2023-08-23 17:02:58 ET
Summary
- Dr. Reddy's Laboratories stock remains an attractive long-term investment.
- The company's Q1 FY'24 earnings showed strong growth in total revenues and gross margins, driven by sales expansion in its generic business.
- RDY's growth is supported by manageable working capital and cash flows, allowing for sustainable expansion.
- Net-net, reiterate buy.
Investment briefing
The broad healthcare basket has sold at lower multiples leading into the second half of 2023, with many names sold off in sharp succession.
In spite of this, the equity stock of Dr. Reddy's Laboratories Limited (RDY) remains as an attractive long-term compounder in my opinion, that offers investors attractive business economics, strong capital appreciation prospects, and capital returns by way of dividends. Since my June publication , the stock sells ~25% higher, and sells 30% higher from the February rating —strong money-weighted returns for the diligent investor who sized up in RDY in similar fashion.
This report will cover the latest investment updates and link these back to the broader buy thesis. Net-net, reiterate buy, eyeing $80–$85 as the next price objectives.
Figure 1.
Critical investment facts for reiterated buy thesis
Fundamental, sentimental and valuation factors are the primary feeders of upside potential to the RDY buy thesis in my opinion. Each of these are outlined below in greater detail.
Fundamental factors
The firm's growth engine remains well in situ based on the latest findings. In particular, its Q1 FY'24 numbers were strong and evidenced continued momentum at the sales and profitability level [note: RDY reported Q1 FY'24 earnings last period, corresponding to Q2 CY'23. For simplicity and consistency, I'll be talking in terms of Q1 FY'24. Further, all figures are reported in USD].
Q1 insights
RDY's booked total revenues of $821mm from all portfolio segments, up 29% YoY, and growth of 7% sequentially. Reconciling for the several brand divestitures it recently completed, underlying growth came to 35% YoY and 12% sequentially. It pulled this down to EBITDA of $260mm otherwise a c.32% margin, adjusting to $225mm less depreciation and amortization.
Critically, from the $821mm in revenue it recognized gross of 58.7% on this, it's up 880bps YoY—a tremendous gain in leverage on cost if you ask me. Most of this was due to product mix, but a good chunk came down to cost savings at the manufacturing level.
Sales expansion can be attributed to strengths in its generic business—predominantly in the US MLD markets and Europe. I highlighted this extensively in the last publication, noting the potential tailwinds emerging from its industry positioning in generics manufacturing. This looks to be a meaningful contributor to top-line growth into the coming years.
Concentration risk in RDY's revenue clip is dampened by its broad geographical exposures. The geographical breakdown of its Q1 sales is as follows:
- North American generics booked sales of $389mm, up 69% surge and a substantial 25% increase sequentially. Lenalidomide sales underscored the bulk of this growth. Critically, the cadence at which RDY is launching new product lines is proving to be a key insulator to the macro-forces hitting various pharmaceutical players in the U.S., including the Medicare hole, sequestration and the inflation reduction act ("IRA"). To illustrate, it launched 8 new products in Q1, and is currently working on around 11 biosimilars—this, along with broader market shares in existing products, effectively mitigated the impacts of any price erosion. As a competitive advantage, this is definitely something worth considering in the investment debate.
- Sales in its Euro business came to €57mm in the quarter, up 13% YoY, again sporting new labels, and growth in the core business units are already present in Europe.
Growth economics well supported via working capital + cash flows
On the topic of long-term growth, RDY has pushed top-line sales at a reasonable clip since 2020. The potential risk is receivables running away from the firm as it books sales forward before converting these through to cash receipts. Figure 2 outlines the total receivables as a percentage of revenues each quarter, on a TTM basis. It shows that RDY has maintained the receivables account at ~30–35% of TTM sales each period since FY'20. It was again 30% in Q1 FY'24. Income from new and existing accounts thus hasn't outpaced the recognition of revenue and suggests a good portion of revenues are realized in good time.
Figure 2.
This is exacerbated by the following points on "cash revenues":
- Whilst receivables as a function of sales have held the 30–35% line these past 2.5 years, the actual cash flows backing revenues have crept up in linear fashion.
- The percentage of cash flows behind each revenue print has grown from 14% in 2020 to 24% last period, bottoming at 8% in the pandemic era in 2021 [Figure 3].
- These points are integral to RDY expanding at a sustainable rate of growth and allowing it to recycle cash flows back into additional inventories and launching new products. This is integral to it deploying this cash at high rates of return, a fact it has enjoyed so far and looks to continue enjoying into the remainder of its FY'24. This was discussed at lengths in the last publication (see: " 2. Returns on incremental capital ", and also " Figure 3 "). It also clipped $82mm in free cash flow before any cash deployment to acquisitions.
Figure 4 illustrates the firm's relevant uses of cash from Q4 CY'20–Q1 CY'23 on a rolling TTM basis. Only the 'relevant' uses of cash are shown, which I define as major operating and non-operating sources. Why non-operating? I always want to get an idea of how and where a firm is redeploying capital. Part of this involves gauging the working capital requirements to support steady-state operations, and what every new $1 in revenue will require in working capital. Working capital involves core and non-core uses of cash–i.e, that which generates operating income, and that which does not. Purchase of marketable securities, for example, does not generate further operating income (interest income is derived instead). Debt repayments are the same on the liabilities side. Cash taxes and cash interest are now shown here.
Figure 3.
The firm has spent a cumulative $1.73Bn towards capital expenditures, repaid $1.16Bn in debt principle, and allocated $1.4Bn towards the purchase of marketable securities (note: these are calculated on a rolling TTM basis, as mentioned earlier). These purchases picked up rapidly in 2022 as short-term rates began to offer 4–5% starting yields in the money markets, so not surprising to see. It has recycled $922mm into additional inventories, $666mm into the purchase of new intangible assets, and $621mm in dividends paid up.
Figure 4.
Market-generated data
Examination of the market data reveals the positive sentiment in the equity stock of RDY. The cloud charts displayed in Figures 5 and 6 serve as an excellent illustration of this. Since May, the stock has surpassed the cloud top and experienced a rapid expansion to the upside. At present, it is breaking away from the cloud with authority. Based on this trend, the stock can potentially consolidate to $70.00 by October and still remain on trend. In my view, this is a bullish setup.
Figure 5.
The weekly chart presents the same facts pattern as above, and is worth noting to consider for the coming months. The sharp up-leg in price action was followed by the lagging line breaking through the cloud with conviction last quarter. This chart suggests that there is ample space for consolidation and an extension of the move. Based on this analysis, the long-term trend is bullish in my view.
Figure 6.
The above findings are supported by the point and figure studies below. Based on the latest thrusts off lows, there are upsides to $82.70, adding weight to the bullish asymmetry of the thesis. These studies effectively remove the noise of time and intra-trend volatilities. It eyed the moves to $58/$59 with precision, adding confidence to these targets. Therefore, the $82 mark appears to be well supported as well. Moving forward, I'll be closely monitoring this as a technical target.
Figure 7.
Valuation and conclusion
RDY sells at 18x forward earnings as I write and 12x forward EBITDA which are reasonably attractive growth multiples considering the growth numbers underlying this. Adjusting for growth estimates, you're at a PEG ratio of 0.35, indicating the stock is well priced when factoring in this as a variable. Investors have valued the company's net assets with $4 in market value for every $1 in NAV. To me, these are reasonable prices that are in-line with sector multiples and adjust to be undervalued vs. the sector when factoring in future growth. In my last publication I valued the company at 21x forward earnings, and I've pushed this higher for its FY'24, eyeing ~22x forward. This equates to ~$80-85/share, in-line with technical objectives above, and net income of ~$600–$610mm and a market value of $13.2Bn.
Figure 8.
In short, RDY continues ratcheting up key performance metrics, compounding the value for shareholders in doing so. Returns on capital employed into the business remain strong and cash flows backing revenues are equally so. I talked about these factors being major growth levers into the new fiscal year and RDY appears to have delivered on these in its Q1. Net-net, there is scope for the company to sell higher in my view, and I'm looking to $13.2Bn in market value as the next objective. Net-net, reiterate buy.
For further details see:
Dr. Reddy's: Growth Supported By New Labels, Profitability