Dr Reddy’s: BUY. Dr Reddy’s Laboratories: Ready, steady, go

Indian equities have been volatile, thanks to the slowdown in China’s economy and uncertainty of the US Fed’s rate hike move. But the BSE Healthcare Index gained one per cent since August 11, even as the Nifty lost over 7 per cent.

Even so, a few fundamentally sound pharma stocks have given up some gains, in line with the broad market. Now may be a good time to accumulate such stocks, one of which is Dr Reddy’s Laboratories.

The stock has lost almost 10 per cent since August and now trades at about 21 times its estimated 2016-17 earnings. This implies a discount of over 15 per cent to peers — Lupin and Sun Pharma. Given the robust pipeline of products pending approval in the US, Dr Reddy’s is well placed to sustain healthy growth in the medium term. Investors with a two to three year horizon can buy the stock.

Dr Reddy’s revenue from the US market has more than doubled from $413 million in 2010-11 to $1,062 million in 2014-15. The company’s operating profit margin has also increased significantly during this period — from 22.4 per cent in 2010-11 to 24.4 per cent in 2014-15, thanks to the healthy profit margin in this market. To sustain the growth pace, the company has increased its research spend significantly over the last two years. From 7 per cent of revenue in 2012-13, the company’s research and development expenses has risen to 12 per cent in 2014-15 as it stepped up investments into building a differentiated product pipeline in the US.

Dr Reddy’s has shifted focus towards niche and complex products such as oncology injectables, inhalers and transdermal patches which enjoy higher profit margin due to limited competition.

The pay offs from these efforts are expected to accrue over the next two to three years. Currently, about 68 generic products are yet to be approved by the US drug regulator.

Besides this, approval for the company’s three innovative drug applications filed with the US Food and Drug Administration (FDA) through its subsidiary Promius Pharma is awaited. These should support growth over the next three to five years.

The company has undertaken remedial measures at the API (active pharma ingredient) facility at Srikakulam (Andhra Pradesh) and is awaiting response from the US FDA.

Approval for large opportunities such as the gastro drug Nexium, which has been re-filed from a different facility, when it happens, should provide a leg-up to its US business. Given that Dr Reddy’s derives almost half its revenue from the US, depreciation of the rupee against US dollar should also have a positive rub off on profitability.

In the home market, which accounted for about 13 per cent of revenue in the June quarter, Dr Reddy’s has managed to sustain healthy double digit growth over the last few quarters.

The company recently completed integration of Belgian drug maker UCB’s domestic brands, acquired for ₹800 crore in April 2015. This, along with the scale up of its existing business should support growth in the domestic market over the next few quarters.

The company’s performance in the Russia and CIS market, which deteriorated due to a slowdown in the region’s economy and sharp depreciation of the ruble is expected to stabilise over the next few quarters.

The price hikes taken by retail chains to compensate for the currency weakness led to a steep fall in volumes. However, retailers have now begun to reverse the price hikes taken over the last few months.

This should lead to volume improvement for Dr Reddy’s too. Russia and CIS accounted for about 8 per cent of the company’s revenues in the June quarter. Given the steep fall in ruble over the last several months, further downside may be limited.

Dr Reddy’s is consciously scaling down the low margin products sold under its pharma services and active ingredients business.

This should also boost the company’s profitability. The segment’s gross profit margin (sales minus raw material cost) improved by 1.4 percentage points to 23.7 per cent in the June quarter, compared with the same period last year.

The company posted revenue growth of 7 per cent year-on-year in the June quarter. Its operating profit margin improved by 2.8 percentage points to 26.6 per cent. Net profit grew 14 per cent in the June quarter. In 2014-15, the company reported 12 per cent and 3 per cent growth in revenue and net profit.

COMMENT NOW