Orchid Chemicals & Pharmaceuticals: Hold and avoid fresh exposures

Recommendation: Hold and avoid fresh exposures

Sanjiv Shankaran

ORCHID Chemicals is at the crossroads. The company's fast growth in the past, its intention to tap the developed markets and its huge appetite for additional capital, place it in a tricky position for the equity investor. To get a better insight into the situation, the past is a good place to start.

In the early 1990s, Orchid started off as an export oriented unit (EOU) manufacturing cephalosporin bulk drugs. Bulk drugs are the active chemical ingredients that are the essence of formulations (drugs in a ready-to-consume form).

Infectious start

Cephalosporin is a fast growing class of drugs that is used to treat infections. The nomenclature covers different generations of the product, the thumb-rule being, longer the product has been around, more the competitors manufacturing it and greater the chances that it will be eclipsed by later generations.

East Asia was a critical market for Orchid after it set-up shop. By late 1990s, the situation was difficult for most bulk drugs producers because the general level of price for most drugs began to weaken sharply, thereby putting profitability of operations under pressure.

Orchid notched an impressive performance during this phase by constantly increasing capacity, working on reducing the cost of the process and moving up the value-chain in cephalosporins by making sterile cephalosporins, which provide higher realisations.

The capacity for the cephalosporin plant rose from about 100 tonnes in mid-1990s to 700 tonnes now. Therefore, not only did the company scale-up in a difficult environment, it also increased the realisation of the aggregate output over the last few years.

Move to formulations

With the track record of a successful bulk drug manufacturer, Orchid entered the formulations market in 1998-99 second half. Typically, formulations provide better realisations and greater stability to the income stream. But the business is different from the bulk drug business, with a heavy emphasis on marketing strategies.

The move into formulations is natural for Indian companies that achieve success in the bulk drug market. Dr. Reddy's Laboratories is a case in point. It made a successful move into formulations recently after making a mark in the bulk drug market.

But formulations, especially of late, has not been an easy market to successfully break into. By 1999, the level of competition in the market had increased significantly. Also, that was the year when the demand in the domestic formulations market seemed to slow down, impacting the performance of players across-the-board in the industry.

In the backdrop of stiff competition, coupled with slow demand, Orchid's formulation business does not seem to have matched initial expectations. In the first half of this fiscal, the division contributed less than 10 per cent of the aggregate turnover. A difficult market may not have solely contributed to the disappointing performance. Orchid may not have hit upon the right strategy at the beginning.

Diffused focus

The company has narrowed its presence in formulations to a handful of therapeutic segments _ cephalosporins, anti-hypertensives, pain management, nutraceuticals and osteoporosis. But the field force was assigned to promote all of them together, thereby diluting focus. Another factor that may have diluted focus was that the field force may have spread too wide and, therefore, lost out on effectiveness.

Jump in capital employed

While the formulation entry was underway, there was another noteworthy development. The capital employed by Orchid in its pharmaceutical business grew by a compound annual growth rate of 47 per cent to Rs. 718 crore between 1998 and 2000. Contributing to the huge increase in capital employed _ one of the highest among listed pharmaceutical companies _ was the Rs 175-crore private placement of equity shares to Schroder Ventures Group.

The capital was employed in different projects. Orchid acquired a bulk drug plant in Aurangabad from Ajanta Pharma for Rs. 21 crore, being used to make non-cephalosporin anti-infectives. In the recent past, the company's manufacturing complex near Chennai has installed facilities to manufacture nutraceuticals. And, probably, the most critical part of the expenditure would be to upgrade manufacturing facilities to match the requirements of the US Food and Drug Administration (USFDA), a pre-requisite for an entry into the US market.

Move to developed markets

After acquiring a significant amount of turnover from East Asia, especially China, Orchid is eyeing the developed market. Here, the US is likely to be the most crucial market, where Orchid hopes to initially capture a section of the market for the supply of bulk drugs, primarily in Cephalosporins. To assist, Orchid has sought the advice of the consultant, McKinsey.

Before taking a look at the potential of the American market, a closer look at the sharp increase in capital deployed in the business is necessary. Mr Raghavendra Rao, Managing Director, Orchid Chemicals, feels the crucial parameter is the operating profit margin as that would serve as a barometer of the profitability of the business.

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Orchid's operating margin is around 28 per cent, one of the highest in the industry. Mr Rao feels that as long as the company can maintain a high operating margin, capital expenditure to prepare for the future is justified. The logic makes sense because to move to the developed markets such as the US, a higher capital outlay is certainly required. And bulk drugs is a capital-intensive business. As long as Orchid can maintain a high level of operating efficiency in the relatively riskier market of Asia, expensive preparation for developed markets may well pay-off.

As for the American itself, Orchid believes a significant advantage is that it is almost a one-stop-shop for cephalosporins. The company has entered into preliminary arrangements with the US entity (identity not yet disclosed on account of conditions in the agreement) that has triggered a FDA inspection of its facility.

The opening up of the American market, in particular, is believed to be one of the most significant developments for the pharmaceutical companies. The sheer size, coupled with the manner in which the Indian industry has evolved, makes the American market a lucrative one for the Indian companies that seek to become international generic players (a generic drug is one that is off patent and therefore open to all manufacturers).

Pitfalls loom ahead

After the initial unwarranted projections about the American market, reality seems to have struck hard. The market does not appear an easy one to break into, both for formulations and bulk drug suppliers. While the realisations will be higher there, a few Indian companies have seen delays in the launch of products. Consequently, initial forecasts have gone haywire.

Into this market, Orchid enters with a track record as a successful player in the cephalosporin bulk in unregulated markets. A successful move into regulated markets such as the US and Western Europe will reduce the risk associated with the company's turnover. But the whole move, ironically, is fraught with the risk of time and cost overruns.

But a move into these markets is almost inevitable with the environment in the pharmaceutical world slowly changing in favour of tighter norm for intellectual property rights. Thus far, Indian pharmaceutical companies have grown in a relatively looser intellectual property environment.

In this context, Orchid hopes to use its research and development (R&D) skills to move into the developed market. Thus far, R&D has proved successful in cutting down process costs, but basic research that is big on Orchid's agenda is a different game. And one where only Dr. Reddy's, among the Indian companies, has tasted some success. The company has filed for a US patent for a drug delivery system, but for investors it may be too early to take a firm view on the potential success of the delivery system.

Wait and watch

All the developments lead to the questions as what should be the next move on Orchid's stock that currently rules around Rs. 102. The company has a good track record, but the situation right now is quite different. Recent developments suggest that investors may better off waiting for a few tangible developments rather than going by mere potential before taking further exposures.

At a price-earnings multiple of about 8 on the annualised earnings of the first half of this fiscal, Orchid seems an attractive investment. But keeping recent developments in the sector in mind, investors may avoid fresh exposures in Orchid till a few tangible developments emerge. Shareholders can stay invested and hope for a re-rating of stock.