Wednesday, May 23, 2012

>BIOCON: PFE deal termination was a body blow; Concerned with AxiCorp

BIOS’ shares have had an uninspiring run post the termination of the PFE deal, which dealt a body blow to its biosimilar insulin aspirations. Whilst the deal is now terminated, it will continue to throw its shadow over future earnings, thanks to an aggressive accounting policy that will see BIOS shift biosimilar insulin R&D costs off the P&L. This, along with use of a creative transaction structure for AxiCorp, leaves us frustrated with corporate governance standards at the company, and we downgrade our accounting and corporate governance rating from AMBER to RED. Stripping out biosimilar insulin (90% valuation haircut) and Dificid, BIOS is currently trading at ~12x FY13E EPS. We cut our FV by 47% to Rs. 186 (from Rs.350 earlier) and switch to SELL.

PFE deal termination was a body blow
Earlier in the year, BIOS’ biosimilar insulin aspirations were dealt a body blow following the termination of its global development and commercialization deal with PFE. This sent the shares down by ~10% on the day, with shares continuing to drift post Q4’FY12 results earlier in the month. Post the deal’s termination, the focus now shifts to BIOS’ internal progress on the biosimilar insulin program.

Another incidence of aggressive accounting policies
There has been considerable confusion over the timing and accounting treatment of PFE milestones through the P&L, as BIOS currently has deferred revenues of ~Rs.4930m on the balance sheet. In our experience, globally, post a deal termination, the balance of deferred revenues lying on the balance sheet is typically recognised in year-1 as a one-off revenue item. This is in line with matching principle as the revenues from a terminated deal should not ideally be matched against costs of another deal (internal or external). Based on the guidance provided by the management, we believe that the company is likely to recognize the deferred
revenue in line with R&D costs associated with biosimilar insulin program in a particular year. We see this accounting policy as aggressive (the auditors have drawn an emphasis in this regards). This marks the third instance of aggressive accounting with regards to recognition of income/costs for biosimilar insulin. We believe it will lead to consistent over-reporting of EPS (and potentially over-valuation) to the tune of 20% every year during FY13-15 while also leaving investors blind-sided with the clinical spend and progress in biosimilar insulin development.

Concerned with AxiCorp “circular” transaction
In April ’11, BIOS sold its 77% stake in AxiCorp to existing minority investors for a ~EUR40m valuation, ~33% higher that its acquisition cost of EUR30m, and implying a P/E of ~7.4x. However, the nature and structure of the transaction raises eyebrows as BIOS used a creative deal structure at the time of acquisition that allowed it to pay ~EUR16m cash for AxiCorp but required it to transfer the rights to biosimilar human insulin and glargine for Germany to AxiCorp for EUR14m. Our analysis indicates that BIOS received only ~EUR5m in cash for the divestment, which is surprising given that AxiCorp had a net profit of ~EUR5m in FY11. Moreover, while it seems that BIOS made a profit of ~EUR10m on the transaction, in reality, there was a cash loss of ~EUR10m and a notional loss of ~EUR21m in buying back the IP rights. Despite this, the deal structure ensured that BIOS was not required to report any loss on sale in the P&L.

Cash drain not reflected in EPS – Valuing BIOS on SOTP
With the PFE deal terminated, we see little reason to own BIOS shares in the wake of only modest growth prospects for the base business. We expect the FCF generation to be further pushed out by 2-3 years resulting in a haircut of ~90% on rNPV of insulin deal from Rs.40 to

To read report in detail: BIOCON