Dr. Reddy’s (DRRD) 2QFY18 sales were largely in line with EE, while EBITDA and earnings beat estimates on a lower opex owing to cost control initiatives taken by management. US revenues declined ~US$ 9mn qoq despite the gDoxil launch, indicating steep price erosion in the base portfolio. We think the US business has reached an inflection point, with earnings likely bottoming out and growth expected ahead led by (1) the launch of high-value products viz. gSuboxone, gNuvaring and gCopaxone, and (2) cost control measures. This should in turn enhance margins going forward. We assign Long rating given impending triggers and attractive valuations with Dec’18 TP of Rs. 2747, derived by assigning 22x to Dec’18 earnings.
US sales down qoq; traction in high-value products to aid revenues: US sales declined US$ 9mn qoq despite mid-teen contribution from gDoxil, implying steep price erosion in the base portfolio. As the company has launched high-value products, we expect US revenues to grow from here on, with a ramp-up in gDoxil and gRenvela contribution. DRRD has guided for another 16-18 new launches over the next 18 months, which would include some niche products like gCopaxone (20Mg Tad on 10 Nov’17, 40Mg in Mar’18), gGleevec, gMozobil, gVelcade, gNuvaring (TAD Mar’18) and gSuboxone (TAD 4QFY18).
Regulatory update - Duvvada re-inspection likely towards 4Q-end: DRRD mentioned that Duvvada would require a re-inspection, estimated likely by 4QFY18E-end or later. There are a few warning letter queries related to the Srikakulam API facility, which the company expects to respond by Dec’17 end. On Bachupally plant, USFDA has asked query on a particular observation, which they will be responding in the coming weeks.
DRRD stated that there are a few sizable opportunities stuck due to facility issues, and the company is looking for site transfer to secure approvals.
Domestic business remains muted: Domestic business grew by tepid 2% yoy, while at like to like basis (at gross level ex. tax) it grew by 10% yoy. DRRD mentioned that channel inventories have not returned to previous levels and may take few months before it normalizes.
R&D muted: During the quarter, R&D expenses stood at Rs 4.2bn or ~11.7% of net sales. The company expects R&D expenses for FY18E to be in the range of last fiscal, i.e. ~US$ 300mn.
Gross margins to remain at current levels: Management indicated that gross margins are unlikely to return to previous levels of 60% again. It expects them to remain at current quarter levels, and increase to 55-56% on the back of high-value launches.
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