Dr. Reddy's Laboratories' Q1FY20 results (Neutral) - Mixed bag; Lower GMs and likely gNuvaring delay disappoint

Q1FY20 result highlights

• Consolidated revenues came at Rs 38.4bn vs est of Rs 39.5bn (Adj. Q4 was Rs 38.4bn). US revs came higher at $234m (Q3 $213m; est $230m). The domestic business grew at 15% yoy vs est of 11% - positive surprise. PSAI sales declined steeply to Rs4.5bn (est of Rs5.9bn) – mgt cited manufacturing issues which have subsequently been sorted.
• EBITDA came lower at ~Rs7.3bn/18.9% (Adj. Q4 – Rs6.4bn) vs est of Rs7.8bn/19.7% margins. Pressure in GMs continued - came at 51.7% due to substantially lower PSAI GMs (7%) and muted global generics GMs at 57.6% (est 59%). Mgt ascribed 80bps impact to inventory impairment. SG&A came at Rs9bn (flat yoy) while R&D stood lower at Rs 3.6bn 
• Other income came considerably higher at Rs3.76bn vs est of Rs250m. This includes a one-off income of Rs3.5bn received from Celgene related to settlement of damages for gRevlimid in Canada.
• PBT (ex-Celgene income) was in line. Tax rate stood lower at 22% (est 26%). Reported PAT came in higher at Rs6.6bn vs est of Rs3.7bn
• gNuvaring – likely to receive CRL leading to potential delay in launch. gCopaxone – no further updates; launch likely in FY21 as guided earlier
• Srikakulam API plant – Resolution subject to re-inspection
• US Proprietary business – Exited front-end business model and will now only focus on developing new products and licensing them
• M&A – Mgt guided that they continue to actively pursue assets across all target markets. Will leverage DRL’s balance sheet strength to exploit opportunities which are likely to open up in a meaningful way.

Impact on financials: Increase FY20 earnings by 7% to account for higher other income

Valuations & view

DRL’s Q1 results are a mixed bag with the lower GMs mitigating the positive of strong revenue growth in US and India.  At a broader level, 37% EBITDA growth in FY19 despite 8% yoy decline in US generic sales underlines the significant operational turnaround in DRL’s business in recent quarters. EM sales growth combined with cost rationalization focus have enabled strong earnings recovery despite limited contribution from the US business over this period. This has created a strong platform for medium term growth with the anticipated pick-up in US sales adding to the momentum. DRL has one of the most valuable ANDA pipeline amongst peers which should deliver going forward. Delay in big ticket launches (reflected in multiple delays in gNuvaring / gCopaxone guidance) remain a risk to estimates. While the worst is likely behind, we believe that the turnaround is largely priced in at current levels. Maintain Neutral with target price of 2782 (18x FY21E).