Orchid Chemicals & Pharmaceuticals

Shareholders can consider paring their exposure to the stock of Orchid Chemicals & Pharmaceuticals, which recently sold its antibiotic injectables business to the US-based Hospira Inc for $400 million (about Rs 1,870 crore).

Even though the deal valuations are attractive and would more than address Orchid's debt problems , it threatens to render the company's overall growth prospects unappealing. The generic injectables business enjoyed high-growth and high-margins and was the company's growth driver.

With the growth engine wedged out from its portfolio, Orchid's business would now primarily straddle across its low-margin API and oral dosage formulation businesses only. This is likely to reduce both revenues and margins, even as the company would enjoy significant savings on its interest outgo and depreciation charges.

At the current market price of Rs 184, the stock trades at about 14 times its likely FY-11 per share earnings. While this is at a discount to most peers, much of the premium that the company had earlier commanded was due to its presence in the niche antibiotic injectables area. With that gone, discounted valuations may be here to stay.

Parting with growth engine

As per the deal agreement, Orchid will transfer seven products (including two products in pipeline) in cephalosporins vertical and two products (including one in pipeline) in the penicillins vertical. It will also transfer its carbapenem line with key products such as meropenem and imipenem (with an estimated $1 billion market opportunity per product). In addition to the drugs, Orchid will transfer the manufacturing facilities of cephalosporin, penicillin, carbapenem and a R&D facility too. What's more, the sale also includes Orchid's key business of Tazo-Pip, for which it had acquired six-month exclusivity in September this year. Fortunately for it, the end of exclusivity for Tazo-Pip coincides with the transfer of business to Hospira.

This means by March 2010, when the businesses would effectively be transferred to Hospira, Orchid may have extracted peak sales from the Tazo-Pip opportunity.

On the whole, however, the company appears to have parted with its growth engine, for had it held on, it would have benefitted significantly from the opening up of business opportunities in carbapenem, where a handful of products were expected to go off-patent in the next couple of years.

Given the limited competition in these niche businesses and Orchid's low-risk and low-cost strategy of launching drugs with overseas partners, the divestment is certain to slice away a chunk of its future revenues.

The silver lining, however, comes from the 10-year agreement that Orchid has struck with Hospira.

As per the agreement, Orchid will supply active pharmaceutical ingredients (APIs) or bulk drugs required for producing the injectables. Not only will this help Orchid utilise its manufacturing capacities, export APIs that these would be, it may also help the company realise better margins. In addition to this, though it still may be early days, export API deals could also open up significant custom manufacturing opportunities for Orchid in the long run.

Deal money to help retire debt

On the valuations front, however, the company appears to have made the best of the deal. The antibiotic injectable business, which was expected to make up over $90 million in revenues this year, has been valued roughly at over four times, at $400 million.

For a company that was grappling with a debt of over Rs 2500 crore, including foreign currency convertible bonds worth $150 million redeemable in 2012, the deal money would provide the much-needed breath of fresh air, needed to sustain operations. The company had provided about Rs 109 crore as interest cost in the first half of the current year (about 18 per cent of its revenues) and Rs 76 crore as depreciation.

The influx of the deal money would help the company retire a chunk of its debt and improve cash positions. Orchid plans to retire its entire long-term debt of Rs 1200 crore and part of working-capital loan of Rs 550 crore. By doing this, the management expects to save around $40 million in interest cost alone.

And since the sale also involves transfer of assets (estimated fall in gross block of fixed assets at about Rs 600 crore and net block Rs 450 crore), it will help bring down depreciation charges too. Orchid expects the saving in interest cost and depreciation to help improve it's per share earnings by about Rs 7-8 next year.

Revenue concerns

Even though Orchid is likely to enjoy significant savings on the cost front, these near-term benefits are unlikely to supersede the lack of visibility on its revenue front. Post-deal, the management expects the company's revenues to be lower by $90 million and it's EBITDA to fall by over $30-40 million in FY11.

Operating margin too, as a result, is also likely to come under pressure as the share of the high-margin formulation business expected to go down from the likely 65 per cent level in FY10 to about 45 per cent in FY11. The management, however, is hopeful of improving the share of formulations to 50 per cent by FY-12. It expects the non-antibiotics segment to give it the next growth impetus, having filed 21 ANDAs with the USFDA.

Of those, seven are Para IV FTF (first-to-file) products, including the two FTFs that were recently settled with the US-based Schering-Plough. While the prospects do appear promising in the long run, given the inherent uncertainty and risks associated with FTF opportunities and drug application approvals, investors may be better off taking fresh exposure to the stock when such opportunities present themselves rather than remaining invested and wait them out

via BL