Dr. Reddy's Laboratories' Q2FY20 results (Neutral) - Soft quarter; US pickup is key monitorable

Q2FY20 result highlights

• Consol revenues came at Rs40.8bn vs est Rs40.6bn. US sales along with domestic sales was a key miss; US sales came at $203m vs $235m; est $245m; Mgt cited Ranitidine recall (Rs170m) and temporary supply disruptions; adj for these, revenues were bit lower qoq (not quantified) – impacted by price erosion and lower volumes. Sharp qoq decline in US despite 8 new product launches was a big negative surprise.
• India sales grew 9% yoy lower than est of 13%. API sales Rs7.1bn vs est Rs5.4bn was key positive; EM (ex-Russia) marginally beat est
• EBITDA – Rs6.88bn vs est Rs8.46bn; Q1 was Rs7.3bn; EBITDAM – 16.9% vs est 20.9%. GMs came at 50% vs est 53.4%; mgt cited normalized margins at 51.5% (Rs231m Ranitidine inv writedqwn etc). While PSAI margins improved to 24%, GG margins dipped 200bps qoq to 55.5%
• R&D expenses – Rs3.66bn – continued to stay low. Other expenses came at Rs9.8bn; Q2F19 Rs9.4bn; Mgt cited adj for Rs1bn one-offs (Rs328m on PP divestment, balance unspecified), other expenses were lower qoq
• Additionally, DRL booked Rs7.2bn gains on PP product divestment. DRL booked Rs3.5bn impairment charge;
• PBT came at Rs7.6bn; Adj for PP income and impairment, PBT was Rs4bn vs est of Rs6bn. DRL booked gain of Rs5.2bn due to recognition of deferred tax asset. Reported PAT Rs10.9bn – much ahead of estimates
• gNuvaring / gCopaxone – Have received CRLs and working to resolve them. Did not provide a guidance for resubmission.
• Srikakulam API plant – Resolution subject to re-inspection
• M&A – Will aggressively pursue opportunities esp in India 

Impact on financials: Increase FY20 earnings to account for MAT tax credit and one-off PP divestment income; FY21e broadly unchanged

Valuations & view

DRL’s Q2 has been marred by multiple one-offs across various items. Even adjusting for the one-offs (several unspecified) cited by the mgt, numbers are weak especially in terms of US sales, India sales and GMs. Overall, these one-offs create some level of ambiguity on the profitability of the recurring business and therefore H2 earnings trajectory will be key to assess the underlying business profitability and pace of earnings recovery. Structurally, EM sales growth combined with cost rationalization focus have created a strong growth platform for DRL despite limited contribution from the US business in recent quarters. DRL has one of the most valuable ANDA pipeline amongst peers which hopefully should deliver going forward. While the worst is likely behind, given the earnings volatility, we believe that the turnaround is largely priced in at current levels. Maintain Neutral with target price of 2889 (19x FY21E).​