The management of Merck Ltd. does not believe in the tortoise and the hare fable and to hell with the mythical race anyway. Slow and steady is the unwritten policy however. The business is in any case making money overall, and who gives a damn for market share too. A 51.8 % subsidiary of the German parent Merck KGaA, the company believes in treading with acute caution, in spite of being a player in the country's economy for over 44 years now. It also makes do with minimal addition to gross block to crank out the turnover. In 2001 the company posted a turnover of Rs 3.4 bn on a gross block of Rs 1.3 bn. Nine years down the line in 2010, the gross turnover has grown to Rs 5.1 bn on a marginal increase in gross block to Rs 1.5 bn. In other words the asset to turnover ratio had risen from 2.7 times to 3.3 times. The fact of the matter is also that the accumulated depreciation as a percentage of gross block was as high as 68% in end 2010. (But this anomaly was also accentuated due to a sudden and one time exceptional charge of Rs 143 m that it debited to depreciation account in 2010, due to the impairment of certain fixed assets).The freehold land is valued at a minimal Rs 5 m and it suffers no depreciation. On the contrary the market value of this land today will be in the countless multiples to the face value.
That the company makes do with a depreciated gross block to make life sustaining medicines, and chemicals is in itself a very interesting revelation. Pharma companies one presumes require both a squeaky clean operating and automated environment to function in, to start with. The company has two operating divisions - pharma and chemicals. The former brings in 71% of the big bucks while the latter chips in with another 29%. Both the divisions however account for similar segmental margins of 14.3% on their respective sales.
Pre-tax profits nudging up
On paper the company recorded an almost similar pre-tax profit of Rs 957 m (Rs 965 m) in 2010. But if one adds back the exceptional depreciation charge of Rs 143 m, then the difference in the margins becomes very distinct. The pre-tax profit rose 14% to Rs 1.1 bn (Rs 965 m). The interesting factor in its pre-tax profit generation is the contribution of other income. Such other income (which includes sales related other income) toted up to Rs 434 m (Rs 432 m). The contribution of other income to pre-tax profit in 2010 was a hefty 39% (45%). As the 10 year financial highlights shows, other income is a steady and dependable feature in the company's income schedule in the last five years. The big money spinners in the other income schedule are essentially threefold: interest on deposits, income from other services rendered, and service tax credit. The company also resorts to buying and selling debt securities on a very large scale, but does not seem to make much out of it at the end of the day. On a humungous purchase/ sale transaction during the year aggregating to over Rs 19 bn, the company appears to have eked out a profit of only Rs 1.1 m! But, it definitely gives sustainable employment to its staff!
A bagful of excess cash
The company's bigger problem is its embarrassment of cash riches. It had a bagful of excess cash of Rs 3.2 bn in end 2009, and no avenues to spend it productively. (It seems to have totally missed the bus in the frenetic mergers and acquisitions scene in the pharma industry space). Annual spending on gross block adds up to a mere Rs 100 m and is well taken care of by the cash generated from operations in any case. Its efforts to buy back shares from the open market were a dismal failure, and that is when the directors cottoned on to refunding a part of the excess cash to the shareholders. So in 2010 the board declared a more than sumptuous interim dividend of Rs 95 per share which led to a dividend outflow of Rs 1.6 bn excluding the tax on interim dividend of Rs 262 m. (The parent not only pocketed its share of the dividend but also made do with royalty payment of close to Rs 100 m). But cash and bank balances at end 2010 was still at a very healthy Rs 1.4 bn. With the directors having decided to err on the side of caution, the company invests just the bare minimum in debt securities. This sure as hell appears to be one nutty way to run a company- and a health care company at that.
What is the game plan?
What exactly is the game plan of the management on the operations front is difficult to comprehend. The director's report is completely bereft of any positive vibes. The company has an installed capacity on paper to manufacture Bulk Drugs, Injection/Nasal Drops, and Tablets/Capsules. Its production of bulk drugs is equal to its installed capacity, that of injections etc is in excess of its installed capacity. And that of tablets etc is far in excess of its installed capacity. Separately it also makes syrups/powders, ointments etc. which apparently is a part of the above capacities, and a miniscule quantity of Reagent/Chemicals. In 2010 it mothballed the plant which makes Oxynex - this product also generated export sales. The closure of this unit is coming in a mere two years after the capacity to make Oxynex was expanded! Even the best laid plans of mice and men can come apart at the seams. Whether the closure will have a deleterious effect on gross sales in the current year is not known, but apparently it was a big ticket item considering the book value of gross block written off in this regard.
So any sales increase can apparently only come from higher price realisations in the market place, assuming that it cannot crank up the capacities beyond what it is already doing. Help can also come from export sales which currently account for around 10% of gross sales. The vast bulk of the export sales are affected to fellow subsidiaries and to its German parent and they appear to be quite prompt in paying up their dues. There are nil trade debtor dues from these companies at year end. The company also purchases goods from the same lot and it is just as prompt in paying its dues to them.
Its extended group arm
There is a another group company (a fellow subsidiary) playing out in India called Merck Specialities Pvt Ltd which is also subsisting on the good offices of Merck Ltd. The latter had extended a loan of Rs 521 m to this company during the year (partly repaid) and as a quid pro quo extended services worth Rs 126 m (Rs 95 m) to this company. This income features in the 'other income' schedule of Merck Ltd. From the looks of it the company does not appear to levy any interest on the 'handsome' loan that it has extended, or probably the interest is levied via the 'services rendered' route.
There is really very little to commend this script. The only plus point is that the low equity base of Rs 166 m (16.6 m shares of Rs 10 each) also infers very miniscule floating stock. Thus the share price is also subject to high volatility.
Disclosure: Please note that I hold 25 shares in this Company
This column Cool Hand Luke is written by Luke Verghese. Luke has been a business journalist, financial analyst and knowledge management head with a professional experience of more than 20 years. An avid watcher of the stock market, he has written extensively on stock market trends. His articles have featured in Business Standard, Financial Express and Fortune India amongst others. He has also been the Deputy Editor, Fortune India and the Financial Editor of The Business and Political Observer.