RBS: Dr Reddy's Laboratories – Overpriced expectations

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We believe DRL's robust US pipeline is largely priced in. The execution slippages in its annuitytype pipeline in the US and 37% of its business (PSAI & Betapharm) facing headwinds do not
merit the recent stock outperformance (13% vs Sensex in the last three months), in our view. We
downgrade DRL to Sell.
Robust US pipeline seems largely factored in; execution slippages a concern
The recent company presentation re-emphasised DRL’s robust limited-competition pipeline in the
US (Table 1). We highlight that we have already factored in upside potential from its robust
pipeline in the US business (26% of FY11F revenues) – recent launches (generic (g) Lotrel,
gPrograf and gPrevacid) and its near-term product pipeline – gAllegra D-24 in 4QFY11;
gZyprexa, gArixtra, gExelon and gClarinex in FY12 – in our estimates. However, we cannot
overlook DRL’s recent execution slippages: delay in regulatory approval for gArixtra and litigation
overhang for gAllegra D-24. Management stated that only one of its facilities (intermediates) of
gArixtra has been inspected and approved, with the other (syringe filling) now scheduled for this
month. We highlight that a US court verdict on gAllegra is also due this month. The market’s
bullish 3Q expectations (interims scheduled for 25 January 2011) are in line with our 45% yoy
earnings growth estimates (pre extra-ordinaries) and seem to us priced in. Excluding one-offs, we
estimate 2% yoy earnings growth.

Weak business mix – headwinds in PSAI and Betapharm are added dampeners
Its businesses in the US, India (16% of revenue) and Russia/CIS (14%) are on a strong footing,
but the PSAI (26%) and Europe/Betapharm (11%) businesses still face headwinds. PSAI
revenues declined 11% yoy and gross margin contracted from 35% in 1HFY10 to 22% in
1HFY11, and Betapharm revenues fell 20% yoy in 1HFY11 on pricing pressures.  

Downgrade to Sell on rich valuations, execution slippages and weak business mix
Thus, with its US product pipeline seemingly largely priced in, coupled with execution slippages
and 37% of the business (PSAI and Europe) facing headwinds, we believe DRL’s 13%
outperformance of the Sensex over the last three months is unwarranted. We maintain our target
price of Rs1,460 (21.3x FY12F core EPS and Rs29 for its one-offs (Para IV pipeline)), which
implies a discount of about 10% to the current pharma sector multiple. With 14% potential
downside, we downgrade our rating on the stock to Sell from Hold.