By Suhani Adilabadkar
Divi’s Laboratories is the second-largest Indian pharmaceutical company in terms of market capitalisation. The company’s Q2FY22 results, however, were below street estimates. This was due to a poor show by the generics business, rising raw material costs and supply chain disruptions. Operating margins were weak and net profit growth was helped by lower taxation, but sequential performance in the September 2021 quarter was muted overall. Investor sentiment was also dented by the dimming prospects of Divi’s key customer, Merck’s star anti- Covid-19 oral drug Molnupiravir. Pfizer’s competitor drug Paxlovid was shown to have higher efficacy, and these results came out on November 5, a day before Divi’s Labs announced its Q2FY22 results. Divi’s Labs stock slipped 8% intraday post results.
The Hyderabad High Court dismissed all cases against Divi’s Labs’ Kakinada Plant, construction will start soon
Divi’s Labs plans capital expenditure (capex) of Rs 300 crore in H2FY22 and another Rs 1,000-2,000 crore for its upcoming Kakinada and Krishnapatnam plants in the next 2-3 years
Operating margins in the near term could be impacted by volatile raw material prices and logistic issues
According to management, the oral anti-Covid pill opportunity is around $70 billion
Muted September 2021 quarter results
Divi’s Labs manufactures generic active pharmaceutical ingredients (APIs), nutraceuticals, and custom synthesis (CS) of active ingredients for innovator companies. Operating revenues for Q2FY22 came in at Rs 1,988 crore compared to Rs 1,749 crore, a rise of 13.6% YoY.
Revenue growth was mainly driven by the CS segment (Rs 1,073 crore) which grew 53% YoY and 9% sequentially in Q2FY22. APIs revenues (Rs 746 crore) fell 15% YoY and 11% QoQ in September 2021 quarter.
Nutraceutical revenues were flat at Rs 168 crore in Q2FY22. The segment revenues increased by 22% QoQ. The nutraceutical segment includes vitamins and carotenoids and in the present Covid times, the company expects this immunity booster product portfolio to perform better in the coming quarters.
Operating margins were reported at 41.2% contracting 120 basis points (bps) YoY and 230 bps sequentially. The company had to bear the brunt of rising raw material prices and high logistics expenses due to soaring shipping costs and the unavailability of containers during the quarter. Net Profit was at Rs 606 crore in the September 2021 quarter, a rise of 17% YoY and 9% sequentially aided by a fall in taxes. Exports accounted for 88% of revenues in H1FY22 for Divi’s Labs, with Europe and the US regions contributing 72% of total revenues. This growth was driven by the CS segment.
Molnupiravir vs Paxlovid – efficacy battle gives Divi’s investors the jitters
Merck announced positive results of its phase 3, clinical trials for Molnupiravir, an oral antiviral medicine on October 1, 2021. According to the company, Molnupiravir reduced the risk of hospitalization or death by approximately 50% for patients suffering from mild to moderate Covid-19. Merck filed an emergency use authorization (EUA) application to the US FDA for Molnupiravir on October 11. Earlier in June 2021, Merck inked a deal with the US government to supply roughly 1.7 million courses of Molnupiravir. Divi’s Labs’ is the authorized manufacturer for Molnupiravir API in India. Driven by the strong prospects of Molnupiravir, Divi’s Labs' stock price surged 11% in the first fortnight of October 2021.
Apart from Merck, there are a few more companies in the race for orally administered antiviral COVID-19 drugs, namely Shionogi Pharma, RedHill Biopharma, Atea Pharmaceuticals, and Pfizer. Shionogi Pharma’s anti-Covid19 pill is still undergoing Phase 2 and 3 clinical trials. Atea Pharmaceuticals and RedHill Biopharma failed to meet the primary goal of the Phase 2/3 clinical trials. While Phase 1 trials test safety, Phase 2 and 3 test effectiveness and potential side effects of the drug before approval is given by regulatory authorities.
On November 5, Pfizer announced that its Phase 2 and 3 trial results of the antiviral pill for Covid-19 treatment among adults reduced the risk of hospitalisation or death by 89%. Pfizer's anti-Covid pill, Paxlovid, might get US FDA approval by the end of the year.
As per the recent US FDA update released on November 26, by Merck, Molnupiravir reduced the risk of hospitalisation or death by just 30%, lower than the earlier 50% estimate. Pfizer’s management on the other hand is confident that the Paxlovid pill will be effective even against the latest Covid-19 variant, omicron. Compared to vaccinations, oral antiviral Covid-19 pills would be able to treat a larger number of people at a faster rate, especially those in the early stages of infection. Covid-19 cases are surging again in the EU, Australia, and many other countries, and with the widespread underlying risk of Covid-19 mutations, oral Covid-19 medication assumes significance.
Divis Labs stock is again down 3.5% since last Friday. Divi’s Labs’ investors are disappointed with the recent results of Merck’s anti-Covid-19 pill efficacy levels and the company’s ability to drive near-term growth through the Molnupiravir opportunity is now unclear. While Paxlovid’s higher efficacy levels dented investor sentiment, rising raw material costs have also restrained the company’s stock’s upward trajectory. In addition, power outages in China are impacting raw material supply, and higher shipping costs due to crude inflation are weighing on operating margins. This is what makes the weak performance of the API generic business concerning.
Near-term pressure on margins, API segment’s long term growth intact
While analysts expect near term pressure on operating margins, Divi’s Labs’ management is optimistic about maintaining its margins in the coming quarters. Murli K Divi, Managing Director at Divi’s Laboratories, said the company exports 88% of what it produces to large customers in the US and Europe. The company’s long-term contracts with these customers have inbuilt cost enhancement clauses which help in passing on short-term cost escalations.
Compared to its peers, Divis Labs is on a better footing in terms of cost savings due to its backward integration initiatives over the past 2-3 years. But the higher cost of coal, and basic solvent costs rising significantly over the past few quarters, might play truant. Coal cost has more than doubled YoY and the spike in solvents (5-10% of total expenditure for Divi’s Labs) is around 300% YoY in Q2FY22.
Driven by high inventory stocking as customers diversified API supplies due to Covid uncertainty, Indian players witnessed robust growth in FY21. API revenue growth moderated for most of the Indian companies due to a higher FY21 base and the return of Chinese supplies. Divi’s Labs reported negative API revenue growth on a YoY basis over the past two quarters.
But for the management, the generic API segment is a significant growth engine and the company intends to revive the segment by adding new products going off patent between FY23-24, which is a $20 billion opportunity. Divi’s Labs, a world leader in Naproxen (anti-inflammatory drug), Gabapentin (preventing seizures), and Dextromethorphan (cough suppressant) with 65-85% market share is also growing at 10% YoY. The company achieved complete backward integration in all these large volume generic APIs and is free from China dependence in terms of raw materials.
Divis is also expanding capacities for its next line of generic API products such as Levodopa (Parkinson) and Valsartan (high blood pressure) where it has a 20-30% market share which will add to the topline in the near future. The company aims to achieve strong backward integration, once it achieves 60-70% market share in these products in the next few years.
Divi’s Labs is also getting into sartans in a big way. All sartans require the key starting material, Ortho Tolyl Benzonitrile (OTBN) which is made in-house by Divi’s Labs. The company’s ability to control nitrosamine and azido impurity ( which causes cancer) in the production of sartans API, a major US FDA concern is another advantage for Divi’s. With a strong position in Valsartan, the company aims to enter sartan manufacturing on a large scale. The global sartan market is around $20-25 billion and Divis aims to capture a large pie of the sartan market in the next few years. Speaking on sartan opportunity, Dr Divi said that the company is quite strong in backward integration in basic raw materials for all sartans which gives a huge cost advantage and helps in controlling impurities.
The company also ventured into contrast media APIs on a large scale in Q3FY21. According to the management, Divi’s Labs is currently one of the large players in the industry and has signed on several big companies and innovators, the results of which will be visible in the next two-three years. Contrast media are substances administered orally or are injected to highlight internal organs or structure of the body for x-rays (such as angiography), MRI scans and CT scans. Driven by Covid-19 complexities, contrast media opportunity is around $4-6 billion growing currently at 15% to 25%.
‘Sky is the limit’ for custom synthesis business, Kakinada plant construction on track
On the custom synthesis (contract research and manufacturing services) side of its business, the company received fast-track projects from big US and European pharma companies in Q2FY21. Divi’s Labs spent Rs 400 crore capex on these fast-track projects, of which the Molnupiravir-Merck project was one. According to the management, the company is bound by confidentiality agreements with Merck and cannot disclose Molnupiravir sales. However, the management indicated that the Molnupiravir project reported sales for the first time in Q2FY22. The custom synthesis segment is on a strong footing over the past six quarters. The company recently received two big long-term fast-track custom synthesis projects, benefits of which will be visible in the next few years. Divis Labs has a long-standing relationship with 12 out of the top 20 big pharma companies across the US, EU, and Japan for more than 10 years.
And while Molnupiravir prospects are currently unclear, Murli Divi said the oral anti Covid19 pill opportunity is around $70 billion. He also said that all cases filed against the company’s 500-acre land for its Kakinada plant were dismissed by the High Court. The land will be soon handed over to the company by the Andhra Pradesh Industrial Infrastructure Corporation (APIIC). Construction is expected to start soon on the Kakinada plant and the company plans a capex of Rs 1000-2000 crore for its upcoming Kakinada and Krishnapatnam plants in the next 2-3 years.