Event update: Dr Reddys Lab (Neutral) - Strategic realignment of proprietary business

Event

Dr. Reddy's Laboratories sells its neurology branded products (Zembrace Symtouch & Tosymra) to Upsher-Smith Laboratories, LLC

Key highlights

• DRL has signed an agreement with Upsher Smith to sell rights for its two proprietary CNS products – Zembrace and Tosymra (formerly called DFN-02). DRL will receive $70m upfront, $40.5m in near term milestones etc and will subsequently receive sales based royalty on a quarterly basis.
• This follows the earlier decision to divest its proprietary dermatology portfolio during FY19
• Post this divestment, DRL’s Promius (proprietary drug arm in US) will not have any commercialized products; At a financial level, divestment will help to improve consolidated profitability as we understand the business is currently incurring annual losses of $20-25m
• Mgt indicated that DRL’s proprietary strategy will now be R&D driven - focus on development of new products and monetizing the same.  Given the challenges faced in successfully commercializing speciality products, the company will not invest in marketing speciality products going forward.  Currently 5 products in late stage clinical development and the company is looking to build on this pipeline. 
• Overall, this is a surprising move as mgt had been indicating strong outlook for the recently approved Tosymra and this product was expected to form the core of DRL’s proprietary business going forward.
• Also, this decision is in contrast to most peers who are investing aggressively to build a US speciality business given the challenges in US generics. Notably, DRL was amongst the earlier Indian players to invest in building a US speciality business and their decision is reflective of challenges inherent in building a successful US speciality business for other Indian peers.
• Broadly speaking, this decision is inline with the strategic rethink underway at DRL under the new COO, Mr Israeli wherein the company has been working to optimize its operating structure and enhance profitability.
• The company has been focussing on the imperative on make each business unit self-sufficient and we believe this strategic realignment of the proprietary business is in-line with this thought process. Company believes that they can leverage their R&D strengths to generate income from licensing their proprietary research products on a regular basis and generate meaningful returns on their R&D investments. This is preferable to deploying significant capital in commercializing these proprietary products and building a sustainable revenue stream thereon.
• This divestment further strengthens DRL’s balance sheet and the company intends to use the same for buybacks or for higher investments in its target markets like India, China, US generics etc.

Valuations & view

DRL’s 37% EBITDA growth in FY19 despite 8% yoy decline in US generic sales 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. Ongoing business model optimization efforts will provide further tailwinds. DRL continues to have one of the most valuable ANDA pipeline amongst peers which should deliver going forward. Recent launches of interesting products like gCubicin, gPropofol highlight the potential of the pipeline. Operationally, we believe that DRL has turned the corner and the worst is likely behind. Delay in big ticket launches (as reflected in multiple delays in gCopaxone guidance) does remain a risk to estimates. Maintain Neutral with target price of 2782 (18x FY21E).