Growth to taper over approval delays and margin erosion
Dr Reddy?s Laboratories reported results in line with expectations led by a strong performance by the pharmaceuticals services and active ingredients (PSAI) business. Margins came 150 bps below expectation due to inferior mix and lower margins in US business, where the company has a strong presence. Going forward, we expect growth to taper led by approval delays and margin erosion. Domestic growth for the company remains below industry. Growth drivers for company are in early stages and we believe company will face growth pressures in the interim. Hence, we maintain hold and roll-forward our target price of R1,850 per share to June-2014.
Valuation
We adjust our estimates for the company. Our FY14-15e EPS (earnings per share) falls by 6-7%. We expect base EPS CAGR (compound annual growth rate) of 11% over FY13-15e, below peers? 20% CAGR. Trading at 17.1x core FY15 PE (price-to-earnings ratio), the stock factors in the positives.
Strong performance by PSAI as domestic growth slows: Pharmaceuticals services and active ingredients business reported strong 36% y-o-y growth. This included impact of bulk orders. Domestic business growth slowed to 9%. US revenues came in below expectations. Management indicated that the majority of Finasteride exclusivity revenues were booked in Q4FY13 itself. EMs (emerging markets) showed strong performance and grew 37% y-o-y, led by CIS.
Margins continue to be under pressure: Despite a ramp up of high margin products in the US, overall gross margin declined quarter-on-quarter and came 350 bps below expectation. The management indicated that this was partly due to inventory adjustments and also lower margins in the exclusivity product. The management highlighted that pricing pressure in the US remains high, due to rising competition and consolidation of customers. Impact of these will flow through in the coming quarters. We expect base margins to decline 100 bps over the next two years.
R&D spend to increase as focus on complex products: The management indicated that R&D expenses will increase from current 7% levels going forward impacting margins further, as the company focuses on complex products and biosimilars. We factor in a 100 bps increase in research and development in FY14 over FY13.
Strong pipeline but approval delays the main risk: The management refrained from giving guidance for FY14 citing lack of visibility in USFDA (US Food and Drug Administration) approvals. This remains the key risk in our view. While the company has filed of niche products and expects to launch 1-2 niche products every year, delays in approvals would impact growth and pressure margins.
Quarter highlights
* The company has filled 7 ANDAs (abbreviated new drug application) in the fourth quarter.
* It launched 18 products globally in the quarter.
* Outstanding cash flow hedges stand at $480 million booked in the 56-59 range.
* Additionally balance sheet hedges of $350 million remain on book.
* Net debt stands at $247 million implying net debt-to-equity of 0.20x.
* R&D expenses increased to 7% in the quarter. Management indicated that R&D spend will increase, going forward.
* The quarter included $22.5 million of settlement income.