Dr. Reddy's Lab Strong, but in-Line, F4Q13; Staying OW:: Morgan Stanley India

We maintain our OW rating on DRL in view of steady
growth momentum, driven by India, US, and RoW
businesses and reasonable valuations. We believe
that the company’s efforts to focus on complex
generics and bio-similars will help sustain high-teen
P/E multiples. Raise PT to Rs2,288.
Business Outlook – Management refrained from giving
F2014 financial guidance. However, longer term, it is
optimistic about the company’s growth and expects
up-trending margins. Nearer term, it expects non-US
businesses (India, Russia, PSAI, etc.) to retain their
trend-line growth, and US to deliver 1-2 complex
generics p.a. (subject to FDA approval). It expects
F2014 R&D expense to rise to 7-8% of sales, an F2014
tax rate of 22-23%, and capex of Rs5-6bn.
Conference call highlights – US pricing is being hurt
by customer consolidation (largely baked in the quarter)
and incremental competition (such as tacro, lanso –
some effect may still come). Incremental US filings are
focused on differentiated products, including injectables,
delayed release, topical (steroid and non-steroid), and
patches. DRL does not see imminent risk to business
from the proposed government rules in Russia for local
manufacturing (for government-funded products).
Capex is for injectables, bio-similars, and SEZ facilities.
In-line F4Q13 – REDY reported total revenue of
Rs33.4bn, up 26% yoy (17% qoq), largely driven by US,
Russia, and PSAI segments. OPM (ex. one-time
settlement income) expanded 290bp yoy (210bp qoq),
to 18.6%. These factors led to adjusted net profit of
Rs4.4bn, up 29% yoy, 17% qoq, vs. our Rs4.3bn
estimate (reported net profits were Rs5.7bn)
Price target change: Our higher price target is largely
based on a higher target multiple, as visibility improves
and industry valuations rise.

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Investment Thesis
• We rate the stock OW in view of
F2013-15 earnings growth potential,
spurred by multiple drivers and
modest valuations.
• DRL is a fully integrated generic play
on global markets; it is building its
proprietary pipeline to supplement its
generic platform.
• Dominant market positions in India,
Russia, the US, and Germany.
• Globally aging population, pressure to
contain costs, significant patent
expiries, and new markets (such as
Japan) define global opportunities.
Key Value Drivers
•Emerging markets: Continuing growth
momentum in India/Russia. Entry into
new markets: South Africa and
Venezuela.
•Regulated markets: New launches
and market share gains for existing
portfolio, especially in the US.
•Bio-similars: Deepening portfolio,
Merck deal (announced June 2012).
Potential Catalysts
• Market share ramp-up in: Toprol XL,
Amoxil, Lipitor, and lanso OTC.
• Market share trends for fondaparinux.
• Launch of niche products in the US.
• Competitive outlook for niche
products in the US.
• Development/regulatory progress of
505(b)(2) candidates.
Downside Risks
• Adverse action by regulator for two
industrial accidents, loss of and/or
delays in niche opportunities in the US,
forex risk and price erosion in EM (incl.
Russia, CIS), including higher
government price controls.

Investment Case
Summary & Conclusions – OW
DRL is building pipeline of complex generics – peptides,
bio-similars, delivery system, difficult injectables. Nearer term,
we expect 14-15% EPS CAGR from F2013’s high base. This,
in addition to modest valuations (16.4x F2015e EPS), drives
our OW rating.
Conference Call Takeaways
Outlook – Management refrained from providing F2014
financial guidance.
However, longer term, it is optimistic about the company’s
growth and expects up-trending margins.
Nearer term, it expects non-US businesses (India, Russia,
PSAI, etc.) to retain their trend-line growth, and the US to
deliver 1-2 complex generics p.a. (subject to FDA approval).
US business – Reported revenues of US$214mn, up 22% yoy.
Key focus areas in the US will be complex/difficult-to-make
products, including injectables, delayed release, topical
(steroid and nonsteroid) and patches. Customer consolidation
and incremental competition could hurt pricing. The company
expects filing momentum to continue (it filed 19 ANDAs/NDA in
F2013). For generic Propecia exclusivity (launched in
Jan-2013), given that higher revenues (undisclosed) were
booked in F4Q13, DRL expects revenues to normalize in
F1Q14.
Russia/ other CIS business – Reported revenues of Rs4.5bn,
up 28% yoy, 3% qoq. Per management, 55-60% of its portfolio
is under the essential drug list.
India formulations – Reported revenues of Rs3.5bn, up 9%
yoy, down 6% qoq. Its growth for F2013 was 13.7% vs. industry
growth of 10.2%, per IMS. Management expects the
better-than-industry performance to continue in the ensuing
period.
Pharmaceutical Services and Active Ingredients (PSAI) –
This segment reported revenues of Rs10.2bn for the quarter,
up 36% yoy, 43% qoq. For F2013, the PSAI segment grew
29%. Management expects the growth momentum to continue,
driven by new launches and new contracts.
Research and development – R&D spend for F2013 was at
6.6% of sales and about 7% of sales for the quarter.
Management expects the spend to be in a similar range going
forward, driven by continuous product filing momentum and
focus on complex products. It is setting up an oral solid
research lab in the US.
Bio-similars – Per management, filing in various major
markets (mainly EM) is progressing per expectations.
Separately, it has a pipeline of 5-6 products under
development. DRL’s biosimilar portfolio in India grew 25% yoy
during F4Q13.
Forex hedges – Outstanding forex hedges are about
US$480mn hedged in the range of Rs56-59/USD. In addition,
the company has balance sheet hedges of US$350mn.
Net debt as of Mar 31 was US$267mn.
Capex target for F14 is about Rs5-6bn. Capex in F2013
(US$123mn) was largely towards injectable, bio-similar and
SEZ facilities.
Valuation and Price Target
The stock trades at 18.6x and 16.4x our F2014e and F2015e
earnings, respectively, about a 0% discount to large-cap peers.
Our revised price target of Rs2,288 (Rs2,037 earlier) is
achieved by applying an 18.5x P/E multiple (up from 17.5x) to
our Mar-2015e EPS of Rs123.7. Our price target change is
driven by rolling forward our target EPS by six months to
March-2015 and increasing our target P/E – driven by better
visibility of monetization of US pipeline (approvals of
isotretinoin, Toprol XL, Propecia, etc.), and rising India
pharmaceuticals industry valuations. Our target multiple is at
about a 10% discount to the industry average.
We believe that a modest discount to the industry is warranted
for DRL on account of:
1) The increasingly low risk to earnings, given the multitude
of niche opportunities – both in the market (Toprol XL,
fondaparinux, isotretinoin,) and likely to be launched
(Vidaza, Dacogen, undisclosed niche launches) and
longer-term opportunities;
2) The gradual build-up of its IPR-intensive portfolio, including
bio-similars, NDDS and NCE.
…versus offsetting factors including

1) its relatively high share of short-duration opportunities in
overall profits;
2) competitive (tacrolimus, lansoprazole, fondaparonux)
risks to niche opportunities; and
3) modest longer-term sales growth outlook for the base
business.

Bull and Bear Case Scenarios:
Bull case – Visibility of niche launches (Rs2,592). Key
drivers for this scenario include:
• Better growth and profitability for the base business,
especially bio-similars in emerging markets and GSK deal
(Rs114/share);
• Re-rating driven by better visibility of technology-intensive
products, such as NCE and those with differentiated
delivery systems (NDDS) (Rs160/share); and
• Surprise niche launches in the US (Rs30/share).
Bear Case – Deterioration in non-US markets (Rs1,556).
Key drivers for this scenario include:
• A significant setback in Russia (due to reforms and local
currency depreciation) and competitive pressures in niche
products (Rs286/share);
• De-rating driven by setbacks in IPR and adverse regulator
action for industrial accidents (Rs286/share); and
• Lower earnings driven by Rs appreciation (Rs160/share).
Risks
Key downside risks to our price target include: loss and/or
delays of niche product opportunities in the US; higher
competitive intensity for niche opportunities in the US, such as
Toprol XL, tacrolimus, lansoprazole, Augmentin and
fondaparinux; weakness in the Russian ruble and Russian
regulatory risks; fruition of domestic pharma pricing policy; cost
mismanagement slows recovery of base business margins;
forex risk for the export business; and adverse regulatory
action resulting from two industrial accidents.