Granules India: Leveraging Vertical Integration?
Granules India is a highly vertically integrated pharmaceutical company in India. It undertakes manufacturing of Active Pharmaceutical Ingredients (API), Pharmaceutical Formulation Intermediaries (PFI), and Finished Dosages (FD).
Granules India is one the largest manufacturers of Paracetamol (2nd / 3rd largest manufacturer for regulated markets), Ibuprofen, and Metformin (Amongst the Top 3 global players for Metformin API) globally and supplies to over 250+ customers in 60+ countries.
Granules India has a simple three-pronged business strategy:
1) Core Business – Target High Volume Commoditized Molecules
The company manufactures a select few commoditized ‘first line of treatment’ molecules such as Paracetamol (pain reliever), Ibuprofen (pain reliever), Metformin (anti-diabetic), Methocarbamol (muscle spasm reliever), and Guaifenesin (chest decongester). These molecules tend to be high volume and low value. It leverages its extensive vertical integration to manufacture the entire value chain (API -> PFI -> FD). An unparalleled focus on manufacturing efficiency, low manufacturing costs due to vertical integration, and critical mass (extremely high volumes) have allowed the company to become a low-cost high-quality producer. This segment requires low R&D but high manufacturing efficiencies.
In the manufacturing of any Pharmaceutical finished dose, roughly 80% of the entire manufacturing cost is in the PFI segment. Granules India has the world’s largest 6-ton PFI batch size which when combined with backward integration into APIs allows the company to enjoy economies of scale. This has further strengthened its relationships with its customers.
For most of these molecules, the company supplies the product to the customer. However, in Metformin the company has decided to focus primarily on its own brands in the US market.
The molecules from this segment will continue to grow due to entry into new geographies.
2) US Generics- Focus on High Value Complex and Niche Products in Varying Dosage Forms
The company through its subsidiary in USA (Granules Pharmaceutical Inc) aims to target high value but low volume therapeutic areas while playing to its strengths (which is manufacturing prowess in certain molecules). By targeting a smaller market size in the generics space, the company hopes to attain a sizeable market share in it (the smaller the market size, the lesser the competition). The company is looking at developing differentiated and extended release dosage forms.
This segment entails high R&D commitment and plays on the ‘Make in America’ theme, and the company is looking to market its own products (80% are Rx-Prescription Drugs and 20% are OTC-Over the Counter).
3) Emerging Business – Fully Integrated Facility to offer APIs and FDs in Various Therapeutic Areas
This segment caters to a wide array of therapeutic areas and customers. The company lays moderate emphasis on R&D and manufacturing capabilities. Products in this segment tend to be moderate volume and moderate value. Much of the portfolio and two manufacturing facilities (Multipurpose API plant at Visakhapatnam and API Intermediate facility at Bonthapally) were acquired from Auctus Pharma.
Key products include Losartan (anti hypertension), Cetirizine (antihistamine), and Fexofenadine (antihistamine). Going forward, the company is entering the oncology APIs business and operations are expected to be CMO/CDMO catering to certain strategic partners.
Granules India has grown strength to strength over the last decade and has added several new APIs and their corresponding downstream derivatives (PFI and FD). Over the years, it has seen customer migration from primarily APIs and PFIs to FDs. This has allowed the company to move up the value chain and improve margins.
The company derives over 70% of its revenues from regulated markets where the regulation on quality is very stringent. This is an entry barrier for other players but can also be detrimental to the company if it fails any USFDA inspections.
API Portfolio: (Blue indicates Core Business) (Orange indicates Emerging Business) (Bold & Italics indicates acquired from Auctus Pharma in 2013)
API Intermediates – Bonthapally
API – Bonthapally (Paracetamol API), Jeedimetla (Metformin, Guaifenesin, Methocarbamol APIs), Vishakhapatnam (Multi API facility and Oncology block)
PFI – Gagillapur (Flagship facility), Jeedimetla
FD – Gagillapur, Virginia (USA)
Competitive Advantages and Economic Moats enjoyed by Granules India:
Extensive Vertical Integration
Having a manufacturing presence across the entire value chain enables the company to be highly competitive in the global market.
Economies of Scale
A mixture of integration and high volumes allows the company to attain critical mass thereby pushing costs lower and achieving economies of scale.
Strong Regulatory Track Record
Over the past few years, the company has had a decent regulatory track record with the USFDA giving EIRs to all its plants, albeit with a few minor observations from time to time.
Clear Strategic Focus
Granules India core products for the past 9 years have remained unchanged (contributing 80%+ to total revenue). Going forward, the company is looking to reduce their dependence on these core products by focusing on their new range of APIs and their respective downstream products. However, the core products will continue to grow in absolute terms as they start entering newer geographies.
The company has shown a consistent track record in delivering on their goals and has divested its stake from two Join Ventures which were non-core businesses.
Risks Faced by Granules India:
The company derives the bulk of its revenues from regulated markets where quality control is stringent. Hence, any USFDA / EU inspection that fails can hamper the company’s growth.
Recently, the company voluntarily recalled twelve batches of Metformin Hydrochloride Extended Release Tablets (750mg) due to detection of higher than permissible NDMA levels (Nitrosodimethylamine). This particular dosage level tablet contributes roughly 5% to the company’s Metformin portfolio, and the company has undertaken all precautionary measures and is rectifying the anomaly swiftly.
GDUFA (Generic Drug User Fee Act) is a policy enacted in the US that essentially promotes competition amongst generic players thereby leading to pricing power erosion. On the flip side, the act also helps get approvals a lot faster. I think that Granules India US Generics strategy will get more advantages due to GDUFA than disadvantages.
Raw Material Risk
The company has started seeing increasing higher key raw material prices and has started to pass on these elevated costs to the customer, although the pass-on happens with a lag of 3-4 months. Margins could come under pressure temporarily. Due to the Covid-19 pandemic, some of the company’s supply chains from China have been disrupted due to increasing shipping freight time (a trip that would take 14 days, is now taking 45 days). This has led to the company increasing its raw material stocks which has led to rise in inventories (capital locked up).
To de-risk parts of their supply chain, the company is working with domestic partners (who are looking to take advantage of the Government’s PLI scheme) to secure long-term supplies of Key Starting Material (KSM).
The promoters had pledged their stake in the company to raise fresh funds for the aggressive capex taken through the previous years. (Note: The company has had negative free cash flows and hence one can understand the pledge. Furthermore, I believe that it is a sign of confidence in the business and in the management). Its also indicative of ‘skin in the game’ in this instance.
However, Promoter Pledge has come down drastically from 43% in 2019 to 3.64% in 2021 which is an excellent sign.
Competition and Commoditized Molecules
The commoditized nature of the core molecules along with competition can pull down the return profile for the company. However, Granules India is a market leader in their core molecules and with their efficiency and capacity they should be able to maintain their share.
There are no direct substitutes to the core molecules and hence product substitution risk is low.
High Capex Needs due to Extensive Vertical Integration leading to Pressure on Free Cash Flow
- Rising disposable incomes and increasing affordability of medicines.
- Higher prevalence of diseases such as diabetes and cancer. Facility in Vizag is expected to manufacture oncology and non-oncology products which are high margin.
- Company’s foray into the complex and niche high value low volume generic markets in USA.
- De risking of supply chains from China places Granules in a very good position due to its unique position as an efficient high-quality vertically integrated manufacturer.
- Upcoming vertically integrated Multi-API and Oncology facility at Visakhapatnam is expected to help add capacity and drive growth for the three business segments.
- Expansion into newer geographies, primarily Europe and Latin America.
- New greenfield capex for PFI and FD in Hyderabad (functional by 2024) will drive growth in the long term.
Granules India has a book value of D/E of 37%. Much of this is foreign debt and hence currency fluctuations affect the value from time to time. The market value of D/E is around 7.65%. Margins have seen a steady improvement due to multiple reasons such as,
- Product Mix Changes. Increasing contribution from higher margin FDs.
- Higher Capacity Utilizations leading to operational efficiencies. The API and PFI facilities are being utilized nearly a 100% while the FD utilization stands at 85%.
Free Cash Flow (to the Firm) has been largely negative over the past years due to extensive reinvestment. The company seems to have turned the corner and is expected to start generating consistent positive Free cash Flows.
North America and Europe can be considered as regulated markets. The rest of the geographies are semi-regulated.
The company stopped giving a breakdown since 2018 as a strategic move to counter competition. What we do know is that the top 5 molecules continue to contribute 80%+ revenues. The company has set a target for 2025 to increase ‘Other’ APIs volumes thereby reducing dependency on the top 5.
Improving margins as Finished Dosages contribution increases (product mix changes) and volumes increase.
I modeled my valuation around a 8-9% revenue CAGR for the next 10 years along with terminal operating margins at 16%. Cost of capital lies between 7.82% and 8.67%. Reinvestment for the next 2-3 years will be high due to heavy capital expenditure undertaking.
Based on my narrative, the intrinsic value for Granules India lies between INR 287.7 and INR 303.35 (conservative basis).
At today’s valuations, Granules India seems to be slightly overvalued.
Fundamentally, Granules India seems to have a robust business model, evident from their consistent performances. There has been some chatter about a Private Equity firm looking to take over the company, but the management (promoters) have repeatedly denied this.
It seems to me that Granules India is on the cusp of reaping stellar benefits from their robust business model built around extensive vertical integration!