Worst for the US business seems over.
FY18 was a year of transition for Dr. Reddy’s Laboratories (DRRD) as pricing pressure in the US and GST in India emerged as major deterrents. As such, while the top line remained flat, bottom line slumped 19%. Business generated free cash flow of Rs 7.1 bn in FY18 against negative free cash flow of Rs 19.4 bn last year, despite weak profitability. R&D expenses reduced to 13% of sales from 14% in FY17. RoCE slipped to 7% in FY18 from 18.8% in FY16. Key highlight for the year was filing of sumatriptan nasal spray in USA and recent approval of gSuboxone (early FY19). Going ahead, management’s key priorities include: (i) launch of complex pipeline like gCopaxone and gNuvaring in US; and (ii) remediate issues raised in the USFDA warning letter. Maintain Buy with TP of Rs 3,350.
US performance stabilising, exciting launch pipeline ahead
Worst for the US business seems to be over—despite 13% price decline, the revenue declined by 2% in FY18. In formulation business, gross margin declined by 300bps from 62% in FY17 to 59% in FY18. Primary reasons for the same were: (i) 13% price erosion due to increase in competition in key products like gValcyte, gDacogen and gVidaza (ii) termination of the contract with McNeil Consumer Healthcare (PAT impact of Rs 25 mn) affected US revenue. Key positives included: (i) 19 new product filings in the US, taking cumulative filings to 107 including 63 Para IVs and 30 FTFs; (ii) DRRD recently got the approval for gSuboxone; (iii) Filing of 505 (b)(2) sumtriptan nasal spray in the US.
Decent free cash flows despite tough times
Free cash flow (before acquisitions) improved by 68% to Rs 7.1 bn, while net debt declined by ~Rs 1.3 bn. Capex for the year stood at Rs 11 bn declining by 37% from FY17 after two years of elevated investments in new injectable, biosimilar and API plants. Working capital as a percentage of sales increased to 31% from 29% due to GST transition. Also, tax rate was higher at 31% due to re-measurement of deferred tax in the US as the government reduced the tax rate.
Outlook and valuations: Revival continues; maintain ‘BUY’
We believe a promising complex generics pipeline, strong earnings revival over FY18-20e and compelling valuations at 13.4x FY20e EPS render DRRD a prime re-rating candidate. We maintain ‘BUY/SP’ with target price of Rs 3,350.
Revenue remained flat
DRRD’s net revenue grew 1% to Rs 142 bn with revenues increasing across all geographies except the US. The company’s generics business (80% of total revenue) grew marginally due to lower contribution from North America (42% of total revenue) accompanied by relatively high growth in Russia at 9% and in Europe at 8%. PSAI segment too reported low growth of 3%. However, proprietary business (including others) posted a sharp increase of 46% attributable to out-licensing agreement with Encore for Impoyz which triggered milestone recognition of Rs 1.5 bn. Adjusted for same, proprietary business still grew at a healthy rate of 10%.