Should Dr Reddy's Go On A Binge?

M&A
Should Dr Reddy's Go On A Binge?

Definitely. Gobbling up sister-firm Cheminor Drugs will do wonders for its ADRs.

By Dilip Maitra

K. Satish Reddy, MD, DRL The chemistry should manifest itself in a merger. Even though it denies it, the Hyderabad-based Reddy Group will, probably, amalgamate Cheminor Drugs Ltd (CDL) with the flagship, Dr Reddy's Laboratories (DRL), soon. No wonder the bulls on the bourse are excited--the CDL scrip shot up from Rs 130 on January 10, 1999, to Rs 280 on April 6, 1999--with DRL's plans to tap the American Depository Receipts (ADR) market in the near future spurring them on.

Any witchdoctor would recommend a merger to K. Satish Reddy, Managing Director, DRL. For, at one stroke, such a merger will result in a bigger DRL (combined turnover: Rs 650 crore in 1998-99). In terms of size alone, such an entity will have a chance of charging a higher premium on its ADRs. That explains why, months before its ADR issue, Satyam Computers too decided to merge its 3 subsidiaries into itself. But despite the logic, the 32-year-old Reddy denies the move: "We don't have any plans to merge the 2 companies."

However, there are financial synergies--and, of course, the NASDAQ listing--to be derived from the merger. Argues D.G. Shah, 57, CEO, Vision Consultancy Group: "For any company with global ambitions like DRL, absolute size matters, and the merger (with CDL) will help DRL. Agrees Visalakshi Chandramouli, 29, a Research Analyst at Prime Broking: "The merger is imminent, and will happen within 2 years."

According to BT's estimates, a 1:4 swap ratio--one DRL share for every 4 CDL shares--will increase the equity base from Rs 26.49 crore to only Rs 30.05 crore. And, despite DRL's 8.63 per cent stake in CDL, which will get extinguished post-merger, the promoters' holding in the merged entity will be 33 per cent, or 1 per cent higher than their current stake in DRL. Finally, the Book Value Per Share (as of March 31, 1998) will go up from Rs 78.84 for CDL and Rs 128.73 for DRL to Rs 154.66 for the combined entity.

The flip side: CDL's low margins of 2.99 per cent in 1997-98--compared to DRL's 14.56 per cent--will impact the earnings ratios. While Earnings Per Share will drop slightly from Rs 18.43 for DRL to Rs 17.88 in the case of the merged entity, the Return On Net Worth and the Return On Capital Employed will fall more sharply from Rs 14.33 to Rs 11.56, and from Rs 15.42 to Rs 12.16, respectively.

Operationally, CDL's strengths in the manufacture of bulk drugs--like Ranitidine (anti-ulcer), Ibuprofen (analgesic), and Naproxen (antibiotic)--may not readily translate into gains for the merged entity. After all, DRL derives 62 per cent of its sales from formulations products in segments like gastro-intestinal care, anti-infectives, and cardio-vasculars. Says a Mumbai-based equity analyst: "The merger does not have much operational synergy because the products are different. But, financially, it makes sense." Adds Shah: "The merger will bring savings in excise duty as bulk drugs are bought from outside by DRL."

Of course, DRL will gain from the fact that CDL does export bulk drugs to the US market--grossing over Rs 53-crore, or 33 per cent of its turnover in 1997-98--which will make it attractive to its prospective American investors. It will also reduce DRL's corporate taxes, which, in 1997-98, constituted 10 per cent of its pre-tax profits. That, however, is only an insignificant by-product of a merger that is inevitable.

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