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Dr. Reddy’s: An unforgettable year! - Views on News from Equitymaster

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Dr. Reddy’s: An unforgettable year!

May 18, 2007

Performance summary
Dr. Reddy’s has announced strong results for the fourth quarter and full year ended March 2007. The robust topline growth during the year has been attributed to revenues from acquisitions, authorised generics revenues from ‘Proscar’ and ‘Zocor’, 180-day exclusivity received for ‘Zofran’, limited competition and hence higher revenues from ‘Allegra’ and growth in its core businesses. Operating margins have considerably expanded on the back of reduction in almost all costs (as percentage of sales) excluding raw material costs. All these factors have contributed to the superlative growth in the bottomline despite the surge in interest costs.

Consolidated numbers
(Rs m) 4QFY06 4QFY07 Change FY06 FY07 Change
Net sales 6,899 16,755 142.9% 23,466 64,346 174.2%
License fees and service income 114 428 276.5% 161 910 465.4%
Expenditure 6,481 10,939 68.8% 20,558 48,701 136.9%
Operating profit (EBDITA) 532 6,245 1074.9% 3,069 16,555 439.4%
EBDITA margin (%) 7.7% 37.3%   13.1% 25.7%  
Other income 191 457 139.0% 1,206 1,162 -3.6%
Interest (net) 514 141 -72.6% 644 1,526 136.9%
Depreciation 536 1,190 121.8% 1,617 3,791 134.5%
Profit before tax (327) 5,371   2,013 12,399 515.9%
Tax 58 982 1598.8% 546 2,744 402.6%
Minority interest (1) (1)   (0) 4  
Profit after tax/(loss) (386) 4,388   1,467 9,659 558.3%
Net profit margin (%) -5.6% 26.2%   6.3% 15.0%  
No. of shares (m) 76.7 167.9   76.7 167.9  
Diluted earnings per share (Rs)*         57.5  
Price to earnings ratio (x)*         11.7  
(* 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 FY07?
Authorised generics, acquisitions drive topline: The robust 174% 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: During the year, the API segment witnessed a 44% YoY growth on a consolidated basis led by the 47% YoY revenue growth in Europe (driven by ‘Sertraline’, ‘Finasteride’, ‘Losartan’ and ‘Ramipril’) and 93% YoY revenue growth in rest of the world markets (driven by ‘Sertraline’, ‘Rabeprazole’ and ‘Clopidogrel’). API revenues from North America also registered a 18% YoY growth mainly driven by the increase in sales of new products as well as key commercialized products such as ‘Sertraline’ and Naproxen’. However, API revenues from India declined by 10% YoY owing to decrease in sales of quinolones (type of anti-infectives) on the back of significant decline in prices.

  • Generics: Dr. Reddy’s generics business witnessed strong growth during the year 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 2.4 bn (5% of total sales) during the year. 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 33% to revenues in FY07 (Rs 15.8 bn). Investors should note that the exclusivity period expired for both these products in December 2006. Having said that, following the US FDA approval, the company has now launched all the strengths of ‘Simvastatin’ in the US market.

    Another significant development during the year 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 December 26 2006 generating revenues to the tune of Rs 2.9 bn during the fiscal. Dr. Reddy’s has garnered 55% market share for ‘Ondansetron’ despite the presence of an authorised generic (Sandoz), which is commendable. Revenues from this drug will also be reflected in the 1QFY08 numbers. During the year, Dr. Reddy’s filed 33 ANDAs and received approval for 19 ANDAs (including tentative approvals). At the end of December 2006, the total ANDAs pending approval stood at 69, addressing innovator sales of US$ 57 bn.

    In Europe, revenue growth from generics was driven by contribution from Betapharm (the German company acquired in February 2006), which contributed 17% to total sales during the year. 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 declined by 11% YoY owing to the significant decline in the prices of ‘omeprazole’ and ‘amlodipine’.

    Standalone business snapshot
    (Rs m) 4QFY06 4QFY07 Change FY06 FY07 Change
    APIs and Intermediates 2,161 4,470 106.8% 8,536 13,109 53.6%
    PBIT margin (%) 3.1% 34.2%   9.9% 24.3%  
    Formulations 2,103 2,911 38.4% 9,831 12,213 24.2%
    PBIT margin (%) 22.9% 29.3%   36.5% 34.4%  
    Generics 423 2,455 480.7% 2,206 11,763 433.4%
    PBIT margin (%) -78.5% 45.6%   -9.2% 65.6%  
    Critical Care and Biotechnology 141 195 38.6% 587 747 27.1%
    PBIT margin (%) -51.1% 6.6%   -4.0% -2.4%  
    Custom Pharmaceuticals Services 841 1,474 75.3% 996 4,149 316.7%
    PBIT margin (%) -6.5% 27.7%   -10.5% 23.5%  
    Drug discovery 0 46   2 138 6481.0%
    Total gross revenues 5,669 11,550 103.8% 22,158 42,119 90.1%
    PBIT margin (%) 0.9% 32.2%   15.5% 36.2%  

  • Formulations: In the formulations segment, Dr. Reddy’s international sales grew by 24% YoY on a consolidated basis, driven by strong performances of Russia, Romania, Venezuela and the CIS markets. While revenues from Russia grew by 35% YoY, revenues from the CIS and CEE (Central & Eastern Europe) markets registered a 35% YoY and a 46% YoY growth respectively. Domestic formulations revenues grew by 16% YoY driven by its key brands ‘Omez’, ‘Nise’, ‘Stamlo’ and ‘Razo’.

  • Custom manufacturing (CPS): Revenues from the custom manufacturing business witnessed significant traction due to the revenue contribution (11% of total sales) from the acquisition of Roche’s manufacturing facility in Mexico. Revenues from this facility crossed the US$ 100 m mark during the year, which Dr. Reddy’s had projected for FY07. Excluding this acquisition, revenues from this business grew by a strong 130% YoY during the year due to growth in its customer base and product portfolio.

Sharp margin expansion: Margins expanded by 1260 basis points (12.6%) during the year, largely driven by a steep fall in R&D expenditure and selling and other expenditure (as percentage of sales). The sharp margin expansion was all the more pronounced in the fourth quarter largely due to the 180-day exclusivity for ‘Ondansetron’, which enabled the company to earn higher gross margins. However, for the full year, raw material costs witnessed a considerable rise due to the 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) 4QFY06 4QFY07 FY06 FY07
Raw material 37.8% 32.6% 35.1% 42.8%
Staff cost 17.4% 10.1% 14.9% 10.0%
R&D expenses 7.9% 4.7% 7.4% 3.8%
Selling expenses 12.4% 6.2% 11.9% 7.4%
Other expenditure 18.4% 11.7% 18.3% 11.6%

Bottomline bloats: The bottomline grew at a much stronger pace than the topline during the year registering a superlative 558% YoY rise despite the higher interest charges. Dr. Reddy’s had obtained a long-term loan for funding the acquisition of Betapharm, which led to the higher interest charges. Thus, it was the huge expansion in the operating margins that was largely responsible for the strong growth in the bottomline.

Quarterly trend
(%) 3QFY06 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07
Net sales growth 26.5% 71.2% 148.4% 246.5% 165.3% 142.9%
Operating profit margin 12.5% 7.7% 18.9% 25.1% 19.7% 37.3%
Net profit margin 11.4% -5.6% 9.6% 15.0% 7.1% 26.2%

What to expect?
At the current price of Rs 671, the stock is trading at a price to earnings multiple of 14.1 times our estimated FY09 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. While the 180-day exclusivity received for ‘Ondansetron’ will contribute to revenues in 1QFY08 too, the company is nevertheless 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. 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 positive view on the stock and will soon update our research report on the company.

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