2023-10-27 14:23:03 ET
Summary
- Generic pharmaceutical manufacturers could benefit from structural tailwinds and are attractive in the current market environment.
- Dr. Reddy's Laboratories Limited (RDY) has posted impressionable Q2 fiscal '24 results, supporting a long-term investment outlook.
- The data supports a buy over the mid to long-term horizon, with a potential short-term pullback as an attractive entry point.
Investment Update
Generic pharmaceutical manufacturers are ripe to catch a bid in the current environment given a number of structural tailwinds.
One, generic offerings of key drugs are cheaper than branded alternatives, albeit with the same mechanism of action and therefore safety + efficacy. Being the low-cost provider in today's market is attractive, and promotes two advantages: (i) Capital/inventory turnover, increasing the ratio of sales to capital tied up in the business, and (ii) driving production advantages, differentiating on price to increase return on business investments.
Two, the current inflationary element has prescribers and customers alike drifting to the lower-cost end of the pharmaceuticals market.
Three, investors are eyeing key fundamentals and any point of differentiation within the healthcare spectrum is a standout to an otherwise defensive sector that, according to Merrill Lynch's " investment clock," is attractive in an economy with weaker growth and moderating inflation.
Since my August publication , the stock of Dr. Reddy's Laboratories Limited ( RDY ) has consolidated with the broad market and crossed its 50-DMA and 200-DMA last month. It has closed a prior gap from July and could push further into weakness given 1) premium multiples, and 2) technical softness.
The company posted Q2 FY'24 earnings today with an impressionable set of results that support a long-term investment outlook, in my opinion.
In that vein, my recommendations following the company's Q2 fiscal '24 numbers across all horizons are the following:
- Short term (next 6–12m)— Neutral — balanced multiples at 14x forward EBIT (discount of 8% to the sector, and 18.6x forward earnings (3% premium), pullback to $55—$61.00 not unlikely,
- Medium-term (1–3 years)— Bullish — Sales and earnings growth continue advancing, excellent returns on operational assets, above-sector growth rates in profit plus sales looking forward, consolidations could be buying points.
- Long-term (3+ years) — Bullish — Business returns tremendously high, compounding economic earnings and intrinsic valuation. Look for pullbacks to add on weakness.
Collectively, I rate RDY a buy over the mid- to long-term horizon, meaning a short-term pullback to $55–$61 may be considered attractive once a reversal has started from this range. Net-net, rate buy, retaining my previous target of $80–$85/share.
Figure 1. RDY long-term price evolution, broke through 50-DMA and 200-DMA in the last two months
Data: Updata
Q2 FY'24 earnings insights
As a reminder, RDY reported its Q2 FY'24 numbers, which correspond to Q3 CY 2023. All figures are reported in USD at the cross rate of 1 USD = Rs 83. 28 at the time of publication.
It marked another strong quarter for RDY, with growth observed throughout the P&L and balance sheet. It put up ~$825mm in top-line sales, growing the business by 9% YoY and 200bs sequentially.
The critical takeouts form the quarter are as follows:
- U.S. segment performance—
- RDY reported revenue of ~$381.5 million in the U.S., marking a 13% YoY increase. This was flat from the previous quarter, so it didn't gain momentum leading into its H2 FY'24. The growth was underscored by upsides across its core portfolio. However, it did mention some pricing pressure which compressed margins, as you'll later see.
- Crucially, as is absolutely essential to its continued growth, the company introduced four new products to the U.S. market could see it capture market share if it continues top-line growth at above sector rates.
- India segment performance—
- In India, it booked ~$143.5 million in revenues, reflecting a 3% YoY growth and 3% sequential increase from Q1. G was attributable to pricing growth and the introduction of new products. However, it was tempered by the impact of the National List of Essential Medicines ("NLEM"). Demand also was impacted by "a weak acute season" per the company.
- Marginal analysis—
- It pulled this to gross margin stood of 58.7%, a compression of 40bps YoY. Its generics business was the major profit winner, in line with my investment thesis. It booked 63.6% gross margin vs. the active ingredient margin of 17.8%. This really highlights where the potential alpha is in this company. Broad margin compression was the result of price volatility in specific segments of the portfolio.
- In terms of capital allocation, the company made the following investments:
- R&D investment of $64.7 million, representing 7.9% of revenues. Capital was allocated to ongoing clinical trials on clinical assets and further commitments to its pipeline assets in small molecules and biosimilars.
- Capex investment of ~$38.5 million, leading to free cash flow of $174.2 million (before acquisitions).
As a standout, the company's return on capital employed remains exceptionally high, at ~39% on investments made into the business. This is in keeping with prior periods. Assigning a 12% threshold margin for analysis (representing the opportunity cost at long-term market averages), RDY continues to compound shareholder wealth, producing 27% economic profit or ~$5.95mm in economic earnings for the period.
Figure 2. All figures are reported in Rs. The USD at the cross rate is equal to 1 USD = Rs 83. 28 at the time of publication.
Source: RDY Q2 FY'24 Earnings Press Release
Technical insights for price visibility going forward
Leading into its Q2 numbers, the company had sold off with the broad market. Understanding price action over the coming weeks and months is therefore critical.
Medium-term technical view (coming weeks):
Figure 3. Daily cloud chart, looking to the coming weeks—
- Price line has crossed the line, but the lagging line yet to cross and confirm the bearish signal.
- A break below the $65 level would be remarkable, bringing the lagging line into a neutral at best zone.
- The chart suggests a further pullback to the $55–$60 zone is not unexpected, potential value for long-term buyers.
Data: Updata
Long-term technical view (coming months):
Figure 4. Weekly cloud chart, looking to the coming months—
- Price and lagging lines still bullish although heading toward cloud top. Ideally, you want price line traveling in the same direction as the trend/color of the cloud when it's above the clouds top.
- Bounced from cloud base hard in May, leading to latest rally. Again, $60 is the key level to watch out for as support. Could find buyers at this level.
- Still remain bullish over the coming months on RDY based on this chart.
Data: Updata
Valuation and conclusion
The stock sells at 14.1x forward EBIT , and ~13.2x trailing EBIT heading into the session. It did $779mm of pre-tax income in the TTM. With its strong set of results, this could be an attractive level to capture gains over the coming 12 months, depending on how the market is valuing the company. If it's pricing RDY on earnings multiples, maybe not, as it currently trades at 18.6x forward earnings, 3% premium to the sector on its market cap of $10.84Bn. Critically, the company invested ~$187mm of additional capital into the business from Q1—Q2, producing a pre-tax return on incremental investment of 4.1% on this, ~12% annualized.
Assuming the same 13.2x multiple, the company is worth $11.5Bn (779x1.02x13.2 = 11,516) in my opinion, around 8% upside potential at the time of writing. It is early days since its Q2 numbers, so my estimate there will be a post-earnings drift to account for, which could drive multiples, and therefore the company's implied market value higher (or lower for that matter). Net-net, I continue to rate RDY's a buy over a long-term investment horizon.
For further details see:
Dr. Reddy's: Continued Q2 Earnings Growth, Supports Long-Term Investment Outlook