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Strong margin recovery with scale-up in US sales

Dr. Reddy’s Laboratories’ (DRL) Q2FY22 performance was above our estimates on all parameters. Revenue grew 17.7% YoY to Rs57.6bn (I-Sec: Rs52.3bn) driven by strong growth in India & emerging markets as well as scale-up in US sales. Domestic growth was also supported by supplies of Sputnik V vaccine. US sales grew 8.5% QoQ to US$255mn driven by new launches including Vascepa and volume gain in key products. EBITDA margin at 23.2% was up 490bps QoQ, better than our estimates of 21.8%, aided by higher revenue and one-time licensing income. We expect the growth momentum in branded generics business (India & EMs), export of Sputnik V vaccine and new launches in US to continue in coming quarters which provide visibility for continued growth. Considering improved growth visibility and attractive valuations, we upgrade DRL to BUY from ADD.

* Business Outlook: India sales grew 25% YoY led by traction in base business, new launches and covid related sales including commercialization of Sputnik V vaccine. Excluding covid related sales, India sales growth remained healthy in mid-teens. US revenue grew 8.5% QoQ to US$255mn (est US$245mn) driven by new launches including Vascepa and volume gain in key products despite continuous price erosion. ROW and Russia reported robust YoY growth of 91.4% and 44% driven by new launches and traction in volumes. EU generics reported 10.1% growth led by new launches partially offset by price erosion. However, PSAI business reported decline of 1.6% YoY on a high base and lower demand. EBITDA margins were up 490bps QoQ to 23.2% (I-Sec: 21.8%) driven by 120bps QoQ improvement in gross margins to 53.4%, lower S,G&A expenses and one-time licensing income. Gross margin has been volatile on quarterly basis but we expect it to sustain at ~53%. We expect EBITDA margin to improve going forward with improvement in revenue.

* Key Concall Highlights: 1) Received eight observations from USFDA for duvvada plant 2) Reiterated 25-26% effective tax rate 3) increase in raw material prices expected to offset by improvement in productivity 4) Expect 24-25% EBITDA margins in near to medium term 5) Preparing to launch 15 products for China tender business.

* Outlook: Overall, we expect revenues and earnings to grow at 15.2% and 32.7% CAGRs, respectively, over FY21-FY23E with 410bps 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. Sputnik V started contributing to India sales in Q2FY22 and exports would add to overall growth.

* Valuations and risks: We increase earnings estimates by 2-5% for FY22E-FY23E to factor-in better visibility in revenues and improvement in margins. Upgrade to BUY from ADD with a revised target price of Rs5,534/share based on 25xFY23E EPS, an additional Rs330/share for Revlimid and NPV of Rs137 for Sputnik V vaccine (earlier: Rs5,395/share). Key downside risks: delay in launching new products, regulatory hurdles and negative outcome on subpoena.

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