Multiple headwinds for Dr Reddy's in FY17

Price erosion in the US and higher R&D costs are major concerns

The Dr Reddy’s Laboratories (DRL) scrip was down two per cent on Thursday, after news that the US Consumer Product Safety Commission (CPSC) asked the US justice department to seek a civil penalty against the company for failure to comply with norms on packaging and reporting.

While the maximum penalty is $15.15 million, there could be additional penalties for misrepresentation of certification claim in the US. The brokerage firm’s analyst Surajit Pal believes possible civil penalty charges in this case, which dates back to 2011, could be limited between $15 and $30 million (up to Rs 200 crore) for DRL violation of packaging norms. The possible outcome of civil penalty will have limited one-off earnings impact for DRL in FY17, he adds, pegging the current earnings per share (excluding potential one-off impact due to this issue) at Rs 128.4. The company, however, says it had complied with the legal requirements and will defend itself.

This is the second instance of a US regulator which has pointed to lapses. The US Food and Drug Administration (USFDA) has issued warning letters related to manufacturing practices at three of DRL’s facilities, which has led to a stop in new product approvals from these.

While other companies, such as Sun Pharma, Cadila and Ipca Labs, have also been impacted by USFDA actions, be it warning letters or import alerts, analysts at Edelweiss Securities believe the severity of observations is higher in the case of DRL and Ipca, and will take longer to resolve. The issues are coming up at a time when a major part of DRL’s US portfolio is facing pricing pressures. DRL had indicated price erosion was on the rise, pegging it at high single digit. With competition in key products such as Vidaza (anti-cancer drug) and Decitabine (anti-viral), Valcyte and limited Venezuela sales, expect FY17 earnings to be flat year-on-year, say analysts at Religare Institutional Equities.

Higher research and development (R&D) cost, estimated to cross 13 per cent of revenues in FY17, would impact earnings further. DRL’s R&D costs as a percentage of sales at 11.5 per cent are already the highest among its larger peers.

Though the stock is down 29 per cent since November and trades at reasonable valuations of 16 times the FY18 estimates, given the regulatory overhang, investors will be better off awaiting clarity on resolution of the regulatory issues.