India and Africa are steady growth markets: We expect India and Africa, along with Middle East (70% of overall revenue), to remain the key growth drivers in the near-to medium-terms. Despite disruption in the domestic market due to pricing policy, Cipla has been able to outpace industry growth by a wide margin and the company expects growth momentum to sustain making for a positive impact on shares. In Africa, Cipla is consolidating its position by acquiring front-ends and expects growth momentum to accelerate from H2.
Respiratory franchise—poised for growth: Cipla has been investing in respiratory portfolio to build a formidable franchise in this lucrative market. While Cipla has been in the forefront of respiratory market in India, it is steadily building both pipeline as well as front-end in regulated markets. While the launch of respiratory products in the EU is a medium-term trigger (CY15/16), the company expects respiratory portfolio in the US to unfold beyond CY17.
Operational structure in place; operating leverage to kick in: While the gross margin over the past 12 quarters has moved from 53% of sales to 62%, Cipla has reinvested the profit in building the front-end (personnel cost up 6% over the past 12 quarters) and pipeline (R&D cost up 2%). We expect operating leverage to kick in from Q4FY14/Q1FY15. The organisational setup is almost complete now with all the key people on board and expect personnel cost to consolidate at these levels.
FCF generation to increase: With the investment cycle behind us, we expect Cipla to generate strong FCF (free cash flow) over the next three years. Cipla generated FCF of Rs 5.2 bn in FY13 and could generate Rs 33 bn FCF over FY14-16; 10% of current m-cap. Further, with ramp-up in capacity use, and an improving margin profile, return ratios would improve.
Valuations to reach historical level: Cipla is trading at a 20% discount to peers and its five-year multiple of 20-21x. With improved earnings traction, FCF and return ratios, valuations should go back to historical level. We maintain our Buy rating with a price objective of Rs 505 (24% upside potential).