It is always nice to have prejudices vindicated and this week, Pharmstandard delivered a truly impressive illustration of the dangers of doing business in Russia, particularly if you are the minority shareholder of a quoted company. Information about exactly what is going on has been seeping out gradually and further disclosures will presumably follow, but our current understanding of the situation is as follows:
– Pharmstandard will split into two companies, one (‘NewCo’) owning the branded OTC assets and the other (rump Pharmstandard) getting the rest of the business, which consists of unbranded OTC products, prescription drugs and products sold on behalf of third parties. NewCo is expected to be registered in November this year;
– The shareholder structure of the two companies will be the same (initially, at least) and both will be quoted on Micex;
– A series of inter-company agreements will be put in place, as Pharmstandard will contract manufacture NewCo’s products and also provide it with services such as product registration;
– At the same time, Pharmstandard plans to acquire a Singapore-registered company called Bever for a maximum consideration of $630m. This company, which was formed only a couple of months ago and is controlled by an undisclosed member of Pharmstandard’s Board of Directors, appears to have as its only asset a 20-year exclusive supply contract (to the CIS) for the APIs used in two of Pharmstandard’s leading products, Arbidol and Alfabazol. Bever, if acquired, will be folded into NewCo, thus lowering NewCo’s COGS and improving its profitability. However, this gain will presumably be largely, if not entirely, offset by the costs that NewCo will incur due to using Pharmstandard as its contract manufacturer and service provider.
From an operational perspective, the contemplated split makes no sense whatsoever. Whereas Pharmstandard’s prescription drug business as a stand-alone operation would be in the mid-tier of Russian operators, the company is number two in the OTC space and a dominant player. Moreover, OTC is the business area that everyone wants to be in. It is tied directly to consumer spending and is at much less risk of pricing controls than Rx, particularly if the government finally introduces some form of universal health insurance. According to the company’s management, it would be more efficient to grow the OTC and other businesses separately, but this is nonsense, at least within the retail segment (tenders are another matter). The legal line between OTC and prescription drugs is a very blurry one in Russia and pharmacists see little distinction between products sold OTC and those that are supposed to be prescribed. Hence, Pharmstandard will be spinning out the most attractive part of its overall pharma business, leaving the remnant Rx company substantially weaker in the marketplace.
Since a sale would be counter-productive operationally, the rationale can only be financial. Even if there had not already been strong rumours in the market place that Pharmstandard was in the process of trying to sell its OTC assets to a big pharma buyer, the combination of the company split and the Bever deal would make this crystal clear. Channelling raw material inputs via a company owned by one or more of the shareholders of a quoted company is a time-honoured method of siphoning off cash and ensuring that some shareholders are more equal than others. However, it is not something that would stand up to even cursory due diligence by a potential acquirer. Because Bever is a new company with a new supply contract, Pharmstandard is able to maintain that Bever has managed to cut the supply price from the ultimate manufacturer and hence its incorporation will save NewCo money. However, a far more convincing explanation is that the owner of Bever also owned the companies that supplied the APIs for Arbidol and Alfabazol previously and has simply set up Bever to make the whole thing appear cleaner and prevent the tax authorities coming after his historic earnings. Pharmstandard has provided no data to back up Bever’s $630m valuation and we doubt that it can ever be justified. All the more so – as was pointed out by one of the shareholders on the company’s conference call – given that Arbidol is already off patent and Alfabazol loses patent protection in 2017, so the value of a 20-year fixed price supply contract for APIs is highly questionable.
Perhaps a more interesting question is why Pharmstandard’s controlling shareholders want to sell the best part of their business. Our presumption is that, on the one hand, they see better opportunities for making money in developing ‘biosimilars’ that can substitute for imports and, on the other, that they want to take some cash off the table as a precautionary measure. The company is closely associated with the current political regime, which means that any major change in the administration poses a risk. And selling the whole business is harder than selling part of it, both because the pool of potential bidders gets smaller as the transaction size gets larger and because the business practices that the company deploys in order to succeed in government tenders for prescription drugs (where it has been incredibly successful) could not be used by a western owner.
But as with [Graucho] Marx’s assertion that he wouldn’t care to be a member of a club that would admit him, potential purchasers of NewCo should be asking themselves whether they really want to buy something that Pharmstandard is keen to sell to them. There is less political risk in OTC than in prescription drugs, but there are nevertheless features of NewCo that could make western pharma companies uneasy. For a start, there is the company’s leading product, Arbidol, which is used to treat flu and accounted for 26% of total OTC sales in 2012. As far as we can see, Arbidol contains a genuine active ingredient, yet it was launched OTC without ever having been a prescription drug first and without any good clinical data to back up its claims of efficacy. Not only does this mean that it could never be sold outside the CIS, it also makes it vulnerable to any tightening up of the regulations in Russia (which might easily happen sooner if the product is owned by a non-Russian company). Then there is the fact that NewCo will remain dependent on Pharmstandard for manufacturing. Russian legislation makes it very difficult to transfer production from one place to another, so the new owner of NewCo would be tied to Pharmstandard for the long term, which could prove uncomfortable. And finally there is the valuation. A figure of $2.5bn has been mentioned in the press, but this would represent more than 17x 2012 EBITDA (based on the historic figures – it is hard to say how these will change when both the impact of Bever and of outsourcing manufacturing are taken into consideration), which seems pretty steep for a business that experienced declining sales in 2012.
Pharmstandard’s depository receipt price has almost halved in the last week as it has become apparent to minority shareholders that they have no effective way to prevent their company from spending a huge amount of money to acquire earnings that should rightfully belong to them anyway, or from undertaking a strategic move that diminishes the value of their overall holding. A cynic would argue that such things are only to be expected in Russia and that there are plenty of precedents outside the pharma sector. We would merely suggest that the companies that are looking at buying Pharmstandard’s OTC business should think long and hard about whether owners who are happy to ride roughshod over the rights of their minority shareholders are the sort of partners that they want to do business with.