Why I like JB Chemicals JB Chemicals [JBCPL] is a ₹11.76bn Indian pharmaceutical company with well known

brand names like Metrogyl, Rantac, Nicardia in its portfolio. In 2014, it has a major

presence in cardiac, antacid, pain management, anti peptic ulcerant segments. It has a

presence in anti-infectives, cardiovascular and gastro-intestinal segments which are

some of the fastest growing verticals in Indian pharma space.

It has 5 business units- Russia/CIS, Rest of the World, Domestic Formulations, API and

Contrast Media. The Russian unit had both OTC as well as Prescription (Rx) business till

2011. In 2011, JBCPL sold the OTC business to Cilag GmBH, a Johnson and Johnson

company, for a sum of ₹960cr. Out of this, it has given away approximately ₹412cr as

dividend (and dividend tax), 114cr as debt repayment, 215cr as purchase of investments

and ₹72cr as purchase of fixed assets. Post sale, it still retains the Russia/CIS Rx business

and has the contract of supplying for 5 years of so to Cilag, the same product portfolio

which it bought in the form of OTC business. The three important brands Doktor Mom,

Rinza and Fitovit constitute the bulk of the Russian OTC business. As a part of the deal,

their worldwide rights are also ceded.

Another ₹200cr will be given to the Russian Rx business in exchange of the inventory. Net

net, the deal looks very interesting on the first look. Its quality will be dealt later in this

thesis. Looking ahead, the company has a decent API business. As per 2012-13 Annual

Report, the total API sales stand at ₹62cr, registering a growth of 56%. Its pipeline will be

robust with 6-10 ANDAs filed every year. The management has earlier hinted at these

ANDAs being turned into an opportunity for contract manufacturing. This will be a

partnership deal with other US-facing pharma companies.

The Health of the business units

The business units of JBCPL are not dominant players in any segment. They have in the past

not exploited growth opportunities fanatically. For too long, their focus was on Russia/CIS

countries and domestic formulations. And for too long their efforts at branding didn’t really work

well. However in the last few years there has been a change in the company’s strategy. They have

been showing growth from a low base and have today become the third largest company in

Contrast Media in India.

Many of the data is missing from the following table, due to lack of such information in annual

reports.

2012-13 2011-12 2010-11 2009-10

Formulation Exports 36% 37% 24%

Contrast Media 15% 10% 10%

Domestic Formulations 10% 15% 15% 18%

Biotech 17% 13%

API 56%

ANDA 10mn 7mn

However it is evident that they have been growing and growing well. Their formulation

exports business has been growing well. And Contrast Media business is picking up growth due

to their consolidation of market share. The Domestic Formulation business have been showing

some slowdown. However the recent DPCO policy enables a 6-7% increase in prices of essential

listed pharma products. Coupled with it a volume growth of another 6-7% and the company can

match the growth of Indian pharma market in the coming years (15%).

In 2011, JBCPL acquired 49% stake in Biotech Pty Ltd, a South African pharmaceutical

company. This not only allows the company a foothold in Africa (South Africa mainly), but also a

dossier of 56 products and veterinary space which will be manufactured by the company in India.

This is a very important step and points to higher margins in the coming years. The marketing

will be done by Biotech Pty.

In summary, it can be concluded that JBCPL may not be a dominant company in its business

verticals, but it is a profitable, value creating business entity.

The Economics of the Slump Sale

Analyzing the deal economics can shed necessary light on two of the most important facets

for a business like JBCPL. For a company which is still a midcap at best, for it to emerge,

managerial decisions are the most important factors in value creation (http://wp.me/p4bHa8-

1T). Given this, analyzing the slump sale decision will reveal the managerial ability and

transparency (the first facet). Secondly it will also reveal on the likely path JBCPL is taking from

the perspective of business.

The Russia/CIS OTC business did a business worth $67mn annually. It was sold for a sum of

$276mn. The valuation of 4.2x of topline is definitely a worthy premium to shareholders of JBCPL.

Additionally, the rationale quoted for such a sale was the higher incremental funds required for

marketing purposes to push the brands (Doktor Mom,Rinza and Fitovit) to the next level.

The data culled from the company annual reports does prove the same point.

Claim: The slump sale of Russian OTC business was because taking it to the next level would require a lot of promotional funds

2013 2012 2011 2010 2009

Expenses in Sales,Promotion and Publicity[Standalone] 54 47 105.27 87.52 88.41

Total Sales [ Standalone] 842 715 812 687 738

Expenses in Sales,Promotion and Publicity[Consolidated] 37.69 50 107.49 89.63 89.24

Total Sales [Consolidated] 894 830 897 771 732

Sales/Publicity [consolidated] 23.7198 16.6 8.34496 8.60203 8.2026

The funds required in net sales was substantial till 2011, but got rationalized post 2012. On

the contrary, the sales consistently improved even though marketing budget shrinked. This

clearly indicates a higher ‘bang for the buck’ present now. And this essentially makes sense. The

Russia/CIS business needed a lot of cash to market its products. Their annual TV ad budget was

about $4.7mn. The reason is obvious. In the last 10 years, Russian rouble has appreciated so

drastically on the back of oil boom that Rouble (along with Brazilian Rial) is the costliest Emerging

Market currency. Selling this vertical has definitely been a good strategic decision for JBCPL.

Seen in another way, Doktor Mom and Rinza combinedly are 100cr brands. Selling these two

along with Fitovit for 11 times was a very good idea.

But the question of growth remains. At an ROCE of 17% [JBCPL India] 1160cr will be far more

valuable than a low margin, 15% topline growth vertical like that of Russia/CIS business.

These three perspectives, in my view are strong enough reasons to consider that the slump

sale has been a very important and necessary hard step for the company.

In 2013, to settle certain claims made by acquirer Cilag GmbH smoothly, the company has

returned a sum of ₹64.50 cr to avoid the litigation costs. This doesnt materially affect the

financials/valuations of the business. However it is a positive that precious time and energy will

be saved by not pursuing litigation.

Creating Shareholder Value

The managerial ability of businessman can be measured on two fronts- his strategic decisions

and capital allocation decisions. In the previous section, the former was analysed and checked. In

this section, a manager’s capital allocation decisions need to be put under microscope.

Approximate schema of capital allocation as done by JBCPL

Particulars 2013 2012 2011 2010 2009

Cash Profit 127 865 187 159 57

Cash Outflow in Working Capital 9.47 -167 15 22.77 -2

Purchase of Fixed Assets 49.21 80 34 12.63 15.7

Purchase of Investments 72 215 60 18

Dividend 9.98 412 10.54 9.83 4.96

Debt Repayment 17.51 101 -33 36.63 28.19

Interest Paid 9 25 19.65 23 14.74

Investment in Business -63.3 100 49 34 28.88

The table is the approximate schema of capital allocation done by the managers of JBCPL. The

particular heads under which the capital allocation is done forms the main relevant portions for

a business like JBCPL. Of course there are other cash inflows, sometimes substantial like Foreign

Exchange Gains in 2009 and regular cash outflows like Taxes Paid, but they are ignored. The

reason being - they don’t shed any light on the inherent managerial ability.

What we can note from this table are:

1. The Manager rightly realizes that JBCPL has low ROCE (~17%) and hence is better off,

parking funds in other avenues. Hence JBCPL has substantial mutual fund investments

2. It is a consistent and strong dividend payer.

3. It has consistently paid off its debts over the years out of the cash income.

If we put these scenarios together, it is evident that manager is indeed adding shareholder

value, through satisfactory capital allocation.

The Business under a microscope

Right in the beginning we talked and discussed about the business, then we moved to analyze the

sale of Russia/CIS OTC business. We connected it with managerial decision making. Then we

moved on to understand the shareholder value accretion as done by capital allocation of manager.

But it is still important to analyze the business from a deeper perspective.

And connected with this understanding will be the valuation this business will be able to

command, if we would like to acquire it.

Of worth noting in this snippet of last 10 year balance sheet is that, the Reserves and Surplus

has posted a gain of 432%, never turning in an unprofitable year. The amount of loan funds is

about consistent. And the deferred tax liability, which serves to be an interest free loan from the

Government of India has doubled in the last ten years. All in all, it reflects a satisfactory state of

affairs as JBCPL. At 8.4cr shares floating, its book value per share is 118/-.

The current cash and cash equivalents stands at 149cr. The current investments of the

company valued at the lower of market or cost stands at 394cr (here 434 cr includes subsidiary

investments). Which together brings cash and liquid investments at 149+394cr i.e. at 543cr.

Of concern is the sundry debtors account which though has tempered down in the last 5-6

years still stands at a substantial level of the working capital.

A true picture of their working capital demands in the last 5 years emerges with this table. In

retrospect we can well claim, that their working capital has started being utilized well since the

OTC sale.

Claim: Working Capital is better used since OTC sale

2013 2012 2011 2010 2009

Sundry Debtors[standalone] 194.64 131.2 385.45 407.27 374.49

Loans and Advance[standalone] 92 109 52 55.5 51.5

Sales[standalone] 842 715 812 687 738

Sales[standalone]/SundryDebtors[standalone] 4.32594 5.4497 2.10663 1.68684 1.97068

Sales[standalone]/Loans&Advances[standalone] 9.15217 6.55963 15.6154 12.3784 14.3301

Sundry Debtors[consolidated] 191.27 136 345 344 302

Loans and Advance[consolidated] 97 110 55.41 59.68 58

Sales[consolidated] 894 830 897 771 732

Sales[consolidated]/SundryDebtors[consolidated] 4.67402 6.10294 2.6 2.24128 2.42384

Sales[consolidated]/Loans&Advances[consolidated] 9.21649 7.54545 16.1884 12.9189 12.6207

In the last 10 years, each year they have grown their topline and in the last 10 years only 3

years they have shown a decline in their profit before tax(in the last instance, it was due to the

sale of Russia/CIS OTC business). And their net profit has declined only once.

This inherently proves a very important aspect of the business. It surely is not a high flier in

terms of growth, but it is as robust as they come.

The Valuation of the Business

This business can be valued conservatively from many perspectives. Each perspective telling

us a different side of the story and supporting different viewpoint. However it will be shown that

a slight analysis of each viewpoint leads to a conclusion that the present valuation which market

is awarding to this business is pessimistic.

The Value of Enterprise

In the last 10 years, the average Return on Capital Employed for JBCPL has been about 21%.

Let us try to do a very basic calculation, here.

Market Value of Equities = Book Value of Equity + Future value of all EVAs

Assuming the ROCE maintained at the average level for the rest of its lifetime i.e 21%. Its Cost

of Capital, given the low amount of debt presently in its books will merely equate with the

opportunity cost. The opportunity cost of investing the said funds in JBCPL and not markets. And

markets over a historic period have been offering a 16% CAGR annually.

Henceforth the weighted average cost of capital will be close to 16%, internal rate of

return for JBCPL is 21%.

Hence EVAtoday= (21%-16%)*Stockholders Equity

=5%*992cr = 49.6cr

Assuming it doesn’t grow this EVA at all for the rest of its lifetime, which is an extremely

pessimistic number, plugging it away in Gordon Growth model gives the net present value of all

such future EVAs as ~ 49.6*(1.16)/0.16 = 360cr.

As a result, even with the most pessimistic valuation market should consider atleast 1352cr

(current book value + sum of all future EVAs= 992 + 360cr) for JBCPL. Right now the market value

of the equity (alternatively called the ‘current enterprise value’) is about 900cr.

(1200cr (=market cap) less by 149cr (=cash), 200cr (50% discount to valuation of unquoted MFs, which are valued at lower of

going rate or cost) added to 45cr (debt outstanding) which gives about 900cr)

For a strategic buyer considering JBCPL, he will not be seeing a company with 0% growth

rate! It will be seeing a company which even if nothing, matches the growth of the Indian

pharmaceutical market (~15%). And this is what an acquirer will see it as. It has currently a total

portfolio of 108brands or so.

That’s a fantastic margin of safety! How much it is going to be worth is open to conjecture, but

I can surely say it is not going to worth mere 1350cr (and thus definitely greater than 900 odd

crores as the current enterprise value) even if it grows its business at a reasonable rate.

Let us look at it another way.

The Price of Cure

Let us try to merely analyze the ‘knowns’ and take the unknown positives as margin of safety.

What do we have here is a company with robust brands like Metrogyl, Nicardia, Dicloran which

are proven and well recallable names in Indian markets. Approximately 50% of Indian revenues

(400cr in 2013) comes from these drugs.

Let us not assume pricing power embedded in these products. Hence the margins to the

company for these drugs will be very low. In fact these margins should ideally reflect the nature

of the business JBCPL is i.e. a manufacturing unit. In effect the company margins are ~10%. Thus

the cash inflow to the bottomline due to these drugs are ~20cr.

Assuming a terminal growth of 6%, discounted over the long term inflation (~10%)* we

arrive at a valuation of ~550cr for the existing drug portfolio.

* Here the rationale for using inflation and not weighted average cost of capital mentioned before, is because here we are valuing

a cash flow, and for cash the discount is the long term inflation and nothing else. Whereas earlier we were valuing an investment hence

for that we need to use opportunity cost as its discount. Technically, we can replace this opportunity cost with the highest yield

offering security in our portfolio, but here it is assumed that the portfolio has no other security and the only other choice is index

funds.

To quote, Warren Buffett in his 2003 Annual Meeting: “Everything is a function of opportunity cost.”

Similarly, the contrast media business is adding 40cr to the bottom-line (assuming the same

margins), with no growth considered the value of the contrast media business comes to ~ 440cr.

Combined, these two verticals itself yield a 990cr worth valuation. Which is what the current

Enterprise Value of the entire company is (~900cr)!

This again reflects a very strong margin of safety for this company. At zero growth for contrast

media and a modest 6% growth for the India drugs business, it is indeed a very safe price.

Is there a rationale behind considering 6% as a modest growth?

Yes indeed!

The products of JBCPL has come out from a cost plus ceiling pricing mechanism to average

price mechanism. And under this, the consideration of inflation will be factored in the pricing of

these drugs.

Hence we see a fair business with an extremely cheap valuation, where as margin of safety

we are receiving the entire export business (exports to US, Australia, Africa, Latin America,

Russia/CIS etc), its drug pipeline, contract manufacturing business for free!

Streams of Revenue and their price

A very simple and crude consideration, this method asks how many times will a strategic

buyer pay for a business which is generating approximately 800cr in topline. At 900cr of

Enterprise Value (calculated elsewhere), a strategic buyer pays close to ‘nothing’ for this revenue

stream (i.e. nothing extra)

However, a company which is aiming to grow at 15% for the next 5-6years, matching the Indian

pharmaceuticals growth, it can be very well valued at 1.5-1.8x the revenue stream conservatively.

It must not be forgotten that the managers sold the Russia/CIS business at a 4x topline valuation.

Clearly 2x is worth achievable for this business, given the impressive list of well recognizable

names in the portfolio.

Implying a conservative valuation of 1300-1400cr for the business, whereas the current

enterprise value is ~900cr.

Valuing the Cash Flow streams

Given below is the owners cash earnings calculation for the financial year 2013.

At an Enterprise Value of 900cr, we are getting the core business for a free cash flow multiple

of 9.73x. We are getting a 21% ROCE business for a bargain basement multiple of 9.73x.

A conservative value will be about 12-13x the cash earnings.

A final word about the nature of the investment

JBCPL is not an investment cut from the Munger-Fisher cloth. There has not been any attempt

at projecting it as so. We can’t foresee the nature or amount of earnings in the years ahead. In

other words, there is not much visibility and predictability which is necessary out of such

businesses.

However, what we can reasonably assume is that this business is definitely not worth what

market is offering today. Put in other words, it is definitely and substantially larger than what

market is offering for it today. In essence it is a Graham-ian investment.

Markets have a tendency to swing between different moods. Coupled with it, businesses are

not static entities where the performance is frozen. Business results surprise on both ends. As a

result, due to the combination of these two effects, there are times when a company’s value

changes from neglected cheap bargain basement prices to pricey, growth valuations. JBCPL can

turn out to be such an investment. However the operative word here is ‘can’.

For many a rational investor, at 20x PE for broader markets pouring in money in index funds

can entail some risks. In my view, investments like JBCPL can be used as a proxy for money market

funds with two difference. Higher yields and volatility, yet not be inherently riskier.

Soham Das sohamdas@gmail.com 22/04/2014

About the Author

Soham Das is a value investor based out of India and manages his family investments

independently. His markets of choice are Indian equity markets, however he keeps an active tab on

US equities as well. Practicing very concentrated focus investing since 2011, he has posted a gain of

70% (till 2014, April) vis a vis 34% of broader index and 6.01% of benchmark (BSE Small Cap). He

can be contacted for consulting, writing assignments and career opportunities.

His interests are in swimming, chess, mental models, business valuation and strategy analysis.

@sohamdas http://stoicstudy.wordpress.com sohamdas@gmail.com

http://linkedin.com/in/sohamdas