By AltG Innovation Centre On Behalf Of Poornima Vardhan And Taponeel Mukherjee
Cipla Deal has taken the spotlight in recent weeks with a series of significant developments. It all began with Blackstone's bold offer of $3.8 billion for a 33.46% stake in the Hamied family's business. Subsequently, Torrent Pharma is rumoured to enter the scene with a non-binding bid that carried a 30% premium over Blackstone's offer. The latest reports suggest that Bain Capital and Dr Reddy's Lab may also be preparing to join the competition for Cipla.
There are only 2 rules in Private Equity: Rule No. 1: Purchase Price Matters, Rule No. 2: Don't forget Rule No.1
At the current valuation of $12.5 billion and P/E of 31.25, the 5-year return on invested capital (ROIC) on the Cipla investment for Blackstone will be a meagre 7.5-8.5% (assuming the earning growth in the next 5 years is the same as 5 year historical CAGR of ~8% and the multiple remains constant) way below the SENSEX return in the last 5 years.
However, there are a few cases in which Blackstone can substantially earn a higher return:
1. P/E Multiple Increase:
If we assume the earnings growth to be constant at 8% over the next five years, an increase in P/E multiple from 31.25 to 40, 45 and 49.5 (Torrent's current P/E multiple) will generate 13.5%, 16.2% and 18.4% return respectively for Blackstone.
However, Cipla is a stable business with consistent margins and predictable cash flows (excluding Covid); a substantial growth event is needed for a significant change in the P/E multiple in the next few years.
2. Earnings Increase: Cipla has highlighted 2 major growth channels it is currently pursuing: The launch of Cippoint, the diagnostics medical device for the Indian market and the increase in B2C footprint focusing on wellness instead of illness. However, the verdict on the success of earnings growth from these initiatives is still out, with limited traction at this time.
Suppose we keep the current P/E multiple constant, for an earnings growth of 13% and 15% (vs. current CAGR of 8% at a current valuation of $12.5 billion and P/E of 31.25). In that case, Blackstone's 5-year return on Cipla investment will be 13% and 15% approximately in INR terms.
The Winning Strategy: Creative Deal-Making For Torrent Pharma
While Torrent Pharma has an established history of growing through acquisitions, the buyout of Cipla to create the 2nd largest Pharma company can be a real winner on the following accounts:
1. Highly EPS Accretive:
While Cipla trades at a P/E of 31.25, Torrent trades at a 59% premium at a current P/E of 49.5, thereby making the transaction highly EPS accretive. Torrent can also creatively use its stock or a mix of stock and cash to generate substantial long-term shareholder value, thereby a win-win for all parties.
This is similar to the highly successful asset-swap deal between Novartis and GlaxoSmithKline in 2014.
2. Higher Operating Margins and Realised Cost Synergies:
Rationalising manufacturing footprint and leveraging economies of scale, Torrent Pharma is positioned to generate high returns by buying Cipla.
If we keep the current P/E multiple constant for Torrent constant at 49.5, for an earnings growth of 8%, 13% and 15% (vs. current CAGR of 8%), Torrent's 5-year return on Cipla investment will be 18.5%, 24% and 26% respectively in INR terms. The returns calculated assume that once Torrent buys Cipla, Cipla's earnings will be valued at Torrent's current P/E multiple of 49.5.
This is a very attractive outcome for Torrent Pharma which will also get access to a much more extensive North America portfolio.
The Latest Horse in the race: Dr Reddy's Laboratories (DRL)
With DRL's volatile growth and margins, there will be a limited upside to acquiring Cipla at a substantial premium to the current valuation. This is true even if they partner with a financial sponsor (rumoured to be Bain Capital)
Low P/E Multiple: DRL trades at a current P/E multiple of 19.7, 63% of Cipla's current multiple. This implies that this deal will be value dilutive, unlike the case with Torrent Pharma.
Operating Margins And Realised Cost Synergies: Even with Cipla's improved margins (to match DRL's 12% 10-year earnings growth CAGR), buying Cipla has very limited upside for DRL.
If we keep the current P/E multiple constant for DRL constant at 19.7, for an earnings growth of 12% and 15% (vs. Cipla's current CAGR of 8%), DRL's 5-year return on Cipla investment will be a miniscule 2.13% and 4.9% respectively in INR terms. The returns calculated assume that once DRL buys Cipla, Cipla's earnings will be valued at DRL's current P/E multiple of 19.7.
Even in the best-case scenario, the return on this deal is 300 basis points lower than the 5-year Government Bond Yield (currently at 7.187%).
The Unlikely Pharma Heroes
The 2 other pharma giants that can potentially look at acquiring Cipla are Sun Pharma and the newly IPO'd Mankind Pharma. Both these companies have unique strengths: Sun Pharma's enviable and extensive sales team can drive the topline significantly vs. the cash-rich Mankind Pharma with a significant P/E premium at 58.7 (vs. Cipla's P/E at 31.25) and a comprehensive consumer portfolio might just be what the doctor ordered for next phase of Cipla's growth. A merger of Cipla with any of these two companies will be accretive.
Any reference to “returns” above means “Return On Invested Capital” (ROIC)
All returns are in INR terms
Conversion Rate Assumed: 1 USD = INR 80
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