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Work-in-progress for a better outlook

We recently met Divis Laboratories (DIVI) management to understand the business outlook. Below are the key takeaways:

* The cost pressures are easing across major factors, indicating improved profitability going forward.

* The outlook for contrast media segment remains encouraging, given DIVI’s capability to have better Iodine recovery and limited investment by formulators to manufacture API.

* The green-field capital expenditure at Kakinada would not only cater to the company’s growth requirements from FY25 onwards, but also, would reduce the concentration of DIVI business at Hyderabad/Vizag.

* While the improvement in outlook is encouraging, the valuations remain high, considering the flat earnings growth in FY24 (43x FY24E earnings/33x FY25E earnings). We have a Neutral rating on the stock.

Reducing cost pressure to drive profitability

* DIVI has witnessed reduction in raw material cost in the recent past. Also, it has largely consumed the higher-cost raw material. Further, there has been relaxation in power/fuel and freight cost as well.

* The inventory in the trade channel is returning to normalcy and is expected to lead to gradual recovery in demand (for API products in the base portfolio) at the industry level. This would further enable improvement in operating leverage.

* On an overall basis, easing cost pressures is expected to revive the profitability for DIVI going forward.

DIVI well placed to tap opportunities in contrast media space…

* The global market share of Iodine-based contrast media formulation remains with limited number of companies (~4-5). The formulation industry size is ~USD6-8b and the API industry size is about USD2b, growing at 10- 15% per annum.

* The increased impetus toward diagnosis (X-ray/MRI scan) before medical treatment is driving the demand for contrast media products.

* Factors such as a) the lesser intent of formulators for captive API manufacturing, b) sharp rise in Iodine prices, and c) DIVI’s capability to have 95%+ Iodine recovery/recycle provide strong boost for business opportunity in this segment. In fact, DIVI’s process of high Iodine recovery has helped the company gain certain custom synthesis opportunities as well.

* Management is working on gadolinium-based compounds as well to expand the offerings in contrast media space.

…as well as Peptides space

* The global peptide-based therapeutics industry size is about USD43.5b (CY22) with 6.5% CAGR expected over the next five years. ? Most of the peptides are delivered intravenously or subcutaneously due to degradation and limited absorption in gastro-intestinal tract.

* With a lot of development work happening to change the delivery mode to oral mode, there is renewed interest in peptide class of drugs. DIVI’s strong capability in peptides, provides the company with large opportunities in peptide-based Custom synthesis segment.

Lower levels of impurities puts DIVI ahead of competition in Sartans

* The company’s strong backward integration measures and its ability to manufacture sartans with lower impurity levels than peers puts DIVI in a good stead across custom synthesis as well as generics segment. ? DIVI continues to invest in base API portfolio to maintain/improve leadership position.

* While DIVI has shown phenomenal capabilities in small molecule/large volume products, it also has the capability to manufacture small molecule/small volume products as well. For instance, it produces Capecitabine to the tune of ~60T per year. It has small volume multi-stage reactors to cater to such growth opportunities as well.

* Strong backward integration measures till petrochemical levels enable DIVI to minimize manufacturing cost pressures and places it in a better position than its peers

All-set for starting CAPEX at Kakinada

* With all clearance in place, DIVI is kick-starting its capex at Kakinada. It would start with an investment of INR10b over the next 12M and has scope of investing up to INR30b at Kakinada.

* While INR28b capital expenditure incurred at its existing sites would cater to the company’s growth requirements over the next 12-24M, investment at Kakinada would drive growth beyond FY25.

* Given the fungible nature of manufacturing facility, which was used to produce Molnupiravir, DIVI can utilize the site for alternate products as well.

Valuation and view

* We factor 260bp margin expansion over FY23-FY25, led by reducing cost drag, scaleup of custom synthesis business in contrast media/peptide category as well as sartans/other new molecules in API business.

* We expect 15% earnings CAGR over FY23-25, with ~30% YoY growth in FY25. We expect earnings to be flat YoY in FY24, partly due to Molnupiravir-related benefits accrued in 1HFY23 and partly due to gradual improvement in profitability/outlook in the API generics segment.

* We value DIVI at 30x 12M forward earnings to arrive at a price target of INR2,620.

* We have a Neutral rating on the stock.

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