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Dr.Reddy’s: Stellar performance - Views on News from Equitymaster
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Dr.Reddy’s: Stellar performance
Jan 24, 2006

Performance summary
Dr. Reddy’s has announced robust results for the third quarter and nine-month period ended December 2005. The topline has grown at a healthy double-digit pace led by its active pharmaceutical ingredients (API) and branded formulations business. Decrease in R&D expenditure on the back of partnership with ICICI Venture has aided margins. This, coupled with a significant rise in other income, has percolated down to the bottomline, which has recorded a superlative growth.

Standalone numbers
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net sales 3,686 4,756 29.0% 12,021 15,078 25.4%
Expenditure 3,621 4,192 15.8% 11,092 12,439 12.1%
Operating profit (EBDITA) 65 564 764.7% 929 2,640 184.0%
EBDITA margin (%) 1.8% 11.9%   7.7% 17.5%  
Other income 151 566 275.7% 510 1,038 103.6%
Interest (net) 19 47 143.0% 82 122 49.3%
Depreciation 245 283 15.5% 674 816 21.1%
Profit before tax (48) 801   683 2,739 300.8%
Tax (91) 258   (60) 488  
Profit after tax/(loss) 43 543 1150.0% 744 2,251 202.6%
Net profit margin (%) 1.2% 11.4%   6.2% 14.9%  
No. of shares (m) 76.5 76.5   76.5 76.5  
Diluted earnings per share (Rs)*         28.3  
Price to earnings ratio (x)*         36.8  
(* trailing twelve months)            

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 is the first from India to get an Exclusive Marketing Right (EMR) in the US market for Fluoxetine Axetil. The company exports bulk drugs, branded and generic formulations to over 60 countries. Active Pharmaceutical ingredients (API's) constituted 39% of the company's business in 9mFY06. Formulations business is another big contributor to revenues (47%). The generics business in regulated markets formed 11% of total revenues in 9mFY06. The rest came from diagnostic, critical care and biotechnology businesses.

Consolidated numbers
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net sales 4,407 5,572 26.5% 14,331 16,567 15.6%
License fees and service income - 4   - 47  
Expenditure 4,309 4,882 13.3% 13,207 14,077 6.6%
Operating profit (EBDITA) 98 695 611.1% 1,124 2,537 125.8%
EBDITA margin (%) 2.2% 12.5%   7.8% 15.3%  
Other income 149 630 322.3% 448 1,014 126.6%
Interest (net) 22 49 123.5% 88 131 49.1%
Depreciation 332 379 14.2% 922 1,081 17.3%
Profit before tax (107) 896   563 2,341 316.0%
Tax (70) 259   (24) 488  
Minority interest 2 (1)   11 1 -93.6%
Profit after tax/(loss) (35) 637   598 1,853 210.1%
Net profit margin (%) -0.8% 11.4%   4.2% 11.2%  
No. of shares (m) 76.5 76.5   76.5 76.5  
Diluted earnings per share (Rs)*         23.1  
Price to earnings ratio (x)*         47.3  
(* trailing twelve months)            

What has driven performance in 3QFY06?
Scorching revenue growth: Dr. Reddy’s revenues clocked an impressive 27% YoY growth during the quarter on a consolidated basis, led by a 60% YoY growth of the API business. Sales from Europe increased by 78% YoY primarily driven by sales of ‘montelukast’, ‘terbinafine’ and ‘omeprazole’. Domestic API sales grew by 50% YoY. However, North American API sales declined by 6% YoY mainly on account of decline in sales of ‘ranitidine hydrochloride’. Pressure in the US markets was despite higher sales of ‘naproxen’ and ‘sertraline’. Other international API sales grew by 85% YoY driven by the Turkish, Mexican, Bangladeshi and Chinese markets.

Standalone business snapshot
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
APIs and Intermediates 1,370 2,190 59.9% 4,926 6,375 29.4%
PBIT margin (%) -8.8% 13.3%   4.3% 12.2%  
Formulations 1,838 2,643 43.8% 5,943 7,728 30.0%
PBIT margin (%) 29.9% 43.4%   36.5% 40.2%  
Generics 613 442 -28.0% 1,643 1,783 8.5%
PBIT margin (%) -14.4% -7.8%   1.9% 7.2%  
Critical Care and Biotechnology 135 148 9.3% 335 447 33.4%
PBIT margin (%) -26.1% 1.8%   -3.9% 10.9%  
Drug discovery 0 1   1 2  
Total gross revenues 3,956 5,423 37.1% 12,847 16,334 27.1%
PBIT margin (%) 0.9% 21.7%   11.6% 21.0%  

As far as formulations are concerned, domestic formulations revenues grew by 34% YoY, led by a strong growth in its top brands, in particular ‘Nise’ and ‘Omez’. The company also launched eight new products during the quarter. International formulations (excluding US and Europe) grew by 33% YoY led by strong performance in the markets of Russia, CIS, Romania, South Africa and UAE.

On the generics front, revenues from Europe increased by 10% YoY due to strong volume growth witnessed in its products ‘omeprazole’ and ‘amlodipine maleate’. However, North American generics continued to face the brunt of severe pricing pressure. Revenues from this region declined by 26% YoY on the back of pricing pressure witnessed in its key product ‘fluoxetine’. This was despite the launch of ‘glimepiride’, which contributed revenues to the tune of Rs 66 m.

Sharp margin expansion: Margins during the quarter witnessed a considerable improvement. There are two factors to be taken into account. One is due to a low base effect (the company had a very difficult FY05). The other is mainly due to sharp fall in its R&D expenditure. It must be noted that the company had entered into an agreement with ICICI Venture, wherein the latter would fund the ANDAs filed by the company during FY06. R&D expenditure also reduced due to lower spend in generics. Selling, general and administrative (SG&A) expenses, however, increased due to higher marketing and legal expenses incurred during the quarter.

Cost break-up (Consolidated)
(as % of sales) 3QFY05 3QFY06 9mFY05 9mFY06
Raw material 32.7% 34.4% 32.8% 34.0%
Staff cost 16.6% 14.1% 15.0% 13.9%
R&D expenses 14.6% 7.3% 11.8% 7.2%
Selling expenses 11.8% 12.9% 10.3% 11.7%
Other expenditure 22.0% 18.8% 22.2% 18.2%
Total 97.8% 87.6% 92.2% 85.0%

Surge in bottomline: A strong topline growth and operating margin improvement contributed to the superlative bottomline growth. The bottomline also received a boost due to the other income component. This included profit to the tune of Rs 388 m, which the company received on the sale of its formulations plant in Goa.

Quarterly trend
(%) 2QFY05 3QFY05* 4QFY05* 1QFY06 2QFY06 3QFY06
Net sales growth 0.1% -9.4% -10.3% 27.8% 20.1% 29.0%
Operating profit margin 13.3% 2.2% -4.4% 17.5% 23.2% 11.9%
Net profit growth -47.7% - - 105.2% 176.2% 1150.0%
* Net loss in these quarters

What to expect?
At the current price of Rs 1,041, the stock is trading at a price to earnings multiple of 43.2 times our estimated FY08 earnings, which is at the higher end of our valuation spectrum. The company has come back strongly in the current fiscal so far after a tough and challenging FY05. The partnership with ICICI Venture has reaped benefits, which has consequently eased the pressure on the company. The considerable drop in R&D expenditure is testimonial to the fact. The company, besides investing in high-risk Para IV filings, is also focusing on relatively less risky Para III filings, which is a positive. Besides this, the company is planning to make significant strides in the speciality segment, which have higher margins and custom manufacturing, which will ensure a steady revenue stream. As far as the latter is concerned, Dr. Reddy’s recently acquired Roche’s contract manufacturing facility in Mexico to scale up this business. As far as the generics market is concerned, the company has planned the launch of minimum six products in FY07.

Dr. Reddy’s also formed ‘Perlecan Pharma Pvt. Ltd’ by roping in ICICI Venture and Citigroup Venture Capital. The formation of this company will be beneficial to the company in the sense that it will mitigate the risks and costs associated with clinical development of the molecules, consequently leading to an improvement in its margins going forward. Therefore, we are positive about the growth prospects of the company from a long-term perspective. After a strong 9mFY06 performance, we will have to upgrade our numbers. Having said that, we believe that despite the above-mentioned positives, valuations at the current levels appear stretched.

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