Senior equity analyst Michael Waterhouse analyses Dr Reddy's Laboratories believes that its low-cost manufacturing and emerging-market exposure add up to attractive growth prospects.
Fair Value Estimate: Rs 2,560
Our FVE is maintained given our continued outlook on the persistence of U.S. generic price erosion and remediation costs in response to a 2015 warning letter. We use an exchange rate of approximately Rs 68.3 per $1 as of January 2017.
Our FVE implies a price/earnings ratio of approximately 26 and an enterprise value/EBITDA of 16. We project lower revenue growth over our forecast period—high-single-digit average growth—thanks to a tough pricing environment in the U.S., suspension of business in Venezuela, and longer expected recovery in the company’s API unit. We anticipate that fiscal 2017 U.S. generic and API sales will be depressed as the firm sorts through quality issues highlighted by the 2015 warning letter regarding three of its Indian-based plants. We model average U.S. generic revenue growth at 10% to account for price erosion partially offsetting an acceleration of product launches over the next couple of years.
We continue to forecast double-digit generic sales in India, thanks to rising personal incomes and increased utilization of generic drugs. However, we have excluded Venezuelan generic sales from our rest of world projections given the amount of political uncertainty and cessation of operations. We anticipate that Europe will continue to struggle through low-single-digit growth during the next few years. Our forecast culminates in mid-single-digit growth in the active pharmaceutical ingredients segment and low-double-digit growth in the proprietary pharmaceuticals segment through 2020.
We expect gross margins can remain above 55% thanks to new launches of higher-margin products and the growing contribution from the firm's higher-margin generic drug sales. Apart from regulatory concerns, we expect Dr. Reddy's product shift will continue to bolster gross margins, but believe the company's developed market generics segments and the heavily commodified API operations will face greater pricing pressure toward the end of the patent cliff. Our forecasts for selling, general, and administrative and research and development costs going forward assume ongoing quality efforts and increased focus on new product development will keep operating margins near 18%. As a result, returns on capital dip to 13% in 2017 and creep back up to 14% in 2020. We estimate Dr. Reddy's cost of equity at 10%.
Economic Moat: Narrow
Low-cost operations form the cornerstone of Dr. Reddy's narrow moat. With its operations in India, Dr. Reddy enjoys low-cost labor and a low tax base. Additionally, the company owns vertically integrated active pharmaceutical ingredient manufacturing capabilities, which allow it to save considerably on raw material costs. Dr. Reddy can aggressively price its products as a result of its lower cost structure, and in addition, these cost-saving measures allow the firm to maintain some of the highest profit margins in the generics industry. The company also has relatively strong brand recognition among physicians and pharmacists in many of the emerging markets where it operates. Although these branded generics lack patent protection, they generally enjoy favorable pricing among a loyal customer base.
For the most part, Dr. Reddy's capital allocation decisions appear on par with its peers in the industry, but the company's acquisition of Betapharm as part of its planned European expansion was a large misstep. We'd be skeptical of any big future international acquisitions. Aside from the black eye of Betapharm, management has done a solid job of expanding into other global generics markets and establishing the firm as a major global competitor.
We like that management takes a very modest paycheck, by developed-country standards, and doesn't seem overly concerned about earnings per share targets and other short-term metrics.
The company's drug-specific strategy places a higher degree of success on limited product launches. As such, product recalls represent modest setbacks since the company's product portfolio lacks the diversity of its larger competitors. Dr. Reddy's faced some limited product recalls in 2009 and 2014, as well as a year-long import ban on its Mexican manufacturing facility in 2011. More recently, in 2015 the company was slapped with a U.S. Food and Drug Administration warning letter regarding three of its India-based facilities. The impact of the regulatory scrutiny is highly uncertain, and could range from an outright production ban on the facilities to temporary increases in operating expenses or depressed sales as the company gets its processes up to par.
The company's foray into Europe has been more painful. The company extended its reach into Europe through the 2006 acquisition of Betapharm, a German generic manufacturer, for about $570 million. Soon thereafter, Betapharm's revenue crumbled as the German market shifted to a partial tender-based market system. Betapharm's losses have forced Dr. Reddy to take significant write-offs on its assets. As a result, we’d be skeptical of any future potential international acquisitions. Also, Dr. Reddy's brand recognition is likely to face stronger competition in the coming years as larger players with greater financial resources hope to expand and diversify operations in the faster-growing emerging markets.