Aurobindo Pharma Ltd is paying up to $1 billion (Rs7200crore) to acquire a slice of the generics business of Sandoz, a division of Novartis AG. While that’s a sizeable outlay, Aurobindo’s prime motivator for the acquisition appears to be the dermatology business. The oral solids portfolio (tablets and capsules) is bigger in size but is one where Aurobindo’s main aim will be to use scale and lower costs to improve profitability.

The acquired business had sales of $1.2 billion in 2017 and $600 million in 2018. Aurobindo said revenue in the first 12 months will drop to around $900 million. The $300 million difference is partly explained by in-licensed products where agreements will terminate, and from rationalisation of acquired products. Perhaps, Aurobindo had to acquire a basket of products as part of the deal, but expects to chop some unprofitable ones. Some products could also overlap with Aurobindo’s existing US portfolio.

Initially, Aurobindo will pay $900 million, which is equal to one-time revenues in the first 12 months. It will pay an additional $100 million depending on performance. Last year, when reports of the dermatology unit being put up for sale had emerged, the value being talked about was $1-1.5 billion.

The price Aurobindo paid is relatively lower, and probably reflects how price erosion in the US market has affected valuations. In the first half of 2018, Sandoz saw sales decline by 3% in constant currency, despite volumes increasing by 5% as the price declined by 8% chiefly due to the US market.

Now, Aurobindo is acquiring the dermatology business, which contributes to 30% of the acquired business’s revenues, with the remaining contributed by the oral solids business.

The main thrust is dermatology with most of its investor presentation focusing on this business. Aurobindo will now be second in the market by value and volume, with generics, branded products and over-the-counter products. A sales force and manufacturing facilities will also accrue to it. This therapeutic area has been one of the focus areas for Indian companies targeting the US generic market. With this acquisition, Aurobindo takes a leading position in the segment.

Along with dermatology comes a large oral drugs business that Aurobindo will have to work upon in order to improve its profitability. This is another key element of how successful this acquisition is. Scale and cost savings are what will make this part of the acquisition worthwhile. In FY18, Aurobindo’s US business had revenues of $1.2 billion and this acquisition increases its size by 75%. That’s a substantial jump.

The third element of this acquisition is what is in the pipeline, which includes generic drug filings, including ones with a first-to-file status. If these find their way to market, that could improve the payoffs.

Aurobindo is financing the acquisition entirely by debt. Its net debt to equity ratio that was 0.3 times on 31 March will move up closer to 1. That is still comfortable and Aurobindo claims that the acquisition will add to earnings in the first 12 months itself. That indicates confidence that even after paying interest on debt for the acquisition, it will still be a profitable one.

The main risk here is competition in the US market and price erosion as there’s no point in becoming bigger, if the profits from the business are going to decline. Aurobindo’s US business has performed better compared to some of the other Indian companies in the market. Investors may be hoping it can repeat that with the acquired business. More importantly, for them, the purchase price is much lower than what they may have feared. These two factors may explain why its shares are up by 8%.