Divi's stock: Pricing pressure for drug makers can lead to more outsourcing

Divi’s Laboratories is among the few pharma companies that have outperformed in the last one year with its share price ticking up 75 per cent.

Regulatory concerns regarding the contract research and manufacturing services (or CRAMS) major, which get most of its revenue from exports, have hurt the Street’s sentiment. But Divi’s has initiated several measures to resolve US Food and Drug Administration (FDA) issues.

The company’s Unit II at Vishakhapatnam had received an import alert from the FDA in December 2016. But Divi’s has completed the remediation in time and received an establishment inspection report in 2017.

Having cleared regulatory issues, Divi’s is seen well-paced to report good growth in FY19. During the December 2017 quarter, the company’s operating income had witnessed growth against declines in the previous three quarters.

However, foreign exchange losses have affected its operating performance. Since Divi’s will not be spending much on remediation costs to resolve regulatory issues, its operating performance is expected to get a leg-up. The company had incurred remediation cost of Rs140 million, according to analysts, who expect the same to decline to Rs 50-60 million in Q4 FY18, and become nil in FY19.

Analysts at Motilal Oswal Securities expect Divi’s earnings before interest, tax, depreciation and amortisation (Ebitda) margin to improve by 400 basis points to 36 per cent.

Besides, expansions at its unit I and unit II will drive growth. Divi’s has invested in a new nutraceuticals plant and has planned to capitalise an additional Rs 1.75 billion with respect to Unit I’s expanded capacities in Q4 FY18. If its Kakinada plant expansion, which is facing litigations, gets an approval, it will add to Divi’s revenue visibility.

However, after resolution of FDA issues at Unit II, the Street expects Divi’s other units to face inspections. 

Analysts at Motilal Oswal Securities had said Unit I, which accounts for 35 per cent of total revenue and exposure to the US, is at 11 per cent of total revenue and was last inspected in June 2014. It will be crucial for the company to successfully clear the FDA inspection (particularly because the FDA had cited data integrity issues at Unit II).

On the positive side, there are immense opportunities for Divi’s. Pricing pressure and competition for the industry is expected to increase outsourcing opportunities for Divi’s, and a significant uptick may lead to a re-rating, analysts said.

Considering remediation expenses to be on the decline and a sequential improvement in overall performance, analysts at Phillip Capital estimate Divi’s earnings to grow 26 per cent annually over FY18-20.