Long Term Prescription

A bad performance by a good company is a great opportunity to invest in the stock at lower levels and reap the benefits. One such company is Hyderabad-based Cheminor Drugs, part of the Dr Reddy's Laboratories group. Cheminor Drugs makes bulk drugs like ibuprofen, ranitidine, naproxen and intermediates like D+ acid and S Methoxy Methorphan.

Since 1987, Cheminor has been the only supplier of ibuprofen to the US market. It sells little in the highly competitive Indian market. Cheminor is one of the largest manufacturers of naproxen also and is the largest manufacturer of ranitidine in the country.

Ranitidine, which went off patent in July 1997, is not only the largest selling anit-ulcer medicine but is also one of the largest selling branded drugs in the world. Cheminor is one of the few suppliers of ranitidine Form 1 to the US having gone through a successful Food and Drugs Administration (FDA) inspection for this product.

For the year 1996-97 and for the first half of the current year, the company came out with disappointing results. For 1996-97, sales at Rs 130.4 crore registered a rise of 3.2 per cent. The operating profit margins fell from 23.9 per cent to 18.4 per cent. The bottomline diminished by a massive 60 per cent to touch Rs 7.4 crore and exports fell 66 per cent at Rs 49.7 crore of the turnover.

For the first half, things further worsened. Sales fell 3.12 per cent to Rs 64.05 crore and the net profit by 83 per cent to Rs 1.07 crore. Exports fell 16.3 per cent. No wonder, the stock price of the company fell in from Rs 180 on June 24, 1996 to touch its 52-week low of Rs 65 on June 3, 1997. But on the news of investment from Schein Pharma of the US, the price rose to Rs 164.50 on October 10, 1997 and after the poor first half results, it again fell to Rs 123. In fact, this was one of the few pharma stocks which did not take part in the price rally when major pharma stocks scaled new highs.

Then does it make sense to invest in a company which is performing poorly? Yes, because its a long term story, says Jignesh Bhate, analyst with Birla Marlin Securities. Before we look at the future potential of the company, let us look at the reason for the poor performance by the company.

According to managing director GV Prasad, Cheminor Drugs, There were three reasons for the fall in sales and profits. The deal with Hoechst Celanese came to a premature end during 1996-97. Secondly, there were frequent changes in the production schedule of ranitidine because of capacity expansion at the facility and the production facility of D+ acid was shifted from Pedadevulapalli plant near Hyderabad to the Vizag plant. This transition took a longer time than we expected. Lastly, the falling prices of bulk drugs are also responsible.

Cheminor had a tie-up with Hoechst Calenese (HC) of Germany for the supply of SMM (S Methoxy Methorphan, an intermediate to produce dextromethorphan), but the deal came off because HC exited from the over-the-counter (OTC) business and hence did not purchase the minimum guaranteed quantities. This took away nearly Rs 30 crore off Cheminors turnover.

Apart from the loss in anticipated profit, says Prasad, We took a hit on account of the inventories that we had to hold and the prohibitive cost of finance incurred in the process. We have filed a suit to recover these damages. The loss from ranitidine was estimated at Rs 10 crore and the D+ acid took reduced the turnover by nearly Rs 5 crore. The increasing competition from the small and medium players had put lot of pressure on the prices of major bulk drugs. But adds Prasad, Drop in profits is a short-term aberration.

The reason for the poor first half performance was the failure of ranitidine and naproxen in the US market as there was a delay of commercial supplies due to the market situation there. Exports to the US contribute 27 per cent to its total export turnover.

The other reason was the increase in interest expenditure, which is expected to come down in the second half of 1997-98 on account of inflow of funds from the US company.

So where does the potential lie? According to Prasad, We have continued making investments in assets without corresponding immediate returns. We havent started selling the products for which we have built facilities.

Cheminor has set up a state-of-the-art formulation facility near the outskirts of Hyderabad at a cost of Rs 40 crore. This plant will manufacture tablets (1,500 million nos. a year), capsules (150 million nos. a year) and softgel capsules (150 million nos. per annum). The plant has been equipped with sophisticated equipment confirming to the US and European design, layout and production standards. Cheminor Drugs is awaiting approval from the USFDA.

Over the next three years up to the turn of the century, products worth $10 billion are likely to lose their patent protection. Here lies the immense potential. With the given world class production facilities, Cheminor Drugs is well placed to tap the full potential.

To get access to these markets, the company has adopted two pronged strategy for tapping huge potential offered by the products which will be going off patent. First, it starts its work six to eight years in advance before the product goes off patent. With production facilities of international standards (approved by FDA), and tie-up with global giants, it is in a better position to tap the market.

Secondly, it has entered into a marketing alliance with major pharma majors. Schein Pharma Inc., the generics subsidiary of German multinational Bayer AG and HMS, a US base distribution firm has picked up 0.3 crore shares at an average price of about Rs 170 aggregating to Rs 54 crore.

As a result, the equity of the company will go up from Rs 13.63 crore to Rs 16.63 crore by the end of next year. The promoters' stake has fallen from 65.79 per cent to 53.71 per cent and Schein will hold 18.01 per cent. Further, it also acquired the marketing rights for some chemical formulations. The tie-up will lead to an assured demand for its bulk drugs and drug intermediates.

To further strengthen its position in the US market, it has entered into an alliance with Pharma Resources Inc. of the US to supply bulk drugs and intermediates and finished dosage form. This alliance was reached through Reddy Cheminor Inc., a New Jersey based subsidiary of Cheminor Drugs.

The products involved have market potential of over $3.6 billion. This alliance will help the company to take the major share of the huge market. Says Bhate, Strategically the company is well positioned to ride the generic wave.

Prasad says, From the second half of 1997-98 we expect to start doing distinctly better when some of these products start hitting the market as their erstwhile patents begin expiring. We should hit nearly Rs 200 crore in turnover in 1997-98, but the year after should be a big one when product introduction accelerates.

With various expansion plans of the bulk drug facilities completed during the first quarter of the current year, the volumes will start going up. Further, the formulations (where the value addition is high) will start contributing from 1998-99 onwards. This will not only push up the sales but also the margins. The scrip is currently trading at Rs 112.75. So one can use the bad results as an excellent opportunity to enter into the scrip and stay invested for two years.

Nitin Jaiswal - Transparent management

Hyderabad-based companies over the last few years have earned a very bad reputation for themselves. But there are exceptions like Cheminor Drugs. The annual report for 1996-97 shows the management intention, concern for shareholders and transparency of its activities. In short, the report is very comprehensive. The company had performed badly during the year. Unlike other companies which shy away from the giving details to shareholders, Cheminor Drugs on the other hand has carried an interview with its managing director, wherein he had explained the reasons for the poor performance and what steps he is taking to put Cheminor Drugs back on the growth track.

Further, it has information like sensitivity analysis about the factors which will affect the company's performance. For example, the impact on operating profit is Rs 1.17 crore if the prices of ibuprofen falls by 5 per cent. It has information on the major possible threats the company can face in the future. The detailed information on the products which will go off patent in the coming two years is very comprehensive and worth reading. At a time when companies are still debating about corporate governance, Cheminor has carried the steps taken for ensuring corporate governance in the company. Definitely, the annual report of Cheminor Drugs could well become a model for other companies to follow.