Cipla Limited (Cipla) is a pharmaceutical company focused on developing new formulations for existing and new drug substances. It derives approximately 55.0% of its income from operations outside India. It is making large investments in formulations facilities at Sikkim, Goa, and Indore that would make the finished forms of medicines (source: moneyvidya.com)
The whole reason for any business to exist is to generate sales revenue and make more profits. At a minimum, the parameters listed below should have continuously increasing trends. All the data below is based on last 8 years 2000 to 2008.
- Revenue: Increasing trend with average growth of 24% (SDev. 9%).
- Earnings per share: Increasing trend with average growth of 24% (SDev. 16%).
- Net cash flow from operations: Overall, the net cash flow from operations has an increasing trend. However, the net cash flow is consistently less than reported net profit. I would like to understand (if possible) how company is showing continued profit is when its cash inflows are always lower.
- Profit/Loss from operations: Looking at standalone profit only, the corporation is showing consistently increasing profits from its operations.
- Reported net profit: Increasing trend.
- Gross margins: Sustainable gross margin, averaging 19.5% (with a very narrow standard deviation of 1.36%). Purely on numbers alone, this may seem very good. However, I would like to understand how company is able to maintain such a tight control on its profitability.
- Operating margins: Sustainable operating margin, averaging 22.2% (SDev. 1.20). Again, I would like to understand the narrow standard deviation.
Quality of Dividends
In this part of my analysis, I am trying to understand dividend growth rate, consistency, and ability of the corporation to demonstrate sustainability. In is also an indirect way to gauging management’s policy vis-à-vis sharing the profits with common shareholders.
- Dividend per share: Chart 3 shows the dividends have decreased relative to 2005. It has become stagnant.
- Payout factor: This is ratio of dividends per share dividend by EPS. It was sharing large percentage of its profits (39% to 75%) with its shareholder. However, it has now dropped to low 20%s. What is reason that company decided to share less of their earnings with their shareholder?
- Dividend growth rate: The rate of dividend growth is highly variable. It is -43% (2005), and 0% (2006, 2007). At a minimum, I would like to see growth in dividends that covers inflation. I am also concerned that good economy of 2006 and 2007 did not result in any dividend growth.
- Ratio of cash from operations to reported net profit: This ratio is consistently less than one. For me this is not a good sign. I would like to understand where are all of profits coming from?
- Ratio of profits from operations to reported net profit: This ratio is more than one. A silver lining.
- Ratio of Cash from operations to total debt: This ratio is all over the place. Until 2003/04, it was doing more than 1.0. Since 2003, it has been very flirting with 1.0, and in 2007 it was at 2.7. The company seems to have taken on debt. Is this showing up as less dividends, because company has to service its debt! This wild swings in this ratio is not a good sign for me.
Dividend Cash Flow vs. Risk Free Savings Cash Flow:
Why should I take risk if I can get a same or more cash flow by putting my capital into any risk free savings, fixed deposits, or any such risk free accounts? Therefore, I try to understand how dividends will affect my cash flow in 10 years of time period. The baseline assumptions are (1) the stock’s dividend yield is 0.9% at current price of Rs. 227.10; and (2) savings interest rate is 7%.
- Best case scenario: considering average dividend growth rate of 13% for last eight years, the dividend cash flow will be only 0.21 times the cash flow from savings interest.
- Worst case scenario: considering low end of the dividend growth of 2% for last five years, the dividend cash follow will be only 0.08 times the cash flow from savings interest.
- In order to have equal cash flow (i.e. dividends = savings interest) in 10 years time period, the current yield should be 4.3% with worst case dividend growth of 2%. At this yield the buy price is Rs. 48.00.
Beta-based expected return:
I measured Beta of Cipla’s stock risk (or price movement) relative to the S&P CNX NIFTY (or index movement). Here, I am trying to understand how a stock price behaves relative to the market and how to factor in the capital appreciation into my expected returns.
- The stocks eight year Beta value is 0.17. This means Cipla’s stock is relatively less volatile w.r.t. S&P CNX NIFTY index.
- The expected return is 8.5%. Expected return = [risk free return, 7.0%] + Beta, 0.17 x [expected market return, 15.5% – risk free return, 7.0%]. I will provide more details on this calculation in future post. So stay tuned!
- Now factoring in 8.5% of expected return into the worst case dividend growth of 2% and current yield of 0.9%, the total cash flow is 1.45 times the savings interest rate.
Fair Value Calculation
Based on the analysis so far, I do not believe Cipla will be a good long term investment for my risk profile and my long term strategy. However, I am continuing my analysis to estimate the fair value and understand risk return characteristics for my readers.
- NPV price based on 15 year DCF: Rs. 115.4
- Average high yield price calculated based on past 8 years: Rs. 97.0
- Pricing relative to 8 year average PE ratio: Rs. 192.6
- Pricing based on PE ratio of 12: Rs. 101.7
- Graham number: Rs. 95.9
The range of fair value is calculated as Rs. 100.0 to Rs. 120.5. This is determined by taking average of above five parameters and using one standard deviation for high and low values.
Cipla has a long history of operating in a generic pharmaceutical space making new formulations and new generic drugs. While it is showing growth in term of revenue, I would like to understand how the company is showing consistently higher profits when its cash flow from operations are lower. The company has embarked upon a capacity expansion. This expansion seems to be funded by combination for debt and increasing capital base. The balance sheet shows that the total debt has increased from Rs. 24 crore (in 2000) to Rs. 580 crore (in 2008). In addition, the company capital base increased in 2006 (from Rs 60 crore to Rs 155 crore) and it also diluted its share count by splitting shares in 2004.
I took are quick look at company Chairman’s August 2008 speech. Throughout his speech the focus was on humanitarian aspect of low cost drugs, impact of patent concern, revenue growth, market share, and capacity expansion. In addition to present state-of-business, I would have liked to see what the company is doing in future. Cipla’s near future focus is on capacity expansion. I was not impressed.
The analysis shows that Cipla falls short for my income portfolio’s long term (10+ years) objective of dividend-based cash flow and capital appreciation. The stock price is already at PE of 25.
- Initiating a position at current pricing of Rs 227.10 provides a total expected return of 1.45 times the saving interest cash flow.
- Waiting for initiating a position at Rs. 120.5, the total expected return would be 1.57 times the savings interest cash flow.
I make an investment in a company with an expectatoin that I will hold it for 10+ years. During my holding period, I expect a company to pay me consistently growing dividends. In addition, I also expect that my capital appreciation remains somewhat near to the market appreciation. I do not plan on holding Cipla stock in my income portfolio. However, Cipla would be an attractive investment to investor whose objective is to have less volatile stock in their portfolio.
Full disclosure: No position in Cipla.