Sun Pharma's Q2FY20 results (Neutral) - India surprise offsets weak US performance

Q2FY20 result highlights

• Consol revs came at Rs81.2bn vs est of Rs80.6bn. Taro below est at Rs11.3bn vs est of Rs11.7bn; Ex-Taro, revs came at Rs68.2bn - inline. Other operating income stood at Rs1.7bn above est of Rs1bn
• Ex-Taro, US revs came sharply lower at ~$197m (Q1 - $282m) vs est $240m; the generic supply contract which the company had during Q4FY19 and Q1 seems to be much higher than expected (~$70-80m vs est $40-45). Mgt noted that there has been no broad-based improvement in generics business.
• Domestic sales grew 35% yoy vs est +7% adj. growth. Mgt cited underlying growth is 12% adj. for impact in base qtr due to change in distribution channels. RoW+EM sales at $343m (incl. Pola acquisition)
• EBITDA stood at Rs16.2bn vs est of Rs16.8bn; Miss due to lower GP (Rs56.8bn vs est Rs57.3bn). EBITDAM at 20.3% vs est 21.1%; Q1 – 22.8%.
• R&D stood at Rs4.9bn (6.1% of sales) vs Rs4.1bn (4.9% of sales) in Q1.  Mgt guided to increase in R&D costs going forward.
• Interest exp came at Rs839m vs est of Rs1bn. PAT came at Rs10.6bn vs est Rs11bn partly due to higher tax rate (18.6% vs est 15%).
• Sun generated strong OCF of Rs37.7bn in H1FY20 vs Rs16.2bn in H1FY19, translating to an OCF/EBITDA of 1.08x vs 0.55x in H1FY19
• Global specialty business sales of $91m in Q2; flat qoq; Specialty accounted for 24% of consolidated R&D spends in Q2- $16.7m / 1.5% of consol revenues; Much lower than our expectations.
• FY20 Guidance – Low-mid teens rev growth; R&D at 7-8% of sales; $200m capex; Significant DTC spends on Ilumya to continue through FY20. Cequa launched in Q3FY20 – initial response positive

Impact on financials: Reduce FY20/21 earnings by 8%/5%

Valuations & view

Sharp qoq drop in Sun’s Q2 US sales has been a disappointment and is reflective of challenges in growing its US generic business. While generics still accounts for major share of revenues, Sun’s specialty business along with domestic formulations will increasingly be the prime driver of company’s future growth trajectory. With launch of Illumya and Cequa, Sun’s global specialty strategy has taken significant strides forward. While there are multiple challenges in making this transition, it is a strategic imperative for larger Indian players to go down this path. Sun is potentially best placed amongst large domestic peers to make this transition. While Sun’s medium term growth story is interesting, at current levels, we see limited upsides given the volatility in its base business along with the significant growth uncertainties inherent in any early stage speciality business. Maintain Neutral with TP of Rs474 (21x FY21E EPS). Pick-up in Ilumya / Cequa remains key near term monitorable.