Dr Reddy’s has been one of the most revered domestic pharmaceutical companies. The reverence for the company is due to its vision to be a research driven company and the company has been valued more than any other in the Indian pharma sector. Dr Reddy’s has been one of the first few companies in the country to enter in NCE (new chemical entity) research and spending a large proportion of its revenue on the same. Despite these positives, the stock of the company has been ‘hammered’ in recent times. Let us delve into the reasons for this volatility.
The revenue front…
Dr Reddy’s has been following a business strategy, which has subjected its revenues and profits to a high degree of volatility. Here, let us first understand the sources of revenue for the company. There are three major sources of revenue for Dr. Reddy’s –
APIs (active pharmaceutical ingredients), and
Formulations and APIs are two stable sources of revenues for the company. However, the generics business has seen a high degree of volatility in terms of contribution to revenues (see graph below), much of which can be attributed to strategy followed by the company for this business segment. Dr Reddy’s believes in applications under Para IV, which means that if the company is successful in its application, it can witness a huge upside on both revenues and profits front as it happened in case of Fluoxetine. However, if the company loses the case, money spent on costly legal battle will affect its profitability, as was evident in the case of Amlodipine Maleate. Also, in case of Para IV successes, revenues tend to decline after the exclusivity period (six months) comes to an end as more competitors enter the market.
The profitability front…
The change in business mix towards increased contribution from APIs has severely impacted the profitability of Dr. Reddy’s as generics and formulations are more profitable as compared to the API business. Another factor that has affected profitability of Dr Reddy’s is higher SG&A (sales, general and administrative) expenses and R&D (research and development) expenses. For instance, the SG&A expenses have increased by 32% CAGR in the past four years, much higher compared to the 22% CAGR of revenues. Similar is the case with R&D expenditure which has risen with 40% CAGR during this period. The major increase in these expenses has come up in the last 5-6 quarters and we believe that the investment in SG&A expenses will have long-term implications, in terms of revving up the company’s distribution and marketing network in the US and other global generic markets. On the R&D front, the company has two major areas of work i.e. NCE and ANDA (abbreviated new drug application). While, off late, Dr. Reddy’s has increased its spending towards R&D on the ANDA front, the NCE research will take its time to reap any benefit.
What to expect?
We believe that the expenditure on SG&A and R&D fronts are in line with the long-term vision of the company. These expenses are actually investments for the future and the benefits are likely to accrue in the long run. We would like to quote Ranbaxy on this front, which invested heavily in building sales and distribution network in the US markets in the past four years, the benefits of which have started accruing now. We foresee the same thing happening with Dr Reddy’s going forward.
At Rs 834, the stock is trading 32.2 times our expected FY05 earnings. While the last three quarters for the company have been terrible on both revenue growth as well as profitability fronts, we believe that the worse may be over for the company. The investments in sales and distribution and R&D (basically on the ANDA front) are likely to start paying of dividends going forward. While we may see volatility in the stock price in the short term as decisions on some Para IV challenges are likely to come, we are positive on the company from the long-term perspective.
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