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I think Dr. Reddy's Laboratories (NYSE:RDY) presents an attractive reward/risk opportunity for investors with a 2-3 year horizon.

Dr. Reddy's is on the cusp of major growth
RDY fiscal 2010 sales are approximately $1.6 billion. RDY has guided towards a target of 25% ROE and $3 billion in sales by fiscal 2012. In order to get there, I looked for the earnings needed. I make the following assumptions:
  • Net income Margin stays same around historical 13-14% sales
  • ROE guidance for fiscal 2011 will be upped to 25%
Thus earnings during the 3 year period needed to achieve the goal would be approximately $1 Billion. See model here.

I estimate the earnings based on Base Business growth and the one-time special generic opportunities pipeline (see investor presentation of Nov. 2009) in the US. The estimated earnings comes to around $1.7 Billion. This is $0.7 billion in excess of what is needed to achieve the fiscal 2012 goal. So I think Dr.Reddy's will be able to beat the Fiscal 2012 target goal of earnings/sales. It is important to note:
Dr. Reddy's high value US generic opportunities in the next 3 years has the potential to bring in as much as $1 billion.


Valuation
  1. PEG of 1 is a reasonable valuation multiple
  2. RDY will continue to grow at 20% even after the forecast period. RDY has grown historically at a compounded annual growth rate of 25%. RDY being a much smaller generic company ($3 billion estimated in fiscal 2012) compared to a company like Teva (NYSE:TEVA) ($14 billion sales), it can easily grow at 20% rate for many more years
  3. Based on fiscal 2012 earnings of $414 million ($2.48 per share) RDY's share value would be $50.

* Finally, any valuation of Dr.Reddy's would need to assign value to the diabetes drug Balaglitazone, especially considering the successful outcome of the first phase 3 trial and recently published long term studies of safety risks of Actos. While there is uncertainty about the final outcome (the drug still needs to go through a large clinical trial of 5000+ patients and be proven to be statistically better in safety risks over Actos), the results of the trial are promising. If the drug does get approved, the financial value of the drug is susbstantial, considering it will be the only prescription TZD (see below) with a superior safety record selling in the market.

For illustration purposes, I calculated net present value of Balaglitazone. It alone is around $62 per share. (This importantly ignores return due to free cashflow from the drug's earnings). I think the market will realize much of the value of this drug once a partnership with major pharma for further clinical trials is announced.

Growth of RDY is also supported by multiple factors
  • Existing Generic pipeline (62 ANDAs are pending approval at the US FDA, of which 35 are Para IVs and 13 are FTFs) will support growth
  • Increased free cash flow would lead to increased investment/acquisition in more special one time generic opportunities and increased launch rate
  • Increasing population of insured in the US due to Healthcare reform should lead to an increase in the overall generics market and RDY should be able to capitalize on it
  • Growth in Global Generics, especially with GlaxoSmithKline (NYSE:GSK) alliance in new markets of Mexico, Brazil and Turkey.
Factors limiting the downside risk to RDY valuation
  • Even with the uncertainty of litigation outcomes over generic launches, there is a considerable earnings margin of safety of over $0.7 billion to achieve the Fiscal 2012 target
  • Management credibility is very high. Management has done the right thing for shareholders. Betapharm acquisition is an exception and the CEO has acknowledged this.
  • No more big or material impact of "Betapharm" goodwill impairment drag to earnings. Carrying value of Betapharm is only around $127m.
  • Strong Balance sheet. Will be a zero-debt company in 2 years as stated by CFO.

Balaglitazone - Divine drug

Thiazolidinediones (TZD's) are used in the treatment of Type 2 Diabetes. The two TZDs in the market are Actos and Avandia and they will lose patent protection in 2011 and 2012 respectively. Both have been proven to have safety risks causing fluid retention, body weight gain and bone loss. Balaglitazone is a TZD being positioned to have same efficacy as Actos but with lesser side effects.

Surprisingly, market participants have been reluctant to assign any meaningful value to Balaglitazone even after 2 significant events of this year:
1. Success of first of the Phase 3 clinical trials
2. Evidence of long term studies of Actos that it significantly increased risk of bone loss in women.

I think this is due to the fact that the company is largely covered mostly by India- based analysts and there appears to be a lack of understanding of new drug opportunity (so far not a single new drug has come from India). The value of this new drug opportunity is probably 150-200 times the value of even the most highly profitable one-time-exclusivity generic ever sold by Dr. Reddy's.

There is other anecdotal evidence that suggest the market launch of Balaglitazone is more likely than what Mr. Market thinks.

Dr. Reddy's founder had to say this on Balaglitazone on Feb 20th, 2010:

I am passionate about getting a drug out of the company and India. We are very close on the diabetes front, with the most promising molecule, Balaglitazone. It has completed phase III trial. There will be one more trial, followed by filing of new drug application. If things go well, the drug will reach the market in two-three years. It would be a dream realized.

Partner, Nordic Bioscience had this to say on Jan 5th, 2010:

He is convinced that balaglitazone have a commercial future, although both Avandia and Glustin / Actos is very well established in the market and in 2008 sold for total around five billion U.S. dollars.

Balaglitazone's completed Phase 3 clinical study on 409 patients showed improved safety compared to Actos on fluid retention, weight gain and bone loss. However more Clinical trial(s) are required to demonstrate the statistical significance of superior safety compared to Actos on weight gain and bone loss. The earliest possible launch date for this drug could be 2012

A clinical study on rats published in August 2009 showed Balaglitazone 10mg did not cause any bone loss or reduction in bone formation marker while Actos caused bone loss and reduction in bone formation marker.

Potential partnerships

RDY's CEO mentioned possibly partnering with other companies in the January 2010 conference call.

There are several plausible partnership opportunities for Balaglitazone that could be in works.

Takeda (maker of Actos) and GlaxoSmithKline (maker of Avandia - Reddy's has a tie-up with them on generics) are natural partners with their TZD in market losing exclusivity in next 2 years. Both the companies should be interested in switching their patients from their TZD to an alternative before their TZDs lose exclusivity sometime in 2012. Takeda (OTCPK:TKPHF) had been preparing Alogliptin as an Actos replacement. However, the FDA requested cardiovascular studies on Alogliptin; its launch appears unlikely atleast until 2013. Actos would face generic competition in Aug 2011 after its patent expiration.
For Takeda it is a big strategic opportunity to convert Actos patients (3B+ in 2009 sales) to a new diabetes drug or risk losing it's multi-billion dollar diabetes revenue stream. A similar case could be made for GlaxoSmithKline although Avandia's sales were much less (due to heightened cardiovascular risks) and it clocked around $750 million in sales.

Another possibility is a renewal of the partnership with Novo Nordisk (original partner on Balaglitazone). Novo Nordisk (NYSE:NVO) is a renowned diabetes innovation company. In 2004, Novo Nordisk dropped Balaglitazone as at the time it did not find it to have significant competitive advantage. I think things have changed since then with several studies conclusively proving safety risks of Actos and Avandia.

Overall, even without market launch of Balaglitazone, I think RDY presents a good reward/risk investment at the current price for investors with 2-3 year holding period.

Disclosure: I have a long position in RDY
Source: Dr. Reddy's On the Cusp of Major Growth