Dr Reddy’s margins surprise

Dr Reddy’s margins surprise
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First Published: Tue, Jul 21 2009. 10 59 PM IST

Updated: Tue, Jul 21 2009. 10 59 PM IST
Being a pharmaceuticals firm, one would have expected Dr Reddy’s Laboratories Ltd shares to behave as a defensive stock, that is, fall and rise at a lower rate relative to the broad market. While the shares did fall at a lower pace in the market crash between January 2008 and March, they have outperformed the market by a significant margin in the recent rally. The stock has risen 112% from its lows in March, while the Nifty has risen about 74%. At current levels, the stock has even crossed the January 2008 levels.
The company’s results for the June quarter support the recent bullishness in the stock. One of the reasons for Dr Reddy’s outperformance not only relative to the broad market but also to the healthcare sector is its ability to improve margins of late. The company’s gross margin improved by 6 percentage points last quarter to 56%. While this was primarily because of the one-time benefit of sales of the drug sumatriptan, margins improved even for the rest of the business. Assuming the company earned a margin of 80% on sumatriptan, margins for the rest of the business would have risen by about 300 basis points. Although the company’s revenues of Rs1,819 crore were lower than consensus estimates of about Rs1,890 crore, gross margin was higher than expectations. Margins improved thanks to an improved product mix, lower raw material costs and favourable currency movements.
Besides, selling, general and administrative expenses fell by 40 basis points as a percentage of sales (adjusted for the sales of sumatriptan). This is after adjusting for one-off expenses such as a severance package for sales professionals at Betapharm in Germany and the closure of a research facility in Atlanta.
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One area of concern the results throw up is the slowdown in the German market continues, with sales falling 36% last quarter. Although street expectations from the Betapharm acquisition have been toned down considerably owing to regulatory changes in the German market, the sharp drop in sales is a concern.
Another reason for the re-rating of the stock in recent months is the improved earnings visibility. The company is expected to launch omeprazole Mg OTC and fondaparinux within the next 12 months. A Nomura Research report states that these two products are expected to enjoy limited competition for over three years, which, in other words, means that profit margins would be relatively high.
Last month, the company announced that it has entered a strategic alliance with GlaxoSmithKline Plc. (GSK) to develop and market selected products across an extensive number of emerging markets, excluding India. This would give the company a wider reach without having to make large investments in sales and marketing in these emerging countries. Since the company would be sharing profit with GSK on products sold under this arrangement, its profitability would be lower, but in terms of return on investment, the deal would enhance value for shareholders.
But despite all these positives, Dr Reddy’s shares now trade at Rs791, which exceeds Nomura’s target price of Rs781 (set in early June), and Citi’s target price of Rs825 (also in early June). While the company has surprised on the margin front, the results do not warrant a material change in earnings estimates.
As a result, upside for the stock may be limited unless there are some new triggers or if the markets itself get rerated from current levels.
Write to us at marktomarket@livemint.com
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First Published: Tue, Jul 21 2009. 10 59 PM IST