Divis Labs: Hold ::: Business Line

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Steady base business aided by higher utilisation at the new SEZ facility in Vizag may help Divis Laboratories sustain healthy growth over the next two years.

But the 41 per cent run up in the stock price over the last one year may limit the near-term upside.However, the stock has potential to deliver 15 per cent gains over the next 12-15 months.

At the current market price of Rs 1,040, the stock trades 17.3 times the FY14 earnings, implying a 15 per cent discount to its historical average multiple. Investors may continue to hold the stock of Divis Laboratories.

CLIENT ADDITIONS

Custom manufacturing segment constitutes nearly half of Divis Laboratories’ revenues. The company undertakes custom manufacture of APIs (active pharma ingredient) and advanced intermediates for products in different stages of the life cycle, right from the discovery phase.

PATENT CLIFF, AN OPPORTUNITY

In addition to steady growth in revenues from existing clientele, the company has added new customers in this segment. Divis’ profitability in the medium term hinges on the existing molecules advancing into the subsequent stages of clinical trials. Divis also provides contract research services with dedicated research teams catering to client specific needs.

Generics accounts for half the company’s revenues. Using its research capabilities, Divis has developed patent non-infringing process for manufacturing APIs.

In addition to catering to the requirement of leading generic drug manufacturers globally, the company has tapped into the innovators’ market too.

It has tied up with innovators to manufacture cost-effective API for their patented drugs which are on the verge of losing patent protection.

SCALE UP IN CAROTENOIDS

The imminent patent cliff (expiration of patents for many drugs) and heightening generic competition in the US over the next two years may augur well for Divis’ generic business.

The company has also been successful in the synthesis of carotenoids, used in nutritional preparations. Competition from global players such as the Dutch nutrition major DSM and Swiss-based Loanza has led to a slow pick up in the segment’s revenues.

With the approval of production block at DSN SEZ at Vizag and new launches, the management targets 50 per cent growth in the segment’s revenues in FY14.

The company has invested Rs 200 crore in setting up the DSN SEZ at Vizag. The SEZ houses five production blocks. The facility became operational last fiscal and two of the total five production blocks have been inspected by US FDA (Food and Drug Administration).

The inspection of two more units is expected to happen by early next fiscal. The utilisation at the DSN SEZ is low at 45 per cent currently. Improved utilisation levels after approval of two production blocks by the first half of the next fiscal may help margin improvement.

QUARTERLY PERFORMANCE SWING

India has been one of the favoured low-cost contract manufacturing destinations for big global pharma companies. But the caveat here is that the fortunes of the contract manufacturer depend largely on the business health of its key clients.

This could have a bearing on profitability. For instance, inferior product mix led to a 7.3 percentage point decline in Divis’ gross margins in the December quarter.

This was further accentuated by the looming power crisis in Andhra Pradesh, which forced the company to resort to high-cost diesel generated power.

As a result, Divis’ operating margins fell by 2.1 percentage points to 34 per cent in the December quarter.

The company is in the process of addressing the power shortage issue and is actively considering low-cost power sources such as solar power. The management expects power costs to normalise over the next two quarters. Operating margins may improve in the second half of FY14.

In the last nine months, the company’s revenues grew in excess of 30 per cent to Rs 1,478 crore compared to the same period last year.

Better product mix enabled the three percentage improvement in gross margins during this period.

Despite higher power and fuel costs, operating margins improved 1.8 percentage points to 37.9 per cent.

Net profit grew 30 per cent to Rs 430 crore during this period. The management is confident of sustaining growth in excess of 20 per cent over the next two years.