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Dr Reddy's: A year to forget!

May 16, 2005

Performance summary
Domestic pharmaceutical major, Dr. Reddy's, declared its FY05 results recently. The year was full of disappointments for the pharma major. On a consolidated basis, the company finished the year with a 5% revenue dip. But profits got pummeled by 87% YoY, on the back of a sharp shrinkage in operating margins.

Consolidated numbers
(Rs m) FY04 FY05 Change
Net sales 19,334 18,359 -5.0%
License Fees and Service income 0 62 -
Expenditure 16,471 17,575 6.7%
Operating profit (EBDITA) 2,863 846 -70.5%
Operating profit margin (%) 14.8% 4.6%  
Other income 894 657 -26.5%
Interest 19 108 468.9%
Depreciation 1,025 1,256 22.5%
Profit before tax 2,713 139 -94.9%
Tax 202 (181) -
Minority interest 3 10 -
Profit after tax/(loss) 2,515 329 -86.9%
Net profit margin (%) 13.0% 1.8%  
No. of shares (m) 76.5 76.5  
Diluted earnings per share (Rs) 32.9 4.3  
P/E ratio (x)   155.3  

What's the company's business?
Dr. Reddy's Laboratories is a leading pharmaceutical company in the country, which is present in the entire pharmaceutical chain - basic research, finished dosages, generics, bulk actives, biotechnology and diagnostics. The company has filed 64 patents and is the first Indian company to out license a molecule for clinical trial. The company is also the first company from India to get an Exclusive Marketing Right (EMR) in the US market for Fluxotine Axetil. The company exports bulk drugs, branded and generic formulations to over 60 countries. Active Pharmaceutical ingredients (API's) constituted 40% of the company's business in FY05. Formulations business is another big contributor to revenues (44%). Its generics business in regulated markets contributed 13% and the rest comes from diagnostic, critical care and biotechnology business. The company is passing through a rough phase over the last few quarters, where profitability and sales growth have come under pressure.

Standalone numbers
(Rs m) 4QFY04 4QFY05 Change FY04 FY05 Change
Net sales 3,969 3,560 -10.3% 16,666 15,577 -6.5%
License Fees and Service income 0 14 - 0 17 -
Expenditure 4,164 3,731 -10.4% 13,658 14,823 8.5%
Operating profit (EBDITA) (195) (158) - 3,008 771 -74.4%
Operating profit margin (%) -4.9% -4.4%   18.0% 5.0%  
Other income 159 187 17.5% 757 696 -8.0%
Interest 6 18 185.1% 15 100 572.8%
Depreciation 201 251 24.8% 717 925 28.9%
Profit before tax (243) (240) - 3,033 444 -85.4%
Tax (351) (152) - 202 (211) -
Profit after tax/(loss) 108 (88) - 2,832 655 -76.9%
Net profit margin (%) 2.7% -2.5%   17.0% 4.2%  
No. of shares (m) 76.5 76.5   76.5 76.5  
Diluted earnings per share (Rs)* 5.6 (4.6)   37.0 8.6  
P/E ratio (x)         78.2  
(* annualised)            

What has driven performance in FY05?
Revenues:  The company's standalone revenues declined by over 10% during the March quarter, largely owing to the VAT and excise based MRP related concerns. While the company's API sales were down 9%, formulations too fell by 17% YoY during the quarter. The decline in international revenues from API was a factor of decline in revenues from the European market, due to lower sales of 'Ramipril', which saw tough generic competition, and price decline.

Standalone business snapshot
(Rs m) 4QFY04 4QFY05 Change FY04 FY05 % change
APIs and Intermediates 1,847 1,679 -9.1% 7,497 6,604 -11.9%
PBIT margin (%) 16.0% 5.1%   16.5% 4.5%  
Formulations 1,735 1,440 -17.0% 7,118 7,383 3.7%
PBIT margin (%) 22.3% 16.9%   34.8% 32.7%  
Generics 444 562 26.6% 2,529 2,205 -12.8%
PBIT margin (%) -21.0% 9.1%   27.9% 3.7%  
Critical Care and Biotechnology 94 127 34.9% 356 462 29.6%
PBIT margin (%) -10.0% -21.3%   -5.3% -8.7%  
Drug Discovery 3 0 -97.6% 4 1 -78.9%
PBIT margin (%) - -   - -  
Total gross revenues 4,122 3,808 -7.6% 17,505 16,655 -4.9%
PBIT margin (%) 6.6% 4.6%   20.3% 10.0%  

However, the company's generic sales recorded a turnaround, growing by 27% during the quarter. For the full year FY05, generic sales were actually down nearly 13% YoY. This drop in sales can largely be attributed to intense competition in the US market. Also, sales of Fluxotine, and Tizinadine, which were the mainstay of the company in the US market, saw a decline, as new players launched generic versions of their own. The company has not got any Para IV success after the initial success of Fluxotine. Lack of new launches has also added to the woes of the company. But the improvement in the March quarter is an encouraging sign. Apart from this, continued strength in the company's critical care and biotechnology business was also a positive.

Operating margins:  The lacklustre topline performance has led to an even worse bottomline performance. The operating margin of the company has come down from 18% in FY04 to 5% in FY05 (standalone). The major reason for this is higher other expenses and increase in R&D expenses. The R&D expenses of the company have grown by almost by 27% and are now nearly 16% of revenues. The increased R&D expenses are due to the clinical trials of one of its molecules, which the company has initiated recently. Also, intense activity on ANDA front has led to the increased spending. Lacklustre topline growth has led to this skewness in terms of expenses.

Cost break-up(Standalone)
as % of revenues 4QFY04 4QFY05 FY04 FY05
Raw material cost 36.4% 35.1% 34.9% 34.9%
Excise duty 0.8% 0.5% 0.3% 0.6%
R&D expenses 15.6% 16.2% 11.5% 15.5%
Personnel costs 10.7% 13.2% 9.2% 11.7%
Selling expenses 14.7% 13.9% 10.2% 12.0%
Provision for decline in the value ofinvestments 8.7% 4.0% 2.1% 1.5%
Other expenditure 18.1% 21.4% 13.8% 18.8%
Total expenditure 104.9% 104.4% 82.0% 95.1%

Net profit:  Owing to the woes in topline, as well as in operating margins, the net profit of the company was down by 77% YoY on a standalone basis and by 87% on a consolidated basis in FY05. However, lower taxes on account of tax exemption due to higher R&D expenses and new bulk drugs facility in tax-exempted area has cushioned further slide in bottomline.

What to expect?
At Rs 669, the stock is trading at 155 times its consolidated FY05 earnings. The last five quarters for the company have been very poor, both due to higher base effect, as well as investments made by the company on R&D front, and sales and distribution front. Off late, the company has changed its high-risk strategy of Para IV filings (to some extent) and is now considering other options such as entering into the specialty segment. As a result of its current efforts on the R&D and sales/distribution front, its long term prospects are likely to improve. Also, it has tied up with ICICI Venture in a bid to fund its risky R&D strategy. This will benefit it in the long run.

But in our view, things will get better slowly and investors need to avoid taking fresh exposure in the stock. In our view, Cipla is a better visible story at the current juncture.

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