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Dr. Reddy’s: Generics boost! - Views on News from Equitymaster
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Dr. Reddy’s: Generics boost!
Jul 27, 2006

Performance summary
Dr. Reddy’s has announced strong results for the first quarter ended June 2006. The superlative topline growth has been attributed to revenues from acquisitions, authorised generics revenues from ‘Proscar’ and ‘Zocor’, and growth in its core businesses. Operating margins have considerably expanded on the back of reduction in almost all costs (as a percentage of sales) excluding raw material costs. All these factors have contributed to the impressive growth in bottomline despite the surge in interest costs.

Consolidated numbers
(Rs m) 1QFY06 1QFY07 Change
Net sales 5,382 13,368 148.4%
License fees and service income 16 124 672.5%
Expenditure 4,753 10,971 130.8%
Operating profit (EBDITA) 645 2,520 290.7%
EBDITA margin (%) 12.0% 18.9%  
Other income 239 246 2.7%
Interest (net) 35 389 1010.0%
Depreciation 348 848 144.0%
Profit before tax 501 1,529 205.0%
Tax 194 240 23.5%
Minority interest (0) -  
Profit after tax/(loss) 307 1,289 320.1%
Net profit margin (%) 5.7% 9.6%  
No. of shares (m) 76.5 76.7  
Diluted earnings per share (Rs)*   31.9  
Price to earnings ratio (x)*   42.6  
(* 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 1QFY07?
US and Europe drive topline: The robust 148% YoY growth in topline was a result of good growth across all its businesses namely, APIs, generics, domestic and international formulations and custom manufacturing. The API segment witnessed a 20% YoY growth on a consolidated basis led by growth across the domestic and international markets.

The generics business witnessed a strong growth during the quarter 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. Besides this, the icing on the cake was the authorised generics deal that Dr. Reddy’s had signed with the innovator Merck for two of its products – ‘Finastride’ (Proscar) and ‘Simvastatin’ (Zocor). Since the 180-day exclusivity was granted to Teva (for Proscar) and Teva and Ranbaxy (for Zocor), Dr. Reddy’s, being the authorised generics, was also able to benefit from this exclusivity period. Revenues from these authorised generics contributed 24% to revenues in 1QFY07. In Europe, revenue growth from generics was driven by contribution from Betapharm (the German company acquired in February 2006). That said, if one were to exclude Betapharm’s revenues, then the region actually witnessed a decline in revenues due to the fall in prices of its key products – ‘amlodipine’ and ‘omeprazole’.

Standalone business snapshot
(Rs m) 1QFY06 1QFY07 Change
APIs and Intermediates 2,025 2,519 24.4%
PBIT margin (%) 7.3% 12.5%  
Formulations 2,606 3,104 19.1%
PBIT margin (%) 41.7% 40.1%  
Generics 645 1,272 97.2%
PBIT margin (%) -0.8% 32.9%  
Critical Care and Biotechnology 126 170 34.9%
PBIT margin (%) -16.1% -17.4%  
Custom Pharmaceuticals Services 37 1,116 2923.8%
PBIT margin (%) -89.2% 11.2%  
Drug discovery 1 26  
Total gross revenues 5,439 8,207 50.9%
PBIT margin (%) 17.6% 22.5%  

In the formulations segment, international sales grew by 48% YoY on a consolidated basis driven by the performance of Russia and CIS markets. While revenues from Russia grew by 45% YoY, revenues in the CIS markets registered a 56% YoY growth. Domestic formulations revenues grew by 14% YoY. Revenues from the custom manufacturing business witnessed significant traction due to the revenues from the acquisition of Roche’s manufacturing facility in Mexico. Growth in customer base and product portfolio also contributed to the revenue growth from this business.

Cost break-up (Consolidated)
(as % of sales) 1QFY06 1QFY07
Raw material 34.3% 43.3%
Staff cost 13.9% 11.5%
R&D expenses 8.0% 4.1%
Selling expenses 11.0% 9.5%
Other expenditure 21.1% 13.7%
Sharp margin expansion: Margins expanded by 690 basis points during the quarter, largely driven by a steep fall in R&D expenditure and other expenditure (as a percentage of sales). 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.

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.

Quarterly trend
(%) 1QFY06 2QFY06 3QFY06 4QFY06* 1QFY07
Net sales growth 15.0% 7.0% 26.5% 71.2% 148.4%
Operating profit margin 12.0% 20.3% 12.5% 7.7% 18.9%
Net profit margin 5.7% 16.2% 11.4% -5.6% 9.6%
* Net loss in this quarter

What to expect?
At the current price of Rs 1,358, the stock is trading at a price to earnings multiple of 18.9 times our estimated FY08 earnings. Going forward, we expect Dr. Reddy’s performance to be driven by the launches of ‘Simvastatin’ and ‘Finastride’ in the US market in FY07 and revenue contribution from Betapharm and the custom manufacturing business. The custom manufacturing business is expected to scale up going forward with the acquisition of Roche’s manufacturing facility in Mexico. 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. Considering all these factors, while we remain positive on the company’s long-term growth prospects, investors need to be cautious with respect to valuations.

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