Dr. Reddy's Laboratories' Q3FY19 results (Upgrade to Neutral) - Strong quarter despite muted US growth

Q3FY19 result highlights

• Revs came lower at Rs38.5b, vs est Rs39b led by lower US revs $205m (Q2 $204m; est $215m) indicating continued pricing pressure on some semi-exclusive assets. India came in lower at Rs6.7bn (+10%) vs est of Rs6.9bn. EMs surprised positively for the second consecutive quarter and grew by +31% led by Russia Rs4.1bn (est 3.8bn), RoW at Rs2.24bn (est Rs2bn) and CIS at Rs1.4bn (est 1.35bn)
• EBITDA came higher at Rs8.2bn/21.2% vs est of Rs7.4bn/18.8%. GMs were lower at 53.9% vs est 54.7%. While GG GMs were weak at 57.6% (est 60%), PSAI GMs (30.8% vs est 26%) came higher.
• Cost control / productivity enhancement efforts continue to deliver: SG&A came lower at Rs8.9bn (-5% qoq; est Rs9.6bn) along with lower R&D spends of Rs3.7bn (-11% qoq). R&D costs are expected to increase in coming quarters but will likely stay subdued vs previous years.
• Tax rate stood significantly lower at 16% (est 25%) led by tax reversals. PAT came in higher at Rs4.85bn (est Rs3.5bn) aided by higher other income at Rs681mn (incl Rs423mn on sale of API plant).
• Update on Big 4 products :1) gCopaxone –2HCY19 launch guidance maintained 2) gNuvaring –expected approval in 1HCY19 3)gSuboxone – Awaiting court decision 4) DFN-02: approved; planning for launch;

Key positives: Higher EM sales; higher PSAI margins, lower tax rate

Key negatives: Lower US/India revenues, lower GMs

Impact on financials: We have increased FY19 earnings est by 5% to account for lower tax rates

Valuations & view

While the market has focussed on the status of big 3 generic launches, 33% EBITDA growth in 9mFY19 despite 8% yoy decline in US generic sales over this period underlines the significant operational turnaround effected by DRL’s new management team over the last few quarters. Strong growth in EM sales combined with focus on broad-based cost rationalization have enabled strong earnings recovery despite limited / negative contribution from the US business over this period. We believe this dual growth engine has created a strong platform for medium term growth with the anticipated pick-up in US sales significantly adding to the momentum. DRL continues to have one of the most valuable ANDA pipeline amongst peers which should deliver going forward. Operationally, we believe that DRL has turned the corner and the worst is likely behind. Delay in big-3 launches does remain a risk to estimates. While we are positive on DRL’s growth story from hereon, current valuations (17.7x FY21E) offer limited upside. Upgrade to Neutral with target price of Rs2994; recommend adding into any weakness.