So, what do we think of DRG?
We think it is a terrific business. It provides market relevant key information to the Pharma industries that make long term bets on drugs. Good information is absolutely the key to success. The barriers to entry are big as it is tough to replicate the information and add more value and displace DRG at its clients. Piramal claims that 48 out of the top 50 global Pharma are their clients with about 95-95% client renewal rate.
Renewal rates as a % of the R&D budgets of clients is a small. Combined with good information, it can make the customers sticky to DRG.
Combine a good business with a moat and good margins, (15 to 30% EBITDA) (More on EBITDA nonsense later) strong cash flow and low capex -- you get a good durable business. We certainly think that the DRG business will be more valuable ten years from now.
At the buying price of Rs. 3,400 crores or 194 INR a share, it represents around 23% of the enterprise value of the Piramal business.
Now for the meat of it all. What are our concerns?
a. Price paid for the acquisition
b. Pricing Power
c. Foreign Exchange Risk
d. Return on the acquisition
Price paid for the acquisition --- A terrific business is a terrific business is a terrific business. But it is not a worth an infinite price.
Did the seller know more than the buyer? The seller was a PE firm called Providence Partners. In more ways than one, it is good news that it is not a strategic seller on the other side, but a firm with a finite timeline for every investment it makes. PE firms have to maximize returns and at the end of the fund's period, investments are usually milked as against providing the money for growth into the future. So, this might provide some upside potential.
Piramal paid 4X revenues. At 15% margin, it is 26X EBITDA and at 30% margin it is 13X EBITDA. The company indicated that the comparable companies in the space are selling at 10 to 18 times EBITDA. However, higher the margin, higher the sale price for the firm as well. Capping it at 18 times EBITDA, would put the EBITDA margins in the mid 20's for the firm.
We would like to make a huge disclaimer here, we are not enthusiasts on using EBITDA. Any metric that does not take into account Capex and Depreciation and neglects both as non-expense is suspect for us. However, given the limited information on the target and the fact that the business is a low capex business, we will continue looking at EBITDA for this business.
The company has grown at 20% between 2006 and 2011. That sounds like a great number. We have two concerns that came out in the conference call during the announcement of the acquisition.
Question
Three short questions; one is about the 20% CAGR over the last 5 years, can you
broadly break it up into what was organic and what was inorganic; second question is if
you could expand a little bit because you are a gold standard, it’s a 6.5% share, what
prevents you from taking a larger share from that pie, is it that you just have to offer
more services or you have kind of reach the ceiling with what you offer and the third
question is when you look at the 2.4 billion number that you gave us, is that just a
function of a total outsourced market and is the market even larger when you look at
what is in house versus outsourced.
Jon Sandler
In terms of the breakdown of CAGR, I think what I will do is I will talk about how we
think about it on go forward basis which is we think that roughly 50% of growth rate on
the go forward basis can be achieved internally and 50% of that will come from
acquisition.
The company said that 50% of the growth will be organic and 50% will be inorganic. We are concerned about this. As the company, grew about 20% in the back five. Conservatively, we can assume that the company will grow at the same rate in the next five years. (As the company grows bigger, keeping the same rate becomes tougher and tougher) 10% of this will be organic and 10% will be inorganic. For a US based business, with the top 48 of the 50 firms already as clients, we think 20% is aggressive. Even if one were to assume that, 10% will be organic, the other 10% will require additional investments. This is a red flag for us. Providing working capital for a low capex business is different than taking into consideration the acquisition costs to price in future growths.
Our second concern came from another question. My first reaction on reading the news about the acquisition was, -- lip smacking pricing power in this business. Here is what the company management had to say in response to a question
Analyst --- My question was, you have grown at 20% CAGR in the last 5 years so of that how much
would have been through value and through volume, essentially you are adding new
clients every year and deriving the revenue growth or from the same client you have go
the pricing power on the basis of the quality of product?
Jon Sandler
So the growth has largely been driven by volume
The growth was driven by volume. This makes me wonder. If the information is the moat around the business, and DRG is the gold standard of the industry, what is causing the lack of pricing power? This is our second red flag.
So, the question we ask ourselves is how much should we pay for a business that can probably grow 10% organically in the future with no demonstrated pricing power (though it is there potentially) and EBITDA margins between 15% and 25%. The answer is 10 to 18 times EBITDA from a PEG ratio of 1 for a 10% growth business with 15% EBITDA to a PEG of 1.3 for a 15% growth business with 25% EBITDA.
Thirdly, the revenues and cost are in $, the business itself might not require any hedging but the Piramal scrip in India trades in INR and the underlying assets of DRG are in the US. For the same margin and growth rates, at INR 45 and 55, the returns on the acquisition will be vastly be different. The acquisition was done with INR USD at 55. While we do not profess any expertise in knowing what time the sun will rise tomorrow, let alone the exchange rate a few years from now, we are nervous about the currency risk. On the positive side, one can also see that it forms a natural hedge against the gyrations of the Indian market.
We think the return on the acquisition might turn out to be lower than the priced paid for it. Conservatively, we are going to write down the value of the assets by 20% (We are happy to have positive surprises in the future) We will value the DRG assets at INR 155/share or 2,900 crores or 21% of enterprise value. We think there is upside to this but the conservative investors we are, we will stick to this number.
