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Pricing in key approval delays
Dr. Reddy’s Laboratories’ (DRL) stock price has fallen over 10% in the past two months on account of weak Q4 earnings and delay in key approvals. We believe this correction has largely factored-in the approvals delay for generic Nuvaring and Copaxone which are meaningful opportunities. We have assumed the launch of Nuvaring in H2FY20 and Copaxone in Q1FY21. The company’s focus on cost control yielded handsome results with a visible 250bps base business margin improvement in FY19. We believe the cost control benefits would continue in FY20 as well as key product opportunities and reduction in losses of proprietary products would drive expansion (220bps over FY19-21) in the overall margins. Upgrade to HOLD.
* Cost control benefits to continue, key opportunities to further margin expansion:
DRL rationalised product development pipeline to reduce R&D cost and exercised tight control over SG&A expenses (70bps decline in FY19). It helped improve base EBITDA margin by 250bps in FY19. The management’s strategy is to make each business segment profitable and self-sufficient in terms of cash generation. We expect base business EBITDA to additionally improve (40bps) with the ongoing cost control benefits despite likely increase in R&D expenditure. The key product opportunities (Suboxone, Nuvaring and Copaxone) would aid an overall EBITDA margin improvement of 220bps to 21.6% by FY21.
* Complex product opportunities to drive US sales growth:
We expect the company to grow its US business at 12.8% CAGR to US$1.1bn led by key complex products like generic Suboxone, Nuvaring, Copaxone and DFN-02 (proprietary product). The approvals of Nuvaring and Copaxone are important as these are expected to be the largest products with estimated total revenue of US$125mn in FY21. Copaxone approval is contingent on clearance of Srikakulam API facility (currently under warning letter) and the management expects a re-inspection anytime. We expect its launch in Q1FY20. Any delay in the launch of Nuvaring or Copaxone can have a meaningful impact as both would be high-margin products.
* Concentration risk to increase:
We expect the company to register 19.0% earnings CAGR over FY19-21 led by 12.4% revenue CAGR and 220bps EBITDA margin expansion. However, the large part of growth would be driven by top three products which would contribute 22.3% of earnings in FY21 as compared to ~5% in FY19. Any delay in the launch or higher-than-estimated competition in these products would have a meaningful impact on the overall earnings.
* Valuations and risks:
We upgrade the stock to HOLD from Reduce with a target price of Rs2,585/share based on 18xFY21E earnings. Key upside risks: Early launch of Nuvaring and Copaxone. Key downside risks: Delay in key launches and regulatory hurdles
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