Suven is a potent play on the rebound in global innovative R&D spend
SVLS (Suven Life Sciences) is a clinical-stage Biopharmaceuticals company, which manufactures and supplies drug intermediates and speciality chemicals to global innovator companies. It provides Contract Research & Manufacturing Services (CRAMS), including development and supply of pharmaceuticals for New Chemical Entities (NCEs). In addition, it also undertakes proprietary research on NCEs for CNS disorders. SVLS’ expertise lies in Process Research, Custom Synthesis and NCE Development Support Services. Currently, in the NCE space, 13 molecules are at various stages of development.
CRAMS: The primary business segment for SVLS is CRAMS, which drives overall company revenues. It contributes ~91% to the total revenue. The CRAMS segment is divided into three sub segments – Core CRAMS, Commercial CRAMS and Speciality Chemicals. Core CRAMS and Commercial CRAMS make up the Pharma segment while the Speciality Chemicals business caters to Agrochemicals.
SVLS’ CRAMs business revenue has been volatile for the past few years. Most of the volatility like the one witnessed during FY14-16 appears to have emanated from pre-launch supplies for a specific molecule, leading to orders drying up in the subsequent years. Other factors, including molecules going off patent in specific territories etc., have also fueled certain revenue-related uncertainty. However, from FY18 onwards, we believe there are clear signs that volatility in revenue is increasingly a thing of the past with growth visibility gradually improving.
Core CRAMS: It is part of the Pharma CRAMs business and accounts for ~47% of total revenue (FY18). This segment caters to supplying intermediates to NCE projects of global innovators. The segment, which saw overall revenue plateau over the past two years, is now seeing signs of traction in growth. Overall revenue growth in FY19 is expected at ~15% with a FY18-20 CAGR estimated at ~15%.
Commercial CRAMS: It is a high-value and high-margin business segment, which involves supply of intermediates to NCEs that are already launched by innovator companies. SVLS currently has 3 intermediates, which are in the commercialized state. Of this, 2 i.e. Diabetes and Arthritis are already reflected in continuing revenue traction of the past 12-18 months.
The historically volatile revenue trajectory in this segment is largely due to bunching up of intermediate supplies in FY14 and early FY15. These intermediates were consumed by clients in the following year. This early stocking and subsequently lower-than-expected product takeoff meant that Commercial CRAM supplies declined to NIL in FY16. Since then, supplies have improved, both in FY17 and FY18.
Speciality Chemicals: Compared to Core CRAMS and Commercial CRAMS, the business of Speciality Chemicals CRAMS has historically enjoyed strong growth with revenue CAGR of 40% over FY13-FY17. This was primarily driven by one key Agrochemical molecule, supplied to a global innovator. However, in FY18, the business hit an air pocket when patents expired for the product in certain South American geographies. The next set of patents are not expected to expire before FY22 & onwards. Therefore, the overall Speciality Chemicals business can be expected to maintain revenue run-rate of ~Rs1.6bn per annum. Further, SVLS is also working on another 2-3 key projects in this segment, which hold promise of commercialization for the next 2-3 years.
Suven is a potent play on the rebound in global innovative R&D spend:
There are clear signs that the global branded pharma industry is in the midst of a growing spending spree on innovation and R&D pipelines. This is clearly reflected in the increasing funds being raised by biotech start-ups over the past few years (including IPO funds as well as Venture Capital funding). While it’s true that in recent times the nature of R&D spending is getting skewed towards biological drugs, data on small molecule NCEs (New Chemical Entities) also shows a sharp resurgence in the conventional drug pipeline across various stages of clinicals, indicating a strong recovery.
In spite of the revival in global R&D spend, both the CROs (Clinical Research Organizations) and the CDMOs (Clinical Development & Manufacturing Organizations) have witnessed a major consolidation over the past several years. As a result, the clinical services and manufacturing (API) space have far fewer niche manufacturing companies compared to any earlier upcycle of the past.
R&D Spend and NCE Pipeline:
SVLS has been investing in a proprietary NCE pipeline with most drugs researched dealing with Alzheimers. SVLS’ R&D outlay is predominantly (~85-90%) towards proprietary NCE projects. The rise in the R&D run-rate has been one of the key factors putting pressure on margins and EPS over the past 2-3 years. Absolute consolidated R&D run-rate has risen from Rs560mn in FY15 to ~Rs0.9bn in FY18, a CAGR of ~17%. As a result, consolidated EBITDA has been largely flat in the same period. Going ahead, a few factors would ensure that R&D spend is much more normal and is not a drag on the overall improving earnings trajectory.
SVLS has three drugs in clinical trials, with one of the drugs (SUVN 502) currently undergoing phase 2 trials in the US and set to complete clinicals by mid-2019. Assuming success of SUVN 502 in phase trials, SVLS likely to look for out licensing partners and is unlikely to take up further trials on its own.
Revenue concentration should also ease:
Revenue concentration for top 3 clients peaked at ~58% in FY14 with the start of Commercial CRAMs. Since then, the proportion of the top 3 clients has remained quite high. While Commercial CRAMs supplies during FY14-17 have been muted or even NIL, increase in Specialty Chemicals (largely to one dedicated customer) kept the proportion elevated.
However, going ahead, we expect a decline in this level from ~40% in FY18 to ~35% by FY20E. It is noteworthy that some of the comparable Indian peers also draw about a third of their business from dedicated research centers and R&D set-ups. Some of the international peers like ICON Plc also reflect a similar client concentration. Therefore, in that context, SVLS’ future revenue concentration should be in line with industry norms in the coming years.
Consolidated EBITDA margin to remain stable:
EBITDA Margins adjusting for the one off revenues in FY18 to remain stable over the next 2-3 years due to combination of factors including
- A more steady revenue growth with none of the revenue verticals acting as a drag on growth. Moreover, the share of high-margin Pharma CRAMS in the overall revenue pie will increase over the next two years. This should also help shore up the overall margin profile.
- Stability in R&D spend rate will also aid margin expansion. Absolute R&D spend rate to peak in FY19 at Rs1.15bn and then decline to Rs1bn and as % of revenue from 17% in FY19 to 14% in FY20.
Return ratios among the best in its class; set to sustain:
Return ratios of SVLS compares with the best in the industry. While ROE is muted primarily due to the high cash on its books vis-à-vis the equity employed (25% of equity by FY20), ROIC gives a better representation of the underlying profitability/return on capital.
The reason for SVLS’ strong returns profile is a combination of high fixed asset turnover (~1.7x in FY17) and one of the highest EBITDA margins among industry peers (37% EBITDA margin pre-R&D). SVLS’ high client concentration seems to have been an added advantage, as it has helped reduce potential asset downtime to switch across different products. Going ahead, return ratios are set to remain in the range of 28-30%, as growth normalizes and R&D run-rate peaks out.
Valuation multiples to expand with improvement in growth rate and fundamentals:
With a nearly comparable return profile, SVLS trades at a significant discount (30-40%) to comparable Indian peers like Syngene (SYNG IN, Not Rated) and Divis (DIVI IN, HOLD). One of the reasons for the relatively lower multiple is historic volatility and increasing NCE R&D spend rate. As growth normalizes going ahead and SVLS ensures R&D remains capped beyond FY19, we believe that the valuation gap will narrow. We believe SVLS offers not only a healthy earnings compounding story (20% CAGR over FY18-20E), but also a potential valuation expansion of from the current levels.