Will Sun rise again?

Anyone monitoring Ranbaxy’s shareholding pattern in December 2013 would have noticed a new entrant by the name of Silverstreet Developers with a 1.41% stake in the Daiichi Sankyo subsidiary. By March, the same entity had further raised its stake to 1.64%. Though not a significant jump, discerning investors would have known that something was up.

Soon enough they got to know exactly what was cooking. On April 7, Dilip Shanghvi’s Sun Pharmaceuticals made a 5 am announcement of its acquisition of one of India’s leading generic drugs companies that had fallen from grace, following trouble with US regulatory authorities over manufacturing quality lapses. As for Silverstreet — no prizes for guessing — one of its partners was Sudhir Valia, none other than the executive director of Sun Pharma and Shanghvi’s brother-in-law. Whether that would qualify as insider trading or not is something Sebi will probably investigate in due course. But what was Shanghvi thinking while signing the deal?

“Size does not excite us. The quality of business and the ability to manage it and grow faster than competition is what excites us,” Shanghvi declared in a concall following the announcement of the $3.2 billion, all- stock deal. That interest finally started taking shape in the past three or four weeks when Japan’s Daiichi Sankyo, Ranbaxy’s largest shareholder, and Sun Pharma agreed on the larger details of the deal. With the result that Sunday, April 6, proved to be busier than a regular work day for board members of Daiichi Sankyo, Ranbaxy and Sun Pharma as they simultaneously held day long meetings in Tokyo, New Delhi and Mumbai to seal the biggest merger in Indian pharma industry.

High five

The deal will create the world’s fifth-largest generics pharma company

Given the mounting woes in Ranbaxy, Daiichi had for some months been on the lookout for a strategic partner who could help it out of the quagmire it found itself inadvertently stuck in. But Shanghvi is only looking at the bright side of the deal. “The acquisition fulfils a long-held ambition of being a successful Indian companyin the global pharma space,” says the 57-year-old founder of Sun Pharma. Now, that’s an under- statement. The merged entity will strengthen Sun Pharma’s position as the fifth largest generics company in the world with a combined revenue of $4.3 billion, bringing it closer to Mylan. Besides, back home it will also emerge as the leader in the $12-billion Indian pharma market, with a market share of 9.2%, leaving the incumbent, the Piramal-Abbott combine, a distant second with 6.5% share.

Here’s how the deal works out. Apart from Ranbaxy’s equity, Sun Pharma will also take on the company’s debt of $800 million, valuing the firm at $4 billion and 2.2X its 2013 sales. Shareholders in Ranbaxy will receive 0.8 share of Sun Pharma for every share they hold, implying a value of ₹457 per share, a 18% premium to its 30-day average price, based on the closing price on April 4, 2014. Taking a 38% loss on its initial investment, Daiichi Sankyo will become the second-largest shareholder of Sun Pharma with a 9% stake after the merger. The deal will mean a 16.2% equity dilution for Sun Pharma, while reducing its promoters’ stake from 64% to 56%. In other words, while Shanghvi gets to keep his majority, Daiichi will continue to have its skin in the game.

As for deal makers, the entire transaction couldn’t have been any better. Ravi Talwar, senior vice-president, ICICI Securities, who advised Ranbaxy on the deal, says, “Not only are their portfolios complementary, with Sun strong in the chronic segment and Ranbaxy in the acute segment, there are geographical synergies as well with Ranbaxy having a larger emerging market presence and Sun with a dominant presence in the US.” Sun, which gets more than 80%of its revenue from the US and India, can now leverage Ranbaxy’s presence in emerging markets to sell its products the merged company will get about $1 billion revenue from emerging markets. In the US, it will become the largest Indian pharma company, with over $2 billion in revenue. In India, the new entity will have a presence in the top three of the 10 largest therapeutic segments that together account for 90% of the domestic pharma market. According to Sun Pharma’s management, the acquisition will be cash earnings accretive in the first full year of operations, with synergies of $250 million kicking in at the end of the third year, driven by procurement and supply chain efficiencies.

A $4.7-billion lemon

At first glance, the deal seems a win-win for all the parties involved. “Dilip Shanghvi has come as a knight in shining armour and has won the golf game at the first tee!” exclaims Ranjit Shahani, managing director, Novartis India. “These were highly distressed assets and it works out well for all the players. Daiichi is out of it and Sun has an uncut diamond.”

 Daiichi made its entry into India in 2008 by picking up a 63.92% stake in Ranbaxy for $4.7 billion, paying ₹737 per share — which valued the entire company at $8.5 billion. Daiichi mainly bought into Ranbaxy because it offered an entry into India and other emerging markets. Growth in developed markets where it operated was slow and Ranbaxy had a good pipeline of products, including the marketing exclusivity for Lipitor, Pfizer’s blockbuster cholesterol lowering drug. Daiichi planned to leverage these to augment its own growth, but those calculations went completely awry after the $11.4-billion Japanese pharma major realised to its dismay that the information and due diligence that it based its acquisition on were grossly inadequate and did not capture the rot inside Ranbaxy. Just months after the acquisition, the dream buy quickly turned into a recurring nightmare as regulatory issues started flying at it thick and fast.

The troubles at Ranbaxy had started long before Daiichi came into the picture. In 2004, a company executive discovered that fabricated data had been submitted to regulatory authorities for 200 drugs in over 40 countries. He turned whistleblower the next year after quitting Ranbaxy. The company got a strong warning from the US Food and Drug Administration (FDA) in 2006 but it was only two years later — just months after Daiichi took over — that it banned 30 products from two manufacturing facilities at Dewas and Paonta Sahib. In May 2013, the company further pleaded guilty to felony charges related to drug safety and agreed to pay $500 million in civil and criminal fines.

A few months later, after production quality at two other plants was found unsatisfactory, imports into the US from Mohali and Toansa were also banned. Not surprisingly, Daiichi is bitter about its experience with Ranbaxy, claiming the company’s former shareholders had held back critical information, a charge the Singh brothers, Malvinder and Shivinder, not surprisingly, refute.

Not everyone believes that Daiichi got a raw deal, though. “Daiichi was completely clueless about how to leverage the asset it had acquired. It didn’t know what had to be done,” says Sanjiv Kaul, managing director, ChrysCapital and a Ranbaxy old- timer who spent two decades in the company. “With this merger, Ranbaxy will get some direction and leadership, which has been missing in the company for some years now.”

Getting down to business

Once the chest thumping is done and the companies move beyond slick presentations that paint a pretty picture of strength, Sun Pharma has to get down to business and clean up the regulatory mess that is now Ranbaxy. With all four manufacturing facilities in India barred by the USFDA, Ranbaxy is left with only Ohm Labs, New Jersey, in the US to cater to the market there. The ban on Toansa, particularly, came as a big blow as it supplied around 70% of inputs used in the manufacture of generic drugs for the US market.

Ranbaxy was already in talks with third-party suppliers to make up the shortfall, but now with Sun coming into the picture, it can be a good sourcing option for Ranbaxy and could help it launch some of the generic products for which it has 180-day marketing exclusivity, which were delayed because of regulatory issues. That includes blockbuster drugs such as Astra Zeneca’s Nexium for acid reflux, which goes off patent in May 2014, and blood pressure drug Diovan, which went off patent in 2012. Coupled with a possible launch of the generic version of Roche’s antiviral, Valcyte, these products can generate up to $500 million sales for the company.

As for the four Ranbaxy plants that have been barred by the USFDA, Ranbaxy has signed a “consent decree”, which essentially means that it neither accepts nor denies guilt, but agrees to make changes to manufacturing processes. Once the process of complying with the decree is over — which may take two or three years — the plants can resume exports to the US after the USFDA reinspects them and gives its approval. Meanwhile, the plants can continue exporting to other markets, provided they meet the regulatory requirements there.

So far, Ranbaxy has spent $300 million on revamping the manufacturing facilities. But now that the Sun-Ranbaxy combine has a total 47 manufacturing facilities, Sun always has the option of shutting down some plants and transferring the processes from the banned facilities to other approved facilities. Of course, it will have to get USFDA’s approval for this, too. 

Almost everyone agrees that Sun is probably best positioned to fix Ranbaxy’s woes. “Sun Pharma understands the generics business better than Daiichi Sankyo, who couldn’t handle the surprises thrown at them on the regulatory front. Being an old hand in the business, Sun will have better processes and controls in place,” says Aashish Mehra, managing partner (India & Asia Pacific), Strategic Decisions Group (SDG), a US-based management consultancy firm. Novartis’s Shahani goes a step further and gives Sun his vote of confidence. “Sun has a great history of acquiring distressed assets and turning them around. I am confident in 18 months or less, it will have all the plants FDA approved and running,” he says.

Past triumphs

Sun has an enviable record of managing 16 buyouts over the past 16 years

Certainly, Sun Pharma does have a track record that speaks in its favour. The company has made 16 acquisitions, starting with its first international buyout in 1997 when it acquired the US-based Caraco Pharma, to 2013, when it bought URL’s generic business in the US from Japanese pharma company Takeda. The acquisition of Israeli company Taro Pharma was its most challenging where the Indian company was engaged in a four- year legal battle with Taro’s founders before it finally wrested control in 2010. Since then, Sun Pharma managed to bring about a significant improvement in Taro’s performance, with operating profits increasing from $100 million to $400 million in a span of three years.

While investors are hoping that Sun Pharma will repeat its magic with Ranbaxy, it won’t be easy. “Integration will be challenging as there will be too many moving parts and Sun Pharma has to ensure that it has enough management bandwidth to handle the process,” says Kewal Handa, promoter-director, Salus Lifecare, and former MD of Pfizer India. There are also bound to be significant culture differences between the organisations, as well as different pay structures and management styles.

In a company such as Ranbaxy, where falsifying laboratory data was all in a day’s work, bringing about a mindset change and stricter processes and controls will take time. It is unlikely that such serious lapses escaped the notice of the top management at Ranbaxy — employees rarely act in isolation and clearly the culture at Ranbaxy had deteriorated under the Singh brothers. Now, with a change in ownership — and with all these issues out in the open — there is bound to be a change in the company culture as well.

“In the past 8-10 years, I felt there was a certain humility missing in the way Ranbaxy communicated with its stakeholders, including the regulatory authorities in the US and India. With Sun Pharma, the biggest change will be better transparency, processes and controls,” says ChrysCapital’s Kaul. He has a solution, though, for making things easier. “For mergers to work, I believe that the leadership at the top should change at the acquired entity even if the existing team is brilliant. Rather than going through a transition period and waiting for things to fall in place, Sun Pharma must drive the integration with a team that has the capability to channel the whole process.”

And Sun has enough experience in turning around companies. It has a crack management team, including ex-Teva chief, Israel Makov, as chairman, who has managed 12 acquisitions at Teva. Boasting of the highest operating margins in the industry, Sun certainly knows the secret of extracting the best operating efficiency.

Seeking a cure

In the coming months, Sun has several difficult decisions to take, especially regarding rationalisation of products sales force and manufacturing facilities. The combined entity will have a presence in 65 nations with 47 manufacturing facilities and a sales force of 9,000 people. “Having a larger sales force by itself is not an advantage. Unless you can improve their productivity, it will only add to your costs,” points out Handa. A presence in too many markets, too, is not necessarily good. According to Axis Capital, Ranbaxy is making operating losses in most emerging markets, excluding India, due to high overheads and slower revenue growth. While Sun can improve its performance by cost rationalisation, increasing market share and introducing its range of chronic products — which enjoy better margins than Ranbaxy’s acute therapy portfolio — it makes better sense to consolidate presence across markets. “It has to do what Dr Reddy’s did a couple of years ago, where it exited some markets where it was making no headway and strengthened its presence in those that had some growth momentum going,” says SDG’s Mehra.

While Ranbaxy as a company will cease to exist once the merger comes through, the product brands are likely to stay. “Some of Ranbaxy’s products have great brand equity in the market, be it Revital or Volini. Since the connect with the patient and the doctor is high, Sun Pharma would be better off leaving the brands untouched,” says Hemant Bakhru, analyst at CLSA India.

Bakhru is one of the few people who isn’t completely gungho about the merger. “While the acquisition definitely adds scale, it doesn’t help Sun Pharma move up the value chain,” he says. The analyst’s grouse is that while Sun Pharma is adding acute-based therapy products to its portfolio, these are low-margin products that are complex to manufacture and already facing intense competition. Already, the margins of the merged entity at around 30% will be low compared with Sun’s standalone margins of around 41%. That’s because Ranbaxy’s base business only generates 9-10% owing to regulatory issues and slower growth in some markets.

Also, Ranbaxy has posted losses in three of the past six years since the Daiichi Sankyo takeover. At this point, Sun Pharma hopes to change that by improving its operating efficiency and moving across rather than up the value chain to emerge as a serious global generics contender. While it still has about ₹4,000 crore in cash on its balance sheet to acquire more assets in the branded space in the US, the Ranbaxy acquisition will take up most of Sun Pharma’s bandwidth for the time being.

Despite the challenges, it does look like Sun Pharma has got itself a good deal and with Shanghvi’s ability to take long-terms bets ahead of the market, Ranbaxy seems to be in better hands. “Sun Pharma has definitely bought into Ranbaxy at a very attractive valuation giving it a lot of headroom to build on the existing platform and create value for all the stakeholders,” says Handa. It now remains to be seen how good Shanghvi is at making lemonade.