A Victim Of Its Own Success? U-Turn On Taro Merger Could Be A Strategic Call By India’s Sun Pharma

Taro’s strong performance since Sun took a majority stake has complicated the Indian pharma’s merger plans, but analysts say the story may still evolve.

MUMBAI – Late last week India’s Sun Pharmaceutical Industries Ltd. terminated its long-running bid to merge with Taro Pharmaceutical Industries Ltd., leaving Sun still holding a majority share, and causing analysts to speculate that Sun ended up a victim of its own success.

Having helped to engineer an outstanding turnaround for the Israeli firm, from the brink of bankruptcy to record profits in a five-year span, Sun with a 66% equity stake, heightened expectations for the remaining shareholders, according to analysts.

A Long, Bumpy Ride

Taro’s shares on the New York Stock Exchange have surged during Sun’s involvement with the company, fueling higher demands from hedge funds and investment companies that own roughly 33.7% of the company. The funds have repeatedly rebuffed Sun’s overtures to buy out the remaining stake, from $24.50 per share offered in October 2011 to the most recent offer of $39.50 per share (Also see "India’s Sun Pharma Makes Final Move To Take Taro Private; Spins off Booming India Operations" - Scrip, 15 Aug, 2012.).

When Sun first proposed to buy Taro in May 2007, it was a company struggling to keep its operations running, and Sun offered a price of $7.75 a share. The Indian company planned an all-cash deal of $454 million to acquire Taro, valuing the equity at $230 million and refinancing debts of $224 million. Sun also made cash infusions of roughly $60 million to save Taro from a payment default for a short-term loan obligation.

The $7.75 per share offer was a 27% premium over the closing price on May 18, 2007, the last trading day before the deal announcement. Sun later acquired a 66% equity stake (representing 77% of outstanding voting power) after navigating a protracted legal battle with Taro’s founders.

But times have now changed. On Feb. 8, 2013, the day Sun announced its decision to terminate merger plans, Taro touched $50 per share. News reports suggest hedge funds and investment firms IsZo Capital Management LP and Black Horse Capital Advisors LLC are demanding up to $100 per share to cash out.

Even if Sun could have closed the deal at its last offer, $39.50 a share, it would have paid an additional $592 million to acquire the remaining 33.7% equity in Taro. With all the piecemeal transactions Sun undertook to acquire Taro shares over the last five years, analysts say the entire deal value would have reached $900 million to $1 billion – making it the highest overseas buyout ever for an Indian pharmaceutical company.

Sun’s Offer Not Attractive

Yet according to some analysts, that price tag would still be a relative bargain given Taro’s recent performance.

Saion Mukherjee, an analyst at Nomura Securities Ltd., wrote in a Feb. 11 report, “The price offered implied a trailing PE multiple of 6.6x. Given the cheap valuation on the reported financials, we did not expect the agreement to go through at the offer price, and expected resistance from the minority shareholders.” But Mukherjee was also surprised by Sun’s decision. “We expected Sun Pharma to revise up the offer price,” he said.

Strategically, Mukherjee said, “Sun would like to own 100% of Taro to synergize operations. …Given the strategic importance, we think Sun Pharma may revise up the offer price unless there is significant deterioration in Taro’s performance owing to increased competition.”

Ironically, Sun fought hard to acquire the majority stake of Taro’s founders, but gave up on the minority stake in the face of determined investment firms, which saw Sun’s last offer as inadequate given Taro’s financial performance and valuations on similar deals.

Taro – A New Cash Cow

But the story may not be over. Market analysts generally favored Sun’s latest decision to step back, saying the company may be keeping its next set of options close to the vest. Taro’s performance has been exceptionally good over the last several quarters, backed by a few strong product introductions and price hikes.

In the third quarter last year, Taro recorded 25% year-on-year growth and a 15% sequential growth with sales at $186 million, beating analyst’s expectations. “Its EBITDA margin stood at 56% led by robust growth in sales while the gross margins were maintained at 75% and the after tax profit was at $89 million – a surge of 42%,” said a report by India’s Edelweiss Securities. For the nine-month period, Taro reported sales of $506 million, an increase of 27% over the same period last year. And its net profit for the nine months stood at $217 million.

“Sun perhaps knows that the exponential growth at Taro is not very natural for a generics business and may expect a correction in the stock price in the medium term,” said a senior analyst. At that time, he added, Sun may be in a better position to make another offer to purchase the remaining shares.

Synergies Take A Knock But Mood Positive

Meanwhile, Sun Pharma Managing Director Dilip Shanghvi told investors during an earnings call Feb. 8 that Taro's shareholders would be unwilling to approve the merger unless the [offer] price was increased substantially.

“Sun Pharma has decided that it would not be in the best interest of Sun Pharma and its shareholders to do so,” Shanghvi said. “So, Sun Pharma requested that the special committee [formed to decide a reasonable price] agree to terminate the merger agreement and they have agreed to do so.”

Shanghvi, who over the last 25 years has developed Sun Pharma from a modest distributor into the most valued drug maker in India, is known to be cautious about deal valuations and has traditionally focused on buying distressed assets and turning them around.

However, he acknowledged that synergies that could be derived from a single company would be difficult to derive from Taro as a partly-owned subsidiary. Nevertheless, Sun will continue to run Taro the way it has been run until now, Shanghvi said, adding “I don't see that [termination of a merger plan] as a negative.”

Surajit Pal, an analyst at Elara Capital, noted that the same cash infusion of nearly $600 million intended for Taro may now be used for another deal. But one drawback to the failed merger is the minority interest still in play. Future decisions, according to another analyst, may not be flexible for Sun as Taro will continue to have its own board of directors and its cash reserves cannot be used by Sun Pharma.

Also for Sun, it may remain complicated to organize product portfolios into one united company for markets like the U.S. However, given that Sun and Taro are generating strong cash flows, analysts say it will not pose a major issue. Sun has a swelling war chest of $1.2 billion while Taro has $419 million in cash, key indicators that Sun will have sufficient funds to allocate for any proposed deals.

During the last year, Sun made two important acquisitions in the U.S. First it bought Dusa Pharmaceuticals Inc. and then inked a deal with Takeda Pharmaceutical Co. Ltd. for URL Pharma Inc.’s generics division (Also see "A Deal A Month? After Dusa, India’s Sun Bags URL’s Generics Business As Takeda Keeps Colcrys" - Scrip, 17 Dec, 2012.). Another key milestone that Sun highlighted during its analyst call is approval for liposomal doxorubicin on the back of an acute shortage of generic cancer drugs in the U.S. (Also see "Sun’s Generic Doxil Clears FDA; Janssen Uses Alternative Manufacturing Process" - Pink Sheet, 4 Feb, 2013.).