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Sunday, March 02, 2008

Divi's Laboratories

Investments with a two-three year perspective can be considered in the stock of Divi’s Laboratories, a leading player in the pharma contract manufacturing space.

The growing size of its bulk drug business catering to both generic and custom synthesis clients, sustainable operating efficiencies (high EBITDA margins of 40 per cent) and presence of future growth drivers such as peptides and carotenoids point to good earnings prospects for Divi’s.

Divi’s clocked a robust performance driven by organic growth in the third quarter of 2007-08 (September-December) with 90 per cent increase in sales. Custom chemical synthesis vertical (where it provides custom-made compounds) witnessed over a 100 per cent growth, and the generics bulk drugs business clocked nearly a 60 per cent growth on a year-on-year basis. Given its solid performance, Divi’s may be expected to breach the Rs 1,000-crore sales mark for the full 12 months and sustain high operating margins and lower effective tax rate.

At the current market price of Rs 1,400, the stock trades at around 19 times its likely 2008-09 per share earnings. This appears reasonable given Divi’s historical earnings growth (five-year compounded annual profit growth rate of 24 per cent) and expected ramp-up in earnings in 2008-09 owing to additional earnings from the nutraceuticals venture.
Business scenario

At present, the revenues of Divi’s Laboratories are derived in equal parts from the generic bulk drug and custom chemical synthesis segments. Improved product mix in favour of the high-margin custom synthesis business, has translated into higher margins (from 32 per cent to 40 per cent) as the contribution from custom synthesis has grown to 50 per cent from less than 30 per cent in 2006.

Divi’s is engaged in developing processes and custom synthesis of several drug ingredients and intermediate compounds for multinational companies for their discovery products.

These are under various stages of clinical trials (over 60 compounds). As trials progress, volumes in the custom synthesis business tend to be scaled up, especially in the run up to the commercial launch of the molecule. It is to be noted that during 2006-07, the company spent Rs 240 crore on capital expenditure towards enhancing capacities as it set up new production and utility facilities in SEZ (near Vizag) and EOU units (Chippada village in AP).

The other major business segment relates to manufacturing off-patent bulk drugs and also those that are about to enter generic status shortly (catering to generic clients); this has also done well. Divi’s has over 30 drug master files and currently has over 60 products in its bulk drug portfolio. In July-August, a blockbuster epileptic drug will face generic competition and Divi’s is expected to partner the first-to-file generic company for supply of ingredients.
Broad-based products

At end-FY07, on a product basis, Divi’s largest product accounted for one-fifth of the sales, while the top five products contributed more than half of the revenues.

These ratios are expected to change in FY-08 as its product and customer basket widens. Furthermore, revenues from niche segments such as the peptides and carotenoids products manufactured by Divi’s would also gain market approval. Peptide drugs are one of the emerging areas of drug discovery (especially in cancer medicines) presenting significant opportunity as Western companies completely outsource the peptide segment and related derivatives to Asia. Divi’s currently has exposure to around 90 peptide building blocks.

Carotenoids, on the other hand, are pigments that are important in human nutrition as a source of vitamins and preventive agents for cancer and heart diseases. Divi’s two 100 per cent subsidiaries — Divi’s Laboratories (USA) Inc and Divi’s Laboratories Europe AG (Switzerland) are specifically constituted for marketing its nutraceuticals. Divi’s nutraceuticals project is housed at its Rs 102-crore SEZ. The nutraceuticals venture (with nine products spread across dietary supplement, health and personal care etc.) is expected to pay-off soon with key production facilities commissioned recently.

Divi’s operates predominantly in export markets and has substantial exposure to foreign exchange fluctuations. However, it has a natural hedge in the form of a import component of about 50 per cent in raw materials. Sales from contract manufacturing are linked to long-term contracts, which reduces flexibility in pricing.

There has been a significant reduction in the effective tax rate for Divi’s, due to time-bound tax-breaks availed by the company as commercialisation of its SEZ and EOU units have occurred; but old units may lose these benefits soon.

JMC Projects

JMC Projects has managed a successful turnaround, transitioning from a company with eroding net worth to one with a strong balance sheet in two years. Investors can consider exposure in the stock with a 2-3 year perspective. A strong order book, improving financials, enhanced bidding capacity and a strong corporate promoter who is actively involved in the management, buttress our recommendation.

At the current market price of Rs 373, the stock trades at 13 times its expected earnings for 2008-09. The stock has a small market cap of Rs 680 crore and may be subject to sharp volatility linked to movements in broad markets, necessitating phased investments.

From posting net losses in 2005, JMC Projects has returned to profitability in 2007 on the back of restructuring measures. The company reduced the proportion of fixed price contracts and passed on the burden of raw material costs to project owners. Wherever it had to undertake supply of raw materials, the company ensured that it has price escalation clauses built into contracts.

Two, JMC received a healthy infusion of equity through issue of warrants and rights offers. Three, with Kalpataru Power Transmission becoming a corporate promoter (JMC became Kalpataru’s subsidiary in February 2007), the company has received cash infusion and full support from the former, which has helped it capitalise on the opportunities in the infrastructure space.

The above measures resulted in efficient cost management, substantial reduction of debt, improved bidding capacity (as a result of higher net worth) and entry into newer areas of infrastructure such as civil works for power projects.

JMC Projects had an order book of Rs 2,100 crore in December 2007, with infrastructure accounting for about 40 per cent and civil and power projects for the rest. While the order book of over four times sales for FY 2007 does appear challenging, change in management, doubling of workforce and a 54 per cent increase in asset base in 2007 suggest that the company has been preparing to face execution challenges.

Given JMC’s strength in civil construction, the company may be among the beneficiaries of the recent increase in Budget allocation for urban infrastructure, drinking water and sanitation development projects to be taken up by the States. We believe that orders in these segments would be more in number but less in terms of value, involving higher participation by mid-sized companies such as JMC.

While Kalpataru appears to view JMC as a partner to supplement its own skills in the civil and infrastructure space, any move by Kalpataru to merge JMC remains a key risk, as the returns in that event will depend on the swap ratio.