Equity Analysis /
Pakistan

The Searle Company: Negatives are priced in but growth is uncertain; Neutral

    Yusra Beg
    Yusra Beg

    Senior Investment Analyst

    Intermarket Securities
    18 June 2019
    • 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.

    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.