On a high

POUND WISE

Divi's Laboratories is the only major pharma company to see its stock price go up 100 per cent a year for the past two years. Has the stock run up too much, too fast?

The stock of contract research and manufacturing (CRAMS) player Divi's Labs is the top-performing pharmaceuticals stock of recent times. If you had picked up the stock a year ago, it would have doubled your investment in less than a year, and between June 2006 and now, the returns would be 150 per cent!

Even over the past week, it has shot up by 7 per cent against the 1 per cent gain in the Sensex, and is hovering around the Rs 3,000 mark.

The Divi's labs stock has moved up on the back of an impressive set of results in the second quarter of FY07 which saw its sales and net profit double to Rs 160 crore and Rs 31 crore.

With the company set to increase its share from the high margin custom chemical synthesis (CCS) segment and getting ready to launch Astaxanthin ($300 million market worldwide) in the coming fiscal, there is no dearth of growth opportunities.

Integration helps
Divi's Labs is one of the few companies in the pharma sector (Dishman and Jubilant being two others) to have a presence across the CRAMS value chain.

The life cycle of a new drug starts at the drug discovery stage and offers outsourcing opportunities in the pre-clinical, clinical and the manufacturing stages.

Divi's Labs is developing its expertise in the first two stages which involves creating samples and optimising the manufacturing process. Since the difficult part lies in the initial stages, the margins at 40 per cent too are the highest in these stages.

Thus far, the company has been focussing on the manufacturing of active pharmaceutical ingredients (API) and intermediates which still account for up to 70 per cent of its revenues.

To boost its revenues in the CCS segment, the company is eyeing the global CRAMS market which is estimated to be at $27 billion. At $100 million, Indian players have less the one per cent of the manufacturing segment and a negligible share of the research market.

The Indian share in both these segments is expected to jump ten-fold to cross the $1 billion mark in the next five years.

Domestic pharma companies such as Divi's which have domain knowledge, lower manufacturing and labour cost advantages, and the largest number of FDA approved plants outside of the US are banking on the Rs 10,000 crore CRAMS opportunity to step into the big league. However, there are risks that Divi's Labs will have to address if it wants to take a chunk of that number.

Lucrative, but...
The biggest risk is the long gestation period--it takes up to six years from the time of negotiations to product delivery.

Indian companies will have to first set up the facility, start production and have their facilities approved by various regulatory authorities before shipping the product. The initial capital requirement, thus, would be very high.

Procuring and executing contracts is another major risk as India is still evolving as a preferred CRAMS destination. Failure to execute a contract could affect players in this sector.

The relationship with the innovator also plays a key role in ensuring a steady stream of business. A delay in picking up the manufactured quantities or a cancellation will result in piling of inventory at the Indian partner's end and under-utilisation of facilities.

Divi's Labs had a taste of this when an MNC cancelled its contract after Divi's Labs set up a dedicated facility and supplies were to start in April 2006. The company, however, recovered its costs and analysts believe that it is a one-off event, unlikely to repeat itself.

The downside for investors who have put their faith in CRAMS companies is a lack of visibility of earnings due to confidentiality agreements of the innovator company and its Indian partner.

Neither the drug, the size or the tenure of the contract is known which makes it difficult to put a number to earnings.

Going long on CRAMS
Analysts and fund managers we spoke to believe that the fundamentals of Indian CRAMS companies and especially those of Divi's Labs are strong and provide a long term and stable revenue stream with sustainable margins till 2010.

Analysts believe that such companies deserve better valuations as compared to other pharma players not just due to the outsourcing opportunity but also due to the strong relationship that Indian companies have been able to establish with innovators.

Valuations
The numbers at Divi's Labs continue to impress. While top line has doubled in the second quarter FY07, operating profit is up by 63 per cent. Its margins, however are showing a decline both at the operating and the net profit levels for the full year as well as quarter-on-quarter basis.

For the latest quarter however the decline was due to ESOPs of Rs 6 crore and expenditure incurred on shifting production of some products from domestic tariff area (DTA) to its Export Oriented Unit (EOU ). The good numbers however are not limited to the September quarter. 
 

RIGHT PRESCRIPTION
(Rs crore)	FY06	FY07E	FY08E
Sales	389.00	616.00	795.00
Operating profit	123.00	183.00	238.50
Y-o-Y growth (%)	18.27	48.00	30.33
Net Profit	69.00	103.00	145.00
Y-o-Y growth (%)	6.15	49.28	40.78
EPS	54.00	80.00	113.00
P/E (x)	37.00	36.29	25.69

For the six months period ended in September, operating profit grew by 91 per cent while net profit doubled. No wonder interest in the stock is at a peak with volumes shooting through the roof.

At 2,903, the Divi's stock is in the expensive territory with a trailing 12-month P/E multiple of 37. Its peers Jubilant and Dishman are trading at 18 and 26 and are more reasonably priced.

Unless there is a fresh trigger in terms of a new contract from an innovator company, there is no reason for it to continue its gravity-defying march.