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Steps underway to mitigate cost pressures

* ALKEM delivered an inline operational performance in 2QFY23. It delivered a stronger and better than industry growth in the Domestic Formulation (DF) segment. However, price erosion in the US dragged profitability in 2QFY23.

* We have reduced our FY23/FY24 earnings estimate by 3% to factor in: a) steep competition in US Generics, and b) higher operational cost. We value ALKEM at 21x 12M forward earnings to arrive at our TP of INR3,300.

* We model in an improvement in profitability in FY24, led by a strong DF business and benefits from the cost optimization exercise. As current valuations (31x/22x FY23/FY24 earnings) adequately factors the earnings upside, we maintain our Neutral rating on the stock.

Higher employee cost and other expenses hurt margin in 2QFY23

* Revenue increased by 10% YoY to INR31b (est. INR29b) in 2QFY23.

* DF sales grew 13% YoY to INR22b (72% of total sales). International business grew 3% YoY to INR8.3b. US sales declined marginally by 1% YoY to INR6b (20% of total sales). Other international sales grew 15% YoY to INR2b (7% of total sales).

* Gross margin contracted by 470bp YoY to 57.6% due to price erosion in the US market and inflationary raw material cost pressures.

* EBITDA margin contracted by 760bp YoY to 14.7% (est. 16.3%), due to a higher employee/other expenses (up 90bp/280bp as a percentage of sales). EBITDA decreased by 27% YoY to INR4.5b (inline).

* Adjusted PAT declined at a higher rate of 40% YoY to INR3.3b (est: INR3.7b) due to a greater tax outgo.

* Revenue grew 2% YoY, while EBITDA/PAT fell 40%/49% in 1HFY23.

Highlights from the management commentary

* Considering its 1HFY23 performance and the ongoing price erosion in the US base business, the management has guided at an EBITDA margin of 15% for FY23 (v/s its earlier guidance of 16%).

* ALKEM is working on various measures to reduce operational cost like network optimization, reduction in plant overheads, and rationalization of R&D spends. This is expected to drive cost savings of INR2-2.5b over the next 12-18 months.

* As a percentage of sales, the gross margin impact was 480bp, due to severe a price erosion in sales. 

* While other expenses have been higher in 2QFY23, the management intends to maintain the same at 23.5-24% as a percentage of sales.

* The direct/indirect dependence on China for APIs/other raw materials is 65- 70% of the total requirement.

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