Dr Reddy’s Laboratories (DRL) was one of the worst performing stocks in July 2021. Subdued June 2021 quarter results and the subpoena received from the Securities and Exchange Commission (SEC) hurt investor sentiments. DRL’s stock price corrected 10%after its Q1FY22 results were announced. The pharma major’s June 2021 quarter performance was impacted by North America generics (NAG) and the active pharmaceutical ingredient (API) segment. 

NAG reported muted 1% YoY revenue growth and the API segment came in with double-digit revenue decline in Q1FY22. The management is optimistic of strong domestic growth prospects powered by Wockhardt portfolio, Sputnik V and prospective launch of Sputnik Light. Investors on the other hand are concerned about NAG’s performance amid a challenging price environment in the US, which contributes more than one-third of the total revenue base. 

Quick Takes:

• Management guided operating margin to be around 25% levels in the near future aided by new product launches in the US market and scaling up of API activities

• DRL’s top five products in the US market constitutes 30% of total North America generics (NAG) revenues

• Pharmaceutical services and active ingredients (PSAI) segment, revenues fell 12% YoY on account of higher base of corresponding June 2020 quarter in previous year 

• DRL received a subpoena from US Securities and Exchange Commission (SEC) with respect to improper payment practices in CIS countries 

• The company is working on Sputnik Light and is leveraging Russian Phase-3 trials for approval in India

• DRL expects strong revenue flow in the coming quarters from Icosapent (reduces triglycerides) launched in Q1FY22 

Subdued June 2021 quarter, margins hit by price erosion in US 

DRL reported revenue growth of 12% YoY, driven by the global generics business (up 17% YoY) while pharmaceutical services and active ingredients (PSAI) and proprietary products revenues fell 12% YoY and 1% YoY respectively in Q1FY22. Global generics business constitutes NAG, India, Europe, emerging markets and made up 84% of total revenue base in Q1FY22. 

Consolidated revenues came in at Rs 4,945 crore in June 2021 quarter compared to Rs 4,426 crore a year ago. Operating margins contracted 10 percentage points to 14.8% in the June 2021 quarter. Margins were adversely impacted by high US price erosion, selling general & administrative expenses (up 18% YoY) and increase in inventory provisions. Selling, general & administrative (SG&A) expenses rose due to higher digitization costs, marketing costs and increased product filing costs. 

Inventory provisions increased as a result of slow-moving inventory and quality issues during the quarter. Weak operational performance led to low net profit of Rs 380 crore in June 2021 quarter compared to Rs 595 crore, down 36% YoY. Research & development (R&D) spend was Rs 453 crore at 9.2% of sales in Q1FY22.

Price erosion disrupts growth, investors await key product launches

After reporting revenues of Rs 1,833 crore in Q2FY21, NAG revenue growth was muted over the past three quarters. NAG revenues rose 1% YoY in Q1FY22 to Rs 1,739 crore, and constituted 35% of total revenues. Speaking on NAG’s lacklustre performance, Erez Israeli, CEO at Dr Reddy’s Laboratories, said that high price erosion in the US market and continued impact of lower number of elective procedures impacted NAG revenues.

Prevalent for the past 15-20 years, price erosion has been a major growth disruptor for generic pharma companies in the US market. Pricing pressure has forced generic pharma companies to prune their abbreviated new drug application (ANDA) fillings, reduce costs and foray into complex generics and speciality products. Along with vendor consolidation, faster approvals of ANDAs by USFDA increased competitive intensity and pharma margins in the US market over the past few years.

After a short lull due to Covid-19 disruption, price erosion is back with the same intensity as the US economy opened up. Alembic Pharma’s June 2021 quarter results also witnessed the brunt of price erosion mainly in its sartan portfolio in the US market. Biocon’s generic revenues fell 22% YoY because of stiff competition and price erosion in both API and formulations. 

Sun Pharma has also accepted the pervasiveness of the challenging pricing scenario in the US generic market in its post Q1FY22 conference call. Speaking on this, Israeli said that as competitive intensity increases, pharma companies need to defend their market share which leads to price cuts. While peers like Sun Pharma invested in specialty and complex generics to augment future growth and combat pricing pressure, DRL widened its product basket adding 20-25 products every year in the US market over the past three years.

According to Israeli, this is a ‘low risk-high reward strategy’. Instead of being highly dependent on blockbuster products (such as NuvaRing and Copaxone), NAG revenue growth is driven by a low-cost broad product portfolio currently constituting roughly 150 products. The management aims to widen NAG's product portfolio to 350 products. The management expects that a continuous rejuvenation of the product portfolio will lead to higher sales growth, offsetting price erosion effects. A broad, low-cost product portfolio also allows high operating margins and high return on capital employed (ROCE). DRL’s pipeline of 93 generic filings (90 ANDAs and 3 NDAs) pending for approval with the USFDA will also help in fulfilling its long-term goal. 

While the management expects the NAG segment to perform well for the rest of FY22, the high base of Q2FY21 will be tough to beat amid a challenging pricing environment in the US. 

Investors, on the other hand, are awaiting clarity on gCopaxone and gNuvaring CRL. CRL indicates that the USFDA did not approve the drug application. Launch of both these products with a market size of about $ 750 million and $ 1.5 billion respectively is consequently delayed. DRL has a robust product pipeline in the US which includes gCopaxone (multiple sclerosis), gNuvaring (birth control), gRevelmid (multiple myeloma) and gKuvan 500 mg (lower blood Phe levels).

India Business driven by Wockhardt portfolio and Covid-19

Before Wockhardt’s select business acquisition, DRL’s India business growth hovered between single and low double-digit quarterly run-rate on a YoY basis. From Q2FY21, domestic business powered by Wockhardt and Covid portfolio grew above 20% YoY every quarter in FY21. In the June 2021 quarter, the India business reported sales of Rs 1,060 crore with a robust 69% YoY growth supported by both Covid-19 drugs portfolio as well as good performance of the base business, said Israeli. Growth was also high due to the low base effect of Q1FY21 in the previous year.

Focussing on the over the counter (OTC) segment, the company launched Celevida and Curhealth immunity boosters in Q1FY22. To scale up its India business, the company is planning to launch new brands in OTC mainly in the nutraceuticals and wellness segment and expand into rural areas where DRL is seeing strong growth and currently has limited presence. Investing in its OTC business, DRL increased its SG&A spend over the past three quarters on branding, digitization and higher marketing activities. SG&A expenses as a percentage of sales rose to 30% in Q1FY22 from 26% in Q2FY21.  

Strengthening its Covid-19 product portfolio comprising Remdesivir and Favipiravir, DRL launched Sputnik V and 2-deoxy-D-glucose (2-DG) for Covid treatment during the quarter. Speaking on Sputnik V, Israeli said, “The opportunity is big. It's more the way it will play out in terms of supply out of Russia, ramp up and vaccination programs in India”. The company is facing challenges in the supplies of the second dose of Sputnik V expected to be imported from Russia in August. As per the management, DRL might have lost some market share due to delay in availability of Sputnik V in July. The company is closely working with six contract manufacturing organizations (CMO) in India for manufacturing Sputnik V, expected to be available between September-November 2021. The company is also working on a single dose vaccine in Sputnik Light, Sputnik V for adolescents and other Covid products such as Molnupiravir and Baricitinib.

US SEC subpoena heightens investor concerns

Along with robust India business performance, Europe (8% of revenues) and emerging markets (19% of revenues) also contributed strongly to the June 2021 quarter top-line, a rise of 12% YoY and 14% YoY respectively. Emerging markets revenues at Rs 912 crore were mainly driven by Russia, Commonwealth of Independent States (CIS) countries and Romania in Q1FY22. As per the management, emerging markets are expected to continue their double-digit trend in the coming quarters.

DRL turned around its Europe business in the June 2019 quarter and since then growth is on a consistent double-digit growth path. The management believes that Europe (Rs 399 crore revenues in Q1FY22) will continue to be a strong growth driver in the next few years following the dual strategy of portfolio and market expansion. Though India, Europe and emerging markets are moving on a strong growth trajectory, investor concerns are heightened by consistent underperformance of NAG and subdued growth witnessed by PSAI (API business) segment. API business benefited in Q1FY21 (revenues rose 88% YoY) due to higher stocking by customers to mitigate potential Covid disruption.

In dollar terms, US revenues are below $ 250 million since Q4FY20. North America generics and PSAI together account for about 50% of total revenues. And on top of that, a subpoena (written order to attend court) from the US Securities and Exchange Commission (SEC) is another dampener.