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Warning letter at Puducherry, valuation reasonable

Strides Pharma Science (Strides) announced that USFDA has issued a warning letter to its Puducherry plant, a formulations facility. This facility was inspected by the USFDA in Feb’19 and had been classified as OAI (Official Action Indicated) in May’19. The warning letter would not affect the supplies of its six products which are already commercialised from this plant, though new approvals would be delayed. Ten ANDAs (out of 34 of company) are filed from this site. Strides has received all requisite regulatory approvals to exit its Australia business and the deal is likely to be completed in the next few days. This deal would help in bringing down the leverage (D/E to 0.2x from current 0.9x). The stock has recently corrected >15% making valuations reasonable. Upgrade to BUY.

* Warning letter on Puducherry plant: Puducherry is a formulations manufacturing facility. This facility was inspected in Feb’19 and was classified as OAI in May’19. Existing supplies from the six commercialised products in the US from this facility would not be impacted. However, ten ANDAs are pending for approval from this site and these would be delayed impacting growth in the near term. The company would be working with USFDA and consultants on the issues and would work to resolve the same at the earliest. We believe it would take 12-18 months considering historical cases of other companies.

* Impact on financials: We don’t see risk to existing sales from this facility despite the warning letter as existing supplies of six products would continue and five of these products can be manufactured at alternate sites as part of de-risking strategy. We do expect delay in new approvals and incremental cost pertaining to remedial measures. Hence, we cut revenue/PAT by 1-2%/1-3%, respectively, for FY20-FY21.

* Regulatory approvals received for divestment of Australian business: The company has received all the requisite approvals to exit its Australia business (Arrow subsidiary). The transaction is expected to close by 10th July, 2019. As per the transaction, Strides would receive an upfront payment of AU$300mn and a deferred payment of AU$94mn. This deal helps in retiring debt of ~US$150-160mn and lower finance charge to improve profitability.

* Valuations and risks: We expect earnings to more than double over FY19-21 led by scale-up in US revenue and significant reduction in interest cost. Considering warning letter at Puducherry site and exit from Australia business (high margin and high value business), we lower target PE to 15x from 17x. However, we believe recent correction in stock price has made valuations reasonable, hence, we upgrade the stock to BUY from Add with a revised target price of Rs472/share based on 15xFY’21E EPS (earlier Rs544). Key downside risks: Regulatory hurdles and pricing pressure in the US.

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