Dr Reddy's: Regulatory headwinds to cap upside

Stock could be further stressed if regulatory issues escalate

Dr Reddy’s stock hit its nine-month low intra-day, as a spate of negative news flow dampened investor sentiment. While the stock recovered from the sharp fall in the morning trades to close 2.6 per cent down on Thursday, it has lost 23 per cent since the start of November. The reason for Thursday's fall has been US-based law firm Lundin Law PC's announcement that it is investigating claims against Dr Reddy's of possible violations of US federal security laws; this follows a slew of similar plans by other law firms based overseas. The company, however, has denied all allegations saying it has adhered to all disclosure requirements of both the US Securities and Exchange Commission and Indian stock exchanges. While analysts do not put too much importance to the purported moves that may lead to  class action suits, the key overhang continues to be the US FDA warning letters for three of its manufacturing plants.

While the three facilities contribute 10-12 per cent of total revenues or $250-300 million and there is no immediate impact, the overhang will worsen if the warning letters escalate into "import alerts. Analysts at JPMorgan indicate the status of the oncology formulation plant and the potential impact on the injectable revenue is a key factor, as the segment contributes $280 million or 25 per cent of Dr Reddy's US revenues. Estimates suggest an import alert could impact FY16 earnings by 11 per cent. While it is difficult to ascertain how the US FDA issues will pan out, analysts say site transfers and a diversified manufacturing base are mitigating factors.

Analysts say the next couple of quarters would be tough for Indian pharma stocks such as Dr Reddy's, but expect growth to rebound in FY17. This is on the back of higher approvals in the US, strong domestic growth, better margins on account of lower raw material prices (lower crude oil, chemical intermediate prices) as well as transportation cost which account for 5-6 per cent of overall costs. Dr Reddy's portfolio comprising complex generics, proprietary products and biosimilars are long-term positives.

While the Indian large cap pharma space typically trades at 22-28 times its one-year forward earnings, with Sun Pharma at the upper-end of the valuation band, the recent fall has driven down Reddy's valuations to 19-20 times. While analysts say the stock is a good long-term bet, the regulatory and other uncertainties will cap upsides in the near term.