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Dr. Reddy's: Will it recover?

Jun 1, 2005

About the company
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 has filed 64 patents till now and 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 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 came from diagnostic, critical care and biotechnology business.

Numbers at a glance...
(Rs m) FY02 FY03 Change FY04 Change FY05 Change
Net sales 14,788 15,136 2.4% 16,666 10.1% 15,577 -6.5%
License fees and service income 424 -   -   17  
Expenditure 10,413 10,849 4.2% 13,658 25.9% 14,823 8.5%
Operating profit (EBDITA) 4,799 4,287 -10.7% 3,008 -29.8% 771 -74.4%
EBDITA margin (%) 32.5% 28.3%   18.0%   4.9%  
Other income 515 667 29.5% 758 13.6% 696 -8.2%
Interest (net) 109 34 -68.8% 15 -55.9% 100 566.7%
Depreciation 497 609 22.5% 717 17.7% 925 29.0%
Profit before tax 4,708 4,311 -8.4% 3,034 -29.6% 442 -85.4%
Tax 111 391 252.3% 201 -48.6% (211)  
Profit after tax/(loss) 4,597 3,920 -14.7% 2,833 -27.7% 653 -77.0%
Net profit margin (%) 31.1% 25.9%   17.0%   4.2%  
No. of shares (m) 76.5 76.5   76.5   76.5  
Diluted earnings per share (Rs)* 60.1 51.2   37.0   8.5  
Price to earnings ratio (x)           84.8  
(* annualised)              

Over the years...
In FY03, revenues of the company grew by a modest 2% YoY. This was due to the fact that in FY02, the company received a 180-day exclusivity period for marketing Fluoxetine capsules 40 mg, which boosted revenues. In FY03, thus, after the expiry of the exclusivity period, the revenues from the same witnessed a 48% YoY decline. However, increase in the material costs (rose 11% YoY), R&D costs (up by 37% YoY) and operating expenses (up 15% YoY), coupled with reduced sales, depressed the operating margins by 420 basis points. Consequently, the bottomline dipped by 15% YoY. In the year, the company successfully launched the generic formulation, Tizanidine in the US and Omeprazole in the U.K and filed 14 ANDAs.

In FY04, despite the 10% YoY growth in the topline, operating margins fell from 28% to 18%, chiefly on account of a steep 25% YoY rise in expenditure, which was propelled by a 43% YoY rise in R&D spend. The R&D expense as a percentage of sales rose to 11% (from 9% in FY03), which was the highest among all pharmaceutical companies in India. Consequently, the bottomline figure was depressed by 28% YoY. As far as the performance of the segments is concerned, the company successfully launched Ramipril in Europe. In the generics business, it filed 13 ANDAs. In drug discovery, the company initiated Phase-I clinical trials for DRF 10945 in Canada.

Cost break-up
(% sales) FY02 FY03 FY04 FY05
Material costs 29.0% 31.6% 34.9% 34.9%
Personnel costs 6.8% 5.6% 9.2% 11.7%
Operating and other expenses 19.8% 22.1% 22.5% 30.8%
R&D expenses 6.6% 8.8% 11.5% 15.5%

FY05 was a year, which was full of disappointments for the company. The company's revenues declined by over 7% during the year, largely owing to VAT and excise based MRP related concerns in the fourth quarter of the year. The decline in international revenues from API was due to lower sales of Ramipril in the European market, which saw tough generic competition and price decline. Generic sales were down nearly 13% YoY in the US market. This was because sales of Fluoxetine, and Tizinadine, which were the mainstay of the company in the US market, saw a decline, due to intense price competition from existing and new players.Operating margins fell to 5% from 18% due to a 27% YoY rise in R&D expenses. These expenses now constitute nearly 16% of the revenues. The topline and operating margin blues, therefore, resulted in a 77% drop in the bottomline. However, on the new drug research front, the company completed the Phase-I clinical trials for DRF 10945 in Canada.

What to expect?
At Rs 724, the stock is trading at 84.8 times its standalone FY05 earnings. The company has made significant investments in R&D and has partnered with ICICI Venture to fund its investments. Also, 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. These initiatives should augur well for the company in the long run, keeping in mind the fact that now the product patent ordinance has come into force in India and that a lot of blockbuster drugs are going off-patent post 2007. Though the performance in FY06 is likely to remain subdued, the scenario should slowly improve for the company in the long term.

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