A Dose of Profits

02/03/2009 11:36 am EST

Focus: GLOBAL

Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Allan Nichols, editor of Morningstar InternationalInvestor, sees potential in this global generics manufacturer.

India-based Dr. Reddy’s Laboratories (NYSE: RDY) is one of the best-positioned providers of generic drugs and bulk active ingredients. Cheap labor provides a development and manufacturing cost advantage in an industry where size and cost are key.

The firm sells to a global customer base, including India, the US, the European Union, and Russia. Growth in the company’s European and Asian markets dwarfs that of the US.

The company recently established a discovery lab and plans to invest heavily in research to develop proprietary drugs. Dr. Reddy’s branded formulation segment (30% of sales) sells off-patent drugs in India, Russia, and Europe. Gross margins exceed an unbelievable 70%, nearly as high as those of patented drugs in the US.

The pills themselves are commodities. Because India doesn’t have national distribution, a decade of physician education and regional distributor relationships distinguishes the Dr. Reddy label from widely available substitutes. In international markets like Russia, limited competition means even higher margins. Prices will eventually decline as more players enter these niche territories.

Dr. Reddy’s active pharmaceutical ingredient, or API, segment (24% of sales) is much less attractive. However, it supplies more than 50% of the company’s active ingredients for its in-house formulations. This allows Dr. Reddy to pocket, rather than pay, the usual supplier markup on raw materials.

The company recently expanded its share of the US and European generic drug markets (36% of sales). Significant investments have yielded a robust pipeline of generic drug applications, many of which are patent challenges, or candidates for 180-day market exclusivity, in the US. Dr. Reddy’s 2006 Betapharm acquisition expanded the company’s presence in Europe.

On the branded side, Dr. Reddy is developing several early-stage drug candidates. Most candidates are far from approval, but profit-sharing arrangements have accelerated progress while sharing the risk. Like its factory workers, Indian chemists cost multiples less than their US counterparts.

We’re maintaining our fair value estimate of $16 per share. (The stock traded around $9 recently.) The company should return to growth mode in fiscal 2009, now that the one-year spike from authorized generic Zocor sales has come and gone. We estimate 15% average sales growth after 2008, when generic Zocor sales all but disappear.

Operating margins should eventually approach the low to mid-teens, once Dr. Reddy realizes cost savings from the Betapharm acquisition and introduces some branded drugs. We estimate the company’s early-stage drugs currently have a 30% or less chance of approval. If one eventually shows promising late-stage clinical data or is approved, we would substantially increase our fair value estimate.

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