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Orchid Chem: Many questions that beget answers - Outside View by Luke Verghese
 
 
Orchid Chem: Many questions that beget answers

Flying high on paper

Orchid Chemicals, the Chennai based pharmaceutical company became a legal entity in 1992, and began commercial activity in 1994. The company makes Active Pharma Ingredients as an export oriented unit, and manufactures and sells finished dosage forms (formulations) in the domestic and export markets. It currently boasts six direct subsidiaries, one fellow subsidiary, and two joint ventures, making a total of nine companies. Of this lot, five subsidiaries and one fellow subsidiary are incorporated abroad, one in India, and one joint venture each in China and the USA. These siblings have yet to come of age, contribution wise.

The high decibel, slick two tone annual report, (and printed at considerable cost to boot) is nothing short of a calculated attempt by the management to boost the public image of the company. The directors' report goes to extraordinary lengths to harp on its achievements to date, and of the manna in the offing. Oh really? In the ultimate analysis it is the cash that a business generates from operations at the end of the day, which really marks the success of any commercial enterprise. For FY10 the company has reported a profit before tax of Rs 4.6 bn against a pre -tax loss of Rs 368 m in the preceding year. But shorn of the extra fittings, it is in reality a different story. Excluding extraordinary items of income, and onetime capital gains in either year, and the write back of provisions etc (which are all very astutely woven into the scheme of things, under different schedules to the accounts) the company has recorded a pre- tax loss of Rs 5.9 bn in FY10 against a pretax loss of Rs 1.2 bn in the preceding year. This calculation does not however take into account some extraordinary items of expenses such as forex losses, or large scale provisions for doubtful debts on revenue and capital account, and such like - which in the case of Orchid are another story worth telling.

Extraordinary cash Flow

Orchid generated an extraordinary cash inflow of Rs 16.4 bn in FY10 from the sale of its generic injectable formulations business for US$ 400 m equivalent to Hospira, a generic injectable major, incorporated in India (why the dollar denomination?). The management spares no effort in proclaiming that a business line started from scratch just four years ago got itself such a humungous valuation, and that it was for all the ultimate good of the company's shareholders. (It is going to embark on its second growth journey - which one hopes will not lead to another leveraged muck up among other things). The flip side of the coin - and painted in softer hues by the management - is also the bare fact that the company's financials and its basics appear to be under strain and in all possibility the overall business was not generating sufficient margins at the end of the day. (The company generated a negative net cash flow of Rs 402 m from operating activities in FY10). This sale helped to lower long term debt by a not inconsiderable sum of Rs 14 bn for one, as also the future spinoff benefit of reduced cash outflows on account of interest and debt repayment.

Accounts are a puzzle There are puzzles galore about Orchid's presentation of accounts. It is primarily an export oriented enterprise, generating an estimated 81% (Rs 9.8 bn against Rs 9.3 bn in the preceding year) of its net sales from exports as shown in the schedule of 'Earnings in Foreign Exchange'. Given the size of the export basket, the company should be entitled to export benefits that the Sarkar doles out, but there is no evidence of any such income (it operates a 100% export oriented unit for the manufacture of active pharma ingredients). To generate this export effort, the company also imports raw materials in bulk, with raw material imports accounting for 40% of all materials consumption. Separately, it also booked income from the 'export of services, including royalty' for Rs 290 m against 271 m in the preceding year. But there is no separate accounting of this income in the schedule which gives the breakup of the 'Sales and Operating Income'. Or take for example the spending on gross block. In the last two years it spent Rs 6.8 bn on the purchase of fixed assets. In this period it also sold some of its productive gross block. But the installed capacity of the various 'Class of Goods' that it makes is unchanged in either year. Presumably then this spending on capital assets went to shore up the quality of its assets, or some such.

The expenditure schedule

The revenue expenditure and capex schedule throws up some interesting expense items. In the preceding year there is a provision for rebates and discounts of Rs 400 m, while in the latter year the company made do with no such rebates. Apparently then, this is not a recurring expenditure. In both the years the company has taken a whack on the forex front, on derivatives taken on trade receivables, payables, advances, and on the FCCB borrowings. In the latter year there is a write-off for bad debts of Rs 325 m while there is no such expenditure in the preceding year. In all possibility, bad debts come in the modicum of fits and starts-but may refer to bad debts accruing from its subsidiaries. It spends big bucks on its research and development activities, and then some. It has debited Rs 538 m in the latter year to the P&L Account, against a marginally smaller Rs 463 m debited in the preceding year. Quite obviously, this expenditure is not as yet bearing fruit on the bottom-line front. And amazingly enough, its capital stake of Rs 149 m in its research subsidiary, is fully provided for in its books. Okay, so this company with equity base of Rs 148 m had negative reserves of Rs 660 m. Another way of saying it has gone belly up. On a turnover of Rs 60 m it recorded a loss of Rs 196 m in FY10. It is impossible to make any sense of all these figures.

The trade debtors schedule at year end has a provision for doubtful debts in the preceding year, but it makes do with no such provision in the latter year. The company was apparently screening its debtors in the latter year. This is truly remarkable, and Orchid is turning out to be an enigma. More importantly, the trade debtors balances at year end (and possibly including trade creditors too) are subject to confirmation - an important requirement in any audit, which has been bypassed.

The subsidiary cross

The subsidiaries and the joint ventures are an item number by themselves. They collectively yield a value addition of Rs 936 m to the consolidated turnover, while their contribution to the pre-tax profit is a negligible Rs 98 m. The parent's investment of Rs 1.2 bn in the capital of these siblings is a non performing asset, dividend wise. But let that be. One must add here however, that 93% of its capital investment is concentrated in one subsidiary, the US based Bexel Pharma, and its Chinese joint venture, NCPC Orchid Pharma. The auditors in their report state that the audited accounts of two subsidiaries (not specified) and the two joint ventures were not made available, and therefore their financials have been accounted for on the basis of financial data provided by the management. Let that also be. The financials of the subsidiaries makes for very depressing reading.

To start with there is an anomaly in the capital of Bexel Pharma. The parent's investment portfolio shows its capital investment at Rs 888 m (at an average price of Rs 37 per share) but the subsidiary accounts show a capital of only Rs 819 m. It has negative reserves of Rs 1.1 bn. On a middling turnover of Rs 8 m, it recorded a loss of Rs 19 m. And guess what, it has total assets of Rs 1.1 m. No wonder then that it cannot crank up any worthwhile turnover. The other US subsidiary, Orgenus Pharma fares no better. The less said about its subsidiaries in the UK, Japan, and South Africa, the better. Consequently, the company advances loans to them and then provides for these loans as bad debts in its books. The total provisions on this count in the preceding year were Rs 344 m, which grew to Rs 540 m in the latter year. The total loans to the subsidiaries at year end were Rs 935 m against Rs 1 bn in the preceding year. With these siblings gasping for breath there is no question of charging any interest on the sums loaned, that the parent has borrowed in the first place. The two joint ventures however appear to holding their heads above water from the data that the company has furnished. A combined income of Rs 1 bn against expenses of Rs 970 m, for the year ended March 2010.

The company has transactions on the revenue account only with its joint venture based out of China. This is strange as some of the subsidiaries were ostensibly set up, by the parent's own admission, to market what the parent makes. If that is not the case, as is evident from the available data, why then is the parent advancing loans to its subsidiaries and then writing it off? The company delves at length on the good showing of its siblings, but given the data on hand, it is difficult to get a fix on what value they add to the well being of the parent.

All in all, a very perplexing scenario.

PLEASE NOTE THAT I AM NOT A SHAREHOLDER OF THIS COMPANY

This column Cool Hand Luke is written by . 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.

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