Three days back, India Ratings downgraded Wockhardt rating to AA- from AA with negative outlook.
One of our equity analysts is alumni of CRISIL Ltd. As per his knowledge, movements in rating are based on current financial standing of the company. As far as the company’s rating stands above BB+ rating, the company has sound rating and financial stability.
In our case, Wockhardt has AA- rating which is 7 notches above BB+ rating. [AA-, A+, A, A-, BBB+, BBB, BBB-, BB+]
The reason for rating change is in lines with our assessment of company’s standing as on date. We wish to re-iterate that the company has not been able to resolve regulatory concerns since 24+ months. We have also visited Aurangabad for its AGM to understand future course of action by the management.
Top-line: Because of this slow moving resolution, US revenues have taken a hit. Since US revenues have higher margin, profitability looks more subdued than revenues. We expect US revenues to start flowing in from FY18. Meanwhile, the management making an attempt to source drugs through third party facilities. Though margins will be lower in third party manufacturing but from time value of money concept, it makes sense to use this route. To lower the impact of subdued US revenues, the company is working hard in India, Middle East and LatAm markets. Sales growth from these geographical regions is quite encouraging.
Debt: We observe that debt to operating cash flow has been quite in comfortable range despite high R&D cost outgo. Operating cash flow is the cash available after all the expenses, funds held but not released by clients. This should be used to judge whether the company has debt servicing capacity. The management hinted that they have purposely kept debt in control to focus on sustainability of business rather than accelerated growth. One would remember that the company has seen its worst in 2008-2011 due to leverage and derivatives contract working against it. The company has come out of all the pains and the bankers are more than happy to help now. In addition to current debt levels, the bankers are willing to fund more than 1.5x of current debt based on financial viability.
Research: As we had mentioned previously, the company has strong pipeline including anti-infectives. One of the five drug is under abriged phase three trial and likely to get funding from Biomedical advanced research and Development authority. This will partially reduce the R&D costs and release pressure from operating margins. Rest of the drugs are likely to be monetized post FY20.
Succession planning:Dr. Habil Khorakiwala is old and we believe that Murtuza Khorakiwala will take over the reins of the company after him. Murtuza is a doctor from GS Medical and MBA from University of Illinois, USA. He is equally capable and passionate to take the business forward.
Valuation: We are assuming the company to grow its earnings by 19% on due to current low base. Our MRP implies Revenues of Rs. 6000 Cr and net margins of 20%. We have assigned a reasonable 16xEPS price multiple.
In worst case scenario, lets assume revenues to touch Rs. 5000-5500 Cr and margins returning to 16-18%. At our first purchase price of Rs. 1250/- (MCap 11,000 Cr), the stock trades at PE 11-14x earnings. The stock has corrected 40% since then.
At current price of Rs. 693/share, the stock trades at PE 5.7-7x earnings. If we had known earlier that the stock would ever correct back to 5-7X EPS, we would have sat calm till that time. Since we saw value even at 1,250/share, we were happy to accumulate at 11-14xEPS.
A wise person would ask, if its so lucrative why not average at every price correction?
In investing, risk control is equally important as the stock idea. We may find bargains frequently, but its important to assign probabilities to our estimates materializing. Since this business requires very high R&D and R&D can fail to commercialize or undergo failure during trail phase. Taking into consideration all those factors, we have capped the investment to 3% of portfolio. You may add just 1-2% of portfolio at current levels if you want but we do not advise to keep on averaging a stock which goes lower and lower. It defeats the purpose of assigning Max recommended % allocation for downside risk control. Future is always uncertain and things may pan out outside our expectations, hence we recommend holding 15-18 stocks in portfolio.
One has to be prepared to hold this investment for 12-18 months to see some gains. It is ok to hold a company which currently shows paper loss if potential gains are likely to outweigh temporary pains. Unless we see material changes in our valuation, we do not get influenced.
Please read this blog for understanding more. Avoid Noise in long term investing