Divi’s Laboratories rating ‘Hold’: Soft numbers in the final quarter of FY20

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Published: June 13, 2020 3:15 AM

FY21 margins likely to be muted; bright outlook for FY22 due to capex; ‘Hold’ maintained as valuations factor in the positives.

Gross margin benefited from backward integration of starting materials and softening of crude.

Divi’s Laboratories (DIVI) reported soft Q4FY20 numbers. Topline grew mere 4.5% in constant currency and Ebitda margin declined 90bps y-o-y to 32% on fixed operating expenses following partial commissioning of Hyderabad and Vizag brownfield projects. Gross margin benefited from backward integration of starting materials and softening of crude.

While FY21 margins are expected to remain subdued as post-operative fixed costs for newly commissioned capacities will hit the P&L, approvals for developed markets are yet to come in. That said, we expect strong operating leverage in FY22 after full commercialisation of new capacities. While we like DIVI for such clear earnings visibility, we believe current valuations price in the ~25% EPS CAGR over FY20-22e. Hence, we maintain Hold with TP of Rs 2,340.

Higher costs impact margin; capex on track; no guidance

Despite gross margin improvement of 160bps y-o-y, Ebitda margin remained soft on account of higher staff costs (increased 900 staff members in Q4FY20) and fixed operating expenses following partial commissioning of the company’s Hyderabad and Vizag brownfield projects.

Management commented that high gross margins, due to the aforementioned reasons, may not sustain. In FY20, the company capitalised Rs 8.76 bn, with Rs 9.2 bn carried forward as CWIP. Management guided that the balance work on brownfield projects is expected to be complete by H2FY21. Management offered no further guidance for FY21.

Strong outlook and clear earnings visibility make DIVI resilient
Upcoming capex, while presenting near-term challenges, shows promise of a buoyant revenue stream starting FY22. The aggressive ~Rs 17-bn capex positions DIVI to tap larger opportunities in Big Pharma companies, which are seeking to reduce their heavy reliance on China. Additionally, DIVI’s backward integration puts it ahead of the competition, which has only recently sought to reduce its China reliance. The company is poised to benefit not only as a leader and preferred partner in the CRAMs space, but also because of the way it has strategically positioned itself over the past years.

Outlook: Fully valued
The front-ended costs from upcoming capacities will keep margin subdued. The stock is trading at 31x FY22e EPS, which fully captures potential benefit from this capex. Hence, we maintain ‘HOLD/SO’ with TP of Rs 2,340 (30x FY22e EPS).

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