In fine health

POUND WISE

Dr Reddy's turnaround has come on the back of geographical spread and a partnerships approach.

Is the worst over for domestic drug maker Dr Reddy's Laboratories? After two years of serious illness owing to legal setbacks, rising litigation costs and higher research spend, the company seems to be on the recovery path.

The signs are already evident as over the last two quarters, operating profits and margins have improved substantially. Yet, the stock continues to be a laggard on the bourses. Over the past three months, the stock has gained 10.7 per cent compared to a 13 per cent gain in the Sensex.

Similarly, even over the past six months the stock has gained 29.6 per cent, lower than the 32.3 per cent gain in the Sensex.

Though analysts believe the company is in far better shape than before, with a market capitalisation of Rs 5800 crore, the stock is not going cheap as it trades at a price-earnings ratio of 35 times fiscal 2006 earnings.

The ailment
Last year was bad for Dr Reddy's. Operating profit fell 69.8 per cent to Rs 101 crore while operating profit margin declined 1362 basis points to 6.5 per cent.

Among other things, Dr Reddy's had been hit by surging operating costs such as R&D and legal charges for fighting patent suits. Research costs jumped 26.7 per cent to Rs 242 crore in FY05.

As a percentage of net sales, the cost expanded 408 basis points to 15.54 per cent. Even in FY04, Dr Reddy's had grown its R&D budget by 41 per cent to Rs 199 crore.

Plus a rise in legal costs was reflected with other expenditure too, jumping 27.4 per cent to Rs 293 crore. One of the most prominent defeats faced by the company in its patent challenge strategy was in March 2004, when the US FDA barred it from launching the generic version of Pfizer's anti-hypertension drug Norvasc before the patent expiry up to 2007.

This drug had sales of almost $2-2.5 billion. Analysts point out such cases could have cost the company up to $10 million in legal expenditure.

Besides, the US generics market faced mounting pricing pressure. Products such as fluoxetine (medication for treating depression and allied areas ) and tizanidine (medication for multiple sclerosis) saw prices drop by almost 20 per cent y-o-y, according to analysts.

The recovery
Over the past two quarters, the drug major has returned to profit despite the pricing pressures in the US generics market, that has hit practically every player in the segment.

For instance, in the September quarter, Dr Reddy's reported a 63.1 per cent y-o-y growth in its consolidated operating profit to Rs 113.7 crore. Consolidated operating profit margins, too, expanded 685 basis points to 20.15 per cent. Meanwhile, other players such as Ranbaxy Laboratories had witnessed a fall in operating margins by a staggering 2064 points y-o-y to just 2.31 per cent.

Dr Reddy's turnaround has come mainly on account of two essential shifts. One, the company has been increasingly focusing on expanding its geographical spread in the fast growing generics business. Two, the company has successfully leveraged the partnership model in a bid to check R&D costs. 
  

FINANCIALS
Consolidated annual results in crores
	FY 05	FY 04	% change
Net Sales	1835.88	1933.42	-5.04
Operating Profit	84.58	286.32	-70.45
OPM in per cent	4.60	14.80
Net Profit	32.91	251.14	-86.90
Consolidated Q2 FY06
	Q2FY06	Q2FY05	% change
Net Sales	561.06	524.19	7.03
Operating Profit	113.70	69.73	63.10
OPM in per cent	20.15	13.30
Net Profit	90.91	46.91	93.80

Partners in progress
Generic players such as Cipla have been using the partnership model in overseas markets in a bid to de-risk their business model. While Cipla shares profit with its overseas partner, it does not incur expenditure relating to registration and marketing in foreign markets.

As a result, Cipla's operating margin expanded 372 basis points to 26.4 per cent in the last quarter. Dr Reddy's has adopted a similar approach. The company recently entered into two partnership agreements for sharing R&D costs.

The latest one is the setting up of an integrated drug development company Perlecan Pharma, with both Citibank Venture and ICICI Venture investing $22.5 million for a combined stake of 83 per cent.

The company has transferred four new chemical entities to this new company. Earlier the company had entered into an agreement with ICICI Venture for development and commercialisation of generic drugs filed in the US between 2004-05 and 2005-06.

Thanks to the partnership approach, R&D costs fell 37.36 per cent on a y-o-y basis to Rs 35 crore in the September quarter. Even as a percentage of net sales, it had fallen 701 basis points to 6.6 per cent. In the June quarter, too, R & D costs, as a percentage of net sales, fell 238 basis points to 8 per cent.

Not just America
A key driver of Dr Reddy's sales growth has been the company's expansion in new markets in Europe coupled with a revival in domestic sales. Net sales expanded 20.13 per cent in the September quarter to Rs 519.27 crore. In contrast, Ranbaxy had reported a 3 per cent dip on a y-o-y basis in net sales to Rs 1,283 crore in the last quarter.

Dr Reddy's has expanded its presence in faster growing and rapidly emerging markets. For instance, in the September quarter, sales in Ukraine and Kazakhstan expanded 39 per cent y-o-y to Rs 20.3 crore, helped by improved sales of branded finished dosages in the lifestyle segment.

Also, sales of generics expanded 46 per cent in Western Europe to Rs 47.3 crore, helped by expanded sales of medications such as omeprazole (medication for ulcers and anti - acidic segment).

In addition, domestic sales, too, have shown signs of reviving and they expanded 12 per cent per cent y-o-y to Rs 150.7 crore, helped by improved sales in segments such as the cardio-vascular. This growth momentum helped offset the 58.2 per cent dip in the American generics business to Rs 29.9 crore.

Additionally, to bring greater stability to earnings and margins, in the medium term, the company recently acquired Roche's API (active pharma ingredients) business in Cuernavaca, Mexico, including all employees and business supply contracts.

The total investment outlay for this deal is about $59 million ( approximately Rs 250 crore) including working capital. Profit margins in such contract manufacturing business are typically pegged at 12 - 15 per cent and focus on this business segment, has helped other players to better withstand the impact of generic pricing pressures.

For instance, even in a difficult environment, contract manufacturers such as Divi's Laboratories had grown its operating profit margin. The custom manufacturing business of Dr Reddy's is estimated at $10 million (about Rs 43 crore) or approximately 2.8 per cent of FY 05 net sales. The company is keen to expand this business to $100 million in the medium term.

Dr Reddy's still has other strengths as well. It filed 1 US DMFs at the end of the September quarter, taking total filings to about 75, which is one of strongest API pipelines amongst Indian companies. The company has also recently received tentative US FDA approval for its anti-diabetic drug, Rosiglitazone Maleate tablets.

The market size of this product segment is estimated at $2 billion. Analysts highlight that in the medium term, once regulatory approvals are won, the product could emerge as a key earnings driver for Dr Reddy's.

The company's rich product pipeline has helped it to get better valuations. The stock trades at almost 35 estimated earnings for FY 06. In contrast, other generic players like Cipla trade about 27.3 estimated FY 06 earnings, while Ranbaxy gets a discounting of about 57 times estimated CY 05 earnings.