It is our opinion that the current valuations are ahead of the expected growth. The Price to Earnings Ratio of 19 masks the fact that a large part of the profit will be non-recurring after January 31st, 2026. The company’s TTM EBITDA Margin of 27% is significantly higher than its 10 year average of 21%, and a reversion to mean is expected. Based solely on a recurring rate of revenue, the adjusted P/E would be at least 30, while growth prospects seem low. 

The problems with the sustainability of earnings are due to challenges in North America. North America is the largest segment of the business, accounting for around half of the company’s sales. This segment has become the most profitable and highest growing segment over the last 2 years, mainly due to sales of Revlimid in the United States. Our estimates suggest that Revlimid sales account for a very large portion of the company’s current profits. The exclusivity for the drug ends on January 31^st 2026, and the subsequent price erosion would lead to an overall reduction in sales and profits.

The problem is twofold: (a) the company needs to find a replacement for existing profits and (b) find a new source for growth by 31st January 2026. In our opinion, the company’s current pipeline is weaker than that of peers, which makes future growth prospects seem ambitious because replacing Revlimid sales and profits itself would be challenging due to the extremely high profitability of the drug.

Dr. Reddy’s Laboratories Quarterly Call: Key Takeaways

1. Exclusive Partnership with Nestle: The company has formed a JV with Nestle Health Sciences to bring their range of nutraceuticals to India. The contribution from this business should be visible FY27 onwards.
2. Regulatory Scrutiny: The company has received a Complete Response Letter (CRL) from the USFDA regarding their Biologics License Application for a biosimilar rituximab, indicating that the application will not be approved in its present form. This highlights growth concerns.
3. Research and Development: R&D investments for the quarter amounted to Rs. 688 crores, reflecting a 28% year-on-year increase. This growth was driven by the biosimilar products pipeline, along with development efforts in generics and novel oncology assets at Aurigene. The level of R&D for next year will be around 8.5% to 9%. Out of this, 20 is earmarked for biologics.
4. Price Erosion: The company has started to face price erosion in the United States and Europe which are expected to impact sales of current products, excluding Revlimid.
5. Guidance: The company maintains its long term guidance of 25% EBITDA Margins and 25% ROCE, along with double digit revenue growth.

We maintain our MRP of Rs. 5185.  

About the Company

Dr Reddy’s is a leading Indian pharmaceutical company headquartered in Hyderabad, Telangana. Its major therapeutic areas of focus are gastrointestinal, cardiovascular, diabetology, oncology, pain management and dermatology and its major markets include – USA, India, Russia and CIS (Commonwealth of Independent States) countries, China, Brazil and Europe. The company’s main business segments are Global Generics, which includes sale of branded and unbranded generic drugs, and Pharmaceutical Services and Active Ingredients (PSAI), which majorly includes the sale of Active Pharmaceutical Ingredients (APIs).

North America is the largest market for the company’s generics, which accounts for 47% of the total revenue. This is due to the fact that the United States is the world’s largest market with a high GDP per capita leading to higher prices for drugs. Overall, the global generics business accounts for 88% of the total revenue, while PSAI accounts for 11%.

Financial Performance

The financial performance of pharmaceutical company tends to be volatile due to dependence on regulators, product launches, price erosion and price ceilings that may be applicable in various markets. The tables below highlight the volatility in financial performance.

As the table shows, the earnings per share between FY14 and FY24 have been extremely volatile. The period till FY16 marked the benefits of the patent cliff in the United States which led to the launch of various off patent drugs, while the FY17 and FY18 were marked by price erosion, distributor consolidation in the United States and problems regarding FDA facility inspections. Between FY19 and FY23, the company has been able to improve its performance by entering new markets, launching new products, and effective cost control measures. While such improvements have taken place, one must consider the sustainability of earnings given the cyclical nature of earnings. A key change in the company has been the appointment of Erez Israeli as COO in FY19 and CEO in FY20, who has helped make the company more efficient.

Understanding the Business

India: The company derives 17% of its revenue from India through the sale of branded generics. Revenues from India have grown at an annualised rate of 12% over the last 5 years. The company has made strategic investments like Cidmus to improve to cardiac portfolio while divesting certain non-core brands in the dermatology, paediatric, gynaecology, and urology segments.  The company aims to improve its contribution from chronic therapies, which stands at 35% currently.

Emerging Markets: Russia, Commonwealth of Independent States (CIS) and Romania accounted for 64% of the revenue from Emerging Markets in FY24. Many emerging markets are too small for domestic players due to the high research and development costs that would be associated with drug development and therefore depend on imports. India, and therefore Dr Reddy’s Laboratories, is a key exporter to such regions. However, geopolitical issues can have a severe impact on sales as well as the ability to supply such geographies. For example, Venezuela was a profitable emerging market until FY17 that has faced geopolitical and macroeconomic problems. As a result, business in this country had to be significantly curtailed due to the high risks. Additionally, foreign exchange remains a key risk for this business segment. 

Europe: Europe is the largest pharmaceutical market after the United States. The company has grown its revenue from Europe by 21% annually over the last 5 years. This has been achieved through the launch of new products, penetration in newer geographies while facing price erosion due to the competitive nature of the markets. Germany is the largest European market for the company.

North America: The large share of revenue from the United States is primarily responsible for the volatility in sales and profits. With the end of the patent cliff (a period in which a large number of key drugs lose patent protection) in the United States, 2017 and 2018 witnesses significant price erosion leading to a 20% fall in segment revenue over a two year period. The profitability and sales are highly dependent on patent expirations and the ability to compete through early launches. The company launched g-Revlimid in FY2023 through an early settlement with the innovator giving it a limited volume launch. This is largely responsible for the increase in profitability in FY23 and FY24 and is expected to continue until January 2026. Growth after 2026 is expected to come from biologics, as this segment will witness a large number of patent expirations during this period.

PSAI: While this division contributes 11% to the total revenue, the business has a significantly lower gross margin than the generic business. As a result, the overall growth in this segment has only been 4% annually over a 5 year period. Additionally, this business has a high volatility in its gross margins. Due to the lower overall gross margins from this business and the low revenue contribution, the overall impact of this segment on the business is manageable.

What are the growth and margin expectations?

Margins: PAT margins have improved from 9% in FY17 to 20% for FY24. As the table above shows, the major reason for the improvement in EBITDA and PAT Margins is the reduction in R&D and SG&A as a percentage of revenues. R&D has not only declined from 14% in FY17 to 8% for FY24, the absolute spend on R&D has also declined over time until FY24, when it increased. Additionally, SG&A expenditure as a percentage of revenues has fallen from 33% in FY17 to 28% for FY24. While there has been an improvement in gross margins as well, the sustainability of the margins is highly dependent on successful new launches while maintaining the risk of price erosion. 

Overall, the long term EBITDA margins are guided to be around the 25% range as gross margins would fluctuate while other overhead costs are likely to be maintained at the current percentages. 

Growth: India, Emerging Markets and Europe are expected to have growth in double digits over the next few years even though fluctuations are expected on a yearly basis. This expectation is based on the strong positioning of the company in these markets. While Europe does maintain the risk of price erosion, new product launches in this segment and overall low contribution to revenue would not have a strong impact on overall growth expectations.

The growth in the North American market in the previous year is primarily attributable to the launch of g-Revlimid. Growth in Revlimid is expected till January 31^st, 2026 when the company loses exclusivity. Due to a structural change in the North American market, the focus has shifted towards biologics, which are more complex and difficult to replicate. This would lead to lower growth rates for chemical generics than that witnessed in the previous cycle, but overall growth would still remain high. The company has begun development of biologics with significant expected launches between FY27 and FY30 which suggests a long term growth potential for the company. However, the company currently faces regulatory challenges in its biologics division, which might hinder the growth of this segment.

Good results, plans to focus on licensing and collaborating with partners to bring innovation to India and strengthen its presence in the generic business.

Good performance on uptick in exports across North America business and favorable seasonality in the Russia business.

Market Cap Rs. 71,995cr

CMP Rs. 4,321 | PE 19.8x TTM

Click here for 10 year X-ray

Key Highlights:

• US sales growth driven by launch of gRevlimid (revenue of ~$140mn in Q3), 5 new launches and favourable forex movements, which was partly offset by price erosion in some molecules.
• Emerging markets growth was primarily due to the strong growth experienced in Russia (45% YoY). It launched 29 products in Q3.
• India sales growth was led by price hikes and 2 new product launches, although there was volume contraction in certain molecules.

Management Outlook:

• Management expects contribution from gRevlimid to fluctuate quarterly but to remain meaningful on annual basis. It also expects ex-gRevlimid business in the US to grow in single digits.
• Management expects Indian business to sustain double-digit growth through a combination of organic route, product innovation, investments in marketing and divestment of legacy brands.
• The company is looking to file double-digit number of products in China (40-50 over the next 3 years). Meaningful ramp up in growth of China operations  are expected by H2FY24 by the management.
• Management has guided EBITDA margins and RoCE to be ~25%.