Dr. Reddy’s: All fall down!

Performance summary

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• Revenues decline by 35% YoY in 2QFY08 owing to the high base effect in 2QFY07, wherein the company generated revenues from the authorised generics deals.
  

• Excluding the impact of the authorised generics, revenues have registered a 4% YoY growth.
  

• EBDITA margins contract sharply by 980 basis points (9.8%) on the back of an increase in R&D expenses and SG&A expenses (as percentage of sales).
  

• PAT falls by 62% YoY led by the fall in operating profits despite higher other income and lower interest and tax expenses.

Consolidated numbers

(Rs m)	2QFY07	2QFY08	Change	1HFY07	1HFY08	Change
Net sales	19,440	12,557	-35.4%	32,807	24,484	-25.4%
License fees and service income	196	147	-25.3%	320	209	-34.8%
Expenditure	14,754	10,785	-26.9%	25,725	20,181	-21.6%
Operating profit (EBDITA)	4,882	1,919	-60.7%	7,402	4,512	-39.0%
EBDITA margin (%)	25.1%	15.3%		22.6%	18.4%
Other income	190	562	195.7%	436	1,097	151.9%
Interest (net)	474	137	-71.1%	862	476	-44.8%
Depreciation	827	1,033	24.9%	1,675	1,969	17.5%
Profit before tax	3,771	1,310	-65.3%	5,300	3,164	-40.3%
Tax	850	206	-75.8%	1,090	190	-82.6%
Minority interest	4	1	-67.5%	4	4	2.5%
Profit after tax/(loss)	2,925	1,106	-62.2%	4,214	2,978	-29.3%
Net profit margin (%)	15.0%	8.8%		12.8%	12.2%
No. of shares (m)	153.5	168.1		153.5	168.1
Diluted earnings per share (Rs)*					50.1
Price to earnings ratio (x)*					12.6

(* on a trailing 12-months basis)

What is the company’s business?

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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 2QFY08?

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Revenues – Considerable decline: Dr. Reddy’s revenues in 2QFY08 exhibited a considerable fall of 35% YoY. This was attributed to three factors – sharp appreciation of the rupee, supply constraints faced by Betapharm in Germany and more importantly the high base effect in 2QFY07 due to revenues from the authorised generics deals, which were not present during the current quarter. Excluding the impact of authorised generics, revenues grew by 4% YoY in rupee terms.

• API: During the quarter, the API segment witnessed an 11.5% YoY growth on a consolidated basis led by the 40% YoY revenue growth in India. Sales in India were driven by higher sales of ‘Ciprofloxacin’, ‘Clopidogrel’ and ‘Ramipril’. While revenues from North America recorded a robust 46% YoY growth on the back of new product launches, revenues in the rest of the world markets decreased by 9%. This was largely due to the impact of higher sales from the supplies of ‘Sertraline’ to Teva during the 180-day exclusivity accorded to the latter in 2QFY07.

• Generics: Dr. Reddy’s revenues from the generics business (both the US and Europe) witnessed a 64% YoY decline during the quarter. This was largely due to the high base effect on the back of the authorised generics deals (for ‘Simvastatin’ and ‘Finasteride’) in 2QFY07 in the US. Excluding this impact, revenues from the US generics market clocked an impressive 63% YoY growth. In the US, ‘Fexofenadine’ (Allegra) generated revenues to the tune of Rs 586 m (5% of total sales) and achieved market share of 46%, albeit at significantly lower prices than last year. Revenues from ‘Finasteride’ reported revenues of Rs 631 m (5% of revenues), out of which a large part was due to the commencement of supplies to the US government department. During the quarter, Dr. Reddy’s filed 1 ANDA taking the total filings in the first six months of FY08 to 9 and received approvals (including tentative approval) for 8 ANDAs. The company now has 69 ANDAs pending approval.

  In Europe, revenues fell by 25% YoY during the quarter largely due to supply constraints faced by Betapharm in Germany. Betapharm reported a 27% YoY dip in revenues for the quarter. The regulatory changes introduced by the German government leading to severe pricing pressure also impacted sales. To combat this, Dr. Reddy’s is in the process of transferring products to India to ease the supply constraints and has so far transferred 20 products. Besides this, in line with the regulatory changes, Dr. Reddy’s is also focusing on listing its products with the insurers in Germany. The key launches made by Betapharm during the quarter were ‘Oxycodone’, ‘Finasteride’ and ‘Amlodipine Besylate’. ‘Oxycodone’ gained a market share of 8% and contributed 7% to Betapharm’s revenues.

  Consolidated business snapshot

  (Rs m)	2QFY07	2QFY08	Change	1HFY07	1HFY08	Change
  APIs	2,906	3,240	11.5%	5,215	5,857	12.3%
  - India	502	703	40.0%	1,127	1,238	9.8%
  - International	2,404	2,537	5.5%	4,088	4,619	13.0%
  Branded Formulations	3,283	3,815	16.2%	6,810	7,866	15.5%
  - India	1,891	2,054	8.6%	3,633	4,076	12.2%
  - International	1,392	1,761	26.5%	3,177	3,790	19.3%
  Generics	12,113	4,392	-63.7%	18,850	8,639	-54.2%
  - US	9,041	2,092	-76.9%	13,341	3,892	-70.8%
  - Europe	3,072	2,300	-25.1%	5,509	4,747	-13.8%
  Custom Pharmaceutical Services	1,668	1,160	-30.5%	3,086	2,177	-29.5%
  - Organic business	234	528	125.6%	412	715	73.5%
  - Mexico	1,434	632	-55.9%	2,674	1,462	-45.3%
  Others	69	62	-10.1%	127	148	16.5%
  Total	20,039	12,669	-36.8%	34,088	24,687	-27.6%

• Formulations: In the formulations segment, Dr. Reddy’s international sales grew by a robust 27% YoY on a consolidated basis, driven by strong performances of Russia and the CIS markets. While revenues from Russia grew by 25% YoY, revenues from the CIS markets registered a 25% YoY growth. As far as the domestic business is concerned, revenues from the same grew by 9% YoY driven by key brands namely ‘Omez’, ‘Stamlo’, ‘Beta’, ‘Atocor’ and ‘Razo’.

• Custom manufacturing (CPS): Revenues from the custom manufacturing business declined by a significant 31% YoY due to the 56% YoY fall in revenues from the Mexican business. This was attributed to the softening of demand for a key product ‘Naproxen’ due to piling up of inventories with the customers and hence the volume growth was not as high as in the corresponding quarter last year. The organic business reported a splendid 126% YoY growth and capped the decline in revenues from the overall custom manufacturing business.

Cost break-up (Consolidated) (as % of sales) 2QFY07 2QFY08 1HFY07 1HFY08 Raw material 49.0% 36.5% 46.7% 33.9% Staff cost 8.1% 14.8% 9.5% 14.7% R&D expenses 2.2% 7.1% 2.9% 6.5% Selling expenses 6.9% 11.6% 8.0% 10.4% Other expenditure 9.7% 15.8% 11.3% 17.0%

Sharp margin contraction: Margins contracted by 980 basis points (9.8%) during the quarter. However, this has to be viewed in context of a larger revenue base last year on the back of the authorised generics deals. Having said that, raw material costs (as percentage of sales) were lower due to the absence of authorised generics this quarter, as they enjoy lower gross margins. Both R&D and SG&A expenses (as percentage of sales) witnessed a rise. R&D expenses included the payment of US$ 1.5 m to Rheoscience for ‘Balaglitazone’ entering Phase III clinical trials. Besides this, the reimbursements under its R&D partnerships were much lower this quarter than what it was in 2QFY07. SG&A expenses increased as certain expenses spilled over from the first quarter coupled with certain exceptional items.

Bottomline tumbles: A 61% YoY drop in operating profits led to the 62% YoY dip in net profits for the quarter despite the substantial rise in other income and lower tax expenses. Other income was higher due to forex gains of Rs 256 m in 2QFY08 as compared to Rs 55 m in 2QFY07. Tax expenses were lower due to the benefit of the reduction in deferred tax liability relating to Betapharm to the tune of Rs 1.5 bn. This reduction was primarily on account of lowering of the tax rate to 30% from 39% at the time of acquisition.

Quarterly trend

(%)	1QFY07	2QFY07	3QFY07	4QFY07	1QFY08	2QFY08
Net sales growth	148.4%	246.5%	165.3%	142.9%	-11.1%	-35.4%
Operating profit margin	18.9%	25.1%	19.7%	37.3%	21.8%	15.3%
Net profit margin	9.6%	15.0%	7.1%	26.2%	15.8%	8.8%

What to expect?

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At the current price of Rs 630, the stock is trading at a multiple of 13.1 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. Besides this, the company is increasing its focus on biologicals as they attract higher margins due to lesser competition and complexity in manufacture.

As regards Betapharm, the company is expected to face difficult conditions in the medium term due to regulatory changes in the German market. But, in the long-term, Betapharm is expected to boost Dr. Reddy’s presence in the European region. We maintain our positive view on the stock from a long-term perspective.