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Dr. Reddy’s: Top down, bottom up - Views on News from Equitymaster

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Dr. Reddy’s: Top down, bottom up
Jul 23, 2007

Performance summary
  • Revenues decline by 11% YoY owing to the high base effect in 1QFY07, wherein the company generated revenues from the authorised generics deals.

  • Excluding the impact of the authorised generics, revenues have registered a 10% YoY growth.

  • EBDITA margins improve by 290 basis points (2.9%) on the back of fall in raw material costs as there were no revenues from authorised generics in this quarter.

  • PAT grows by 45% YoY led by higher other income and reduction in tax expenses.

Consolidated numbers
(Rs m) 1QFY07 1QFY08 Change
Net sales 13,368 11,881 -11.1%
License fees and service income 124 109 -12.1%
Expenditure 10,971 9,396 -14.4%
Operating profit (EBDITA) 2,520 2,594 2.9%
EBDITA margin (%) 18.9% 21.8%  
Other income 246 535 118.0%
Interest (net) 389 339 -12.7%
Depreciation 848 936 10.3%
Profit before tax 1,529 1,854 21.3%
Tax 240 (15)  
Minority interest - 3  
Profit after tax/(loss) 1,289 1,872 45.2%
Net profit margin (%) 9.6% 15.8%  
No. of shares (m) 153.4 168.0  
Diluted earnings per share (Rs)*   60.9  
Price to earnings ratio (x)*   11.0  
(* 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 18% of the company's business, while formulations contributed 19% to revenues in FY07. The generics business in regulated markets formed 39% of total revenues in FY07. 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 1QFY08?
Revenues – High base effect: The 11% YoY decline in the topline was largely a result of the high base effect in 1QFY07, when the company reported strong revenue numbers from authorised generics. Excluding the upsides from the authorised generics deals, revenues have clocked a 10 YoY growth.
  • API: During the quarter, the API segment witnessed a 13% YoY growth on a consolidated basis led by the 24% YoY revenue growth in the international markets. Revenues in Europe rose by 22% YoY driven by the increase in sale of key products, while those from North America grew by 19% YoY led by combination of new launches as well as new products under development. However, API revenues from India declined by 14% YoY owing to volume decline in key products.

  • Generics: Dr. Reddy’s revenues from the generics business witnessed a 37% YoY decline during the quarter largely due to the high base effect on the back of the authorised generics deals in 1QFY07. In the US, while ‘Fexofenadine’ (Allegra) generated revenues to the tune of Rs 517 m (4% of total sales), ‘Ondansetron’ (or ‘Zofran’) for which the company garnered the 180-day exclusivity recorded revenues of Rs 66 m. It must be noted that the exclusivity period has ended and the benefits from the same will no longer accrue from 2QFY08 onwards. Dr.Reddy’s, however, has attained a good market share of 25% in ‘Fexofenadine’ and 54% in ‘Ondansetron’. Excluding the impact of the authorised generic deals, revenues from the US generics business reported a strong 59% YoY growth led by the first full quarter of revenues from all the new products launched during FY07. During the quarter, Dr. Reddy’s filed 8 ANDAs including 3 first-to-file (FTF) opportunities and received approval for 4 ANDAs (including tentative approvals).

    In Europe, the 4% YoY revenue growth from generics was driven by a strong performance by Betapharm (the German company acquired in February 2006), which grew by 10.5% YoY during the quarter. After the regulatory changes introduced by the German government, while pricing pressure continued, Betapharm was able to record growth in volumes (up 36% YoY). As per the company, Betapharm has the largest number of contracts with insurance companies covering about 70% of the total insured population in Germany, which has probably propelled volumes. That said, revenues from the UK witnessed a 23% YoY decline capping the overall revenue growth from the European region.

Standalone business snapshot
(Rs m) 1QFY07 1QFY08 Change
APIs and Intermediates 2,541 2,776 9.2%
PBIT margin (%) 11.6% 21.0%  
Formulations 3,252 3,275 0.7%
PBIT margin (%) 37.9% 30.2%  
Generics 1,272 696 -45.3%
PBIT margin (%) 32.9% -50.5%  
Custom Pharmaceuticals Services 1,116 600 -46.2%
PBIT margin (%) 11.2% 3.7%  
Drug discovery 26 18  
Total gross revenues 8,207 7,364 -10.3%
PBIT margin (%) 22.5% 13.7%  
  • Formulations: In the formulations segment, Dr. Reddy’s international sales grew by 14% YoY on a consolidated basis, driven by strong performances of Russia and the CIS markets. While revenues from Russia grew by 11% YoY, revenues from the CIS markets registered a 25% YoY growth. Domestic formulations revenues grew by 16% YoY driven by its key brands ‘Omez’, ‘Nise’, ‘Stamlo’, ‘Atocor’ and ‘Razo’. Besides this, the company launched 7 new products in the domestic market during the quarter.

  • Custom manufacturing (CPS): Revenues from the custom manufacturing business declined by 29% YoY due to the 31% YoY fall in revenues from the Mexico facility. The reason for this decline was attributed to the shortfall in supplies of one of the key raw materials. Revenues from India, however, increased marginally by 5% YoY during the quarter.

Margin expansion visible: Operating margins expanded by 290 basis points (2.9%) during the quarter, largely driven by a steep fall in raw material costs (as percentage of sales). It must be noted that raw material costs were higher in 1QFY07 due to revenues from authorised generics, which have lower gross margins. Since these deals were not present in 1QFY08, the raw material costs witnessed a fall. R&D expenditure increased both in absolute terms and as percentage of sales. While the company was reimbursed by Perlecan for the expenses on NCE research, the benefits from its R&D partnership with ICICI Venture for reimbursement of expenses incurred for the filing of ANDAs in the US no longer accrued during this quarter.

Cost break-up (Consolidated)
(as % of sales) 1QFY07 1QFY08
Raw material 43.3% 31.2%
Staff cost 11.5% 14.5%
R&D expenses 4.1% 6.0%
Selling expenses 9.5% 9.1%
Other expenditure 13.7% 18.3%

Bottomline scenario: The bottomline recorded a 45% YoY growth led by a higher other income and reduction in interest costs and tax expenses. The interest costs were lower as the company repaid a part of its long term euro loan (for the funding of Betapharm) and some of its short term borrowings.

Quarterly trend
(%) 4QFY06 1QFY07 2QFY07 3QFY07 4QFY07 1QFY08
Net sales growth 71.2% 148.4% 246.5% 165.3% 142.9% -11.1%
Operating profit margin 7.7% 18.9% 25.1% 19.7% 37.3% 21.8%
Net profit margin -5.6% 9.6% 15.0% 7.1% 26.2% 15.8%

What to expect?
At the current price of Rs 667, the stock is trading at a multiple of 13.6 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. While FY08 will be a challenging year (the company does not have authorised generics deals), Dr.Reddy’s 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. While uncertain, any further 180-day exclusivities could be upsides to its revenues. Investors should, however, note that we have not factored the same in our revenue estimates.

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.

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