Surya Pharmaceuticals

According to an old saying, either you succeed or you learn. In case of Surya Pharmaceuticals I learned. Attractive valuations when we consider ratios such as P/E (~2), P/OCF and P/B (~0.4) and then there are some red flags.

Business:

The company has presence in presence in API (Active Pharmaceutical Ingredient, 53% of business), Menthol (46% of business), formulations (1%, new business line) and organized retail in pharmaceutical (new segment). Entry into formulation seem to be motivated by the expected sale loss in US due to patent expiry of some key drugs over the next five year. Menthol segment is expected to be strong given the high demand (more than supply), capacity expansion and strong position of the company (added some key customers such as Colgate, etc). Progress on the organized retail front seems to be encouraging at least on the face of it from the readings from annual report. Formulation is expected to grow, which again is a story that is easy to digest. All in all from a business point of view everything sounds perfect.

However, MD&A doesn't say anything about potential threats. I don't know whether this is a standard practice or not, but that sounds like a red flag. Any business has to have some threats to it.

Operating Cash Flow:

Operating cash flow calculation methodology of the company has changed from IFRS (till 2009-10) to GAAP in the current year. Cash flow according to IFRS in current year is negative due to huge outflow of interest (around Rs 109 Crores). As most of this interest (around 70%) is the interest charge of working capital loan, this should be accounted for as operating cash flows (even if we argue according to the spirit of it). Also, there was no explanation provided for the change in standards. Again a red flag.

Inventory:

Another glaring factor in the company's annual results is the bloating inventory (mainly work in progress inventory). Inventory has been consistently been high over the past few year, however, particularly in 2011 there was a 70% increase in inventory levels. High inventory and in turn high working capital has lead company to take working capital loans (around 70% of the loans are working capital loans). Again throughout the report, management doesn't mention any reason for increase in inventory. A potential red flag.

Reporting standards of inventory are doubtful. The inventory has been "physically examined and certified by the management" - according to a CA friend (Anandh Sundar), this is a clear red flag. Auditors don't want to take any responsibility for the inventory. Inventory accounts for a major percentage of book value of the company. With a low equity base (~30%) any major impairment in inventory can wipe off the equity.

However, there is a positive here as well that the working capital loan is secured by current assets which includes inventory. Thus, there is a possibility that physical examination of inventory would have been done by the bank providing working capital loan.

Final Statement:

In the end, I will avoid this stock for now. Will wait for some more clarity on the books. All these red flags might not mean anything and it turns out to be a great stock, or the red flags might be true and this turns out to be a messy stock - I am not in a mood to take the chances when there are some other good opportunities. Hope to find another one soon !