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India drives earnings growth, while North America/PSAI drags it down

Longer wait for commercial benefit from certain niche launches

* Dr. Reddy’s Labs (DRRD) delivered a miss on earnings in 1QFY22, affected by a) higher price erosion in North America (NAM) sales, b) the deferment of offtake by DRRD’s customer in the Pharma Services and Active Ingredients (PSAI) segments, and c) quarterly lumpiness in the Tender business in the Russia segment. DRRD exhibited strong growth in Domestic Formulations (DF), led by demand recovery, COVID products, and the addition of Wockhardt’s DF business.

* We reduce our EPS estimate by 4% each for FY22/FY23E, factoring in delays in the ramp-up of potential launches in the US market and the commercial scale-up of the Sputnik vaccine, as well as increased opex toward marketing activity in DF. We value DRRD on an SOTP basis (25x 12M forward base business EPS of INR195 + INR260 as NPV per share from the g-Revlimid opportunity). Accordingly, we arrive at Target Price of INR5,200 for DRRD. We believe the current valuation adequately factors in the upside in the base business and incremental contribution from niche launches. Hence, we remain Neutral.

* We await clarity on the further course of action post the receipt of a subpoena from the Securities and Exchange Commission (SEC) for the production of documents for allegations related to improper payments to healthcare professionals in Ukraine and certain other geographies.

Product mix and lower operating leverage impact profitability

* DRRD’s 1QFY22 revenues grew 11.4% YoY to INR49.2b (v/s est. of INR48.6b). DF sales are up 69% YoY to INR10.6b (22% of sales) and Emerging Markets (EM) sales were up 14% YoY to INR9.1b (19% of sales). Particularly, the ROW segment within the EM segment grew 29% YoY to INR4.2b. Europe sales were up 12% YoY to INR4b (8% of sales).

* CIS/Russia revenues (INR1.4b/INR3.5b) grew moderately by 4%/8% YoY. Sales growth YoY was dragged down by US sales, flat at INR17.4b (~USD234m; 35% of sales). PSAI revenue declined 12% YoY to INR7.5b (15% of sales).

* The gross margin (GM) contracted 380bp YoY to 52.2% due to a change in the product mix. The EBITDA margin contracted at a higher rate of 690bp YoY to 18.3% on account of higher SG&A expenses (up 280bp YoY as a percentage of sales).

* EBITDA declined ~19% YoY to INR9b (v/s est. INR10.6b).

* The effective tax rate was lower YoY at 23.1% in 1QFY22 (34.1% in 1QFY21). Accordingly, adj. PAT declined at a lower rate of 2% YoY to INR5.7b (v/s est. INR6.1b).

Highlights from management commentary

* GM was down 380bp YoY / 140bp QoQ on a) reduced export benefit, b) higher price erosion in the US, and c) higher inventory provisions for certain products.

* Operating working capital increased by USD160m QoQ on higher inventory and receivables. Particularly, receivables increased due to the planned discontinuation of receivables discounting as a result of the narrowing of the interest differential between the US and India.

* DRRD expects the supply of Sputnik V vaccine to increase over Sep–Nov’21, with the six contract manufacturers commencing supply in a phased manner. It is also working on Sputnik Light, for which the Russia phase 3 trials would be leveraged for India approval.

Valuation and view

* We lower our EPS estimates by 4% each for FY22/FY23E, reflecting a) price erosion in the US base portfolio, b) the gradual accrual of commercial benefit from niche launches, and c) higher SG&A spend towards marketing for key brands and the buildup of DTC, Nutrition, and Digital Health & Wellness.

* We expect a 23% earnings CAGR over FY21–23E, led by a sales CAGR of 13% in NAM, 27% in DF, 25% in Europe, and 11% in PSAI.

* We value DRRD’s base business EPS of INR195 at a 12M forward P/E multiple of 25x and add INR260 per share of NPV from the g-Revlimid opportunity. Accordingly, we arrive at TP of INR5,200 on a 12M forward earnings basis. We maintain Neutral on a limited upside from current levels.

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