Dr Reddy's Labs

Investors may not initiate fresh purchases for now in the stock of Dr Reddy’s Laboratories, a frontline pharma major which derives one-third of revenues from branded formulations (finished dosages).

Heightened concerns about profitability of German generics business, chiefly Betapharm (that accounts for 17 per cent of turnover), lack of significant upside in terms of exclusive product launches and slow growth in Indian formulations business cloud the earnings picture.

At the current market price of Rs 635, the stock of Dr Reddy’s trades at 17 times its 2008-09 earnings per share — this is at a discount to like-sized peers of similar scale — but may be justified due to the unexciting prospects of the company over the medium-term. Better growth opportunities are currently available in the listed pharma space.

The recent quarterly results in which Dr Reddy’s reported 26 per cent drop in net profits despite 21 per cent organic sales growth on a year-on-year basis, indicate that the company is not out of the woods yet. Barring US where the company continues to do well (sales up 62 per cent) and plans to introduce products in the over-the-counter and specialty segment, as it targets exclusive launches over the long-term, growth in major geographic areas has been at best, modest.

Operating margins (down to 12 per cent from nearly 18 per cent earlier) were affected as Dr Reddys’ selling and administrative costs grew sharply this quarter. SG&A costs may not materially decline from these levels. Some respite on revenues and margins may come from the launch of authorised generic Sumatriptan (anti-migraine) scheduled for late 2008, the benefits of which seem priced into the stock.

While the company may achieve its guidance of 25 per cent revenue growth (off a low-base), Dr Reddy’s, as an investment candidate, suffers from lack of earnings visibility, low rate of success in R&D and pressures on cost.
German trouble

In February 2006, Dr Reddy’s acquired Betapharm, then the fourth-largest German generic drug maker with a market share of 3.5 per cent, for Rs 2,550 crore. However, the ‘strategic’ German market changed from mid-2007. The government gave more bargaining power to insurance companies necessitating several price reforms and compelling the companies to operate on thin margins driven more by volume growth than profitability (EBITDA in FY-08 at $27 million against $42 million in FY-07). Compared to its German peers, Betapharm has a smaller portfolio of medicines; it is absent in certain key business segments, has not won any major Government tenders and has been slow in outsourcing manufacture to cut costs.

All this elongates the pay-back period and suggest a slow recovery for acquired businesses. These account for nearly 90 per cent of Dr Reddy’s Global Generics segment in Europe. With further price-cuts announced in June, Betapharm may continue to drag margins.
Slow in India

While the Custom Pharmaceutical Services in India has done well for Dr Reddy’s, the slow growth in the formulations business is a cause for concern. As against an industry trend of 13-15 per cent, Dr Reddy’s grew by only 9 per cent in March-June quarter with key brands witnessing a decline and unexplained delays in product launches.

While the company expects growth to pick up in the days ahead, Indian formulations, which contribute 15 per cent of the turnover (third-largest area after North America and Europe), are the most profitable market and muted performance there creates earnings uncertainty. For the company to achieve its full-year guidance of 50 per cent plus gross margins, Indian business will play a crucial role.
Perlecan back

Dr Reddy’s has decided to buy back the shares of Perlecan Pharma, its demerged drug discovery arm, for $18 million from ICICI Ventures and Citigroup. Dr Reddy’s had earlier hived off the company (with four drug candidates) in 2005 and sold the demerged entity’s stake (85 per cent) for $22.5 million.

While Perlecan has carried forward losses that may provide tax benefits, its coming back into fold will result in rise in R&D spend (though, not in near-term) with just one new drug entity eligible for out-licensing.