Nicholas Piramal

The demerger of Nicholas Piramal's R&D arm will improve cash flows and help the company focus on core business. First it was Dr Reddy's followed by Sun Pharma to hive off their R&D units into separate entities. Now, Nicholas Piramal India too has joined this group of pharma companies trying to balance increasing R&D costs with rapid expansion of the core business. This idea is gaining further currency–Ranbaxy too is weighing its options on splitting R&D from its core manufacturing activity.

The Mumbai-based company decided to demerge its R&D unit into a separate company called Nicholas Piramal Research Company (NPRC). With this demerger, the company will be left with two businesses – a domestic formulations business generating revenues of Rs 1,200 crore and custom manufacturing business with a turnover of Rs 1,100 crore. While Nicholas can now focus on improving its core businesses, why did it opt for separating its R&D arm and how do shareholders benefit?

The need for demerger

With all its five compounds in the research pipeline at the pre-clinical stage few years ago, Nicholas could fund its R&D costs from internal sources. Now, it has 13 compounds, four of which are in clinical stages. With R&D accounting for 5 to 6 per cent of sales (Rs 126 crore) and clinical stages accounting for two-thirds of the R&D costs, funding was becoming an issue. Says N Santhanam, CFO, Nicholas, "NPRC is expected to have a revenue expenditure of Rs 73 crore for FY08 which may move up to Rs 140 crore in the next fiscal depending on the number of compounds in the clinical phase." After the demerger, NPRC can raise capital either by accessing the markets by way of listing or a rights issue; or by bringing in financial or strategic investors.

Another reason for the demerger is that even though the company has a choice of out-licensing its compounds at an early stage, Nicolas has chosen to continue its development and bring the compound to market. Out-licensing is transferring costly clinical trials to another research company but retaining the patent, and sharing future revenues on the development. Nicholas believes that rewards would be optimal if it outlicensed after proof-of-concept stage which is the end of phase II clinical trials. For compounds such as cancer drug P-276, its best bet, the company may develop and market the product on its own as the patient size for clinical trials is a few hundreds and the drug needs a smaller team to market it.

NPRC prospects

While shareholders will get one share of NPRC for every 10 shares held in Nicholas, a bank of 13 compounds at various levels of development and a few facilities, are there any growth prospects for the demerged research entity? The two sources of revenues for NPRC are from out-licensing its compounds or sales after the compound is launched.

In the best case scenario, the company expects to complete clinical trials for P-276 and launch it in FY11. Till then, it will have only expenses to show for its efforts, unless it outlicenses some of the compounds. Thus, shareholders aren't going to get revenue growth in this high risk, high returns business of developing new chemical entities over the short term.

So how does the market value a pure research company? An indicator is the sole listed R&D unit, Sun Pharmaceuticals Advanced Research Company, the demerged R&D arm of Sun Pharma. This company got listed in July at Rs 87.20 and is currently trading at Rs 80 with a market capitalisation of nearly Rs 1,600 crore. It has one NCE lead, an antihistamine molecule, which is in phase II trials in the US and is few years away from being commercialised.

The market for the 13 compounds that NPRC is working on has a size of $48 billion, but it will be some time before benefits flow to the NPRC shareholders. But shareholders have the Nicholas Piramal stock to look forward to—it should clock 25 per cent growth over the next two years.

CMO and international operations

Thanks to the Morpeth acquisition in the UK last year, Nicholas's custom manufacturing operations (CMO) business grew 41 per cent y-o-y in the first quarter. From a single customer — Pfizer – with which it has a supply arrangement till 2011, the company has added three more customers. This will help the Morpeth business to grow at 20 per cent and achieve operating margins of 15 per cent for FY08. The Morpeth facilities contribute 10 per cent to the total turnover.

The company has also been able to improve revenues at Avecia, its other UK operation acquired nearly two years ago. Says Santhanam, "A 20 per cent growth in revenues was achieved in the last fiscal by getting new clients and sourcing raw material from India." This has resulted in cost savings and the business has turned around from a 13 per cent loss at the operating level to an estimated 5 per cent positive contribution in FY08.

Morpeth and Avecia's Scottish operations are likely to be the growth drivers as far as Nicholas' international operations are concerned with growth rates of 15-20 per cent. Going forward, the company expects the principal manufacturing centre of Avecia at Huddersfield in the UK to act as a feeder site for Indian operations. The share of Nicholas's international operations would be around 25 per cent in FY08 revenues of around Rs 3,000 crore

Valuations

The June 2007 quarter results have not been good for Nicholas Piramal. Due to government action on supply of codeine, sales of Phensedyl cough syrup slumped. This best-selling brand caused a top line erosion of Rs 25 crore and a Rs 15 crore drop at the operating level. But going forward, the management does not see any problems in sourcing codeine. After the demerger announcement of NPRC, Nicholas has raised its guidance from Rs 13 to Rs 17 for FY08 largely due to the reduction in R&D costs. At the current price of Rs 293, India's largest Crams stock trades at 17 times its FY08 earnings, while peers in this category Divi's (Rs 1210), Jubilant (Rs 291) and Dishman (Rs 310) trade at 31, 17 and 20 times their estimated current fiscal earnings.