Dr. Reddy's Laboratories' Q2FY18 results (Underperformer) - Revenue miss; EBITDA beat led by lower R&D and SGA costs

Q2FY18 result highlights

• Revenues were down 1% yoy to Rs35.5b, against est of Rs36.1b. US revs came at $220m (Q1 $230m) vs est of $240m while domestic sales grew 2% (+10% like to like). Branded formulations exports came at Rs5.5bn vs est of Rs5.9bn while PSAI came in at Rs5.6b vs est of Rs4.9b.
• EBITDA was sharply higher at ~Rs6.6bn (Rs3.1bn Q1) vs est of Rs5.3bn. OPM was 18.7% (9.2% in Q1FY18) vs est of 14.6%.
• Gross profits came in at Rs18.9b vs est of 19.1b. GMs were 53.3% (51.6% in Q1FY18). EBITDA was driven by sharply lower SGA costs at Rs8bn (-9%/-10% yoy/qoq) vs est Rs8.9bn. R&D costs also came in lower at Rs4.2bn (-20%/-18% yoy/qoq) led by deferral of some expenses
• PAT came in higher at Rs2.85bn (Rs591mn in Q1FY18) vs est Rs2.3bn

Key positives: Higher margins led by lower SGA and R&D cost

Key negatives: Lower sales across most geographies, lower GMs

Impact on financials: We have reduced FY18 earnings est by 22% and maintained our FY19 earnings estimate

Valuations & view

DRL’s excellent job on controlling SGA / R&D costs in Q2FY18 has driven a sharp EBITDA surprise (despite sluggish revenue growth) on a relatively low expectation base. We see limited possibility of the quarterly fixed costs (SGA plus R&D) going much below Rs12-13bn. This, in turn, limits the possibility of generating incremental EBITDA upsides purely from cost control initiatives. Therefore, DRL needs to significantly increase its gross profits from the Rs17-19bn reported in the last few quarters to deliver any meaningful EBITDA growth going forward. A sharp pickup in US sales and profitability through launch of multiple big ticket ANDAs remains key to achieve any meaningful EBITDA growth. Though DRL has one of the most valuable ANDA amongst peers, currently there is limited visibility on the timing of approval of new big ticket drugs from this pipeline. This creates significant uncertainty in terms of predicting the timing and extent of the recovery in DRL’s profitability in FY19. Given reasonably rich valuations and significant earnings uncertainty, we maintain Underperformer.  Visibility on niche ANDA approvals (e.g. gCopaxone / gNuvaring / gSuboxone) will be key upgrade triggers.