In our bl.portfolio edition dated March 5, 2022, we had given a buy recommendation on the stock of Zydus Lifesciences (Zydus), which was then trading at cheaper valuations, ignoring its growth prospects. The stock has since returned 38 per cent, outperforming the Nifty Pharma index, which is down by 2 per cent during the same period. The stock is now trading closer to its historical range (20 times one-year forward earnings) at 19 times FY24 earnings.

In recent years, the company has capitalised on opportunities that have manifested into better earnings growth. At present Zydus has sufficient triggers to sustain its growth momentum in the next few years as well. While we remain positive on the stock, given that valuation is now at par with historical levels, there are some risks associated with its concentrated portfolio. We recommend that investors accumulate the stock on dips.

US portfolio

In the US generics market, Zydus has operated via a concentrated portfolio, which continues even now. Levorphanol, mesalamine, metoprolol or androgel, the large product opportunities significantly boosted revenues earlier and later faced intense generic competition. Asacol HD (used in treatment of bowel disease) is the current heavyweight in Zydus’ portfolio and may face increasing competition similar to earlier products. Zydus also garnered product approval for gRevlimid, a volume-limited lucrative opportunity, in September 2022 and can scale up revenues from this product in the short to medium term. Zydus also launched Topiramate extended release capsules in Q3FY23, which is also a limited competition product. The US portfolio will be centred around these three products, with an overhang of deceleration, until the Moraiya plant can launch products in large numbers.

Moraiya plant and transdermals

Moraiya, Zydus’ main plant for US markets, recently (November 2022) received clearance from US FDA, which unlocks significant value. First out of the gate should be transdermal products (limited-competition products owing to manufacturing difficulty) with five awaiting clearance, including Estradiol. This should significantly buttress the company’s target of 30-35 launches per year, with value added products. Zydus has commercialised a plant in Ahmedabad for US oral solid doses which, along with Moraiya plant, will aid in the high-volume launch plan. A transition to volume and value-based US growth for Zydus would ensure lower volatility in revenues compared to earlier periods.

Saroglitazar to drive India growth

Apart from pricing, product launches, in-licensing opportunities and biosimilar portfolio (13 launched and more in development) driving India growth (common levers in Indian branded generics markets), Zydus is ramping up sales from Saroglitazar. The product is approved for treatment of NAFLD (non-alcoholic fatty liver disease) and NASH (non-alcoholic steatohepatitis), apart from diabetic dyslipidemia approved earlier. Another new chemical entity (NCE), desidustat, approved in India for anaemia in chronic kidney disease patients is also ramping up well. The company hopes to add 5-8 per cent to India sales through these two products in the next two years. Overall, Zydus in India should sustain above market growth (expected at 10-12 per cent growth annually) with these products and earlier mentioned growth levers.

NCE can surprise positively

Zydus is conducting global clinical trials with Saroglitazar for launch in US and other regulated markets if successful. While transdermals, Indian launches, and biosimilars may have already been priced into the stock, NCE options are yet not factored in owing to the binary outcomes. Hence there is decent scope for positive surprises if they transpire. The immediate option relates to Phase II(b)/III PBC indication (primary biliary cholangitis) under way in the US with initial results expected in FY25-26. NASH, an indication with wider revenue potential, is also under way along with desidustat for Chemotherapy Induced Anaemia. This should add a significantly differentiated revenue stream (compared to generics) for Zydus if successful.

Financials and valuations

Zydus reported 10 per cent Y-o-Y revenue growth in 9MFY23 to ₹12,569 crore even as the previous year base period had significant contribution from Covid portfolio. The EBITDA growth at 2 per cent in the same period was below expectations as margins declined from 23.5 per cent in 9MFY22 to 21.9 per cent in 9MFY23. Gross margins decline accounted for 100 bps of the decline (higher input costs) and higher spends on R&D for NCE development also impacted the margins. With a higher run rate of product launches in US, continued NCE development in late-stage trials, the R&D expense should be higher at 7-9 per cent of sales in the next two years, weighing down on margin expansion. But a higher proportion of value added portfolio (gRevlimid, transdermals and biosimilar launches in emerging markets) should offset the higher R&D expenses.

Consensus estimates imply a 10.5 per cent earnings CAGR for Zydus in FY22-24. This assumes a sharp uptick in US launch rate with high-value products to offset the deceleration caused by Asacol HD or topimarate or any other heavyweightproduct. Considering the high base of US revenues by FY23 end which will include as yet limited competition products gRevlimid, Asacol HD, and Topiramate, the ask rate will be high from Zydus’ US business . The stock is currently trading in line with its long-term average of forward earnings at 19 times FY24 earnings.

Why
Valuation gap has narrowed
Strong portfolio in India and US
NCE development will weigh on margins