Dr Reddy’s Laboratories: Signs of recovery - Buy

The past few years have not been promising for Indian pharma companies, especially those exporting to the US market. Regulatory tightening, coupled with multiple headwinds in the US and other key markets, have not augured well for Indian drug makers.

However, in recent quarters, there has been a recovery in the business growth of a few pharma players, thanks to subsiding regulatory woes and healthy revenue growth in key markets.

Dr Reddy’s Laboratories is one such company. The pharma major seems set for a rebound from the decline seen over 2015-2017. The last three quarters registered a sequential improvement in its revenue and earnings, driven by growth in its businesses in India, Russia and active pharmaceutical ingredient products.

The company’s operating margin improved significantly in the third quarter of 2018-19 to 23 per cent, from 16 per cent recorded in Q4 FY18, due to optimisation of costs and growth in emerging markets.

Going ahead, Dr Reddy’s is expected to generate better numbers, with improving approval momentum in the US, new launches and product-level cost optimisation. Any early regulatory resolution will improve the company’s earnings.

Investors with a long-term horizon can consider buying the stock.

At the current price of ₹2,787, the stock trades at about 21 times its estimated 2019-20 earnings, compared with its three-year historical average of 35 times. This PE multiple is lower than the valuations that peers such as Lupin and Cipla enjoy — 23 times and 22 times, respectively.

Regulatory hurdles

Dr Reddy’s earnings over the last few years have been adversely impacted due to regulatory clampdown, competition in some key products and delay in drug approvals.

Its key facilities — Srikakulam, Duvvada and Miryalaguda — received a warning letter in November 2015 from the US drug regulator for the significant violations of current good manufacturing practice (cGMP) regulations. The delay in the remedial measures has weighed on the overall performance.

While the company was able to address the issues with Miryalaguda facility, the other two plants continue to remain under a scanner. Lately, in January 2019, the company’s Srikakulum Unit I received Form 483 from the US regulator with four observations. Further delay in regulatory clearance will continue to impact the earnings.

In mid-June 2018, the company launched the blockbuster Suboxone generic drug (indicated for the treatment of opioid dependence) in the US and enjoyed a windfall gain of $15-20 million till the company received a temporary restraining order from the US court.

The court prevented the company from selling Suboxone drug in the US while a patent-infringement lawsuit is pending. The timeline of relaunch is not clear so far. Dr Reddy’s may relaunch the product, if the district court denies the innovator’s appeal for a re-hearing. The Suboxone business in the US will be a four-player market if delayed, albeit Dr Reddy’s is expected to gain around $25 million per quarter from its sale in the next few quarters, once launched.

Healthy US pipeline

Dr Reddy’s US business contributed 39 per cent to the total revenue (as of Q3 FY19) and grew by 12 per cent CAGR over the last five years, thanks to the new generic launches. However, its US business has been under trouble in the last few years due to regulatory tightening and price erosion in the base products. Price erosion in key molecules in the US is likely to continue in the next few quarters which would impact its gross margins. Delays in niche product launches are also risk to earnings in the near term.

However, its US business is well-positioned for growth from the generic pipeline in the medium to long-term with niche generic launches, including Suboxone, Copaxone and Nuvarin.

The company has guided for two-three launches every month as the portfolio has been accumulated over the last few years.

The pending pipeline in the US comprises 103 pending approvals (59 Para IV filings and 33 first to file) including three NDAs under the 505 (b)(2) route.

Opportunity in EMs

While the European business is witnessing a steep pricing pressure for the company in the recent quarters, the business from emerging markets, including Russia, India, Brazil and China show strong traction. The company has indicated that it would leverage its hospital portfolio in emerging markets, which would allow it to build a self-funded model for biosimilar development.

The business from the emerging markets is expected to be strong on the back of a stabilising currency, geographical expansion, robust biological portfolio and ramp-up in institutional business.

In Russia, Dr Reddy’s expects a healthy performance from the tender-driven biosimilar business. This region contributed around 20 per cent to total sales.

The company’s India business contributes 18 per cent to total sales. It has revamped its management for the domestic business and is looking to build mega brands.

The company plans to launch new products, including clinically differentiated products. Its domestic acquisitions have enhanced its presence in the fast-growing chronic segments, including dermatology, respiratory and paediatrics diseases.

China is another growth driver for the company over the long run as the regulatory changes allows for participation in the market by leveraging on its pipeline for the US.

Currently, the company has a high-margin product portfolio in China and has identified around 70 products that would meet local requirements and will help ramp-up its product registrations. In FY19, the company expects R&D spending to be 12-13 per cent of sales. Around 60 per cent of the R&D amount is spent on API and generics and the balance on proprietary products, biosimilars, etc.

For the nine months ended 2018-19, Dr Reddy’s consolidated net sales were ₹11,369 crore, up 7 per cent over the same period last year. Consolidated net profit was ₹1,445 crore, up by 113 per cent Y-o-Y.

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