Two more initial public offerings (IPOs) have launched this week. Alkem Laboratories Ltd and Dr Lal PathLabs are both accessing the primary market in issue sizes of up to Rs.1,350 crore and Rs.638 crore, respectively. Both companies are entering the listed space through an IPO to give existing promoters and investors a chance to sell some stake.
Dr Lal PathLabs is well known for its chain of diagnostic centers across Indian cities and overseas as well. The company was incorporated as a private limited company in 1995, but most of the expansion took place over the past 15 years. According to industry research quoted in the IPO prospectus, there is a lot of potential for healthcare expenditure in the economy to increase. Within this, evidence-based treatment is becoming a requirement for many doctors; this supports diagnostics, which is expected to show an annualised growth rate of 16-17% over the next three years.
As per a research note on the IPO published by Motilal Oswal Securities Ltd, the strong pan-India brand franchise of the company, its hub and spoke business model and net cash balance sheet work in its favour.
However, the industry itself is fragmented and highly competitive. The company will have to diversify in areas beyond North India—a region from which it derives the bulk of its revenues— to have a competitive advantage. Moreover, the low entry barriers in the industry can keep profitable expansion slow.
The company has a good set of financial numbers. Revenues have clocked around 29% compounded annual growth rate (CAGR) in the past four years, with margins of 23-25% and net profit growth of 32% CAGR for the same period. Moreover, this is a cash rich and zero debt company, which also goes down well for future expansion plans.
According to Arun Kejriwal, an independent market analyst based in Mumbai, “Private equity investors having put money in the company shows that the business itself is good. However, the pricing of the IPOs is driven by the need to give these investors an exit. The issue is priced exorbitantly.”
Alkem Laboratories is a four-decade old manufacturer of branded generics and active pharmaceutical ingredients, among other things. Alkem markets these not only in India but also to other countries. Over the past 4 years, the company has managed to increase contribution from overseas markets (primarily from the US) to 25% of total revenue. The company has a wide manufacturing base and strong capability of scientists and pharmacists, which enables it to innovate consistently.
While Alkem is positioned well in the domestic market, it has primarily relied on organic growth. Moreover, margin expansion hasn’t kept pace with revenue growth. A lot of the future growth depends on success with US filings. Other than that, the company’s financial health seems stable with reducing debt and stable cash balance. The company grew its revenues at around 22% CAGR in the past four years and net profit growth was 11.7% for the same period. But the return on capital is showing a declining trend and is much lower than that of some others in the industry.
This could be a result of the declining operating margin; down to around 13% (March 2015) from levels of 18% seen just 3 years ago.
According to Kejriwal, “Alkem has the opportunity to grow its business in a big manner in the US. At the same time, it is comforting that 75% business is from India, which lowers the immediate risk of any potential issues arising from non-compliance with US FDA (US Food and Drug Administration) regulations.”
Valuations of neither of the two companies is cheap. At the IPO price range of Rs.525-535 (considering the retail discount of Rs.15 per share), the company trades at an financial year 2016 estimated price-to-earnings (P-E) multiple of 37-38 times. In the absence of listed participants, it’s difficult to compare this P-E, but for a profit growth of 30-35% per annum combined with a declining net worth, the positives seem to be more than priced in.
Alkem is priced 23-24 times FY16 estimated earnings if the growth trajectory remains stable. While this is lower than that of some listed companies, the worry is on capital utilisation, which is inadequate compared to some of the other listed peers. In case of IPOs, pricing is a critical factor. “There are many listed stocks that are underpriced and make for a better buying opportunity. In case of IPOs, artificially created volumes generate interest but that’s not viable for retail investors,” said Kishor Ostwal, chairman and managing director, CNI research.
Given the fundamentals, both stocks are worth owning as part of a long-term portfolio. But applying to the IPO is fraught with risks of low allotment and unexpected low listing gains. A better option would be to buy in the secondary market once the price settles, even if you get shares at a price slightly higher than the IPO allotment price. If you want to invest in the IPO, experts suggest booking profits on listing. The grey market premium on these two issues is 15-20%. So, there is a probability of allotment being low.