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Allan Gray favours Square Pharmaceuticals in Bangladesh

Portfolio manager Varshan Maharaj explains that, as a least-developed nation, the company has exemption from patent restrictions and currently is trading on under 10 times earnings.
Image: Moneyweb

SIMON BROWN: I’m chatting now with Varshan Maharaj from Allan Gray. I appreciate the early morning. That was a really fascinating note you sent out around pharma emerging companies note you sent out around pharma emerging companies. I want to get to the one in particular that you like in Bangladesh. But there’s this little issue, which I was completely unaware of: essentially an agreement that allows least-developed countries to produce generic versions of patented products without needing permission from the innovators. This really does create a massive opportunity for some of these pharma companies in these least and, I imagine, lesser-developed markets as well.

VARSHAN MAHARAJ: Good morning, Simon. Thanks very much for the opportunity to speak to you this morning. I must say, I’m a big fan of all of your shows.

Firstly, Square Pharmaceuticals*. Why we like the company is, as you mentioned, the exemption from the patent clause, which I’ll get into in a moment. This exemption, combined with their low cost base, translates into high margins and good free cash flows.

They’ve been the domestic market leader since 1985. Depending on the year, their market share ranges from 17% to 20%, and they’ve grown revenue at over 10% per annum in the last decade in US dollars, and we expect that to continue.

Regulation favours local companies in these markets, and management have skin in the game. They own 35% of the company. They gave an update late last week regarding their 2021 financial year; earnings are up 19% year on year. [The share] trades on an undemanding valuation. If we exclude net cash, [the company has] about 21% of the market cap in net cash. Then it’s trading on under 10 times earnings, which is a great multiple for a business of this quality.

I’ll just pause there. If perhaps you want me to speak a bit about the patent’s exemption, I can do that.

SIMON BROWN: The patent exemption – there are some nuances to it, and in essence it might actually disappear in the next five years or so. That’s because of the developed-nation status, as a least-developed nation. In your report, you say this happened in India almost 20 years ago and it didn’t have a significantly negative impact on the business. In a sense they’ve got that market share, got the production and sales distribution, and they can still utilise that for profitability.

VARSHAN MAHARAJ: Yes. that’s a great summary. Just for context for your listeners, the exemption that we are referring to is the World Trade Organisation agreement on trade related to intellectual property rights. There is some uncertainty regarding this for Square Pharmaceuticals in particular. This patent-law exemption is expected to expire somewhere between 2026 and 2033, but it will apply only to products released after the date of graduation.

So, assuming that the exemption expires in 2028, the company will be permitted to produce products, as they were [doing], without paying royalties for all the products released up until that date. Then royalties would apply only to products from this date of graduation. As you mentioned, in India they had graduated in 2005 and many investors expected the earnings of these companies to collapse; but that wasn’t the case since there were new patent protections to serve as an incentive for multinational corporations to invest in India. This has altered in knowledge transfer and skills transfer, and those local companies were able to grow their export revenues significantly. We’ve seen their earnings increase at a very steady pace since then.

The Bangladesh government is following similar steps to what was done in India. Of course there is execution risk, but I would expect them to execute on those successfully.

SIMON BROWN: If they can keep their existing [status]. You note 80% of sales are generic products, but they’ve got the base and they can continue to sell those both within Bangladesh – which is of course a giant market in itself – but I imagine they can sell it regionally at the same time.

VARSHAN MAHARAJ: That’s correct. Another thing worth noting is that in order to run plants of that scale you need to sell to a target market of at least a hundred million people. Bangladesh is fortunate in that its local population is somewhere in the order of 165 million.

So, when we look across frontier markets there’s really only a handful of companies that have this sort of scale – and only a few of them are listed. There are several in Bangladesh, there are several in Pakistan, one in Vietnam, a few in Egypt. So these are really scarce companies which makes them more valuable.

SIMON BROWN: I get that point, absolutely. That’s Square Pharmaceuticals, listed in Dhaka, Bangladesh. You [need some] digging around to find it. This isn’t just sort of a waltz into the New York Stock Exchange.

We’ll leave that there. Varshan Maharaj from Allan Gray, I appreciate the early morning time.

*Allan Gray’s largest holding in Bangladesh is in Square Pharmaceuticals.

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Interesting. According to the World Bank, SA ranks just below Bangladesh in terms of US$ GDP ($3bn vs $3.3bn). Rotation to value in a more developed market?

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