $1 million in FY2007 (1.5% of total FY2007 revenues) to $18.3 million in FY2012 (8.8% of total FY2012 revenues). Currently, the company owns around 14 IPs and is continuously investing in building IP both on its own (close to 5% of its manpower deployed on IP creation) and through collaborations with leading universities, research laboratories and clients. PSL is also actively looking at the inorganic route (it has already made three acquisitions in the IP space) to acquire the right IPs to enhance its growth prospects. Going forward, the management is aiming to earn 20% of its revenues from the non-linear space in the next three to four years. This, we believe, will differentiate the company from the rest and help improve its margin in the coming years.  Undemanding valuation, buy: PSL has proven expertise in the OPD space, a strong presence in the newer technologies, strength to improve its IP base and the best-in-the-class margin profile which set it apart from the other mid-cap IT companies. Its earnings are expected to grow at a CAGR of 23% over FY2012-14. At the current market price of Rs414, the stock trades at 9.3x and 7.7x FY2013 and FY2014 earnings estimates respectively. In view of the niche offerings, the best-in-the-class margin profile and strong cash kitty (Rs85 per share), the current valuation seems to be undemanding. We initiate coverage on PSL with a Buy rating and a 12-month price target of Rs552 based on our target PER of 10x FY2014E earnings.   SECTOR UPDATE Pharmaceuticals New drug pricing policy-less severe than anticipated Group of Ministers, which was constituted to look into the drug pricing policy in India, has finalized its recommendation and the same would be sent to the cabinet within a week to get the final approvals. Key points The key highlights of a new drug pricing policy: (1) All drugs mentioned in National List of Essential Medicines (NLEM) would be under a price control (ie 348 drugs and 654 dosages forms); (2) a ceiling price would be fixed on the basis of weighted average price of brands having at least 1% market share and (3) there would be no exemption from price control on any other grounds if it falls under NLEM. Besides, the panel also discussed topics to make it mandatory for physicians to recommend only price-controlled drugs.  Broad-based coverage but less severe impact: The policy is estimated to cover at-near 60% of the market on average basis (coverage will vary in different therapeutic groups) as compared with 25-30% of the market previous. This indicates that most of the Indian players will have certain proportion of drugs under price control. Although the new pricing policy expands the span of price control, mechanism to fix ceiling price is relatively favorable than existing pricing policy, which uses cost-based price fixation. The market price-based ceiling will give a cushion to adjust with the fluctuation in the raw materials and market competition.  MNCs are likely to be the most affected; Indian players may see an average 10-12% reduction in prices: We expect that the multinational players like GlaxoSmithKline Pharmaceuticals, Abbott, Pfizer and Novartis to be the most affected due to high brand prices of their products and market leadership in certain segments. However, for Indian players, the average reduction in price should not be higher than 10-12%. For our pharma universe, the impact should be limited to 2-3% on earnings per share (EPS) due to price control. In particular, Cadila Healthcare and Glenmark Pharmaceuticals are likely to have relatively higher impact than Sun Pharmaceutical and Lupin Pharmaceutical.  Most of the adverse impact already factored in; estimates to be reviewed along with Q2 results: We believe most of the adverse impact of the price control policy is largely to be factored in the valuations. We remain constructive on the pharma stocks and would fine tune the earnings estimate of our universe along with the forthcoming quarterly result update. Click here to read report: Investor's Eye Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a postition in the companies mentioned in the article.

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