Syngene International is engaged in providing contract research and manufacturing services from lead generation to clinical supplies to pharmaceutical and biotechnology companies worldwide. Syngene’s services include integrated drug discovery and development capabilities in medicinal chemistry, biology, in vivo pharmacology, toxicology, custom synthesis, process R&D, formulation and analytical development along with clinical development services.
Syngene is well established in the custom research and manufacturing services (CRAMs) segment. The primary competitive advantage of the company is that it caters to the entire lifecycle of a new molecular entity. The company has over 360 active clients and 8 collaborations with top 10 pharmaceutical companies. It employs more than 4200 scientists and has significant research and development facilities. Generally, innovators don’t keep more than two to three suppliers in the initial years of commercial launch of their patented product. This enables the supplier to have long term contracts at significant margins as there is no threat of generics for a significant amount of time.
As mentioned earlier, Syngene is vertically integrated in the lifecycle of a new molecular entity from discovery to manufacturing. This is a source of tremendous competitive advantage as it ensures significant switching costs. Also, very few formulation players can enter this space because of intellectual property theft concerns. This ensures significant barriers to entry. Since the company is primarily a services company the risk of failure is still largely borne by the innovator company.
There are significant opportunities for growth. Large innovator companies are outsourcing research as the expenses are bringing down their return on capital. The trend is even more notable among the small and medium players. Syngene is well placed to capture this space considering the human resource cost in India is lowest in the world right now. Additionally, companies like Syngene offer manufacturing capacity and specialty services with the option of scaling up which provides much needed flexibility to innovator companies.
Needless to say, I am a fan of the company and its business model. However, I am an investor and investing is a craft in which stories need to be complemented by numbers. So, let’s look at the numbers and the numbers paint a pretty picture too. Revenues have grown at 22% CAGR in the last ten years, be as it may on a small base. Its net profit margin at 20.45% is one of the best in the industry. The return on equity is also decent at around 19%.
Next step, I use my optimistic story to estimate my inputs for my valuation:
- Period and Rate of growth: Going by size of the opportunity I estimate a growth period of 15 years and a compounded annual growth rate of 15%. This gives me a revenue of 16,363.63 crores at the end of the 15th year (currently 2011 crores). Post this, I assume the company will become a mature company and will grow at a rate of 3%.
- Target Net Profit Margin: The company’s net profit margin is already very high. The high switching costs ensure that the company can charge a premium on its services. I expect the company to maintain its margins and better it to 24%.
- Target Return on Equity: There is a link between Net Profit Margin and Return on Equity and is given by the following formula:
Return on Equity=Net Income/Sales*Sales/Book Value of Equity
The first part of this equation is the net profit margin. The second part of this equation translates into a measure of revenue generated per invested equity capital. Right now, the sales to capital ratio is less than one. But this is because the company has invested a lot and there is a lag between revenues and invested capital. As the business develops sustainable economies of scale, I expect this ratio to increase. Hence, I estimate the Return on Equity to increase to 31% by the end of the 15th year.
- Reinvestment Rate: The reinvestment rate is a critical piece of valuation. Growth comes from the choices a company makes. Here, I introduce you to a formula that value investors are very proud of:
Growth Rate=Equity Reinvestment Rate*Non-Cash Return on Equity + Efficiency Growth
How to think about this is that growth in profits will need to come from whatever is reinvested into the company multiplied by the return on that investment. Hence my equity reinvestment rate for a particular year will be the growth rate that year after subtracting the growth rate due to efficiency divided by the return on equity that year.
- Cost of Equity: The cost of equity is my measure of risk. It is the discount rate I use to discount my future cashflows. I use the CAPM i.e. Capital Asset Pricing Model to estimate my cost of equity. It is given by:
Cost of Equity=Risk Free Rate + β*(Equity Risk Premium)
Let me explain this equation:
Risk Free Rate: For this I took the latest 10-year government Bond rate (5.96%) and subtracted the default spread to arrive at the true risk-free rate. The default spread is calculated using India’s government bond rating and is currently at 1.69%.
Equity Risk Premium: For this I generally take the latest mature market implied equity risk premium (5%) and add the emerging market country risk. In the case of Syngene International, 95% of the revenues come from outside India, hence I didn’t add country risk
Beta: Beta is a measure of systemic risk of the company relative to the market. Given the essential nature of the company’s products and services, I estimated a relatively low unlevered beta for the company at 0.75. However, given the financial leverage with the debt to equity ratio at 0.38, my levered beta for Syngene rises to 1
I plugged in the numbers and arrived at the cost of equity of 9.27%.
- Employee Stock Options: Employee Stock options are essentially pieces of equity that a company gives away and hence must be subtracted from the overall market value of equity. I used the Black-Scholes option pricing model to estimate value of employee stock options:
I now have all the inputs for my discounted cash flow valuation. They are summarized below:
I plugged in the inputs into my spreadsheet and get the following result:
The value per share that I get for Syngene International after adding back cash and subtracting the employee stock options is 534. As I write this, that the stock is trading at 489.30. This is within the margin of safety of 8-10%.
Conclusion: The Cat is out of the Bag
Is Syngene International a good company capable of generating significantly more than the cost of capital due to its significant competitive advantages? The short answer is yes. But in investing, excess returns are earned when you know something that the market doesn’t and in the case of Syngene, the market knows. The market knows and has priced in all the good things that are likely to happen with the company. This is what makes investing exceptionally hard and opportunities for excess returns remain ever so elusive.
Build Your Own Valuation:
To the extent, that the inputs to this valuation contain my forecast for the company, this will always be my valuation. If you disagree with it or if you know something I don’t, go ahead and build your own story for the company. I am attaching my valuation spreadsheet here and encourage you to build your own valuation by changing the inputs. The inputs might change but the framework remains the same in valuation.