Lack of valuation comfort may limit gains in Divi's Laboratories stock

Revenue growth prospects, however, remain strong driven by multiple factors

The stock of India’s second largest pharma company by market capitalisation, Divi’s Laboratories was down a tad on Monday despite better than expected operating performance. The flattish stock performance was on account of expensive valuations and worries of whether margins are peaking out. 

At the current price, the stock is trading at over 40 times its FY23 estimates and factors in most of the near term upsides. While valuations are at a 75 per cent premium to the NSE Pharma index, they are also at a sharp premium to its own 5-year averages. Rahul Jeewani of IIFL Securities expects the company’s earnings per share grow at 20 per cent over the FY21-24. While he has a buy rating, rich valuations means that the potential upside according to him is only 9 per cent. 

The other factor the street will keep a watch out for is the margin trajectory. Aided by a superior product mix and lower raw material costs, the company posted a 420 year basis points year-on-year (y-o-y) expansion in gross margins to 67.2 per cent. Operating profit margins (OPM) however expanded a lower rate of 300 basis points y-o-y given higher employee costs and other expenses. 

Though the extent of profitability expansion was lower as compared to the gross profit level, the OPM at 43.5 per cent was at a record high and better than street estimates. Despite cost pressures, the management indicated that they would be able to sustain margins on the back of operating efficiencies, backward integration projects, yield improvement steps and green chemistry. Jeewani of IIFL Securities points out that these factors and energy savings had helped the company post a rising trend of margins since the March quarter of FY20 when they stood at around 32 per cent. 

While margins were strong, revenue performance was lower than expectations. The overall growth of 13 per cent y-o-y was led by the custom synthesis segment. While this segment grew 38 per cent y-o-y, it was offset by the generic active pharmaceutical ingredient (API) segment which saw a revenue decline of 6 per cent. The drop in generic segment was on account of quarterly volatility and change in product mix.  The two segments account for 43-50 per cent each of the revenues. 

To sustain its growth going ahead, the company has chalked out a six-point strategy. Three of these are related to API segment. In the legacy APIs, where it has a 60-70 per cent market share, the company is expanding capacity in line with industry growth; the expected growth for this portfolio is 10 per cent. The company is looking at ramping up sales and expanding capacity in exising APIs where its market share is 25-30 per cent and where there is potential to raise it over 60 per cent. New generic APIs which face patent expiries by 2023-2025 and have a market size of $20 billion. Market share gains in the iodine-based contrast media products, expansion of its sartans portfolio and a couple of large scale custom synthesis projects are the other growth drivers.

On the generics side, Kumar Gaurav and Samitinjoy Basak of Kotak Institutional Equities believe that company is well positioned to gain market share from competitors in existing products while introduction of new APIs will drive a robust 16 per cent average sales growth in the segment over FY21-23. On the custom synthesis front, revenue growth in the near term will be driven by scaling up of antiviral drug Molnupiravir. There could be headwinds over the longer term led by decline in tonnage requirements of chemical entities bringing down addressable opportunity size, say the analysts at Kotak.

While the company surprised on the margin front and has strong growth levers, investors should await for a better entry point given the lack of valuation comfort.