Aarti Drugs Limited (524348) Earnings Call Transcript

Ladies and gentlemen, good day, and welcome to the Aarti Drugs Conference Call hosted by Centrum Broking Limited. [Operator Instructions] Please note that this conference is being recorded. I now hand the conference over to Ms. Cyndrella Carvalho from Centrum Broking. Thank you, and over to you ma'am.

Good afternoon, everyone. On behalf of Centrum Broking, I welcome you all on today's Aarti Drugs earnings con call for the fourth quarter. I take a moment to thank the management for giving us this opportunity and their time. From the management today, we have with us, Mr. Harshit Savla, Joint Managing Director; Mr. Harit Shah, Whole-Time Director; Mr. Adhish Patil, our CFO; Mr. Vishwa Savla, Director of Pinnacle Life Sciences. Over to Adhish, CFO, please.

Thank you for introducing us. We welcome you all for the conference call of Aarti Drugs Limited. I think the main purpose of the call, as you all know, is to brief you about the quarterly performance of the company and the current market conditions for the business. In March quarter, company recorded the consolidated quarterly revenue of INR 449.64 crores with a year-on-year decrease of around 2%. Domestic sales of the API segment grew by approximately 1.31% and exports down by 14.93% due to unavailability of cargo. Formulation segment revenues grew by around 26.52% on year-on-year basis. For the March 2020 quarter, API segment contributed approximately 89% of the total consolidated revenues and Formulation segment contributed approximately 11%. Within the API segment, 63.57% of the revenues came from domestic market and 36.43% from the export market. In the Formulation division, 49% of the sales came from exports. For the period ended March '20, revenues from the API segment can be broadly classified into following therapeutic categories. The antibiotic therapeutic category contributed to around 44%, antiprotozoal around 16%, anti-inflammatory around 10%, antidiabetic around 10%, antifungal around 7% and the rest can be classified as others category. As compared to last financial year of 2018-'19, antibiotic segment has increased from 41% to 44%, mainly on the account of higher sales of ciprofloxacin, ciprofloxacin and norfloxacin. In March 2020 quarter, consolidated EBITDA is INR 80.68 crores, up by 32.47%, and consolidated profit after tax for the quarter ended March 2020 is INR 58.86 crores, up by 114.48%. Consolidated EBITDA margin improved to 16.08% even after removing exceptional item of land sales in this quarter. Company has improved on its gross margins on the account of better operational efficiency and better realizations in selling prices. Due to continuous improvement in the working capital, the company was able to further reduce its debt-to-equity ratio to 0.58 as of March 2020 on consolidated basis. Company has already scaled up its antidiabetic, anti-inflammatory capacity, and it will give impetus to revenue growth in financial year 2021. Further CapEx is planned for introducing new products in antidiabetic category. Due to lockdown, a lot of services are scarce, and hence, it is affecting productivity to some extent. However, due to essential nature of our business, we are running our factories after practicing appropriate social distancing measures, regular health checkups and enhanced insurance, et cetera. Now we would like to open up question-and-answer session and take questions from the participants. Thank you.

Shall we open the floor for question-and-answer session?

Yes. We will open for the Q&A session.

[Operator Instructions] The first question is from the line of Aditya Khemka from DSP Mutual Funds.

Adhish, on the gross margins for the quarter, so we were earlier -- if you look at our FY '18 numbers, we were at this 37%, 38% gross margin. From there, we came down to 32%, 33%. We cited the increase in cost from China on raw material as the main reason. And this quarter now, we are back to 37%. So one question is what drove the gross margin in the fourth quarter of FY '20? What changed from third quarter to fourth quarter in terms of the gross margins? And number two, how sustainable do you think it is?

Okay. So one thing is, the fall in the crude prices. Definitely, reduce the arranged rate for us. Apart from that, we have been continuously improving on the efficiency part of our business. So that is the ongoing process, and we have improved a lot as compared to previous quarter. Product mix also plays a role. But most importantly, I would like to point out that in this particular quarter we got much higher selling prices, the realization was much better because of lot of disruptions were there in the market during last quarter. So on a going-forward basis, as of today, the margins are stable, but then once this vaccination of corona comes out, then maybe but still we can eye EBITDA margins of around 15% to 16% on an ongoing basis still.

The pricing realization improvement in the fourth quarter was the biggest driver of gross margin improvement or was it crude?

So it's a mix of both actually, mix of both.

Understood. And how does the lower crude price help us relating it decreases the cost of our raw material? And how does it help us?

Yes, Yes. So a lot of crude based raw materials like our basic materials. So the pricing goes down for those items.

And the vendors for those basically pass on the fall in their cost to us?

Yes. Most likely. Yes.

Understood. Understood. And just in terms of your other expenses and employee expenses, right? So both of them are up -- so employee cost is up 25% year-over-year and other expenses, although it has been high for the past 2 quarters, is again high for say INR 76 crores, INR 77 crores, 45% growth year-over-year. So one, what drove this high cost on employee as well as other expenses this quarter? And next year, what is the outlook on both these costs?

Actually, we had some views in fact for our labor contracts, negotiations are going on. So approximately INR 1 crore of extra payment was done in this quarter for the areas of the labor contracts. So that is why there was some exceptional bump of INR 1 crore in this quarter. And apart from that, we have also grown the number of facilities as compared to last year. So the workforce has also increased along with the increase in the salaries of the people.

So yes, other expenses, growth of 45% is largely driven by capacity expansion?

Look, yes. It is also processing cost. And also, yes, I will also like to point out in other expenses, manufacturing expense will also be the part of that. So in that, we are focusing more towards stating the effluent and moving towards 0 discharge in most of our factories. So because of which -- these of operational expenses also goes up in evaporating all these liquid effluents. So that is also one of the reasons why the manufacturing costs has gone up.

Understood. Just a couple of questions on the follow-up. So let's say -- so your improvement in manufacturing infrastructure to make it 0 discharge, et cetera, all that is already done or is it a work in progress and therefore, the cost will continue to grow?

It is a work in progress. So it is both, the CapEx nature and also the OpEx nature. Even the CapEx is -- we have taken up -- so keeping a budget of around INR 10 crores or a little bit around that figure for coming year also so that we can get better technologies in evaporating the effluent so that our OpEx part will reduce. And we are also trying to -- again, as we did it in past, also trying to get more and more byproducts out of the effluent stream so that there will be some addition to the revenue also which will take care of the increase in OpEx. But this is an ongoing process.

So for next year, also, we should expect like a 20%, 30% growth in other expenses?

20 -- that will depend on the volumes. We'll check the volume growth, then a little confident.

And along the same lines, how much was the volume growth in fourth quarter and how much was the price growth in your revenue?

So in volume growth, we were able to reduce, but that the problem was in the last week starting almost March 22, because of the lockdown, the dispatches were halted. So our inventory went up a little, finished goods, because of that. And that is why there was no volume growth as such. We have seen -- local, we were able to match the volumes. But in exports, whatever we had produced that got stuck at the plant level itself. So exporting -- in fact, you can see a 14% reduction in exports because of the lockdown.

Right. And your tax rate going forward will be this 22%, 23% or do your tax rate will be...

Correct. So including all the surcharges around 25%.

Tax rate. Okay.

22%. Yes. Yes.

Okay. And lastly, on your CapEx, so you said you have INR 10 crores budget of CapEx for improvement and how much would be a total CapEx budget?

Okay. So total CapEx budget, we have a 2 years plan. So that is more. But in the coming financial year, possibly anywhere between INR 70 crores to INR 100 crores because already, we have passed 2, 3 months in the lockdown. So because of that, maybe major of -- a little bit of the CapEx will be to shifted the next financial year. But still, we are keeping a budget of INR 70 crores to INR 100 crores in CapEx.

The next question is from the line of [ Sajal Kapur ], Individual Investor.

So I have a couple of questions. So first one being over the last 10, 20 years, the API industry has seen some serious headwinds in terms of the competitive intensity, mainly from the Chinese players as they have had some unfair advantages like much lower power cost, reduced financing costs and other state-funded incentives, which our Indian players obviously don't get. But when I look at your 10-year performance, the cash generated from operations has grown at a very healthy CAGR of 28% and the market value of the business as a whole has compounded at a similar CAGR of 28%, 29%. So the question is, what according to you have been the critical success factors? And as the external environment has been very hostile and very challenging, if not completely hostile, but you have still delivered a very healthy CAGR on both on the cash side as well as on the market cap side. So what are you doing differently or better than the competition, please?

Yes. Thank you for the fair detail analysis of our company since last 10 years. I would just like to point out that in last 10 years I think it is the first...

I have been a shareholder. I've been a shareholder.

Yes. Okay. Okay. So out of last 10 years, I think first 5 years were really good in terms of the growth. We had a very exponential growth. Last 5 years, there were a lot of challenges, frankly speaking. As you correctly pointed out, the collapse of crude 2x -- a heavy collapse of crude that is, right, from [ $140 ] levels till the [ $90 ] and then from [ $90 ] to [ $30, $40 ]. So that's when the pricing went down for a lot of raw material and so the selling price also went down. So that was one factor. Pollution was another key challenge which we faced since last 5 -- which we are facing since last 5 years because our India's government has also become strict on that part, which is rightly so. Chinese competition has always been there. In fact, what I would like to point out the China competition is relatively easing out since last 3, 4 years. Since that November 2017, when the Chinese government took that drive of making all the pollution norms stringent and closing down a lot of China factories. I think that had been a structural change and a lot of global competition is also moving more towards India as compared to China. So as an API player, which we were always talked from the technological front, in technology and in technical front, our main focus area has always been to consolidate on our strength. So whatever our top 10 products for the earlier, the contribution of top 10 products was at 55%, then become 60%, 65%, 75%. It has now come to around 75% to 78% range. The main reason has been we improved if -- we enhanced our capacity in the top 10 products and we consolidated the market position in those products. So that had given us another benefit in becoming more competitive in those products and because of which, fortunately, our company had a very healthy profit growth. And also, as you correctly pointed out, the operating cash flow has improved drastically. That is mainly because of the few market dynamic changes in the API industry since last 2, 3 years. Our credit period with the receivables have become better and the credit terms have also increased in terms of China. So that is one of the reasons why the operating cash flow also improved drastically.

Okay. Understood. Understood. And the second question I have is, if I look at your annual reports over the last few years, our company has had difficulty in-sourcing raw materials for antibiotics as well as the other therapeutic areas. And to mitigate that risk, we went for backward integration and A to reduce the cost and the dependency on a somewhat easy supply chain. And we have been incurring an annual CapEx of approximately INR 100 crores. I think last fiscal was a little less than that, but on an average basis it's INR 100 crores over the last 4, 5 years. So my question is, are we relatively immune now in terms of the future supply chain related disruptions across all our key therapeutic areas. How confident are you now?

In terms of disruptions in the raw materials supply?

Yes, exactly because you have done a lot of backward integration, right, to mitigate that risk and are we -- we should be in a better position now, right?

Right. We are in a better position definitely as compared to past 2 years, but we still foresee quite a few risk in terms of sourcing a few of the key raw materials. In fact, we are working in that direction. You must be aware that -- in fact, even the government has identified many of our few key raw API intermediates and bulk drugs which they want give subsidy to the private players and come up with large capacities in India to reduce our dependence on the China. In fact, many of our products are highlighted in that. So in fact, there was...

No, no, so I was just adding to that question. So I think on the top of my head, there are about 53 APIs, if I'm right?

Correct, correct. Perfect.

And some were in that ballpark. So how many of Aarti Drugs APIs are in that...

We could -- as far as I remember, not accurately, but 4, 5 are there our products.

So 10%?

Yes. And in fact, most of them are from our top 10 list. So they are big for us.

Okay. Right. That bodes well, then right. Okay. And so you said that there is still a looming threat in terms of the supply chain disruption. So as a percentage, if I remember, I think, it's about 20%, 30% of your raw materials you're still getting from China or some of these Iffy jurisdictions. So is that number reasonably correct? It's 30%...

It's slightly higher. I would say around 40% to 50% is sourcing from China. But what we are trying to do, when the number of manufacturers are more and that particular raw material is going in lot of applications, then we don't go further back. But if the application is narrow, and it is -- means the application is only for our APIs, in that case, we do go for backward integration because then we become overly dependent on the supplier.

No, correct. So 50% is that risk but I heard that in the previous calls as well that you were looking to sign in some Indian vendors to mitigate that risk.

Correct. Correct. Correct. We have done that. We have done that.

So to cross with 33% what is your net exposure?

I didn't understand the meaning of net...

So 50% is what you get and so that RM is at risk. But of that 50%, you have started qualifying some of the Indian vendors for the raw materials. So what is the net risk? I'm just trying to get the net risk...

Net risk -- correct, net risk could be anywhere between 15% to 20%, possibly.

Yes. So that's more like the number that I thought.

The next question is from the line of Manish Poddar from Nippon Asset Management.

So yes, this is Manish here from Nippon AIF. So just wanted to get a sense, what is the outlook, let's say, on volumes this year?

In terms of volume growth?

Yes.

Because of this COVID-19 situation, production of the first quarter is hampered a little bit. Tentatively, you can say we would be able to achieve around 70% of our actual capacity, 70% production of our actual capacities on an average basis in the first quarter. So that will hamper a little bit of volumes. But apart from that, from demand point of view, we feel that there is significant growth available. We are expecting anywhere between 10% to 15% growth still, like in spite of this COVID situation on a yearly basis.

And this is just volumes? Minimum volumes 10% to 15%?

Yes, correct, correct. Considering this not entirely volumes, it will be both. So the major is around 70-odd percent volume driven and 30-odd percent will be rate-driven, something like that.

Okay. And can you just provide an update on the -- this chloro-sulphonation line which you are planning to put? What is the status of that?

Yes. So we already have the land. The CETP is already placed by the GIDC in that area. Now the only problem is because of this COVID-19, we had planned certain visits to -- outside India for the techno -- to get with the technology partner and all. So because of this COVID-19 that plan is a little bit delayed. So maybe after the lockdown is lifted, we will again start with the process. But then that is still in the designing phase, designing as in the layout of the plant and all. We have the process, but we still have to design the plant and finalize everything.

So when you say this CapEx number of INR 7,200 crores, that doesn't include this chloro on CapEx, right?

So the part of chloro, we have an option of putting in Tarapur itself. So that we might go ahead with. So around a small part of INR 7,200 crores might go in that. But otherwise, in the INR 7,2000 crores we haven't considered the main specialty chemicals space. Even if comes, it will come in phase-wise manner. So suppose, even if the project is of INR 150 crores, we might end up spending only INR 20 crores, INR 30 crores in this year, something like that. It will be in these figures.

The next question is from the line of Aditya Khemka from DSP Mutual Fund.

Adhish, so this year, we have done free cash flow, that is operating cash flow minus your CapEx of about INR 200 crores, right? How have we used this cash flow? Can you break it up into debt repayment, buyback and then reinvestment into the business?

Can you come back to the first line, what you said?

Yes. Yes. So this year, our operating cash flow has been INR 250 crores consolidated and our capital expenditure has been about INR 48 crores. So free cash flow that we have at disposal is INR 200 crores after CapEx. So how have we -- yes -- FY '20?

Yes. Understood. So the thing is most of it has gone into debt repayment. We did a total outflow to shareholders was around INR 30 crores to INR 33 crores, something like that because it included 2 dividends. We had one unplanned dividend just before 31st of March, plus we had one planned dividend back in August. These 2 dividends and 1 buyback took place in last year. So it went there. And plus it went in the reduction of working capital rate.

Right. So our net debt today stands at how much, I mean, because I can't see borrowings on your balance sheet?

Yes. So our -- on consol basis, around INR 380 crores. On a stand-alone basis, it is around INR 360 crores.

INR 380 crores on consol, which would mean -- okay. So I can see INR 330 crores, INR 340 crores on your balance sheet. Rest INR 30 crores, INR 40 crores will be under other financial liability?

Correct, with the long-term loans stable in 12 months.

Right. That will be under other financial liabilities?

Correct. Correct. Perfect.

Or other current liabilities -- sorry, other current liabilities.

Yes.

Okay. Got it. So INR 380 crores. So next year, assuming, say, CapEx of INR 70 crores, INR 100 crores, you said. So let's say, next year, you do INR 100 crores of CapEx and your operating cash flow also goes by INR 50 crores, right, because we have a INR 250 crores base of operating cash flow, so 20% growth. So if you are looking at INR 300 crores of operating cash flow and INR 100 crores of CapEx, how would you plan to use the INR 200 crores of recash next year? How much of borrowings -- so INR 80 crores of borrowing is coming due next year, right, which is your other current liabilities, INR 80 crores of borrowing is coming up for repayment next year, right?

Repayment yes, correct.

So INR 80 crores will be repaid and you will be left with INR 120 crores of cash after repayment of borrowings and everything. So how would that be utilized?

Mainly, it will be utilized in -- first of all, all the CapEx plans will take care of that. Working capital debt might go down a little, then obviously, we'll be doing a shareholder payout. But typically, we keep it around 30% approximately -- around 30% profit. And the thing is we do have a lot of CapEx planned maybe in the year after that. So we will not pay it out to shareholders completely, but then release the debt considerably. And then, again, when the new projects come in, our debt will slightly go up. So that will help us there.

Correct. And to a previous participant's question, you said that out of the list of products that the Indian government has released for increased self-reliance, you have 4, 5 products which had appear in that list. How significant are these 4, 5 products as a percentage of revenue today?

I don't have the exact number but then this thing is, it will be quite significant. We can safely assume 15% to 20% of our revenues.

15% to 20%. So this will be mostly floxacins?

Floxacins are there. Yes, they are also there. If floxacins are, metronidazole is there and then these products are there.

And how do you benefit from this because you still get the raw material for these from China, right? So Indian government follows it loudly?

So I mean M&As we were importing. In fact, we were importing from a couple of Chinese sites, one was our own JV in China and one was another player. We have another player in India who is an exclusive partner to us for that product. So we are increasing that because we will be getting capital subsidy also most probably. And this is all not retained from that ideas, most probably we might get capital subsidies. So we might expand those intermediates also in India. If not directly then through our partners.

Right. And your partner has enough capacity to substitute the Chinese volume?

Yes -- no, means we will be putting capacity.

Okay. So greenfield you will do the capability.

Greenfield or brownfield something like that.

Okay. Okay. Got you. And sorry, I missed your response to my previous question on how much has the rupee-dollar helped you in this margin expansion?

Rupee-dollar did not help much because the thing is our -- we have net-net or exports is also -- sorry, imports is also there. In fact, we have booked around INR 9 crores of ForEx losses in the March quarter.

Which is under which line item?

They will be in the raw material.

Raw material.

Yes, raw material.

Okay. Understood. So if the rupee-dollar continues at the current rate of INR 75, INR 76, would you see upside to your margin guidance of 15%, 16% or it would be downside?

If it's absolutely stable in this because the thing is the dollar rate went up gradually from 1st Jan to 31st March. But all the equities are open were to be valued at 75 points or something of that exchange rate. So all the notional loss has been booked. So now if the -- it remains fail, no further notional loss will come. However, all the exports will be done at the higher rate -- all the pending orders what we have will go at a higher rate. So we might benefit a little bit more there.

Right. So what was the average currency realization for you on the export side for fourth quarter?

We don't have that number. I will get back to you on that. We'll note down that question.

Understood. Understood. No problem. We can discuss later. Also, Adhish, on the gross block turnover, so we are doing CapEx and our average gross block turnover in the past has been 1-point something, right? It has been 1.16, 1.2 in that range. What is -- I mean, in your new CapEx, what kind of gross block turnover do you expect given the current scenario? I mean, is the cost of putting the plant going up more than the potential revenue or is the revenue going up more than the cost of putting up the capacity?

Actually, more or less the numbers are same, means it is not that, means whatever CapEx we had been doing in the last couple of years, more or less the assets turn is same. It depends on product to product basis is different, but it was -- anywhere between 3 to 4.

So that implies -- but I mean, my question -- the reason I asked that question was because some of your CapEx seems to be done on the vertical integration part, right?

Right. In that what we can do is...

So when you do more CapEx on -- yes, so that will not necessarily reflect in your sales, it will actually reflect in your margins.

Correct, correct. So now the new CapEx which we have planned, mainly it is all related to the one which will be sold out there.

Okay. So in the past, what you had done is more on vertical integration, but going forward...

Yes, Yes. Correct, correct.

But going forward, your CapEx is going to be more on capacity expansion and not vertical integration?

At least for the next couple of years we can say that actually for the mix revenue more...

Understood. Understood. And this China sort of diversifying away from China globally becoming a theme and obviously, you are also working towards adding domestic vendors to your arsenal, are you also getting more customer inquiries because of them looking at an alternate source other than China for your products?

Definitely, we have seen that trend that people -- at least from the long-term contracts point of view that we are talking with -- there are ongoing talks also for not exactly contracts trends actually, but the kind of that for -- especially for products which are coming from China -- in terms which are coming from China. So we might manufacture that also as import contribution. So which indicates that people are more and more moving towards Indian companies.

Understood. Understood. Sorry, one last question. So this government scheme that came out for API manufacturers, how far along is the government in implementing this because I saw that you hesitated in responding to if you get capital subsidy or not. So I just want to understand, although the government has announced the scheme, where is the implementation today and how long do you think it will take to implement? Number one. Number two, assuming it gets implemented perfectly, how does it benefit -- how much does it benefit you across these different lines in terms of cost or capital expenditure or whatever? How does it impact you?

So I haven't worked on this at all, impacting numbers, how exactly it will impact us finally. But where it will help, I will tell you. One, we feel that -- actually we are also in talks with a few of the officials through PhDs which are working in those government committee. They took out few circulars regarding the incremental sales will get 10% of sequentially, something like that for few of the products. But that is absolutely wrong strategy on the part of government because you cannot talk about incremental sales of 2019-'20 because the existing supplier will have no benefit. Anyone who puts a new capacity, they will be at benefit. So there are few likelihoods in the way they are trying to implement, but we are constantly giving them feedback. So we have given this feedback to the committee. So that they will come up with appropriate figure. So that is why I was a little hesitant in saying that though they have the will to do it, but now the way they do it is more important.

But it defeats the purpose, right? I think the idea of the incentive is to make India more competitive versus China?

Exactly. Exactly. Exactly. So the thing is our industry needs to give them feedback because they may not have the real-time experience of manufacturing and also in making the policies. If they don't take the feedback from the existing players, they might mess up a little bit.

That I think, therefore, is not good for the industry, right?

Correct. But then, I think they are very much open to listening to industry. So that is because in fact, the 1% contracted from their side to us, so which is a good thing. As I think they want to know how the industry will be held from the industry itself rather that doing it on the road.

Okay. Sorry, one last question for me, Adhish. On the formulation sales that we have booked this quarter and how we have been doing in the past, so we have seen a very good ramp-up from what FY '19 was to FY '20. Would you care to comment on what has driven the growth in formulations FY '19 -- 2019?

Yes, I think Vishwa will answer your query.

Yes I'll take that. So the major reason for the increase in sales and increase in margins has been the growth in the export formulation business. So since the last -- past this year, we were in the process of finding a lot of products in many territories and kind of establishing our marketing presence. So that has started coming along, and that's the reason since the last few quarters there's been an increase in the export sales and where we drive better margins and that helped us grow the business.

Right. So when you say you promote yourself, are these branded generics or are these like those unbranded generics that you sell in developed markets of U.S., Europe, et cetera?

So we are presently in U.S. It depends on the country of operation. In some, especially in the emerging markets of Africa and Asia, we are more in the branded generics. Those products are ethically promoted. And also, there are some countries in Latin America and other parts of the world where we are selling them as generic substitute, similar to how it's sold in the U.S.

What percentage would be branded of your current revenue in formulations and what is unbranded?

From the export sales, it could be about -- 60% to 70% would be branded and the remaining would be generic.

And your domestic formulation revenues are all unbranded, right?

Domestic is all contract manufacturing revenue, which is solely -- it's more like a service product. We manufacture it for the domestic players and they brand it further.

And your customers are branded players in the domestic formulation sales?

Yes. Yes. And they're kind of most of the top Indian companies.

Got it. And 40% of your export formulation revenue -- 40% of your formulation revenue is exports?

Yes.

Is that the comment I heard from Adhish in the opening remarks, 40%?

Yes. It was about 49% in this quarter and...

49%? Okay.

Because we would expect it to be around 40% would be exports.

Sorry, come again, going forward?

40%, between 40% to 50% would be exports contributions going ahead.

Export contribution. And how different is your gross margin in your export formulations versus your gross margin into domestic formulations?

It's -- export margins are significantly higher than domestic.

Got it. And going forward, which of the 2 segments would you see growing faster, exports or domestic?

We will see exports growing faster.