MOSL: ALKEM LABORATORIES (Upgrade to Buy)-Uniquely positioned-Fundamentals strong-valuations reasonable

​ALKEM LABORATORIES: Uniquely positioned; Fundamentals strong; valuations reasonable

(ALKEM IN, Mkt Cap USD3.6b, CMP INR1968, TP INR2500, 27% Upside, Upgrade to Buy)

Domestic business set to grow at >20% over next three quarters: Alkem Laboratories (ALKEM) has guided for GST-adjusted (impact of ~7%) growth of mid-teens in the domestic market in FY18. This would translate into >20% growth in 2HFY18 (growth will be >25% if we normalize it for GST). Also, in 1QFY19, we expect similar growth levels due to a low base effect (had lost almost one month of sales in 1QFY18 due to GST-related channel destocking). We expect strong growth over the next three quarters, given 1) a low base of 2HFY17 (impacted by demonetization) and 1QFY18 (impacted by GST) and 2) likely recovery of 8-10 days of sales in 3QFY18 due to channel restocking post GST. Also, the domestic business EBITDA margin has historically been >21% (>25% in Acute). Thus, high growth in the domestic business will lead to ~20% EBITDA margin over the next three quarters, as against a normalized EBITDA margin of ~17-17.5% for the company.

Lower tax rate from FY19 to boost PAT by ~10%: Tax rate for ALKEM has shot up to ~23% in FY18, as two of its three plants have come out of the tax haven status. However, given that the new Sikkim plant has become operational and will enjoy full tax benefits, the tax rate is expected to come down significantly to ~15-16% in FY19. Besides this, ALKEM is planning to shift production of profitable products to the new Sikkim plant, which will ensure tax savings.

Opportunity for margin improvement in medium term: Acute business (ex Indchemie and Cachet), which accounts for ~52-53% of its total sales, makes an EBITDA margin of >25%. However, the consolidated EBITDA margin for ALKEM was significantly low at ~17% in FY17 and 17.5% in 1HFY18E, primarily because all the other business verticals (~48% of revenue) make sub-par EBITDA margin of ~7%. Indchemie, Cachet and Chronic businesses make EBITDA margin of 5-9% in the domestic market, ~5-7% in the US and 11-12% in ROW. The US and domestic chronic businesses have been delivering lower margins, as these verticals were in the investment phase and achieved breakeven only 12-18 months back. There is scope for improvement though, in our view – if only the US and Chronic business EBITDA margins improve to ~20%, the consolidated EBITDA margin can improve by ~400bp to ~21%.