Description

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.

Why India?

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

Para IV:

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 Numbers:

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:

API Business:

56 DMFs filed with the FDA
18 PMFs filed in Canada
10 EDMFs filed in Europe

Generics:

35 ANDAs filed with the FDA. Most of these are Para IV i.e. with exclusive possible.

NCE:

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.

Method 2:

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 Value:

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:

http://www.drreddys.com/site/pdfs/Final-Analystmeet-ppt.pdf

Transcript of the Q105 Conference Call:

http://www.drreddys.com/q1fy05/Transcript-Q1FY05.pdf

Forbes 2001 Article on Dr. Reddy’s

http://www.forbes.com/global/2001/1210/026.html

Catalyst

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.