Divis Laboratories Ltd - Stock Valuation and Financial Performance

About the Company

Divi’s Laboratories is a leading Indian pharmaceutical company renowned for its expertise in manufacturing active pharmaceutical ingredients (APIs) and intermediates. Founded in 1990 by Dr. Murali K. Divi, the company has grown to become a significant player in the global pharmaceutical industry, supplying products to over 95 countries. Divi’s Laboratories operates through two main divisions, one focusing on generic APIs, including nutraceuticals, and the other on custom synthesis of APIs and intermediates for global innovator companies. With a strong emphasis on research and development, the company boasts state-of-the-art manufacturing facilities that adhere to stringent quality standards, ensuring the production of high-quality pharmaceutical ingredients. In FY24, the company earned a revenue of Rs. 7845 crores, with exports accounting for 87%, and the segmental split between generics and custom synthesis was 55%/45%.

Financial Performance

The financial performance of the company shows that the recent performance of the company is worse than the long term performance. Between FY22 and FY24, the company has faced significant challenges in both revenue and profitability, across all the main line items. Overall revenue fell by 12%, while EBITDA and PAT fell by 43% and 46% respectively. While this may look like erosion in business quality, the financial performance mainly shows that aftermath of the high demand witnessed during the Covid-19 pandemic. In the long term, the company’s performance is expected to normalise through margin reverting back to mean and revenue growing in double digits as a result of investments.

Business Segments: 

a. Generic APIs:

The company is one of the leading players in the global Active Pharmaceutical Industry. In this segment, the company’s strategy is to focus on few molecules but high market share, which would lead to lower pricing pressure. As a result, Divi’s is the world’s largest manufacturer for multiple APIs such as Naproxen, Dextromethorphan, Gabapentin, Valsratan and Levetiracetam, which account for about 65% of total API sales. In Naproxen, Dextromethorphan and Gabapentin each, the company has a 60-70% market share, and in Levodopa, Pregabalin, Carbidopa and Mesalamine, the company has a 20-30% market share. Divi’s is one of the top 2 API manufacturers in the world for 18 out of the 30 molecules. The company constantly innovates at the technological level to produce products at lower costs, to be more competitive and gain a stronger market share. 

This strategy allows the company to have more pricing power than its competitors along with higher demand visibility. However, the API division faces pricing pressure from time to time, as witnessed in the last 3 years. Such pricing pressures occur due to inventory destocking at the client level, which impacts sales and prices, and raw material price increases, which lead to a reduction in margins.

The company adds new products as drugs lose patent protection. Patent expiries tend to be lumpy as the number of high value drugs losing patent protection varies year to year.

The generic API division has a lower margin than the custom synthesis business, but has strong competitive advantages due to the company’s high market share in key products.

Nutraceuticals: 

Nutraceuticals is a part of the Generic API business. Divi’s Laboratories' nutraceutical business focuses on the development and production of high-quality nutritional ingredients and supplements that promote health and wellness. In FY24, the business accounted for 9% of total revenue and 17% of the generic API business. The product portfolio includes a complete set of Carotenoids such as Beta Carotene, Astaxanthin, Lycopene, Canthaxahnthin  as well as other finished forms such as Lutein, Vitamins (A, D3, D2, E Acetate and A Palmitate).

b. Custom Synthesis:

Divi’s Laboratories' custom synthesis business focuses on providing tailored solutions for the production of active pharmaceutical ingredients (APIs) and intermediates for global innovator companies. This division collaborates closely with pharmaceutical companies during the drug development process, offering expertise in complex chemical synthesis, process optimization, and scale-up production. Divi’s has a competitive advantage due to its strong technical knowhow and the low lag time for manufacturing.

In FY22, the company got a one-time Covid-19 related contract for the producing Molnupiravir from MSD, a leading pharmaceutical company. As a result, the sales for the division increased by 90% in FY22, and fell subsequently.

The Custom Synthesis division has a higher gross margin and the lack of growth from this segment in FY23 and FY24 has significantly impacted margins.

Future Prospects:

1. Capex: The company’s Kakinada facility should be operational in and after Q3FY25. The facility spans 500 acres, of which only 200 acres will be utilised in Phase 1. The investment in this facility is expected to be around Rs. 1500 crores. This would inevitably lead to higher revenue in the future without delays for additional capital expenditure.
2. Patent Expiry: Over the next 5 years, a large number of drugs will face patent expiry, creating a $200 billion opportunity for pharmaceutical players. As a result, Divi’s has a large opportunity to provide APIs for these now off patent drugs, leading to an increase in revenue.
3. Revival in Custom Synthesis: The custom synthesis segment will continue to fuel the company’s growth. The company has announced a long-term supply agreement with an MNC and is planning a capacity addition with an estimated investment between Rs. 650 crores to Rs. 700 crores, which will be funded from internal accruals. The proposed facility is expected to be operational by January of 2027.
4. Sartans: Sartans, also known as angiotensin II receptor blockers (ARBs), are a class of medications primarily used to manage hypertension (high blood pressure) and heart failure. The company is able to produce Sartans with extremely low levels of impurities which gives the company a competitive edge. These products are a part of both generic API and custom synthesis segments.
5. Contrast Media: The company has made inroads into contrast media chemistry, which is used for MRIs and CT Scans. While Iodine is used for CT scans, Gadolinium is used for MRI scans and the markets are worth around $5 billion and $4-4.5 billion each respectively. These product baskets will be a part of generics as well as custom synthesis. The customers contrast media APIs are extremely concentrated. The company has iodine recovery technology that reduces its raw material cost while showcasing greener technology usage, which gives it a competitive advantage.

Risks:

1. Raw Material Risk: The company is not immune to raw material price risks. In FY23, solvents, lithium and iodine prices increased drastically. The company faced pricing pressure in its generic API business as a result. However, the company is backward integrated which reduces its raw material risk. Additionally, the custom synthesis business has higher resilience to raw material price volatility.
2. Demand Risk: As the company already has the largest market share in certain products, the incremental growth rate in such products can be low. The company’s growth plans include growth in new products and end markets such as contrast media and sartans, which reduces the risk of demand saturation at the company level.
3. Compliance Risk:  Divi’s Laboratories faces compliance risk from regulatory agencies, mainly from the FDA (USA). While the company has faced issues in the past, the company’s high global market share in certain products and quick resolution showcase the strong compliance culture at the company.

Sluggish results but management retains double digit growth guidance for FY24.

Despite increase in sales sequentially, margins disappointed on account of high inventory cost and elevated pricing pressure in generic APIs. Overall weak numbers.

Divi's Laboratories Ltd | Market Cap: 111,439 Cr

CMP Rs. 4,194 | P/OCF 39x FY23

Recommendation | Sell 50% of your holdings

Results: Divi’s Lab reported 28.7% growth in sales and 59% growth in operating profit year on year. The revenue growth was aided by strong growth across the API and custom synthesis business.

We recommend tracking operating cash flow of Divis’ lab versus PAT as it has large working capital requirement in terms of inventories.

Check 10 year X-ray here

Key highlights: 

• Revenue from generic API segment stood at 60% of sales, while that from custom synthesis stood at 40%. Going ahead, the company plans to have a mix between both the segments of around 50:50.
• The share of revenue from the developed markets of the US and Europe stood at 71% for the quarter, while the share of exports stood at 90%. For the full year FY21, the exports constituted around 88% of sales.
• The company has identified new areas, which would fuel growth going ahead; and this includes the next set of 10 molecules, which have gone off patent and offer a sizeable growth opportunity.
• For its new generic molecules, validation and regulatory submission are under process. And on manufacturing front, the company operated at 86% operating capacity.
• The company has declared a dividend of Rs. 20 for FY21.

Outlook: As per the management, the company faced logistical challenges due to the ongoing pandemic and blank sailing. Due to the investments made in the backward integration to basic chemicals for most of its generic API and diversified supplier base, it overcame most of its procurement issues. 

Divis is an authorized manufacturer of MSD's (Merck Sharp & Dogme) Molnupiravir API and supplier of the same to MSD's voluntary licensing (VL) partners in India. Additionally, it has created one more stream in unit 1 to produce the same for which validation has begun and commercial production is expected to start in the coming quarters.

Divis Labs has almost doubled its capacity this led to the sales growth. As of end of FY21, the capital work in progress stood at ?710.6 crore. During the year, it took a project to fast-track its customs synthesis segment and the capex for the same was ~?400 crore. The immediate capex for the construction of its Kakinada plant is expected to be ?600 crore.

MoneyWorks4me Opinion: We had recommended BUY on Divis Labs at 650/share. 

We had recommended Divis Labs and Syngene before market started recognising their long term potential. Today market is exuberant on the other extreme, it is pricing them as if nothing can go wrong. 

While customer synthesis and API manufacturing are growth businesses, the growth comes at a cost of reinvestment in plants and inventories. We believe that current prices assume no reinvestment. 

Even after assuming 25% growth over next 2 years, Divi’s labs trades at steep 39x EV/Operating Cash flow with leaves very limited margin of safety. 

We had recommended 50% SELL recommendation on Divi’s near 1600/share based on then expected growth rate. However, benefits from supply chain moving out of China gave further fillip to Divi’s fortunes. So today, we maintain 50% SELL on valuation concern and hold the rest for positive surprise if any. Because we have bought at very good prices, our risk is limited, while late entrants are vulnerable to poor returns even if growth materializes. 

Note: Margin of safety and reasonable prices lies at the core of our investment philosophy. We discourage buying stocks at very high valuation as it makes you vulnerable to steep cuts if growth rate don’t sustain. Base rates show that very few stocks manage to grow at very high rates for long. 

“Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.”

– Seth Klarman

Divi's Laboratories Ltd | Market Cap: 100,296 Cr

CMP Rs. 3,782 | P/OCF 45x FY22; Price to Sales 10x FY23

Recommendation | Sell 50% of your holdings

Results: Divi’s Lab reported 22% growth in sales and 40% growth in operating profit year on year. We recommend to track operating cash flow of Divis’ lab versus PAT as it has large working capital requirement in terms of inventories.

Check 10 year X-ray here

Key highlights: 

• APIs (forming 52% of the sales) reported 22% growth, Custom synthesis segment (forming 41% of the sales) reported 19% growth and Carotenoids reported 45% year on year.
• API industry is witnessing high demand and the growth momentum is expected to continue as more opportunity shifts from China to India in medium term.
• Divis’ edge comes from large scale manufacturing at lower cost, even if it means it has to hold large inventories

Outlook: Divis Labs has almost doubled it’s capacity to take advantage of large volume manufacturing. Although the company is confident to maintain steady growth led by new capacity expansions but it awaits for US FDA inspection and clearance.

MoneyWorks4me Opinion: We had recommended BUY on Divis Labs at 650/share. Buying early and at discount prices leads to positive surprises.Currently we see that capacity addition will lead to better sales growth next two years but current prices already factor in very steep growth.

We had recommended 50% SELL recommendation near 1600/share based on then expected growth rate. However, benefits from supply chain moving out of China gave further fillip to Divi’s fortunes. Even after assuming 25% growth over next 2 years, Divi’s labs trades at steep 35x EV/Operating Cash flow with leaves very limited margin of safety. We maintain 50% SELL and hold the rest for positive surprise if any.

Note: Margin of safety and reasonable prices lies at the core of our investment philosophy. This not only increases our upside potential but also give limited downside over long term.

We discourage buying stocks at very high valuation as it makes you vulnerable to steep cuts if growth rate don’t sustain. Base rates show that very few stocks manage to grow at very high rates for long. 

“Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.”

– Seth Klarman

Divi's Laboratories Ltd | Market Cap: 73,929 Cr

CMP Rs. 3,205 | P/OCF 45x FY21; P/E 34x FY21

Recommendation | Sell 50% of your holdings

Results: Divi’s Lab reported 49% growth in sales and 78% growth in operating profit year on year. 

Check 10 year X-ray here

Key highlights: 

• APIs (forming 52% of the sales) reported 54% growth, Custom synthesis segment (forming 41% of the sales) reported 49% growth and Carotenoids reported 20% year on year.
• API industry is witnessing high demand and the growth momentum is expected to continue as more opportunity shifts from China to India in medium term.
• The green field manufacturing site of the company in Kakinada is yet to be resolved by the state Govt and hence the uncertainty remains.
• In order to fight against Covid, Divis has developed manufacturing capability for Remdesivir intermediates. These products haven’t contributed in Q1 but could surprise positively going ahead, considering its cost-effective manufacturing.

Outlook: Divis Labs capitalized assets worth Rs 870 Cr (including a large portion of backward integration project worth Rs 300 Cr and effluent treatment augmentation project worth Rs 190 Cr). The balance capex of Rs 920 Cr is carried forward and is expected to be completed by FY21. Although the company is confident to maintain steady growth led by new capacity expansions but it awaits for US FDA inspection and clearance.

MoneyWorks4me Opinion: We had BUY on Divis Labs at 650/share. Currently we see that capacity addition will lead to better sales growth next year but current prices already factor in very steep growth. We have recommended 50% SELL recommendation near 1600/share. We remain optimistic on Divis Labs future prospects but upside from the stock is limited in our view. Even after assuming 20% growth over next 2 years, Divis trades at 2 year forward 37.5x Price to Operating Cash Flow. Since we have already sold 50%, we would wait to see any more upside surprises.

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