Poised for growth, never mind the quarterly blip

Q4FY13 Ebitda was below estimates: For Q4FY13, Divis Labs reported an 8% year-on-year decline in revenues to R6.5 billion (vs est. of R8.1bn). Ebitda declined 11.4% to R2.51 bn (vs est. of R2.89 bn) and 15.3% decline in PAT (profit after tax) to R1.82 bn (est. of R2.17 bn). However, Ebitda margins at 38.6% (down 140 bps y-o-y) were above est. of 35.8%. There was a forex loss of R98m for the quarter (included in other expenses), adjusting for which Ebitda margin stood at 40.1% (flat y-o-y).

Both CRAMs and APIs (contract research and manufacturing services & active pharmaceutical ingredients) business contributed 48% to total sales for Q4 (and FY13 as well) and stood at R3.2 bn. This implies a 15% y-o-y decline for CRAMs and 2% decline for APIs on a high base. Carotenoids contributed the balance 4% and stood at R265m for the quarter, up 26% y-o-y. Ebitda margins are higher than estimates due to better gross margins, lower employee costs and other expenses.

Key takeaways from discussion with management: The management stated that this y-o-y decline during the quarter is mainly due to high base effect and there is no slowdown in the business and order flows. Q4FY13 topline performance was below expectation because of lower capacity utilisation at existing units due to capacity expansion initiatives and ongoing inspections.

Both CRAMs and APIs business contributed 48% to total sales for Q4 (and FY13 as well) and stood at R3.2 bn. This implies a 15% y-o-y decline for CRAMs and 2% decline for APIs on a high base. Carotenoids contributed the balance 4% and stood at R265m for the quarter, up 26% y-o-y. Topline growth for FY14e has been guided to be line with FY13 growth of 15%, with 20-25% growth expected in FY15e. The DSN SEZ units are expected to reach peak capacity utilisation in FY15e.

Cash capex will be R600-700m for FY14e with another R3b addition to gross block from CWIP (capital work in progress). Tax guidance retained at 22-23%. The management indicated that FDA inspection for the remaining blocks at DSN SEZ, expected in H1FY14, as per schedule.

Long-term growth drivers in place

Growth drivers in place for API business: While, revenue contribution from top products (Naproxen and Dextromethorphan) in the API division continues to be robust, future growth is expected to be driven by new as well as recently introduced products. The company has 20-25 products under development.

No deterrents in CSM division: Custom synthesis/manufacturing (CSM) business is not expected to see any growth challenges from the drying innovator pipeline. The management has indicated that customer order-flow continues to remain robust.

Commercialisation of DSN blocks to support Ebitda margins: Divis Labs spent R5b on capacity expansion (including the DSN SEZ unit). So far, two out of five blocks at the DSN SEZ unit have been approved by the USFDA and commercialised, while another two are expecting approval in H1FY14. We believe that the commercialisation of these units will not only drive sales growth, but also provide the benefits of operating leverage to the Ebitda margins. This could partially offset the impact of rising power costs in AP.

Increasing power cost: The company continues to face increased cost pressure from the power shortage in AP; it is sourcing power at as high as R15-20/unit. The expected synchronisation of power grids in 2014 is expected to relieve this pressure.

Valuation and view

Divis is well-positioned in the CRAMS space, given its strong relationships with innovators, presence across the CRAMS value chain, and its ability to support the innovator in late life-cycle strategies. Unlike other generic API players, Divis earns strong margins due to its global cost and market leadership in some APIs (global market share of 50-70%), pricing power and strong backward integration. We expect Divis to be a key beneficiary of the increased pharmaceutical outsourcing from India, given its strong relationships with global innovator pharmaceutical companies. It has undertaken a large capex at its new SEZ, implying positive prospects for outsourcing business.

We believe long-term growth drivers for Divi to be in place and maintain a Buy rating with a target price of R1,250 (20x FY15e EPS). The stock trades at 19.9x FY14e and 16.1x FY15e earnings.