Going against the industry trend, the commodity bulk drug manufacturer shows high profitability because of captive Sri Lankan subsidiary

Nectar Lifesciences (NecLife), formerly known as Surya Medicare, manufactures semi-synthetic pencilin (SSP) and the cephalosporin range of oral and sterile bulk drugs. It has received WHO-GMP certificates for its products like cefotaxime sodium (sterile), ceftriaxone sodium (sterile), cefazolin sodium (sterile), cefuroxime sodium (sterile), chloramphenicol sodium succinate (sterile), ceftazidim for injection (sterile) and cefepime for injection (sterile).

NecLife has two manufacturing units at Derabassi, Punjab, and has taken on lease a manufacturing facility of Aster Pharmaceutical. These are used to manufacture bulk drugs for the oral and sterile SSPs and cephalosporins.

As part of its growth strategy, NecLife is strengthening its presence in the cephalosporin segment and entering the non-antibiotic segment by setting up a formulation facility at Baddi (Himachal Pradesh) and a plant to manufacture sterile cephalosporin as per US FDA standards at Derabassi. The company will also put up a research and development (R&D) and corporate quality control center at Derabassi. The estimated project cost of the expansion is around Rs 86.20 crore.

NecLife’s standalone performance was not exciting in FY 2005. In fact, in FY 2005, the sales grew by mere 3% to Rs 220.70 crore, while the margin shrinked by 360 basis points to 9.7%, resulting in a 25% fall in operating profit to Rs 21.40 crore. The decline in profitability was largely due to the lackluster performance of the entire cephalosporins industry. But an over 16-time jump in other income to Rs 10.70 crore (most of which came as dividend from the 100% subsidiary in Sri Lanka, Chempharma) in FY 2005, from Rs 0.60 crore in FY 2004, boosted the profit after tax (PAT) by 23% to Rs 13.30 crore.

On a consolidated basis (comprising the financials of NecLife and Chempharma), the revenues and PAT in FY 2005 were Rs 229.80 crore and Rs 22.60 crore, respectively. The noteworthy point is that 41% (i.e., Rs 9.30 crore) of the consolidated PAT comes from Chempharma, which is largely because of the transfer price adjustments between the parent and the subsidiary.

Chempharma sells a majority of its production to the parent unit. The subsidiary is based in an export-oriented tax-free zone, which provides tax exemption benefit up to January 2009. In addition, Chempharma is not liable to pay any custom duty on the import of raw material (as per the agreement with the country's investment board). Also, it is not liable to pay export duty on exports of API intermediates to Indian parent (as per Indo-Sri Lanka free-trade agreement). Such fiscal benefits support the consolidated financials.

Strengths

NecLIfe’s endeavor to enter the non-antibiotic segment and froward integrate to manufacture formulations by setting up a non-antibiotic plant at Derabassi and a formulation plant at Baddi will strengthen the business model of the company going forward. However, the company is very late on both these counts.

Weaknesses

In FY 2005, both the oral and sterile cephalosporins businesses contributed Rs 139.20 crore, accounting 75% of the total turnover, while SSPs accounted the balance 25% at Rs 47.40 crore. Both SSPs and cephalosporins are undergoing a rough phase of the business cycle with lower margin and sluggish demand growth.

One of the director of NecLife, Vijay Shah, is the managing director of Stallion Laboratories Pvt. Ltd and also of Endurance Healthcare Ltd. The two companies are engaged in businesses, which are similar to NecLife.

As per the FY 2005 financials, 41% of the consolidated PAT comes from the Chempharma, largely because of the transfer price adjustments between the parent and the subsidiary. So far, NecLife has not prepared a report on transfer prices, but it is in the process of conducting the transfer pricing study vis-à-vis regulations. Any adverse findings may result in litigation.

NecLIfe depends largely on the domestic business and exports contribute only 23% of the total revenue, as per FY 2005 financials.

The floor price of Rs 200 gives a price/earning per share (P/E) of 13.2 times FY 2005 consolidated earning (on post-issue equity). At a ceiling price of Rs 240, P/E works out to 15.8 times. The nearest comparable companies like Orchid Chemicals and Aurobindo Pharma are currently trading at high P/E multiples of 22.6 and 36.1. That’s either because of the various stories of their molecule licensing, acquisition, and GDRs or their FY 2005 performance has been miserable and the fall in EPS has boosted P/Es.