Home / Market / Mark-to-market /  Orchid sheds a good asset to cut debt

Would Orchid Chemicals and Pharmaceuticals Ltd have sold a good slice of its active pharmaceutical ingredients (API) business if it was not weighed down by debt? Perhaps not, and that may explain why investors do not appear thrilled by the transaction, despite it being done at a good price. Orchid’s shares have fallen by 1.8% from its closing price on Tuesday (the deal was announced on Wednesday).

The company is planning to sell its penicillin and penem (types of antibiotics) API businesses, along with employees, assets and associated research infrastructure to Hospira Inc. for $200 million (around 1,115 crore today). APIs are the basic ingredients used to make medicines.

This business contributed about 450 crore to Orchid’s consolidated revenue and had an Ebit (earnings before interest and taxes) margin of about 16%, said the company’s chairman and managing director in an interview with CNBC-TV18. The company, therefore, got a price of about 2.5 times the sales of the unit, which is a good valuation for a contract manufacturing business, reflecting Hospira’s keenness to control the full manufacturing process. It was buying these APIs from Orchid to make the finished products.

Orchid will lose a steady and profitable revenue stream, but it also expects to repay rupee debt of about 700 crore, and use the remaining cash to fund growth. A sizeable debt burden meant that interest ate away about 78% of its Ebit in 2011-12. It hopes to save 110 crore in interest costs as a result of this deal (including interest on working capital for the business being transferred). That should result in profits looking much better.

Investors will appreciate that, but their attention is on the impact on Orchid’s operations. Investors would have assumed the company would repay its debt through cash flows from its business, and not by an asset sale. A lot depends on whether Orchid has timed this deal in such a manner that it can spur the remaining parts of its business to grow faster. It has a residual API business and also makes generic drugs. APIs are the main contributor to revenue, at 72% of sales.

Orchid’s high debt burden was already reflected in its valuation and was being balanced by expectations of faster business growth. While debt will fall, and earnings will improve, the question is whether it can make good the lost sales and profits. The deal is expected to close in the December quarter. The full impact of this transaction will thus be visible in 2013-14, a year in which the company expects to earn revenue from first-to-file generic drug opportunities in the US. If Orchid offsets the dip in API revenue with higher contribution from generic drug sales, investors may find the deal worthwhile in hindsight.

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