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Dr.Reddy’s: Mitigating risks! - Views on News from Equitymaster
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Dr.Reddy’s: Mitigating risks!
Sep 30, 2005

Domestic pharma major, Dr.Reddy’s, recently announced the formation of India’s first integrated drug development company ‘Perlecan Pharma Private Ltd.’ In this article, we shall analyse how this company will benefit Dr.Reddy’s in the long term. About Dr.Reddy’s

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 businesses.

What is Perlecan Pharma’s role?

Perlecan Pharma will be a private limited company and will get an initial equity capital commitment to the tune of US$ 52.5 m. Out of this, ICICI Venture and Citigroup Venture Capital will fund US$ 22.5 m each and Dr.Reddy’s will bring in the balance US$ 7.5 m (around 14% stake). Dr.Reddy’s will later increase its stake to 80% in the next three years depending upon the milestones reached in the drug development process.

Perlecan Pharma’s role will involve clinical development and out-licensing of Dr.Reddy’s NCE (new chemical entity) assets. While Dr.Reddy’s will focus on drug discovery of new molecules, Perlecan Pharma will focus on advancing the clinical development of these NCE assets and thereafter exploring in-licensing and joint commercialization opportunities. Currently, Dr.Reddy’s has 4 NCE assets, which are undergoing various stages of clinical trials. The rights and titles including the commercialization of these 4 NCE assets will be transferred to Perlecan Pharma, which will also have the first right of refusal on future pipeline of Dr. Reddy’s at fair market value. Dr. Reddy’s will be offered commercial rights to Russia, India, China and other countries in the Commonwealth of Independent (CIS) states at fair market value for all NCE assets of Perlecan Pharma.

How does Dr. Reddy’s benefit?

FY05 was an extremely tough year for Dr.Reddy’s, which saw a 7% YoY decline in revenues and a 77% YoY drop in net profits. Despite this huge setback, the company did not curb its R&D expenditure (14% of revenues in FY05) due to its vision of becoming an innovative global pharmaceutical company in the long term. However, huge R&D spends including increased activity on the ANDA front (it follows the highly risky strategy of making Para IV filings), led to sharp erosion in operating margins (fell to 5% in FY05 from 18% in FY04).

Against this backdrop, the formation of Perlecan will be beneficial to Dr.Reddy’s in the sense that it will mitigate the risks and costs associated with clinical development of the molecules, consequently leading to an improvement (to a certain extent) in its margins going forward. Also Dr.Reddy’s will share the rewards if any significant breakthrough is achieved in the development of these molecules. At the same time, Dr.Reddy’s, as part of its vision of being a discovery led company, will be able to focus its R&D efforts on the discovery of new molecules in the areas of metabolic disorders and cardiovascular.

Dr.Reddy’s in its latest annual report has stressed on the concept of ‘smart R&D’. This means doing research in a manner that maximizes the expected value of a company’s R&D pipeline and also exploring the possibilities of co-development, out-licensing and attracting risk capital in a bid to de-risk and mitigate the costs of clinical trials and product development. The formation of Perlecan, therefore, seems to be in line with its strategy.

It must be noted that in a bid to mitigate the risk of high legal costs associated with the launch of generic products, Dr.Reddy’s had also entered into a US$ 56 m agreement with ICICI Venture for the development, registration and legal costs related to the commercialization of ANDAs to be filed in FY05 and FY06 in the US.

What to expect?

At the current price of Rs 838, the stock is trading at a price to earnings multiple of 34.7 times our estimated FY08 earnings, which is at the higher end of our valuation spectrum. The company performed well in 1QFY06 after a poor show in FY05. The partnership with ICICI Venture has started to reap benefits, which has consequently eased the pressure on the company to a certain extent (R&D expenditure was 9% of revenues in 1QFY06). Off late, 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 and focusing on Para II and Para III filings to ensure a steady revenue stream. All these initiatives are likely to benefit the company in the long run.

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