I apologize for the length of this write-up, but wanted to give the full story. Also, before you reach for the “2 button”, please spend some time digesting the information. This is not a traditional VIC value, but value it is.
Dr. Reddy’s Laboratories (RDY on the NYSE as an ADR and REDY.BO on the Mumbai Stock Exchange) is a compelling story at a very compelling valuation. One has to dig into the business and numbers to get to intrinsic value. Intrinsic value is atleast double the current market price with a very high probability of being realized over the next 2-3 years.
Background and History:
RDY is one of the three largest pharmaceutical companies in India – and it is the only one currently listed on the NYSE. Until Dec. 31, 2004, the lax Indian patent laws allowed Indian drug companies to become extremely good at reverse engineering a wide range of US/European drugs for sale in India at rock-bottom prices with no royalties payable to the major international pharma companies.
This capability, over the last few years, has been exploited by companies like RDY, Ranbaxy and Cipla to develop generic versions of drugs as the underlying patents expire – and then sell these into US and European markets. Indeed, over the next few years India is destined to dominate the generic drug business worldwide. The average well-trained research chemist in India makes under $10,000/year versus over $140,000 in the US. The differential is even more extreme than the software industry. India today has more FDA-approved drug manufacturing facilities than any other country in the world. As an example, the anthrax-fighting Cipro is a generic that is made and sells in India for 12 cents a pill versus $5.50 in the US. The Indian drug industry is the most competitive in the world in developing and manufacturing Active Pharmaceutical Ingredients (API) and generic drugs.
Several factors make India an attractive alternative for sourcing active ingredients. India has low development costs, complex synthesis capabilities, growing experience with cGMP compliance, and a large local dose market in which to gain experience. India is also known for having a large number of strong chemists, many with Ph.D.s from the U.S. and Europe, providing rapid, and creative, process development. With these resources, Indian companies can tackle complex syntheses in relatively short periods of time. Such responsive and well-staffed development teams have prompted Reddy-Cheminor, for example, to claim a development speed twice that of any U.S. or European company. Further, India’s lax patent laws have resulted in strong domestic demand for many finished dose products, giving API and dose form manufacturers more experience with a product over a longer period of time than manufacturers in regulated countries. In fact, new drugs are often launched early, if not first, in India. Thus, India has established itself as a source for both complex synthetic active ingredients and finished dose form products in regulated and unregulated markets.
And just like India’s software industry, India’s drug industry is moving up the value chain. RDY is at the forefront of this movement. The company began operations in 1984 and in 1987 got FDA approval for its first API for Ibuprofen. Then it entered bulk actives and in 1997 hit a breakthrough with licensing its first molecule for diabetes to Novo Nordisk (Large European Pharma) to take it through the trials and regulatory process. In 2001, it licensed its third molecule. In 2001, it also became the first India pharma company to get a 180-day exclusive from the FDA for its Floxetine capsule as that drug patent expired. The FDA gives this exclusive to encourage the generic players to enter markets aggressively as patents expire – in return companies like RDY reap super-normal profits for the six months and beyond as they establish marketing and distribution beachheads.
For the folks outside the pharma industry, here are some terminology definitions:
ANDA: An Abbreviated New Drug Application (ANDA) contains data which when submitted to FDA's Center for Drug Evaluation and Research, Office of Generic Drugs, provides for the review and ultimate approval of a generic drug product. Once approved, an applicant may manufacture and market the generic drug product to provide a safe, effective, low cost alternative to the American public.
API: Active Pharmaceutical Ingredients (API) are bought by drug companies to make end drugs.
DMF: A Drug Master File (DMF) is a submission to the FDA that may be used to provide confidential detailed information about facilities, processes, or articles used in the manufacturing, processing, packaging, and storing of one or more human drugs.
EDMF: European version of DMF
The legislative basis for the entire US generics industry is the Drug Price Competition and Patent Restoration Act, better known as the Waxman- Hatch Act, enacted in 1984. In order to encourage generic manufacturers to contest weak patents and bring the generic drugs to market earlier, the Hatch-Waxman Act provides an incentive in the form of 180-day marketing exclusivity. The current rule states that the first company, which has filed a Paragraph IV ANDA, which is received by the FDA in a substantially complete form, is eligible for the 180-day marketing exclusivity.
Why a Suit?
Once a (generic) firm files a paragraph IV ANDA, it needs to notify the patent holder of the submission of the ANDA. If the patent holder files an infringement suit against the generic applicant within 45 days of the ANDA notification, FDA approval to market the generic drug is automatically postponed for 30 months, unless, before that time, the patent expires or is judged to be invalid or not infringed. Normally brand drug companies file infringement suits to avail the incentive for a 30-month stay on marketing approval.
NCE: New Chemical Entity – i.e. a new drug (when approved) with full patent protection
The salient financial metrics are:
Net Current Assets: $255 Million
(Cash is over $200MM and this is excess capital).
Revenue (Year Ended 3/31/04): $463 Million
Net Income: $57 Million
RDY spent $46 Million in R&D and $29 Million in legal costs for patent challenges etc. Both these costs are fully expensed annually, but represent the hidden value in RDY. Excluding these expenses, Net Income would have been $132 Million. Ofcourse, that would pretty much take out any meaningful growth prospects. However, to value the business, one needs to assume some IRR on the R&D and Legal Spend.
RDY’s R&D spend is increasing. It is now over 10% of revenue and legal spend is over 5%. Also, remember that the R&D effectiveness for RDY is atleast 4 times that of the big pharmas – mainly due to India’s lower cost structure. The payback on these numbers is reflected in the following:
56 DMFs filed with the FDA
18 PMFs filed in Canada
10 EDMFs filed in Europe
35 ANDAs filed with the FDA. Most of these are Para IV i.e. with exclusive possible.
RDY is targeting one NCE every 2 years, leading to its own molecule launch in 2008. Today there are 8 molecules in the pipeline – All created by a company which spent just $17 Million last year on NCE research. Shows the dramatic cost advantage.
The company does not issue earnings guidance, but surprisingly did state in the last conference call that revenue for the year ended 3/31/05 would be over $500 Million. This is heady because they lost past exclusivity and 6/30/04 quarter sales were just $106 Million. So they are expecting about $400 Million in the next 3 quarters. They also stated that they expect revenues to exceed $1 Billion in the medium term. I’d guess this is 3-4 years.
They are firing on all cylinders. India’s own market is growing a lot. Plus they sell to 60 countries with big footprints in Russia, UK and ofcourse the US. Many of these country expansions have entailed significant start-up expenses, all of which are expensed. Being the lowest cost manufacturer gives them a huge leg up and lots of room to grow worldwide. Even the US climate with some $35 Billion in annual revenue drugs coming off patent this decade is terrific for them.
What is RDY’s intrinsic value?
The market cap is about $1.3 Billion with about $200 Million in excess cash. Earnings are probably going to be in the $60-odd million range with another $75 Million socked away by R&D and legal. You’re paying $1.1 Billion for a business that is generating $135 million in discretionary cash flow. That’s worth atleast 12-15x or $1.6 to 2 Billion. In addition, the business is turning around and redeploying much of that profit into ventures that are likely to yield returns of atleast 40% annualized and probably even much higher considering the R&D cost advantage. Large US Pharmas have generated high rates of return on R&D dollars – even though their research has become a lot less effective and they have bloated cost structures.
Worst case, you’re buying the business at a modest discount to intrinsic value with a free moonshot option. Heads you break even; Tails you make 2x or more in 2-3 years. As an FYI, RDY is trading at near its 52 week low and about 50% off from its 52-week high. I believe the 2x in 2-3 years is pretty much a given. Any large US pharma would love to buy them at a big premium to the current valuation. They’d get in-place R&D, a solid pipeline of new drugs and a sold core generics and API business with the lowest cost producer advantage.
The “hidden asset” in RDY is the spending on drug discovery.
5% a year being spent on legal and another 4% a year on NCE (New Chemical Entities). This is $45 Million per year annually. The history of this spending where the benefit is in the future is:
2006 $55 Million
2005 $50 Million
2004 $45 Million
2003 $40 Million
2002 $25 Million
2001 $20 Million
2000 $20 Million
1999 $10 Million
TOTAL $325 Million
Given that India’s R&D cost is less than 1/10th of the US, even if you assume just a 4x factor in blended effectiveness, the ROI on these dollars would be huge – well over 40% a year. Its takes over 5-10 years to start seeing the results of the pipeline investments. Assuming a conservative 40% ROI, the 2006 value of these past investments is:
2006 $55 Million
2005 $70 Million
2004 $88 Million
2003 $110 Million
2002 $96 Million
2001 $107 Million
2000 $150 Million
1999 $105 Million
Pre-1999 $100 Million
TOTAL $881 Million
The company that never issues guidance has guided that it expects revenues to be about $1 Billion in the “mid-term” i.e. 2007-2009. That implies atleast $750 Million in 2007 revenue with atleast $90 Million in FCF.
15x 2007 FCF: $1.35 Billion
Excess Net Current Assets in 2007: > $400 Million
Pipeline Value: > $900 Million
Total > $34.41/share
With a present price of $16.50/share this a nice 100+% return in 2-3 years.
Here are some links to delve further:
Corporate Overview Presentation:
Transcript of the Q105 Conference Call:
Forbes 2001 Article on Dr. Reddy’s
Value is its own catalyst. As the company continues to deliver quarter after quarter the street will learn to ascribe it an appropriate valuation. It’s unlikely to take more than 2-3 years, but even at three years, it’s a very healthy 25+% annualized rate of return.
|Entry||10/22/2004 05:02 PM|
|I love generic drug stocks, but unfortunately a lot of investors also like them and the price reflects that, so it is difficult to purchase them at bargain prices.|
How doest it compare in terms of valuation to Ranbaxy (another Indian generic drug stock), Cipla (I don´t know if it is public), Teva (Israel), and other companies in the same sector (e.g. Canadians)?
|Entry||10/23/2004 04:17 AM|
|I had been looking at this one myself and agree with your thoughts. Its a good idea. Question is how are the key executives, how much of the company do they own, is there any evidence of insider buying, and most importantly, are they of high integrity and ability and good capital allocators? If you have met or spoken to management, I would appreciate your thoughts as to how they stack up vis a vis backgrounds, ability, and capital allocation versus other teams in India and the US. Finally, do you have any insights into why the market is valuing the company in the manner that it is?|
|Subject||Why this valuation?|
|Entry||10/24/2004 11:54 AM|
|This is last Neo question: Finally, do you have any insights into why the market is valuing the company in the manner that it is?|
|Entry||10/24/2004 12:51 PM|
|re adding back legal... is it not possible without the legal expenses, the profitability would decline rapidly as they would immediately loose all legal challenges if they didn't defend. I also wonder if without the R&D, you wouldn't see a pretty rapid trail off in profitability?|
|Entry||10/24/2004 04:37 PM|
|1. You mention that any Big Pharma company would like to buy RDY...why do you think this has not yet happened?|
2. How do you think the Chinese will evolve as competitors in this area...thay would seem to have all the same cost/legal/home market advantages?
|Subject||Generic drug sector|
|Entry||10/29/2004 05:52 PM|
|Looked RDY in depth myself a couple of months ago. Like the company. The recent price drop probably has a lot to do with slowing revenues and earnings the past 4 quarters. Revenue down from $116 M Sep03 to $102 M Mar 04 back to $110 M in June. EPS down from 26¢ in Sep 03 to 4¢ Jun 03. Prozac sales declined and this was a huge part of sales. They also lost Plavix and Lamisil disputes. Such is the nature of generics. |
Part of the decline in EPS is due to the increase in R&D-- $16 million in 02 to $43 million in 04. This is expense and may or may not pay off. They have drugs in development, but are years from approval. Most are Phase I and Phase II.
Like the API segment--gives them some valuable vertical integration.
Attempting to break into biotech--a difficult field and not easy to bring drugs to market. The medications tend to be difficult to make and expensive. They seem to commited to spending R&D dollars here.
Their margins are a little lower than some of the competition. Net is 12%--Mylan is 24% and Teva is 21%. But neither of those companies is attractive as RDY for other reasons.
RDY also has a lower ROE 12% and ROIC 9%. Taro comes in at 41% and 20% respectively. Taro has some appeal as an investment. Again at this point RDY is a bit more attractive.
The really interesting thing here is the unabashed family nepotism. This runs rampant through Indian companies. Insiders hold a lot of the company--can be good or bad. Think Adelphia. In Reddy's case I think its OK. Its the family co and has been since the 1950's. They dont take any options to speak of and don't grant themselves huge salaries and bonuses. They give a lot of ancillary business to family members. It is not so easy to evaluate this since we don't have any idea of competitive pricing.
And they loan money to employees for cars, homes etc. This is a practice that would send US investors running for the exits.
---We provide loans to employees who are not executive officers or directors to meet specified exigencies. These loans are all interest free and are repayable over fixed periods ranging from one month to eight years. As of March 31, 2001 and 2002, there were Rs.41.5 million (U.S.$0.9 million) and Rs.69.4 million (U.S.$1.4 million) in loans outstanding to employees. As of March 31, 2003, there were Rs.63.2 million (U.S.$1.3 million) in loans outstanding to employees--
I wondered if it was a "perk" to keep employees on. I corresponded with a rather brilliant East Indian financial prof at Stern and he said this might be pushng the envelope even with India's lax corporate rules. I calculated the expense at 2¢ and would ding them for this amount in a DCF.
I calculated an IV at around $15 (10% growth 5 years stable growth 3%) after adjusting R&D as a capital expense rather than an operating expense. This boosts the value tremendously as opposed to expensing it. Otherwise, I arrived at a value of $6. My inputs were fairly conservative. The R&D is temporarily eating them up. It may pay off.
Recent approval may boost earnings:
Dr. Reddy's Laboratories Ltd. said on Thursday it received US regulatory approval to sell a cheaper copycat version of Forest Laboratories' $1.1 billion antidepressant Celexa.
|Entry||10/29/2004 07:26 PM|
|Haven't submitted an idea. Almost did submit RDY. Been here since Sep|
My DCF is very conservative. The low EPS from R&D gave them a ludicrous IV of $6. Which is why I backed out R&D and capitalized it. The IV of $15+ gave them an IV close to what they were trading at when i valued them and that gave me the impression I was on the right track.
Generic drug cos are cruising around 52 week lows and several of them look like potential investments. RDY is at the top of my list. I have absolutely no doubt they will get back to $30 before they ever go to $6.
They all go through tremendous gyrations as ANDAs come on line. The paragraph IVs are the most profitable as you know, free from comp for 180 days. Otherwise, they are all bringing the drugs to market and competing for sales. RDY hasn't been in the generics business long and I suspect they are just in the early stages of building a core of the cheap faceless generics that provide a nice base to the flashier P IVs. Cos like Mylan and Teva have much larger stables. RDY does not yet have this base to fall back on and will probably continue to gyrate--but they all do. Look at the cycles a co like Taro has been through. I think this is a well run small co and even though the generics aren't there yet, the API business will see them through.
The employee loans were pretty meaningless at 2¢ per share and didn't alter my valuation. It's just something to watch. I would like to know why they do it. It just has to some kind of employee benefit.
Nice write up
|Entry||02/21/2005 07:00 PM|
An interesting write-up.
I have a question about Para IV generic drug applications. Given that there is upside from being the first to file (and therefore getting the 180 day exclusive), and also that the penalty for not successfully challenging a patent is to be blocked from the market for 30 months, why wouldn't every generic company have its lawyers rady to file a Para IV application 30 months ahead of expiration?
Is the issue that lawyers have different perceptions of chinks in the patent armor? Or is it legal expenses?
Any help is welcome.
|Subject||Reply to Thistle|
|Entry||02/22/2005 12:56 AM|
The laws are, in general, biased towards the generic makers. The Waxman-Hatch legislation does help companies like Dr. Reddy's tremendously.
However, the legal challenges due involve frictional costs and there is more than one generic player in the world. So you're best off "picking your battles" where you believe the odds of getting the 180-day exclusivity is reasonable and also where you've decide to invest R&D dollars to reverse engineer the drug.
As a generic drug maker, one has to consider margins in an environment where no 180-day exclusive was gained and there is significant competition. To this end, Reddy prefers to play in segments where they make the APIs as well for the underlying drugs, so they have higher margins and profitability than the other generics and can price match and still make decent margins.
They believe that being a vertically integrated general drug provider gives them enduring competitive advantage and I find that logic sound. Amongs these drugs, they they pick the best candidates for Para IV filings.
Hope that helps.
|Entry||02/23/2005 03:48 PM|
seems pretty important - RDY could be beneficiary, but could also be blindsided.
|Entry||03/30/2005 01:15 PM|
A question about RDY's filing pipeline. How does the company calculate the $ sales of the patents it is contesting?
As an example, RDY seems to have 26 Para IV filings targeting $22B of sales in the US. Of these, 13 are FTFs, targeting $8B.
Upcoming trials noted by Smith Barney's latest generics research report (March 17, 2005) show Dr. Reddy's as one of three firms contesting Zyprexa, and the lone firm contesting Lipitor. But sales of these compounds are $2.8b and $7.7b, respectively.
My question has three parts:
1. Does RDY claim the entire US sales of a compound, even if there are multiple plaintiffs?
2. How lumpy do you think the RDY pipeline of claims is generally? I like the idea of the market not liking the uncertainty of the pipeline, but I don't like the idea of concentrated risk.
3. I thought the Lipitor filing was FTF, but that would lead to a $10.5b FTF pipeline (assuming full credit) - so I am confused by the math and/or assumptions.
I have tried to contact IR, but they are not responsive (time zones away, to be sure, but still not great).
Thx for any help.
|Subject||correction on Lipitor|
|Entry||03/30/2005 01:45 PM|
|The Lipitor challenge is by Ranbaxy - so never mind the math question|
But still, how lumpy do you think the pipeline is?
And how do they account for their pipeline in terms of shared credit to multiple FTF plaintiffs?
|Entry||06/30/2005 09:47 AM|
Do you have any views on the deal by RDY management to sell forward profits from the ANDA pipeline? Disclosure is not great, but the compounds in question are for 04/05 and 05/06, leaving the bulk of the pipeline still 100% owned by RDY.
I like this idea because I think public markets are bad at assessing ANDA pipeline valuations - a question of uncertainty rather than risk. But sharing that value with financial investors better able to weigh probabilities sounds like a loss of value to me. And maybe management is losing its nerve, either for cash flow reasons, or (worse) out of a desire to smoothe earnings.
And how much value do you think was lost from loss of Zyprexa challenge?
Any thoughts are appreciated.