The Grand Strategy of Ajay Piramal

Even if you put zero value on Ajay Piramal, as the stock market is doing right now, you’d have to agree that he’s beaten the hell out of that insanely crazy market.

Since 1988, when he took charge over what is now called Piramal Healthcare, and may soon be called by another name — Ajay Piramal has made his long-term investors not just rich. He’s made them fabulously rich.

Ajay Piramal

Ajay Piramal’s Track Record Speaks for Itself

Consider this: Over the last 23 years, investors in Ajay Piramal’s flagship company have compounded their money at an average annual rate of 28%. In contrast, Sensex compounded at only 17% a year. The difference between compounding money at 17% a year and at 28% a year becomes truly staggering over time. While Rs 100 became Rs 3,700 with Mr. Sensex in 23 years, they became Rs 29,230 with Mr. Piramal instead.

Ajay Piramal’s track record becomes even more impressive if one considers that the 28% a year return delivered by him was computed by using the currently undervalued stock price of Piramal Healthcare.

As I write this, the company has 20.9 crore shares outstanding selling at Rs 479. By the time you read this, however, the company would have bought back and extinguished 4.2 crore shares (20% of the total) at Rs 600 each.

An indication of the price at which the remaining 16.7 crore shares may be valued by the market after the buyback, one can look at the April 2011 futures price now quoting at Rs 450 per share. In effect, post buyback, the stock market is valuing Piramal Healthcare at about Rs 7,500 cr.

When Ajay Piramal bought Nicholas Laboratories from its foreign parent in 1988, the company’s market value was only Rs 6 cr. This launch pad into the drug space enabled him to ride on the wave of huge subsequent growth of the Indian pharma industry. After several brilliant acquisitions, mergers, spinoffs, and other corporate restructuring transactions orchestrated by him over the next 23 years, the company morphed into what became known as Piramal Healthcare.

Then, in May 2010, he stunned the business world by announcing that he has sold part of Piramal Healthcare’s business, constituting about half the company’s revenues, for a staggering $3.8 billion, or about Rs 17,140 crores, to Abbott Labs of USA. Two months later, he sold the company’s diagnostic business to Super Religare for Rs 600 crores.

These two deals, having an aggregate value of Rs 17,740 crores delivered an upfront cash of about Rs 10,200 crores to the company. The balance Rs 7,540 crores — almost all of it due from Abbott — would be received over the next 42 months. Having an insignificant credit risk, these future receipts, which are not conditional upon the achievement of any milestones, have an estimated present value of Rs 6,300 crores, assuming a discount rate of 10% a year.

India’s Largest Cash Bargain

The value of cash already received (Rs 10,200 crores) plus the present value of receivables (Rs 6,300 crores) comes to Rs 16,500 crores. From this, if we deduct taxes paid amounting to Rs 3,700 crores on the huge profits made on these disposals, Rs 2,500 crores utilized for the buyback, debt of Rs 793 crores, and two minor items relating to the payment of a non-compete fee and charity, we are left with net cash and cash equivalents of about Rs 8,700 crores as of now.

On a per share basis (post buyback), this comes to Rs 517.This is the number I want you to focus on because it exceeds the stock price of Rs 450 per share.

If Piramal Healthcare were to be liquidated today for just the cash and its equivalents, with no value received from the sale of its three operating businesses which Ajay Piramal decided not to sell, the stockholders would get about Rs 517 per share. The stock market, it its own “wisdom,” is valuing the whole company at Rs 450 per share.

In other words, if you were to believe the stock market, this company is worth more dead than alive.

For long-term investors, however, this is a great opportunity to partner with one of India’s great wealth creators on very favorable terms.

Given that the current market value of the company is less than cash assets alone, the stock market is putting no value at all on the three operating businesses which appear on its balance sheet. Then, of course, there is Ajay Piramal, who does not appear on the company’s balance sheet but, nevertheless, is its most important asset. He comes free too.

How often do you get a combination of: (1) a company with a large market capitalization; (2) cash in excess of its market value; (3) other assets having substantial future value; and (4) a brilliant and ethical owner-manager who has a demonstrated track record of enormous wealth creation for his long-term partners? Not very often, in fact, its very rare.

Ajay Piramal is a rare occurrence and his story is worth telling you about. But the real story of the man is not just about how remarkably he sold the formulations business to Abbott. Nor is it only about the numerous smart acquisitions he has done although that has grabbed most of the media’s attention over the years.

Ajay Piramal’s story is also about a man who has a contrarian bend of mind, who ceaselessly explores multiple ways of creating value, and who has a very long-term orientation about wealth creation.

A Wealth Creation Machine

Take a look at the following table, taken from a presentation available from the company’s website.

A Snapshot of Long Term Operating Performance

The stunning growth depicted in the table is the result of both organic and inorganic growth. That’s another very rare combination. Being successful in M&A transactions is rare enough (about 70% of acquisitions fail to create value). Being successful in M&A and in operating several businesses in multiple countries is very rare indeed.

One test of long-term managerial performance I use, and which is favored by Warren Buffett, is an “earnings-retention test.” The test measures how every rupee earned, and not paid out as dividends, by a company gets reflected in incremental market value over a five—year rolling period basis.

For companies that destroy value, every rupee of earnings retained is, over the long run, expected to translate into less than one rupee of incremental market value. For value creators, the equation is opposite. Every rupee retained should become much more than one rupee of incremental market value.

Going back to 1990, I applied this test to Ajay Piramal’s flagship company. Even if we ignore that the company’s stock is undervalued (which severely penalizes the results of this test), here is the report card: From 1990 to date: 5.8 times (that is, every Rupee 1 retained became Rs 5.80 in incremental market value); From 1995 to date: 5.5 times; From 2000 to date: 5.1 times; and From 2005 to date: 4.7 times.

Any way you look at it, Piramal Healthcare has been a consistent wealth creating machine, one which has been only partially recognized by the stock market. Had the market given full value to the cash, the three operating businesses, and Ajay Piramal at the company’s helm, the above results would look even more impressive.

Even with one hand tied behind his back, Ajay Piramal has been a champion jockey. Why, then, is the market treating him like an also-ran?

Meeting Ajay Piramal

To find out the answer to that question, and many others, I met Ajay Piramal at his office in Mumbai last August. I met him again today (25 March).

Ajay Piramal

Before meeting him, I studied every acquisition done by him since 1988 including Nicholas Laboratories in 1988, Roche Products in 1993, Boehringer Mannhiem in 1996, Hoechst Research Center in 1998, Rhone Poulenc in 2000, and ICI Pharma in 2002.

As I went through each of these deals, and as I studied his track record of managing the business over 23 years, a pattern emerged.

A Contrarian Mind

In deal after deal, it emerged that Ajay Piramal is a contrarian. Over and over again, he seems to watch what the crowd is doing, and then he goes and does the exact opposite.

Back in 1990s, when MNC pharma were participating in a kind of a “Quit India Movement,” Ajay Piramal bought them out one by one at distressed prices. Now, when MNC pharma is desperate to be a part of the “Indian pharma growth story,” he has sold out to Abbott.

His vision to expand the formulations business which focused on India, while other Indian pharma companies were focusing on exporting generics to the west, was another superb contrarian decision.

Ajay Piramal enjoys taking the road less travelled by. And it certainly has made all the difference.

A Value Investor

Another pattern that emerges is that like any good value investor, he simply does not overpay for assets and he often finds value where there is a distressed seller.

When I asked Ajay Piramal about his acquisition strategy, he listed his three acquisition principles.

“One, there has to be a strategic fit and you have to be honest when you evaluate that. I have seen that there are many investment bankers and consultants who want the deal to happen and so they convince you that there is a strategic fit.”

“Two, M&A is a very heady thing to do for a CEO. At least for the first few weeks, everybody puts your photo in the newspapers and talk about you and so there is this tendency to over pay. And, as you know, 70% of M&A deals don’t create value. So whatever the value you have set out, you should not exceed that. We don’t believe that you can get value out of overpayment.”

Ajay Piramal

 

“Three, never look for a perfect asset. If you are going to acquire a perfect asset then the whole world is going to bid for it and its a very easy calculation to understand value and then you have to keep outbidding the next bidder. So there has to be some chink.That asymmetry which you can recognize that is there today — an inefficiency perhaps, or something wrong which you can correct — that is where the value is created.”

“In every acquisition of ours there was something that other bidders found wrong and that’s why they didn’t do it.Take the classic case of Nicholas Laboratories in 1988. That company was a small multinational and for two or three years they was struggling and they wanted to exit. Another multinational had the offered to buy them out, they had gone through with it in terms of value. Everything was agreed because it was another UK company.”

“But the reason they did not do it, and this is what one of their directors later told me, is because they realized there was some contingent liability relating to some excise duty matter. And you know in many corporations nobody is willing to take the final decision. You need clearance from accounts, you need clearance from legal and so on.”

“If you asked a legal person if there is a risk? Yes there is a risk. But you have to evaluate the risk.Is it really going to materialize and if it does what could be the consequences. In multinationals nobody is willing to take the chance. Instead, they always say, we can’t do it. And that’s how we entered the pharma industry.”

“Or take a look at the Roche and Rhone Poulenc deals. In both these transactions, there was something which was wrong and thats why I tell people when they do M&A deals within our group that if you find everything right, then please understand you have to pay top dollar plus.”

“In the case of Rhone Poulenc, when we acquired it, we realized there was a manufacturing plant in Mumbai. A plant in Mumbai that does manufacturing is a cost. It is a value destroyer because the costs are high. And there are issues of union etc. To most people, that’s a negative. For us, that was a positive because we knew that we can deal with unions and that we can realize value from that asset by developing it.”

One metric commonly used in the pharma M&A deals is price-to-revenue. The highest Ajay Piramal ever paid was 3 times revenues for ipill, the popular oral contraceptive brand he bought from Cipla in March 2010). More typically, he paid less than one times revenue for most of his acquisitions.

When it came to the sale of formulations business to Abbott, however, he was able to obtain a stunningly rich price of 9 times revenues. In contrast, Ranbaxy sold out to Daiichi in June 2008 for 5 times revenues. Indeed, the sale of the formulations business to Abbott, is one of the most richly-priced pharma deals ever.

Seamless Web of Deserved Trust

A big part of the reason why he got such a rich price, is to do with a “seamless web of deserved trust” Piramal has created with big pharma over the years.

When I mentioned this idea to him — an idea that was first articulated by Charlie Munger, Warren Buffett’s partner — he smiled at me. He knew what I was getting at. After all, Ajay Piramal is a Buffett and Munger fan and often goes to attend Berkshire Hathaway meetings in Omaha.

Charlie Munger attributes Berkshire Hathaway’s enormous success to this idea. “When you get a seamless web of deserved trust,” he once said, “you get enormous efficiencies. It’s what the Japanese did to beat our brains out in manufacturing: suppliers, employers, the purchasing company, management – all created a seamless web of deserved trust. It’s the same with good football teams. We are trying to live in a seamless web of deserved trust. It has worked for us, and it is the ideal way to live. How can Berkshire Hathaway work with only 15 people at headquarters? Nobody can operate this way. But we do.”

Now that we were warming up, Piramal wanted to tell me more about the creation of his own “seamless web of deserved trust” over 23 years.

“This web of trust extends to our dealings with everyone including those from whom we have bought businesses and those to whom we have sold. In almost every acquisition that we have done, there was somebody who was willing to pay higher — from Nicholas Laboratories, Roche, Rhone Poulenc, to ICI — there were higher bidders but we ended up acquiring these businesses. Why did this happen? The only reason why it happened every time is because of the trust we have.”

“Why did we get this valuation from Abbott? It is because of this trust. Seeing what other transactions in the environment before us (he is talking about Ranbaxy—Daiichi deal), they could have gotten another asset at much lower price. So why did they come to us? Because there was this level of trust and understanding.

Ajay Piramal

 

“Having a “web of trust” is our philosophy. I am comfortable with it. We don’t have a single legal case. Why? Why did we not go into patent challenges? Because you can’t have a relationship where you keep fighting.”

Ajay Piramal wants you to know that by refraining from fighting big MNC pharma companies on their turf (as many Indian pharma companies have done), he was able to get a much better value for the formulations business from them on his turf. Can this advantage be replicated? I think so. How could it be otherwise?

Take for example the CRAMS business about which he is optimistic and has a long term vision. This is a small business at present but Piramal expects it to grow. Pfizer (the world’s largest drug company) is a customer of Piramal Healthcare in its customs manufacturing business.The act of letting someone else handle your intellectual property by big innovative pharma companies, requires a very high degree of trust in the manufacturing partner. By leveraging his web of trust, Piramal expects to become a “partner of choice” for big pharma companies.

Of course this requires a very long term vision, which is another element of the pattern that emerges by studying his track record.

Long Term Vision

He tells me “I don’t take much cognizance of the stock market which focuses on the short term. I will do what’s right for the business and the shareholders.Frankly, I don’t owe my job to an analyst. So, therefore, I can afford to take a long term view.”

For instance, he decided to go into drug discovery business very early. This business requires very long term thinking, ability to take risks, and to be prepared for failures, for the success rate is very low. Moreover, there is hardly any earnings visibility — something that most analysts abhor. But if you get lucky, then the sky is the limit.

If you step back a bit and see what is happening to the big pharma companies in USA and Europe, you will see that there is this big wave coming. Its a wave of shift of innovation from west to the east. Its a small wave right now. But Ajay Piramal can see it becoming a tidal wave in a few years.

Through Piramal Life (the unit was spun off from Piramal healthcare in 2007), Ajay Piramal has positioned himself just ahead of this approaching tidal wave. Shakespeare, who wrote “There is a tide in the affairs of men, which taken at the flood, leads on to fortune,” would have approved.

Grand Strategy # 1: Drug Discovery

A big part of Ajay Piramal’s grand strategy is to retain Piramal Life. But why did he spin it off in the first place and what will he do with it now?

He tells me that Piramal Life was spun off from Piramal Healthcare in 2007 because it had a very different risk profile. By its very nature, the drug discovery business is a highly speculative business. Mixing it with the formulations business did not make sense, hence the spin off.

To many, Piramal Life’s spin off may have appeared as an attempt to correct a past mistake of going into the drug discovery business in the first place. After all, spin offs are often used to get rid of troublesome businesses created by overoptimistic and overconfident men. This, most definitely, was not the case here.

Both Ajay Piramal, as well as his highly qualified and accomplished spouse, Swati Piramal, who runs the company, are very optimistic about the long—term potential for the drug discovery business in India. In many ways, their contrarian traits can be seen from the way Piramal Life has been managed.

For example, if you run a drug discovery company, one way to de-risk the business is to out-license your molecules to a big, and more prosperous pharma company who will then put its financial, technical, and political strength behind its development and approval by regulators such as the FDA. Of course, they would do that in return for a big part of the upside. This is how drug discovery model has worked for decades.

Well, that’s not how contrarians Swati and Ajay would like to make it work for them. Piramal Life has 14 molecules under development, and has no intention, (at least, as of now) to out—license any of those molecules. The reason is simple: They don’t want to give away the upside. If they decide to out-license now, I won’t be surprised that they would be able to negotiate and obtain upfront, and subsequent payments several times the current market value of the company (current market cap at Rs 108 per share is Rs 274 crores). But that is not how they think. They think in terms of not years, but decades. They think in terms of not maximizing near term reported earnings, but maximizing eventual net worth.

Both of them share a dream of leading the first Indian company which goes from discovery of a molecule to the global launch of a drug. Can they do it?

Let me ask you the question another way. Given the resources — technical, human, financial, and their excellent relationships with big pharma — they now have, is there anyone else in India who can do it? And if they do it, can you imagine the financial consequences?

Sometimes in life, exposure to low—probability—high—positive—impact situations (positive black swans) can massively improve the financial results of that lifetime if you get lucky, for you only have to get lucky once in a big way to make it worth your while. And the best way to get lucky is to organize for good luck to come to you.

Louis Pasteur was right when he wrote: “Luck favors the prepared mind.” The minds of Swati and Ajay Piramal are prepared and they have positioned Piramal Life to have a chance for the “best shot at the goal” in the drug discovery business.

There are two more interesting aspects about Piramal Life worth noting here. One, the company has negligible revenues, is highly leveraged (at least when measured against debt service ratios), and has large accumulated losses. Typically, this implies a large bankruptcy risk.

However, the way I see it, the day Piramal Healthcare sold the formulations business to Abbott, the bankruptcy risk in Piramal Life disappeared because a very rich, committed, and long—term oriented parent now stood behind it.

Two, the large accumulated losses in Piramal Life alone would be quite useful to highly profitable and tax paying Piramal Healthcare. That’s because in a merger, they could be used as a tax shield. Back-of-the-envelope calculations show that these accumulated losses alone, are worth about Rs 60 per Piramal Life share, to Piramal Healthcare.

For these strategic and financial reasons, it makes imminent sense for Piramal Life to return to its very rich parent although there is no certainty by which this would happen.

Grand Strategy # 2: Expansion of CRAMS, Critical Care, and OTC

Another part of Ajay Piramal’s grand strategy is to expand the three businesses that he did not sell. These are Custom Research and Manufacturing (CRAMS), Critical Care, and Over-the-counter (OTC) business. These businesses are small right now, but should grow in size as well as profitability over the next few years. Keep in mind that the growth-oriented Piramal is always on the lookout of cheap inorganic growth and it wouldn’t surprise me if he made a few very smart acquisitions in these businesses over the next few years.

The key thing, when you have cash, is to also have discipline. Famous fund manager Peter Lynch once wrote about the “bladder theory of corporate finance,” according to which the more the cash that builds up in the treasury, the more the pressure to piss it away. While this principle is largely followed by many companies and men who have suddenly come into cash, is it likely that Ajay Piramal is such a man?

I doubt it very much. His track record of demonstrated discipline in acquisitions speaks for itself. And recently, when Paras Pharma was being auctioned, while he had an interest in acquiring the company, he walked away because the asking price was too high. He agrees with Warren Buffett, who once said that the smarter side to take in a bidding war is often the losing side.

The key thing to remember here is that, given the current market value of the company, all of these businesses come free to the buyer of the stock at the current price. These include some of the most well recognized brands in the OTC business including ipill, Lacto Calamine, and Saridon.

Do you remember the jingle, “Sirf ek Saridon aur sardard se aaram. Na rahe pida na rahe dard. Bas ek, sirf ek, sirf ek Saridon?”). I’ve been humming it all day! (see this video: http://vimeo.com/20980858)

Well, if you own the stock at the current price, then among many other OTC products, ipill, Lacto Calamine, and Saridon come free (the brands, not the pills or the lotion).

Grand Strategy #3: Diversification

Since the sale to Abbott, the media has been chasing Ajay Piramal about his plans for the cash. In response, he has consistently said three things.

One, he will reward shareholders. This is already done through the buyback. Two, he will expand the remaining three businesses he did not sell. And three, he will diversify into one or more new businesses.

This last statement has spooked the markets. Anytime a company announces a plan to diversify into a new business, the markets tend to dislike it. Usually the market is correct in this assessment because companies do tend to waste cash through diversification. However, my view is that you cannot paint everyone with the same brush.

Just as the market’s skepticism for Ajay Pirmal’s grand strategy of growth though acquisitions was wrong, its skepticism for his decision to diversify is also likely to be wrong. The market forgets that his original decision to move into the pharma business in 1988 was also a decision to diversify away from the textile business.

Nevertheless, the investment community is skeptical about what he will do with the money. Will he go into real estate? (He has denied this.) How about insurance? Or Retail?

My question about this is: Does it matter? Should one not focus on the man’s track record of wealth creation instead of worrying about whether he will go into real estate? And if he does go into real estate business, so what? Of all the people in India, he has one of the best experiences in the business. He was behind Peninsula Land, he was behind India REIT, he was behind India’s first retail mall (Crossroads) and he is behind Sunteck Realty.

Indeed, if Ajay Piramal were to announce that he will diversify into real estate, investors should rejoice for two reasons. One, the man has experience and track record of having done exceptionally well in that space. Two, the space is full of opportunities where he can create value by buying into distressed situations prevalent in the real estate space at present.

Then there is talk about his acquiring Hindustan Dorr—Oliver. So I asked him, not whether he would diversify into the real estate business in Piramal Healthcare, or whether he is going to buy Hindustan Dorr—Oliver. Instead, I asked him, what are the things he seeks when he wants to buy into a new business. He simply repeated his three acquisition principles mentioned earlier. How consistent! He did, however, mention, that he would expand overseas in both related, as well as unrelated ares.

Valuation of Piramal Healthcare (Or Why DCF Sucks)

One of the paradoxes about Ajay Piramal is that while he has a disdain for elaborate excel models of DCF valuation taught at business schools, it is the very same DCF (or rather the absence of the possibility of using it) which is a key reason for the street’s neglect for the stock.

When I asked him about how does he, when he buys into “less than perfect” assets, go about valuing them, and whether he uses formal DCF models or a more simple back-of-the-envelope calculations, this is what he told me:

“Management students may not like this. I am also a management student and both my kids are but let me tell you that management schools are doing a disservice by (overusing) DCF. There is nobody in the world who can predict what’s going to happen in 10 years. And I was a student, so I know how to “create value” — you change the terminal value and instead of 0.5% you will make it 2% growth and suddenly the value increases. So I don’t believe in this. I really do believe you have to get the back-of-the-envelope calculations right.”

“Who can predict what the market growth is going to be. If you tell me anybody who had predicted that the markets will grow like they have in India today. I don’t think so. If anybody could predict to me what is going to happen to the exchange rate which is another big variable? I don’t think so. Nobody can predict what happened to interest rates. So everything is variable and yet on that basis we make a fixed 10 year projection and do the DCF? I don’t believe in this and in my entire life I have never done it.”

So here is the paradox: Ajay Piramal has not made his money by relying on elaborate DCF modeling. On the other hand, sell-side analysts and many investment professionals make their living by DCF modeling. Pick virtually any research report on any stock and turn to the pages in the end and you will see what I mean. There will be projections about the future (many of which will turn out to be wrong), based on which there will projections of future cash flows, which would have been brought back to present value using more projections about cost of capital. This “false precision” is yet another form of “physics envy,” practiced by men (mostly) who forget that its better to be roughly right, than to be precisely wrong.

The trouble with doing DCF on Piramal Healthcare is this: How do you make the projections about a company, which is largely sitting on cash, and has plans to deploy that cash in some new businesses but at this time, even the owner—manager does not know which businesses the company will enter into? So, the analyst is thinking: “How can I even begin to apply DCF on Piramal Healthcare.”

“To a man with a hammer, everything looks like a nail.” The analyst, who only knows DCF, is like that man. He has just one tool — DCF — and he tries to use it on Piramal Healthcare and he fails, so he tries again by beseeching Ajay Piramal to tell him where will he put the company’s money, just so that he can make a model, but Ajay Piramal says: “I don’t know yet.”

After several failures, the analyst gives up.

My advice to the analyst is that he needs another tool, one which he will find if he reads the influential paper “Investing in the Unknown and the Unknowable (http://www.hks.harvard.edu/fs/rzeckhau/unknown_unknowable_PUP.pdf), by Harvard Professor and a, much admired by Charlie Munger, champion bridge player, Richard Zeckhauser.

The World of uU investing.

In his paper, Prof Zeckhauser states, “Most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear… However, unknowable situations have been and will be associated with remarkably powerful investment returns… Indeed, I would speculate that the major fortunes in finance, have been made by people who are effective in dealing with the unknown and unknowable. This will probably be truer still in the future.”

When it comes to valuing Piramal Healthcare, yes there is uncertainty. There is no visibility. But is this “uncertainty” the same as “risk?”

“Risk,” advices Warren Buffett, should be thought of as the probability of permanent loss of capital. While most uncertain situations are also risky (e.g. new startup ventures), this doesn’t mean that every uncertain situation is also risky.

I ask you to carefully think about this. Given what you now know about Ajay Piramal, given his past track record, and given the asking price for becoming his partner (free), how likely is it that if you do become his partner, and if you have a long—term view, you will suffer a permanent loss of capital?

While the street steers clear from Piramal Healthcare, India’s largest cash bargain, because “the outlook is uncertain and there is no clear visibility and that makes it too risky” does that have to mean that you should steer clear too?

That’s a question I will leave for you to answer. As for me, I have to tell you that I own shares in Piramal Healthcare, and I have to tell you that Ajay Piramal bought shares in the company in November 2010 at around Rs 460 per share, and that the company has just completed a buyback at Rs 600 per share. The stock is selling for 450. The cash per share is 517. Everything else is free.

The author is a Professor at MDI, Gurgaon where he teaches Behavioral Finance and Business Valuation. A condensed version of this post, will appear in the forthcoming issue of Outlook Profit.