Dr. Reddy's Laboratories' Q3FY20 results (Upgrade to Outperformer) - Strong operational performance

Q3FY20 result highlights

• Consol revenues came at Rs43.8bn vs est Rs41.4bn. US sales along with domestic sales were largely inline; US sales came at $225m vs $203m in Q2 (8% qoq); Russia and API performed better than est
• India sales grew 13% yoy to Rs7.6bn higher than est of 12%. API sales stood at Rs6.9bn vs est Rs6bn; EM (ex-Russia) were inline at Rs4.3bn. Russia stood at Rs4.9bn vs est of Rs4.2bn
• EBITDA – Rs10.2bn vs est Rs8.6bn; Q2 was Rs6.9bn; EBITDAM – 23.2% vs est 20.7%. GMs significantly improved to 54.1% vs est 52.1% due to better product mix and better manufacturing operating leverage. While PSAI margins improved to 30%, GG margins rose 250bps qoq to 58%
• Overall, key positive surprise was the strong GP performance at Rs23.7bn vs est Rs21.9bn; highest ever GP booked by DRL without any meaningful one-off US launch. This, in turn, has driven significant operating leverage.
• R&D – Rs3.9bn. Other expenses Rs9.6bn- lowest as a % of sales in 8 qtrs. Mgt remains positive on further cost optimization opportunities.
• Additionally, DRL booked Rs13.2bn one-time impairment charges. This includes a Rs11.1bn impairment charge taken due to price erosion in gNuvaring, and Rs2.1bn impairment pertaining to other products
• Reported PBT came at a loss of Rs5.3bn; Adj for impairment, PBT was Rs7.9bn vs est of Rs6bn. Reported PAT at loss of Rs5.7bn. Adj. PAT came at Rs6.5bn vs est of Rs4.6bn. Adj. tax rate lower at 18.2% vs est of 23%
• Srikakulam API plant – Re-inspection by FDA initiated
• Balance sheet net cash positive, Will pursue M&A opportunities in EMs especially in India but organic growth higher priority

Impact on financials: Decrease FY20/21 earnings by 39/ 5% on account of one-off impairment charge and diminished outlook on gNuvaring; we also introduce FY22 earnings

Valuations & view

Q3FY20 performance underlines the potential of DRL’s new business model to deliver strong profitability growth despite limited contribution from big ticket US generic launches. DRL’s clearly articulated strategy, under the new management, to reduce reliance on select US generic launches and to enhance focus across India / EMs / PSAI backed up by aggressive and multi-pronged cost optimization initiatives has imparted significant solidity to the business and enhanced its medium term growth visibility. Given the ongoing flux in the global generic industry especially in US generics market, we believe this successful strategic transformation lends significant competitive advantage to DRL from a medium to long term perspective. Additionally, DRL’s strong US pipeline (consisting of filings like gRevlimid) continues to remain a potential source of significant valuation upsides. Upgrade to Outperformer with TP of Rs3572.