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Miss in 2QFY23; Growth factors to face softness over medium term

No visibility yet to the start of the Kakinada project

* DIVI delivered an earnings miss in 2QFY23. Reduced traction in Custom Synthesis (CS), coupled with lower operating leverage, resulted in an earnings decline for the first time after 12 quarters of a strong performance.

* We cut our FY23/FY24 estimates by 18%, factoring in: a) a deceleration in the CS business and commercial benefit from certain newer projects on completion of clinical trials (FY24 onwards), b) moderation in the API business, and c) delayed scale-up in the Nutraceuticals business, despite a capacity expansion. We also lower our P/E multiple to 30x from 33x to factor in lower visibility on Kakinada capex, considering capex to be one of the leading growth indicators for DIVI. Accordingly, we arrive at our TP of INR3,250 (from INR4,280 earlier).

* We have downgraded our rating to Neutral, considering the muted outlook (a 4.5% compounded decline in earnings over FY22-24). Valuation is yet to factor in the same.

Inferior product mix and reduced operating leverage drag earnings

* Revenue declined by 6.7% YoY to INR18.5b (est. INR21.8b) in 2QFY23.

* Gross margin contracted by 340bp YoY to 63.6%.

* EBITDA margin contracted at a higher rate (800bp YoY) to 33.5% (est. 37.8%), largely due to lower GM and higher other expenses/employee cost (up 330bp/120bp as a percentage of sales).

* As a result, EBITDA fell 24.7% YoY to INR6.2b (est. INR8.2b) in 2QFY23.

* Adjusted for INR308m of forex gains, PAT fell 24% YoY to INR4.7b (est. INR6.3b).

* Sales rose 4% YoY to INR41b in 1HFY23, while EBITDA/PAT fell 12.5%/10.4% to INR14.6b/INR11.2b.

Highlights from the management commentary

* The share of CS-to-Generics in 2QFY23 revenue stood at 43:57.

* Sales of Nutraceuticals stood at INR1.6b in 2QFY23. ? Assets worth INR890m have been capitalized, and INR5.4b is CWIP.

* The management is awaiting clearance from the state government to kickstart the Kakinada project.

* DIVI’s dependence on China has reduced by 20% YoY in 1HFY23.

* Capacity utilization stood at 80-83% in 2QFY23.

* Certain molecules in the CS segment are closer to completing Phase III clinical trials and are near a launch. Meaningful commercial benefits are expected from FY24.

* DIVI has filed multiple DMFs in several regulated markets. The commercial benefit from the same is expected from FY24.

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