Stock Call. Why Dr Reddy’s remains a good long-term bet despite recent rally

Many Indian pharma stocks have rallied in the current market turmoil amid the Covid-19 pandemic, thanks to their attractive valuation and improving growth outlook.

In fact, the Indian pharma sector has been one of the few least-impacted sectors in the current meltdown, registering a positive return after five years of underperformance. Year-to-date, the S&P BSE Healthcare index (TRI) has gained as much as 18 per cent, while S&P BSE 100 index (TRI) is down 16 per cent. Though there are headwinds such as unavailability of labourers and disruption in supply of raw materials, many stocks in the Indian pharma sector are poised to gain from favourable currency tailwinds and stable outlook for India, US and European businesses.

Dr Reddy’s Laboratories is one among them. The stock has rallied as much as 35 per cent since our last buy call given in December 2019. The substantial rise in its stock price is on account of its improved earnings performance in recent quarters, supported by its superior execution strategy across business segments.

At ₹4,025, the Dr Reddy’s stock trades at about 32 times its trailing 12-month earnings, which is slightly higher than its three-year average of 30 times. It is cheaper than similar-sized peers such as Cipla and Divi’s Laboratories that trade at price earnings multiples of 33 and 48 times, respectively, while it is more expensive than Sun Pharmaceutical Industries, which is trading at 28 times.

Strong prospects

Dr Reddy’s is likely to continue exhibiting a strong execution in the medium to long term, given its healthy ANDA (abbreviated new drug application) pipeline for the US market, growing reach in the Europe market and positive impact of the Wockhardt deal on the domestic market.

Having resolved the regulatory issues at most of its key facilities, the company is now expected to ramp up its performance further, led by approvals in the US, new launches and product-level cost optimisation.

The firm’s focus on biosimilars, along with its foray into the Chinese generic market, will further improve its profitability.

The company’s focus on non-US business, divestment of non-core assets, trimming of the workforce and rationalisation of R&D over the past two years can lead to an improvement in margins and return ratios going ahead.

Considering the above aspects, despite the recent rally, the stock holds good prospects in the medium to long term. Investors with a medium to high risk profile can accumulate the stock for a three- to five-year time horizon.

In the fourth quarter of FY2019-20, the company’s consolidated revenue grew by 10 per cent (year-on-year) to ₹4,432 crore. Its consolidated net profit was up by 76 per cent (y-o-y) to ₹764 crore, partly due to recognition of MAT (minimum alternative tax) credit in the fourth quarter of FY20.

North America and Europe markets contributed much during the quarter by growing (y-o-y) by 21 per cent and 80 per cent, respectively, while the growth was moderate in the domestic market, at 5 per cent. The company’s operating margin stood at 21.2 per cent during the period compared with 20.4 per cent in the fourth quarter of FY19, thanks to lower employee cost and other expenditure.

As regards Covid-19-related impact in the fourth quarter, the management has revealed that there were some incremental sales (temporary) in certain markets, including the US, Europe and Russia, due to increase in panic-buying, while the sales got impacted or deferred in India and a few other emerging markets due to logistical issues.

For the full year of FY20, the consolidated revenue of the company grew 13 per cent from FY19 to ₹17,460 crore and the net profit grew 4 per cent to ₹1,950 crore.

Opportunities

Dr Reddy’s US business, which contributes 41 per cent to its total revenue (as of Q4FY20), has been in trouble over the past few years due to regulatory tightening and price erosion in key drugs.

The pricing pressure is likely to subside going ahead, given its low product-revenue concentration and new launches of complex and limited-competition products.

The company has been one of the best Para IV ANDA filing entities in the industry.

Of the 99 pending ANDAs, 56 are Para IV filings and 30 have FTF (first-to-file) status.

In the near term, limited-competition products such as Copaxone and NuvaRing, which have been long-pending for approval, are expected to generate significant revenue for the company, once launched.

Dr Reddy’s domestic business, which contributes 15 per cent to the total revenue, has been growing strongly, driven by new launches and high volume growth in existing products.

Around 20 per cent of its domestic portfolio is under the NLEM (National List of Essential Medicines) price-control list.

In February 2020, the company acquired Wockhardt’s select domestic branded business and a few emerging markets business — Nepal, Sri Lanka, Bhutan and Maldives — for a consideration of ₹1,850 crore.

The deal will bode well for the company over the long run (scaling up its domestic business especially) as it adds 62 brands across therapies such as respiratory, neurology, dermatology, gastroenterology, pain and vaccines.

Dr Reddy’s Europe business recorded has a significant sales growth in the recent quarters, driven by improvement in base business, new product launches and ramp-up in three new markets.

The business from emerging markets (Russia, Brazil and China) is expected to be strong going ahead, on the back of a stabilising currency, geographical expansion, a robust biological portfolio and a ramp-up in institutional business.

The company’s Europe and emerging markets businesses comprise 8 per cent and 18 per cent of total sales, respectively.

On the other hand, any delay in product launches in the US, re-emergence of regulatory issues and adverse foreign exchange fluctuations could be key downside risks for the company.