India

Ratios- Cipla Ltd.Pharmaceuticals.
19 June 2011 Gross profits have almost doubled over the last five years

Ratio Analysis
 Income Statement
 Gross Profit:-

Gross profits have consistently increased over years. It has almost increased 100% and doubled itself from the base year 2006 when it was Rs. 13,202 millions to Rs. 26,755 millions at the end of 2010. The growing demand, with domestic growth consistent at around 10% y-o-y and exports growing consistently at around 12% y-o-y is the main driver for this increase in gross profits.

EBITDA:-

Profit before tax showed a 48% growth based on the sale of intellectual property rights

EBITDA figures too have shown an increase over the years with increased gross profits. However the sharp increase in 2010 on y-o-y basis can be attributed to the decreased other expenses due to a decreased loss in foreign exchange owing to comparatively lower fluctuations in the value of Rs vs. USD vis-à-vis 2009. Also a reduced expense on Research and Development vis-à-vis last year contributed to the increased EBITDA.

Operating Profit (EBIT):-

A sharp increase of 35% y-o-y in the EBIT is partially attributed to the increase in EBITDA and partially to the sluggish growth of depreciation which reduced to 10% y-o-y in 2010 from 30% y-o-y in 2009. This reduction was as a result of capital subsidy or government grants on specific depreciable assets.

PBT:-

Profit before tax showed a whopping 48% growth to Rs.13261 millions in 2010 as opposed to Rs. 8955 million due to the sale of intellectual property rights and technical know-how of “i-pill”, an emergency contraceptive pill to Piramal Healthcare Limited, for the territory of India, for the aggregate consideration of Rs.950 million.

Net Income:-

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India

Sector Review

09 May 2011

Net Income too showed a 40% growth on a y-o-y basis due to the increased PBT due to sale of certain rights related to one of its product. The Net Income for Cipla Ltd. Stands at Rs. 10,826 million as of March 2010, thereby crossing the coveted Rs.1 billion mark for the first time in it’s history.

 EPS:-

The positives of decreasing material costs are nullified due to increase in mfg. expenses

Significant decrease in EPS in the year 2007 was because of the increased number of shares due to a scrip issue of 3:2 declared in April 2006. The EPS, since then, has increased consistently. The sharp increase in 2010 was due to the increased profit attributable to a one-time revenue for the sale of intellectual property rights. .

 Horizontal Analysis
 Net sales have increased consistently over the years. However, the growth rate has decreased on a y-o-y basis. This decrease in growth rate is attributed to the high base figure which is ever increasing. The driver for net sales is the domestic demand growth which is steady at 10% and the export growth lingering between 12% to 14% y-o-y. The sharp decrease in growth rate in 2010 over 2009 is chiefly due to the non-availability of important rawmaterials, lower tender business in anti-retrovirals and unfavourable movements in foreign exchange rates. Other Income largely consists of technical know-how fees and export incentives along with other investments and miscellaneous income. Other Income dipped slightly to -0.3% on a y-o-y basis. This was basically due to the high base figure in 2009, wherein the company received a one-time technical know-how fee. However, the export incentive increased by around 70% to Rs. 924.1 million which relatively off-sets the effect of the decrease in the fee received. Material Costs have consistently been decreasing which is a good sign. However the sharp decreased in 2010 was an exception as it was due to the unavailability of important raw materials. However, the advantage due to decreased material cost is negated by the increase in manufacturing costs, as a result of which, the cost of goods sold remains unchanged. Growth in the ‘Research and Development expense’ decreased by over 60% to show a 6.5% y-o-y growth vis-à-vis 15.5% in 2009. A major reason is the increase in the revenue expenditure eligible for weighted deduction under the Income tax act.

Main driver for expenses, material costs, contribute around 62% of total expenses


EBITDA and operating profits, as a fraction of Net Sales, have taken a major hit over the past five years, except 2010.

 Other expenses dipped by 10% majorly due to a decreased loss in foreign
exchange owing to comparatively lower fluctuations in the value of Rs vs. USD vis-à-vis 2009.

Profit before tax showed a whopping 48% growth to Rs.13261 millions in 2010 as opposed to Rs. 8955 million due to the sale of intellectual property rights and technical know-how of “i-pill”, an emergency contraceptive pill to Piramal Healthcare Limited, for the territory of India, for the aggregate consideration of Rs.950 million.

 Vertical Analysis
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Sector Review

09 May 2011

 Material cost is the main driver for expenses contributing around 49% of the net sales and around 62% of the total expenses. Material costs as a percent of Net sales have traditionally been very high for Cipla Ltd. due to its niche products. This is also very high as compared to its competitors, for whom these costs are typically around 30%. Cipla is banking on its product mix and technology to reduce these costs.  Manufacturing costs have shown a decreasing trend which indicates the improvement of operational efficiency at Cipla Ltd.

The dividend payout ratio is observed to be decreasing on a y-o-y basis

 EBITDA and operating profit, as a percent of sales have taken a hit over the years, except for 2010, due to lower foreign exchange fluctuations, lower expenditure on research and development and capital subsidy and government grants. However, this is not a sustainable phenomenon and hence the decreasing margins are a concern.  The decreasing EBITDA and operating margins have shown its effect on the bottom line as net income or profit after tax as a fraction of net sales also have been decreasing. The exception in the financial year 2010 is partially due to higher EBITDA and EBIT and partially due to the sale of intellectual property rights and technical know-how for a aggregate consideration of Rs. 950 million.

 Difference between the operating profit margin and net income margin is significantly less indicating that financing costs of the company are low.

Cipla Ltd. is facing a severe cash crunch, partially due to high debt repayment in the past few years.

 Effective Tax Rate: The effective tax rate for Cipla Ltd. has been changing

through years from an effective rate of 14% in 2006 to 18.3% in 2010. One of the main reasons for the fluctuating tax rates are the benefits given to a manufacturing company like Cipla Ltd. These benefits range from the export incentives provided for promoting exports, the revenue expenditure exempted due to spending in domestic research and development as well as the incentives provided for manufacturing in SEZ’s. Such fluctuating effective tax rates are an integral part of any manufacturing industry in general and pharmaceutical industry in particular.

 Dividend Payout Ratio: Cipla has consistently declared a 100% dividend on
its face value of Rs.2/- for the past five years and can be expected to do so in the future as well. The dividend payout ratio is seen to be decreasing over years which mean company is investing greater percentage of its income back to the business.

 Dividend Tax Rate: Dividend tax rate is seen to be consistent around 16%
with no major fluctuations observed post 2006.

 Balance Sheet  Horizontal Analysis
 Inventories have shown an increasing trend, which validates the growth story Cipla has been projecting. The decrease in inventory, the only such instance
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09 May 2011

being the year 2010, is due to the unavailability of important raw materials during the year. However, the materials are expected to be available in the current year and a similar trend for inventory can be estimated.  Cipla Ltd’s cash and bank balance have shown a somewhat fluctuating picture of the company. With an increase of nearly 200% in cash balances in 2007, mainly due to the low figure in the base year, it has dipped considerably over the following years. Cipla is facing a severe cash crunch and this is partially due to the amount of debt they have repaid in the recent years. However, the management will try to raise the figure, which is way below industry standard, to a respectable level, which ensures their creditors; a particular level of security. The amount of long-term debt for Cipla reduced by 99% year-over-year to Rs.50.7 millions owing to the repayment of the loans during the financial year 2010. This is way below the average long-term debt of Rs. 18000 millions for its peer companies. To leverage this gap, Cipla may be expected to raise money from the debt market in the next two to three years.

Cipla’s inconsistent debt structure makes in highly unpredictable.

The imbalance in the ratio of total short term debt to total long term debt, places a huge question mark over Cipla’s strategy. The rival companies have a balanced ratio which makes them more stable and predictable.

 Vertical Analysis
 Current assets add up to 67% of the total assets of the company, the remaining 33% comprising of fixed assets like plant and equipments along with long term investment. A major part of the current assets are the inventories and money lent or debtors which comprise of nearly 85% of the total current assets. The remaining are the cash and bank balances, loans and advances and other current assets. Long term investments are on an average around 2% of total assets. It has however shown a rising trend and in 2010, it went up to 3.4% of the total assets. Current Liabilities, as a fraction of total assets have decreased over the past 5 years, highlighting the better operational efficiency of the management. A similar trend is seen with provisions as well. However, the sharp decrease in provisions is due to the change in the accounting principle, which now does not require the firm to make separate provisions for taxation.

Cipla has a high current ratio driven by increased levels of inventory

Deferred tax liabilities have been constant at around 2.5% of the total assets.

 One distinguishing factor of Cipla’s balance sheet is the varying amount of
debt. Continuous repayment and issue of debt has given this line item an unpredictable trend. It is now as low as 0.07% of total assets in 2010 from a high of 14% in 2009. Such unpredictable trends leave a question mark over the management’s strategies.
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India

Sector Review

09 May 2011

 Debt & Interest Costs
 The amount of long-term debt for Cipla reduced by 99% year-over-year to Rs.50.7 millions owing to the repayment of the loans during the financial year 2010. Cipla has shown a fluctuating trend in its long-term debt over the past five years with constant issuing of new debt and simultaneous repayment of the old ones.

The imbalance in the ratio of total short term debt to total long term debt, places a huge question mark over Cipla’s strategy. The rival companies have a balanced ratio which makes them more stable and predictable.

Interest cost for Cipla Ltd. turns out to be very low. It was just below 2.35% in 2006 and was around 4.86% in 2010. Such low interest costs are not practically possible.

Cipla Ltd. also doesn’t show a schedule or does not throw any light on how the interest costs are calculated, thereby adding to the confusion. It is not a net expense but a standalone interest expense.

 Solvency Ratios  Current Ratio: Current Ratio of the company has gradually increased over the
years, with 2008 being and exception, and is generally found to be around 3, which is better compared to its peers. Cipla has maintained a current ratio of more than 1 over the last 5 years which indicates that company is capable enough to meet its current liabilities with its current assets. A higher current ratio means a higher amount of current assets as compared to the current liabilities, which indicates a better liquidity position of the company, when compared to its peers and competitors.

 Quick Ratio: Quick Ratio is a more stringent measure of liquidity as it
excludes inventories from it’s calculation of assets, assuming the fact that inventories cannot be liquidated easily. It is a more conservative approach. The quick ratio of Cipla Ltd. Is slightly better than the industry average and has been increasing steadily.

 Cash Ratio: Cash Ratio is the most stringent measure of liquidity considering

only Cash and Cash equivalents as current assets. Cipla Ltd. Has a cash ratio lower than that of the industry which points towards the possible cash crunch the company is facing. A higher current and quick ratio but a lower cash ratio indicates either higher credit periods given to customer or higher investments in marketable securities of short-term.

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Sector Review

09 May 2011

 Turnover Ratios

 Receivables turnover: Receivables turnover is around 3 times or
A Cash ratio lower than industry standards hints towards a possible cash crunch that the company faces

approximately 120 days which is slightly higher than the industry average. This means that Cipla has liberal credit policies. Although this liberal policy may attract customers and distributors, it may be a drawback for Cipla owing to the current cash crunch that it faces. Also, the cash is stuck in the system thereby increasing the cash conversion cycle of the company.

 Inventory turnover: Inventory Turnover is normally calculated as the ratio of

Cost of Goods Sold by average inventories. It denotes the number of times in a financial year that the inventory is converted to cash. A lower inventory turnover, of around 2 or 187 days is seen in Cipla, as compared to the industry, thereby increasing the Cash Conversion cycle.

Higher days of receivables turnover, inventory turnover increase cash conversion cycle

 Payables turnover: Payables Turnover is

5.2 or approximately 70 days which is comparatively lower. This indicates that Cipla Ltd. has to pay suppliers at a faster rate than the rate at which customers pay them. This may mean raising short-term debt to pay the suppliers and then repaying the short-term debt as soon as the customers/distributors pay the company, which increases the current liabilities of the company and thereby decreases the current ratio making it a little less favourable on the liquidity front.

Lower payable days contribute to the severe cash crunch

 Operating Efficiency  Total asset turnover: Total asset turnover ratio measures the company’s
overall ability to generate revenues with a given set of assets. This ratio has been decreasing for Cipla Ltd. It decreased from 0.87 in 2007 to 0.77 in 2010. A ratio of 0.77 means that the company generates 77 paise of revenue for every Re.1 of average assets. A higher ratio indicates better efficiency.

 Net fixed asset turnover: It measures how efficiently the company generates

revenues from its investments in fixed assets. Generally a higher level of fixed assets turnover indicates a better management of fixed assets in generating revenues. This ratio too, for Cipla was seen, reducing from 2.6 to 2.1. However, a ratio above 1 indicates efficient use, even though it has come down for Cipla, the fixed assets are still managed efficiently.

 Equity turnover: The equity turnover ratio for Cipla is around 0.2 and has
been more or less constant over the past few years.

 Operating Profitability  Return on total capital: Return on total capital for Cipla showed a 20% y-o-y

increase to 18% in 2010 after four consecutive years of decreasing returns on total capital. This is a positive sign and Cipla will be looking forward to sustain this trend. However, one of the chief reasons for the increased returns is the decrease in the total debt and hence the capital employed which increased the returns. This, however cannot be sustained for too long, as Cipla is likely to issue new debt over due course of time.

 Return on total equity: Return on total equity (average) for Cipla showed a
marginal increase over last year and stands at 21% in 2010 to 19% in 2009.
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Sector Review

09 May 2011

Return on equity stands at 18.3%, marginally higher than last year but unsustainable.

This may be partially attributed to the amount received by the sale of intellectual; property rights which provided an impulse to the decreasing trend of the past four years.

 ROE DuPont Analysis: Return on equity through DuPont analysis turns out to

be at 18.3%. This is different from the Return on Total Equity as it considers average equity as opposed to DuPont’s method which considers the total equity for only the given year. Return on Equity marginally increased by 0.6% from the 2009 value of 17.7% to 18.3% in 2010.

 Profit Margin: Profit margin has dipped consistently over the past years with

2010 being an exception. This exception was due to the sale of intellectual property rights and technical know-how, which is a one-time revenue source.

Financial leverage looks good at 1.3

 Asset Turnover: Asset turnover ratio measures the company’s overall ability
to generate revenues with a given set of assets. This ratio has been decreasing for Cipla Ltd. It decreased from 0.87 in 2007 to 0.77 in 2010. A ratio of 0.77 or 77%means that the company generates Rs. 77 of revenue for every Rs.100 of average assets. A higher ratio indicates better efficiency

 Financial Leverage: Financial leverage measures the total amount of a
company’s assets relative to the equity capital. A higher ratio indicates better operational efficiency. Cipla Ltd. has shown a nearly consistent level of financial leverage with an average of 1.3. It can be expected to stay at a similar level.
Debt to equity remains at similar levels as reduction in long-term debt is substituted with increase in short-term debt.

 ROE: ROE measures the return a company generates on its equity capital. A

higher return indicates better profitability for the equity shareholders. Cipla has shown a disappointing ROE in spite of the sector doing well. The ROE has been decreasing and is at 18.3% as of 2010. No signs of revival are seen in the near future.

 Financial Risk Ratios  Debt to equity ratio: It measures the amount of debt capital relative to the

amount of equity capital. Due to a fluctuating debt structure, there is a fluctuating debt to equity ratio. The ratio currently stands at 0.39 in 2010. The effect of decreased long-term debt is offset by the high amount of shortterm debt issued.

 Debt ratio: The debt ratio measures the amount of company’s capital
contributed by debt. It totally depends on the company and the industry as different industries have different debt ratios. Cipla has a debt ratio of 0.28 as of 2010 i.e. 28% of the total capital is contributed by debt. The remaining 72% is contributed by equity.

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India

Sector Review

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 Interest coverage ratio: It is the number of times the company’s EBIT can
cover the interest payments. It is of primary interest to the creditors or suppliers. The interest ratio for Cipla is around 0.28, which has decreased considerably due to 99% debt repayment in 2010.

High cash inflow from operation , though unsustainable, follows the trend . High CapEx leads to high cash outflow through investments.

 Cash Flow Ratios  Cash Flow from Operations: Cash flow from operations has shown a
consistent increase with almost a 195% growth y-o-y basis in 2010. However, this growth is from one-time revenue generated and is not sustainable. Nevertheless, the cash inflow has been growing consistently.

 Cash Flow from Investments: Cash flow in investing activities has
Fluctuating financing cash flows due to uncertain and unstable debt structure.

consistently increased. One of the major reasons for this increased cash outflow is the high capital expenditure. One of the main reasons for this high capital expenditure is the construction of a new plant in Indore SEZ. Cipla has historically been a company with high capital expenditure and the same can be expected to happen in the near future with consistent growth in the demands.

 Cash Flow from Financing: Cipla Ltd has shown a fluctuating cash flow from

financing with a continuous issue and repayment of debts through the last 5 years. A huge fluctuation in the amount of short-term loan and long-term loans in 2010 brings uncertainty and unpredictability. With almost 99% debt repayment in the year 2010, Cipla is under-leveraged as far as the debt market is concerned and hence Cipla would be looking to tap the debt markets in the next few years.

 Relative Valuation analysis:
EBITDA, in line with its peers, is likely to increase due to operations at the Indore SEZ A Beta value of 0.32, below that of the industry at 0.75, attracts risk averse investors.

Cipla is the third largest company in the Indian pharmaceutical market based on revenues and the largest standalone domestic company.

The amount of long-term debt for Cipla reduced by 99% year-over-year to Rs.50.7 millions owing to the repayment of the loans during the financial year 2010. This is way below the average long-term debt of Rs. 18000 millions for its peer companies. To leverage this gap, Cipla may be expected to raise money from the debt market in the next two to three years.

EBITDA for Cipla, though in line with its peers, have reduced due to the cost incurred at Indore SEZ. Since the factory is expected to operate to full capacity within the next 12 months, Cipla looks well poised for higher revenues.

With a Beta value as low as 0.32, in contrary to the industry average of 0.75, Cipla scores over its peers and attracts risk-averse investors. However, the

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Competitors score over Cipla due to atleast 10 folds higher cash inhand.

India

Sector Review

09 May 2011

downside is the relatively low amount of returns which repels short-terms investors.

High cost of goods sold, a major concern for Cipla as it decreases the gross profit.

The imbalance in the ratio of total short term debt to total long term debt, places a huge question mark over Cipla’s strategy. The rival companies have a balanced ratio which makes them more stable and predictable.

High P/E ratio than its competitors might not attract common equity shareholders

Alarmingly low amount of Cash and cash equivalents are a huge concern. Cipla is facing a huge cash crunch and this might scare away short term investors as well as creditors. Cash as a percent of total assets is as low as 0.85% as against Ranbaxy’s 24%, Dr.Reddy’s 9.5% and Sun Pharma’s 10.5%. It is also way below industry average.

 Gross profit margins have increased 1% year-over-year to around 50%, but

its still below industry average and way below its rivals Ranbaxy, Dr. Reddy’s and Sun Pharma. Cipla is hugely banking on the operations at the Indore SEZ and its technology to increase the margin to industry standards.


Lack provisions for the alleged penalty of Rs. 11571 mn can hurt Cipla, if the case rules against them.

Cipla needs to improve drastically to reduce its cost of goods sold. It is stuck at around 50% of net sales as compared to Ranbaxy and Dr. Reddy’s 35% .Ranbaxy and Dr. Reddy’s show a very high gross profit margin owing to the reduced cost of goods sold. The cost-volume benefit comes in to picture here as the sales of Ranbaxy and Dr. Reddy’s are way higher than that of Cipla due to higher exports.

Cipla’s P/E ratio is on the higher side with only two of the eight competitor companies showing P/E higher than that of Cipla. Thus, the effects of higher COGS as well as lower EBITDA are directly reflected on the most common price multiple.

R & D expenses are difficult to estimate and may be modified

The fundamental strength of Cipla can be seen from its EV/EBITDA ratio, which stands at 18.09. It is slightly lower than the industry average of 18.83, which indicates it is under-valued with respect to the industry.

P/CF and P/BV pretty much highlight Cipla’s strong fundamentals and brings it on par with its competitors.

 Accounting Observations/ Gimmicks
The following are a few accounting observations noted from the way Cipla Ltd. Prepares and presents in financial statements in their annual reports.

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Financing costs for Cipla turns out to be very low which is practically not possible.

Cipla s facing a few pending legal cases on account of alleged overcharging in respect of certain drugs under the Drug Price Control Order. The aggregate amount of the demand notices received sums up to Rs.11571.2 million (inclusive of interest). The company has been eally advised that there is no probability of the demand becoming payable by the company. Hence, no provision was considered necessary. However, any unfacvourable outcome can have an adverse effect on the company. To be on the conservative side, a provision should be made regarding the same.

One of the main problems during reviewing the accounting policies and the nature of the expenses incurred is their reliability, especially in the case where companies are actively involved in the process of Research and Development.

Research expenses are the most difficult to estimate and justify. Cipla Ltd does not show adequate detailing of their expense on research and has made a head of ‘other research expenses’ and there are chances of it being manipulated. There have been cases in the past where companies have included the opportunity cost of the capital employed for research activities as the cost of research. Such a gimmick is carried out to inflate the expense on research and avail tax benefits.

The Indian Government, till financial year 2012, has allowed a weighted tax deduction of a 150% on the domestic expenses made on in-house research and development. To avail such benefits, companies do tend to modify these expenses

The management has valued inventories at the lower of cost and net realisable value. However, it has been a bit liberal in considering these items realisable at cost if the finished products in which they are used are expected to be sold above cost.

Interest cost for Cipla Ltd. turns out to be very low. It was just below 2.35% in 2006 and was around 4.86% in 2010. Such low interest costs are not practically possible.

Cipla Ltd. also doesn’t show a schedule or does not throw any light on how the interest costs are calculated, thereby adding to the confusion. It is not a net expense but a standalone interest expense.

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Sector Review

09 May 2011

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