Dr. Reddy's -What if the operating leverage upside does not play out?:: Credit Suisse,

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Dr. Reddy's --------------------------------------------------------------------- Maintain OUTPERFORM
What if the operating leverage upside does not play out?


● Dr. Reddy’s is trading at 17x FY13 consensus core EPS and the
stock has been capped in a range of Rs1,500–1,600 for the last
six months. We attribute the muted performance to (1) high SG&A
cost so far that negates consensus expectation of margin
expansion in FY13 and (2) overhang of reduced DEPB benefits.
● Margin expansion is expected (Fig 2) as strong sales growth in
FY12/13 is driven by US generics, which require lower SG&A vs.
branded generics. But operating leverage has not played out as
yet (Fig 3). FY13 guidance of 25% RoCE implies margin
expansion but may include one-offs and hence is early to factor in.
● We note that 100 bp change in EBIT margin changes EPS by
Rs5/share for FY13. At 20x FY13, CMP implies EPS of Rs77 (adj.
for pipeline value of Rs50), which is the reduced value of our
FY13 core EPS (Rs85) if no margin expansion is assumed.
● Pricing pressure in India and import alert on Mexico facility implies
margins may remain subdued for next two quarters. The stock
may be capped in this period unless (1) visibility is provided on
FY13 guidance or (2) operating leverage starts to play out.

Operating leverage expected due to high growth from US…
Strong sales growth in FY12 and FY13 (Fig 1) would be driven by high
growth in the US generics. Gross margin for US generics is lower than
branded generics and therefore overall gross margin of the generics
segment should decline but EBIT margin are expected to expand as
the SG&A required for the US generics is significantly lower than the
branded generics in India and the CIS. The same expectation is built
in CS and consensus expectation for FY13 (Fig 2).

… but DRL yet to reap rewards of operating leverage
Dr. Reddy’s single-digit sales growth on its base business in the last
two years (excluding Sumatriptan and Allegra D-24 Rx opportunities)
meant that it could not benefit from operating leverage. However,
when sales growth was strong at 18% in 1Q12, SG&A expenses
increased by 22%. Management expects high SG&A base in 1Q12 to
be the new base, delaying margin expansion opportunity in FY12.

We found high variation in consensus expectation on EBIT in FY12/13
(Fig 4), supporting different views on operating leverage for DRL. The
25% ROCE target for FY13 implies EBIT margin should reach closer
to 20% but Dr. Reddy’s guidance includes US$400 mn extra sales
over FY13 consensus estimates, which could have one-offs included.

Current price implies no operating leverage upside in FY13
At 20x FY13, the current market price adjusted for pipeline value of
Rs50/share (from Zyprexa, Geodon and Finasteride 1mg) implies EPS
expectation of Rs77/share in FY13. We note that 100 bp change in
EBIT margin leads to EPS change of Rs5/share for FY13. Therefore,
if we were to build no margin expansion in FY13 then our core EPS of
Rs85 in FY13 would decline to Rs77 in FY13. Therefore, the current
market price is not factoring in possible operating leverage in FY13.
Pricing pressure in the Indian business (two consecutive quarters of
low growth and 2Q12 is also expected to be weak) and import alert on
the Mexico facility has meant margins may remain subdued for the
next six months. Therefore, unless the management (1) provides
more visibility on FY13 sales guidance of US$2.7 bn and RoCE of
25% or (2) shows signs of significant control on SG&A expenses, the
stock may remain capped around the current levels for the next six
months.