Update : Dr Reddys Underperformer

(BSE: 500124 | NSE: DRREDDY | ISIN: INE089A01023)

Dr. Reddy’s 1QFY08 results disappointed on both revenues and profits. :Significantly lower Ondansetron sales, supply issues at CPS Mexico facility as well as negative impact of currency appreciation were primary reasons for the disappointment. With a 50% earnings decline in FY08, outperformance is linked to expectations of FY09 turnaround in Germany, which is uncertain. Future earnings face significant headwinds from uncertainty in Germany, potential incremental competition in Allegra as well as currency appreciation. We are 20% below consensus and believe consensus downgrades will weigh on near term performance, even as downside is limited. Downgrade to Underperformer

1QFY08 revenues below expectations :Shelf stock adjustments led to significantly lower than expected Ondansetron sales at Rs66m despite almost a full quarter of exclusivity. Supply linked issues led to Mexico CPS revenues declining 33% YoY. c10% rupee appreciation also negatively impacted export revenue growth as well as margins in our view, even as Rs285m of forex gain helped neutralise the impact. Amlodipine API supplies and a few other product opportunities positively impacted the API segment with gross margins expanding to 35%. Formulations growth was also strong at 15% YoY and excise benefits from Baddi plant boosted segment profitability. Continuing limited competition in Allegra is a positive, but 28% QoQ decline in revenues despite marketshare gains indicates weaker pricing. Further competition in Allegra with entry of Mylan can be a further negative.

Germany, Rupee appreciation cloud near term outlook :Structural transition of German generic market from a branded generic to a generic generic market as well as cost pressures because of renogiated contract with Hexal is pressurising near term profitability for Dr. Reddy’s. In the longer run, DRL can do site transfers to India as well as cut on its marketing force to improve profitability but the transition process will be painful and full of uncertainty as market pricing can deteriorate further by the time site transfers happen. With 80% of revenues from exports, 10% rupee appreciation is another significant risk for margins even as forex denominated costs offer some natural hedge.

Consensus downgrades to limit upside : We are 20% below consensus driven by concerns on German market profitability and rupee appreciation. While valuations at 24x FY08CL and 19xFY09CL are not steep, near to medium term upsides will be limited given risks of consensus downgrades. FY08 and FY09 earnings to a large extent are dependent on continuing limited competition in Fexofenadine and turnaround in Betapharm respectively. Disappointment on either can be a significant negative for the stock. We are downgrading the stock to U-PF based on above concerns. Key risk to our recommendation is market ascribing value to Dr. Reddy’s R&D pipeline (Rs50-100 per share).

1QFY08 conf call highlights

India

  • Domestic formulations grew faster than industry average in April and May
  • 2 new market divisions set up to focus for dermatology and nephrology
  • Domestic market profitability also benefited from excise and income tax benefits from Baddi facility.

US

  • Ondansetron sales have been impacted by shelf stock adjusted
  • Fexofenadine market share has risen to 25%, helping reduce the impact of pricing decline. Key risk is entry of new players.
  • Exploring new channels in the US generics – Private label, OTC,
  • opportunity to supply generics to US govt.
  • The company has filed 8 ANDAs ($5bn) including 3 FTF opportunities during the quarter

Betapharm

  • The management is optimistic about turnaround in Betapharm (Germany) by FY09 driven by volume growth and transfer of products to India.
  • Initial product transfers are expected to start in 2HFY08 and accelerate going forward.
  • Dr Reddy’s is waiting for the supplies to stabilise before aggressively bidding for tenders
  • The company expects FY09 profits to be better than FY08
  • Company has stopped sharing Betapharm gross margins – an indication of poor profitability to us.

API business

  • Gross profit margins at 35%
  • No rabeprazole API contribution during the quarter
  • Amlodipine Besylate supplied during the quarter – helped segment margins and also a vindication of Dr. Reddy’s business model of multiple partnerships for its large API pipeline.

CPS

Mexico business impacted supply constraints of key ingredients Dr. Reddy’s has set up a new facility to produce the intermediates in house and expects the business to be back on track by next year In the long run, Dr. Reddy’s expects CPS gross margins to expand to c30% from 21% in current quarter.

R&D

  • Balaglitazone moves into P-III
  • Upsides possible from R&D valuation, especially after strong listing of Sun Pharma’s demerged R&D entity.

Gross margins

  • API- 35% (27%)
  • Branded – 72% (70%)
  • Generics – 48% (39%)
  • CPS – 21% (29%)

SG&A – YoY and QoQ decline

  • Rupee appreciation
  • Lower legal costs
  • Reduction in Betapharm and branded formulations selling expense.

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