Chapter 1 Introduction

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Introduction to Finance

Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really investing if you aren't performing fundamental analysis. Because the subject is so broad, however, it's tough to know where to start. There are an endless number of investment strategies that are very different from each other, yet almost all use the fundamentals. The goal of this tutorial is to provide a foundation for understanding fundamental analysis. It's geared primarily at new investors who don't know a balance sheet from an income statement. While you may not be a "stock-picker extraordinaire" by the end of this tutorial, you will have a much more solid grasp of the language and concepts behind security analysis and be able to use this to further your knowledge in other areas without feeling totally lost. The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance. A good part of this tutorial will be spent learning about the balance sheet, income statement, cash flow statement and how they all fit together. But there is more than just number crunching when it comes to analyzing a company. This is where qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company. Finally, we'll wrap up the
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tutorial with an intro on valuation and point you in the direction of additional tutorials you might be interested in.

What is Fundamental Analysis?

In this section we are going to review the basics of fundamental analysis, examine how it can be broken down into quantitative and qualitative factors, introduce the subject of intrinsic value and conclude with some of the downfalls of using this technique.

The Very Basics

When talking about stocks, fundamental analysis is a technique that attempts to determine a securitys value by focusing on underlying factors that affect a company's actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements. Fundamental analysis serves to answer questions, such as:

-enough position to beat out its competitors in the future?

Of course, these are very involved questions, and there are literally hundreds of others you might have about a company. It all really boils down to one question: Is the companys stock a good investment? Think of fundamental analysis as a toolbox to help you answer this question. Note: The term fundamental analysis is used most often in the context of stocks, but you can perform fundamental analysis on any security, from a bond to a derivative. As long as you look at the economic fundamentals, you are doing fundamental analysis.

Fundamentals: Quantitative and Qualitative You could define fundamental analysis as researching the fundamentals, but that doesnt tell you a whole lot unless you know what fundamentals are. As we mentioned in the introduction, the big problem with defining fundamentals is that it can include anything related to the economic well-being of a company. Obvious items include things like revenue and profit, but fundamentals also include everything from a companys market share to the quality of its management. The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isnt all that different from their regular definitions. Here is how the MSN Encarta dictionary defines the terms: capable of being measured or expressed in numerical terms. related to or based on the quality or character of something, often as opposed to its size or quantity. In our context, quantitative fundamentals are numeric, measurable characteristics about a business. Its easy to see how the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets and more with great precision. Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a companys board members and key executives, its brand-name recognition, patents or proprietary technology. Quantitative Meets Qualitative Neither qualitative nor quantitative analysis is inherently better than the other. Instead, many analysts consider qualitative factors in conjunction with the hard, quantitative factors. Take the Coca-Cola Company, for example. When examining its stock, an analyst might look at the stocks annual dividend payout, earnings per share, P/E ratio and many other quantitative factors. However, no analysis of Coca-Cola would be complete without taking into account its brand recognition.
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Anybody can start a company that sells sugar and water, but few companies on earth are recognized by billions of people. Its tough to put your finger on exactly what the Coke brand is worth, but you can be sure that its an essential ingredient contributing to the companys ongoing success. Concept of Intrinsic Value Before we get any further, we have to address the subject of intrinsic value. One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stocks real value. After all, why would you be doing price analysis if the stock market were always correct? In financial jargon, this true value is known as the intrinsic value. For example, lets say that a companys stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value. This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long the long run really is. It could be days or years. This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals. The big unknowns are: 1) You dont know if your estimate of intrinsic value is correct; and 2) You dont know how long it will take for the intrinsic value to be reflected in the marketplace.

Criticisms of Fundamental Analysis

The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the efficient market hypothesis. Technical analysis is the other major form of security analysis. Were not going to get into too much detail on the subject. Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stocks price movements give more insight than the underlying fundamental factors of the business itself. Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the markets many participants, making it impossible for anyone to meaningfully outperform the market over the long term.

Qualitative Factors - The Company

Before diving into a company's financial statements, we're going to take a look at some of the qualitative aspects of a company. Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since qualitative factors, by definition, represent aspects of a company's business that are difficult or impossible to quantify, incorporating that kind of information into a pricing evaluation can be quite difficult. On the flip side, as we've demonstrated, you can't ignore the less tangible characteristics of a company. In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of. Business Model Even before an investor looks at a company's financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model it's how a company makes money. You can get a good overview of a company's business model by checking out its website or reading the first part of its 10-K filing (Note: We'll get into more detail about the 10-K in the financial statements chapter. For now, just bear with us). Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand. Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest
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loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt. At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were. Competitive Advantage Another business consideration for investors is competitive advantage. A company's long-term success is driven largely by its ability to maintain a competitive advantage - and keep it. Powerful competitive advantages, such as Coca Cola's brand name and Microsoft's domination of the personal computer operating system, create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achieve competitive advantage, its shareholders can be well rewarded for decades. Harvard Business School professor Michael Porter distinguishes between strategic positioning and operational effectiveness. Operational effectiveness means a company is better than rivals at similar activities while competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Investors should know that few companies are able to compete successfully for long if they are doing the same things as their

competitors. Professor Porter argues that, in general, sustainable competitive advantage gained by:

--vis competitors ctivities tailored to the company's strategy

ensure sustainability)

Management Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financial success. Some believe that management is the most important aspect for investing in a company. It makes sense - even the best business model is doomed if the leaders of the company fail to properly execute the plan. So how does an average investor go about evaluating the management of a company? This is one of the areas in which individuals are truly at a disadvantage compared to professional investors. You can't set up a meeting with management if you want to invest a few thousand dollars. On the other hand, if you are a fund manager interested in investing millions of dollars, there is a good chance you can schedule a face-to-face meeting with the upper brass of the firm. Every public company has a corporate information section on its website. Usually there will be a quick biography on each executive with their employment history, educational background and any applicable achievements. Don't expect to find anything useful here. Let's be honest: We're looking for dirt, and no company is going to put negative information on its corporate website. Instead, here are a few ways for you to get a feel for management:

1. Conference Calls The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host quarterly conference calls. (Sometimes you'll get other executives as well.) The first portion of the call is management basically reading off the financial results. What is really interesting is the question-and-answer portion of the call. This is when the line is open for analysts to call in and ask management direct questions. Answers here can be revealing about the company, but more importantly, listen for candor. Do they avoid questions, like politicians, or do they provide forthright answers? 2. Management Discussion and Analysis (MD&A) The Management Discussion and Analysis is found at the beginning of the annual report (discussed in more detail later in this tutorial). In theory, the MD&A is supposed to be frank commentary on the management's outlook. Sometimes the content is worthwhile, other times it's boilerplate. One tip is to compare what management said in past years with what they are saying now. Is it the same material rehashed? Have strategies actually been implemented? If possible, sit down and read the last five years of MD&As; it can be illuminating. 3. Ownership and Insider Sales Just about any large company will compensate executives with a combination of cash, restricted stock and options. While there are problems with stock options (See Putting Management Under the Microscope), it is a positive sign that members of management are also shareholders. The ideal situation is when the founder of the company is still in charge. Examples include Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you know that a majority of management's wealth is in the stock, you can have confidence that they will do the right thing. As well, it's worth checking out if management has been selling its stock. This has to be filed with the Securities and Exchange Commission (SEC),
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so it's publicly available information. Talk is cheap - think twice if you see management unloading all of its shares while saying something else in the media. 4. Past Performance Another good way to get a feel for management capability is to check and see how executives have done at other companies in the past. You can normally find biographies of top executives on company web sites. Identify the companies they worked at in the past and do a search on those companies and their performance. Corporate Governance Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations. The purpose of corporate governance policies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conduct unethical and illegal activities. Good corporate governance is a situation in which a company complies with all of its governance policies and applicable government regulations (such as the Sarbanes-Oxley Act of 2002) in order to look out for the interests of the company's investors and other stakeholders. Although, there are companies and organizations (such as Standard & Poor's) that attempt to quantitatively assess companies on how well their corporate governance policies serve stakeholders, most of these reports are quite expensive for the average investor to purchase. Fortunately, corporate governance policies typically cover a few general areas: structure of the board of directors, stakeholder rights and financial and information transparency. With a little research and the right questions in mind, investors can get a good idea about a company's corporate governance.

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Financial and Information Transparency This aspect of governance relates to the quality and timeliness of a company's financial disclosures and operational happenings. Sufficient transparency implies that a company's financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the company's current financial situation. Stakeholder Rights This aspect of corporate governance examines the extent that a company's policies are benefiting stakeholder interests, notably shareholder interests. Ultimately, as owners of the company, shareholders should have some access to the board of directors if they have concerns or want something addressed. Therefore companies with good governance give shareholders a certain amount of ownership voting rights to call meetings to discuss pressing issues with the board. Another relevant area for good governance, in terms of ownership rights, is whether or not a company possesses large amounts of takeover defenses (such as the Macaroni Defense or the Poison Pill) or other measures that make it difficult for changes in management, directors and ownership to occur. Structure of the Board of Directors The board of directors is composed of representatives from the company and representatives from outside of the company. The combination of inside and outside directors attempts to provide an independent assessment of management's performance, making sure that the interests of shareholders are represented. The key word when looking at the board of directors is independence. The board of directors is responsible for protecting shareholder interests and ensuring that the upper management of the company is doing the same. The board possesses the right to hire and fire members of the board on behalf of the shareholders. A board filled with insiders will often not serve as objective critics of management and will defend their actions as good and beneficial, regardless of the circumstances.
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Information on the board of directors of a publicly traded company (such as biographies of individual board members and compensation-related info) can be found in the DEF 14A proxy statement. We've now gone over the business model, management and corporate governance. These three areas are all important to consider when analyzing any company. We will now move on to looking at qualitative factors in the environment in which the company operates.

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Qualitative Factors - The Industry

Each industry has differences in terms of its customer base, market share among firms, industry-wide growth, competition, regulation and business cycles. Learning about how the industry works will give an investor a deeper understanding of a company's financial health. Customers Some companies serve only a handful of customers, while others serve millions. In general, it's a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues. For example, think of a military supplier who has 100% of its sales with the U.S. government. One change in government policy could potentially wipe out all of its sales. For this reason, companies will always disclose in their 10-K if any one customer accounts for a majority of revenues. Market Share Understanding a company's present market share can tell volumes about the company's business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far. Furthermore, this could also suggest that the company possesses some sort of "economic moat," in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry. Industry Growth One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow. In
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some markets, there is zero or negative growth, a factor demanding careful consideration. For example, a manufacturing company dedicated solely to creating audio compact cassettes might have been very successful in the '70s, '80s and early '90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of what it was during the peak of its popularity. Competition Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms. One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power. Regulation Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes. In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation. In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug
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industry is one of most regulated industries. And for good reason - no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public. However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development. All in all, investors should always be on the lookout for regulations that could potentially have a material impact upon a business' bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.

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Introduction to Financial Statements

The massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. On the other hand, if you know how to analyze them, the financial statements are a gold mine of information. Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use the quantitative information gleaned from financial statements to make investment decisions. Before we jump into the specifics of the three most important financial statements - income statements, balance sheets and cash flow statements - we will briefly introduce each financial statement's specific function, along with where they can be found. The Major Statements The Balance Sheet- The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner: Assets = Liabilities + Shareholders' Equity Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years. The Income Statement- While the balance sheet takes a snapshot approach in examining a business; the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a
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month or even a day, but you'll only see public companies report quarterly and annually. The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period. Statement of Cash Flows-The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities: -to-day business operations Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets

borrowing of funds The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason some investors use the cash flow statement as a more conservative measure of a company's performance. 10-K and 10-Q Now that you have an understanding of what the three financial statements represent, let's discuss where an investor can go about finding them. Management Discussion and Analysis (MD&A) As a preface to the financial statements, a company's management will typically spend a few pages talking about the recent year (or quarter) and provide background on the company. This is referred to as the management discussion and analysis (MD&A). In addition to providing investors a clearer picture of what the company does, the MD&A also points out some key areas in which the company has performed well. Don't expect the letter from management to delve into all the juicy details affecting the company's performance. The management's analysis is
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at their discretion, so understand they probably aren't going to be disclosing any negatives. Here are some things to look out for:

ficant financial trends over the past couple years? (As we've already mentioned, it can be interesting to compare the MD&As over the last few years to see how the message has changed and whether management actually followed through with its plan.) lear are management's comments? If executives try to confuse you with big words and jargon, perhaps they have something to hide.

Disclosure is the name of the game. If a company gives a decent amount of information in the MD&A, it's likely that management is being upfront and honest. It should raise a red flag if the MD&A ignores serious problems that the company has been facing. The Auditor's Report The auditors' job is to express an opinion on whether the financial statements are reasonably accurate and provide adequate disclosure. This is the purpose behind the auditor's report, which is sometimes called the "report of independent accountants". By law, every public company that trades stocks or bonds on an exchange must have its annual reports audited by a certified public accountants firm. An auditor's report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements. The typical auditor's report is almost always broken into three paragraphs and written in the following fashion:

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Independent Auditor's Report Paragraph 1 Recounts the responsibilities of the auditor and directors in general and lists the areas of the financial statements that were audited. Paragraph 2 Lists how the generally accepted accounting principles (GAAP) were applied, and what areas of the company were assessed. Paragraph 3 Provides the auditor's opinion on the financial statements of the company being audited. This is simply an opinion, not a guarantee of accuracy. While the auditor's report won't uncover any financial bombshells, audits give credibility to the figures reported by management. You'll only see unaudited financials for unlisted firms (those that trade OTCBB or on the Pink Sheets). While quarterly statements aren't audited, you should be very wary of any annual financials that haven't been given the accountants' stamp of approval. The Notes to the Financial Statements

Just as the MD&A serves an introduction to the financial statements, the notes to the financial statements (sometimes called footnotes) tie up any loose ends and complete the overall picture. If the income statement, balance sheet and statement of cash flows are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. Therefore, if you aren't reading the footnotes, you're missing out on a lot of information. The footnotes list important information that could not be included in the actual ledgers. For example, they list relevant things like outstanding leases, the maturity dates of outstanding debt and details on compensation plans, such as stock options, etc. Generally speaking there are two types of footnotes:
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policies. It may be that a firm is practicing "cookie jar accounting" and is changing policies only to take advantage of current conditions in order to hide poor performance. Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt - such as maturity dates and the interest rates at which debt was issued - can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings involving the company. The majority of investors and analysts read the balance sheet, income statement and cash flow statement but, for whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking for information that others typically wouldn't. No matter how boring it might be, read the fine print - it will make you a better investor. The Income Statement The income statement is basically the first financial statement you will come across in an annual report or quarterly Securities And Exchange Commission (SEC) filing. It also contains the numbers most often discussed when a company announces its results - numbers such as revenue, earnings and earnings per share. Basically, the income statement shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain time period. When it comes to analyzing fundamentals, the income statement lets investors know how well the companys business is performing - or, basically, whether or not the company is making money. Generally speaking, companies ought to be able to bring in more money than they spend or they dont stay in
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business for long. Those companies with low expenses relative to revenue - or high profits relative to revenue - signal strong fundamentals to investors. Revenue as a investor signal Revenue, also commonly known as sales, is generally the most straightforward part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenue by business segment or geography. The best way for a company to improve profitability is by increasing sales Accounting Methods This type of footnote identifies and explains the major accounting policies of the business that the company feels that you should be aware of. This is especially important if a company has changed accounting revenue. For instance, Starbucks Coffee has aggressive long-term sales growth goals that include a distribution system of 20,000 stores worldwide. Consistent sales growth has been a strong driver of Starbucks profitability. The best revenue are those that continue year in and year out. Temporary increases, such as those that might result from a shortterm promotion, are less valuable and should garner a lower price-to-earnings multiple for a company. What are the Expenses? There are many kinds of expenses, but the two most common are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company. For example, if Wal-Mart pays a supplier $4 for a box of soap, which it sells to customers for $5. When it is sold, Wal-Marts cost of good sold for the box of soap would be $4. Next, costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. SG&A also includes depreciation and
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amortization. Companies must include the cost of replacing worn out assets. Remember, some corporate expenses, such as research and development (R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may make for a better-looking earnings report. Finally, there are financial costs, notably taxes and interest payments, which need to be considered. Profits = Revenue - Expenses Profit, most simply put, is equal to total revenue minus total expenses. However, there are several commonly used profit subcategories that tell investors how the company is performing. Gross profit is calculated as revenue minus cost of goods sold. Returning to Wal-Mart again, the gross profit from the sale of the soap would have been $1 ($5 sales price less $4 cost of goods sold = $1 gross profit). Companies with high gross margins will have a lot of money left over to spend on other business operations, such as R&D or marketing. So be on the lookout for downward trends in the gross margin rate over time. This is a telltale sign of future problems facing the bottom line. When cost of goods sold rises rapidly, they are likely to lower gross profit margins unless, of course, the company can pass these costs onto customers in the form of higher prices. Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. High operating margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings. Net income generally represents the company's profit
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after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings". When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times - leaving them even better positioned when things improve again. Conclusion You can gain valuable insights about a company by examining its income statement. Increasing sales offers the first sign of strong fundamentals. Rising margins indicate increasing efficiency and profitability. Its also a good idea to determine whether the company is performing in line with industry peers and competitors. Look for significant changes in revenues, costs of goods sold and SG&A to get a sense of the companys profit fundamentals. The Balance Sheet Investors often overlook the balance sheet. Assets and liabilities aren't nearly as sexy as revenue and earnings. While earnings are important, they don't tell the whole story. The balance sheet highlights the financial condition of a company and is an integral part of the financial statements.

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The Snapshot of Health

The balance sheet, also known as the statement of financial condition, offers a snapshot of a company's health. It tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets" or "shareholders equity". The balance sheet tells investors a lot about a company's fundamentals: how much debt the company has, how much it needs to collect from customers (and how fast it does so), how much cash and equivalents it possesses and what kinds of funds the company has generated over time. The Balance Sheet's Main Three Assets, liability and equity are the three main components of the balance sheet. Carefully analyzed, they can tell investors a lot about a company's fundamentals. Assets There are two main types of assets: current assets and non-current assets. Current assets are likely to be used up or converted into cash within one business cycle - usually treated as twelve months. Three very important current asset items found on the balance sheet are: cash, inventories and accounts receivables. Investors normally are attracted to companies with plenty of cash on their balance sheets. After all, cash offers protection against tough times, and it also gives companies more options for future growth. Growing cash reserves often signal strong company performance. Indeed, it shows that cash is accumulating so quickly that management doesn't have time to figure out how to make use of it. A dwindling cash pile could be a sign of trouble. That said, if loads of cash are more or less a permanent feature of the company's balance sheet, investors need to ask why the money is not being put to use. Cash could be there because management has run out of investment opportunities or is too short-sighted to know what to do with the money. Inventories are finished products that haven't yet sold. As an investor, you want to
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know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventory. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers. Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the company is moving merchandise through the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deteriorating fundamentals. Receivables are outstanding (uncollected bills). Analyzing the speed at which a company collects what it's owed can tell you a lot about its financial efficiency. If a company's collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can spell trouble later on, especially if customers face a cash crunch. Getting money right away is preferable to waiting for it - since some of what is owed may never get paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise, equipment, loans, and best of all, dividends and growth opportunities. Non-current assets are defined as anything not classified as a current asset. This includes items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is in financial distress and is liquidating assets, investors need not pay too much attention to fixed assets. Since companies are often unable to sell their fixed assets within any reasonable amount of time they are carried on the balance sheet at cost regardless of their actual value. As a result, it's is possible for companies to grossly inflate this number, leaving investors with questionable and hard-to-compare asset figures. Liabilities There are current liabilities and non-current liabilities. Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers. Non-current liabilities, meanwhile, represent what the company owes in a year or more time.
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Typically, non-current liabilities represent bank and bondholder debt. You usually want to see a manageable amount of debt. When debt levels are falling, that's a good sign. Generally speaking, if a company has more assets than liabilities, then it is in decent condition. By contrast, a company with a large amount of liabilities relative to assets ought to be examined with more diligence. Having too much debt relative to cash flows required to pay for interest and debt repayments is one way a company can go bankrupt. Look at the quick ratio. Subtract inventory from current assets and then divide by current liabilities. If the ratio is 1 or higher, it says that the company has enough cash and liquid assets to cover its short-term debt obligations. Quick Ratio = Current Assets - Inventories Current Liabilities Equity Equity represents what shareholders own, so it is often called shareholder's equity. As described above, equity is equal to total assets minus total liabilities. Equity = Total Assets Total Liabilities The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares. In other words, retained earnings are a tally of the money the company has chosen to reinvest in the business rather than pay to shareholders. Investors should look closely at how a company puts retained capital to use and how a company generates a return on it. Most of the information about debt can be found on the balance sheet - but some assets and debt obligations are not disclosed there. For starters, companies often possess hard-to-measure intangible assets. Corporate intellectual property (items such as patents, trademarks, copyrights and business methodologies), goodwill and brand
27

recognition are all common assets in today's marketplace. But they are not listed on company's balance sheets. There is also off-balance sheet debt to be aware of. This is form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep the debt levels low.

The Cash Flow Statement

The cash flow statement shows how much cash comes in and goes out of the company over the quarter or the year. At first glance, that sounds a lot like the income statement in that it records financial performance over a specified period. But there is a big difference between the two. What distinguishes the two is accrual accounting, which is found on the income statement. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. At the same time, the income statement, on the other hand, often includes non-cash revenues or expenses, which the statement of cash flows does not include. Just because the income statement shows net income of $10 does not means that cash on the balance sheet will increase by $10. Whereas when the bottom of the cash flow statement reads $10 net cash inflow, that's exactly what it means. The company has $10 more in cash than at the end of the last financial period. You may want to think of net cash from operations as the company's "true" cash profit. Because it shows how much actual cash a company has generated, the statement of cash flows is critical to understanding a company's fundamentals. It shows how the company is able to pay for its operations and future growth. Indeed, one of the most important features you should look for in a potential investment is the company's ability to produce cash. Just because a company shows a profit on the
28

income statement doesn't mean it cannot get into trouble later because of insufficient cash flows. A close examination of the cash flow statement can give investors a better sense of how the company will fare. Three Sections of the Cash Flow Statement Companies produce and consume cash in different ways, so the cash flow statement is divided into three sections: cash flows from operations, financing and investing. Basically, the sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash. Cash Flows from Operating Activities This section shows how much cash comes from sales of the company's goods and services, less the amount of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a net positive cash flow from operating activities. High growth companies, such as technology firms, tend to show negative cash flow from operations in their formative years. At the same time, changes in cash flow from operations typically offer a preview of changes in net future income. Normally it's a good sign when it goes up. Watch out for a widening gap between a company's reported earnings and its cash flow from operating activities. If net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs. Cash Flows from Investing Activities This section largely reflects the amount of cash the company has spent on capital expenditures, such as new equipment or anything else that needed to keep the business going. It also includes acquisitions of other businesses and monetary investments such as money market funds. You want to see a company re-invest capital in its business by at least the rate of depreciation expenses each year. If it

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doesn't re-invest, it might show artificially high cash inflows in the current year which may not be sustainable. Cash Flow From Financing Activities This section describes the goings-on of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stockrepurchases. Cash Flow Statement Considerations Savvy investors are attracted to companies that produce plenty of free cash flow (FCF). Free cash flow signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. Free cash flow, which is essentially the excess cash produced by the company, can be returned to shareholders or invested in new growth opportunities without hurting the existing operations. The most common method of calculating free cash flow is: Ideally, investors would like to see that the company can pay for the investing figure out of operations without having to rely on outside financing to do so. A company's ability to pay for its own operations and growth signals to investors that it has very strong fundamentals. A Brief Introduction To Valuation While the concept behind discounted cash flow analysis is simple, its practical application can be a different matter. The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows: For simplicity's sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value
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of the company to determine whether the company is a good investment, based on it being undervalued or overvalued. There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration. As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and everyday investors to estimate a company's value. For more information and in-depth instructions, see the Discounted Cash Flow Analysis tutorial. Ratio Valuation Financial ratios are mathematical calculations using figures mainly from the financial statements, and they are used to gain an idea of a company's valuation and financial performance. Some of the most well-known valuation ratios are price-to-earnings and price-to-book. Each valuation ratio uses different measures in its calculations. For example, price-to-book compares the price per share to the company's book value. The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.

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Conclusion Whenever youre thinking of investing in a company it is vital that you understand what it does, its market and the industry in which it operates. You should never blindly invest in a company. One of the most important areas for any investor to look at when researching a company is the financial statements. It is essential to understand the purpose of each part of these statements and how to interpret them.

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1.2 Introduction of Research Topic

The market value of a company depends primarily on two factorsvalue of its current operations and value of future growth options. The value of current operations factors in the expected growth of current operations. Therefore, future growth options denote expected value from pipeline products/flexibility of operations. This is largely uncertain and hence very difficult to value. The traditional cash flow-based valuation only captures value of current operations and fails to justify the full market value. Since growth options are risky and at times need large investments, the traditional cash flow method may return a negative value of the future growth plan. A business also derives value from its flexibility of operations. For example, an automobile company may have to decide as to whether it should make significant investment in plant modernization which will enable the company to move towards a multi-product production platform from the present single-product production platform. If the company is currently producing only one variety of vehicles, justifying such significant investment for catering to the future needs (which may or may not arise) is not easy. Apparently such investment analysis may show negative net present value (NPV) and the project may get shelved. But, the flexibility of handling more products in future has an advantage. The question the company faces in such investment decision is, therefore, whether it would like to have the flexibility option. Another example could be justifying electronic banking network expansion for a bank where the results obtained using real options analysis enabled the networks senior management to identify conditions for which entry into the POS (point-of-sale) debit market would be profitable(Benaroch and Kauffman, 2000). The traditional approaches for evaluating information technology investments may produce the wrong recommendations. Answers to these two examples lie in the application of a
33

popular concept called real options. Results obtained using real options analysis may provide evidence to justify such investments for flexibility and/ or future growth. A popular overview on the use and application of the concept of real options is available in Luehrman (1998) who mentions that a project which may appear to be a marginal-to-terrible project through a discounted cash flow (DCF) lens may appear to be an attractive one under option valuation analysis. Various other studies have shown that the concept of real options can be applied to capture value of R&D investments in pharmaceutical industry, petroleum industry, industrial units, and even in the field of multi-media research. These studies have also shown that the DCF method cannot properly capture the options value in R&D. The extraordinary premium paid for technology stocks have caused observers to wonder whether traditional models of valuation are obsolete (Boer, 2000). The fact that market value of such stocks is primarily driven by future growth potential makes the DCF methods appear as an incomplete method of business valuation. The DCF approach favours short-term projects in relatively certain markets over long-term and uncertain projects. This point is confirmed by Dixit and Pindyck (1995) who state that the conventional NPV-Rule for capital budgeting only yields the same results as real option analysis when market and technology uncertainty tend to zero and the investment that is required for market introduction of the newly developed product is reversible. Managers intuitively use options in many business situations such as when they delay in completing an investment programme until the results of a pilot project are known. Real option models tend to give a scientific explanation to such intuitive valuations. For example, Mercks Finance Group used the Black-Scholes option-pricing model to determine the option value of an investment project (project Gamma) which required an up34

front investment of $2 million in research for a bio-technological drug. Merck had the option to abandon the project at any time if dissatisfied with the progress of the research. The present study applies the real option concept to value a pharmaceutical company in India. The study found that the traditional DCF method could hardly explain around 39 per cent of market capitalization of the company based on authors assumptions and estimates. This is because, for pharmaceutical companies, much of the market value is driven by milestones achieved in research which is not captured in DCF. The real option model to value pipeline products has improved the valuation. Similar results are observed in the US pharmaceutical industry where cash flow from current products and operations could account for about 50 per cent of market value, while the remaining was thought of as future growth value from drug development activities.

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1.3 Subject Background of the Study

Valuation of Pharmaceutical Company, Ashok Banerjee The market value of a company depends primarily on two factorsvalue of its current operations and value of future growth options. The value of current operations factors in the expected growth of current operations. Therefore, future growth options denote expected value from pipeline products/flexibility of operations. This is largely uncertain and hence very difficult to value. The traditional cash flow-based valuation only captures value of current operations and fails to justify the full market value. Since growth options are risky and at times need large investments, the traditional cash flow method may return a negative value of the future growth plan. A business also derives value from its flexibility of operations. For example, an automobile company may have to decide as to whether it should make significant investment in plant modernization which will enable the company to move towards a multi-product production platform from the present single-product production platform. If then company is currently producing only one variety of vehicles, justifying such significant investment for catering to the future needs (which may or may not arise) is not easy. Apparently such investment analysis may show negative net present value (NPV) and the project may get shelved. But, the flexibility of handling more products in future has an advantage. The question the company faces in such investment decision is, therefore, whether it would like to have the flexibility option. Another example could be justifying electronic banking network expansion for a bank where the results obtained using real options analysis enabled the networks senior management to identify conditions for which entry into the POS (point-ofsale) debit market would be profitable(Benaroch and Kauffman, 2000). The
36

traditional approaches for evaluating information technology investments may produce the wrong recommendations. Answers to these two examples lie in the application of a popular concept called real options. Results obtained using real options analysis may provide evidence to justify such investments for flexibility and/ or future growth. Valuation of Cadila Healthcare Limited, Emkay Shares Cadila Healthcare has been bogged down by various concerns like loss of revenue due to the generic launch of Pantoprazole, its foray into newer markets impacting profitability and slack domestic growth. We have analysed the various concerns surrounding the company and are of the view that the management has taken adequate measures to counter these concerns. We believe that the earnings from Hospira JV are likely to moderate the negative impact of the Pantoprazole generic launch. With the US business on high growth path (30% CAGR) and the French and Brazilian operations turning earnings accretive, Cadila's international business is likely to be the key growth driver. They expect the international business to grow at a 28% CAGR during FY08-10E. Cadila's domestic business, with its large size, lends stability to the company's operations and they view it as a cash cow to fund its international expansion.

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Chapter 2 Research Design

2.1 Statement of Problem-: a. What are the factors that affect intrinsic value of company? b. What are the factors that affect intrinsic value of Pharmaceutical Company? c. What is the application of fundamental analysis? d. What is the application of real option valuation? e. How to do economic analysis, industry analysis, and company analysis?

2.2 Research Objectives

1. Primary Objective: To do real option valuation and fundamental analysis of Pharma company 2. Sub-Objectives:

1. To understand the application of fundamental analysis 2. To understand the application of the real option valuation 3. To know the factors affecting the valuation of the company 4. To know the factors affecting the valuation of pharma company 5. To understand the application of economic analysis, industry analysis, and company analysis

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2.3 Research Scope

1. Analysis of various factors that have effect on value of Pharmaceutical Company. 2. Economic analysis, industry analysis, and company analysis of

Pharmaceutical Company. 3. Doing real-option valuation of Pharmaceutical Company.

2.4 Research Methodology

1. Research Type-: we will do descriptive research for the purpose of our study.

2. Research Method-: we will use secondary data analysis method for the purpose of our study.

3. Data Collection-: our study will be based on secondary data which will be collected from various available sources.

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2.5 Limitations of Study

1. We have made analysis mostly on secondary data base. 2. Secondary data can be bias so we cannot get perfect result. 3. Time Constraints 4. Resource Constraints

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Chapter 3 Data Analysis

3.1 Economic Analysis

1. State of the Economy and GDP Growth Rate

The economy has moved decisively to a higher growth phase. Till a few years ago, there was still a debate among informed observers about whether the economy had moved above the 5 to 6 per cent average growth seen since the 1980s. There is now no doubt that the economy has moved to a higher growth plane, with growth in GDP at market prices exceeding 8 per cent in every year since 2003-04. There was acceleration in domestic investment and saving rates to drive growth and provide the resources for meeting the 9 per cent (average) growth target of the Eleventh Five-Year Plan.1 Macroeconomic fundamentals continue to inspire confidence and the investment climate is full of optimism. Buoyant growth of government revenues made it possible to maintain fiscal consolidation as mandated under the Fiscal Responsibility and Budget Management Act (FRBMA). The decisive change in growth trend also means that the economy was, perhaps, not fully prepared for the different set of challenges that accompany fast growth. Inflation flared up in the last half of 2006-07 and was successfully contained during the current year, despite a global hardening of commodity prices and an upsurge in capital inflows. Due to recession in the global economy, Indias growth rate was declined in financial year 2008-09.

Taken from Page No. 1, http://indiabudget.nic.in/chap11.pdf at 2.00 p.m. on 21st January, 2009.

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As per the Advance Estimates of GDP for 2008-09 released by the Central Statistical Organisation on 9, February, 2009, the growth of GDP at factor cost (at constant 99-2000 prices) is estimated to grow at 7.1% during the year. The growth of GDP during 2007-08 (Quick estimates) was 9.0%.2

Taken from India's GDP estimated at 7_1% for 2008-09 - EquityBulls_com.htm at 2.00 p.m. on 21st January, 2009.

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2. Per capita income and consumption

Growth is of interest not for its own sake but for the improvement in public welfare that it brings about. Economic growth, and in particular the growth in per capita income, is a broad quantitative indicator of the progress made in improving public welfare. Per capita consumption is another quantitative indicator that is useful for judging welfare improvement. It is therefore appropriate to start by looking at the changes in real (i.e. at constant prices) per capita income and consumption.

The pace of economic improvement has moved up considerably during the last five years (including 2007-08). The rate of growth of per capita income as measured by per capita GDP at market prices (constant 1999-2000 prices) grew by an annual average rate of 3.1 per cent during the 12- year period, 1980-81 to 1991-92. It accelerated marginally to 3.7 per cent per annum during the next 11 years, 1992-93
3

Taken from Page No. 1, http://indiabudget.nic.in/chap12.pdf at 2.00 p.m. on 1st January, 2009.

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to 2002-03. Since then there has been a sharp acceleration in the growth of per capita income, almost doubling to an average of 7.2 per cent per annum (2003-04 to 2007-08). This means that average income would now double in a decade, well within one generation, instead of after a generation (two decades). The Per Capital income at current prices is estimated to grow at 14.4% during 2008-09 to reach Rs 38,084 as compared to a growth of 12.7% during 2007-08. At constant prices the per capita income is expected to grow at 5.6 percent in 2008-09 as compared to a growth of 7.6 percent in 2007-08. Per capita private final consumption expenditure has increased in line with per capita income. The growth of per capita consumption accelerated from an average of 2.2 per cent per year during the 12 years from 1980-81 to 1991-92 to 2.6 per cent per year during the next 11 years following the reforms of the 1990s. The growth rate has almost doubled to 5.1 per cent per year during the subsequent five years from 2003-04 to 2007-08. The growth in Private Final Consumption Expenditure is expected to moderate to 6.7% in 2008-09 from 8.1% in 2007-08. The growth in Government Final Consumption Expenditure is estimated to increase from 7.4% in 2007-08 to 16.8% in 2008-09. Growth in Gross Fixed Capital Formation is anticipated to decline to 8.9% from a 12.9% in 2007-08. This increase in growth of Government Final Consumption Expenditure will offset partially the decline in Private Final Consumption Expenditure and would result in GDP growth at constant market prices to touch 7.1% in 2008-09.4 The average growth of consumption is slower than the average growth of income, primarily because of rising saving rates, though rising tax collection rates can also widen the gap (during some periods). Year to year changes in consumption also suggest that the rise in consumption is a more gradual and steady process, as any sharp changes in income tend to get adjusted in the saving rate.
4

Taken from India's GDP estimated at 7_1% for 2008-09 - EquityBulls_com.htm at 2.00 p.m. on 1st January, 2009.

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3. Aggregate Demand

The most important contribution to demand growth has come from investment, while the external trade made negligible or negative contribution. The growth of GDP at market prices accelerated from 3.8 per cent in 2002-03 to 9.7 per cent in 2006-07, giving an average annual growth of 7.9 per cent for the Tenth Five Year Plan. The average rate of growth of gross capital formation during the Tenth Five Year Plan has more than tripled to 17.3 per cent per year from an average growth of 5.3 per cent per annum in the Ninth Five Year Plan. Consequently, its contribution to overall demand, as measured by the increase in GDP at market prices, tripled from 19 per cent in the Ninth Five Year Plan to 65 per cent in the Tenth Five Year Plan. The most important component of investment, namely, gross fixed investment, grew by an average of 14.3 per cent per annum during the Tenth Five Year Plan period. The relative share of private consumption in GDP was 60.9 per cent while gross fixed capital formation had a share of 27 per cent. Though the average growth of private consumption (PFCE) accelerated somewhat to 5.9 per cent per annum from 5 per cent, its contribution to growth of demand declined from 59 per cent to 46 per cent between the two plans. The contribution of net exports of goods and services to overall demand also declined between the two plans to a negative 5 per cent. Thus the external trade has had a dampening effect on aggregate demand during the just completed plan. Export growth, because of its spillover effects on productivity and efficiency, can, however, still act as a driver of growth.

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4. Sector Contribution

Rate of growth of GDP at factor cost at 1999-2000 prices (Percent)

The deceleration of growth in 2007-08 is generally spread across most of the sectors except electricity, community services and the composite category trade, hotels, transport & communications. The deceleration in the growth of the agriculture sector is attributed to the slackening in the growth of rabi crops. Manufacturing and construction, which grew at 12 per cent in 2006-07 decelerated by about 2.5 percentage points in 2007-08. The slower growth of consumer durables (as reflected in the IIP) was the most important factor in the slowdown of manufacturing. Cement and steel, the key inputs into construction, grew by 7.4 per cent and 6.5 per cent respectively, during April-November 2007- 08, down from 10.8 per cent and 11.2 per cent in the previous year, dampening the growth in the
5

Taken from Page No. 1, http://indiabudget.nic.in/chap11.pdf at 2.00 p.m. on 1st January, 2009.

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construction sector. There was also a deceleration in the growth of revenue earning freight traffic by railways, passengers handled at airports, and bank credit in AprilNovember 2007-08, which formed the basis for the full year assessment.

5. Savings and Investments

A notable feature of the recent GDP growth has been a sharply rising trend in gross domestic investment and saving, with the former rising by 13.1 per cent of GDP and the latter by 11.3 per cent of GDP over five years till 2006-07. The average investment ratio for the Tenth Five Year Plan at 31.4 per cent was higher than that

Taken from Page No. 1, http://indiabudget.nic.in/chap15.pdf at 2.00 p.m. on 1st January, 2009.

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for the Ninth Five Year Plan, while the average saving rate was also 31.4 per cent of GDP higher than the average ratio of 23.6 per cent during the Ninth Five Year Plan. The 1990s reforms transformed the investment climate, improved business confidence and generated a wave of entrepreneurial optimism. This has led to a gradual improvement in competitiveness of the entire corporate sector, resurgence in the manufacturing sector and acceleration in the rate of investment. The FRBMA mandated fiscal correction path was also helpful in raising the credibility of the Government with respect to fiscal deficits, in which India was at the bottom of global rankings. This has improved perceptions about the long-term macroeconomic stability of the economy. Moderate tax rates, coupled with buoyant sales growth, increased the internal accruals of the corporate sector. The improved investment climate and strong macro fundamentals also led to an upsurge in foreign direct investment. The combined effect of these factors was reflected in an increase in the investment rate from 25.2 per cent of GDP in the first year of the Tenth Five Year Plan to 35.9 per cent of GDP in the last year. The higher investment was able to absorb the domestic savings and also generated an appetite for absorption of capital inflows from abroad. Gross domestic savings as a proportion of GDP continued to improve, rising from 26.4 per cent in 2002-03 to 34.8 per cent in 2006-07 with an average of 31.4 per cent during the Tenth Five Year Plan. The savings-investment gap which remained positive during 2001-04 became negative thereafter. In a modern economy, the excess of domestic saving over domestic investment suggests a deflationary situation in which demand has not kept pace with increased capacity. Thus the reversal of the saving-investment balance should be viewed as corrections of the domestic supply-demand balance, occurring through above normal (and welcome) increase in demand during 2005-06 and 2006-07.
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6. Inclusive growth

Faster economic growth is also translating into more inclusive growth, both in terms of employment generation and poverty reduction. The Tenth Five Year Plan was formulated in the backdrop of the concerns over jobless growth. Employment growth slowed to 1.25 per cent per annum during 1993-94 to 1999-2000 with 24 million work opportunities created during this period (annual average of 4 million). The Tenth Five Year Plan, therefore, set a target of creation of 50 million new opportunities on current daily status basis (CDS). The 61st Round of NSSO Survey found that 47 million work opportunities were created during 1999-2000 to 2004-05, at an annual average of 9.4 million. Employment growth accelerated to 2.6 per cent during this period. The labour force, however, grew at 2.8 per cent per year, 0.2 per cent point faster than the workforce, resulting in an increase in the unemployment rate to 8.3 per cent in 2004-05 from 7.3 per cent in 1999-2000. These rates based on the CDS approach are higher than those obtained by the usual status and weekly status approaches, indicating a high degree of intermittent unemployment. Unemployment rate measured in terms of number of persons as per the usual principal and subsidiary status basis was only 2.5 per cent in 2004-05. 7 The proportion of persons below the poverty line declined from around 36 per cent of the population in 1993-94 to 28 per cent in 2004-05 as per the uniform recall period. Based on the mixed recall period, the number of persons below the poverty line has declined to 22 per cent in 2004-05 from 26 percent in 1999-2000. Further, the growth of average monthly per capita expenditure at constant prices between 1993-94 and 2004-05 (61st Round of NSSO) also indicates broadly

Taken from Page No. 10, http://indiabudget.nic.in/chap17.pdf at 2.00 p.m. on 21st January, 2009.

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similar growth across different rural and urban income classes, though it may have been less uniform for urban than for rural population.

7. Inflation

Inflation management has always been a key policy concern of the Government. Traditionally, it has been a structural issue, where seasonal variations in production, particularly of wage goods, along with market rigidities have resulted in a build up of inflationary expectations translating local impulses and concerns into a more widespread impact on the consumers. Of late, however, the changes in the structure of the economy and its more globalized nature have made management of inflation a complex task. With rising capital inflows, various monetary policy mechanisms have a more decisive role to play now. At the same time, inflationary impulses from global commodity prices have to be tackled through the use of fiscal and trade policy instruments.

8. Agriculture production

The Directorate of Economics & Statistics in its second advance estimates of agricultural production (February 7, 2007) has placed total foodgrains production at 219.3 million tonnes, marginally higher than the 217.3 million tonnes in 2006-07 (final estimate). While the production of kharif foodgrains is expected to be 5.3 million tonnes (4.8 per cent) higher than the production in 2006-07, rabi production is expected to be lower by 3.3 million tonnes. The production of cereals

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is expected to be 205 million tonnes as against 203.1 million tonnes in 2006-07 (final estimate).8 There has been a loss of dynamism in the agriculture and allied sectors in recent years. A gradual degradation of natural resources through overuse and inappropriate use of chemical fertilizers has affected the soil quality resulting in stagnation in the yield levels. Public investment in agriculture has declined and this sector has not been able to attract private investment because of lower/unattractive returns. New initiatives for extending irrigation potential have had a limited success during the Tenth Five Year Plan and only a little over 8 million ha could be brought under irrigation and only three-fourths of that could be utilized. The agricultural extension system has generally not succeeded in reducing the gap between crop yields that could have been obtained through improved practices. The Government of India has launched the National Food Security Mission and the Rashtriya Krishi Vikas Yojana to rejuvenate agriculture and improve farm income. Since these programmes have only been launched in the current year, it is not possible to assess their impact. A second green revolution, particularly in the areas which are rain-fed, may be necessary to improve the income of the persons dependent on the agriculture sector. 9. Balance of payments

The World Economic Outlook (WEO, IMF October 2007) observed that the recent expansionary phase in the global economy, with average growth of 5 per cent, was the longest since the early 1970s. The WEO update on January 2008 has, however, revised these estimates based on new PPP exchange rates from the 2005 international comparison programme (ICP). There is considerable uncertainty in
8

Taken from Page No. 10, http://indiabudget.nic.in/chap17.pdf at 2.00 p.m. on 1st January, 2009.

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quantifying the downside risk to global growth arising from the downturn in housing market and the sub-prime mortgage market crisis in the United States. Monetary policy actions by the United States and other developed countries seem to have contained its immediate impact, though more surprises in the next six months cannot be ruled out.

The Indian economy has been progressively globalizing since the initiation of reforms. Trade, an important dimension of global integration, has risen steadily as a proportion of GDP. Inward FDI has taken off and there is a surge in outward investment from a very low base, with net FDI continuing to grow at a good pace. The surge of capital flows in 2007-08 is a third indicator that testifies to the growing influence of global developments on the Indian economy. Capital flows, as a proportion of GDP, have been on a clear uptrend during this decade. They reached a high of 5.1 per cent of GDP in 2006-07 after a below trend attainment of 3.1 per cent in 2005-06. This is a natural outcome of the improved investment climate and recognition of robust macroeconomic fundamentals like high growth, relative price stability, healthy financial sector and high returns on investment. Even as the external environment remained conducive, the problem of managing a more open capital account with increasing inflows and exchange rate appreciation surfaced.

The current account has followed an inverted V shaped pattern during the decade, rising to a surplus of over 2 per cent of GDP in 2003-04. Thereafter, it has returned close to its post-1990s reform average, with a current account deficit of 1.2 per cent in 2005-06 and 1.1 per cent of GDP in 2006-07. The net result of these two trends has been a gradual rise in reserve accumulation to over 5 per cent of GDP in 2006-07.
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10.External Trade Indias greater integration with the world economy was reflected by the trade openness indicator, the trade to GDP ratio, which increased from 22.5 per cent of GDP in 2000-01 to 34.8 percent of GDP in 2006-07. If services trade is included, the increase is higher at 48 per cent of GDP in 2006-07 from 29.2 per cent of GDP in 2000-01, reflecting greater degree of openness. 1.54 Indias merchandise exports and imports (in US$, on customs basis) grew by 22.6 per cent and 24.5 per cent respectively in 2006-07, recording the lowest gap between growth rates after 200203. Petroleum products (59.3 per cent) and engineering goods (38.1 per cent) were the fastest growing exports. The perceptible increase in share of petroleum products in total exports reflected Indias enhanced refining capacity and higher POL prices. The rising share of engineering goods reflected improved competitiveness. The value of POL imports increased by 30 per cent, with volume increasing by 13.8 per cent and prices by 12.1 per cent in 2006-07. Non-POL import growth at 22.2 per cent was due to the 29.4 per cent growth of gold and silver and 21.4 per cent growth of non- POL non-bullion imports needed to meet industrial demand. 1.55 In the first nine months of the current year, exports reached US$111 billion, nearly 70 per cent of the years export target. During April- September 2007, the major drivers of export growth were petroleum products, engineering goods and gems and jewellery. Machinery and instruments, transport equipment and manufactures of metals have sustained the growth of engineering exports. There was a revival of the gems and jewellery sector with export growth at 20.4 per cent for April- September 2007, after a deceleration in 2006-07. 1.56 Imports grew by 25.9 per cent during April- December 2007 due to non-POL imports growth of 31.9 per cent, implying strong industrial demand by the manufacturing sector and for export activity. The merchandise trade deficit in
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April-December 2007 at US$ 57.8 billion was very close to the trade deficit of US$ 59.4 billion for 2006-07 (full year). Despite the large overall trade deficit, there was a large (but declining) trade surplus with the United States and UAE, and a small surplus with the United Kingdom and Singapore (till 2006-07). The surplus with the first three has continued in 2007-08. The largest trade deficits are with Saudi Arabia, China and Switzerland. The trade deficit with China has increased further in April September 2007.

11.Fiscal Deficit The Centres fiscal deficit is projected at 5.5 per cent of the gross domestic product (GDP) in 2009-10 as direct fallout of the increased spending envisaged on various schemes to spur the economy in the wake of the global downturn, coupled with lower estimates of tax revenue collections.

For the current financial year, the fiscal deficit, a yardstick that measures government spending beyond its means, was targeted at 2.5 per cent of the GDP, as per the stipulation of the Fiscal Responsibility and Budget Management (FRBM) Act. However, owing to the fall in tax revenues and the two stimulus packages put in place to combat the global financial meltdown, the fiscal deficit has shot wide off the target at 6 per cent. Presenting the interim budget for 2009-10 in the Lok Sabha, External Affairs Minister Pranab Mukherjee, who is in charge of Finance, pegged the revenue deficit at 4 per cent of the GDP for the new fiscal. The higher projection follows the over four-fold increase in revenue deficit at 4.4 per cent this fiscal as against 1 per cent of the GDP estimated in the budget for 2008-09. As a consequence, the new regime at the Centre, following the general elections, will have to rely on
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increased market borrowings to fund the higher allocations on the numerous social and employment-oriented programmes, especially when the global crisis is expected to turn grimmer during 2009. The governments gross tax revenue during 2008-09, as per the interim budget, is expected to fall short by about Rs. 60,000 crore over the budgeted estimates for the fiscal. The shortfall, Mr. Mukherjee explained, was on account of the governments proactive fiscal measures initiated to counter the impact of the global slowdown on the Indian economy.

For the new fiscal beginning April 1, 2009, the government has projected its gross tax revenue at Rs. 6,71,293 crore, which is lower than the Rs. 6,87,715 crore estimated in the budget estimates for 2008-09 but higher than the revised estimates at Rs. 6,27,949 crore for the fiscal. However, to facilitate the increased spending, the government proposes to borrow Rs. 3,08,647 crore through market loans in 2009-10.

Barring revenue collections by way of service tax, mop-up through all other major taxes, including corporation tax, income-tax, customs and excise duties, witnessed shortfalls when compared with the targets budgeted for 2008-09.9

12.Monetary Policy

Significant monetary easing since mid-September 2008 preclude further rate cuts RBI has been aggressive and pre-emptive in cutting key policy rates in the past
9

Taken from The Hindu Business Fiscal deficit pegged at 5_5 per cent of GDP.htm, at 2.00 p.m. on 1st January, 2009.

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four months in an effort to contain the considerable moderation in growth. In the aforesaid period, CRR has been reduced by 400 bps to 5%, Repo rate by 350 bps to 5.5% and reverse Repo by 200 bps to 4%. The room for such expansionary monetary steps has been provided by the rapidly falling inflation. In addition to these conventional measures, RBI also implemented various unconventional measures (reduction in SLR, special refinancing window, forex swap facility, etc) to boost liquidity in the banking system and to ensure continued flow of credit to productive sectors. In aggregate, all the above actions of the central bank are likely to augment actual/potential liquidity of over Rs3,880bn. As these measures take time to take full effect (for instance, CRR cut takes 4-6 months to take full effect), RBI preferred to keep policy rates unchanged in the interim.

Expansion in liquidity still to fully reflect in lower lending rates

The impact of unprecedented rate cuts of the recent past has been limited on the lending rates of banks whereas money market and bond market have adjusted quickly. Benchmark prime lending rates (BPLRs) of major public sector banks have come down by 150-175 bps. Major private sector banks have reduced their BPLRs by 50 bps, while major foreign banks are yet to do so. Banks have been reluctant in reducing lending rates due to 1) diminishing willingness to lend with increase in risk aversion and emphasis shifting on capital conservation and controlling asset quality 2) substantial portion of bank deposits have been mobilized at fixed interest rates in the recent past. On the other hand, overnight call rates have come-off significantly from their peak of 20% in October 2008 to below 5% at present. The 10-year G-Sec yield has declined from above 8.5% in September 2008 to below 6% currently. As liquidity easing needs to be complemented by commensurate cut in lending rates to have any demand inducing
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effects, RBI wants banks to react more actively to its policy cues. We believe that sustained weakness in credit demand may force some banks to cut lending rates sooner than later. Other highlights of the policy review Non-food bank credit growth as on Jan 2 09 at 24% yoy higher than previous year Credit to industrial sector has risen sharply on yoy basis (30% growth YTD08 v/s 25% growth YTD07) Sharp decline in credit from non-bank sources (capital markets, ECBs, etc) to the commercial sector YTD fiscal deficit at ~7% of GDP including oil and fertiliser bonds significantly higher than BE 2.5% Downward revision in Real GDP growth projection for FY09 from earlier 7.5-8% to 7% (with a downward bias) implying significant slowdown in H2 FY09 (below 6.5%) WPI inflation estimated to moderate to below 3% by end-March 2009; monetary policy to continue to anchor inflation expectations in the range of 4-4.5% Money supply growth projections raised to 19% from earlier 16.5-17% Estimated growth in non-food credit revised upwards to 24% from 20% RBI to maintain ample liquidity in the system and overnight call rates within the LAF corridor10

10

Taken From IndiaBulls_monentary_policy_review_280109.Pdf at 2.00 p.m. on 1 st January, 2009.

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3.2 Industry Analysis

1. Introduction The pharmaceutical industry is the worlds largest industry due to worldwide revenues of approximately US$2.8 trillion. Pharma industry has seen major changes in the recent years that place new demands on payers, providers and manufacturers. Customers now demand the same choice and convenience from pharma industry that they find in other segment.11

Indian Pharmaceutical Industry is poised for high consistent growth over the next few years, driven by a multitude of factors. Top Indian Companies like Ranbaxy, DRL, CIPLA and Dabur have already established their presence. The pharmaceutical industry is a knowledge driven industry and is heavily dependent on Research and Development for new products and growth. However, basic research (discovering new molecules) is a time consuming and expensive process and is thus, dominated by large global multinationals.

Indian companies have only recently entered the area. The Indian pharmaceutical industry came into existence in 1901, when Bengal Chemical & Pharmaceutical Company started its maiden operation in Calcutta. The next few decades saw the pharmaceutical industry moving through several phases, largely in accordance with government policies. Commencing with repackaging and preparation of formulations from imported bulk drugs, the Indian industry has moved on to become a net foreign exchange earner, and has been able to underline its presence in the global pharmaceutical arena as one of the top 35 drug producers worldwide.
11

Page No. 01 Indian pharma-recent outlook.pdf.

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The pharmaceutical industry in India is going through a major shift in its business model in the last few years in order to get ready for a product patent regime from 2005 onwards. This shift in the model has become necessary due to the earlier process patent regime put in place since 1972 by the Government of India. This was done deliberately to promote and encourage the domestic health care industry in producing cheap and affordable drugs. As prior to this the Indian pharmaceutical sector was completely dominated by multinational companies (MNCs). These firms imported most of the bulk drugs (the active pharmaceutical ingredients) from their parent companies abroad and sold the formulations (the end products in the form of tablets and capsules, syrups etc.) at prices unaffordable for a majority of the Indian population. This led to a revision of Government of Indias (GOI) policy towards this industry in 1972 allowing Indian firms to reverse engineer the patented drugs and produce them using a different process that was not under patent. The entry of MNCs was also discouraged by restricting foreign equity to 40%.12 The licensing policy was also biased towards indigenous firms and firms with lesser foreign equity. All these measures by GOI laid foundations to a strong manufacturing base for bulk drugs and formulations and accelerated the growth in the Indian Pharmaceutical Industry (IPI), which today consists of more than 20,000 players. As a result the Indian pharmaceutical industry today not only meets the domestic requirement but has started exporting bulk drugs as well as formulations to the international market. Currently the main activities of Indian pharmaceutical industry are broadly restricted to producing (i) bulk drugs and (ii) formulations with very few companies risking investing in primary research aimed at developing and patenting
12

Page No. 11, Indian pharma-recent outlook.pdf.

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new drugs. The bulk drug business is essentially a commodity business, where as the formulation business is primarily a market driven and brand oriented business. Multinational companies which have entered the Indian market have mostly restricted themselves to formulation segment till date. The domestic pharmaceutical industry (MNCs and Domestic) meets about 90% of the countrys bulk drug requirement and almost the entire demand for formulations. The economics of bulk drug business and that of formulation business are quite different. Since a majority of the Indian companies are producing both bulk as well as formulations, these are considered together for the purpose of the present study.

The Changing Environment During the early 1990s, markets were opened by removing restrictions on imports and in 1994 licensing were abolished for producing bulk drugs and formulations. Other than this FDI restrictions into this sector have been modified to allow 74% foreign equity through the automatic route. More favorable conditions are to follow in future particularly for MNCs as soon as Product Patents and Exclusive Marketing Rights (EMRs) are permitted. In a situation like this, there is a lot of speculation that the indigenous companies that have been the mainstay of the Indian pharmaceutical industry over the past couple of decades finally becoming a formidable part of Indian economy and a major source of foreign income might be facing uncertain market conditions in the future. It may also come down to a state where most of the small scale companies have to close down, with the multinational companies dominating and monopolizing the industry once again. There is a justified reason for this, and that is, so far Indian companies have made use of the cheap labor and the reverse engineering skills under the favorable conditions of process patent regime and developed generic replicas to drugs that were under patent in developed countries, which then were sold in the domestic markets and exported to other unregulated
60

markets elsewhere in the world. This generic business enabled them to compete with multinational companies in India and abroad and resulted in good revenues. However, once the product patent regime gets implemented from the year 2005, one is not allowed to reverse engineer drugs that are patented after 1995, and the revenues from this business will suffer. Whereas, the multinational companies in India, which have an impressive new product portfolio will get exclusive marketing rights to sell their products at higher prices and will be in a position to dictate the terms.13

Given the above, survival of Indian companies depends on producing generics of drugs whose patent has lapsed and export the same to regulated markets. This is possible only if these firms are able to formulate these products at much lower prices allowing then to face competition from established players in the international markets. Other than this, avenues like contract research and manufacturing for multinational companies have become popular business models for many small scale and medium scale firms. Given this situation it is highly likely that individual firms adopt different strategies for growth. These strategies are dependent more on the managements perception of the individual firms strength in terms of finance, manpower and material in relation with the other firms within the industry for a given environmental context. Some of these strategies may end in failure due to unexpected changes in the environment or bad judgment on the part of the management. The main question is Do internal efficiencies have any role to play in the growth of a firm irrespective of the individual growth strategies adopted in a dynamic environmental context. The above question becomes very important for firms which operate in a transition economy. This is particularly true if the transition is aimed towards being a part of
13

Page No. 03, Indian pharma-recent outlook.pdf.

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the global economy. This would create an environment where firms are faced with a completely new opportunity set in terms of investment and growth. These opportunities encourage firms to adopt high growth strategies at the cost of immediate returns. The success or failure of any such strategies is dependent on the nature of competition faced by these firms over time. Therefore it would be very reasonable to assume that a firms internal efficiencies may become the crucial deciding factor in dictating the survival and growth of these firms in various segments of pharmaceutical industry.

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2. Current Scenario

India is one the fastest growing pharmaceuticals markets in the world, growing at the CAGR of almost 10% consecutively over the last five years. From the being a purely reverse engineering industry, it has transformed into a research driven, export-oriented global industry, offering a wide range of value added products and service. The post patent era has placed it on a new growth trajectory. Strengthening of patent laws is encouraging MNCs to significantly increase the scale of investments and explore the Indian markets. Today no global major can ignore India either as a competitive sourcing base or as a destination to benefit from the rapidly growing domestic drug markets. It is quite remarkable to note that today several Indian Pharma companies are approved by US Food and Drug Administration and listed on NASDAQ and NYSE.14 In fact, since the beginning of this decade, it has been the 10th largest receiver of FDI in the country.

Improving rate of health insurance penetration, boost from medical tourism segment, and favorable regulatory mechanism and support from government have all contributed to the domestic formulation markets growth. Due to the spurt in global generics markets and superior margins, the export market is witnessing a faster growth than the domestic market. Today, the industry rank 4 th in terms of volume, with approximately 8% share in global sales. In terms of values, it ranks 13th and produces 24% of the worlds generic drugs. With the share of about 6.5%, Indian pharma industry is also one the top five Active Pharmaceuticals Ingredients producers. The industry ranks 17th with respects to export value of bulk actives and dosages. The pharmaceuticals exports in 2007-08 stood at 6.68$ bn, up against 5.73$ bn in 2006-07, registering a growth rate of 16%.
14

Page No. 05, Indian pharma-recent outlook.pdf.

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3. CRAMS (Contract Research and Manufacturing Service)

Crams refers to the contract for research and manufacturing services, which are undertaken either on a cost plus basis or a full-time equivalent basis (FTE). The complexity, time and risk involved in producing a new molecule (NME) induce innovators to outsource part of their activities to low-cost destinations. The product-patent regime (in effect from 1 Jan 2005) has changed Indias pharma sector dynamics. Reverse engineering is out the window. The options for local players (process patent experts) are: (1) remain in the low margin, highcompetition generics sector; (2) invest heavily in long gestation and risky R&D; (3) or become a Crams player. A few with an R&D background or high-quality manufacturing abilities have chosen the last option. Those who ventured into Crams have recorded performances relatively better than the pharma sector average, mainly due to high entry barriers and little competition. Fast growing: Crams (contract research and manufacturing services) is a high-potential, fast-growing sub-segment of the pharmaceutical sector in India. In FY08, revenue of the top 12 Crams players grew 42%, to Rs52bn, driven mainly by acquisitions. We expect a 30% CAGR in revenue from FY08 to FY10.

Value proposition: The top players in the sector have recorded strong operating margins 19-35%. Moreover, the risk is low, as most jobs are either on a cost-plus or a full-time-equivalent basis.

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 High entry barriers: First, Crams requires multi-technical skills. Second, R&D is highly sensitive, making customers wary of new relationships. Third, the regulatory process for approval is long and expensive, driving customers to maintain long-term partnerships.

Global outsourcing: Growth in Crams would be driven by the rising costs of drug discovery and manufacturing in developed markets, and the outsourcing trend towards low-cost destinations. India is thus turning into a preferred destination. It has the highest number of US FDA-approved plants outside the USA. In addition, India has a favorable regulatory environment and a highly skilled workforce. Initiating coverage: Crams is the fastest-growing sub-sector within Indias pharma industry, rising 38% each year from 2004 to 2008.15 This growth was driven mainly by acquisitions and outsourcing. We initiate coverage of Dishman Pharmaceuticals and Jubilant Organosys with Buy ratings, and Divis Labs and Nicholas Piramal with Hold.

15

Page No. 08, Indian pharma-recent outlook.pdf.

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4. Future Prospects The product patents regime heralds an era of innovation and research resulting in the launch of new patented product launches. In the longer run, domestic companies would face fresh competition from MNCs, as they would make aggressive new launches. However, the latter would most likely be subject to price negotiation. Drugs having estimated sales of over US$ 28 bn are expected to go off patent in the US between CY08 and CY10. With the governments in the developed markets looking to cut down healthcare costs by facilitating a speedy introduction of generic drugs into the market, domestic pharma companies will stand to benefit. However, despite this huge promise, intense competition and consequent price erosion would continue to remain a cause for concern. The life style segments such as cardiovascular, anti-diabetes and antidepressants will continue to be lucrative and fast growing owing to increased rbanization and change in lifestyles. Growth in domestic sales in the future will depend on the ability of companies to align their product portfolio towards the chronic segment. Contract manufacturing and research (CRAMS) is expected to gain momentum going forward. Indias competitive strengths in research services include English-language competency, availability of low cost skilled doctors and scientists, large patient population with diverse disease characteristics and adherence to international quality standards. As for
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contract manufacturing, both global innovators and generic majors are finding it profitable to outsource production. Currently, India has the highest number of US FDA approved plants outside the US at 75.16

16

Page No. 03, 2005-August-Pharmamethodology.pdf.

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5. Industry Profit Potential-Porters Five Force Model Todays business environment is extremely competitive and in economics parlance where perfect competition exists, the profits of the firms operating in that industry will become zero in long run. However, this is not possible because, firstly there is no perfect competition and no company is a passive price taker (i.e. no company will operate where profits are zero). Secondly, they strive to create a competitive advantage to thrive in the competitive scenario. Michael Porter, considered to be one of the foremost gurus of management, developed the famous five-force model, which influences an industry.

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Industry competition Pharma industry is one of the most competitive industries in the country with as many as 10,000 different players fighting for the same pie. The rivalry in the industry can be gauged from the fact that the top player in the country has only 6% market share, and the top five players together have about 18% market share. Thus,

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the concentration ratio for this industry is very low. High growth prospects make it attractive for new players to enter in the industry. Another major factor that adds to the industry rivalry is the fact that the entry barriers to pharma industry are very low. The fixed cost requirement is low but the need for working capital is high. The fixed asset turnover, which is one of the gauges of fixed cost requirements, tells us that in bigger companies this ratio is in the range of 3.5 to 4 times. For smaller companies, it would be even higher. Many smaller players that are focused on a particular region, have a better hang of the distribution channel, making it easier to succeed, albeit in a limited way. An important fact is that pharma is a stable market and its growth rate generally tracks the economic growth of the country with some multiple (1.2 times average in India). Though volume growth has been consistent over a period of time, value growth has not followed in tandem. The product differentiation is one key factor, which gives competitive advantage to the firms in any industry. However, in pharma industry product differentiation is not possible since India has followed process patents till date, with laws favouring imitators. Consequently, product differentiation is not the driver, cost competitiveness is. However, companies like Pfizer and Glaxo have created big brands in over the years, which act as product differentiation tools. This will enhance over the long term, as product patents come into play from 2005. Bargaining power of buyers The unique feature of pharma industry is that the end user of the product is different from the influencer (read Doctor). The consumer has no choice but to buy what doctor says. However, when we look at the buyers power, we look at the
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influence they have on the prices of the product. In pharma industry, the buyers are scattered and they as such does not wield much power in the pricing of the products. However, government with its policies, plays an important role in

regulating pricing through the NPPA (National Pharmaceutical Pricing Authority). Bargaining power of suppliers The pharma industry depends upon several organic chemicals. The chemical industry is again very competitive and fragmented. The chemicals used in the pharma industry are largely a commodity. The suppliers have very low bargaining power and the companies in the pharma industry can switch from their suppliers without incurring a very high cost. However, what can happen is that the supplier can go for forward integration to become a pharma company. Companies like Orchid Chemicals and Sashun Chemicals were basically chemical companies, who turned themselves into pharmaceutical companies. Barriers to entry Pharma industry is one of the most easily accessible industries for an entrepreneur in India. The capital requirement for the industry is very low; creating a regional distribution network is easy, since the point of sales is restricted in this industry in India. However, creating brand awareness and franchisee amongst doctors is the key for long-term survival. Also, quality regulations by the government may put some hindrance for establishing new manufacturing operations. Going forward, the impending new patent regime will raise the barriers to entry. But it is unlikely to discourage new entrants, as market for generics will be as huge.

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Threat of substitutes This is one of the great advantages of the pharma industry. Whatever happens, demand for pharma products continues and the industry thrives. One of the key reasons for high competitiveness in the industry is that as an on going concern, pharma industry seems to have an infinite future. However, in recent times, the advances made in the field of biotechnology, can prove to be a threat to the synthetic pharma industry.

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6. SWOT Analysis Strengths Cost Competitiveness Well Developed Industry with Strong Manufacturing Base Access to pool of highly trained scientists, both in India and abroad. Strong marketing and distribution network Rich Biodiversity Competencies in Chemistry and process development. Weaknesses Low investments in innovative R&D and lack of resources to compete with MNCs for New Drug Discovery Research and to commercialize molecules on a worldwide basis. Lack of strong linkages between industry and academia. Low medical expenditure and healthcare spend in the country Production of spurious and low quality drugs tarnishes the image of industry at home and abroad. Shortage of medicines containing psychotropic substances. There are 4000 such brands of medicines that fall under the Narcotics Drugs and Psychotropic Substances (NDPS) Act, 1985.Under a clause of this Act, the retailer has to sign the consignment note provided by the stockist. The police check this note regularly to prevent these medicines getting diverted to the drug mafia and they can arrest the retailer if the signatures are under suspect. To protest against this clause, the retailers have stopped stocking these medicines, some of which is life saving.
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Opportunities Significant export potential. Licensing deals with MNCs for NCEs and NDDS. Marketing alliances to sell MNC products in domestic market. Contract manufacturing arrangements with MNCs Potential for developing India as a centre for international clinical trials Niche player in global pharmaceutical R&D. Supply of generic drugs to developed markets. Threats Product patent regime poses serious challenge to domestic industry unless it invests in research and development R&D efforts of Indian pharmaceutical companies hampered by lack of enabling regulatory requirement. For instance, restrictions on animal testing outdated patent office. Drug Price Control Order puts unrealistic ceilings on product prices and profitability and prevents pharmaceutical companies from generating investible surplus. Lowering of tariff protection The new MRP based excise duty regime threatens the existence of many small scale pharma units, especially in the states of Andhra Pradesh and Maharashtra, that were involved in contract manufacturing for the larger, established players.

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7. Cost Structure and Performance indicators of Indian pharmaceutical industry The pharmaceutical industry is characterized by low fixed asset intensity and high working capital intensity (ICRA 2002). The Material cost, Marketing and selling cost and Manpower Cost constitute the three major cost elements for the Indian pharmaceutical industry, accounting for close to 70% of the operating income. In the past 6-7 years, material costs, which account for almost 50% of the operating cost have declined owing to the decrease in prices of bulk drugs and intermediates, increase in exports which enabled procurement of raw materials in large quantities and hence at low prices and finally due to increase in production efficiencies. On the other hand, the marketing and selling expenses, comprising of promotional expenses, trade discounts, advertising and distributing costs; and freight and forwarding costs have increased in the past few years owing to the increase in emphasis on sales of formulations.17 This increased focus on marketing partly lead to the increase in the manpower costs of pharmaceutical companies during the last decade. The other factor for the increase in the manpower costs, at least in case of a few companies might be due to an increase in R&D efforts, which requires quality research personnel.

17

Page No. 05, analyzing_the_indian_pharmaceutical_industry.pdf.

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3.3 Company Analysis

Introduction Cadila Healthcare Ltd. (Cadila) is a global healthcare provider and one of the top five pharma companies in India. In 1995, the group restructured its operations and now operates as Cadila, under the aegis of the Zydus group. Over the years, Cadila has transformed itself from a primarily domestic play into a fast growing global generic play with presence in key geographies like US, France, Brazil, Japan and 26 other countries.18

18

Page No. 06, analyzing_the_indian_pharmaceutical_industry.pdf.

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77

While domestic market has been the major forte of the company, exports have grown rapidly contributing about 37% of the total sales. In order to capitalize its strong manufacturing capabilities, Cadila has formed JV's with international companies like Nycomed (earlier known as Altana) and Hospira (earlier known as Mayne). In the long term, the company is pursuing a goal of becoming a global research-driven company, through its early stage R&D pipeline, which involves 5 New Molecules Entities (NME) and New Drug Delivery Systems (NDDS).19 Restructuring to sharpen focus In order to have better focus on each business, management has decided to restructure its healthcare and consumer business into two separate entities. This will not only strengthen the brand building activities of each company but will also enhance the distribution network of the consumer care division, through the combined field strength of 400 people. Changing business model Cadila is currently undergoing a major change in its business model, driven by a shift from acute therapy management to fast growing life style segment. Moreover, its initiative to increase its global sales through alliances, acquisitions and building aggressive generic pipeline in US and other key geographies like France and Brazil have started yielding fruitful results. Today, the company has established front end marketing capabilities in key geographies like US, France, Spain, Japan, Brazil and 26 other semi-regulated markets, through organic and inorganic initiatives. Over the period of last three years, contribution of exports has increased from 16% in FY05 to 37% as on FY08.
19

Page No. 07, analyzing_the_indian_pharmaceutical_industry.pdf.

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On domestic front, Cadila has improved its ranking to become the 4th largest pharmaceutical company in India with a market share of 3.7% (as per ORG IMS MAT Mar-08). Cadila has wide therapy coverage through three multi-therapy divisions and eleven speciality divisions with a total workforce of more then 2700 people in the domestic division. The group is a leader in cardio-vascular, gastrointestinal and women's healthcare segments. It also has strong presence in the respiratory, pain management, CNS, antiinfectives, oncology, neurosciences, dermatology and nephrology segments.

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Segment-wise revenue break-up (Domestic)

4% 3%

14% 21%

3% 2% 6%
10%

Biologist, Diagnostic, Dermetology, CNS, Pain Mgt Anti-Infective, Respiratory,

10% 16%
11%

The group has 16 brands that feature amongst the top 300 pharmaceutical brands in India. The group has a globally compliant manufacturing infrastructure, comprising of eight state-of-the-art facilities, which support product launches not just in India but also in the regulated markets of U.S., Europe and Latin America. Changing business mix Shift from domestic to exports Late entry in exports market and focus on consolidating its position in the domestic markets had kept the contribution of domestic market on the higher side. However, the fast ramp-up in exports has resulted in its contribution increasing from 16% in FY05 to 37% as on FY08.

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Shifting focus to chronic Indian pharma sales have traditionally been dominated by the acute segments. This has a seasonal flavour to it as living in a tropical country; Indians are at the mercy of changing seasons. Over 75 percent of the Indian market is accounted for by acute therapy products, and this has not changed in the recent past. However, there has been a perceptible increase in the revenues from the chronic ailments segment. As prevalence of chronic diseases increase, therapies for cardiovascular diseases and diabetes are expected to have the highest growth rates. According to ORGIMS, in 2007, the chronic segment outperformed the acute segment with growth of 21% as against 11%. In January 2008, the chronic segment continued to grow strongly at 18%.20 The acute segment accounted for 72 percent of sales in India in January 2008. Both acute and chronic therapy areas continue to grow in unit and value terms. However, the chronic areas are growing faster. At an overall level, like more developed markets, India too is gradually shifting to lifestyle disorders. This trend is likely to dictate the fortunes of various therapeutic categories in the future. It
20

Page No. 09, analyzing_the_indian_pharmaceutical_industry.pdf.

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may be pointed out that the domestic industry is principally being driven by the chronic segment (like Cardiovasculars, diabetics, CNS) which has grown by 17.8% in 2007. Against this backdrop, uptake of acute segments (anti-infectives, gastrointestinal, nutritional, etc) has been slow and has grown by 10.1% only. And over the next five years, cardiovascular and anti-diabetic therapeutic segments will record the highest growth rate of over 13%, as against anti-infectives, which will grow at nearly half of those segments. Similarly, looking at the change in the growth and focus to chronic from acute, Cadila over the period, has shifted its focus to chronic segment from acute segment. As on FY2008, chronic segment in Cadila's portfolio contributes around 51% of the branded formulation as compared to 47% as on FY2005.21

21

Page No.06, 27en0ko62bsazpmhffhy.pdf

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International businesses - Key growth driver

We expect Cadila's foray into newer markets to yield rich dividends in the future and also diversify their business. We expect the international business to be the key growth driver for Cadila. The US operations now contribute Rs2,568mn or 11% of overall sales, within just three years of operations. Even their foray into the Brazilian and French markets turned earnings accretive in FY08. We believe that such investments are likely to generate good returns in the future and also establish Cadila as a global player. We expect their forays into Japan, Spain and South Africa to turn EPS accretive in FY11E. We do agree that Cadila has been a late entrant in the international markets (unlike its peers), but it has been able to ramp up its international businesses quite fast. The US business currently contributes 29% of its total exports within just three years of operations. Similarly, its France and Brazil operations have started generating profits in FY08. In order to further expand its presence across the globe, Cadila has taken some inorganic initiatives by acquiring front end capabilities (marketing and distribution) in countries like Japan, Spain and South Africa. All these initiatives need front end investment and Cadila management has justified all these investments by demonstrating a growth of 69% in its exports revenues over FY05-08. Going forward, we expect its revenues from international business to grow at a CAGR of 28% over FY08-10E to Rs14226mn.

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Key Risk Factors for the Cadila Healthcare Limited

1) Pricing pressure in the regulated markets Regulated markets, especially the US, are characterized by strong competition and price erosion, making the margins vulnerable. 2) High dependence on domestic markets Despite increased contribution from exports, domestic markets are expected to contribute a major chunk of overall revenues. Thus, any change in the pricing policy by DPCO can have a negative impact on Cadila. 3) Worse than expected performance of Nycomed JV More than expected loss from Nycomed JV's operations may have a negative impact on Cadila's earnings. 4) Exchange rate Cadila business can be affected by foreign exchange rate fluctuations as a substantial portion of revenues and imports are transacted in foreign currencies. 5) R&D investment- high-risk, high-reward business

84

Cadila is investing around 7% of its revenues in R&D. R&D is a high-risk, highreward business. Any failure with respect to its pipeline may have a negative impact on its profitability. 6) Break-up in JVs Break-up in alliances can impact the profitability of the company

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Chapter 4 Valuation of Cadila Healthcare Limited

Value of a company is basically derived from two things. 1. Current Operations 2. R& D Pipeline So we will first find out the value from current operation and we will find out value from R & D pipeline using real option valuation.

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4.1 Valuation of Cadila Healthcare Limiteds Current Operations

Cash Flow Projections for Explicit Forecast Period

(Figures are in Millions) Financial Year Domestic Sales Total Export Total Sales Other Income Total Operating income Raw Material Employee Cost Selling & Distribution Exp. Depreciation EBIT Interest Earnings Before Tax Effective Tax EAT Depreciation Cash Inflow Increase in Working Capital Investment Interest Net Cash Inflow Discount Factor @ 10.01% Present Value of Free Cash flow 2009 2010 2011 2012 17006 18883 21262 23941 11378 14226 18209 23308 28384 33109 39471 47249 598 658 724 796 28982 33767 40195 48045 9934 11818 14068 16816 2898 3377 4019 4804 7825 9117 10853 12972 1085 1161 1184 1148 7240 8294 10071 12305 427 293 293 293 6813 8001 9778 12012 886 1040 1271 1562 5927 6961 8507 10450 1085 1161 1184 1148 7012 8122 9691 11598 1491.68 1275.75 1717.74 2100.1 1500 1000 1000 1000 427 293 293 293 4447.32 6139.25 7266.26 8790.9 0.909 0.8263 0.7511 0.6827 4042.6 5072.9 2013 26958 29834 56792 876 57668 20184 5767 15570 1056 15091 293 14798 1924 12874 1056 13930 2577 1000 293 10646 0.621

5457.7 6001.6 6607.1

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Explanation

1. Explicit forecast period is taken of five years from FY2009 to FY 2013. After that we expect that Cadila Healthcare may have stabilized its operation in most of the markets. Beyond explicit forecast period, it is assumed free cash flow will grow at 3%. 2. During explicit forecast period, we have taken growth rate of international business at 28% and growth rate of domestic business at 12.6% with reference to research done by Emkay Shares. 3. By keeping in mind the past trend, other incomes are assumed to be growing at the rate of 10%. 4. Various expenses are assumed to as follows on the basis of past trend. Expenses Raw Material Employee Cost Selling & Distribution % of Sales 35 10 27

5. CHLs interest burden is Rs. 427 mn in FY2009 and thereafter Rs. 427 mn as per the research done by the Emkay Shares. 6. From financial year 2009 effective tax rate for pharmaceutical companies is 13%.

88

7. Calculation of WACC Beta Risk Premium Risk free rate Cost of Equity Cost of Debt Wd We WACC 0.78 10% 7.00% 14.80% 3.91% 0.44 0.56 10.01%

8. Investments are assumed to nil in coming years with reference to the teleconference of Chairman and MD, Pankaj Patel. 9. Capital Expenditure is Rs.1500 Mn in FY2009 and Rs.1000 Mn thereafter with reference to the teleconference of Chairman and MD, Pankaj Patel. 10.Cost of debt is assumed to be 7% with reference to the teleconference of Chairman and MD, Pankaj Patel. 11.As per the past trend working capital is assumed to be 27% of sale. 12.Calculation of Increase in Working Capital

Year FY2009 FY2010 FY2011 FY2012 FY2013

Current year 7663.68 8939.43 10657.17 12757.23 15333.84

Previous Year Increase 6172 1491.68 7663.68 1275.75 8939.43 1717.74 10657.17 2100.06 12757.23 2576.61

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A. Value from Operations During Explicit Forecast Period

Year FY2009 FY2010 FY2011 FY2012 FY2013 Total

PV OF Free Cash Flow ( Million) 4042.6 5072.9 5457.7 6001.6 6607.1 27181.9

B. Value from Operations beyond Explicit Forecast Period Free Cash Flow(n+1) WACC Growth Rate PV of Free Cash Flow Beyond Explicit Forecast Period 6805.21 Mn 10.01% 3% 97078.60 Mn

Total Value of CHL from Current Operations

(Figures are in Millions) Value of Current Operations During Explicit Forecast Period Value of Current Operations Beyond Explicit Forecast Period Total Value From the Current Operation 27181.9 97078.6 124260.5

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4.2 Real-Option Valuation of R&D Pipeline of Cadila HealthCare Limited

The drug development cycle of a pharmaceutical company for a researched drug shows that R&D is bo th time & cost intensive. The patent process takes 4-5 years time. Therefore pharmaceutical companies apply for patent right after the discovery stage along with pre-clinical trial. In other words, a drug research company applies for patent registration once a molecule shows promise of therapeutic effectiveness. This is done to ensure that patent registration is obtained when the research enters the clinical trials phase. Normally Indian companies involved in therapeutic research apply for

simultaneous patent registration in India (to drugs controller general of India) as well as in the US (food & drug administration or FDA). FDA registration is a clear passport to the export market. The FDA process is more rigorous. However drug authorities approval has to be taken at each stage of clinical trial& only when all the three clinical trial phases are successfully completed can the product be launched? The patent period starts right from the day the patent is granted. Hence, the longer the clinical trial period (after registration), the shorter the unexpired patent period. The pharmaceutical company has to recover its costs & even profit within that protected patent period. It is, of course, true that even if the product goes off patent, revenues do not dry up. As per FDA norms, patents expire 20 years from the date of filing. Recent WTO norms also prescribe a product patent life
91

of 20 years. This rule has been applied in India from 2005.Therefore, the moment a patent application is filed with FDA after discovery stage, the clock start & if the patent is granted after five years then only 15 years will be the unexpired patent period. If the researcher delays further due to clinical trials, the unexpired patent period gets even reduced. It costs around US $350 million to US $500 million to develop a drug & the average time taken is 14 years (VIKALPA). This cost may be significantly lower for an Indian pharmaceutical company developing a drug in-house. Developing an innovative new drug, from discovery to worldwide marketing, now involves investments of around $1 billion, and the global industry's profitability is under constant attack as costs continue to rise and prices come under pressure. Pharmaceutical production costs are almost 50 percent lower in India than in Western nations, while overall R&D costs are about one -eighth and clinical trial expenses around one-tenth of Western levels. India's long established manufacturing base also offers a large, well -educated, English-speaking workforce, with 700,000 scientist s and engineers graduating every year, including 122,000 chemists and chemical engineers, with 1,500 PhDs.10 The industry provides the highest intellectual capital per dollar worldwide, says OPPI. Costs of clinical

92

trials in India are around one-tenth of their levels in the U.S., and it is estimated that they could be worth $300 million to India by 2010. CHL has new molecules under discovery phase in four broad therapeutic segments anti-obesity, anti-diabetes, dyslipidemia,

inflammation & pain.

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The present study would only attempt to compute real options value of, following product because only these products are entered into the clinical trials. 1. ZYH1 : Dyslipidemia 2. ZYH2 : Diabetes 3. ZYO1 : Obesity 4. ZYI1 : Inflammation & pain 5. ZYH7: Dyslipidemia Though difficult, we have accessed different sources to gather necessary reliable information. The real options valuation shown here is strictly based on this information & certain assumptions. The results will differ under different assumptions. However, we would a pply sensitivity analysis were we feel that deviation could be there & hence is critical for arrival of the overall valuation. This in turn would help us to arrive a broad valuation if not the perfect. This research will drive home the fact that all these products under various stages of research (Table2) have significant future value.

94

Underlying Asset Value The BS model uses continuously traded underlying assets, for which continuously time series data are available. It is, therefore, relatively easy to derive value of this traded variable. In option pricing theory, it is important that the underlying asset is traded to carry out arbitrage free evaluation. But if the underlying asset is not traded (i.e., it has no market price), it is practically imposs ible to build a duplicate portfolio to determine the option value. In case of R&D projects, the underlying investment is not traded & hence market value cannot be determined. Most of the studies use future cash flows of the R&D project as the proxy for th e underlying asset. However, the future cash flows would largely depend on the probability of success of the drug. A successfully tested drug may not be successful in the market. A drug reaching the market could fall unto one of five quality categories: (a ) dog, (b) below average, (c) average, (d) above average, or (e) breakthrough. The revenues attached to each quality category are highly skewed & the variance can be as high as 95%. Thus estimating the underlying asset value for a researched drug could be very complex. In our study we have assumed that each of the molecules under development would be a breakthrough. Hence the underlying asset value for each of the molecule would be equivalent to its market potential & share of CHL within that market.
95

Exercise Price Exercise price may be known (e.g., in case of fixed price stock option) or stochastic. The exercise price of an R&D project is not always known. In the present case, as both the compounds have entered the clinical phase, it is assumed that all the three phases of clinical trial will be carried out & hence the present value of R&D costs has been considered as the sunk cost. The exercise price of the option to commercialize the products after clinical trials is, therefore, the investment required launching the products. Time to Expiration

Like exercise price, the time to expiration can neither be known or unknown. Competition may force early investment but a regulation may delay the time to maturity. Usually stock options have a comparably shorter time to maturity. But, real options have a longer maturity period. Since CHL has applied to FDA as well for patent
96

registration, we assume that it will get FDA appro val for 20 years patent period. Clinical trials may take 6 -8 years (table 3) & hence the time to expiration could be 6 -8 years at the earliest. This CHL will get only 12-14 years of patent life after the products are launched. We will not consider revenue post-patent period in our study. We assume here that CHL will not wait after successful completion of Phase III. The products will be launched immediately. Volatility (Risk) Measuring the volatility of an R&D investment project is difficult because it is difficult to get historical volatility date. Merck & company of US uses the historic volatility of a bio -technology index of related stocks, which are traded at NASDAQ. In absence of such information, volatility of stock prices of pharmaceutical companies may be used as a weak surrogate. We have assumed volatility of 36 %. In fact the annualized variance on the basis of monthly variance of CHLS share on the NSE comes out to 3.1372 %, which is equivalent to a variance of 36 %. Convenience Yield For a traded underlying asset, convenience yield is the annual dividend yield on traded asset. For R&D projects, estimating an appropriate convenience yield is a difficult task. An investment
97

project generates cash flows that are often not exactly known by time, frequency or amount. For a pharmaceutical company evaluating an R&D project,

convenience yield should indicate the estimated net revenue that would have been lost due to not being able to market the drug after patent registration. It is argued that the potent ial for excess return exists only during the patent life of the drug & therefore, competition will wipe out excess returns beyond the patent period. Hence any delay in launching the drug by a year will cost the firm one year of patent protected excess returns (Vikalpa, 2003). In case of CHL, the current cash operating margin is 20%. If the expected future margin from patented four compounds is 25%, the excess return that CHL may lose in the clinical phase will be the difference between expected operating ma rgin & current operating margin. This would give us a cost of delay of 5% per annum for CHL.

98

1. Parameters for Real Option Valuation of ZYH1 :Dyslipidemia Molecule Input Underlying Asset (S) Assumptions Present global market size for Dyslipidemia drug=US$20 bn With 10% annual growth rate. We have assumed a share of 0.5% for CHL & through various adjustments we have derived Rs 27507 mn. Exercise Price (K) Myers and Howe (1997) Cost of launching the products showed that in the very first is assumed to be Rs 2750.7 million, which is equivalent to the entire estimated cash flows in the first year of launch year of product launch, the entireRevenue is spent as marketing expenses. We have been optimistic. We have assumed 10% 0f total cash flow to be achieved in first year of launch. Time to Expiry. (t) Volatility (variance) () Cash operating 25 per cent 36 per cent 4 Years. Phase II +Phase III =(2*1/2+3) Years Annual Volatility of CHL on NSE. Present operating margin of CHL is 22% but for new Rationale/Source Analyst Pharma sector, Kotak securities.

99

Margin

product we think it will be higher.

Effective tax rate Convenience yield (y)

13 per cent

5 per cent

_ Rate of return on Govt. Bond

Risk-free rate 7 per cent

100

Real Option Valuation of ZYH1 : Dyslipidemia Molecule

C = SN(d1) Ke - r t N(d2)
Where, d1 = l n(S/K)+(r y + 2 /2 )t t d2 = d1 - t

These yield the following estimates for d & N (d): d1 = 25.0215 d2 = 24.9015 N (d1) = 1.0000 N (d2) = 1.0000

Real Option Value : = [27507*1.0000] [2750.7e = Rs. 25261.61 Mn

(-0.07 *4)

*1.0000]

101

2. Parameters for Real Option Valuation of ZYH2: Diabetes Molecule

Input Underlying Asset

Assumptions Present global market size for antidiabetes drug is US $15 billion, with 20% annual growth rate. We have assumed a share of 0.5% for CHL & through various adjustment we have derived S=Rs. 19080 mn. Cost of launching the products is assumed to be Rs 1908 million, which is equivalent to the entire estimated cash flows in the first year of launch

Rationale/Source www.leaddiscovery.co.uk

Exercise Price

Myers and Howe (1997) showed that in the very first year of product launch, the entire Revenue is spent as marketing expenses. We have been optimistic. We have assumed 10% 0f total cash flow to be achieved in first year of launch. Phase I + Phase II + Phase III = (1*1/2+2+3)=5.5 Annual Volatility of CHL on NSE.

Time to Expiry. Volatility (variance)

5.5 Years.

36 per cent

102

Cash operating Margin

25 per cent

Present operating margin of CHL is 22% but for new product we think it will be higher. _

Effective tax 13 per cent rate Convenience yield 5 per cent

Risk-freerate 7 per cent

Rate of return on Govt. Bond

103

Real Option Valuation of ZYH2: Diabetes Molecule

C = SN(d1) Ke - r t N(d2)
Where, d1 = ln(S/K)+(r y + 2 /2)t t d2 = d1 - t

These yield the following estimates for d & N (d): d1 = 23.2054 d2 = 23.0854 N (d1) = 1.0000 N (d2) = 1.0000

Real Option Value : = [19080 *1.0000] [ 1908e = Rs. 17765.62 Mn

(-0.07 *5. 5 )

*1.0000]

104

3. Parameters for Real Option valuation of ZYO1: Obesity molecule

Input Underlying Asset

Assumptions

Rationale/Source

Present global www.leaddiscovery.co.uk market size for antiobesity drug is US$1600 million, with 20% annual growth rate. We have assumed a share of 0.5% for CHL & through various adjustment we have derived S=Rs.2226 mn. Cost of launching the products is assumed to be Rs 222.6 million, which is equivalent to the entire estimated cash flows in the first year of launch Myers and Howe (1997) showed that in the very first year of product launch, the entire Revenue is spent as marketing expenses. We have been optimistic. We have assumed 10% 0f total cash flow to be achieved in first year of launch. Phase II + Phase III = (2+3) = 5.

Exercise Price

Time Expiry. Cash operating Margin

to 5 Years.

25 per cent

Present operating margin of CHL is 22% but for new product we think it will be higher.

105

Effective tax 13 per cent rate Convenience yield 5 per cent

Risk-freerate 7 per cent Cash operating Margin 25 per cent

Rate of return on Govt. Bond Present operating margin of CHL is 22% but for new product we think it will be higher.

106

Real Option valuation of ZYO1: Obesity mo lecule

C = SN(d1) Ke - r t N(d2)
Where, d1 = ln(S/K)+(r y + 2 /2)t t d2 = d1 - t

These yield the following estimates for d & N (d): d1 = 23.6950 d2 = 23.575 0 N (d1) = 1.0000 N (d2) = 1.0000

Real Option Value : = [2226 *1.0000] [222.6e = Rs. 2067.28 Mn

(-0.07 *5)

*1.0000]

107

4. Parameters for Real Option valuation of ZYI1: Inflammation & Pain Molecule

Input Underlying Asset

Assumptions Present global market size for pain management drug is US$26 billion, with 20% annual growth rate. We have assumed a share of 0.5% for CHL & through various adjustment we have derived S= Rs. 35775 mn. Cost of launching the products is assumed to be Rs 1073.25 million, which is equivalent to the entire estimated cash flows in the first year of launch

Rationale/Source www.leaddiscovery.co.uk

Exercise Price

Myers and Howe (1997) showed that in the very first year of product launch, the entireRevenue is spent as marketing expenses. We have been optimistic. We have assumed 10% 0f total cash flow to be achieved in first year of launch. Phase II +Phase III =(2*1/2+3) Years Present operating margin of CHL is 22% but for new product we think it will be higher.
108

Time to Expiry. Cash operating Margin

4 Years

25 per cent

Effective tax rate

13 per cent

Convenience 5 per cent yield Riskfreerate Cash operating Margin 7 per cent

Rate of return on Govt. Bond

25 per cent

Present operating margin of CHL is 22% but for new product we think it will be higher.

109

Real Option valuation of ZYI1: Inflammation & Pain M olecule

C = SN(d1) Ke - r t N(d2)
Where, d1 = ln(S/K)+(r y + 2 /2)t t d2 = d1 - t These yield the following estimates for d & N (d): d1 = 25.0215 d2 = 24.9015 N (d1) = 1.0000 N (d2) = 1.0000

Real Option Value : = [33775*1.0000] [ 3377.5e = Rs. 31198.32 Mn

(-0.07 *4)

*1.0000]

110

5. Parameters for Real Option Valuation of ZYH7 : Dyslipidemia Molecule

Input Underlying Asset (S)

Assumptions Present global market size for Dyslipidemia drug=US$20 bn With 10% annual growth rate. We have assumed a share of 0.5% for CHL & through various adjustments we have derived Rs 27507 mn

Rationale/Source Analyst Pharma sector, Kotak securities.

Exercise Price (K)

Cost of launching the products Myers and Howe (1997) is assumed to be Rs 825.15 million, which is equivalent to the entire estimated cash flows in the first year of launch showed that in the very first year of product launch, the entireRevenue is spent as marketing expenses. We have been optimistic. We have assumed 10% 0f total cash flow to be achieved in first year of launch.

Time to Expiry. (t)

6 Years.

Phase I+ Phase II +Phase III =(1+2+3) Years

111

Volatility (variance) ()

36 per cent

Annual Volatility of CHL on NSE.

Cash operating Margin

25 per cent

Present operating margin of CHL is 22% but for new product we think it will be higher.

Effective tax rate

13 per cent

Convenience yield (y)

5 per cent

Risk-free rate 7 per cent

Rate of return on Govt. Bond

112

Real Option Valuation of ZYH7 : Dyslipidemia Molecule

C = SN(d1) Ke - r t N(d2)
Where, d1 = ln(S/K)+(r y + 2 /2)t t d2 = d1 - t These yield the following estimates for d & N (d): d1 = 22.8216 d2 = 22.7016 N (d1) = 1.0000 N (d2) = 1.0000

Real Option Value : = [275 07 *1.0000] [ 2750.7e = Rs. 25674.09 Mn

(-0.07 *6)

*1.0000]

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Valuation of R&D Pipeline

Molecule

Value

R&D Cost (Sunk Cost)

Net Value

ZYH7 : Dyslipidemia ZYI1: Inflammation & pain ZYO1: Obesity ZYH2: Diabetes ZYH1 : Dyslipidemia Total Value of R&D Pipeline

25674.09 31198.32 2067.28 17765.62 25261.61 -

22790 22790 22790 22790 22790 -

2884.09 8408.32 -20722.72 -5024.38 2471.61 -11983.08

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Value per Share

Total Value From the Current Operation (Mn) Total Value of R&D Pipeline (Mn) Total Value of Cadila Healthcare Limited (Mn) Total Debt (Mn) Total Value of Equity Shares (Mn) No. of Equity Shares (Mn) Value Per Share

124260.5 -11983.08 112277.42 8377 103900.42 62.8 1654.47

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Chapter 5 Findings and Conclusion

Economic Analysis The economy has moved decisively to a higher growth phase. Till a few years ago, there was still a debate among informed observers about whether the economy had moved above the 5 to 6 per cent average growth seen since the 1980s. There is now no doubt that the economy has moved to a higher growth plane, with growth in GDP at market prices exceeding 8 per cent in every year since 2003-04. But due to recession in the global economy, Indias growth rate was declined in financial year 2008-09. As per the Advance Estimates of GDP for 2008-09 released by the Central Statistical Organisation on 9, February, 2009, the growth of GDP at factor cost (at constant 99-2000 prices) is estimated to grow at 7.1% during the year. The growth of GDP during 2007-08 (Quick estimates) was 9.0%. The Centres fiscal deficit is projected at 5.5 per cent of the gross domestic product (GDP) in 2009-10 as direct fallout of the increased spending envisaged on various schemes to spur the economy in the wake of the global downturn, coupled with lower estimates of tax revenue collections. Significant monetary easing since mid-September 2008 preclude further rate cuts RBI has been aggressive and pre-emptive in cutting key policy rates in the past four months in an effort to contain the considerable moderation in growth. In the aforesaid period, CRR has been reduced by 400 bps to 5%,
116

Repo rate by 350 bps to 5.5% and reverse Repo by 200 bps to 4%. The room for such expansionary monetary steps has been provided by the rapidly falling inflation. In addition to these conventional measures, RBI also implemented various unconventional measures (reduction in SLR, special refinancing window, forex swap facility, etc) to boost liquidity in the banking system and to ensure continued flow of credit to productive sectors.

117

Industry Analysis India is one the fastest growing pharmaceuticals markets in the world, growing at the CAGR of almost 10% consecutively over the last five years. From the being a purely reverse engineering industry, it has transformed into a research driven, export-oriented global industry, offering a wide range of value added products and service. The product patents regime heralds an era of innovation and research resulting in the launch of new patented product launches. In the longer run, domestic companies would face fresh competition from MNCs, as they would make aggressive new launches. Drugs having estimated sales of over US$ 28 bn are expected to go off patent in the US between CY08 and CY10. With the governments in the developed markets looking to cut down healthcare costs by facilitating a speedy introduction of generic drugs into the market, domestic pharma companies will stand to benefit. However, despite this huge promise, intense competition and consequent price erosion would continue to remain a cause for concern. The life style segments such as cardiovascular, anti-diabetes and antidepressants will continue to be lucrative and fast growing owing to increased urbanization and change in lifestyles.

118

Company Analysis

In order to have better focus on each business, management of CHL has decided to restructure its healthcare and consumer business into two separate entities. This will not only strengthen the brand building activities of each company but will also enhance the distribution network of the consumer care division, through the combined field strength of 400 people.

Cadila is currently undergoing a major change in its business model, driven by a shift from acute therapy management to fast growing life style segment. Moreover, its initiative to increase its global sales through alliances, acquisitions and building aggressive generic pipeline in US and other key geographies like France and Brazil have started yielding fruitful results. Cadila over the period, has shifted its focus to chronic segment from acute segment. As on FY2008, chronic segment in Cadila's portfolio contributes around 51% of the branded formulation as compared to 47% as on FY2005. Following are the key risk factors for the cadila Healthcare Limited 1. Pricing pressure in the regulated markets 2. High dependence on domestic markets 3. Worse than expected performance of Nycomed JV 4. Exchange rate 5. R&D investment- high-risk, high-reward business 6. Break-up in JVs

119

Valuation The market value of a company depends primarily on two factorsvalue of its current operations and value of future growth options. The value of current operations factors in the expected growth of current operations. Therefore, future growth options denote expected value from pipeline products/flexibility of operations. Value of current operations can be obtained using discounted cash flow technique while the value of R&D pipeline should be obtained using the real-option technique. Total Value from the Current Operation of CHL is 124260.5 (Mn). The factors responsible for such high value from current operations are as follows. 4. Growth rate above industry average in domestic business 5. High growth rate in international business 6. Lower cost of capital 7. Low effective tax rate 8. Continuous improvement in profit margin Total Value of R&D Pipeline of CHL is Rs. -11983.08 (Mn). This is mainly due to the high negative real-option value of Diabetes and Obesity molecule. Value of this molecule are negative because at 0.5% world market share their potential revenue are very less compare to the R&D cost of developing these products. This is mainly due to the low market size of these molecules Total Value of Cadila Healthcare Limited Rs. 112277.42 (Mn) and value per share is Rs. 1654.47
120

Chapter 8 Recommendations

If our assumptions hold true, the investor should buy the share of Cadila Healthcare Limited because it is presently selling in the range of Rs. 200 to 300 while value of the share as per our estimate is Rs. 1654.47. If the management CHL is expecting the market share of 0.5 % or below for the obesity and diabetes molecules, it should abandon further R&D expenses on these products. This is mainly due to the fact that at the market share of 0.5 % or below for the obesity and diabetes molecules, their real-option value are negative and so that they will adversely affect the shareholder value. CHL should continue R&D projects for the molecules other than obesity and diabetes but only if company is expecting 0.5% or more market shares in these products. This is mainly due to the fact that at 0.5% or more market share real-option value of these molecules is positive. CHL should try to complete its R&D projects as soon as possible because as the time to complete the project increases its patent period reduces and so the revenue during the patent period decreases.

121

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of

Pharmaceutical

Sector. on

http://www.naukarihub.com//india/pharmaceutical/overview/introduction 28th February, 2009.

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Healthcare.http://www.emkay.com/27en0ko62bsazpmhffhy.pdf. February, 2009. page no. 2 14.Garg, Healthcare.http://www.emkay.com/27en0ko62bsazpmhffhy.pdf. February, 2009. page no. 5 15.Garg, Manoj.

Manoj.Cadila on 28th

Cadila on 28th

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