Piramal Healthcare is a company that is going through a significant transformation. In FY11 (year ending March 31, 2011), the company sold its domestic formulations business to Abbott for total cash consideration of USD 3.8 bn. The domestic formulation business manufactured, marketed and sold prescription based pharmaceutical products in India. In addition, the company also sold its stake in Piramal Diagnostic Services Private Limited (PDSL) for INR 6.0 bn. As a result of the divestments, Piramal ended FY11 with three main operating segments:
- Pharma Solutions – Provides manufacturing and development services to global pharmaceutical companies. The division had sales of INR 10.2 bn in FY11.
- Critical Care – Supplies drugs specifically to hospitals worldwide. This division had sales of INR 3.9 bn in FY11.
- Consumer Products Division – Caters to domestic Indian consumers and provides OTC medications including well known brands such as Lacto Calamine, Saridon, Polycrol, Supractiv, i-pill and Itchmosol.
In general, I applaud management teams who attempt to maximize shareholder value through divestments. Typical corporate managers are always attempting to expand their kingdoms even if acquisitions don’t make complete sense. I’m sure the decision to sell their main Pharma solutions business was note taken lightly. In a worst case scenario, you have corporate managers such as the ones who ran Kodak. In 1975 an engineer at Kodak created the first digital camera. Despite actually creating the technology, the managers at Kodak never supported digital cameras out of fear of cannabilizing their monopoly film business. As Steve Jobs famously said, “If you don’t cannibalize yourself, someone else will.” As we now know, Kodak went bankrupt because they failed to keep up with consumer demand. Thus, it’s important for corporate managers to continuously develop new products and expand into segments as customer demands and market dynamics necessitate. Piramal has clearly taken steps to expand into different business lines but it remains to be seen whether they will be successful. Furthermore, attempting to value a business that is transitioning into different segments is also dangerous. In general, the best approach is to maintain a larger than normal margin of safety as future projections of cash flows will have a higher degree of uncertainty associated with them.
As my regular readers know, I believe the key to making money in the stock market is to accurately determine the intrinsic value of a stock and then purchase it with an adequate margin of safety. Determining intrinsic value is not difficulty but you do need a valuation methodology. My preference is use to discounted owner earnings as defined by Warren Buffett to calculate intrinsic value. Buffett actually explained his valuation methodology in a 1986 annual report for Berkshire Hathaway, which you can read here. Essentially, Buffett converts reported earnings into owner earnings by using the following equation: Net Income + Depreciation & Amortization +/- One-time items – Capital Expenditures. Once you’ve calculated owner earnings you need to do a present value calculation and then add current net asset value. The art of valuation comes into play when determining which one time items should be included or excluded from you calculation of owner earnings. In my full valuation report on Piramal Healthcare, I go into additional detail about how owner earnings should be calculated. Finally, once you’ve determined intrinsic value you need to decide on a margin of safety that is appropriate for you. At a minimum, your margin of safety should at least be 25%. For example, if your intrinsic value for a share was INR 100, you would only purchase it if the shares were trading at INR 75, resulting in a 25% margin of safety. At this point you must be wondering whether I’ll ever get to my view on Piramal healthcare. You can read my full report for free but you’ll have to register first.
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