This company appears to be run more for the benefit of the worldwide group that for its own greater glory.
What is the business plan?
It is difficult to comprehend what exactly are the Indian business objectives of Merck KGaA, Germany, the parent company of Merck India. It appears that for the present they are perfectly content with matters as they are, despite occasional noises to the contrary about regulatory controls, licensing of products, and monitoring. The company is more than happy to drift along with the organised chaos, in our very own Bharat. There is no other conclusion that one can arrive at. There are no plans to expand capacities, or introduce new drugs and formulations, no expansion of gross block, no effort at mergers and acquisitions, a contagion that is bestirring the pharmaceutical industry no nothing for that matter. Consequently, the top-line and bottom-line that it generates each year have to make do with some innovations of their own.
In the latest year end ended December 2011, the company registered net sales of Rs 5.5 bn (Rs 5.1 bn previously), other income of Rs 489 m (Rs 434 m) and a profit before tax of Rs 813 m (Rs 1.1 bn). The latter figures are after making adjustments for accounting adjustments that are a feature of all annual reports - the write off of impairment loss on its manufacturing facility in Goa for Rs 142 m last year and its write- back in the current year. A significant aspect of this company's revenue generation and profits is the constitution of other income in its wellbeing. (The company is thus in a sense well insulated for its inertia in operational matters). Other income accounted for 60% of its pre-tax profits against a lower 40% previously. The figures that go to make up Other Income are quite varied and there is subtlety in the variation. But we will dwell on this factor later on in this copy.
The directors have forgone the dividend for the year against an eye-popping payment of 950% in the preceding year. The ostensible reason for passing over the dividend appears to be the seemingly foolhardy payout in the preceding year on the one hand, and the need to conserve resources on the other. The dividend, including the tax on dividend, amounting in all to Rs 1.8 bn, far exceeded the profit after taxation for the year. This dividend payment appears to have been occasioned out of frustration - its inability to sell its buyback offer to minority shareholders. This adds to the mystery of what the management of this company is really up to. The second reason proffered - of the need to conserve resources - is equally opaque. The company is debt free, has no capex plans on hand, has enough spare cash to advance loans of Rs 465 m to two group affiliates - Merck Specialities Pvt. Ltd and Millipore India Pvt. Ltd - a healthy bank balance of Rs 1.1 bn at year end, and an investment portfolio of Rs 227 m in debt securities, does not quite gel with the directors' learned observations. Besides, it appears that the loans doled out to Merck Specialities are interest bearing, while the loans advanced to Millipore India are of the free for all variety.
But the catch here for forgoing dividend is somewhat different. During the financial year it was out of pocket on the cash flow front. That is to say it had a negative cash flow of Rs 255 m from operations, against a positive cash flow of Rs 660 m previously. The problem was that it completely messed up its production planning during the year, leading to sharply higher levels of inventories, along with an increase in trade debtors, and compounded by an increase in loans and advances. The result was that it had to shoulder an additional cash outflow of Rs 722 m on this account. This led to a severe mismatch so to speak. So the company had to draw on its cash resources to the tune of Rs 600 m to make good the shortfall. In this muddled state of affairs the company also saw value in buying and selling debt securities for a cumulative value of Rs 11.3 bn. If it earned any money in this deal making, then it is not showing up separately in its income schedule.
Higher input costs
The other learned observation of the company that input costs soared as a result of higher inflation and forex fluctuations appears to be fairly tenable. But here too the chief culprits are the increase in HR costs and Other Operating expenses. HR costs rose close to 19%, while Other operating costs rose 22%, and Materials cost rose 17%. Net manufactured sales on the other hand rose 10%. Sales here include export income of Rs 539 m against Rs 469 m previously. Export income accounts for close to 10% of net manufactured sales in either year. Then there is also the factor of traded sales. A substantial part of these exports are affected to group affiliates. The company has not quite clarified whether the export sales were cash flow positive or cash flow negative, and the position pertaining to traded sales. There is no regulatory requirement on this matter either.
This is an important matter as export sales are fairly substantial in the overall context. Only then will we get to know where the shoe really pinches. Further, the other operating expenses also include Royalty payment of Rs 104 m against Rs 99 m previously. Equally important is the fact that the company sources substantial sums of goods from its group affiliates worldwide - these imports constitute both raw materials and finished goods. Such imports amounted to Rs 788 m in the latest accounting year against Rs 473 m previously. The total value of consumption of all materials amounted to Rs 2.4 bn against Rs 2 bn previously. Such inter-se deals can even play oddball with its financials. As a matter of fact the bond between the Indian subsidiary and its affiliates is quite pernicious as it includes services rendered of Rs 188 m and services received of Rs 276 m between the group companies. How much of an increase in operational parameters can the Indian company achieve in the face of such oddities please? No wonder then that the parent is trying to buy back shares from the minority investors!
Need for exacting regulatory guidelines
The regulatory requirement on this score is limited to providing the brief statement of accounts of division wise incomes and expenses or what is known as the Information about primary business segments. The company divides its operations under two segments -Pharmaceutical and Chemicals. Pharma sales account for 68% of all revenues, while the latter accounts for the balance 32%. The former earns a segment profit of 10.3% of sales, while the latter begets it 21.3% of sales. The segmental assets are however almost evenly divided between the two.
This brings us to its biggest individual run getter - namely the Other Income component of its revenue streams. The biggest individual contributor to the gold mine is Income from other services rendered at Rs 201 m. Strictly speaking this is a sales related income judging from its nomenclature, but let that be. But, what items exactly constitute other services rendered please? This is followed by Interest on deposits and others at Rs 138 m. The only other big ticket contributor is Service tax credit at Rs 84 m. There are seven other entries in this schedule but they collectively add up to little. In reality none of the credits in the schedule can be counted upon for a repeat performance each year - barring the first named - given their very income earning pattern. The first named is an exception as it relates to fees received from affiliates and can be timed to perfection. But the company has the uncanny ability to do an encore each year on all counts.
There are not many multinational pharma companies appearing on Capital Market Magazine's Corporate Scoreboard - a mere nine entries. Many of the pharma MNC biggies have gone private. The remaining make for not much of a comparison. But even in this depleted list Merck makes for a poor showing. It has a P/E ratio of 19 against an industry PE of 29. Even this feat is achieved by the fact that there is a shortage of floating stock in this scrip. The total volume of shares on hand is 16.6 m shares. Of this, roughly 52% or 8.6 m shares represent non floating stock. That leaves for only about 8 m shares in the pipeline. But the true numbers of stock available for trade will be much lower. This is another reason for even this PE rating that it enjoys.
Disclosure: 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.