Divi’s Labs: Should you buy, sell or hold?

From its peak stock price and valuation (forward PE metrics) reached in October-2021, Divi’s Labs has corrected 38 and 21 per cent respectively by December-2022. As Covid sales troughed this fiscal along with added cost pressures, earnings contraction followed (19 per cent YoY EPS decline in Q2FY23). Divi’s current valuation at 33 times FY24E earnings is still at a 10-per cent premium to its 5-year average. However given the growth drivers and execution ability of the company, we suggest investors with a long-term view can hold the stock.

Operations

Divi’s revenue segments include Active Pharmaceutical Ingredients (APIs) (36 per cent in FY22), Custom Synthesis (57 per cent) and Nutraceuticals (7 per cent). Divi’s operates from Unit-I near Hyderabad and Unit-II near Visakhapatnam, cumulatively spread over 1,000 acres and more than 40 multi-purpose production blocks.

The API segment is active in only 20-30 molecules in its more than 30-year history (with no molecule being dropped) as Divi’s targets leading market share for its products. Nutraceuticals is similar to API operations but focussed on the high-growth segment.  

Custom Synthesis or CS is a CMO (contract manufacturing organisation) operation where the client, depending on their stage of product development across Phase-I/II/III or commercialised product, requests for API supplies in respective quantities. Covid products Favipiravir, Remdesivir and Molnupiravir are the short timeframe, but high-volume API processes developed by Divi’s in this segment.

Divi’s generates around 25 per cent of revenue from the US, 45 per cent from Europe and the remaining from other regions.

Opportunities

Post Covid, Divi’s revenues are expected to decline in FY23 which contrasts with its strong top-line growth of 16 per cent CAGR during FY15-FY22. But as Divi’s returns to normal operations so will the growth drivers in the medium term.

The traditional API products are chosen with a focus on sustained growth, including chronic therapies, pain, seizures, and analgesics, which are some of the earliest products. As chronic diseases, old-age population and insurance coverage increase, Divi’s can expect 5-10 per cent growth even in this basket where it has 65-85 per cent market share. But pricing will be an offset to volume growth, as API players too are facing pricing pressures from the US and Europe.

Recently introduced APIs for Divi’s (Levodopa, Pregabalin, Mesalamine and Carbidopa) can improve market shares from current 20-30 per cent, backed by recent capacity expansion. Furthermore, pipeline portfolio for Divi’s in this segment includes APIs for which innovator sales (around $20 billion) are expected to go off patent in 2023-25 period. The API market for these products should be ₹1,600-1,800 crore. Although not new patent expiries, sartans (for hypertension) hounded by nitrsamine impurity issues at the API level for others, presents Divi’s with a strong opportunity and three are in validation stages. The other big opportunity is in contrast media APs (injectables for imaging process). There are only 2-3 players in this large market and Divi’s has so far secured a 10 per cent market share and is validating two more APIs in this segment.

In the CS space, Divi’s expects commercialisation from new chemical entities (NCEs) that are in Phase-2/3 stages. As products move from Phase-1 to commercialisation, the volume growth will be exponential.

Products in CMO space are generally outsourced at pre-phase-1 level and rarely at Phase-2/3 levels. The lateral entry of these new projects indicates some scope of China +1 strategy by the innovator, although unconfirmed. Overall, reiterated by recent and sporadic supply chain issues in China and decreasing cost differential in India, the structural factors in research outsourcing moving to India can be potentially large. Divi’s, being the leader in size, supply history and trained personnel, is at the forefront of exploring this opportunity.

Divi’s has so far operated in small molecule API space which are still the dominant molecules in pharma. Divi’s is in very early stages of exploring ADCs (anti-body drug conjugates) which are technically in the biologics space, indicating further scope.

Capacity

The top-line growth at Divi’s can be tied to its gross asset addition at 18 per cent CAGR in FY15-FY22, which includes an intense phase of last three years where it added close to ₹2,800 crore. A minor portion was directed towards debottlenecking (mainly traditional products), which released 25-30 per cent more capacity. Capacity expansion was aimed at newer products, pipeline and CS blocks, which accounted for the major portion of capex.

Divi’s also invested into backward integration for its portfolio of products to ensure smooth supply operations. It expects to add another ₹1,000 crore to its gross block in the next one-two years, excluding its Kakinada project. The Kakinada project with 500 acres land allotted to Divi’s has run into farmer agitations and the ₹600-1,000 crore capex has been delayed for some time on this account. The company will look at Krishnapatnam after Kakinada project, indicating a continued appetite for capacity additions.

Financials

Divi’s reported 30 per cent growth in FY22 revenues aided by capacity expansion and in part by supplies of Covid portfolio. On the high base, and accentuated by sharp decline of Covid products, consensus estimates indicate 7 and 23 per cent revenue and EPS decline in FY23, before returning to 12/13 per cent growth in FY24.

Aided by debottlenecking and backward integration (improving self-reliance) EBITDA margins improved 580 basis points from 39 per cent in FY15 to 45 per cent in FY22 (Covid products may have played a part). Facing high cost of raw materials, energy, logistics and price decline in the US, the EBITDA margin declined to 36 per cent in H1FY23. With improvement in raw material and energy costs, passing on costs to customers and asset utilisation improving to earlier ranges (1.6 times in FY15-17 declined to 1.3 times in FY20-22), Divi’s should scale back to 40 per cent EBITDA margin range in the medium term.

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