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Promising outlook; comfortable valuations Multiple drivers to underpin growth over the next 2-3 years

Dr. Reddy’s Labs (DRRD) had demonstrated considerable improvement in operating margin (600bp) over FY17-21, despite pricing headwinds in its key US market. However, during 9MFY22, there has been some moderation in margin due to the increased raw-material/supply chain costs, impairing margins in the PSAI segment.

We expect DRRD’s earnings growth momentum to sustain over the next 2-3 years (17% CAGR over FY22E-24E), led by niche product pipeline, ongoing outperformance in the branded generics market and better PSAI segment outlook. Further, given its underperformance v/s the broader market, attractive valuation (23x/19x FY23/FY24 – Ex-Revlimid basis) and improving earnings outlook, DRRD is in a favorable riskreward position. Retain BUY with a TP of INR5,160, implying 21% upside potential.

Key risks: a) delay in launch of niche products, b) adverse regulatory outcome, c) inferior execution in Domestic Formulation (DF) segment and d) prolonged currency headwinds in Russia business

The North America business is following a healthy growth trajectory

After witnessing a 9% compounded decline in North America (NA; 35% of total sales) during FY16-19, DRRD delivered 4% sales CAGR over FY19-21 and similar YoY growth for 9MFY22. Despite ongoing price erosion in the base business, DRRD has been able to grow buoyed by a robust pace of launches (about 45 launches over the past two years). The enhanced efforts towards regulatory compliance and sustained momentum in launches (comprising some niche launches like g-Kuvan, g-Revlimid) are likely to further lift DRRD’s growth trajectory. We expect 19.4% sales CAGR over FY22-24 to USD1.4b. Limited competition products and improved sales base are likely to augment its overall profitability over the next 2-3 years.

Well-placed to deliver better-than-industry result in the DF segment

DRRD has outperformed the India Pharma market (IPM) by ~200bp over the past four years driven by new launches and superior execution in the existing portfolio (DF forms 20% of sales). With a broad-based presence in therapy, comprising chronic as well as acute therapy, DRRD posted a robust 20% YoY growth across gastro/cardiology/anti-diabetes therapies; and mid-teens YoY growth in respiratory/dermatology therapies over the past 12 months. The anti-infectives therapy expanded notably (+56% YoY), led mainly by Remdesivir. With COVID-related sales normalizing, a healthy show in core therapies as well as a benefit derived from the inflation-linked increase in prices for portfolio under NLEM, is anticipated to drive 8% sales CAGR over FY22-24 (adjusted for COVID-related sales).

New launches and enhanced pharma services to improve the PSAI outlook

DRRD delivered 7% sales CAGR over FY16-21, with a sharp uptick in growth seen in FY21 and sales sustaining in 9MFY22. This was largely led by new launches with almost 30 products launched over the past two years. DRRD continues to file Drug Master Files (DMFs; 14/7 in FY21/9MFY22) to drive the Active Pharma Ingredient (API) business within the PSAI segment. DRRD is also leveraging its strength in process chemistry to service innovator pharma companies, thus driving custom pharmaceutical services within the PSAI segment. Accordingly, we expect the PSAI segment to post 13% sales CAGR to reach INR39b over FY22-24.

Currency headwind may get offset to some extent by market share gain in Russia

DRRD has been well ahead in terms of growth in the over-the-counter (“OTC”) segment compared with the Russian industry. Russia sales accounted for 9% of DRRD’s 9MFY22 total sales. Within that, the OTC segment contributed about 45% of sales, driving overall growth in Russia and had exhibited 11% sales CAGR over FY16- 21. However, a moderate 6% CAGR in prescription segment sales had some bearing on its overall growth in Russia. While there is normalcy in Russia business in constant currency terms, the sharp 23% rouble depreciation against INR over the past one month may adversely affect DRRD’s near-term performance. However, there is a scope of market share gain, if there is withdrawal of products by western pharma companies. We await clarity on this aspect to understand the medium-term outlook for DRRD’s Russia business segment.

At a favorable risk-reward position – Maintain BUY with 21% upside

Overall, we expect 17% earnings CAGR for DRRD over FY22-24. We value DRRD’s base business EPS of INR198 at a 12M forward P/E multiple of 25x and add INR210 per share of NPV from the g-Revlimid opportunity. Accordingly, we arrive at a TP of INR5,160 on a 12M forward earnings basis, implying 21% upside potential.

We remain positive on the company underpinned by its niche products build-up for the US market, strong brand franchise in DF, superior execution in emerging markets and product additions/improved services in the PSAI segment. Further, the stock has underperformed by 8% over the past six months, which provides valuation comfort. This along with improving earnings outlook puts DRRD in a favorable riskreward position. Maintain BUY.

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