Cipla Limited Case Study: Impact of Acquisition on Intrinsic Value
Valuations can change
Introduction:
If you're a regular reader of my newsletter, you've likely noticed that I conduct thorough research on companies before making investment decisions. My strategy involves long-term investments, often spanning a decade or more. If you're new here, I recommend exploring my fragility series, which delves into the intricacies of my investment methodology.
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In this post, I'll delve into one of the numerous aspects of valuation using Cipla Limited as case study.
Cipla Limited
Cipla is engaged in the Business of Pharmaceuticals and is India’s oldest Pharmaceutical company. Cipla is presently the 3rd largest pharmaceutical player in India and leader in therapies such as respiratory and urology. It also ranks 2nd in the overall chronic business. It is the 2nd largest Indian exporter in emerging markets.
Cipla has nearly 90 years of rich history. In 1935, Cipla was founded by Khwaja Abdul Hamied as the Chemical, Industrial & Pharmaceutical Laboratories in Mumbai. In July 1984, the name of the company was changed to 'Cipla Limited',
One of his famous statements was:
"Never again will India be starved of essential drugs."
He said this in an advertisement of Cipla in 1947, when India was facing a shortage of medicines due to the partition. He also said:
"Unlike other pharmaceutical companies around the world, we are not here to make profits but to bring relief and healthcare to the poor who may otherwise have to die for want of quality drugs."
He said this while handing over his company to his son, Yusuf Hamied, who continued his legacy since the 1970s. In 1999, under Yusuf Hameid leadership, Cipla joined the Indian Pharmaceutical Alliance as a founding member in an effort to promote the development of generic drugs in India.
On July 27th, 2023, there was news from CNBC-TV18 that Cipla’s promoters are in talks with private equity firms to sell a part of their total holding in the company. At present, The promoters own 33.47 percent stake in the company.
Cipla immediately clarified the following:
This refers to the news on CNBC TV18 regarding Cipla promoters looking to sell a part stake in the promoter shareholding to private equity investors with some detail. Pursuant to Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirement) Regulations 2015 (Listing Regulations), we hereby clarify that the Company is not aware of any event that requires disclosure under Listing Regulations. The Company will make appropriate disclosure in compliance with the Listing Regulations as and when any such requirement arises. Kindly take the above information on record.
There were subsequent news articles stating that the third/fourth generation of the promoter family is not interested in continuing the legacy and looking at exit. Further, Strategic investors like Torrent Pharma and Financial investors like Blackstone and Baring Asia are interested in acquiring a stake in the company. Cipla has not confirmed any of these news articles.
The said news may or may not happen. In this post, as a thought experiment, I would like to address one of the many interesting aspects of valuation of a company.
Intrinsic Value of Cipla Limited
Before getting into valuation, let’s look at the financials of the company.
All the four key financial ratios indicate that the company is robust and not fragile.
Now that we are convinced that the company is not fragile, we can move to the next step in the investment process i.e. valuation.
In FY2023, the company on consolidated basis earned revenue of ~Rs 23000 Crs and PAT of ~ Rs 3000 Crs as against revenue and PAT in FY2012 of ~Rs 7000 Crs and ~ Rs 1100 Crs.
The Profits and revenue nearly tripled in 10 years which is a CAGR of 12%. If we extrapolate this growth for next 10 years, then the company will likely earn revenue of Rs 70000 Crs and PAT of Rs 9000 Crs.
The company on an average traded at PE of 31 in the last 10 years. Considering this as terminal PE after 10 years, then the company's value after 10 years will work out to Rs 2,79,000 Crs.
Now here’s where calculating intrinsic value gets interesting. The intrinsic value depends on the growth rate/return the investor is seeking.
For example, if an investor looks at growing his/her investment at a CAGR of 15% for next 10 years, then we need to discount Rs 2,79,000 Crs by 15% to arrive at a present value of ~Rs 70000 Crs i.e share price of Rs 867 per share.
If an investor instead is looking at growing his/her investment at a CAGR of 12% for next 10 years, then we need to discount Rs 2,79,000 Crs by 12% to arrive at a present value of ~Rs 93000 Crs i.e share price of Rs 1152 per share.
Cipla is presently trading at valuation of Rs 95,740 Crs at share price of Rs 1186 per share which is nearly 12% CAGR growth rate as calculated above.
While the average PE of Cipla in the last 10 years was 31, the PE fluctuated from as high as 55 to as low as 20. In the last 10 years, If an investor had accumulated the shares of the company whenever PE was below 31 and held the shares without further accumulation whenever PE crossed 31, then the returns can be further maximized over 12% as acquiring PE will be much lower than average PE of 31. This is one of the strategies an investor can utilize when accumulating shares of a company to maximize returns i.e. acquiring whenever share is trading below average PE.
While I covered how intrinsic value can change with expected returns of minority investors like us and at PE levels at which the share is acquired. I also would like to cover another aspect of how acquisition by a majority investor can impact a company's valuation.
The Impact of Acquisition on Intrinsic Value
One of the strategic investor i.e. Torrent Pharma is looking at acquiring the company. We don't know whether this news is true or not as both Torrent and Cipla denied the news. However, what we are doing here is only a thought experiment.
Torrent Pharma is valued at ~ Rs 63000 Crs is the 10th largest Pharma company looking at acquiring Cipla which is the 3rd largest Pharma company. Cipla’s promoters presently hold a stake of 33.46% in the company. They are expecting a sale price of Rs 1350 per share i.e. at market cap of Rs 1,10,000 Crs. Value of promoters' stake at Rs 1350 per share works out to Rs 36000 Crs.
Apart from paying ~ Rs 36000 Crs to acquire promoters stake, Torrent is also required to give an open offer of acquiring further 26% stake as per SEBI guidelines for a consideration of ~ Rs 28000 Crs. That means, Torrent Pharma or any other acquirer needs to be ready with funds of Rs 64000 Crs to acquire Cipla Limited.
The Rs 64000 Crs to be paid to acquire Cipla is more than market cap of Torrent Pharma. Torrent Pharma is required to raise funds at various levels including raising debt in Cipla itself to acquire the company.
Raising debt in Cipla to acquire Cipla is called leveraged buyout. Raising Debt in Cipla will increase fragility in the company. To raise debt at moderate fragile levels, debt of 3 times PBT can be considered. PBT of Cipla in FY2023 is Rs 4000 Crs. That means, Torrent can look at raising debt in Cipla to the tune of Rs 12000 Crs to part fund the acquisition. In FY2023, Cipla had cash and investments of Rs 4500 Crs and Debt of Rs 800 Crs. Accordingly, net cash surplus available with the company is Rs 3700 Crs. Torrent can also look at utilizing this money for acquisition. Accordingly, Torrent can look at withdrawing cash of Rs 3700 Crs and also raise debt of Rs 12000 crs i.e. total amount that can be raised from Cipla for its acquisition is Rs 15700 Crs.
From a minority investor’s point of view, the value of Cipla will deteriorate by ~Rs 15700 Crs due to this leveraged buyout as that much money is taken out. Further, considering the increase in fragility of the company due to leveraged buyout, we may consider to further discount the value of the company by 20% i.e. another ~Rs 18600 Crs. Accordingly, value of the company will deteriorate by Rs 34300 Crs i.e. revised value of the company for an investor looking at 12% CAGR will now work out to Rs 58700 Crs i.e. Rs 730 per share as against present trading value of Rs 1186 per share.
As calculated, the value of a company can change due to changes in capital structure or how it is acquired.
Conclusion
Discount rate i.e. rate of returns sought by investors can impact valuation of a company. Further, change in capital structure like in leveraged buyout can also impact valuations of a company.
Stocks discussed in this newsletter are not recommendations and are for education purposes only.
If you found this post valuable, please like/comment and do share it with your friends and colleagues who might also benefit from it by asking them to subscribe to my weekly newsletter - weekly posts every Sunday at 8 AM (please note that there may be occasional interruptions due to personal commitments). You can forward this email or click on the social media buttons below. Thank you for reading and subscribing to my newsletter! Your support is greatly appreciated.
Nice post. Looks attractive to me. Two possibilities:
1. Buyout occurs: Avail open offer/exit position.
2. Buyout does not occur: Strong balance sheet, strong brand and distribution. Demographic tailwinds of increasing human population, increasing prosperity and leading to increasing per-capita spends on medication.
Thoughts?
Leveraged buyout seems unfair.
In layman terms if I want to buy a car but don't have enough money to buy the car, Then I will raise money by selling the music system of the car that I am going to buy?