Granules India – An Overview

Granules is a major B2B supplier. It manufactures APIs, PFIs and Finished dosages for 5 molecules, namely: Paracetamol, Metformin, Ibuprofen, Guaifenesin, Metocarbamol

Paracetamol: It is a pain reliever and a fever reducer.

Metformin: It is an oral diabetes medicine that helps control blood sugar levels. Metformin is for people with type 2 diabetes.

Ibuprofen: Ibuprofen is used to reduce fever and treat pain or inflammation caused by many conditions such as headache, toothache, back pain, arthritis, menstrual cramps, or minor injury.

Guaifenesin: It helps loosen congestion in your chest and throat, making it easier to cough out through your mouth. Guaifenesin is used to reduce chest congestion caused by the common cold, infections, or allergies

Metocarbamol: It is muscle relaxant and relieves pain and discomfort caused by strains, sprains, and other muscle injuries. It works by slowing activity in the nervous system to allow the body to relax.

Before reading further, I strongly recommend you to go through my article on an overview of the Pharmaceutical sector. You can read the article here.

Business Model diagram for Granules:

Let us now try to look at the business model for Granules. The below business model is how I visualize Granules as a company.

Let us now try to look at each of the above 9 segments of the business model.

1. Customer Segments:

Segmented Market: Granules is a predominantly B2B companies. The products that Granules manufactures (API, PFI, FD) are predominantly sold to large pharma companies. Since different companies have different requirements, Granules tweaks its final product to suite the customer. Companies like Omnichem, (and possibly) Mylan etc. are its immediate customers.

Mass Market: Recently, granules has started to sell directly to end users in US via retail chains like Walmart. Hence Granules has entered the mass market segment as well.

2. Value Proposition:

Cost: Granules manufactures the products at large tonnage, So in a single batch of production it is able to produce a large quantity of medicine, hence cost per unit of medicine goes down. Hence it is able to supply its products to its B2B customers at a relatively lower price.

Quality: There are two aspects to quality: (a) Quality of final product (b) Quality of Manufacturing facility. Granules manufactures higher tonnage of medicines, hence the quality of finished product is uniform for all batches of medicines. This ensures that the B2B customer gets same results for the entire batch that it buys from Granules. The other aspect is the manufacturing facility. Granules has never faced USFDA bans. There have been minor observation by the USFDA team during the inspection of Granules’s manufacturing facility but granules has responded appropriately to each of these notings.  Due to this constant focus on quality, customers who manufacture the final dosages using Granules’s APIs (or even the customers who use the final dosages from granules) are assured of the quality and need not worry about end user complications.

Variety: Granules provides each of its products in 3 varients, namely, API, PFI and Finished dosages. Hence customers are free to buy any one (or more) based on their requirements. This flexibility is an important one that customer must be appreciating.

3. Channels

Based on the type of customer segment, Granules reaches its customers directly or indirectly

Direct: It reaches its segmented market (B2B) customers directly using its sales force.

Indirect: For the Mass market (B2C) customers, it reaches indirectly via partner stores (Walmart, and I believe Walgreens as well).

4. Customer Relationships

Since granules is a B2B company, its customer relationships should ideally be limited to personal assistance. The company could be having a CRM team that handles queries and issues from customers. If granules was an e-commerce company or a real-estate company, it would have needed a dedicated model and staff for customer relations. Being a B2B company, I believe, it reduces the customer engagement requirements.

5. Revenue Streams

The major revenue stream for Granules is asset sales. I.e. it sells whatever it produces. Granules produces four different types of products for its customers. It is currently producing Intermediates from its Vishakhapatnam plant for the Omnichem JV. It produces APIs for customers who prefer to buy APIs, it produces PFIs for some select customers. Granules also manufactures Finishes dosages for few other customers. Hence its revenue streams comprises all possible segments of pharmaceutical products.

Now, how does the company fix the price for its products? There is no information available in public domain about this. So I am guessing that:

For some customers it sells at list price.

For some customers, based on what they are buying (PFI, API, FD), the prices vary.

For B2B customers it might have a different pricing compared to indirect sales through Walmart.

Based on the quantity that the customer buys, some customers might be getting a discounted rate.

6. Key Resources

Physical:

Since Granules is a manufacturing company, the factories are a key resource for the company. The company has 7 manufacturing facilities in Andhra Pradesh. Some factories manufacture the APIs, some of them the PFIs and some the Finished dosages. A new plant in Vishakhapatnam is reserved for the omnichem JV. Other than this Granules owns a plant in China as a JV with Hubei Biocause Heilen Pharmaceutical company.

Intellectual:

Granules needs regular ANDA approvals for its submissions. Hence the intellectual right to manufacture the molecules is a key resource. Granules also gets periodic reviews from USFDA for its plants. Granules needs an OK from the USFDA for its plants so that it can sell its products.

Human:

Being a pharma company, it is in a niche area. Hence employees with specialized knowledge are a key resource. Also the Managing Director is the driving force behind the company. Hence, he is the key resource for the company as well.

7. Key Activities

The key activities that the company performs are:

Production: Production of the medicines.

R&D of new Molecules: Granules does not have big presence in this space. However, with its Actus arm, it wants to design new molecules and file ANDA for these new molecules. Abacavir is an example of a new product derived from the R&D initiative.

8. Key partners

Granules has 2 joint ventures. One JV with Hubei biocause to manufacture Ibuprofen and the other JV with Omnichem. The Omnichem JV is a promising one with scope for future growth as its mandate is to manufacture APIs that shall be used by Omnichem to manufacture FDs for medicines from large pharmaceutical companies that are going off-patent.

9. Cost Structure

The above figure captures all aspects of the Cost incurred by the company. The cost can be divided into operational expenses and capital expenses.

Risks:

The business model listed above does not capture an important aspect of a business, i.e. Risk. Below are some of the risks that I believe the company can face.

1. Chinese Attack on base business

For products like paracetamol there is a constant risk of low cost Chinese substitutes. However the regulated markets in developed countries tend to weigh quality over price. Hence the large companies tend to buy from quality suppliers. However, a simple molecule like paracetamol can come under Chinese low cost attack. One simple way to find out if Granules is getting impacted by the competition is to keep a close watch on absolute sales numbers for paracetamol. If the year-on-year sales number start to come down then it is a big RED flag.

2. US FDA inspection

     When the US FDA inspects the manufacturing facilities of Granules, if it finds anomalies then it might issue a warning. If Granules is not able to rectify the deficiencies identified by US FDA, it could result in import alerts in US which would have a major impact on Granules.

3. Failure to Grow

     Over the years a major source of revenue for Granules has been its low profit API business. The company is trying to move towards Finished Dosages. Any lack of commitment from the management in this direction would be a RED flag. Failure to become a majority FD player would mean the company will have to be content with low margins which is not good.

     Failure to launch new molecules would again be a case of “Failure to Grow”. If Actus does not come up with new APIs then new ANDAs would not be filed which would mean that Granules would have to be content with its existing mass market, volume based five molecules. The Omnechem JV may act as an additional revenue source, however the dream of investors to own a company that can generate 25% ROE would remain just that, a dream.

4. Death or attrition of their MD Krishna Prasad

     The company revolves around its MD Krishna Prasad. An untimely separation of him from the company would be a disaster for the company.

Business Model (According to the company):

Granules has its own way of defining its business model. This model has 4 aspects, namely, Focus, Scale, Quality and Relationships. Granules believes that by employing these four aspects, Granules has created an entry barrier in the products that it focuses on.

Focus: As noted in my article on pharmaceutical sector the huge sector tailwind for pharmaceutical companies has been the patent expiry of many medicines in US. Most of the large cap companies in India had their generic version ready. As soon as the patent gets expired, one of the generic companies gets a chance to launch its generic version of the medicine and has a 6 months exclusive period. During this period this company has exclusive market access and can sell tons of low cost generic medicines. This makes a lot of money for that financial year for the company. After the 6-month exclusivity, other companies are allowed to launch their version of the generic competition (generally 3-4 more companies launch their version) and over the years many more companies launch similar products and they compete with each other for the market share for that molecule. This process gets repeated for each of the patent that gets expired. If you are a pharmaceutical company that is chasing these patent expiries then you are basically aiming to make a killing in the 6-month exclusivity period and then you will have to compete with other generic manufacturers like you for future sales post the 6-month exclusive period. This is an interesting strategy and it does make money. The large pharmaceutical companies in India follow this. You constantly get to hear about this in the media that the patent for a medicine “M” has expired and the Company X has got an exclusive license to sell the generic version of the medicine. Companies A, B, C and D are waiting to launch their generic versions after the exclusive period.

However Granules India has decided not to follow this strategy. In the annual report for the year FY13 says the following and I quote:

 “Instead of jumping from product to product to leverage short-term profits, we chose to focus on a select product portfolio. Our portfolio consists of safe, established products with a large, built-in user base with no alternatives. These products have been ignored by many pharmaceutical companies because the products are viewed as low-value commodities. However, we know there is tremendous opportunity in these products.”

From the above explanation from the management it appears that the management believes that the companies that are chasing the patent expiry are “Jack of all trades, but master of none”. Granules India does not want to be party to this. It believes that one should focus on few products and be the market leader of these products. No wonder the company calls “focus” as their first pillar for their business model.

Scale: For a company to improve or maintain its profit margin, it needs to have pricing power. Lack of pricing power will result in reduced profit margins which in turn will result in decreased valuation of the company. Granules believes that it has the pricing power because of its scale. The company can manufacture 11 million tablets (Finished Dosage) and six-ton of PFI per batch. Because of the large batch size the company achieves higher efficiency and consistent quality. This reduces the cost of manufacturing for the company and hence it has pricing power.

Quality: Customers demand quality and because of operational efficiencies, Granules is able to meet the quality requirements of its current and prospective customers. Customers of Granules need large quantity of these high volume low cost products. Because of the huge batch size, Granules is able to satisfy the needs and maintain the quality of the product. This results in repeat orders from customers. Granules provides supply based guarantee hence customers are guaranteed of the supply this is another quality aspect that customers like. Hence quality is the 3^rd pillar of the business model as described by Granules.

Relationships: Granules has relationships with brand owners as well as generics leaders and supplies its products to them. Because of its scale, it is able to divert any discussion about pricing towards quality and supply guarantee. It has also entered into relationship with Hubei Biocause (or Ibuprofen) and Omnichem (for CRAMS business).

Business Segments:

Base business (Core molecules):

Granules started as a Paracetamol player. Later on it added four other molecules. Till FY13, most of its revenue was due to the sale of these 5 molecules (either as API or PFI or FD).

Actus:

In FY14, Granules bought India based API manufacturer Actus. When Granules bought actus, it had an USFDA approved manufacturing facility. It also has an API base of 12 APIs. By purchasing the company Granules got access to 12 APIs. However actus has been a loss making company as the its predominant sales were intermediates and APIs which generate lower profits. Granules has been revamping the division. From the conference calls I get a feeling that they plan to turn Actus into an API hub. All their future APIs might come from Actus facility. The company also seems to be phasing out few of the APIs from the Actus portfolio which is generating is low revenue and low profit. Instead, it is planning to add new APIs to the portfolio. Abacavir is a result of the efforts in this direction. The turnover plan also includes phasing out sales of low profit intermediates and concentrate on converting the APIs sales to finished dosage sales. In FY14 a 10,000 Sq. ft. R&D center in Hyderabad to create new APIs under the Actus umbrella. The plan seems to be to file ANDAs for these new APIs. Look out for R&D expenses in future ARs for Granules. However, these expenses are capitalized and then amortized when sales starts. I am not too comfortable with this concept but then it is generally accepted as a valid way of justifying investment (or rather expenditure) that will show results in the future.

Actus seems to have branched out thinly in various segments. It has APIs in the following areas: Antimetabolite, Antihypertensive, Antifungal, Antihistaminic, Antithrombotic, Antiulcerative, Analgesic, Chemotherapeutic, Antiretroviral, Antipyretic, Antibacterial, Antiviral, Anticonvulsant [1]. It appears like they spread out thin. No wonder the Granules management is cutting down some of the APIs/Molecules and concentrating on few of these.

Omnichem JV:

Ajinomoto OmniChem is a 40 year old CRAMS manufacturer. It manufactures the patent protected products for some of the largest drug companies in the world. But as the products go off-patent, these need to be manufactured at an optimized cost. Omnichem on its own will not be able to do it as its plants are in Europe and it is expensive to manufacture there. Hence omnichem decided to form a JV with Granules to manufacture them in India. This JV would be a win-win for both companies. Omnichem gets to retain its large customers by supplying them with high quality low cost generics for the drugs that are going off patent. So the original patent holder can sell the same drug as an off-patented product at a lower cost in developed countries. On the other hand Granules gets to improve its revenue as well as margins as it expands into CRAMS segment.

Omnichem is a specialist in the following areas: Azidation, Chiral chemistry, Catalytic hydrogenation, Hydride reductions, Organometallic chemistry, Enzymatic reaction. The JV could lead granules gaining an experience in all these areas.

CAPEX/Investments and breakeven:

Granules is a moderately CAPEX intensive company. Since it is in the business of manufacturing medicines any incremental sales of meaningful size would need new plants or expanding existing plants. This is evident from the Rs. 450 crores the company needs as CAPEX for FY16 and FY17. CAPEX plans are always a touchy issue. It raises many questions. How will the company fund the CAPEX requirements? Will it be via Debt or Equity? When will the new plants breakeven to offset the debt/equity burden?

The only way to judge this is based on past experiences. In the recent past, Granules has undertaken two initiatives that triggered CAPEX requirements, namely:

• Buying Actus
• JV with Omnichem

Actus was bought in FY14 and the work on Omnichem JV started in FY13. Actus has almost breakeven as of FY16. On the other hand Omnichem JV started production in August 2015 and by FY16 end it will breakeven. Hence, past experience show that, Granules can breakeven on its ventures within a reasonable time.

Loans (Debt):

One thing that can bring down any company is the amount of debt a company has. There are two types of loans that a company takes, namely short term loans and long term loans. Short term loans, also called working capital, are used for the company that is needed for day-to-day operations. The other is the long term loans that the company takes. There long term loans are generally used for the CAPEX plans of the company. The outstanding long term loan is to the tune of Rs. 346 crores. The short term loans are about Rs. 111 crores.

For FY16 and FY17, the company has an ambitious plan. Granules is planning a CAPEX of Rs. 450 crores. This is being funded partly by the equity infusion by the promoters (about 200 crores). Rest of the funding could come via long term loans. One needs to keenly observe and follow this funding shortage.

Traits of an excellent company:

In the interview Nilesh Shah of Envision Capital lists some of his criteria on what stocks to buy.

Criteria 1: Is the Company Growth Oriented

For the first criteria, Nilesh says, and I quote:

“First of all, is this company a growth oriented, is there an aspiration to grow and is there headroom for this company to grow?”

Some acts of management that signal to me that they are growth oriented are listed below:

1. JV with Ajinomoto Omnichem
2. Buying of Actus and the efforts to add new APIs like Abacavir. New ANDAs planned in future years.
3. Capacity expansion for PFI by 4000 tons and future CAPEX plans to debottleneck the API manufacturing.
4. Setting up of an US subsidiary to concentrate on high margin APIs.

Criteria 2: Is the company Capital efficient

For the second criteria, nilesh says, and I quote:

“Two is capital efficiency. The management needs to be very capital efficient. If it can generate the internal cash flows to fund growth, that is a fantastic situation to be in. We always try and look at an asset-light model but as long as even if it is not asset light, but if it can generate cash flows to fund growth, that is the second big thing. ”

Granules has both long term debt (of about 350 crores) and short term debt (of about 115 crores). So it is not a debt free company. It has CAPEX plans of close to 450 crores and it issues equity to promoters for 200 crores. So it does not have huge cash to fund its expansion. The rest 250 crores for CAPEX is planned from internal accruals which means it does have some cash to fund its own CAPEX. Hence, as per Nilesh’s criteria for a company to capital efficient, Granules in my opinion is partially capital efficient and I believe, as it grows into a Midcap company, it MAY be able to fund its own growth.

Criteria 3: Does the company have a Differentiation

For the third criteria, Nilesh says, and I quote:

“third, is there any differentiation which this company has…”

If you ask me does this company have any differentiation? I would be hard pressed to identify any differentiating factor. It is a predominantly B2B generic drug exporter. Noting much to differentiate it. However if you put a gun to my head, I can only say that the relentless pursuit to be efficient is their differentiating factor. In every call, every discussion the management keeps stressing that they want to bring in efficiency in manufacturing. When you focus on efficiency, especially efficiency in your manufacturing, you tend gain two advantages:

• Your revenues increase because you tend to improve the volume of your finished goods by re-using the existing manufacturing capacity thereby reducing your CAPEX.
• You increase the EBIDTA and the bottom line because your revenues are higher and raw material costs tends to come down.

Here is what Krishna Prasad (MD of the company) says on this point in the Annual report of FY14, and I quote:

“Our core strength of efficient manufacturing is not easily replicable which is why we have been able to create margins in what are viewed as commodity products.”

Here are some more quotes from FY14 AR:

“…we decided to become the market leader for our products by focusing on improving manufacturing efficiencies across the value chain…”

“…While our focus on manufacturing efficiencies is not common in the pharmaceutical industry, our performance speaks for itself. Although our products are growing in the mid-single digits, sales have grown at a compounded five year rate of 24%…”

In FY14 when Granules bought Actus, Krishna Prasad discloses this news. Along with this information he also adds a point and I quote:

“We believe we can leverage our core competency of efficiently manufacturing high-volume products and maximize value at Auctus.”

I can only say one thing: “A management that focuses on the bottom line is an efficient management”.

Dividends and Taxes:

Considering the fact that people generally own limited amount of stocks, dividends received on those stocks always seem a paltry amount. Hence it is often spare cash for an investor that does not even count. However dividends are extremely important part of the investment process. When a company releases its quarterly results, it provides information on revenue earned, raw material consumed, EBIDTA, depreciation data, amortization data and so on. As an investor how does one rely on these information? We go by the assessment of the chartered accountant who corroborates the results. The chartered accountant is supposed to go through all the documents furnished by the company and then state that the quarterly results and annual results that the company is stating is accurate. Hence our investment in a company is entirely dependent on this assessment.

As investors we have 2 sources to verify the authenticity of the results (to some extent). They are:

• Dividends
• Taxes

The numbers stated in any financial statement can be cooked to any extent. Any company can say that they earned 10,000 crore revenue with an EBIDTA of 3,000 crore. All these are on paper and offered to you in a PDF document every quarter or at the end of financial year. But the company cannot cook two things, i.e. dividends and taxes. Dividend is an actual outgo for a company. If a company says it is paying a dividend of Rs. 2 rupees per share then it has to pay this and it will reach your account. It cannot simply cook up a dividend in the PDF document. Each of us can check our bank balance to ensure that we did receive Rs. 2 for every share that we own. Hence a management that consistently declares and remits the dividends gains the trust of investors.

Similarly, tax is another outgo for a company that can be easily tracked. If a company says it paid Rs. 50 crores as taxes to the government, it can be easily tracked. If a company is cooking results and has no profits then where does it get money to pay taxes? There is another aspect that an investor can cross check. Generally the corporate taxes are in the range of 25% to 30%. If a company pays, say 5% as taxes, then that is a red flag to dig further. No company can have very low taxes unless the revenue or expenditures are being cooked up in the earnings report.

The track record for Granules has been predictable as far as taxes and dividends are considered. The company has paid dividends regularly and I hope that shareholders have received the dividend. The annual report shows that the company pays taxes regularly. It is a healthy sign.

The dividends for FY16 have been unpredictable. For the first time Granules has announced three interim dividends in FY16. Personally I was not expecting this! We can speculate the reason for this rather generous dividend, but it seems to deviate from the unsaid history of dividends being issued only once a year. Phil Fisher in his book “Common stock uncommon profits” says that companies should have predictable dividend history. I hope the management maintains a consistent dividend policy and use the profits to build the company. Below table lists the dividend payment history of Granules (Source : Moneycontrol.com website)

Date	Dividend Type	Dividend (%)
28-01-16	Interim	15
2-011-15	Interim	15
27-04-15	Final	50
28-07-15	Interim	15
25-04-14	Final	35
25-04-13	Final	20
24-04-12	Final	20
29-04-11	Final	15

Numbers: Revenues, Net profits and Profit Margins

Let us look at three import figures for Granules over the years.

Revenue:

Granules has been able to grow the revenues every single year over the past 8-10 years. However the revenue growth have not shown a consistent pattern. Below table summarizes the revenue in the past 6 years. For FY 17 the management is giving a guidance of 15-20% revenue growth.

Year	Revenue (Crores)	Revenue Growth (%)
2015	1292	18
2014	1095	43.32
2013	764	17
2012	653	37.47
2011	475	3.03
2010	461

Net Profits and profit Margins:

As we have seen, Granules manufactures mass market products. Such products have lower profit margins. Hence Granules has to sell loads of such medicines to earn a decent profit growth. This can be seen from the table below. The management wishes to increase the profit margin to 10% in the next couple of years. This is a healthy sign as improving revenues with improving profit margins will result in healthy profit growth.

Year	Profits (Crores)	Profit Growth (%)	Profit Margins (%)
2015	90.91	20.84	7.03
2014	75.23	130.9	6.86
2013	32.57	8.74	4.26
2012	29.95	43.3	4.57
2011	20.9	9.08	4.27
2010	19.16		4.15

Moat:

Granules does not manufacture medicines whose patent is going to expire. Hence it does not gain windfall from first mover advantage. Granules is not a knowledge based companies (like Suven) that can gain from sudden windfall gains from contract research. Neither is granules a big player in contract manufacturing.

Hence this begs an important question. Does granules have a moat? I believe granules has the following moat:

• Efficient Manufacturing (i.e. large scale cost efficient manufacturing of commoditized products).
• On path to be one among the largest manufacturers for the molecules that form its base business.

Summary:

Warren Buffett and Charlie Munger have always stressed the fact that people should invest in the area of their competence.  To invest in pharmaceutical company is a challenge because it is a specialized field. Not everyone understands the medicines that are being manufactured by a company, potential impact of these medicines, the competitors, the risk factors associated with pharma companies compared to say Garments industry companies like Page Industries. So, gaining competence as an investor in pharma companies is difficult, time consuming and a challenge. However companies like Granules provide a unique advantage that they have fewer molecules/products to understand. The therapeutic areas that granules caters to are fairly well known and relatable. Overall Granules seems to be a company that is worth tracking. The following points are worth noting about granules.

1. To keep a tab on the topline, competitive advantage, look at the growth of its base business, especially Paracetamol. If Paracetamol sales are showing negative growth for multiple quarters then it means the company’s Moat (efficient manufacturing) is at risk. Competition (aka Chinese companies) is catching up. That is a red flag.
2. To keep a tab on the bottom line, monitor closely the contribution of API, PFI and FD. FD has a higher profit margin. Hence, if the growth of FD business is faster than API and PFI business then it means the company is on path to achieve consistent 10% plus PAT margin and improve the bottom line on a sustained basis.

References:

[1] Annual Report for Granules for FY 14

[2] Annual Report for Granules for FY15

[3] Annual Report for Granules for FY13

Disclaimer:

I am not a SEBI registered research analyst. The information provided above is my subjective view based on what I have read on different websites, annual reports, and quarterly reports of various companies which I assume to be accurate. The above information should not be treated as an offer/advise to purchase a specific stock/investment instrument. Since these are my subjective opinions, I could be wrong in my understanding or presentation of information. I do not claim that the above information is complete or can be relied upon as such. I cannot be held responsible for any loss or damage caused due to any inadvertent error in the above information. I will not liable for investment decisions made by readers of this article based on the above information. I am not an investment adviser. I may or may not have position in the above company. Please consult your investment adviser for all your investment needs.

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