Dr. Reddy's: Continues To Stumble. Longer-Term Thesis Intact

| About: Dr. Reddy's (RDY)


First-quarter stumble not unexpected.

Although not behind RDY, considerable progress has been made on plant remediation.

Still expect recovery in late FY17/FY18.

Current prices offer even better risk-reward opportunity.

Due to the remediation efforts at three of Dr. Reddy's Laboratories' (NYSE:RDY) India plants, generic pricing pressure in the US, and a suffering business in emerging markets due to currency swings in light of plummeting oil prices, we recently recommended RDY because we believe it's an excellent long-term risk-reward opportunity. Yesterday, the company reported Q1:17 results. The stumble continues. And things look absolutely bleak on just about all fronts, with several of the risk factors we pointed out coming into play. Although some of the emerging markets that had been hit by plummeting oil prices appear to have stabilized, generic price erosion in the US and non-payment from Venezuela nonetheless sent consolidated revenues down 14% in the quarter, slamming gross margins by 490 basis points. That said, we are undeterred. With the stock down 15%, we find the long-term risk-reward better than ever.

We did not anticipate that the business would begin to recover until the second half of FY17. That would appear to be the case. As we mentioned in the recommendation, we believed that management's assessment of the plant remediation might be somewhat optimistic. Yesterday, the company indicated it believed that most of the obligations it had committed to were complete and it had requested a meeting with the US FDA to resolve issues. Presumably, this will also involve plant reinspection requests as well. As stated in our original recommendation, the remediation issue (and product approvals that are tied to resolution) may not happen on the timeline set forth by management, and we believe it is more realistic that FY18 will be the pivotal year. From our model, anything earlier would be upside.

We do not expect a quick turnaround in the US generics market given the relative glut in approvals across the board. However, as remediation issues are settled, Dr. Reddy's has a considerable portfolio of products that can come to market in total; the company had 14 new generics filings in the US during the year (13 ANDAs and one NDA). Cumulatively, 82 generics filings are pending for approval with the USFDA (79 ANDAs and three NDAs under 505(b)(2)). Of these 79 ANDAs, 52 are Para IVs, out of which the company believes 18 have "First to File" status.

Moving beyond generics, the company is differentiating itself by concentrating on new drug applications with pharmaceuticals that are technically challenging. The company focuses on the dermatology and neurology space, which offers numerous opportunities, which maximize its technical and marketing strengths. In the past few months (since the warning letter discussed below), the company has received approval for three NDAs: Sernivo, a topical steroid of psoriasis; Zembrace, autoinjector triptan for migraines; and Zenavod, a modified-release doxycycline for rosacea. Both Sernivo and Zembrace have recently been launched and should help bolster revenue growth over time. These will be marketed by Promius with gross margins at 90%+ versus 55-60% for the base generics business.

Dr. Reddy's intends to file two NDAs per year with several products with a larger potential in late-stage development, such as a nasal triptan for migraines, a novel combination for genital warts (40 million people are infected with the HPV virus, the cause of genital warts, in the US) and a novel zero contact retinoid face wash. Management expects the total portfolio to generate over $500M in revenue by 2022 with a net margin of 30%+.

Even though, it was a tough quarter and remediation issues still linger, this was not entirely unexpected. Such a short-term setback was included in our numbers. With the stock down 15%, we continue to recommend Dr. Reddy's because of its breadth of product, savvy NDA strategy, glut of generic products at the US FDA, and excellent risk reward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Drug Manufacturers - Other, , Earnings, India
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