Dr Reddys Laboratories reported subdued operating performance driven by weak sales in India and Russia. PSAI (pharmaceuticals services and active ingredients) also remained weak on both sales and margin. A sharp recovery in generic gross margin was the key positive for the quarter?we expect this trend to sustain given the recent US launches and revival in India/Russia growth in Q2FY14. Maintain Buy rating with a target price at R2,450 (from R2,400), valuing the stock at 20x one-year forward EPS (earnings per share). No change in EPS estimates.
Weak operating performance: Dr Reddy?s net profit of R3.6 bn (7% year-on-year) is 5% ahead of our estimate driven primarily by lower tax rate (12.4% versus estimate of 22%). At the operating level, Ebitda (earnings before interest, taxes, depreciation and amortisation) at R5.4 bn (8.3% y-o-y) is 5% lower than estimates due to lower sales while margin (at 19%) is in line. Sales at R28.5 bn (12% y-o-y) were weak due to muted growth in branded markets (India/Russia) and PSAI.
US sales at $193m (21% y-o-y) were in line and included $10m in Finasteride sales (FTF?first-to-file).On a sequential basis, sales declined by $20m due to seasonality (higher OTC/antiinfectives sales in Q4) and lower Finasteride sales. The key launch for the quarter was generic Reclast. Market share gains in Toprol-XL and select price increases were offset by price erosion in Lansoprazole.
India growth was flat y-o-y impacted by channel de-stocking and impact of chemist strike in Maharashtra. The company expects India sales to revive in Q2FY13 and full-year growth to be in line with market. Russia growth at 6% y-o-y was lower due to higher base and changes in stocking pattern due to seasonal variations.
PSAI sales growth at 6% y-o-y was impacted by delay in customer launches and price erosion in existing molecules. Growth may remain weak for FY2013 with growth expected to normalise over the next few quarters.
US launches and business mix drive recovery in generic gross margin: Gross margin at 52.8% was in line?beat in generic gross margin offset by weak PSAI. Selling general and administrative margin (29.2% versus our estimate of 31%) benefited from operating leverage and postponement of marketing spends. R&D at 8.5% was higher by 180 bps and expected to remain at 8-9% range.
The key positive for the quarter has been the generic gross margin at 61.6%, which is driven by limited-competition launches in the US and improvement in business mix (exiting low value business in Europe). The company has launched two limited-competition launches in Q2FY14 (Decitabine and Donepezil 23 mg), which will further drive the margin improvement.
Key call highlights
* US launches?the company expects FY2014 to be a busy year with respect to US approvals/ launches. The company expects generic Reclast launch to be a good opportunity in the medium term. There are currently three generics with the FDA final approval.
* Decitabine is expected to be a key earnings driver in the US generics business for FY2014.
* There has been price erosion in the Toprol-XL market with the entry of Dr Reddy?s.
* Spillover domestic sales in Q2FY14?there was market disruption in Maharashtra during June (due to chemist strike) which was resolved later.
* There has been increased R&D focus on non-oral solids within the US generics business. .
* PSAI margin at 19% was well below the 30-32% range witnessed in recent quarters. The weakness in PSAI margin is driven by product mix and higher fixed costs.
