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Vishal Koul

Best Buys Worst Picks

Ajay Relan
His bet on Natco Pharma’s differentiated product portfolio paid off while Monnet Ispat taught him to be wary of over-ambitious entrepreneurs

Krishna Gopalan

In my previous stint at Citigroup Venture Capital (CVC), we had done fairly well investing in the pharmaceutical industry. We invested in Lupin Pharmaceuticals and Jubilant Life Sciences and both delivered healthy returns of 9x and 3x respectively. 

So in 2010, we were again scouting for a generic pharma company. The stories around the larger companies were already well documented and priced in, but we felt there was still some value-unlocking left in the mid-cap pharma space, where we began to hunt. By that time, new drug pipelines were slowing down, so it was also clear to us that only companies that had differentiated portfolios could offer a good potential. In short, we were looking at three things — a mid-market pharma company, differentiated strategy with respect to products, and a business with a stable base. 

We had first heard of Natco from Lupin, which had partnered with it on some generic launches in the US. Natco was founded around the same time as Dr Reddy’s. In the mid-90s, Natco’s balance sheet was stretched because of diversification into infrastructure, which they subsequently exited. But the lost time meant it was a smaller company than Dr Reddy’s (a turnover of 457 crore in 2010, compared to 7,028 crore for Dr Reddy’s). But now, it was a lot more focused. It came across to us as an interesting company with chemistry capabilities far beyond its size. 

We did a lot of research on the company and its promoters VC Nannapaneni and Rajeev Nannapaneni. Natco was the number one domestic player in the over 1,000 crore oncology market. Rajeev’s logic about being focused on oncology was sound. Though cancer care is expensive in India, it does not require a large sales force, which makes it an inherently high-margin business. Natco was easily reaching out to 1,700 cancer specialists in India with a sales force of just 200. 

Natco’s strength was in chemistry. That’s what they stuck to, especially in the US market. They partnered with the likes of Mylan and Alvogen to launch products. These arrangements allowed Natco to focus on product development, while the partner would help with the legal landscape and marketing the product. This was a profit-sharing agreement. We really liked the idea of a company working on complex molecules in the US, which could become a significant entry barrier.

We were first drawn to Natco's oncology prowess. There was very little by way of competition in the mid-market segment in oncology in India except Cipla. While we were tracking the company since 2011, the discussions with the promoters began only in May 2013. We interacted a lot with Rajeev during this period, and we saw in him a promoter with clear strategic thinking. He was very knowledgeable about both product identification and product development. He spoke of the potential commoditisation when no one was even thinking about it. Rajeev was clear he wanted to go after niche products since buyers would push for price cuts on generics. We found merit in that logic. 

Also by this time, CX had already invested in Sutures India, which sold disposables for surgical oncology, and Thyrocare Technologies, a diagnostic chain which provided PET-CT scan services used in the diagnosis of oncology. So that helped us a great deal in mapping the opportunity in the oncology market.

We first agreed to buy a 7% stake in Natco Pharma in October 2013 for $25 million (153 crore), which was revised to 5.14% in December for $18 million (108.5 crore) at 638.4 per share (pre-split). The reason we cut the deal size was to pick up more just in case the stock fell. As luck would have it, the price never ever fell after we invested and in retrospect, we should have put in more money. 

Our investment case is usually built around targeting a 25% IRR and value creation through growth in revenue and profit, apart from improving cash flows. In the case of Natco, its track record gave us enough confidence that these parameters would be met. In the period that we observed the company (2011-2013) revenue grew by 45% while profit increased by 54%. Cash flows from operating activities increased from 63 crore in FY11 to 73 crore in FY13. Natco’s stable oncology business, which made up more than 55% of the business, could comfortably grow at 15% each year, we predicted.

Still, Natco looked expensive when we bought, quoting at 24x trailing P/E, while other mid-cap companies were at 18-19x. On an EV/Ebitda basis, the stock was at 14x, while others were at 11x. But there were significant pluses in Natco’s favour. For instance, there were 11 ANDA filings that had been approved with another 15 in the pipeline. Of them, two molecules had a combined market size of $4 billion each.

Following our investment in Natco, a couple of key decisions helped the company’s fortunes. Natco received the license to market Hepatitis C drugs from Gilead in September 2014, and launched its first product in March 2015. Within two years of launch, the drug became the market leader generating nearly 500 crore in revenue. We did not visualise the Hepatitis C story when we made our investment. Natco sells its Hepatitis C drug only in India and Nepal. They have filed for registrations in 23 more countries and we firmly believe it can reach out to at least 30 countries more. 

While the international formulation business, which brought in 55% of overall revenue, had been growing steadily, the company’s overall revenue got a significant boost from the Tamiflu oral capsules last year. That alone has added 700 crore or 34% to overall revenue and constitutes 60% of the Ebitda in FY17, as Natco was the first one to launch in the US.

The Hepatitis C opportunity and the robust product pipeline it had built for the international business resulted in its P/E multiple in FY15 expanding to 80x, while EV/Ebitda was 40x. This was when we took some money off the table by selling stock worth 80 crore in FY15, making a 2.5x return. When we invested in 2013, the P/E was 24x, while EV/Ebitda was 14x. Post the Tamiflu launch when there was a run-up in the Natco stock price, we sold our second lot at an average of 935 per share (post-split) in June 2017. That fetched us 140 crore or a 7x return.

Today, we still hold 53% of our original investment, which at the current price is worth 325 crore. It is logical to ask why we did not sell out completely given the returns it could have fetched during the recent exit. Our typical investment cycle is four to six years and we have been in the stock for less than four years now. Our view is that there is more juice left. The next two years promise to be a period of solid growth for the international business. For instance, there is a significant opportunity in Tamiflu suspension, which is a $250 million market.  Besides, the launch of Doxil ($200 million) and Vidaza ($190 million), both chemotherapy drugs, could be another growth trigger. They are not huge bets but will complete the oncology portfolio for Natco. The launch of Copaxone 20mg following the USFDA approval in the next 12 months and Copaxone 40mg after that could be the next big trigger for the stock to outperform.

We continue to believe in a promoter who anticipates the changing market landscape much ahead of time. That, coupled with the company’s ability to respond to those changes, leads us to believe that the stock will continue to outperform and so we remain invested.

Investing lesson

Our takeaway was that with patience and a methodical top down approach, one can find less understood but spectacular businesses to invest in. Natco’s promoters bring together strong technical capabilities, rare clarity of thought, humility and above all grit — a winning combination. 

There is a bit of history that Citigroup Venture Capital (CVC) has had with Monnet Ispat & Energy. We invested $10 million in Monnet in 2004 and exited in 2008 at $50 million, a return of 5x. That experience was what we banked on when we looked at the company again at CX Partners. 

I was on the board of the company during the CVC investment. The company manufactured sponge iron, a key input for steel. It was the second largest player after Jindal Steel & Power and had a 0.5 million tonne per annum plant in Raipur, Chattisgarh. At a time when power was in short supply, Monnet had a 110 MW power plant out of which 70% was for in-house production, and the rest it could sell at 7 per unit, making a cool profit. Just between 2004 and 2008, its revenue increased from 247 crore to 1,159 crore, while net profit moved from 28 crore to 166 crore. In short, it was a well-run company that had gained from the positive cycle that started around 2004. 

Being a board member during my previous stint at CVC gave me a glimpse into the kind of entrepreneur Monnet’s promoter, Sandeep Jajodia, was. Apart from being young and dynamic, he definitely knew the business well and was able to scale it up with efficient operations in place, thus ensuring high margins, which is not an easy task to achieve in a commodity business. So, it was an easy decision to bet on him again in 2009.

Monnet had already announced its decision to set up a 1,050 MW coal-fired power plant in Odisha through its subsidiary, Monnet Power. We supported the decision as they had captive coal mines for the project. Given the company’s track record in the sponge iron business, we were confident of its execution. Besides, the shortage of power in India threw up a huge opportunity. With the economy starting to look up, we felt the company would also gain from the upturn in the sponge iron cycle.  

The stock quoted at 5-6x Ebitda and the valuation looked cheap. We began picking up stock from June 2009 to October 2009. At 275 per share, we accumulated an 8% stake for 150 crore. So, Monnet Ispat was our first investment from the debut $500 million fund. In July 2010, Blackstone invested in the unlisted Monnet Power (12.5% stake for 275 crore) and in July the following year, they picked up Monnet Ispat stock at 500 apiece. It was comforting for us to see someone from the fraternity investing in projects that we had already backed.   

What caught us on the wrong foot was Monnet’s decision to set up an integrated steel plant in the last quarter of FY10. We had no inkling about this and our immediate reaction was that the promoter was biting off more than he could chew. The total debt in 2010 was 1,720 crore, but with the power business coming in, it would balloon to 5,000 crore to 6,000 crore. It was obvious that the steel foray would increase that debt burden substantially. In our minds, it was clear that management resources would be stretched with both power and steel. All this was being supported only by the operating profit from sponge iron. 

Initially, there was not too much to panic given its strong operating performance. Even as the debt level increased from 2,110 crore in FY11 to 4,098 crore in FY12, sponge iron with strong operating margin (27%) was generating more than enough cash to meet the interest outgo. There was a marginal dip in profit but that didn’t worry us too much. 

What we didn’t anticipate was the aftermath of the Coalgate scam in 2012. The Comptroller and Auditor General in his report said that coal blocks were allocated in an inefficient manner during 2004-09, causing a loss of 186,000 crore to the exchequer. Monnet was one of the companies that was allocated coal blocks. The implication was unknown at that point but we were optimistic that the issue would be resolved.  

To add to the company’s woes, the symptoms of the slowdown in steel were starting to be felt. In FY13, revenue growth was flat but efficient operations meant margins remained stable. However, increasing interest costs started to eat into profit, which fell 15%. Amidst this, the 1.6 million steel plant was finally commissioned in FY14 but increasing operating costs, lower utilisation rates and higher interest costs meant lower operating margin (20%) and profit plunging to 37 crore by the end of FY14. 

What broke the camel’s back was when the Supreme Court cancelled the allocation of 214 blocks including Monnet’s in September 2014. That is when our thesis went haywire, and the huge advantage that Monnet had in power because of access to cheap coal, was no longer there. Coal had to be bought from outside and the company was badly hit.  

Unbridled expansion and declining business climate finally did the company in. In FY15, operating profit margin sank to a low of 5% against 20% the previous year. By then debt had doubled to over 9,000 crore. So a nearly 3x increase in interest costs saw the company post a loss of 869 crore. 

We should have exited our investment in Monnet in 2012, when the CAG report came out on the allocation of coal blocks. We didn’t anticipate that the licenses would be cancelled. Realising that all was not well, we began selling our stock in tranches in FY14 and over the next one year, we were out of it. From an acquisition price of 275, we sold our 8% holding at an average price of 90, resulting in a loss of two-thirds of our original investment.  

When I look back, it is obvious that a few things went completely wrong. Enthused by the steel industry, the promoter decided to shift attention from sponge iron, which was the first mistake. All this was the result of hubris setting in and the promoter’s belief that things could not go wrong. It was the experience of the first investment that made us back Monnet Ispat again. However, it became a case of a young promoter who got carried away as his ambitions ran amuck. 

Investing lesson

Two lessons learnt. First, one has to be careful about the impact of government action. Be it regulation-related like price increases, removal of subsidies, anti-dumping duties and so on or corruption-related cases. Never underestimate the power of the government and understand carefully the ability of the government to alter the trajectory of a business or a company. Second lesson, betting on young and ambitious promoters can be a great proposition but could also backfire badly. In Monnet, when the promoter went overboard with his ambitious plans, we realised how challenging it was to restraint a promoter’s ambition. It’s a difficult thing for a PE fund to do, especially in a listed company.

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