How times have changed. Investors in pharmaceutical firms selling to the US generic market traditionally focused more on revenue growth and less on costs. Now that revenue growth has slipped, cost-cutting has gained in appeal. News that Dr Reddy’s Laboratories Ltd is selling one of its API (active pharmaceutical ingredient) units sent its shares up by 4.5% on Monday. The company said this is part of its measures to streamline production and reduce costs. A fortnight ago, it closed another deal to sell its investment in a US antibiotics facility to UAE’s Neopharma Inc.
Monday’s announcement will see an API facility in Hyderabad sold to Therapiva Pvt. Ltd, a joint venture between a subsidiary of Neopharma Llc (parent of Neopharma Inc.) and Laxai Life Sciences Pvt. Ltd. Although Dr Reddy’s has not disclosed details such as consideration or revenues of the units sold in both transactions, investors applauded the company’s actions.
In its last conference call, the company had said it will shut down some of its urban sites, partly due to rationalization and as a reaction to urbanization. It also said it intends to move some production from older to newer sites. But the management also clarified that no major impact on sales or profit was expected as a result. That should be a note of caution for investors.
Dr Reddy’s has seven API plants, according to its website. Four of them are in Hyderabad, including the one being sold. The API business forms part of its pharmaceutical services and active ingredients division (PSAI). “Pharmaceutical services" is doing custom manufacturing for other companies.
Indian companies chiefly run the API business for their captive needs and use surplus capacity to sell to others. While certain APIs can be very profitable, where there is limited competition, the business earns lower margins than formulations.
In Dr Reddy’s case, its PSAI division earned a segment profit margin of 17% in the June quarter, compared to 61.2% for the global generics business. While PSAI earned revenue of ₹ 702 crore, ₹ 148 crore of that is for APIs transferred to the generics business at cost, what is called inter-segment revenue. So APIs will always be part of the production mix.
But a formulation-maker could sell parts of the API chain that are no longer important. Or, it could consolidate API production at fewer locations. Also, the acquirer may have a lower profitability threshold than Dr Reddy’s has. In a win-win arrangement, the acquirer gets a viable API business, while Dr Reddy’s could ink a long-term sourcing arrangement to ensure raw material availability.
In the June quarter, Dr Reddy’s had said that the improvement in profitability was partly due to costs being kept in check. Investors may have assumed the sale of the unit could see profitability improve further.
While their assumptions may be correct, they face the risk of having overvalued the benefits. More clarity on the impact on profitability should be forthcoming at Dr Reddy’s post-results conference call later this month.