Orchid Chemicals

Investment with a two-year perspective can be considered in the stock of Orchid Chemicals and Pharmaceuticals, an exporter of generics operating in the niche segment of antibiotics. Likely earnings from over 12 products over the next two years and the company’s proven track record of garnering shares in regulated markets augur well for prospects over the medium-term.

In the last five years, the company’s profits have grown by a compounded annual growth rate of 28 per cent on the back of 13 per cent rise in sales. Orchid has progressively built its strategy around categories such as cephalosporins, penicillin, betalactams, carbapenems and also non-antibiotic products.

With internal accruals and debt used to build capacities, interest outgo (8-10 per cent of sales) has been a drag on earnings. But, now, with the required facilities in place for formulation manufacturing and bulk drugs, Orchid is well-positioned to capitalise on export opportunities.

Orchid is looking to launch three cephalosporin-based products every six months for the next the two years in the overseas markets. This represents a potential generic market of $1 billion (based on conservative estimates) with limited competition in the offing.
Valuation

At the current price of Rs 213, the stock discounts the company’s 2008-09 earnings by nine times, which appears justified in relation to the earning prospects. Factors such as possible equity dilution through $200 million FCCB issue (used to retire debt), ambitious capex and muted sales growth in recent years have weighed on the stock price. Nevertheless, Orchid’s performance in antibiotic injectibles, guided sales growth of over 30 per cent in 2007-08 and the possibility of five exclusive product launches in 2009, suggest a sustainable earnings picture.
Changing profile

From a fledgling bulk drug player targeting lesser-regulated regions, Orchid has transformed itself into a formulations maker operating in a difficult-to-venture area such as generic antibiotics.

It has gained foothold in sterile injectibles market in the US through Cefazolin, Ceftriaxone and Cefoxitin, mainly through a strategy of launching drugs with overseas partners such as Apotex, Actavis, Hospira and DAVA. These profit-sharing agreements reduce the need to have a front-end presence and also shorten the “time to market” for highly competed drugs.

Cephalosporins, which is now a key revenue contributor, could turn out to be Orchid’s strength over the next two years. With Day One launches becoming a major source of profits on antibiotics, existing players such as Orchid with strong distribution partnerships, may be at an advantage.

However, not many such drugs are going off patent in future. So, in the long-term, to maintain the 50 per cent revenue contribution from US generics,

Orchid has laid emphasis on betalactams (which would kick in from 2008), specific carbapenems going off-patent sequentially from 2009. In the case of non-antibiotics, Orchid has received approval for its ANDA (Abbreviated New Drug Application) for Granisetron Hydrochloride tablets, an anti-emetic product. By 2009,

Orchid would launch six more non-antibiotics in both US and EU, adding 5-7 per cent to revenues. By 2011, as the contribution from cephalosporins decline, the other drug antibiotic classes together with non-antibiotics will hold key to Orchid’s revenues and profitability.
R&D trigger

Orchid’s drug discovery initiative is carried out under its wholly-owned subsidiary, Orchid Research Laboratories Ltd. (ORLL). ORLL has seven pre-clinical entities (total 15 molecules) targeting diabetes, infection, inflammation and oncology areas. With major drug companies spinning off R&D units, ORLL could also turn out to be a possible candidate for the same.

Orchid spends about 6-7 per cent of its sales on R&D. ORLL has filed 162 patent applications for new drugs and other innovative products.

Any possible deal (out licensing) that validates ORLL’s skills and also subsequent spin-off of the unit will be triggers for the Orchid stock.
Risks

Any delay in executing product launches, especially in cephalosporins, disappointments related to Tazobactam and increasing competition from Indian generic companies leading to steeper price erosion are risks to our recommendation.

More than 80 per cent of Orchid’s sales come from exports. Though earnings are exposed to rupee appreciation, eign currency convertible bonds might provide a temporary hedge.

Via BL