NATCO Pharmaceuticals Ltd.

BUY
November 10th, 2018

Natco Pharma demonstrated robust results in the past financial year.

Natco’s Q1FY19 earnings were inline with analyst consensus estimates
on account of strong sales driven through domestic business (which
grew after a sluggish period of 4 quarters) wherein it had good growth
in oncology segment and the hep C portfolio sales stabilized from the
prior quarter. Export business contribution from our generic products of
Liposomal Doxorubicin and Lanthanum Carbonate remain strong
especially due to strong market penetration in Brazilian market. Firm Stock Snapshot
demonstrated 28% Y-o-Y growth in revenue & the profit margin grew by NSE CODE: NATCOPHARM
94% reaching over 181 crores. Though the sales target for the recently
BSE CODE 524816
introduced copoxane drug were reduced the market share reached
CMP: 755.05
about 16% within two quarters of introduction. Given Natco Pharma’s
RECOMMENDATION BUY
strong history of vertical integration, experienced management, robust
R & D pipeline we are bullish on the stock with a expected price of Rs. TARGET PRICE 1015.88
1015.88 and return of 34.54%. TARGET RETURN: 34.54%

Sector Overview: Overall the pharma sector offers a plethora of Shareholding Pattern (%)
opportunities and robust growth potential owing to government’s PROMOTERS: 48.34
increasing push for health protection. The generic drug market in India PUBLIC: 51.66
is stabilizing with a positive regulatory support while on the export side
the regulatory framework in the American and European markets is
settling down post the changes proposed under Trump-care. Indian
companies received 304 Abbreviated New Drug Application (ANDA)
approvals from the US Food and Drug Administration (USFDA) in 2017.
The Government of India unveiled 'Pharma Vision 2020' aimed at making
India a global leader in end-to-end drug manufacture. Approval time
for new facilities has been reduced to boost investments. The drugs and
pharmaceuticals sector attracted cumulative FDI inflows worth US$
15.83 billion between April 2000 and June 2018, according to data
released by the Department of Industrial Policy and Promotion (DIPP).

NATCO Pharma: Natco Pharma derives 47% of its revenues from SALES BREAKDOWN
international markets, primarily United States and 32% of its revenues from India.
It differentiates itself from the rest of the pack by focusing on the complex India International API Others
generics space in the United States where there is significant barrier to
competition due to the technical difficulty and has a fairly sticky portfolio. The 9%
key products it offers in the US are gCopaxone 20/40mg treating multiple
13% 32%
sclerosis and gTamiflu tablets/suspension for flu. The Indian pipeline is strong in
hepatitis c and oncology treatment. The company’s future pipeline has strong
oncology and cardio treatment products which are typically high value
products.
46%
Key Metrics
Particulars Mar-18 Mar-17 Mar-16 Mar-15

Gross Margin (%) 46% 42% 34% 25%

EBITDA Margin (%) 43% 43% 26% 25%

Net Profit Margin (%) 31% 23% 14% 16%

Return on Equity (%) 23% 29% 12% 16%

P/E (x) 21 29 89 93
Investment Thesis:
Improving market share of gCopaxone
The medicine which targets MS is arguably the most valuable drug Key Brands
in Natco’s arsenal. Launched in 2017 the drug has a market value
of 3508 million USD. Even by the most conservative estimates,
Natco’s generic should be able to capture roughly a third of the
market share. The company which initially found it difficult to take
market share has started picking up pace on the back of the
discounts offered by its marketing partner for the drug, Mylan and
now has over 20% of the market. Considering that the market is
sticky and pricing power isn’t hard to get, and that other players
are some distance away from developing this drug, we feel that
the price doesn’t truly reflect this source of revenue.
Source: Investor Presentation
Strong Indian Market
The company’s Indian portfolio is strong in oncology and cardio Stock Market Insights
products which are sold at an average of 98% discount to branded
ones. These are specialty drugs and have grown at a CAGR of 27%
over the past 5 years. The other notable drug that Natco
manufactures for the Indian markets is the Hepatitis C drug
Hepcinat. This drug faced significant price erosion because of new
entrants and was responsible for the marginal dip in the Indian
revenues in FY18. The situation has since improved with marginal
players leaving the market and prices rising again and this can be
seen in the Q1 and Q2 numbers. Source: BSEIndia.com

Upcoming product portfolio US Markets Spending & Growth

The company has an excellent product in its pipeline most
significant of which are Nexavar and Revlimid generics. Nexavar
which comes under oncology has an estimated market value of
7112 million USD. Accounting for the multiple player who have their
eyes on this drug the value for Natco is estimated to be 450 million
USD. The company has confirmed that it has settled the litigation
which also specifies the launch date which is for he time being
confidential. The product is expected to launch in FY22. Closer still,
the myeloma drug Revlimid is in the final stages of approval. While
other competitors like Dr Reddy’s are in contention, the company
seems confident of being getting the FTF tag which would mean a
potential windfall for the company. The company also has 16 FTF
approved drugs which it has yet to launch.

ROW markets
The CEO Mr. Rajeev Nannapaneni indicated that the company
should break even in its Brazilian operation HY2FY19 and post that
should start generating significant cashflow after it got approvals
for 2 of its complex generics in Brazil. It also expects strong growth
in Canada to continue over the next few years. The company
expects is also looking to expand aggressively into the Philippines
with a diverse portfolio. Finally, the company has started exporting
the drug Hepcinat to some of the 105 countries that it has secured
non exclusive rights to from its agreement with Gilead Sciences.

Niveshak, IIM Shillong

Marketing structure
The company targets complex generics with significant entry barriers for entry into the United States.
Additionally, it takes these products in partnership with a strong player like Mylan and BreckenRidge as its
marketing partner. This lets it create a strong brand for its generics in the United States. In countries like India
since they sell only speciality pharmaceuticals, they need a comparatively much lighter sales force to
effectively push their products. The outsourcing of marketing in the United states and asset light marketing in
developing countries means that they can have much higher return on the invested capital focussing on their
core competency i.e. R&D.

Potential Risks
Adverse assessment of a manufacturing facility by any key regulatory body has the potential to significantly
change the business prospects of the pharmaceutical company. The firm also exposes itself to risk arising out
of declining generic drug markets and over dependence on exports. The exports market sales are highly
sensitive to regulatory framework and currency risks. Also, the primary advantage is of low-cost production
which can be mitigated by the ever-rising domestic labor costs & raw material availability. Also, as a policy
the firm focuses on collaborating with marketing and distributing agencies in export markets exposing it to risk
arising out of performance of those firms especially in competitive emerging markets like Brazil where
company’s performance is reliant on third party performance.

Stock Performance
Stock of NATCO Pharma has rewarded its long- 1.15
time investors with adequate returns over the 1.1
last six to twelve months. The stock has 1.05
traditionally been more volatile than the
1
broader markets due to a variety of reasons.
0.95
The firm has shown sector beating growth in
revenues and margins. 0.9
0.85
Strong fundamentals coupled with a strong
0.8
product pipeline makes this stock an attractive 01-Jun-18 01-Jul-18 01-Aug-18 01-Sep-18 01-Oct-18 01-Nov-18
buy at the current valuation.
NATCO SENSEX

Technical Analysis

Technical analysis of NATCO Pharma reassures

our “BUY” rating for the stock. MACD (12,26)
levels of 6.29 has recently moved above the
signal line which indicates a bullish view of the
stock. A breakout above the exponential
moving average of 28 days also assures a
positive potential for growth in the stock of
NATCO Pharma.
RSI of 55.64 also suggest that it is the right time to
take positions in the stock at the current price
levels.

Niveshak, IIM Shillong

Absolute Valuation

NATCO Pharma - DCF Valuation

INR in Millions, except per share items 31-03-2019 31-03-2020 31-03-2021 31-03-2022 31-03-2023

Operating Income: ₹ 10,780.25 ₹ 11,557.82 ₹ 12,335.42 ₹ 13,128.50 ₹ 13,981.45

Less: Taxes: ₹ 2,425.56 ₹ 2,600.51 ₹ 2,775.47 ₹ 2,953.91 ₹ 3,145.83

Plus: Depreciation & Amortization: ₹ 724.06 ₹ 778.00 ₹ 892.00 ₹ 922.33 ₹ 953.69

Plus: Goodwill Impairment: - - - - -
Plus: Deferred Income Taxes: - - - - -
Change in Working Capital (from CFS): ₹ 780.92 ₹ 745.50 ₹ 680.74 ₹ 650.61 ₹ 620.78
Less: Capital Expenditures: ₹ 455.31 ₹ 485.36 ₹ 517.39 ₹ 551.54 ₹ 587.94

Unlevered Free Cash Flow ₹ 15,166.10 ₹ 16,167.19 ₹ 17,201.02 ₹ 18,206.89 ₹ 19,289.69

Present Value of Free Cash Flow ₹ 14,232.47 ₹ 13,361.46 ₹ 12,519.48 ₹ 11,670.27 ₹ 10,888.88

Projection Year: - 1.000 2.000 3.000 4.000 5.000

Normal Mid-Year Convention Discount: 0.500 1.500 2.500 3.500 4.500

Free Cash Flow Growth Rate: 6.6 % 6.4 % 5.8 % 5.9 %

NATCO Pharma - Asuumptions & Output

Terminal EBITDA Multiple: 9.0x
Terminal Growth Rate: 4.5%
Terminal Value: ₹ 2,22,737.28
As per our analysis, we remain bullish on NATCO
Implied EBITDA Multiple: 70.7 x
Pharma’s long-term growth potential backed by
a strong product pipeline that is yet to hit the
markets and a portfolio of market leading PV of Terminal Value: 1,25,733
products. Sum of PV of Cash Flows: 62,673
Enterprise Value: ₹ 1,88,405.99
We expect the margins to go up even further
backed by increased operational efficiencies
and rationalization of costs. The company’s net Terminal Value % EV: 66.7%
profit as a percentage of sales has improved by
as much as 15% in the last three years. Enterprise Value: ₹ 1,88,405.99
The revenue is expected to grow at a healthy Plus: Cash & Cash Equivalents: ₹ 1,720.32
pace of 6-7% in the medium term before falling Plus: Equity Interests: -
to a sustainable growth rate of 4.5%. Less: Debt & Capital Leases: ₹ 1,730.10
Key risks for the company include rising Less: Preferred Stock: ₹ 0.00
regulatory hurdles which can potentially impact Less: Noncontrolling Interests: -
the impact the product launch schedule. Implied Equity Value: ₹ 1,91,856.41
Intrinsic price as per discounted cash flow
analysis comes out to be INR1042.70 Diluted Shares Outstanding: 184.00
Implied Share Price: ₹ 1,042.70

Niveshak, IIM Shillong

 NATCO Pharma - Net Present Value Sensitivity - Terminal Growth Rates"
Discount Rate
$1,042.70 12.8% 13.0% 13.2% 13.4% 13.6% 13.8% 14.0% 14.2%
4.2% ₹ 1,103.49 ₹ 1,079.52 ₹ 1,056.61 ₹ 1,034.69 ₹ 1,018.87 ₹ 993.61 ₹ 974.32 ₹ 955.81
Terminal Growth

4.4% ₹ 1,117.69 ₹ 1,092.99 ₹ 1,069.40 ₹ 1,046.86 ₹ 1,030.59 ₹ 1,004.63 ₹ 984.83 ₹ 965.84

4.5% ₹ 1,132.40 ₹ 1,106.93 ₹ 1,082.63 ₹ 1,059.43 ₹ 1,042.70 ₹ 1,016.01 ₹ 995.68 ₹ 976.18
Rate

4.7% ₹ 1,147.65 ₹ 1,121.37 ₹ 1,096.33 ₹ 1,072.43 ₹ 1,055.21 ₹ 1,027.77 ₹ 1,006.87 ₹ 986.85

4.8% ₹ 1,163.47 ₹ 1,136.35 ₹ 1,110.52 ₹ 1,085.89 ₹ 1,068.16 ₹ 1,039.91 ₹ 1,018.43 ₹ 997.85
5.0% ₹ 1,179.90 ₹ 1,151.88 ₹ 1,125.22 ₹ 1,099.82 ₹ 1,081.55 ₹ 1,052.47 ₹ 1,030.37 ₹ 1,009.22

Market Based Valuation

CMP P/E
Piramal Ent. 2290.80 8.65
Sun Pharma 597.45 35.27
Unichem Labs 216.80 26.25
For the purpose of relative valuation, we Aurobindo Pharma 815.30 20.24
compared NATCO’s P/E ratio with its Cadilla Health 360.25 18.61
competitors in the Indian pharmaceuticals
Dr. Reddy's 2400.00 25.97
market.
Cipla 526.95 29.92
Majority of the trading peers of listed
pharmaceutical companies are currently Average 23.56
trading at a P/E multiple in the range of 20- 25th Percentile 19.43
30x. 75th Percentile 28.09
Average P/E multiple of the sector currently
stands at 23.56x. NATCO Pharma’s last NATCO EPS 37.74
reported full year EPS is 37.74.
Using a weighted average method, we Implied Share Price
calculated an implied share price of Average 889.00
INR935.41. 25th Percentile 733.02
75th Percentile 1,059.81

Price 935.41

Investment Summary

Method Value Weights Fair Value

Market Based Valuation 935.41 0.25 233.85
DCF Based Valuation 1042.70 0.75 782.02
Fair Value 1015.88

Current Market Price 755.05

Recommendation BUY

Niveshak, IIM Shillong