Sun Pharma's Q2FY19 results (Downgrade to Neutral) - Weak quarter; sharp qoq drop in US sales

Q2FY19 result highlights

• Consol revenues came at Rs68.5bn vs est Rs74.4bn; Q1 was Rs71.4bn; Revs missed estimates across segments especially in the ex-Taro biz. US sales (ex-Taro) came at $202m vs est $235m; q1 was $244m while Q4 was $212m; This sharp qoq drop is surprising post a strong Q1. 
• Domestic revs de-grew 16% to Rs18.6bn vs est Rs21.9bn; Mgt attributed it to one-time inventory adjustment. Non US exports (ex-Taro) came at $284m vs est $300; marginally lower qoq
• EBITDA came at Rs14.4bn vs est Rs16bn; 21% margins in-line; Q1 was Rs15.2bn. Ex-Taro, EBITDA was Rs8.56bn vs estRs11bn; Q1 was Rs10.7bn
• EBITDA was aided by strong GMs – Consol GMs were 74.3% vs 70.5% in Q1; GMs were aided by certain provision writeback during the qtr
• SGA increased to Rs21.7bn vs Rs20.7bn in Q1; the big step-up is not visible yet; R&D costs were soft at Rs4.5bn vs Rs4.9bn in Q1; 6.6% of revs vs guidance of 8-9% of revs
• PBT aided by higher other income/other operating income; Other income Rs3.5bn vs est Rs2.2bn; PBT came at Rs13.6bn – vs est Rs13bn;
• Tax rate 16.5% vs est 13%; Adj PAT Rs9.95bn vs est Rs10bn
• Exceptional charge on Modafinil anti-trust settlement – Rs12bn; Sun already provided Rs9.5bn for this Ranbaxy era litigation in FY18 too
• FY19 guidance: early double digit revenue growth with increased marketing spends on speciality launches as well as R&D

Key positives: Higher GMs

Key negatives: Revenue miss across segments; higher tax rate

Impact on financials: We reduce FY19/20 estimates by 9.2% / 6.4%

Valuations & view

Significant quarter to quarter fluctuations in US sales and overall profitability underlines the near-term challenges for Sun’s business as it seeks to undertake a transition to becoming a global speciality player. With launch of 3 potential big ticket speciality products, Sun’s specialty strategy will take significant strides forward from FY19 onwards. While there are multiple and formidable challenge in making this transition and it will take time to yield results, it is a strategic imperative for larger Indian players to go down this path. Sun is clearly best placed amongst large domestic peers to make this transition. While Sun’s medium term growth story is exciting, at 25x FY20e earnings we see limited upsides given the volatility in its base business along with the significant growth uncertainties inherent in any early stage speciality business. Downgrade to Neutral with TP of Rs557. Pick-up in key speciality assets will be the key monitorable going forward