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Dr. Reddy’s: High base effect - Views on News from Equitymaster

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Dr. Reddy’s: High base effect
Jan 25, 2008

Performance summary
  • Revenues decline by 19% YoY in 3QFY08 owing to the high base effect in 3QFY07, wherein the company generated revenues from the authorised generics deals and ‘Ondansetron’ exclusivity.

  • Excluding the impact of the authorised generics and ‘Ondansetron’ exclusivity, revenues have registered an 8% YoY growth in rupee terms.

  • With the exception of raw material costs, all other expenses (as percentage of sales) witness a rise leading to the 490 basis points (4.9%) contraction in EBDITA margins.

  • PAT falls by 41% YoY led by the fall in operating profits despite higher other income and lower interest and tax expenses.

Consolidated numbers
(Rs m) 3QFY07 3QFY08 Change 9mFY07 9mFY08 Change
Net sales 14,784 11,992 -18.9% 32,807 24,484 -25.4%
License fees and service income 162 291 79.5% 320 209 -34.8%
Expenditure 12,038 10,508 -12.7% 25,725 20,181 -21.6%
Operating profit (EBDITA) 2,908 1,774 -39.0% 7,402 4,512 -39.0%
EBDITA margin (%) 19.7% 14.8%   22.6% 18.4%  
Other income 269 378 40.3% 436 1,097 151.9%
Interest (net) 523 210 -60.0% 862 476 -44.8%
Depreciation 926 931 0.5% 1,675 1,969 17.5%
Profit before tax 1,727 1,011 -41.4% 5,300 3,164 -40.3%
Tax 672 389 -42.1% 1,090 190 -82.6%
Minority interest 0 3 625.0% 4 4 2.5%
Profit after tax/(loss) 1,056 626 -40.8% 4,214 2,978 -29.3%
Net profit margin (%) 7.1% 5.2%   12.8% 12.2%  
No. of shares (m) 167.8 168.1   167.8 168.1  
Diluted earnings per share (Rs)*         47.5  
Price to earnings ratio (x)*         12.9  
(* on a trailing 12-months basis)

What has driven performance in 3QFY08?
  • Dr. Reddy’s revenues in 3QFY08 exhibited a fall of 19% YoY. This was attributed to the supply constraints faced by Betapharm in Germany and more importantly the high base effect in 3QFY07 due to revenues from the authorised generics deals and ‘Ondansetron’ exclusivity, which were not present during the current quarter. Excluding the impact of authorised generics and the ‘Ondansetron’ exclusivity, revenues grew by 8% YoY in rupee terms. During the quarter, the API segment witnessed an 8% YoY growth in revenues on a consolidated basis led by the 17% YoY revenue growth in India. API sales in the international markets grew at a slower pace due to the high base effect (in 3QFY07, Dr. Reddy’s benefited from API sales of ‘Sertraline’ to Teva for which the latter had the exclusivity period).

  • Dr. Reddy’s revenues from the generics business (both the US and Europe) witnessed a 46% YoY decline during the quarter. This was largely due to the high base effect on the back of the authorised generics deals (for ‘Simvastatin’ and ‘Finasteride’) and the exclusivity for ‘Ondansetron’ in 3QFY07 in the US. Excluding this impact, revenues from the US generics market clocked an impressive 69% YoY growth. In Europe, revenues fell by 20% YoY during the quarter largely due to a subdued performance by Betapharm in Germany. Betapharm reported a 26% YoY dip in revenues and was impacted by the adjustment of rebate payments to insurance companies from revenues in 3QFY08, ongoing supply constraints, YoY decline in prices and appreciation of the rupee against the Euro. In order to combat supply constraints, Dr. Reddy’s is in the process of transferring products to India, which will also translate into cost savings going forward.

    Consolidated business snapshot
    (Rs m) 3QFY07 3QFY08 Change 9mFY07 9mFY08 Change
    APIs 2,729 2,936 7.6% 7,944 8,793 10.7%
    - India 482 566 17.4% 1,609 1,804 12.1%
    - International 2,247 2,370 5.5% 6,335 6,989 10.3%
    Branded Formulations 3,388 3,854 13.8% 10,198 11,720 14.9%
    - India 1,723 1,992 15.6% 5,356 6,068 13.3%
    - International 1,665 1,862 11.8% 4,842 5,652 16.7%
    Generics 7,682 4,174 -45.7% 26,532 12,813 -51.7%
    - US 4,640 1,744 -62.4% 17,981 5,636 -68.7%
    - Europe 3,042 2,430 -20.1% 8,551 7,177 -16.1%
    Custom Pharmaceutical Services 1,569 1,279 -18.5% 4,655 3,456 -25.8%
    - Organic business 368 456 23.9% 780 1,171 50.1%
    - Mexico 1,201 823 -31.5% 3,875 2,285 -41.0%
    Others 67 78 16.4% 194 226 16.5%
    Total 15,435 12,321 -20.2% 49,523 37,008 -25.3%

  • In the formulations segment, Dr. Reddy’s international sales grew by a decent 12% YoY on a consolidated basis, driven by strong performances of Russia and the CIS markets. As far as the domestic business is concerned, revenues from the same grew by 16% YoY driven by key brands namely ‘Omez’, ‘Stamlo’, ‘Beta’, ‘Atocor’ and ‘Razo’ and the launch of ‘Reditux’. Revenues from the custom manufacturing business declined by 19% YoY due to the 31% YoY fall in revenues from the Mexican business. This was attributed to the softening of demand for a key product ‘Naproxen’ due to piling up of inventories with the customers and hence the volume growth was not as high as in the corresponding quarter last year. The organic business reported a robust 24% YoY growth and capped the decline in revenues from the overall custom manufacturing business.

  • Margins contracted by 490 basis points (4.9%) during the quarter. With the exception of raw material costs, all other expenses witnessed increases (as percentage of sales). Raw material costs were lower due to the absence of authorised generics this quarter, as they enjoy lower gross margins. Both R&D and SG&A expenses (as percentage of sales) witnessed a rise. Besides an increase in the gross R&D spend, the reimbursements under its R&D partnerships were much lower this quarter than what it was in 3QFY07. A 39% YoY drop in operating profits led to the 41% YoY dip in net profits despite the higher other income and lower interest and tax expenses. The company also reported additional amortization of certain product related intangible assets at Betapharm of Rs 2.4 bn during the quarter, which further pressurized profits.

What to expect?
At the current price of Rs 552, the stock is trading at a multiple of 11.5 times our estimated FY10 earnings. Going forward, 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. The company is focusing on building a strong pipeline in the US market with the aim of launching around 6 to 8 products in this market every year. The company aims to have at least one 180-day exclusivity every year going forward. However, due to the uncertainty of the same, we have not factored the same in our revenue estimates. Besides this, the company is increasing its focus on biologicals as they attract higher margins due to lesser competition and complexity in manufacture.

As regards Betapharm, the company is expected to face difficult conditions in the medium term due to regulatory changes in the German market and supply constraints. But, in the long-term, Betapharm is expected to boost Dr. Reddy’s presence in the European region. The company’s financials for 9mFY08 are lower than our estimates and we shall have to downgrade our numbers for the full year accordingly. We shall soon update our research report on the company.

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