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Margin dips on fall in revenue

Divi’s Laboratories’ (Divi’s) Q2FY23 performance was sharply below our estimates. Consolidated revenue fell 6.7% YoY to Rs18.5bn (I-Sec: Rs22.9bn), EBITDA margin slipped 770bps YoY to 33.5% (I-Sec: 41.2%) and adjusted PAT declined 18.6% YoY to Rs4.9bn (I-Sec: Rs6.2bn). Revenue for API division dropped 15.0% YoY while that of custom synthesis division remained flattish. Its strong positioning will help monetise the growth opportunity in API and CRAMS space given its stellar execution track record, continuous aggression in capex, and status as one of the preferred suppliers. While we remain cautious on nearterm outlook, recent correction in the stock (~20% in last 6months) provides some comfort. Maintain ADD with a revised target price of Rs3,893/share (earlier: Rs4,173/share).

* Business review: Divi’s reported revenue decline of 6.7% YoY in Q2FY23 with API segment slipping 15.0% YoY (-27.4% QoQ) due to pricing pressures. Custom synthesis (CS) declined 1.5% YoY (-11.5% QoQ) with falling revenue from Molnupiravir. Gross margin contracted 350bps YoY and 40bps QoQ to 63.6% with changing revenue mix. Lower sales resulted in negative operating leverage resulting in 770bps YoY and 410bps QoQ EBITDA margin contraction to 33.5%. While raw material prices remain elevated, logistical issues are largely resolved with freight costs starting to soften. We expect generic CS, APIs and carotenoids to grow at CAGRs of 4.0%, 6.6% and 11.3% over FY22-FY25E, respectively, on a high base with margins set to improve from current level to ~36-37%.

* Concall highlights: 1) CS: on-boarded several opportunities in the last 6 months that will support growth over the next 4-6 quarters; 2) API: drug patent worth US$20bn expiry between FY23E-FY25E will see revenue FY24 onwards; 3) contrast media: working on two products with innovators and targeting gadoliniumbased contrast media as well; 4) Kakinada project: awaiting government clearance, though all licenses and permissions are in place; 5) China+1 strategy to benefit; logistics issues have eased out and raw material sourcing has stabilised.

* Outlook: Divi’s has a stellar track record in terms of execution. However, considering the high base and near-term elevated costs, we estimate revenue/EBITDA CAGR of 5.4%/0.6% over FY22-FY25E, respectively, as we introduce FY25 estimates. We expect ~Rs57bn FCF over FY23E-FY25E. RoE and RoCE each would be ~18% by FY24E.

* Valuation and risks: We cut our revenue estimates by 3-4% and EPS estimates by 8-9% over FY23E-FY24E to factor in lower revenue growth resultant pressures on margins. However, recent correction in the stock (~20% in last 6months) provides some comfort, hence, maintain ADD with a revised target price of Rs3,893/share based on 38xSep’24E EPS (earlier: Rs4,173/share based on 40xFY24E EPS). Key downside risks: Higher competition in API space and regulatory hurdles.

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