The first question analysts asked when Laurus Labs announced the acquisition of Richcore Lifesciences was, “What is the current capacity?”
The underlying question was clearly, "How does this change my DCF/XL for this year and next?"
Few were interested in:
What can you do with this business in the next three to five years?
Where do you see this business going in the next 5-7 years?
What other competitive advantages does it provide Laurus Labs with? How could the combined businesses surpass their individual strengths?
The margin-of-safety framework, in my view, is pretty simple to understand:
If I am buying something for less than a year, I am banking on earnings growth and a low current valuation for extra comfort. That’s “renting” the stock.
If I am buying something for more than 5 years, I am banking on management first and foremost. Of course, the business and valuations are important, but they are not the primary drivers. I am buying a slice of the business, and I have my “skin in the game”. The mindset is very different now compared to “renting” a stock.
TCE-Management (Slide)
If I am buying something for the long term, then management will make hundreds of decisions on a daily basis, and none of them unless they fall under statutory disclosure norms will ever be released to the stock exchanges.
I have no other option but to rely on the execution capability and ethics of the management. I also need a growth-hungry mindset that can generate returns on capital significantly above its cost over the cycle.
I eat what I cook and serve. The four important elements of my management screening framework are the same as described in chapter 8 of my book (framing business uncertainty) using the example of a US biotechnology innovator.
1. Consistent, long-term goals (#Goals in the Appendix below)
2. A thorough awareness of the competitive environment (#Competition in the Appendix below)
3. Objective evaluation of resources and capabilities (#Capabilities in the Appendix below)
4. The ability to sustain volatility is a key attribute. The ability to pivot and transform over time is also crucial. Proven execution in the current business or current sector or another company in the same sector. (#Decision_Making in the Appendix below)
The snippets below are from Laurus Labs' public disclosures (annual reports and earnings transcripts) throughout the last decade. To gain a comprehensive knowledge of Laurus Labs, I recommend that the reader read this alongside the presentation and my explanation.
Perspectives (Slide)
Flexibility and Growth Options
There are two types of options for any business: growth options and flexibility options.
Growth options allow a company to make small initial investments in a number of future business opportunities without committing to them. When you design capital expenditure projects and plants to be flexible, they can be changed to fit different situations. For example, flexible biologic manufacturing systems let different types of products be made on the same production line.
Likewise, most CDMOs will have their reactors completely fungible across molecules. For instance, a reactor that's making a lower gross margin product, when interchangeable, can make another molecule where pricing can be much higher. Flexibility and fungibility as an optionality improve the terminal value of a business.
Higher capacity and higher output per KL of that fungible capacity!
A CDMO or any other business can design individual projects to introduce both growth and flexibility options. This means avoiding commitment to the complete project and introducing decision points at multiple stages, where the main options are to delay, modify, scale up, or abandon it.
Global pharma innovator Merck, an early adopter of option pricing, notes, “When you make an initial investment in a research project, you are paying an entry fee for a right, but you are not obligated to continue that research at a later stage.”[1]
Customer contract first or capacity first?
Syngene’s capital expenditure plan at the Mangalore site, as well as the Biologics manufacturing complex in Bangalore, was based on the philosophy that customers need to “touch and feel” the physical infrastructure before awarding commercial contracts.
Divis Labs has also walked along this pathway of putting steel in the ground before a firm commitment from the customer.
In recent years, Laurus Labs has been attempting to design and construct capacities ahead of demand, but some companies like Lonza and Neuland are much more conservative in their capital expenditure. They typically expand capacity when the demand is much more certain.
No two fingerprints are the same, and no one strategy can be classified as "bulletproof," because strategy is the sum of strategic goals, growth aspirations, resources, and competencies. All of these are unique to each leadership and board; thus, it's futile to examine decisions without context.
“…. we aim to leverage the advantage of securing customer commitments ahead
of capacity creation …” — Neuland Labs 2023 annual report
Laurus labs have increased capacity at a compounded growth rate of 34% over the last 12 years (from 220 KL in 2011 to 7800 KL today and counting). “Laurus Labs invests in products and capacities ahead of time and requirement.” Laurus Labs 2023 annual report.
Culture of compliance and innovation
Remember that the equation for transforming fragility into antifragility is:
Fragility + shocks (short-term stress) + recovery period for reflection (internalised lessons) = antifragility arising.
I must reemphasise the following primary conditions:
1. Short-term stress and not chronic (intermittent stress is good; when we exercise, we are putting intermittent stress on our muscles and they become stronger like that Hydra)
2. Recovery Period
In the second half of FY22, Laurus released and updated their FY23 guidance. The subsequent humiliation brought on by the wide discrepancy between promise and performance was a “shock,” but such shocks can be blessings if the lessons learned are internalized and the culture of fragile prediction is changed to one in which we “plan but don’t predict anything for the fragile outside world of analysts, impatient investors, and momentum traders.”
Since then, Laurus management has refrained from giving any concrete guidance in public. This clearly demonstrates the behavioural shift from fragile to antifragile. The culture of guidance was washed away by the antidote of "focusing on long-term goals, core capabilities, and capacity and planning extensively but not predicting."
How essential is culture in science and innovation?
The compliance plus mindset is a function of culture. Culture facilitates the core capabilities of any company. Above all, it is a product of the organization’s history, particularly the personalities and beliefs of its founding members.
Culture is never homogeneous within the same company. Different cultures coexist within different functions and departments and even within functions.
A life sciences organisation with hundreds of scientists operating across multiple research labs can easily have different cultures in each of those labs.
Culture is the glue that binds individual skills and competencies into an orchestra of collaboration and coordination. When a merger or acquisition imports or cross-fertilizes the culture, there is a high risk of cross-contamination. Small bolt-on acquisitions are easily manageable, though.
Cultures grow slowly and are hard to modify. The CEO and other top management typically inherit corporate culture. Cross-contamination happens when divergent cultures collide (M&A).
When companies merge, their cultures blend. Cockroaches immediately ruin a pristine kitchen. Laurus imported culture (software called employees) when they bought an API unit from Phalanx Labs in June 2020. The US FDA audited this unit and made five observations. Two of such observations showed Phalanx’s incorrigibly poor culture but, at the same time, exposed the sloppiness of Laurus to not rip off the old software and install its own “fait sur mesure” software on the acquired hardware (property, plant, and equipment).
Laurus made a mistake by continuing with corrupted software. The US FDA findings are not surprising because over 95% of API units in India would fail a stringent Japanese audit even if they cleared the US FDA one.
India has such a poor compliance culture (“chalta-hai” attitude, aka, it’s not a big deal). People don’t follow rules unless doing so could result in jail time or a large fine.
Laurus has clean records with global regulators. So they may get the benefit of past deeds or not, depending on the perception of the auditor who visited them.
Laurus definitely knows that the cost of compliance is far lower than remediation. Indian companies across sectors, and not just life sciences, have a poor compliance culture. Wockhardt and Ranbaxy (now Sun Pharma) have spent more on remediation than what compliance would have consumed.
Losing revenue, market share, cash flows, and supplier and customer mistrust is the remediation cost. Furthermore, reputational damage exacerbates the situation. I have met Dr. Satya and other Laurus executives, and this mistake could cause a “small shock” and a “localized tremor” to help Laurus further towards North Star (anti-fragility).
Appendix
Think about the Lindy effect in the context of fermentation and marinate it with science and technology. That's precision fermentation— microbial and mammalian fermentation.
Richcore Lifesciences was a biotechnology business that Laurus Labs acquired in November 2020. Several significant elements, such as the business’s entry into precision fermentation, a field with rapid growth, and the acquisition of intellectual property related to specialised enzymes, biocatalysis, and recombinant technology devoid of animal products, supported this acquisition.
Targeting innovators in the biopharmaceutical sector who use enzymes for vaccines, insulin, stem cell-based regenerative medicine, and other products to lessen their dependency on products made from animal and human blood and create safer medications may be one of the acquisition’s medium-term objectives…
“… we are very excited on this acquisition, as this gives us entry into high barrier biotechnology segment. Laurus Labs will bring scale to Richcore’ s operations and can become a major player in the biotech CDMO space. This will also help Laurus in becoming a leader in biocatalysis as Richcore brings significant expertise in enzyme development for pharmaceutical and other industrial applications …” - November, 2020 transcript
#TCE #Goals #Resources #Capabilities #Capacities
Tendulkar was a rare cricket talent, but how many times did he get out cheaply? The best people make mistakes and learn from them. If I ever have TCE-grade management and reasonable valuations in my fishing zone, I’m not going to waste it.
Business cycles may come and go in an uncertain and volatile world, but I was extraordinarily lucky to witness the utmost integrity, energy, and enthusiasm in Dr. Satya and CFO Mr. Ravi Kumar to sit through a 2.5-hour presentation and inquire about all the minor nuances.
No one left the room until the presentation was over. Dr. Satya was switched on from ball 1, and he said, “We know you are our well-wisher.” That trust is mutual. Investing is a game of trusting the leadership and their judgement, and that marathon interaction on November 21, 2023, boosted my confidence enormously.
Complexity at scale (3Q FY24)
My question: why are we having such a high ratio of only 60 projects with 750 scientists?
Dr. Satya responded: “It all depends on the stage and complexity of the projects being handled. If it is RSM, which may involve 1 or 2 steps. If it is intermediate, maybe 6, 7 steps, if it is API, it could involve additional steps. I'll give you an example. We executed on project last quarter, including backward integration, we did 15 chemical steps. So you can't compare projects and number across the 60 projects. We also hope to work on some projects which are even more complex than what we handled so far, 30, 40 chemical steps for each project. Then the demand for the scientific talent, I would say depending on number of steps, your initial comment of 4 scientists. It may be valid for 1 step. If we are handling 30, 40 steps, you may need 100 people for project also, depending on the complexity. So the advantage what the company is having is the ability to handle complex projects at scale. Maybe we are in a sweet spot to attract such kind of projects, high volume, high complex, large synthetic schemes. That is taking away a lot of our scientific talent. One good thing is there are not many companies who can offer such complex chemistry and scale. That is the reason we have some interesting projects coming to scale up. I hope I answered your question.”
“It is also very clear we got more RFPs in the last 12 months for late phase projects when compared to previous years. That is an indication that there is a diversification effort from big pharma, and it is clearly visible.”
“All these are going through the balance sheet, but one has to realize, your Company is putting money in the right places for long-term and sustainable growth.” – ImmunoAct and IIT Kanpur
“The capacity going up is the reactor volume and most of the reactor volume, what were increased is utilizing for the manufacture of clinical phase programs for big pharma. So, the capacity increase is not primarily meant for generic APIs, it is majority meant for clinical programs for phase two, phase three and validation batches”
#Guidance
“How can management commit to sales targets without regulators underwriting such claims? Rahul Dravid never gave any guidance when going into a test match, and business is like that test match where the opposition (competition) and umpires (regulators) are never mock spectators.” – my book
“we never gave any quantitative guidance till we gave a billion dollar. So, in a 16 year time we have invested INR5,500 crores into capex. We have 6500 families have been working for us. So, we are very cognizant of it. We also know the margin of safety.” – April 27, 2023
“we do anticipate significant improvement from the EBITDA margins from current little over 15% to definitely behind 20%. We can't give you a number, but it will improve significantly, yes.” – 3Q FY24 (Oct’ 2023)
“As we increase our sales in CDMO space, which we expect next year will increase. The ability to remain at that level for gross margins is very high. And what we are saying as the order book increases and the revenue goes up, and most of the gross margin will flow into EBITDA, not all of that, most of the gross margin. … it's not that we have done that performance earlier. Which we had. Without segment contribution from CDMO, we were at close to 30% of EBITDA. And we came down, but we never went down at a gross margin level. So that's the confidence the management has. And I'm sure we will regain your confidence for sure in as shortest possible time as we can, yes.” – 3Q FY24 (Oct’ 2023)
#Velocity #Capability
“In FY18 73% of revenues came from ARV both APIs and formulations. …. In FY23 37% of revenue only came from ARV, APIs and formulations.”
#Antifragile mindset
My question on 2Q FY24 (Oct’23) earnings call:
“The only real mistake is the one from which we learn nothing.” Do you believe Dr. Satya that failures can sometimes lead to new opportunities or landing strips and provided the lessons are learned and internalized, and if yes, what examples from your own experience over the past year or so might you be able to share?”
Dr Satya responded: “We have several examples. Our conviction put us into a very leadership position. For some products where we failed to validate, some products we failed to get the right costing, but we continue to invest on those products and we enjoyed the success, there are several examples for that. We cannot fail every time. So, we fail once, twice, but we eliminate the opportunities for failure significantly at every failure.”
I asked: “possibility always produces uncertainty and fear of uncertainty is a competitive advantage or mode that keeps their business safe from rivals or competition. And they claim that if something is too simple to discover or develop, then anybody and everybody will eventually get involved in the field of delivering or developing new drugs. So, the uncertainty is kind of a moat that protects their business, that was their hypothesis. I mean, what's your sense on this, if you can please?”
Dr. Satya responded: “Our investment in cell therapy is a lot of uncertainties around that discovery and development. So many people don't go into that. That's one way we had enjoyed success. The second is not many people are investing in gene therapy because of lack of talent, lack of understanding of that segment, we invested there. But it will take some time for us to enjoy success in gene therapy. When it comes to the CDMO, what you said is absolutely right. How many companies in India have created three million liters of new capacity in the last three years? Not many. How many companies have scale at which we are operating? How many companies are having fully integrated development, that means from enzyme design, enzyme manufacturing to biocatalysis to large scale hydrogenations, flow chemistry and all. So, we are creating competitive advantage by investing ahead of the time, that is our success mantra, that's we are saying many a time and you pointed out very well. So, the fear of failure will prevent many people to invest, yes.”
I asked: “What else could potentially harm or disappoint shareholders in the medium term, let's say next two to three years when it comes to the uncertainty that we have on the regulatory front, it could be USFDA audit, it could be some unexpected development, anything on your horizon that we have to be guarded against?”
Dr. Satya responded: “We have derisked significantly, but we can't say 100%. We have multiple facilities now. We are operating in multiple regions. So, we have our bio division in Bangalore, Tumkur and Mysore. We have our R&D in Hyderabad, Telangana. We have API facilities in Vizag, Andhra Pradesh. We have our associate company in Mumbai. And we have our cell and gene therapy facility being created at Kanpur. So, we have diversified significantly regional wise also. And second when it comes to regulatory inspections, you have seen our impeccable track record there and we expect to maintain that”
“See, CDMO, supplies, timelines all depends on what our partner is requesting. Sometimes if the partner asks deliveries in the next quarter, we have to deliver when he needs. So those kinds of uncertainties will be at CDMO. But, our customer list is increasing, our project list is increasing. That is the reason we are also very confident on this segment.”
“We're not giving guidance, but as we mentioned, this is exciting times for us in the company, that means we have many prospects, many exciting projects and things are in a good shape.”
Source: "The Psychology of Money" by Morgan Housel
Part 2: On or before Sunday (2 Feb)
[1] Scientific Management at Merck: An Interview with CFO Judy Lewent by Nancy A. Nichols
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