Is company’s contracts manudacturing business also effected due to these observations?
I am no pharma expert but know someone who is… He is of the opinion that USFDA takes data integrity issue very seriously and it takes a long time to resolve the issue… And generally the issue is not restricted to one site although FDA may have flagged one particular site.
What it means is a massive cost in upgrading of systems, also it sometimes a cultural issue, we Indians jump a signal when there is no traffic police guy… ( this example was given to him by IPCA promoters) so it is sometimes very difficult to comply fully. Although i dont buy this point, it is something to ponder.
The ballpark figure he gave was 3 years to fix the problem and say a cost of 75-100cr … So although divis is in a special situation and historical valuations are screaming buy, i would like to wait somemore time anddiscusswith a few people befoee getting in.
Disclosure: Not invested, bought more of Ajanta
Divis posted good set of Q3 numbers.
Sales 973 CR vs 858 CR
PAT 268 cr vs 246 cr
Regarding USFDA inspection,
Company filed its comprehensive response to the five observations which includes management commitment to remove the deficiencies. also engaged external consultant to work on this issue.
From what I know, US FDA wants to know what corrective action company HAS TAKEN to remove the deficiencies rather than just a commitment to remove them. I know that 15 days is too short for a company to take any corrective action but if the issues raised sound serious and and if so far company has shown only commitment and hired an external agency (indicating they have no idea how to do it themselves) then these action sounds too little too slow. I wish the company was more candid with shareholders in their quarterly release.
Phillipcapital India is very confident on divis lab :
Form 483 concerns overdone; upgrade to BUY
1977219764PC_-Divis_Lab_Co_Update-_Dec_2016_20161226090201.pdf (367.8 KB)
Disclosure : added heavily @ 710 & biased.
Divis had always traded at premium valuations because of its history of strong regulatory compliance. With its recent troubles, all that has gone is its premium. At current levels, it is trading at par with the sector. Based on the 483 observations, I do not think it will go back to its premium valuations any time soon. It takes years to rebuild a stellar reputation
If management and/or analysts think these observations are not serious, they are delusional.
Unknown impurities are neither accurately assessed by the company nor reported to the US FDA
The inhibit integration was used to mask the unknown impurities and the lot containing these was released in the market
The Deputy General Manager for Quality Check confirmed these impurities but failed to explain how then was the produce approved or even met specifications submitted to the US FDA.
There were no audit trails that could be reviewed by the US FDA team. This was for the R&D Division’s chromatographic systems. Also the US FDA team found 7 instances wherein the chromatographic sequences were obscurely named.
Presence of coloured residue/ staining/ material throughout the facility in the piping and on the campaign manufacturing / Use of dedicated equipment.
This was also an observation that one of the customer’s had complained i.e. Customer had observed dark particles in the sample of some product.
Equipment deficiencies was witnessed throughout the facility.
Products failed to meet the desired specifications in the various stages of production in which the R&D team approved the further processing of the product. This meant the batch which was sampled from, was approved and released in November, 2015.
Inter Office Memorandum between the R&D and the manufacturing block mentioned that the lab did not find the same abnormal result in lab experiments and since it was within the acceptable quality limit, the batch was approved for processing.
Of the 3 samples tested, R&D was of the opinion that the first two batches may have failed due to sample contamination without a proper investigation
The US FDA team found 9 such communications/ lapses which led them terming such lapses throughout the entire facility. It also confirmed that the R&D laboratories can support a lower number of products than that is produced at the facility.
Complaints were made on 28-Jun and 30-Jun in relation to the presence of metal particles in some batches which affected at the least 4 separate products.
The root cause analysis conducted concludes that the definite root cause could not be identified from the investigation as the majority of the batch was in line with the requirements and no abnormalities/ deviations were reported.
Inter Office memorandums confirmed absence of suitable alternative cleaning procedures for such heavy metals on 3-Sep-16.
Subsequently it was confirmed that the cleaning issue could not be resolved.
Inter office memorandum between Quality Check Department and R&D team dated 13-Apr-14 given for photocopy was falsified as the original document did not match the photocopy version.
Customer complaint log did not contain the customer complaint identified in the inter office memo dated 11-Apr-15.
Incinerator contained signed documents dating April 2016 including inter office memorandums clearly signifying destruction of important evidences.
Tags on equipment displaying the last cleaning date did not reconcile to the equipment usage log which meant that the cleaning activity could not be confirmed.
Divi’s lab’s traded at premium valuation because of it’s history of strong Operating Profit Margin ( 38% ) while the industry average over 20%. Lumpy but somewhat predictable high margin custom synthesis business makes it possible to maintain this kind of margin.
Somewhat comparable Peer valuation :
Syngene International - 37 PE ( OPM - 32%)
PI Ind - 41 PE (OPM - 21%)
Comprehensive reply given to 483 observations:
Divi’s has sent a detailed reply (Exhibit 2) to USFDA and is taking corrective action (also hired external consultants).It has not seen any inspection requests from customers and other regulatory agencies and has not seen any loss of business.
HDFC sec update on Divi’s Lab: Key Points
Regulatory updates: The management appeared to be confident of resolving the recent 483s received for Unit
2 in Vizag. The company has given a detailed 700-page response to the US FDA, and believes the market has misread the 483 letter. It has also not received / acknowledged any backlash from the client.
You can access full report here : http://hdfcsec.com/Share-Market-Research/Research-Details/StockReports/3021766
The United States Food and Drug Administration (USFDA) has issued an import alert for Divi’s Laboratories’ Visakhapatnam unit-II.
An import alert from the regulator means that products from the facility meant for imports can be refused without a complete physical examination. The latest USFDA move comes as a blow for the pharma company as it hadn’t been expecting an import alert.
Six active pharmaceutical ingredients (APIs) namely Levetiracetam, Gabapentin, Capecitabine, Naproxen, Raltegravir and Atovaquone have been excluded from the import alert, sources told CNBC-TV18.
It is too early to gauge the impact of this, said Surajit Pal of Prabhudas Liladhar. Certain products have been excluded so that there is no shortage of it in the US markets.
The company’s Visakhapatnam unit II contributes 60-65 percent to total sales and 20-21 percent to US sales.
In December, the USFDA has issued five observations to Divi’s Vizag unit, which was inspected from November 29-December 6. The company has engaged consultants to undertake remediation of its Vizag unit, sources said.
Pal further said that the warnings and import alert is still not reflected in the company’s valuation. Divi’s could see some downmove on back of the news.
This time is NOT different!
We have seen this play out in DRL, Sun, Wockhardt, IPCA and now again with Divi’s.
Few random data points to initiate deliberate discussion…
Why 10 APIs (out of total ~35 currently active) have been excluded from Import Alert by US-FDA? Pharmacompass says almost all of these APIs have multiple suppliers. Does it mean some of these are still under patent and Divis would be the primary supplier for the innovators (guaranteed business)?
2) Existing Facilities
Unit-2 Visakhapatnam US-FDA inspection timeline… Nov 2006, Apr 2009, Jul 2012, Jun 2014, Feb 2016
Unit-1 Hyderabad US-FDA inspection timeline… Sep 2000, Apr 2004, Feb 2008, Jul 2011, Jun 2014
Seems US-FDA inspection of Unit 1 is due anytime now. Considering Unit 1 is an older facility than Unit 2, does it mean higher probability of repeat or poorer observations there?
3) New Facility
Glimpse of new facility plan at Ontimamidi (Kona), AP… 670 acres… 600cr… 95 products… 18394.5 MTPA…
Have received Consent for Establishment (CFE) from AP Pollution Control Broad in Oct/Nov 2016
https://www.apindustries.gov.in/APIndus/CMDashBoard.aspx?deptid=01-Approved (row # 1203)
Please post additional data points (for or against).
Disc: Have tracking position
Divi’s Unit II has 65% contribution to sales with US API generics exposure at 20-25% of the top line. It predicts that with an import alert with exemptions for key products (assuming 15% of sales), the impact on earnings is likely to be ~13% in FY19E. In case of a complete ban, it could be more severe – ~30% in FY19.
Valuation and view: At CMP, the stock is trading at 14.9x FY18E and 13.2x FY19E, a steep discount to the historical multiple on the back of the de-rating post 483 for Unit 2. It is also highly likely that the US FDA will exempt key products due to potential shortages or price hikes.
Divis has broadly two segments 1. Generics 2. Custom synthesis . Operating economics of both the divisions are different , hence its worth to discuss separately .
Generics API : Divis generics business comprises manufacturing & supply of generic api & intermediates mostly of matured molecules to various global markets . This division contributes fifty percent of total turnover including Nutraceuticals . Turnover grew by 20 percent over last ten years with 40 percent EBIDTA margins .
- Judicious product selection : Product selection based on volumes ,pricing ,leadership and complexity of molecules .
- Chemistry skills : Complex chemistry skills enable it to develop proprietary , efficient processes and commercialise for clients .
- Low cost manufacturing : With tight control on cost front , divis has ability to control pricing .Compare to other companies divis always build huge plants ( Hundreds of acres ) and stay away from peer clusters . Hyderabad facility ( 500 acres ) , Vizag facility ( 350 acres ) , upcoming kakinada plant ( 500 acres ) . I guess idea would be to built and execute plants at high economies of scale . Apart from this divis SO FAR has known for executional capabilities in new plants and approvals .
- Global leadership : In most of the products Divis aims to attain global leadership . Top three molecules Naproxen , dextromethorphan , nabumetone ( Together 30 percent of total turnover ) divis has more than 70 percent market share . Recent products are again successful like levetiracetam ( 70 percent market share ) and Gabapentin .
- Non infringing patent policy : Clear strategy of respecting peers patent and focusing on matured molecules
By developing products with complex chemistry , tight cost control and priced so as to keep away competition , over the period of time divis attained leadership in couple of molecules . As of now . For example twenty years back there were multiple players in naproxen , divis started to manufacture @ 150 rupees and prices have been crashed to 40 rupees now . Operating at huge scale and process refinements helps to attain stupendous margins . While present molecules act as cash cow and new launches will drive growth .
As of now Divis has been filed 31 DMF to USFDA , 19 COS from European authority and 72 EU dmf’s
Nutraceuticals : This segment is relatively new to Divis , represent five percent of total turnover growing at 30 percent . Global carotenoid market offers $ 1.5 Billion opportunity and Divis started to launch products in feed and health segments with products like beta carotene , lutein etc in european countries …Major players are DSM , basf . It’s difficult segment to crack and offer significant opportunity both in terms of volumes & pricing .
Key risks :
- Incremental growth depend on ability to identify, launch new products
- Most of the present high volume molecules are matured
- Postponement in patent expiries and delay in genericisation
- Regulatory approvals and delay in ratification
- In the intermittent periods of regulatory issues , the chances of aggressive competition can prop up .
Pointers to look for
- Very difficult to analyse product wise data given numerous moving parts .
- Directionally over longer periods patent cliff presents opportunity for companies like divis and how it’s been shaping out
Custom Synthesis : This segment represent collaboration with research partners at NCE development stage and supporting the innovators throughout lifecycle of molecule . This segment represents fifty percent of turnover with higher profitability and growing at 20 percent cagr .
- Ability to offer process design , optimisation and yield improvements
- Development in gm / kilo levels
- Analytical & process expertise to generate reliable data for regulatory submission
- Strict IPR : By maintaining highest standards in IPR , Divis has built very long term and successful relationships with innovator companies
- Strength of mass manufacturing once innovator gets product approval .
- Dedicated research team on FTE basis supports innovators
- Client validations & Regulatory approvals
- As a dedicated crams player , divis has consciously avoided formulations
Chemistry skills ,cost , timelines , compliance , trust , comprehensive services all play role in Custom synthesis business . This segment has relatively high entry barriers and stickiness as players in generally aim long term relationships . Once customers are successful in nda approvals and the probability is high to remain as key supplier .( Generally innovators would have their own manufacturing plant + they will mention somebody else as alternate supplier )
Key pointers to look for
- Given the confidentiality agreements and uncertain nature of business , divis won’t disclose commercialised products , number of projects , clients name etc …
- Given the longer relationships , if there is a big jump in numbers we can safely assume that , one of their client molecule would have been successful and the probability is very high in sustaining volumes .
- Broader trends in contract research opportunity
Key risks :
- Like in investing , froth , optimism & fear are very much involved innovators research . .Companies announce new research projects on hope and shelve at bad patches . Now a days lot of virtual companies are mushrooming in early stages and they work on outsourcing .
- Broadly research outlay has been fairly stable over longer periods , it’s not growing either . Again large companies started to withdraw from early stage molecule development and buying at Phase 2a & 2b .
- Outsourcing research has been a strong theme as innovators are very much losing patented molecules and related cost pressures
- As its molecular research is highly uncertain , companies shelved / postponed their projects from time to time . This happened in 2002-03 and 2009-10 periods .
Key parameters of vendor selection :
- Strong chemistry skills and process optimisation
- IPR compliance & related trust
- Susceptibility of business model i.e… Product , client concentration , balance sheet etc . ( If vendor is vulnerable to above factors , then chances of getting trust from biggie’s would be low , as sustainability is key ) What is something happens to vendor ? Its all about ensuring uninterrupted supplies
Great business # Six sides of great
- Attractive operative economics : Divis with core chemistry skills ( Chiral synthesis ) has grown by twenty percent over last ten years . Building capacities on proper visibilities with reasonable cost structures aiming economies of scale by getting leadership
- Sustainable competitive advantage ; Focused strategy right from identifying molecules , attaining global leadership and by pricing at levels where competition could get waned off . Low cost manufacturing + Strong chemistry skills would be key competitive advantage
- Growing market opportunity : With ever growing cost pressures both in research + manufacturing trend has been outsourcing , It’s getting stronger and stronger . With huge talent pool and strict compliance ( Gaining trust ) compare to our competing countries , India has already been leading to grab major share . THis could grow if not accelerate from here .
- Pricing power : BY attaining global leaderships and low cost manufacturing , Divis enjoy pricing power in manufacturing . Most of the molecules being matured and competitors vacated , Divis could increase prices . 40 percent Ebidta margins + 30 percent ROCE indicates pricing power
- Low capital intensity : Sector itself is a high capital intensive sector , average asset turn has been around 0.9-1 times over ten year periods
- Management : Company has excellent talent pool leading by Mr.Murali.K.Divi and Mr.Ramana with enough depth in the middle management level .Divis has unique culture of retaining employees and most of them are with the company from last 20-25 years . Attrition is very low . Managing 10k people is not an easy task . Capital allocation track record often indicates management quality . With nil equity dilution after ipo , 40 percent + dividend distribution , building capacities on proper visibility and commitment from clients , focus on organic focus indicates quality of management .
Dis : It’s just broader discussion on company based on my understanding . NO Holdings
Thanks for sharing your insights on the business. It was super. Just in few minutes, I could get sense of most of the moving parts of the business.
Thanks @OM_1417 for sharing powerful key Insights. Good to see you posting after a long time. We need folks like you to consistently contribute to shared learning at VP. These should enable folks like us to again re-ignite the debate/discussion about the Investment Opportunity in Divi’s.
Is this a life-time opportunity - Exceptional Bargain - to invest in a seemingly strong business like Divi’s Labs, Or
Is this again a Speculative Call - Important but UNKNOWABLE - in terms of Opportunity Cost - how long you have to stay put - before normalcy returns (as @desaidhwanil has beautifully explained before) - and compounding resumes for the Investor
What is a bargain price for a business like Divi’s (based on Historicals, and Competitive Strengths of the business going forward) if you factor in a weathering-period of 3 years.
I have seen a diversity of reaction from friends we respect
A. Some folks clearly belong to the Camp that this is a speculative call - an unknowable - and thus will not touch this - perfectly reasonable course of action.
B. Some folks had already jumped-in, making that call on factoring in worst-case scenarios. Some are already invested in a Compounder like Divis from long, and wondering course of action. And there are some like me who are still confused, about whether this is a life-time buy opportunity, or perhaps this is not that great opportunity and not that great a price, yet.
There are friends of mine who belong to Camp A. The rest of the involved discussion that we are re-igniting is NOT for them. Request them to kindly have patience, and allow us a good-time in learning how to dissect an extremely interesting investment prospect. (Even if we may not be invested)
I have requested a few invested-friends to put up a more structured Investment Note, to help us examine the assumptions made in the decision-making, so all of us can gain and learn from a proper dissection of an interesting live-case. Please wait for that.
Disc: Not Invested; wanting to measure up the dynamics? Perhaps if we frame the questions the right way, we can have definite answers?
First need is to set reasonable time-frame expectations for revocation of Import Alert. Let’s ignore second-order effects, for now.
Disclosure: I am NOT a pharma/chemistry domain expert. Following are logical observations made by friends interested in Divis opportunity, which I find very relevant
Observation 5: Data falsification evidences, and signed documents found in incinerator signifying destruction of important evidences are very critical observations, no doubt. But one may conclude that as critical (or, even more critical) perhaps is the observation on inability or absence of established processes to identify presence/eliminate metal particles? why??
It is easier to convince FDA authorities on rectification processes for audit-trail, investment in automation, investment in adequate quality manpower (as opposed to R&D led),even if they fail to establish that data-destruction was not inadvertent, say - because there are set precedents - these have happened before, both DIvis and FDA would know investments/timeframes normally needed to overcome, and also replicate across other plants, invest in re-training et al.
Metal Particles presence in some batches - could be the big spoiler. We could check with competent domain experts if the metal particles presence in batches or sample testing is a odd-ball observation, or has been made before. This will probably be that much harder to convince USFDA that NO TRACES of Metal Particles are now present in any products - simply because they need to be 100% sure - and current processes in the company failed to even adequately identify, let alone address and eliminate this issue.
One conclusion would seem inescapable, this is NOT a quick-buck opportunity?
Time frames for revocation of Import Alert itself may be pretty extended, and complete normalcy (all second-order effects mentioned by Dhwanil) that much longer. Opportunists in Divi’s may take worst-case (non-compounding) period to up to 3 years??
Will reach out and revert with domain-expert (non-Divi’s) opinions about above issues raised by many. While we take some time to revert back on this, hope some of the invested-friends will share more of their assumptions.
Disc: Not-Invested; but interested
Thanks @OM_1417 for putting the business parts together. For me Divis has been a case study in terms of risk assessment, probability of various risks playing out and a case of solving price/value conundrum. Just to start I will lay down some basic assumptions that I have been working with before the import alert and I will also bring forth my thoughts post import alert.:
Before import alert assumptions:
Divis is a well discovered business which usually creates a price/value efficiency and places individual investors at a disadvantage. Personally, I have always liked the business in terms of it cash generating ability and the ability to redeploy this cash further. @OM_1417 has captured multiple matrix from sales growth to margins to asset turns which speaks highly of the business.
Since Divis is a well discovered business in normal case the historical median PE should be a decent enough assessment of how the business is perceived. The last three years data before the import alert shows that Divis has been trading between 20/35 times earnings. A median PE would be around 25.(a rough estimate would like to be corrected).The multiple was on account of a consistent growth (20%) and consistent earnings and cash flow generation With the import alert this assumption is broken and it will be fair to assume a downward revision in the multiple.
US Exposure in sales from the Vizag unit is 22%. The company can move some of it to Unit 1 in Hyderabad.
The management has a very high pedigree. They have successfully gone through multiple FDA inspection (around 10) in both their units. I have a huge trust on mgmt. sorting out the issue. Some of their clients is Big Pharma they will support from them technical and otherwise in sorting out these issues. The impact on big pharm in revenue terms due to Divis is a There were also reports of company going through multiple independent consultants. My assumption for max time frame incase an FDA alert was 1.5 yrs (which is from FDA data an average time for good companies).
Generally the import alert takes around a year post warning which is around 40 days from 483. The company will have time to sort out the issues. (I was wrong here)
Despite above the likelihood of an import alert is high. The import alert can come in two flavors:
With Exceptions: Their total US exposure at risk is 22%. Naproxen and Dextromethorphan is where the company has 70% market share and will definitely be exempted. My guess was that total sales impact would be around 10% (some products being also moved to Unit 1). The margin impact will be around 15% to 20%. The EPS without exceptional items this year is going to be around Rs 50 (Q2 had an exception item due to employee bonus).
Without Exceptions: This is the worst case scenario here 22% in revenues and around 35% in PAT should come down.
- In the longer run 5 to 10 year the company should come back to its normal growth trajectory of 15% to 20% with similar margins and return matrix. In the mid term there will be loss of business and margins.
Key questions and their answers:
Does my view on management changes? No
Does the longevity of business/sector change? No. The business will emerge stronger post this.
How does the competitive positioning of company change?
There is a mid term impact but long term no change. The company is supplying not because other competitors cannot manufacture the APIs but because the company is most efficient in bulk APIs an advantage that comes due to chemistry and not due to their relationships. Also the bulk API margins will be retained but on smaller API volumes the margins could come down
- Does the company offer value at these prices?
Assuming both scenarios, after 3 years the company will be able to regain its current sales position and the reason is low cost. The growth will be subdued due to newer project approvals from US not coming through but the company is diversified enough to grow in other areas and this should give a growth of 8% to 10%. There is also upcoming capacity in Kakinada. At Rs 680-750 (which is where I was looking into before import alert) I was confident that the company will be able to achieve its current sales and a growth of 25% in 3 years. At 700 odd I could see all risks covered. The company also
One of the questions that I was always thrown at: This could speed up inspections of Unit 1: Yes it could but will it change the probability of outcome of Unit 1’s regulatory inspection results. No. In fact if Divis will have learnt something from Unit 2 and it will avoid the same issues in Unit 1 inspections implying an improvement.
How does the situation change due to import alert with exceptions:: Import alert with exceptions is a favorable outcome. Import alert with exceptions at this stage is even better since the recovery time frame now shrinks to 2 years from the earlier 3 years.
Coming specifically to questions raised by Donald:
When looking into compounders with an industry tailwind and which are well discovered by market I am happy to get them at t them at 30% to 40% discount. The key points are reducing re-investment risk and a long term industry view.
Well I have had a 3 year period for normalcy to return, with import alert it has come down to 2 years. Ofcourse there is a reasonable element of trust on the management to do things right. The company does have a strong history. I am not sure I understand your definition of Speculation. The Unknowable here is pretty much same as an Unkowable that any other pharma company gets an FDA observation and its compounding stops in a jiffy unless ofcouse one can time his exit well.
Already answered above, of course the answer is highly subjective.
DIscl.: Invested (family and personal). My positions can change.
Can you please elaborate the reasons. IMO, incinerating crucial documents, falsifying photocopies etc is not something to be taken lightly. But I would love to hear your thoughts about why you remain so confident.
Broadly there are two aspects of management 1. Execution skills, competence and 2. Trust and culture. Perhaps you’re talking of (1) and I’m talking of (2)?
Disc: no position
From an execution perspective as you said nothing changes. As far as 483 observations are concerned my take is that a management which has undergone around 10 FDA and other successful inspections until now is highly unlikely to do what has been mentioned in the observations willfully. My take is that the standard of FDA inspection has changed, they have become more stringent both in process and the use of language and Divis management has failed to comprehend these changes. Going ahead they will try to rectify the same.