This article provides in-depth fundamental analysis of Merck Ltd, Indian subsidiary of the international pharmaceutical player Merck Group.
Merck Ltd Research Report by Reader
Q: Hi Dr. Vijay, Could you please suggest your views on Merck Ltd. As mentioned in your articles I have tried to find out some data about the company. Below are the few of the details for Merck Ltd:
- Company is debt free
- CAGR 8% – (Sales Growth fluctuating in between -4% to 24% FY 2005 to FY2014)
- OPM – reducing FY2011 15% to 7%
- NP – if other income removed, NP is 3% for FY2014 (Other income 20cr)
- Tax Paid % in above 30% for last ten years, except FY2006
- Current Ratio 3.39 (last 5 Yr current ratios – 4.22 to 3.39
- Debtors days 40
- Earning Yield 5.24%
- 10year CFO=294cr whereas 10year NP722cr (without other income NP354cr)
- Continues dividend paying company
Dr Vijay Malik’s Response
Thanks for writing to me! Let us first analyse the financial performance of Merck Ltd over last 10 years.
Financial Analysis of Merck Ltd:
Merck Ltd has been growing its sales consistently at a moderate pace of 10-15% year on year since last 10 years (FY2005-14). However, this sales growth has been accompanied by declining profitability margins.
Operating profit margins (OPM) of Merck Ltd, which used to be in the range of 24-26% in FY2005-07 have been consistently falling and have currently reduced to meager 7% in FY2014. Similarly Net Profit Margins (NPM), have declined from about 20% in FY2005-07 to meager 5% in FY2014.
Main reason for this significant decline in OPM has been the unfavorable exchange rate movement for Merck Ltd.
Merck Ltd imports many of its raw material ingredients from international markets, mainly Merck Group companies, and manufactures products in India (Goa) and sells its products in India. About one fourth of its total raw material consumption is imports.
As mentioned above, Merck Ltd has been setup in India by Merck Group mainly to cater to Indian market. This is evident by the revenue profile of Merck Ltd, which is 90% domestic sales and only 10% export sales.
Heavy import bill of raw material in USD and majority of sales within India in INR, is a difficult business situation to be in, when INR has witnessed consistent depreciation against USD over last decade. INR has depreciated by about 60% from 39-40 INR/USD levels in Dec 2007 to 65 INR/USD levels currently. No wonder, the operating margins of Merck Ltd have taken a beating over these years.
Management of Merck Ltd has acknowledged this fact in it communications to shareholders (AR FY2014):
“The continued devaluation of the Indian Rupee vis-a-vis major currencies thereby increasing input costs, impairment of current assets, were key reasons for the dent in the operating margins.”
This impact is in sharp contrast to major Indian pharmaceutical players, who have significantly benefited from the same INR depreciation over this period, mainly due to sourcing their raw material from India and selling their products in overseas markets. However, Merck Ltd does not seem to be established to follow this business model as overseas markets are being catered by other global subsidiaries of Merck Group.
This is evident by the disclosure by Merck Ltd’s management (AR FY2014):
“With Merck Group prevalent in more than 67 countries worldwide, the ability to export remains rather Ltd”
Merck Ltd has been paying taxes at 33-35% rate, which is equal to the standard corporate tax rate in India. This is a good sign.
Operating Efficiency Analysis of Merck Ltd:
Over the years, Merck Ltd is not able to improve its operating efficiency.
Net fixed assets turnover (NFAT) has been ranging from 8-9 over the years without any sign of sustained improvement. Similarly, receivables days has also been in the range of 35-37 days over the years and deteriorating to 40 days in FY2014.
When we notice the Inventory Turnover Ratio (ITR) of Merck Ltd, we see that ITR has witnessed steady deterioration from 8.8 in FY2010 to 5.3 in FY2014. This indicates poor inventory/working capital management by the company. Declining ITR has been leading to funds getting stuck in working capital.
Merck Ltd has not been able to convert its profits into cash from operations. Merck Ltd has PAT for last 10 years (FY2005-14) of INR 642 cr. whereas the CFO over the similar period is INR 318 cr. One of the reasons for profits not being available as cash for the company is that its funds are getting stuck in inventory as witnessed by declining inventory turnover ratio.
Another issue that concerns shareholders is that Merck Ltd has to write off its inventory due to it becoming obsolete. As per management in annual report FY2014:
“Additionally, the Company wrote off current assets that were no longer envisaged as possible to be utilised.”
Margin of Safety in the Business of Merck Ltd:
i) Self-Sustainable Growth Rate (SSGR):
As mentioned in the article on Self-Sustainable Growth Rate, SSGR does not factor in working capital changes. However, we can estimate whether funds are being tied up in working capital by comparing cPAT with cCFO.
Analysis of SSGR indicates that if Merck Ltd can manage its working capital management and operating efficiency properly, then it can grow continuously at about 40-50% growth rate without creating additional debt burden on the balance sheet. However, we can see that Merck Ltd has not been managing its working capital as desired. As a result, its PAT is not getting converted into CFO, but getting stuck in working capital.
As Merck Ltd has been growing at a very low rate of 10-15% as compared to its SSGR, it has been able to manage it without leveraging its balance sheet. However, going ahead it might not be able to grow at high rates of about 25-30% comparable to other Indian Pharmaceutical players, without incurring debt burden, if it does not improve its working capital management.
ii) Free Cash Flow Analysis of Merck Ltd:
Merck Ltd does not seem to have aggressive strategy about India as witnessed by its modest capex over last 10 years. During FY2005-14, Merck Ltd spent INR 151 cr. into capital expenditure, which is low when compared to investments done by some of the equally reputed Indian Pharmaceutical players. Entire capex of Merck Ltd was met through the cash flow from operations (CFO) of INR 318 cr. leaving free cash flow (FCF) of INR 167 cr. as surplus for shareholders.
Merck Group’s India strategy comes out to be modest when we see that Merck Ltd has paid out dividends of about INR 341 cr over last 10 years (FY2005-14) whereas it had a free cash flow (FCF) of only INR 167 cr. The excess dividend has been funded by dipping into the cash & investments that it had. For example, in FY2010, it paid dividend of INR 158 cr. whereas its PAT for that year was only INR 63 cr. The balance amount was funded by liquidating its fixed deposits as witnessed by fall in cash & investments from INR 348 cr to INR 168 cr during FY2010.
The main beneficiary of such large dividend payments is Merck Group, which is majority shareholder of the company.
This strategy of paying large dividends and modest capex can be interpreted that Merck Group is not keen to grow its India operations aggressively. I suggest that any investor should study future investment plans of Merck Ltd in detail before committing her hard earned money to Merck Ltd.
Share market too seems to have recognized such behavior of Merck Ltd. The market capitalization of the Merck Ltd has increased by INR 594 cr. against retained earnings of INR 301 cr. over last 10 years (FY2005-14). Management has created a value of INR 1.97 for the shareholders from every INR 1 of earnings retained & not distributed to shareholders. This value creation is low as compared to the similar companies including other Indian Pharmaceutical players.
Margin of Safety in the market price of Merck Ltd:
However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, takes into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.
In the absence of any strength in the business model of the company, a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.
- 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
- How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
- Hidden Risk of Investing in High P/E Stocks
Overall, Merck Ltd appears to be a company chugging along at a modest pace without any aggressive business plans. Despite being in a very lucrative pharmaceutical space where most of the players have created huge wealth by sourcing & manufacturing in India and selling overseas, the company has been stuck in exactly opposite situation, where it has to buy from overseas and sell in Indian market. This peculiar business strategy has taken a toll on its profitability over last 7-8 years due to INR depreciation whereas other Indian Pharmaceutical players have flourished during the same period. As per management in FY2014 annual report:
“Various regulatory controls and pricing legislations continue to challenge both the segments. Price reduction in some of the major pharmaceutical products bought down the margins. The material costs were severely impacted by foreign exchange fluctuations. Inability to pass on cost pressures due to regulatory price controls for some of the major products, led to dampened results.”
Merck Ltd has been incorporated by Merck Group mainly to cater to Indian market. International markets are being supplied by other international divisions of Merck Group. Therefore, the possibility of the company benefiting from the similar factors of local sourcing and international selling, which have helped Indian pharmaceutical sector to grow leaps & bounds, seems low.
The company seems to be prioritizing dividend payments over capex and thereby looks to be following modest business expansion plans for India. Any investor should keep a close track of business expansion plans while taking any investment decision.
These are my views about Merck Ltd. However, you should do your own analysis before taking any investment related decision about the company.
You may use the following steps to analyse the company: “How to do Detailed Analysis of a Company“
The company has found its profits getting stuck in inventory and then has to write off inventory due to it becoming obsolete. Such incidences ask for improvement in management practices. Investors should keep track of the future performance of the company for signs of improvement or worsening of operating efficiency as part of their monitoring exercise. She may use the steps explained in the following article for monitoring stocks in her portfolio.
Hope it helps!
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- The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
- I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
- Currently, I do not own stocks of the companies mentioned above in my portfolio.