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Dr. Reddy’s: All round growth! - Views on News from Equitymaster
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Dr. Reddy’s: All round growth!
Jan 22, 2007

Performance summary
Dr. Reddy’s has announced strong results for the third quarter and nine-month ended December 2006. The robust topline growth during the quarter has been attributed to revenues from acquisitions, authorised generics revenues from ‘Proscar’ and ‘Zocor’, 180-day exclusivity received for ‘Zofran’ and growth in its core businesses. Operating margins have considerably expanded on the back of reduction in almost all costs (as a percentage of sales) excluding raw material costs. All these factors have contributed to the 66% YoY growth in bottomline despite the surge in interest costs.

Consolidated numbers
(Rs m) 3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
Net sales 5,572 14,784 165.3% 16,567 47,591 187.3%
License fees and service income 4 162 3950.0% 47 482 919.0%
Expenditure 4,882 12,038 146.6% 14,077 37,763 168.3%
Operating profit (EBDITA) 695 2,908 318.6% 2,537 10,310 306.3%
EBDITA margin (%) 12.5% 19.7%   15.3% 21.7%  
Other income 630 269 -57.3% 1,014 705 -30.5%
Interest (net) 49 523 959.3% 131 1,385 961.6%
Depreciation 379 926 144.6% 1,081 2,602 140.8%
Profit before tax 896 1,727 92.7% 2,341 7,028 200.3%
Tax 259 672 159.8% 488 1,762 260.9%
Minority interest (1) 0   1 4 528.6%
Profit after tax/(loss) 637 1,056 65.8% 1,853 5,271 184.4%
Net profit margin (%) 11.4% 7.1%   11.2% 11.1%  
No. of shares (m) 76.7 153.4   76.7 153.4  
Diluted earnings per share (Rs)*         31.8  
Price to earnings ratio (x)*         25.5  
(* on a trailing 12-months basis)

What is the company’s business?
Dr. Reddy's Laboratories is a leading pharmaceutical company in the country, having a presence across the pharmaceutical value chain - basic research, finished dosages, generics, bulk actives, biotechnology and diagnostics. The company was the first from India to get an Exclusive Marketing Right (EMR) in the US market for Fluoxetine Axetil. Active Pharmaceutical ingredients (API's) constituted 39% of the company's business, while formulations contributed 44% to revenues in FY06. The generics business in regulated markets formed 10% of total revenues. The rest came from custom pharmaceutical services and critical care and biotechnology businesses. In 2005, the company formed India’s first integrated drug research company Perlecan Pharma for the purpose of conducting clinical trials on its NCE assets.

What has driven performance in 3QFY07?
Authorised generics, acquisitions drive topline: The robust 165% YoY growth in topline was a result of good growth across all its businesses namely, APIs, generics, domestic and international formulations and custom manufacturing.
  • API: The API segment witnessed a 29% YoY growth on a consolidated basis led by 34% YoY revenue growth in Europe (driven by ‘Sertraline’ and ‘Sumatriptan’) and 62% YoY revenue growth in the rest of the world markets (driven by ‘Sertraline’). API revenues from North America also registered a 39% YoY growth mainly driven by ‘Sertraline’ supplies to Teva during the latter’s 180-day exclusivity period. However, API revenues from India declined by 20% YoY primarily on account of decline in volumes of key products.

  • Generics: The generics business witnessed strong growth during the quarter with contribution from both the US and Europe. In the US, growth was primarily driven by the launch of ‘Fexofenadine’ (Allegra), which saw limited competition even after the lapse of the 180-day exclusivity awarded to US-based Barr Laboratories. This product generated revenues to the tune of Rs 479 m (3% of total sales) during the quarter. However, it must be noted that while there was no competition from newer players for this product, revenues for the quarter were lesser than that recorded in 2QFY07 due to increased competition from existing players. Besides this, the authorised generics (AG) deal that Dr. Reddy’s had signed with the innovator Merck for two of its products – ‘Finasteride’ (Proscar) and ‘Simvastatin’ (Zocor) also played a significant role in propelling revenues. Since the 180-day exclusivity was granted to Teva (for Proscar) and Teva and Ranbaxy (for Zocor), Dr. Reddy’s was also able to benefit from this exclusivity period. Revenues from these authorised generics contributed 23% to revenues in 3QFY07. Investors should note that with the exclusivity period expiring for both these products, prices of these drugs have significantly declined with the advent of more generic competition. Besides, revenues from these AG deals will not be reflected in Dr.Reddy’s revenues from 4QFY07 onwards. Having said that, the company has received US FDA approval for the launch of all the strengths of ‘Simvastatin’, which the company will now manufacture on its own.

    Another significant development during the quarter was the grant of the 180-day exclusivity to Dr.Reddy’s for the drug ‘Ondansetron’ (or ‘Zofran’). The drug was launched in the generics market on Dec 26 generating revenues to the tune of Rs 223 m for the quarter. Dr.Reddy’s has garnered 55% market share for ‘Ondansetron’ despite the presence of an authorised generic (Sandoz), which is commendable. However, the full impact of this drug’s revenues will be reflected in the 4QFY07 and 1QFY08 numbers. During the quarter, Dr.Reddy’s filed 5 ANDAs and received approval for 4 ANDAs. As at the end of December 2006, the total ANDAs pending approval (including tentative) stood at 58.

    In Europe, revenue growth from generics was driven by contribution from Betapharm (the German company acquired in February 2006). Betapharm clocked a 4% QoQ growth contributing 18% to total sales during the quarter. After the regulatory changes introduced by the German government, while pricing pressure continued, Betapharm was able to record growth in volumes. That said, if one were to exclude Betapharm’s revenues, then revenues from the European region grew by 7% YoY. In the European region, Dr.Reddy’s has a strong presence in Germany (through Betapharm), UK and a marginal presence in Spain.

    Standalone business snapshot
    (Rs m) 3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
    APIs and Intermediates 2,190 3,002 37.1% 6,375 8,640 35.5%
    PBIT margin (%) 13.3% 25.1%   12.2% 19.2%  
    Formulations 2,643 2,913 10.3% 7,728 9,302 20.4%
    PBIT margin (%) 43.4% 31.0%   40.2% 36.0%  
    Generics 442 5,458 1136.0% 1,783 9,309 422.1%
    PBIT margin (%) -7.8% 80.5%   7.2% 70.9%  
    Critical Care and Biotechnology 148 168 13.8% 447 551 23.5%
    PBIT margin (%) 1.8% -15.1%   10.9% -5.6%  
    Custom Pharmaceuticals Services 35 765 2098.9% 155 2,674 1627.6%
    PBIT margin (%) -101.1% 44.9%   -32.2% 21.2%  
    Drug discovery 1 30   2 92 4515.0%
    Total gross revenues 5,457 12,336 126.0% 16,489 30,569 85.4%
    PBIT margin (%) 21.0% 50.0%   20.5% 37.7%  
  • Formulations: In the formulations segment, international sales grew by 18% YoY on a consolidated basis, driven by strong performances of Russia, CIS and the Central and Eastern European (CEE) markets. While revenues from Russia grew by 18% YoY, revenues in the CIS and CEE markets registered a 19% YoY and a 60% YoY growth respectively. Domestic formulations revenues grew by 18% YoY driven by its key brands ‘Omez’, ‘Nise’ and ‘Razo’.

  • Custom manufacturing (CPS): Revenues from the custom manufacturing business witnessed significant traction due to the revenue contribution (8% of total sales) from the acquisition of Roche’s manufacturing facility in Mexico. Revenues from this facility crossed the US$ 100 m mark, which Dr.Reddy’s had projected for FY07. Excluding this acquisition, revenues from this business grew by a strong 267% YoY due to growth in its customer base and product portfolio.

Sharp margin expansion: Margins expanded by 720 basis points during the quarter, largely driven by a steep fall in R&D expenditure and other expenditure (as a percentage of sales). Raw material costs, however, witnessed a considerable rise due to increase in contribution from authorised generics. It must be noted that authorised generic players cannot manufacture the generic product on their own but instead have to purchase the same from the innovator company, thereby leading to a rise in raw material costs. The fall in R&D expenditure was on the back of benefits from its R&D partnership with ICICI Venture for reimbursement of expenses incurred for the filing of ANDAs in the US and also for reimbursement of expenses from Perlecan Pharma for its NCE research.

Cost break-up (Consolidated)
(as % of sales) 3QFY06 3QFY07 9mFY06 9mFY07
Raw material 34.4% 45.8% 34.0% 46.4%
Staff cost 14.1% 11.0% 13.9% 10.0%
R&D expenses 7.3% 4.7% 7.2% 3.5%
Selling expenses 12.9% 7.7% 11.7% 7.9%
Other expenditure 18.8% 12.2% 18.2% 11.6%

Bottomline story: While the bottomline growth was robust at 66% YoY, it was nevertheless slower than the growth in operating profits due to a sharp rise in interest costs. It must be noted that Dr. Reddy’s had obtained a long-term loan for funding the acquisition of Betapharm, which had led to higher interest charges. Reduction in other income, higher depreciation charges and tax outgo also played a role in the relatively slower bottomline growth.

Quarterly trend
(%) 2QFY06 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07
Net sales growth 7.0% 26.5% 71.2% 148.4% 246.5% 165.3%
Operating profit margin 20.3% 12.5% 7.7% 18.9% 25.1% 19.7%
Net profit margin 16.2% 11.4% -5.6% 9.6% 15.0% 7.1%

What to expect?
At the current price of Rs 810, the stock is trading at a price to earnings multiple of 17.0 times our estimated FY09 earnings. Going forward, the AG deals for ‘Simvastatin’ and ‘Finasteride’ in the US market will no longer drive growth from 4QFY07 onwards. In such a scenario, Dr.Reddy’s focus on a stronger product flow in the US, growth in Betapharm, custom manufacturing business and other core businesses will be the key long-term drivers. As regards Betapharm, while the company is likely to face pricing pressure in the medium term due to regulatory changes in the German market, in the long-term, Betapharm is expected to boost Dr.Reddy’s presence in the European region. The formation of Perlecan Pharma will mitigate the risks and costs associated with clinical development of the molecules, consequently leading to an improvement in its margins going forward. We maintain our ‘HOLD’ recommendation on the stock.

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