Opto Circuits Stock Analysis Dec 2008

opto_circuits_stock_analysis_151208

Readers, please note:

Uploaded on multiple requests from wannabe analysts for a usable stock analysis template. Use with care ūüôā

This was the first ever report compiled by me in my investment journey back in 2008 ‚Äď when I was a complete greenhorn, and when Opto Circuits business hadn‚Äôt yet run into rough weather (2011) with one acquisition too many. While this report perhaps does justice to business analysis as per PAT Dorsey‚Äôs 5 Rules for Successful Investing book‚Äôs template, it does not do enough diligence on examining the BS with equal depth ‚Äď especially Subsidiaries, Intangibles or Related Party transactions, and the like. The bigger margin of safety was in the Price ūüôā !!

Pharma Sector Investor FAQ

DRAFT Work in progress document. To be revised. Needs approval before wider circulation (Donald)

Pharma Sector FAQ

1. Overview of the Indian Pharmaceutical Industry

The Indian Pharmaceutical industry is highly fragmented with about 24,000 players (around 330 in the organised sector). The top ten companies make up for more than a third of the market. The Indian pharma industry accounts for about 1.4% of the world’s pharma industry in value terms and 10% in volume terms.

Besides the domestic market, Indian pharma companies also have a large chunk of their revenues coming from exports. While some are focusing on the generics market in the US, Europe and semi-regulated markets, others are focusing on custom manufacturing for innovator companies.

2. Indian Domestic market – Acute and Chronic Therapies – breakups.

India is primarily a retail-based branded generic market with 80% dispensed through pharmaceutical outlets. As in most emerging economies, acute therapies dominate and account for close to 70% of the market. Acute Therapies – target short duration diseases – cough & cold, fever, pain – such as anti-infectives, analgesics, pain-killers.

Chronic therapies Рtarget lifestyle diseases and/or recurring in nature Рsuch as diabetes, cardiovasculars, ophthalmology, and products used to treat central nervous system ailments, are growing faster than acute therapy.

3. There is a lot of policy overhang recently on the Sector. The Indian Drug Price Control Order (DPCO) and the US GDUFA being two instances. Kindly Comment?

The drug price control order (DPCO) continues to be a menace for the industry. There are three tiers of regulations ‚Äď on bulk drugs, on formulations and on overall profitability. This has made the profitability of the sector susceptible to the whims and fancies of the pricing authority. In connotation, with pricing policy of 354 drugs, NLEM (National list of essential medicines) was released, which covered the list of the drugs which the authority intends to put under price control. The policy has been stiffly opposed by the pharmaceutical industry.

How would you qualify the impact on Indian pharma companies?

a) Companies having lower proportion of domestic sales vis-a-vis exports are obviously less affected
b) Companies that derive significantly higher proportion of Sales from Chronic therapies (Specialty segment) are unlikely to be affected much

International Generics Pharma business is pursued successfully by many Indian companies. Kindly demystify jargons like ANDA filings, Para IV, Para IV FTF, NDA and 505 (b) 2 filings.

Para I,II, II, and IV pertain to what is called ANDA filings – Abbreviated New Drug Applications

Para III – Actually Para I, II and III filings all pertain to patent-expired drugs. Non-Litigation category

Para IV = These are allowed to be filed – post 5 years of a NCE patent grant by USFDA for a generic version of the Innovator drug

Para IV FTF = 180 day exclusivity = Para IV First to File is another category where even before the first five years are over a company can challenge. If approved that company gets an 180 days exclusive approval to market its generic version of the Innovator drug. This can prove very lucrative for the challenger if granted. On the other hand there are Litigation Risks where the Innovator tries to prove that the challenger has infringed on its patent/process while developing the generic version.

Then there are what are called NDA filings – under which 505 (b) (2) falls.

505(b)(2) = larger period exclusivity = These are meant for a bio-similar, but completely new product. It’s made from a different salt and/or a totally different process. The FDA in its discretion (depending on the benefits/costs of development) awards a higher exclusivity period. For example for our NDA Desvenlafaxine Base Extended Release (bioequivalent version of the innovator drug Pristiq by Pfizer) was approved with a 21-month exclusivity.

How are Indian Generic companies affected by GDUFA?

Introduction of GDUFA (Generic drug user fee Act passed into Law July 2012) in US. As per this act, the generic companies are required to pay user fees to USFDA, for application of drugs and manufacturing facilities. This fee will be utilized by USFDA to engage additional resources in order to reduce current and pending applications and speed up the approval process.

This will probably lead to some escalation in ANDA filing fees. Time will tell how significant an impact this will have and whether this will affect the pace of filing of Abbreviated New Drug Application (ANDA).

4. What is the difference between terms like API, Bulk drugs, Intermediates, Finished Dosage, and Formulations that are common jargons in the Pharmaceutical Industry?

API ‚Äď Active Pharmaceutical Ingredient – is the basic drug itself with the desired medicinal (pharmaceutical) properties. Also referred to as Bulk¬†Drugs.

Intermediates ‚Äď Most chemical reactions are stepwise, that is they take more than¬†one elementary step to complete. An API is a result of a complex chain of chemical¬†reactions in several steps. Intermediates are stable forms a few steps away from the¬†final API e.g. API -3, or API-5.

Finished Dosage or Formulation ‚Äď is the form in which the drug is consumed by us. A¬†dosage form of a drug is usually composed of two things: The API, which is the drug¬†itself; and an excipient, which is the substance of the tablet, or the liquid the API¬†is suspended in, with other masking, stabilising and binding agents/material that is¬†pharmaceutically inert.

APIs are supplied by Pharmaceutical manufacturers to Formulations players or for own consumption for in-house Formulations. Intermediates are supplied to API manufacturers for reducing time-to-market.

5. What kind of regulations govern the marketing of APIs, Formulations and Intermediates?

Pharmaceuticals are a heavily regulated sector. API manufacturers need to file a document known as Drug master File (DMF) with regulatory bodies. DMFs are filed with USFDA, MHRA UK, Japan and other country specific bodies for receiving a marketing authorization grant. A DMF provides the regulatory authority with confidential, detailed information about facilities, processes, or articles used in the manufacturing, processing, packaging, and storing of one or more drugs.

Typically, a DMF is filed when two or more firms work in partnership on developing or manufacturing a drug product. The DMF filing allows a firm to protect its intellectual property from a potential partner while complying with regulatory requirements for disclosure of processing details.

A Formulations player can only use APIs from sources with approved DMFs. Formulation players have to submit samples and documentation for product registration such as ANDA (Abbreviated New Drug Application) using an API source with approved DMFs. It’s difficult to change API partners as it involves a lot of paperwork and re-submissions.

Use of Intermediates by API suppliers are not regulated.

6. We have heard Oncology APIs command higher margins than other APIs. Is that true, why?

There are broadly 3 streams ‚Äď Oncology, Hormones & Steroids that command higher¬†margins.

This is basically because it costs a lot to put up manufacturing facilities for these streams, usually 5-6x than normal, as these drugs require specialized handling. These facilities require stringent entry procedures and isolation chambers/procedures to reduce risks of product contamination, cross-contamination and also protecting people from hazards and toxicity. These are as mandated by the regulatory Authorities. Scaling up proves very costly and barriers to entry are strong.

Consequently, there is less competition and hence more margins.

7. With Many drugs going off-patent in 2013-2015 timeframes, API Players with listed US DMFs stand to gain. Is there a way to guage the potential business a listed DMF API player can access?

You can get a rough estimate of the market size for a drug API. Potential market sizes of popular brands going off-patent are common knowledge. Any small investor can get that info with a little bit of searching. For e.g. you will easily find Gemcetabine had a US$1350 annual market size before patent expiry. Prices crash roughly 70% post patent expiry. So US$405 Mn is the total market size for a Gemcitabine Formulations player. Usually the player who gets the 180 days exclusivity corners 60% of this market as his brand gets established, and Distributors play a very strong role to ensure that others don’t get in subsequently. Other formulation players have to ply their Generic brands at much lower levels.

The API market size for that drug would be ~10%, or $41 Mn. The ANDA registered Formulations players will have tied up with respective API players with approved DMFs. It depends on the existing tie-ups, how much business the API player can target. So the only way you can know how much business is forthcoming is if the API player chooses to disclose that!

DMF Approvals come with a Submit date. Gemcitabine had approved DMFs starting 2005, with some registrations coming in as late as April 2011. Can we take it that those listed earlier in general have a greater chance at securing more tie-ups?

Well in general that may be true. But there are other scenarios. There are Dossier players who file ANDAs and sell them to someone interested in manufacturing. They are not interested in taking it beyond R&D to manufacturing.

Then there are CRAMS players contracted by Innovator drug companies for Formulations. These CRAMS players are usually at liberty to choose API players of their choice. Sometimes the CRAMS player itself is also the API manufacturer.

The new manufacturer or CRAMS player may choose to go with their own API suppliers.

Will this not entail substantial time and costs in re-submission of ANDA documents with the new API sources?

??

8. Please demystify some other jargons like CCS, Custom Synthesis and CRAMS and their importance in the Pharma outsourcing space.

There are three broad outsourcing opportunities available to India ‚Äď Custom Chemical¬†Synthesis or CCS, clinical trials and contract manufacturing or CRAMS. The most¬†scalable business opportunity for Indian players would be contract manufacturing or¬†CRAMS. This is because:

  • CCS would typically involve supply of material at gram or kilogram level, while¬†CRAMS involves supplies in tons.
  • CCS supplies are linked to the success of the partner’s R&D pipeline and are,¬†hence, volatile. CRAMS supplies, on the other hand, are linked to the success of a¬†product post commercialization and can provide relatively stable revenues (since¬†probability of success post commercialization is higher than that at the R&D level).

However, custom synthesis or CCS skills are important from the following perspective:

  • CCS assignments give Indian players an opportunity to lock-in into MNC¬†relationships very early in the product lifecycle. This augurs well for the¬†partnership approach that lays the foundation of the outsourcing business.
  • CCS projects demonstrate a company’s ability in process innovation. CCS skills can¬†help a company to graduate from only a ‘supplier’ to a ‘preferred strategic partner’.
  • CCS projects are characterized by high margins but low scale, but CRAMS projects¬†offer scale plus reasonable margins. Hence, a proper mix of CCS and CRAMS projects¬†is a prerequisite for success in the outsourcing space.

Given the above discussion it would appear that a CRAMS player who is also a substantial API player can enjoy very good profitability

Yes, absolutely. Look at Divi‚Äôs Labs ‚Äď their secret of such high margins is probably this¬†API+CRAMS combination.

9. Can you please elaborate on the key factors that help win Outsourcing Contracts?

Time and quality: Time and quality are of extreme importance to the innovator companies. In R&D, time is very important to save on the limited patent life, and in manufacturing, it is a matter of reputation for innovator companies to market the drugs during the entire patented period. Also, high quality products are essential to win contracts. Due to the nature of pharmaceuticals, threat of product contamination or excess impurities is enough to scare the potential customer. Also, the drug quality has significant implication on the reputation of the innovator and financial liabilities of the company.

Availability of manufacturing capacity: Just as timeliness of supply is critical, sufficient capacity is key to the new business especially for contract manufacturing. Innovator companies generally request rapid turnaround time. Existing manufacturing capacity is critical for time-sensitive projects. However, where supply relationships already exist, the ability to plan for projected new capital needs can be jointly accomplished.

Reputation and track record: If the CRAMS player was the service provider for the innovator company in the past, and had delivered satisfactory services, the customer will most likely opt for the same CRAMS player for similar or new projects on the basis of the trust that has been built. Also, innovator companies will generally prefer big CROs and CMOs due to available infrastructure and service quality.

Array of services offered: Generally, innovators like to get maximum possible services from same contract research company due to ease in administration and effective communication regarding requirements. For example, if a company has synthesized a chemical, it might be a good choice for other services such as process chemistry too.

Reliability and flexibility: Suppliers should be reliable in terms of dedicated management team, financial stability, strong track record of supply, manufacturing, logistics, etc. Flexibility is also extremely important to innovators, as CMOs often collaborate with them to develop a new drug. In particular, the ability to adjust manufacturing schedules to meet deadlines, adjust manufacturing processes, and meet critical timelines is very important.

Scalability: Pharmaceutical customers prefer suppliers who have the ability to increase their scale of production, as products move from early stages to later stages of drug development. In general, this means suppliers should have ready availability of CGMP capacity as products pass through FDA hurdles, or the means to rapidly build additional capacity in conjunction with the anticipated product launch. In addition, it requires a scalable process used to manufacture the molecule. In other words, the contract manufacturer must develop a process that can effectively and affordably manufacture commercial quantities of the molecule. This ties closely to contract-manufacturing process chemistry skills. We believe that these skills are critical, yet very difficult to assess (other than increased contract wins).

Cost: Our discussions with various CRAMS players suggest that before the advent of Asia as the outsourcing destination, cost was not a major selection criterion, as the western CRAMS players had almost the same cost structure as innovators. Rather, it was the relationship and expertise which mattered. This is still true in the case of contract research work, where timeliness and proximity of the service provider is more important than cost. However, entry of Indian and Chinese companies in the space has changed the rules of the game and has made costing a major consideration for innovator companies, as the Asian CRAMS players can deliver the same quality as European players in a timely manner and at considerably lower cost due to structural advantages. Cost is of significant importance for awarding manufacturing contracts especially for products going off-patent.

10. China is not a threat yet?

China is a manufacturing powerhouse in sectors like Textiles, Metals and Commodities,¬†where it derives significant cost advantage through economies of scale. By its very nature,¬†pharmaceutical manufacturing is a batch-process industry, wherein economies of scale¬†are relatively less important and do not result in significant cost advantage. Though China’s¬†labor costs may be less than India’s, the latter enjoys a lead over China in critical determinants¬†like chemistry skills, compliance to strict international regulatory norms, scientific skills,¬†MNC comfort, etc. For instance, India has the largest number of US-FDA approved¬†facilities outside USA, while China has very few such facilities. India accounts for 25-30% of global DMF filings while Chinese companies contribute a minuscule percentage.¬†Hence, we do not expect China to be a major threat to India in the CRAMS space in the¬†next five years despite having the advantage of lower labor costs.

 

Source(s):

1. Interview with Shri Rajesh Joshi ‚Äď VP, International Marketing with a leading¬†Pharma company

2. Motilal Oswal CRAMS Sector Report March 2011

3. Equitymaster Pharma Sector Report

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