Neutral rating on Dr Reddy’s; Weak Q4; sales down ~3% y-o-y

By: | Published: May 23, 2016 7:30 AM

While long-term fundamentals remain intact, stock will stay range-bound in the near term

Dr Reddy’s (DRRD) reported weak Q4FY16 sales of Rs 37.6 bn, down ~3% y-o-y with adjusted Ebitda of Rs 8.2 bn (flat y-o-y), 13% below our estimate (primarily due to high R&D & remediation cost and change in product mix). Q4FY16 reported PAT at R745m included Venezuela related write-offs of Rs 4.3 bn (Adj PAT- Rs 3.8 bn).

* EM, PSAI posted weak sales; US to see more pressure in 1H: Emerging markets (EM) business sales declined by 29% as DRRD reported zero sales from Venezuela and currency pressure in other markets. Rituxan launch expected in FY17 in Russia should help drive growth in EM going forward. US business posted 11% y-o-y growth in Q4. We expect US sales to come under pressure in 1H due to incremental competition in key products (including Vidaza & Valcyte). PSAI (pharmaceutical services and active ingredients) business continued to deliver muted performance and declined by 22% y-o-y.
* Earnings call takeaways: (i) Regulatory update—DRRD provided first and second update to US FDA on 28th Jan and 30th Mar. The company intends to finish the remediation procedure by Q1FY17 end. (ii) Price erosion in US base business was in high single digits in FY16. DRRD stated that volume increase helped largely offset this impact. (iii) DRRD expects approval rate in US to improve from 2H FY17. (iv) DRRD took write-off of R4.3 bn related to translation losses in Venezuela. (v) Russia business to see revival in 2HFY16. (vi) SG&A cost includes consultant cost (related to remediation) of $20m in Q4. This should substantially come down from Q2FY17 onwards. (vii) Capex for FY17 & FY18 expected to be ~R12 bn and should come down thereafter.
* Regulatory concerns cap upside potential, maintain Neutral: We believe the speed with which DRRD is able to resolve regulatory issues with the FDA is going to be critical (unlikely before FY18, in our view). Though long term fundamentals remain intact, the stock will remain range bound in the near term due to regulatory concerns. We maintain our Neutral rating with target price of R3,200 @ 18x FY18E PER (vs R3,300 @18x FY18E PER). We have cut our FY17/18e EPS by 3-4%. The cut in EPS is attributed to higher remediation cost and lower margins due to higher competition in key products.

Business highlights

Q4 revenues declined 3% y-o-y to R37.6 bn, supported by sustained traction in US and India business. PSAI business declined 22% y-o-y to R5.7 bn and Innovator product segment posted 245% y-o-y growth (8% miss) in Q4.
* North America (50% of sales): In Q4, on constant currency basis, DRRD grew 5% y-o-y (declined q-o-q) to $285m, aided by sustained performance of the injectable franchise and market share gain in key molecules. The company is also expected to gain market share in Nexium. However, in Copaxone, it could take at least two quarters for DRRD to successfully reply to US FDA.
* In FY16, company had filed for 14 new products in the US, taking cumulative ANDA filings to 230. Pending ANDAs stands at 82 including 52 Para IVs of which 18 are FTFs.
* India (14% of sales): India business delivered double digit growth for 8th consecutive quarter, on account of sustained improvement in the performance of the top brands. The company has successfully integrated UCB brands in Q2. According to AIOCD, Dr Reddy’s growth in domestic market was at 22% (secondary market data) for the Jan-Mar’16 quarter, much ahead of industry growth of 9.3%.

RoW sales including Russia/CIS (8% of sales): Sharp depreciation in Russian ruble led to 29% y-o-y decline in Russia sales. Increase in drug prices from DRRD and retailers led to significant volume decline for DRRD in Q1. However, these price hikes have been taken back, resulting in healthy CC growth going ahead. The company has guided for better traction in Russia business for next few quarters. Decline in RoW sales is also contributed by Venezuela; DRRD has stopped supplying to Venezuela due to repatriation issues.
* Europe (5% of sales): DRRD registered 25% y-o-y growth in Europe sales at R1.8 bn. The company is expected to launch more products in coming quarters.
* Margins hit by remediation cost and increased competition in US: Q4 Ebitda margins at 22% were 231bp below our expectations (24.3%) due to increased remediation cost of $15m in Q4. Adjusted for Remediation cost  Ebitda margins were at 25% for this quarter. We expect margin to normalise going ahead at 24-25% led by niche US launches (gNexium, complex injectables) & operating leverage.
* Healthy gross margins: Overall gross margins at 56.6% (Up 181bp y-o-y) were driven by better business/product mix and cost control activities at plant level. Gross margins for Global generics and PSAI segment stood at 66.3% and 20.4%, in FY16.
* R&D spends remain high: R&D expense was at 13.0% of sales at R4.9 bn v/s 10.3% of sales in Q3FY16. R&D expense is expected to remain at higher level due to strong product pipeline of complex generics, Biosimilars and Proprietary products. DRRD spends 12-15% of their total R&D on Biosimilar research.
* Derivative hedges stand at  $290m at R64.4-69.3/USD, while balance sheet hedges are at $253m (at average rate of R60-65/USD). Cash flow hedges in other currencies stood at: RUB900m at R0.94/RUB and 6 m euros at 73.7/EUR (maturing over next 12 months).
* Remediation activities: The remediation work has been on and DRRD has already sent updates to US FDA in Jan’16 and March’16 and is expected to send one more update by May’16 end.

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