Divi's Labs: New capex, margin expansion to support earnings growth

Brokerages expect the company's net profits to grow by 30 per cent annually over FY20-23

With gains of 51 per cent, Divi’s Laboratories (Divi’s) has been the best-performing large-cap pharmaceutical stock over the past six months. It hit its all-time high earlier this week, and is within touching distance of the Rs 1-trillion mark. If it tops that, it will be the second company to cross that mark, after Sun Pharmaceutical Industries. 

The recent trigger for the stock has been an earnings upgrade, led by strong margin performance and revenue visibility, on the back of additional capital expenditure (capex). While the second-quarter (Q2) results were ahead of expectations, it was the new capacity expansions announ­ced by the company that added to the Street’s optimism. 

In addition to the projects worth Rs 1,800 crore that Divi’s is setting up and expects to complete by the end of 2020-21, the company indicated that it would invest Rs 400 crore in a new plant to cater to the custom synthesis segment. 

Of the current investments, construction of the greenfield project in Kakinada (Andhra Pradesh), which was delayed earlier due to lack of approvals, is expected to start in the March quarter. The Rs 600-crore project, which focuses on key starting materials and early intermediates, will take a year to complete. 

The company is also contemplating a greenfield project at Vellore in Tamil Nadu after completion of the Kakinada project.

The new capex offers visibility on new projects by global pharma innovators and indicates strong demand for intermediates. While generics and custom synthesis account for over 40-45 per cent each to Divi’s revenues, the nutraceutical segment (10 per cent of revenues) is expected to be one of the key growth areas in the future. Revenues for the segment jumped 31 per cent in Q2 on a sequential basis and 10 per cent over the year-ago quarter. Geographic expansion is expected to help the segment grow in the 10-15-per cent range in 2021-22 (FY22).

Rahul Jeewani of IIFL Research believes these incremental capacities offer revenue visibility, with average growth of 22 per cent over the FY20-23 period. In addition to revenue growth, profitability, too, is expected to remain strong. 

Gross and operating profit margins had hit multi-year high levels in the September quarter, gaining 800 basis points (bps) each over the year-ago quarter, led by higher sales, completion of debottlenecking, backward integration projects, and lower costs.

Margin expansion was one of the key reasons for upward revision in the earnings estimates. Motilal Oswal Research expects the company’s net profit to incre­ase 34 per cent over FY20-23, led by better prospects of custom synthesis and generic segments, as well as a 770-bps margin expansion on better operating leverage. 

While the company has no peer on gro­wth metrics and execution track record, valuations at 37x its FY22 earnings estima­tes are at a steep premium (80 per cent) to that of its large-cap peers, and factor in near-term growth. Investors with a long-term horizon can consider the stock on dips.