The Eclipse of A Star

Investors worry about poor corporate governance practices at Sun Pharma and price erosion in the US generics market

The question was raised quietly but it weighs heavy, especially on a market leader that has been under attack over the past few months. In two notes, dated January 28 and February 18, the Securities and Exchange Board of India (Sebi) asked Sun Pharma to explain a “diversion of Rs.420 billion to a pharma distribution company Aditya Medisales (AML)”, according to media reports. This was reported by a business daily on March 6. The Dilip Shanghvi-led company has dismissed the allegation as baseless, but the niggling questions on corporate governance practices at the pharma major, which started last September, seem to be compounding. 

On December 3, 2018, Shanghvi had decided to break his silence holding a conference call. While this was meant to calm the nerves of investors, his responses, in fact, made matters worse. 

Following his interaction with analysts, the market capitalisation of Sun Pharma fell below Rs.1-trillion mark for the first time since August 2013. In two days, investors of Sun Pharma ended up losing Rs.110 billion with the stock hitting a six-year low of Rs.375. The stock price has marginally recovered to Rs.455 as of March 8 on the back of better-than-expected third quarter results but the overhang is still clearly visible. At its peak, Sun Pharma’s market capitalisation had reached above Rs.2.5 trillion, propelling Shanghvi to replace Mukesh Ambani for the title of the wealthiest Indian. But now “a massive wealth destruction has taken place. The stock has fallen by more than 60% in the past five years post the Ranbaxy acquisition,” says Jeena Scriptech Alpha Advisors’ managing director Gaurav A Parikh. 

The viral circulation of the Australian brokerage firm Macquarie’s note Murky Waters of Sun Pharma last September and complaints of a whistleblower — raised last November about corporate governance practices at the company — dented the pharma giant’s reputation. 

Stony silence 

The note by Australian brokerage firm, which sparked off a firestorm in the investing community, raised questions about Sun Pharma’s inadequate disclosures of related party transactions, and alleged guarantees given over the past two years to real estate firm Suraksha Realty, which is owned by Shanghvi’s brother-in-law Sudhir Valia. It even questioned the selection of London-based firm Jermyn Capital, which had links to the infamous Ketan Parekh and his associate Dharmesh Joshi, to manage Sun Pharma’s $275 million foreign currency convertible bond (FCCB) issue between 2004 and 2007. These concerns were voiced at the December 3 conference call. 

Instead of explaining the rationale behind the decision, Shanghvi managed to sidestep the question. “I think in the past 14 years, regulatory framework, laws, expectations of transparency, corporate governance, everything has changed significantly. So to apply (it) today, with retrospective effect and revisit many of the decisions, which management had taken, I think will put unreasonable burden on people because whatever I decide today is based on the law, which is as I see today, and of a company that I am managing today,” said Shanghvi. 

While Shanghvi ducked old allegations, the response to the new accusations, which are much graver, didn’t pass muster as well. According to whistleblower’s documents accessed by the online news magazine Moneylife, in just over three years, between 2014 and 2017, AML has done over Rs.58 billion worth of transactions with Suraksha Realty. 

AML seems have to earned most of its revenues from distributing Sun Pharma’s products. During the conference call, Shanghvi said that the pharma major’s domestic formulation sales — worth Rs.80 billion in FY18 — were being done through AML. And according to regulatory filings by the pharma distribution company, its turnover for FY18 was just over Rs.80 billion. 

The pharma distribution company is also classified as a promoter shareholder with 1.6% stake in Sun Pharma. But, the pharma major chose to declare AML as a related party only in 2018. 

Defending the decision, Shanghvi claimed that, in 2017, AML came to be a related party due to consolidation of some group companies. He added that they had taken shareholder approval in an annual general meeting (AGM) for continuing to do the distribution through AML. Sun Pharma has denied that AML has given any guarantees to Suraksha Realty. The company didn’t respond to queries from Outlook Business.

In the December 2018 call, the management had also said the arrangement with AML was made for an efficient tax structure, an explanation that didn’t hold water. “The relationship with AML defies logic as Sun Pharma is the largest pharma company in India, and it seems illogical to have AML as a distributor in India for tax efficiency. Investors will find it hard to believe and suspect that this related party transaction is to benefit the promoters,” says Shriram Subramanian, founder and MD of InGovern Research, a proxy advisory and corporate governance firm.

The promoters’ defence only puts the board members in the dock. “I don’t want it to sound like schadenfreude but it’s interesting that a recent private research report opened up several corporate governance issues that should have actually been flagged much earlier by the auditors and the independent directors on the board. Or were board meetings held to decide what not to disclose, rather than what to?” exclaims Parikh.  

Shanghvi stated that he was willing to makes changes to address investors’ concerns. “Now if it is felt that that is not in the best interest of the shareholders because there are now some concerns that were missed at that point of time, we are open to make changes,” he added.

So, now the distribution related to India’s domestic formulations business will be transitioned from AML to a wholly owned subsidiary of Sun Pharma by Q1FY20, post receipt of all requisite regulatory approvals. 

And there more are skeletons tumbling out of the cupboard. Loan and advances given out by the pharma major to the tune of Rs.22.42 billion had also raised several eyebrows. When asked about the nature of loans, Shanghvi refused to divulge names of beneficiaries, hiding behind “business confidentiality”. “I cannot share some materially important information, which is specific for business. I am not able to give you more information about to whom the money is given to; however, I understand your concern, and we will try and address it at the earliest (sic),” said Shanghvi.  

As the pressure mounted and investors turned cautious, Sun Pharma budged a little. In a clarification issued on January 22, the embattled pharma company said that it will be unwinding the “controversial” transactions and disclosed that its consolidated balance sheet had receivables of Rs.22.38 billion from a non-related party. “This liability was in respect of Atlas (Global Trading) assuming the damages on account of Protonix patent litigation settlement entered by Sun Pharma, which was disclosed in the annual report for fiscal year 2014,” it said in a statement. 

In June 2013, Sun Pharma had to pay Wyeth Pharma around Rs.31.9 billion ($550 million), as part of its settlement in the patent infringement case involving pantoprazole, used to treat gastro-intestinal ulcers and hyperacidity. Atlas assumed the liability and in turn Sun Pharma agreed to supply drugs to Atlas at a discounted rate. However, in September 2014, Sun Pharma’s Halol facility in Gujarat was impacted by USFDA’s current Good Manufacturing Practices (cGMP) issues and it could not meet the supply requirements. “Sun Pharma, in FY18, funded Atlas towards non-fulfilment of its supply obligations till the time such obligations are fulfilled in accordance with the agreement. The said funding was included in the loans and advances schedule of Sun Pharma’s FY18 consolidated balance sheet,” the pharma major said. With the Halol issue being resolved, Atlas has agreed to assign all rights and obligations to a wholly owned subsidiary of Sun Pharma and the entries will be squared off in FY19 and the arrangement with Atlas will cease.

And even as the company continues to corrective measures, the non-disclosure had put minority shareholders in a position of disadvantage, according to experts. “Shareholders have a right to know how the funds of the company are being utilised. Sun Pharma also had very high institutional ownership but still hasn’t addressed the corporate governance issues in a proactive manner,” says Subramanian of InGovern Research.

Old ways  

Experts assert that corporate governance has never been the forte of Sun Pharma. In 2014, Sun Pharma’s takeover of Ranbaxy was marred by controversy. Before the announcement of acquisition by Sun Pharma on April 7, 2014, Ranbaxy shares rallied 34% over the six days hitting its 52-week high at Rs.505 on BSE. The suspicious spike in volumes and stock price triggered called for an investigation, and Dilip Shanghvi and nine others had to settle the matter with market regulator by paying a fine of Rs.1.8 million in August 2017. The allegations have again come to haunt Shanghavi with news reports stating that SEBI could re-open investigations into insider trading in the backdrop of new allegations. 

Falling fortunes 

Between 2014 and 2015, Shanghvi was in the limelight for all the right reasons. Its merger with Ranbaxy made Sun Pharma a top player by market share in India and the fifth largest pharmaceutical firm in the world. Following the acquisition of Ranbaxy in 2014, the profits zoomed by 50% between FY14 and FY17. Also the sales were up from Rs.160 billion in FY14 to Rs.302.64 billion in FY17. 

Currently, its US market accounts for around 34% of Sun Pharma’s sales and holds the key to its success. “The results of most of the pharma companies, which have strong presence in the US generics market, were very good in FY15-17. The price erosion was in single digits, may be around just 5-6%. And the consolidation was yet to take place at the buyers’ end,” says Bhavesh Gandhi, a research analyst at Yes Securities. 

However, Sun Pharma started facing hurdles in Q2FY17 in the US market. “A challenging US generic pricing environment coupled with continued investments in building our global specialty business has impacted our Q2 performance,” said Shanghvi in an earnings release that quarter. The company was also getting notices from USFDA with connection to Halol manufacturing plant, causing the Sun Pharma to slow down exports to its most lucrative market, the US. The Halol manufacturing unit is central to Sun Pharma’s performance, according to a Motilal Oswal Research note, and the resolution in June 2018 could add as much as $100 million in revenues annually. 

Woes compound

Adding to the problems, the competition intensified in the US generic drug space with the consolidation of buyers and more generic suppliers entering the market. 

Sun Pharma’s sales have risen by 11.82% in three quarters of FY19 to Rs.216.42 billion. While competitive intensity remains high in the US market and price erosion still persists,the company’s profit has grown to Rs 24.62 billion to 10.37 billion  thanks to a lower base effect as earnings start to normalise (see: The silver lining). “Earnings have stabilised but the company has indicated that they are facing pricing pressure in the US of around 5% like every other pharma player in the generic drug segment,” says Ranjit Kapadia, an analyst at Centrum Broking.    

As the space to grow shrinks in the generic drug segment, Sun Pharma has decided to focus on expanding its specialty business again. “We committed close to a $1 billion on specialty business; we have to justify that investment and produce returns,” said Shanghvi in the company’s earnings call on February 12. 

Sun Pharma has been creating a pool of specialty products over the past three years through various acquisitions and in-licensing products. The pharma giant launched BromSite to treat eye pain and Odomzo to treat skin cancer during the last financial year. It had bought Odomzo from Novartis paying $175 million. In the current financial year, it introduced three specialty products – Yonsa for prostate-cancer, Ilumya (IL-23) for plaque psoriasis and Xelpros for ocular hypertension. 

While Shanghvi remains confident of the specialty products, the cost of marketing and research is expected to dent margins. “Marketing cost would increase in forthcoming quarters as the company increases its specialty spending. It is also looking to expand the usage of Ilumya beyond psoriasis, which would require higher R&D for clinical trials,” says Gandhi of Yes Securities.

Corporate overhang

After announcement of structural changes by Sun Pharma, there is still a large dark cloud looming over Sun. “We believe overhang of corporate governance is likely to continue till there is uncertainty over what the whistleblower may have. The stock will remain subdued,” asserts Kapadia. It’s not just Kapadia, but Parikh also believes that Sun will not be shining anytime soon. “Sun Pharma clearly has been lacking in full disclosure, transparency and accountability. If push had not come to shove recently, they would not have now stated and acted on their openness to changing operating relationships to be seen as above board,” states Parikh. 

The foreign investors seem to be losing faith in Sun Pharma as its performance has taken a knock and corporate governance issues started cropping up. Since FY16, the foreign institutional investors (FII) have reduced their stake from 26.41% down to 14.88% in December 2018 (see: Jumping on to the bandwagon). However, domestic institutional investors seem to be keeping faith in Sun Pharma unperturbed by the allegations increasing their stake from 3.1% to 9.69% during the same period. 

Analysts don’t expect any dramatic changes till the cloud of corporate misgovernance disappears. They also assert that it will take time for the company’s specialty business to yield results. “Sun Pharma’s US business will face pressure till the specialty segment grows and achieves certain scale. We have a negative rating on the stock as risks still linger in the ramp up of specialty business,” says Gandhi. While the analysts estimate that the earnings will normalise in the next financial year, back to FY17 levels, with the specialty market in the US being one of the major growth drivers, the key downside could be the poor corporate governance allegations and regulatory risk for Sun Pharma’s manufacturing facilities catering to global markets. Analysts expect revenue and PAT to grow by 12.5% and 56% respectively in FY20. However, while the results are expected to improve due to focus on specialty business, the plethora of issues surrounding the company, may keep the stock under pressure. 

Due to confluence of factors, the stock has plunged to a five-year low and currently trades at 31.5x for FY19 and 24.5x on one-year forward basis for FY20, much below the five-year average of 41x PE. 

Although the decent December results have provided a much-need relief for the investors, a lot hinges on resolution of corporate governance issues, managing the price erosion in US and performance of specialty business. Investors must adopt a wait and watch approach till the dust settles over the raging corporate governance storm at Sun Pharma.