Dr Reddys Laboratories Ltd Q2 FY2023 Earnings Call

Ladies and gentlemen, good day, and welcome to Q2 FY '23 Earnings Conference Call of Dr. Reddy's Laboratories Limited. As a reminder, all participant lines will be in the listen-only mode, and there will be an opportunity for you to ask questions after the presentation concludes. Please note that this conference is being recorded. I now hand the conference over to Mr. Amit Agarwal. Thank you, and over to you, sir.

Thank you. A very good morning, and good evening to all of you, and thank you for joining us today for the Dr. Reddy's earnings conference call for the quarter ended September 30, 2022. Earlier during the day, we have released our results and the same are also posted on our website. This call is being recorded, and the playback and transcript shall be made available on our website soon. All the discussion and analysis of this call will be based on the IFRS consolidated financial statements. To discuss the business performance and outlook, we have the leadership team of operative comprising Mr. Erez Israeli, our CEO; Mr. Parag Agarwal, our CFO; and the Investor Relations team. Please note that today's call is a copyrighted material of Dr. Reddy's and cannot be rebroadcasted or attributed in press or media outlets without the company's express written consent. Before I proceed with the call, I would like to remind everyone that the safe harbor contained in today's press release also pertains to this conference call. Now, I hand over the call to Mr. Parag Agarwal, over to you, sir.

Thank you, Amit, and greetings to everyone for the current festive season. This quarter, we had strong financial performance with higher server sales, PBT and EBITDA in our quarter. The performance has been supported by the launch of lenalidomide capsules in the U.S. and the rebound of Russia performance over last quarter. Let me take you through the details for the quarter. For this section, all the amounts are translated into U.S. dollars at a continuous translation rate of INR81.37, which is the rate as of September 30, 2022. Consolidated revenue for the quarter stood at INR6,306 crores, that is US$775 million and grew by 9% year-on-year basis and by 21% on a sequential quarter basis. In the same quarter of last year, we had high coverage product sales, adjusted for which we have grown in high teens in this quarter. Consolidated gross profit margin for this quarter stood at 69.1%, an increase of 55 basis points over the previous year and 920 basis points sequentially. The gross margins were mainly aided by favorable product mix and production linked incentive recognition. However, it was partially offset by a provision made on COVID product inventory as the sales on these products have reduced significantly. Gross margin for the global generics and PSAI businesses were at 65.4% and 3.6%, respectively, for the quarter. PSAI gross margins were primarily impacted due to inventory provision on COVID products and adverse leverage on manufacturing overhead on a lower sales base. We expect it to improve in the coming quarters. The SG&A spend for the quarter is INR1,656 crores, that is US$204 million, an increase of 4% year-on-year and 7% quarter-on-quarter, which is in line with business growth. As a percentage of sales, our SG&A has been at 26.3%, which is lower by 140 basis points year-on-year and 340 basis points sequentially. The R&D spend for the quarter is INR487 crores, that is US$60 million and is at 7.7% of sales. We have been making good progress on our R&D pipeline in line with our business strategy. Further, while we continue to drive productivity, we have been investing it back to strengthen our development pipeline, building marketing capability and digitalization. The net finance expense for the quarter is INR16 crores, that is US$2 million. We have been able to manage well the risk arising from the Forex fluctuations in the current volatile environment. The EBITDA for the quarter is INR1,932 crores, that is US$37 million, and the EBITDA margin was strong at 30.6%. Our profit before tax stood at INR1,611 crores, that is US$198 million, which is a growth of 27% year-on-year and a growth of 10% quarter-on-quarter. Effective tax rate for the quarter has been at 30.9% due to the FX effects arising from jurisdictional rates. We expect our normal ETR to be in the range of 25% to 26%. Profit after tax for the quarter stood at INR1,113 crores, that is US$137 million. Reported EPS for the quarter is INR66.89. Operating working capital increased by INR322 crores, which is US$40 million against that on June 30, 2022. Our working capital base is due by 15 days due to optimization of inventory across our businesses and factoring of receivables in Russia. Our capital investment during the quarter stood at INR251 crores, which is US$31 million. The free cash flow during this quarter was INR580 crores, which is $71 million. Consequently, we now have a net cash surplus of INR1,373 crores, that is US$159 million, as on September 30, 2022. Foreign currency cash flow hedges in the form of derivatives to the U.S. dollar are approximately US$402 million, largely held around the range of INR78.8 to 81.7% to the dollar maturing in the next 12 months, 4,320 million at the rate of INR0.99 2.4 million at a rate of AD56.04 and South African Rand $67 million at the rate of INR4.82 to South Africa and maturing in the next 6 months. With this, I now request Erez to take you through the key business highlights.

Thank you, Parag. Good morning, and good evening to everyone. I hope you and your loved ones are keeping well. I am pleased to take you through the current quarter performance, which is marked by record sales, EBITDA and ROCE. In the last few years, we have built a well-diversified business model, which allows us to have multiple growth drivers and reduce the risk of being dependent on a single market or event. We believe that the current environment of geopolitical and economic uncertainties, inflationary pressures, and Forex volatility, our strategy is allowing us to grow. While there may be some fluctuation quarter-on-quarter, we focus on building a portfolio pipeline across markets, driving productivity, investing in innovation, and advancing our ESG agenda. We believe that our strategy, along with a net cash position, will enable us to drive sustainable growth in line with our aspirations. Let me share some key highlights of the current quarter. One successful commercialization of the volume-limited launch of lenalidomide capsules in the U.S. market. The rebound of Russia sales after we normalized the re-channel stock in the last quarter. US FDA approval of products received by our partner, improving visibility and commercialization of our products. Our largest manufacturing facility in Hyderabad has been internally referred to as FTI, and it joined the Global Lighthouse network for economic calls. Now, let me walk you through the key business highlights for the current quarter. Please note that all references to the numbers in this section are in respective local currencies. Our North America Generics business recorded sales of $351 million for the quarter, with strong growth of 38% year-over-year and 53% sequentially. This was largely attributed to new product launch contributions, including the volume-limited launch of lenalidomide capsules in the U.S. market. While we wouldn't be able to mention specific sales volume or value arising from the product, we expect these products will continue to contribute meaningfully over the next few quarters. The price erosion for the base business has been within the normal range over the last 3 quarters. In this quarter, we launched 7 products and expect this momentum to continue during the balance of the fiscal year. Our Europe business recorded sales of $52 million this quarter with year-on-year growth of 10% and sequential quarter growth of 4%. During the quarter, we launched 10 new products across various countries within Europe. We expect to continue with the growth momentum in the rest of FY '22. Our emerging market business recorded sales of INR1,225 crores with a year-on-year decline of 6%. However, there was sequential growth of 6%. The year-to-date decline was due to a higher base effect as we had COVID product sales in Q2 of FY '22. Adjusted for this COVID contribution, we have grown. Within the emerging market segment, the Russia business declined by 2% on a year-over-year basis and grew by 84% on a quarter-to-quarter basis in constant currency. The sales for Russia have reverted to normal levels after the channel inventory stocking was normalized in the last quarter. During the quarter, we launched 31 new products across various countries in emerging markets. We expect this business to continue growing momentum. Our India business recorded INR1,150 crores with a year-over-year growth of 1% and a sequential decline of 14%. Adjusted for the COVID product sales during Q2 FY '22, and the brand divestment income in Q1 of FY '20, we have grown in mid-teens year-over-year and mid-single digits sequentially. During the quarter, we launched 2 new products in the market. As per a report from June 2022, our MAT rank in value terms is at number 10. We will continue to reset our portfolio in the India business, focusing on growing big brand acquisitions, partnerships for targeted therapy, while divesting non-core brands. Our PCI business recorded sales of $81 million with a year-on-year decline of 29% and sequential decline of 12%. Adjusted for the COVID product sales in Q2 of FY '22, the business has declined in single digits over last year. The decline has been due to lower volume pickup by customers for some key products. We expect sales improvement over the next couple of quarters with increasing volume pickup and the launch of new products. We have been progressing well in our journey of building a portfolio of complex and differentiated products, biosimilars, and NC pipeline. We have also made good progress identifying a list of innovative moves for our branded markets. We continue to actively look for investment opportunities for businesses in line with our strategy. We believe that even in the current uncertain environment, there are multiple opportunities to grow our business, and we are committed to pursuing this in line with our strategy. With this, I would like to open the floor for questions and answers.

Thank you very much. We will now begin the question-and-answer session. We have our first question from the line of Tarang Agarwal from Old Bridge Capital.

Three questions from my side. The first question is on Lenalidomide. Just wanted to get a sense of where the volumes bunched in the current quarter as per the agreement with the innovator? Or should we expect the volumes committed by Dr. Reddy’s in the current quarter to probably continue as we proceed? So that's number one. Number two, if I look at the cash flow statement for the business, there's roughly about INR600 crores that's been spent on intangibles. So I wanted to understand what is the nature of this? Is it a purchase of ANDAs or something else? And the third question is on the PSAI business. I believe the gross margins for this business have been declining continuously over the last year, and they came to a low of about 3.5% this quarter. So could you explain what's happening there? Is this supposed to move up going forward? Or how should we look at it? And what is driving this decline, not specifically for this quarter, but over the last 3, 4 quarters?

Thank you. I will take the first and the third, and Parag will take the second question. On the first, it's absolutely within the scope of the settlement we had with the innovator.

Ladies and gentlemen, we've lost the connection. I request you to stay connected. Yes, please go ahead.

Yes. Do you hear me now, sir?

Were there...

Yes, if I'm unable to...

Our line growth, sorry. So on the first question on Lenalidomide. The quantities are within the scope of the agreement that we had with the innovator, and we will continue to sell the product also in the next coming quarters. On the third question, indeed, the volumes of the APIs, especially on some of the oil products went down. And this is the main reason as well as the gross margin. This is a very much a fixed cost type of industry. So what we see that likely the margins will go up. Naturally, with that also the margins will go up. Now over time, strategically, we see growth levers in the PCI in general in all four levers. One is the data itself, primarily driven by certain launches of products in which we will sell commercial quantities for launches that will happen this year, next year, and the year after for those that are in the pipeline. The second is our contract manufacturing business, which is also a problem under this segment that is going to grow, and we do see better traction in that direction. And number three, our activities that what we call the indirect business-to-business sales, especially in the Middle East Asia and Japan. We also see a likelihood of growth. And not least, we do have certain pending deals with organizations that are supporting mid- and lower tiers in terms of economics in developing countries, and we have some interesting projects ahead. So overall, we can guide that we believe that these segments will grow in the future.

Yes. Tarang, regarding the cash flow, the intangible amount you see is related to the acquisitions we have publicly announced in the last couple of quarters. This includes Sigma from Novartis, the Eaton portfolio currently under development, and a few smaller acquisitions for repayment. Essentially, it's all directed towards the acquisition.

Thank you.

We have our next question from the line of Prakash Agarwal from Axis Capital. Please go ahead with your question.

Yes.

We are not able to hear you. Your voice is breaking, sir.

Am I audible now?

Yes, please go ahead.

Call quality is not great.

Yes. Please go ahead.

Yes. So pardon if I'm asking this again, but two questions. One is, how should we think about the base business performance given there is some competition in your key products? Would it be largely flattish or would it have come down? And secondly, on the volume-restricted launch that you have done, most or all of it is already booked for the quarter?

So on the second one, we are going to book sales for this product in Q2 and Q4 and in the years to come. So it's not that it's a one-time event. We are planning to continue to sell this product in a meaningful manner also in the next coming quarters. As for the first question, the best way to discuss it is that we are seeing consistent growth over the long term. Our activities in the U.S. market will continue to grow in the single digits year-on-year while, from time to time, we have mix-ups and distractions in accordance with competition. This quarter, indeed, we faced competitions for some key products. We launched new products and we're going to launch 25 products. Overall, our U.S. market will continue to grow in the same manner that we discussed in past meetings.

Okay. And just to clarify that I understood the second part of the question correctly, you said there is more to come in Q3 and Q4 with respect to Revlimid.

We have the next question from the line of Kunal Dhamesha from Macquarie Capital.

First one on the gross margin. So we have kind of improved gross margin by 550 bps. Can you just quantify various moving pieces here? I think we have product mix, PLI approval, FX impact and then offsetting is the total product provision and the price erosion.

Yes, Kunal. So our gross margin for the quarter has been reported at 59%, and it has, as I stated, improved due to favorable product mix including the impact of new product launches. However, we have recognized the benefit of PLI and a few other normal export incentives during the quarter. Overall, we've taken a provision of around INR100 crores for COVID product inventory, as the sales have come down quite a bit as you would know. So overall, I would say that yes, this is where we stand on gross margin.

And would you be able to share some insight in terms of why our ANDA filing run rate remains low? I think in FY '20, we filed around 8 NDS; FY '21 was slightly better, and FY '22's first half is around 4 NDS filings while our R&D continues to remain elevated. So any insight into why our R&D run rate filing is low?

Yes, it's more of a timing within the year of the submission. Normally, most of the submissions are done in the second half of the year. So you are going to see those numbers pick up. As for the overall numbers, we are focusing our R&D as much as possible on biosimilars and products that have bigger potential. So we are trying not to target 40 products per year but rather aim for about 25 products per year with the potential to be first to market and meaningful growth. The current low filing numbers are also a combination of timing and focus on R&D across markets, not just for the U.S. market.

We have our next question from the line of Damayanti Kerai from HSBC.

My question is on Indian sales. So even after adjusting for COVID base and sale of some non-core brands for the quarter, sequential growth rate is around mid-single digits, which is lower than market growth of double digits. So how should we see growth moving ahead? And what will be the key drivers? A few years back, you mentioned about growing your India sales by almost 50% on the base existing at that time. So are you broadly on track to achieve that?

Yes, we are on track. We are very confident that we are on track. What we are seeing now is a combination of our long focus. As part of our strategy and as discussed in previous meetings, we identified certain segments that we want to focus on. We are putting our resources behind meaningful brands that can grow and sustain for many years, as well as investing in what we call Horizon 2, where India will be a big outlet for that. As part of this, we are divesting brands as well as focusing on stronger brands. For example, the brand that we acquired recently as well as brands that are chronic in nature. We do have some brands that do not perform well, and we are fixing those. Bottom line, I'm very confident that we are going to see solid growth in our India business, and we're planning to achieve our targets.

Sure. My second question is on injectables. This has been one of your focus segments. Can you talk a bit about the competition outlook for this segment, given we have seen competition rising? How do you see the competition scenario building up in injectables over the next few years?

As the patent expires, we invite people to invest behind products that we have patent exploration at this time. As part of the way our portfolio was built, there are increasing numbers of injectable products. We see many companies also investing in their injectable pipelines. Thus, we anticipate that the injectable business will be highly competitive. However, we believe we will see growth and achieve better margins on a global scale. At the same time, every product will face competition, not just in the injectable segment but in every generic segment.

Sure. And my last question is a clarification on the PLI scheme benefit. Is it one-off you are likely to book every year or like in the next quarters also?

This is clearly not a one-off. As you know, it's a multiyear scheme. And even within this year, it is not a one-off. Of course, the quantum fluctuates from one quarter to another, depending on the sales of the products that qualify for the PLI.

We have a next question from the line of Surya Patra from Philip Capital.

Yes. My first question is on the cash flow that we are likely to be generating from Revlimid. So in fact, Dr. Reddy's has been a consistent generator of free cash flow, over INR1,000 crores annually. And given that your qualitative growth outlook, can you clarify your priorities moving forward?

Yes, thank you. Indeed, I agree with you; we are building a very healthy cash flow position. We plan to use it for CapEx, buying and building the future technologies, and for our working capital. After these, we will also look into opportunities for development across all geographies aligning with our strategy. We feel that the current geopolitical and economic situation creates opportunities for us. We do see multiple avenues for growth into the future.

So regarding the R&D, although there is significant growth from Revlimid, the R&D spend has also gone up. Do you think this trend will continue with the ramp-up in the business?

That's right. If you recall in the past, we guided that we are comfortable with a 25% EBITDA margin, which in some quarters we'll exceed and in others we'll fall short. This will help us in financing our R&D activities while maintaining a strong cash position to ensure our growth strategies.

Sure. My second question is on the pre-claim for the biosimilars. How should we see this as an opportunity for us?

Yes. This is a residual agreement with our partner where we are entitled to royalties once the product is launched. We are not participating in the actual production, but we will share the success once we sell the product.

Okay, sure. Just to clarify, you mentioned about the INR100 crore provision. Is it relating to the PSAI and this INR193 crores of government grant, what is the PLI amount related to?

Yes. The government grants include PLI and the other export incentives that we received. It's a total amount. The provision is across all businesses, including India and emerging markets.

Is it possible to share specific numbers for PSAI?

We don't share business-specific numbers.

The INR100 crores provision relates to the PSAI?

Yes, it is across all businesses, including PSAI.

We have our next question from the line of Rebecca from Bloomberg. Since there is no response, we will take our last question from the line of an unidentified analyst.

I have a couple of questions on injectables. Are we seeing any industry-wide challenges in the space? Some peers have been highlighting challenges regarding components or raw materials. Are we facing any of these challenges?

As a company operating in multiple markets globally, we have had some challenges, but nothing significant to report. We do not anticipate major disruptions as we are not dependent on a single supplier or country.

Secondly, what is your long-term strategy for injectables? Do you aim to manufacture in-house, or are you open to tie-ups with contract manufacturers?

Our preference is to manufacture injectables in-house wherever possible. Recently we have qualified several large facilities that expand our capacity. However, for certain products, we'll consider inorganic moves, especially for complex products that do not make sense to manufacture locally.

Thank you. I would now like to hand the conference over to Mr. Amit Agarwal for closing comments.

Thank you all for joining us for today's earnings call. In case of any further queries, please reach out to the Investor Relations team. Thank you.

Thank you. On behalf of Dr. Reddy's Laboratories Limited, that concludes this conference. Thank you for joining us, and you may now disconnect your lines.