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Dr. Reddy’s: Strong finish! - Views on News from Equitymaster

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Dr. Reddy’s: Strong finish!
May 31, 2006

Performance summary
Dr. Reddy’s has announced strong results for the fourth quarter and year ended March 2006. The topline has grown at a healthy double-digit pace led by its active pharmaceutical ingredients (APIs) and branded formulations segments as well as acquisitions. Generics in the US market, however, continued to face pricing pressure. The robust topline growth, coupled with a significant improvement in operating margins has percolated down to the bottomline, which has recorded superlative growth for the fiscal. The bottomline growth has come about despite a considerable rise in interest costs.

Consolidated numbers
(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Net sales 4,028 6,898 71.2% 18,359 23,465 27.8%
License fees and service income 62 114 82.3% 62 161 158.3%
Expenditure 4,369 6,481 48.3% 17,575 20,558 17.0%
Operating profit (EBDITA) (278) 531   846 3,068 262.8%
EBDITA margin (%) -6.9% 7.7%   4.6% 13.1%  
Other income 209 191 -8.6% 657 1,206 83.5%
Interest (net) 21 514 2393.7% 108 644 495.9%
Depreciation 335 536 60.3% 1,256 1,617 28.7%
Profit before tax (424) (328)   139 2,013 1352.1%
Tax (157) 58   (181) 546  
Minority interest (1) (1)   10 -  
Profit after tax/(loss) (269) (387)   329 1,467 345.7%
Net profit margin (%) -6.7% -5.6%   1.8% 6.3%  
No. of shares (m) 76.5 76.5   76.5 76.5  
Diluted earnings per share (Rs)*         19.2  
Price to earnings ratio (x)*         69.5  
(* 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 FY06?
All markets deliver except US: Dr.Reddy’s clocked an impressive 27.8% YoY growth in topline (consolidated), which was largely attributed to a strong performance by its APIs and formulations business. Acquisitions (Roche’s manufacturing facility in Mexico and Betapharm in Germany) also contributed to topline growth. The API segment witnessed a 19% YoY growth on a consolidated basis led by the 30% YoY growth in the European business. While domestic and the rest of the world API sales grew at a healthy double-digit pace, North American API revenues registered a decline due to decrease in sales of new products as well as decline in key commercialised products.

In the formulations segment, international sales grew by 27% YoY on a consolidated basis driven by the performance of Russia and CIS markets. While revenues from Russia grew by 23% YoY, revenues in the CIS markets registered a 40% YoY growth. Domestic formulations revenues grew by 27% YoY. Growth was also attributed to the low base effect in FY05, wherein VAT related issues negatively impacted revenues in FY05.

Standalone business snapshot
(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
APIs and Intermediates 1,679 2,161 28.7% 6,604 8,536 29.3%
PBIT margin (%) 5.1% 3.1%   4.5% 9.9%  
Formulations 1,440 2,103 46.1% 7,383 9,831 33.2%
PBIT margin (%) 16.9% 22.9%   32.7% 36.5%  
Generics 562 423 -24.8% 2,205 2,206 0.0%
PBIT margin (%) 9.1% -78.5%   3.7% -9.2%  
Critical Care and Biotechnology 127 141 10.7% 462 587 27.2%
PBIT margin (%) -21.3% -51.1%   -8.7% -4.0%  
Custom Pharmaceuticals Services 32 841 2544.0% 117 996 752.4%
PBIT margin (%) -12.3% -6.5%   -42.1% -10.5%  
Drug discovery 0 0   1 2  
Total gross revenues 3,840 5,669 47.6% 16,772 22,158 32.1%
PBIT margin (%) 4.4% 0.9%   9.7% 15.5%  

The generics segment, catering to the regulated markets of US and Europe, recorded a 14% YoY growth largely due to a strong performance in the European region. Revenues in Europe (excluding Betapharm) grew by 28% YoY driven by higher revenues from ‘omeprazole’ and ‘amlodipine maleate’ due to higher pricing in first two quarters. Betapharm contributed Rs 705 m in revenues in FY06 (starting 3rd March 2006). North American generic revenues fell by 27% YoY due to decline in ‘citalopram’ and continued pricing pressure in ‘fluoxetine’ and ‘tizanidine’. This was despite the launch of new products ‘glimpiride’ and ‘zonisamide. During FY06, the company filed 12 ANDAs, which included 10 non-Para IV filings and also received 12 approvals including tentative approvals. The total pending ANDA approvals now stand at 49.

Cost break-up (Consolidated)
(as % of sales) FY05 FY06
Raw material 33.3% 35.1%
Staff cost 16.0% 14.9%
R&D expenses 12.5% 7.4%
Selling expenses 10.9% 11.9%
Other expenditure 23.1% 18.3%
Sharp margin expansion: Margins during the year witnessed 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 year.

Bottomline bloats: A strong topline growth and operating margin improvement contributed to the superlative bottomline growth despite 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 led to higher interest charges during the year.

Quarterly trend
(%) 3QFY05* 4QFY05* 1QFY06 2QFY06 3QFY06 4QFY06*
Net sales growth -9.4% -10.3% 27.8% 20.1% 29.0% 40.1%
Operating profit margin 2.2% -4.4% 17.5% 23.2% 11.9% 1.3%
Net profit growth - - 105.2% 176.2% 1150.0% -
* Net loss in these quarters

What to expect?
At the current price of Rs 1,333, the stock is trading at a price to earnings multiple of 18.8 times our estimated FY08 earnings. The company has come back strongly in FY06 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. 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.

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. Therefore, we are positive about the growth prospects of the company from a long-term perspective. We shall soon update our research report on the company.

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