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Weak quarter, higher costs impacted profitability

Dr. Reddy’s Laboratories’ (DRL) reported Q1FY22 performance below our estimates due to higher expenses. Revenue grew 11.4% YoY to Rs49.2bn (I-Sec: Rs50.2bn) driven by India, EU and ROW markets. EBITDA margin at 18.3% was lower 300bps QoQ due to lower gross margin and higher S,G&A expenses.

US sales dropped 1.7% QoQ to US$235mn due to price erosion and we expect it to improve in coming quarters led by new launches including generic Vascepa. We expect the growth momentum in branded generics business (India & EMs), supplies of Sputnik V vaccine and new launches in US to continue in coming quarters supporting overall growth. Retain ADD with a revised target of Rs5,395.

The company has received a subpoena from the Securities and Exchange Commission for producing documents related to certain CIS geographies. This is in relation to an anonymous complaint which alleges that healthcare professionals were provided with improper payments by or on behalf of the company. This may remain an overhang on valuations until resolved.

* India remains strong, US impacted by price erosion: India sales grew 69.3% YoY led by full quarter impact of Wockhardt portfolio integration, upside from COVID-19 related portfolio and strong recovery in industry growth. US revenue declined 1.7% QoQ to US$235mn due to price erosion partly compensated by new product launches. We believe recent launch of Vascepa would help in improving revenue runrate. PSAI business segment reported decline of 11.8% YoY on a high base and decline in volumes with prices. EU generics reported 12.5% growth led by new launches and traction in volumes.

* Margins contract with rising costs: Gross margin was down 150bps QoQ to 52.2%, below estimate of 53.5%, due to price erosion in US, inventory provisioning and drop in PSAI margin. EBITDA margin also dropped 300bps QoQ to 18.3% (I-Sec: 23.3%) due to higher S,G&A expenses and higher R&D spend. Gross margin has been volatile on quarterly basis but we expect it to sustain at ~53-54%. We expect EBITDA margin to improve going forward with improvement in revenue.

* Outlook: Overall, we expect revenues and earnings to grow at 13.8% and 31.3% CAGRs, respectively, over FY21-FY23E with 440bps EBITDA margin expansion. Our estimates include upside from Revlimid in H2FY23E. The focus of the management continues to improve EBITDA margin to ~25% and RoCE through better capital allocation. The company has launched Sputnik V in India and may export it as well. This can provide significant upside in near term to our estimates.

* Valuations and risks: We cut earnings estimates by 6-9% for FY22E-FY23E to factor-in high price erosion in US and rise in S,G&A expenses. Maintain ADD on the stock with a revised target price of Rs5,395/share based on 25xFY23E EPS, an additional Rs330/share for Revlimid and NPV of Rs144 for Sputnik V vaccine (earlier: Rs5,848/share). Key downside risks: delay in launching new products, regulatory hurdles and negative outcome on subpoena.

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