* Overall, numbers are below expectations though they give enough hint of volume recovery from the bottom hit in Q1FY18
* Expect the recovery to sustain through the next few quarters as well, while remediation costs will also moderate, which should give fillip to margins and earnings
* The biggest risk to DIVI’s remains USFDA inspection at Unit 1, which has not been audited now for nearly 3 years. While it’s clear that Unit 2 is systemically important for USFDA for supplies to the US, the criticality of Unit1 is not clear
* We fine-tune our earnings for early remediation of Unit 2 by early-FY19, but maintain our HOLD rating, valuing DIVI’s at PE of 18x FY20E EPS with TP of Rs820/share
* While overall Q2FY18 numbers were below expectations, there are clear signs that a recovery is underway after volume hit bottom in Q1FY18 when DIVI’s had to put in place protocols for more quality checks on ingredients/API’s that are exempted under the import alert. With these measures in place, revenue should rebound in the ensuing quarters. Some uncertainties would still prevail over the extent of loss of volumes in some products.
* Potential inspection of Unit 1 remains a key event risk: The faster-than-expected inspection of Unit 2, after receiving the first 483 and subsequent warning letter, indicates accelerated remediation measures undertaken by the company, supported by the USFDA. However, a key event risk that may resurface as an overhang on the stock is the potential inspection of Unit 1, which has not been audited for nearly 3 years now. We note that USFDA appears to have been as keen as DIVI’s in avoiding any supply disruptions from Unit 2, as it was systematically important for US supplies. It is not clear to us whether Unit 1 (accounts for 30-35% of sales) is as systemically important. In the recent past, USFDA has been taking a holistic view of compliance norms at pharma companies, which is also reflected in several recent warning letters.
* Overall, we remain positive on the CRO/CRAMS space and believe that the industry is at the same inflexion point as the Indian generic industry was back in 2009-10. We see significant structural tailwinds for the sector, including 1) Far more consolidated CRO/CRAM space compared to generics industry and 2) Recovery in pace of USFDA approvals for NCE/NME. However, our HOLD rating on DIVI’s is largely a reflection of the above mentioned concerns on Unit 1 inspection and potential regulatory issues there.
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