Summary
- Growth in key emerging markets, including India and Russian footprint.
- Positive Q3 FY23 results with top–bottom line growth. Solid FCF conversion and returns on capital.
- Reinvesting into growth at high rates of return, sporting respectable valuations. Buy thesis supported by these points.
Investment Summary
Now that we're cemented into the new year our hunt for under-exploited names positioned at all points along the broad healthcare spectrum continues. In this vein, it's essential to get the 'theme' right, especially given the pace of new developments in the biopharma and med-tech domains. One emergent theme that's spurred up in the past 12–24 months has been the skew of distribution of generic drug volumes away from the U.S. towards Indian pharmaceutical companies. This is propelled by FDA regulatory/approval policies and U.S. patent roadblocks facing competing labels. On this front we turned to Dr. Reddy's Laboratories Ltd. ( RDY ) given its differentiated geographic exposure to generic pharmaceuticals. The firm's Q3 FY23 results [corresponding to Q4 CY22] resulted in strong top-line and core EBITDA growth and we've observed the company is reinvesting ~11% of post-tax earnings at good rates of return to fund its future growth initiatives.
Specifically, we've observed several themes in RDY's growth engine that warrant a constructive view, including 1) investment into differentiated and speciality products; 2) exposure to key markets including India and Russia; 3) new investment into its 'Horizon 2' segments; 3) attractive returns on capital; 4) respectable valuation[s].
RDY guides to a long-term 25% EBITDA margin and c.25% long-term return on capital, and, per CEO Erez Israeli's language on the call " double-digit growth and no debt". Subsequently, our observations posit the company is well positioned to achieve these numbers. Net-net, rate buy, seeking objectives of $60–$64 at 21x forward P/E.
Exhibit 1. RDY reinvestment into growth
RDY Q3 results analysis
It was another period of top-bottom line growth for RDY highlighted by its exposure to key growth markets in India and other emerging markets. In particular, revenue at $880mm was a 27% YoY expansion and also 700bps up sequentially, underscored by upsides across the entire company's operating architecture. Looking at the numbers in greater detail, key observations include:
- Top-line growth accompanied core EBITDA of $238mm on a margin of 29%, above RDY's long-term growth forecasts. This is after a quarterly capital investment of $35mm.
- A 545bps decompression in gross margin to 59.2%, driven by more favourable product mix and the tail of growth from new product segments. The highlight was pharmaceutical services and active ingredients ("PSAI") gross margin at ~64.5%, in-line with internal estimates.
- As expected, the firm lost ~17 percentage points of leverage at the SG&A line, given its heavy reinvestment in growth opportunities and broader expense base with new launches. Despite this, the SG&A margin was ~240bps lower YoY at 26.6%.
- Related to point 3), the R&D investment came in to $58mm at ~7% of top-line sales. Again, this reflected further investment into its pipeline assets, but also reflected digitalization and marketing efforts as well.
- It pulled this down to earnings of $151mm and converted FCFF of $239mm from operating cash flow of $281mm, a growth of 21%.
- Turning our optics to the geographic highlights , the standout in our eyes was emerging markets led by its Russian exposure [Exhibit 2]. It launched 29 products in the quarter across its emerging market footprint, leading to 14% YoY expansion in emerging markets and YoY growth in Russia of 29% specifically. In an otherwise unaccessible segment of the market, this provides investors a unique entry to pharmaceuticals in this region. Noteworthy, upsides were realized on the back of biosimilars sales, replicating strong momentum in this segment.
Exhibit 2.
Key support for the buy thesis is the firm's incremental profitability and returns on capital. Each remain a standout in the RDY investment debate. These trends continued into the last quarter and form quintessential data that must be extrapolated for forward estimates and valuation. Remember, a firm creates value when its ROIC exceeds the hurdle rate, and growth only requires a small reinvestment of post-tax earnings. Here we use rolling TTM periods for a wider look-back window from Q2 CY20'–Q4 CY22'. At the end of the company's third quarter, it realized ~19% TTM ROIC, in-line with historical averages. It's important to note that we recalibrated the company's accounting profits to reflect its investing and earning profile, by capitalizing R&D as an investment at a 12% p.a. amortization schedule. You'll note RDY is a long-term compounder of post-tax earnings, accumulating $4.8Bn in NOPAT and $3.3Bn in earnings over the timeframe listed above. The additional growth on these figures was $78mm and $192mm, respectively [Exhibit 3].
As part of its growth initiatives, the firm invested an additional $530mm to generate these numbers, in other words, it reinvested ~11% of NOPAT for the future growth [~16% of earnings]. Supporting the buy thesis, the incremental return on invested capital ("ROIIC") pulls to ~15% [36% for earnings], supporting the company's high distributions of cash to equity holders. Note, after reinvestment for growth, RDY's earnings growth rate was 5.8% over this period, aligned with the 3-year CAGR in its stock price. Looking ahead, this is critical information in understanding RDY's future growth expectations. We'd remind readers also demonstrates management's propensity to create shareholder value: c.16% reinvestment, for c.36% return, with 84% of earnings distributed as residual cash flows for equity holders.
Exhibit 3.
Valuation and conclusion
RDY stock is trading at a discount to sector peers across all money multiples. Notably, it's discounted by ~50% in trailing GAAP earnings but is rated high relative to its book value of equity at 3.4x P/Book value. Further, the stock is trading at deep discounts to its 5-year multiples across all metrics. Excluding this, the Quant system rates it highly across all other measures.
Exhibit 4. RDY Seeking Alpha factor grades
We see the stock trading fairly at 21x FY23E' consensus earnings estimates. Key supportive factors to the valuation calculus include 1) the company's earnings reinvestment and ROIIC to date [we estimate it can hold these into the coming years], 2) RDY's FY23E dividend payout, 3) RDY's growth in emerging markets, including Russia, 4) the investment into new growth initiatives like Horizon 2 in India.
Exhibit 5.
Note: we assume a cost of equity of 690bps from the growth rate and earnings yield per Roberts (1991).
Net-net, RDY is garnering sufficient sales and profitability momentum to support its buy thesis. Additional insulators are in its emerging markets growth, exposure to Russian markets, and the theme of U.S. generics shifting to global Indian-based players. Further, with new reinvestment into growth segments, capital budgeting initiatives and strong returns on capital, we anticipate reasonable FCF conversion looking ahead. Looking at a 21x forward P/E, we are looking to price objectives of $60–$64. Rate buy.
For further details see:
Dr. Reddy's Laboratories: Positive Q3 Results, Growth Supportive Of Buy