Given the high dependence on the US, building a niche product portfolio will be critical to sustaining growth in the medium term.

Investors with a one-year investment horizon can continue to hold the stock of Dr Reddy’s Labs. Though the company has exhibited strength in its key market — US — by gaining share in the existing and new products, the 23 per cent run-up in the stock over the last seven months may limit the upside in the near term.

At the current market price of Rs 1,890, the stock trades at 17.9 times its one year forward earnings, implying a 21 per cent discount to Sun Pharma.

US, the backbone

Dr Reddy’s derives three-fourth of its revenues from formulations, while active pharma ingredient (API) accounts for the balance. Formulation exports to the US constitute almost a third of the company’s revenues.

US formulation revenues jumped 43 per cent year-on-year to Rs 1,719 crore in the first half of this fiscal. Market share gains in products such as ziprasidone, fondaparinux and clopidogrel helped this.

Price erosion in the existing portfolio and limited niche opportunities, given its large revenue base, may moderate growth in the US, beginning FY14. But, upcoming niche launches such as the anti-cancer drug vidaza (likely sales of Rs 275 crore) may partially mitigate risk from competition in the near term.

Also, given the superior margin profile, these products may aid margin improvement.

The company has 63 products awaiting approval, which include seven exclusive products. Given the high dependence on the US, building a niche product portfolio will be critical to sustaining growth in the medium term.

Niche products, key driver

Next to the US, Russia and CIS are the second largest market for Dr Reddy’s. These account for almost 15 per cent of the total revenues. Revenues in these markets grew 25 per cent in the first half of FY13 to Rs 801 crore.

The company has been steadily scaling up its presence in the consumer (non-prescription) segment to hedge against regulatory risks.

Focus on select therapies such as gastro-intestinal, pain, anti-infectives, dermatology and cardiovascular, and a higher consumer mix have helped Dr Reddy’s Russian operations consistently outperform the industry.

Non-prescription business now accounts for almost 30 per cent of Russian revenues. Even as the company managed to achieve healthy revenue growth, competition and higher advertisement spend may impact profitability in the near term.

However, this may be partly mitigated by ramp up in the high margin bio-similars and difficult-to-manufacture products.

India, regaining ground?

India formulation contributes over 13 per cent to Dr Reddys’ revenues. A sedate portfolio with a high acute skew (60 per cent of domestic sales) has been the key impediment to growth.

Top 10 brands, which typically account for over 36 per cent of domestic sales, grew at a tardy 6.5 per cent in FY12.

As a result, India formulation sales grew at a lacklustre 10.6 per cent last fiscal. Despite a 54 per cent increase in field force over the last four years, growth has stagnated in the low teens.

Though healthy growth in the bio-similar portfolio should support Dr Reddys’ India business, a strong product pipeline is required to shore up domestic revenues.

The proposed drug pricing policy, if implemented, may have a small impact on the company’s revenues. But, given the robust domestic margins, the impact on profitability may be meaningful. Yet, higher volumes may partially compensate for the price cuts.

Revenues of the company’s API and custom pharmaceutical services segment grew at a healthy 25 per cent in first half of the fiscal, thanks to patent expiries for key molecules in the regulated markets.

The API exports to Europe and North America grew 29 per cent and 27 per cent respectively year-on-year in 1HFY13.

The company has signed up a deal with the Geneva-based Merck Sorono for co-development, manufacturing and commercialisation of bio-similar drugs in various regulated and emerging markets.

While this deal endorses the company’s biosimilar R&D capabilities, the revenue flow is subject to regulatory approvals and may be back ended.

Dr Reddys’ revenues grew 27.7 per cent to Rs 5421 crore in the first half of the fiscal compared with the same period last year.

Operating margins expanded 1.6 percentage points to 22 per cent. Net profit jumped 30 per cent during 1HFY13 year-on-year.

(This article was published on January 19, 2013)
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