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Margins surprised positively

Divi’s Laboratories (Divis) reported Q1FY22 performance broadly in line with estimates though EBITDA margin beat estimate by 230bps. Consolidated revenue grew 13.3% YoY to Rs19.6bn (I-Sec: Rs20.0bn), EBITDA margin improved 300bps YoY to 43.5% (I-sec: 41.2%) and PAT grew 13.2% to Rs5.6bn (I-sec: Rs5.8bn). The growth was driven primarily by custom synthesis business with generics declining YoY due to general quarterly volatility.

Strong positioning of Divis will help in monetising the growth opportunity in API and CRAMS space given its stellar execution track record and being one of the preferred suppliers. Further, recently done capex of ~Rs25bn and planned capex of ~Rs6bn on Kakinada project reinforces our view on high growth visibility. Considering recent rally in stock which has capped the upside, we downgrade it to HOLD from Add.

* Strong growth in custom synthesis, generics decline: Divis has maintained its strong growth trajectory in Q1FY22 with 13.3% revenue growth. The growth was driven by strong 38.2% in custom synthesis on back of commercialization of fast tracked projects including Molnupiravir. Generic API business declined 5.8% YoY due to general quarterly volatility and change in product mix. Carotenoids witnessed steady growth of 8.7% and management remains confident of strong growth prospects as it is working on few new contrast media projects. We expect generic APIs, carotenoids and custom synthesis businesses to grow at 14.5%, 20.0% and 24.9% over FY21-FY23E, respectively.

* Margins improve on higher base: Divis reported consolidated EBITDA margin of 43.5, an increase of 300/340bps YoY/QoQ. Gross margin also remained strong at 67.2%. This has been driven by focus on technology, backward integration and improving process chemistry skills which would help in maintaining high level of EBITDA margin. We expect EBITDA margin to remain at ~42-43% in FY22E-FY23E with rising share of custom synthesis business.

* Outlook: Divis has a consistent track record of revenue growth and margin improvement. Management also sounded very positive on growth outlook of API and CRAMS business opportunities We estimate revenue/EBITDA/PAT CAGR of 19.3%/22.4%/24.0% over FY21-FY23E. Divis has consistently generated positive FCF over the years and we expect ~Rs36bn FCF over FY22E-FY23E. RoE and RoCE would remain strong at 24.4% and 23.7% in FY23E.

* Valuation and risks: We raise EPS estimates by 3-4% to factor in higher margins and also target P/E(x) to 42x from 40x due to improving financial metrics. However, due to recent rally in stock which has capped the upside, we downgrade the stock to HOLD from Add with a revised target price of Rs4,828/share based on 42xFY23E EPS (earlier Rs4,436/share based on 40xFY23E EPS). Key upside risks: Incremental innovator projects in custom synthesis. Key downside risks: Higher competition in API space and regulatory hurdles.

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