A state court review found last week that AOK has not breached federal law on awarding supply contracts.
The review was the first of a series of cases brought against the AOK by generics companies that say they were unfairly excluded from the chance to sign supply deals with the insurers.
Earlier in December, Germany’s Procurement Chamber had ordered the AOK to suspend two-thirds of its 2009 supply contracts, which cover some 64 active ingredients, and are collectively valued at $3 billion - after producers that failed to be selected by the insurer demanded an official review into the AOK’s selection process.
Outcome of the first AOK case does not necessarily reflect similar verdicts on forthcoming cases that argue that different laws have been breached. We believe the likelihood is high for the AOK to emerge victorious.
Given the importance of these contracts to the governments aim of reducing health expenditure, as well as the danger of a supply shortage if the contracts remain frozen, urgent handling of these cases are possible.
However, we believe a possible delay to the implementation of the AOK tenders from the current deadline of 1 March cannot be ruled out.
DRL has been offered eight products, translating to 33 contracts and representing 17% of AOK volume. It is among the top 3 in terms of the number of contracts awarded and this establishes DRL as a significant competitive player in the tender business going forward in Germany.
However, out of the eight products won by DRL, none of its top 10 products are included. We build in flat sales for Germany in FY3/10 and believe it is fairly conservative.
Pricing pressure in Germany is a near-term issue; however, supply chain re-alignment; transfer of manufacturing to India and volume growth would offset part of the burden.
German market uncertainties and possible intangible amortization due to implementation of AOK tenders in Germany are the risks that investors are concerned about.
We believe a possible one time write-down of the product related intangibles that DRL has on its books is likely due to the implementation of AOK tender.
Outlook and valuation
Post the FDA approval of Imitrex for Teva and Ranbaxy last week, DRL stock has been under pressure. To say competitor product approval was disappointing would imply that we had some expectations, or hope of no competition, lasting another quarter.
One can debate the difference between “hope” and “expectations” but since we are not running for presidency, it would suffice to say that we had built in competition into our earnings model and see little risk to our Imitrex earnings estimate.
Adjusting for the exclusivity earnings, DRL is trading at a PER of 10.6x FY3/10E earnings, at a discount of 25% to its peers.
The discount increases further if you look at the earnings power of the company, excluding amortization of acquired Betapharm intangibles.
Stripping this intangible amortization, it is trading at 9.3x FY3/10E earnings, at a discount of 44% to Cipla, which is trading at 16.5x FY3/10E earnings.
We believe this discount is on the higher side given our forecast of 29% earnings CAGR for FY09E–11E. The stock has corrected 19% in last two months bringing valuations down to an attractive level for long-term investors in our opinion.
We derive a value of Rs612 per share for Dr. Reddy based on a sum-of-the-parts valuation.