icicidirect_divislaboratories_initiatingcoverage

ICICI Securities Ltd. | Retail Equity Research

November 29, 2011

Initiating Coverage

Well poised to capture revival in CRAMS… Divi’s Laboratories Ltd (DLL) is a leading player in the CRAMS space. DLL is engaged in the manufacture of generic APIs, custom synthesis of active pharmaceutical ingredients for innovator companies and other specialty chemicals like Carotenoids and Peptides. DLL’s sales and net profit have grown at a CAGR of 16% and 23% in FY07-11, respectively, mainly driven by healthy growth in both custom synthesis and generic APIs despite negative growth in FY10. With a specific focus on niche generic APIs, traction in the Carotenoids business and proven capabilities in custom synthesis, DLL is back on the growth path after a difficult patch in FY10-H1FY11, in line with global CRAMS dynamics. We project the sales (including other operating income) will grow at a CAGR of ~ 21% to | 1922.4 crore in FY11-13E. We are initiating coverage on the stock with a HOLD rating.

Generic APIs to grow at a healthy rate on the back of incremental Carotenoids sales

In generic APIs, DLL enjoys ~70% global market share in two products Naproxen and Dextromethorphan Hydrobromide. These products are already matured with limited competitors having other priorities. DLL is also increasing its presence in another niche area of Carotenoids after acquiring the requisite capabilities. It has developed various types of Carotenoids including Beta-carotene, the largest in the group. We expect sales from the generic APIs and Carotenoids segment to grow at a CAGR of 27% to | 1059 crore between FY11 and FY13E.

Custom synthesis to support margins DLL is the largest custom synthesis player in India with a proven track record. Strong R&D capabilities and India based cost arbitrage along with IP adherence are some of the key strengths, which will drive incremental assignments from MNCs. We expect custom synthesis to grow at a CAGR of 14% to | 843 crore between FY11 and FY13E.

Valuations At the current market price of | 738, the stock is trading at 20.8x FY12E EPS of | 35.5 and 17.6x FY13E EPS of | 42. We expect sales, EBITDA and net profit to grow at a CAGR of 20.7%, 18.4% and 13.1%, respectively. We have valued the stock at 18x FY13E EPS of | 42 to arrive at a target price of | 756. With a virtual debt-free status, cash (liquid investments) of ~| 525 crore, healthy EBITDA margins in the range of ~36-39% and revival in the CRAMS space, we believe the valuation is justified. Exhibit 1: Valuation Metrics

(Year-end March) FY09 FY10 FY11 FY12E FY13ESales (| crore) 1,203.5 946.7 1,318.5 1,640.4 1,922.4 EBITDA (| crore) 503.3 429.2 509.1 608.7 713.4 Net Profit (| crore) 424.4 344.2 435.6 470.3 556.8 EPS (|) 32.0 25.9 32.8 35.5 42.0 P/E (x) 23.1 28.4 22.5 20.8 17.6 Price / Book (x) 7.8 6.3 5.4 4.6 3.9 EV/EBITDA (x) 19.2 21.8 18.2 15.2 12.4 RoCE (%) 34.7 24.0 24.6 25.1 25.1 RoE (%) 33.6 22.3 23.8 22.3 22.4

Source: Company, ICICIdirect.com Research; Sales includes other operating income

Divi's Laboratories (DIVLAB) | 738

Rating Matrix Rating : Hold

Target : | 756

Target Period : 12 months

Potential Upside : 2%

YoY Growth (%) (YoY Growth) FY10 FY11 FY12E FY13ENet Sales (21.3) 39.3 24.4 17.2 EBITDA (14.7) 18.6 19.6 17.2 Net Profit (18.9) 26.5 8.0 18.4 EPS (|) (18.9) 26.5 8.0 18.4

Current & target multiple FY10 FY11 FY12E FY13E

P/E 28.4 22.5 20.8 17.6 EV / EBITDA 21.8 18.2 15.2 12.4 P/BV 6.3 5.4 4.6 3.9 Target P/E 29.1 23.0 21.3 18.0 Target EV/EBITDA 22.4 18.7 15.6 12.8 Target P/BV 6.5 5.5 4.7 4.0

Stock Data Bloomberg/Reuters Code DIVI IN / DIVI.BOSensex 16,024.3 Average volumes 136,406.0 Market Cap (| crore) 9,789.6

52 week H/L 834 / 590Equity Capital (| crore) 26.5 Promoter's Stake (%) 52.2 FII Holding (%) 10.9 DII Holding (%) 17.0

Comparative return matrix (%)

Return % 1M 3M 6M 12MDivis Laboratories Ltd (3.2) 5.6 (1.7) 19.3 Dishman Pharma (13.5) (32.4) (51.6) (65.6) Jubilant Life Scie. (6.7) 4.8 16.3 (33.5)

Price movement

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Analyst’s name

Siddhant Khandekar [email protected]

Krishna Kiran Konduri [email protected]


Divi's Laboratories (DIVLAB)

Company background Established in 1990, Divi’s Laboratories Ltd (DLL) is a Hyderabad based pharma company. DLL is engaged in the manufacture of generic APIs and intermediates, custom synthesis of active ingredients and advanced intermediates for pharma MNCs, other speciality chemicals like Carotenoids and complex compounds like peptides and Nucleotides. After successfully developing and marketing generic APIs and intermediates for generic players, the company started custom synthesis of NCEs developed by MNCs by providing APIs and advanced intermediates. The company started Carotenoid supplies in FY09. Promoted by Dr Murali K Divi, the company raised | 17 crore through the maiden IPO in March 2003. DLL’s product portfolio comprises two broad segments- (i) generic APIs including Neutraceuticals and (ii) custom synthesis of APIs, intermediates and speciality ingredients for innovator pharma MNCs. It also includes peptide building blocks. The sales break-up between these two segments is almost 50:50 (FY11). The company remains committed to only a few research driven niche opportunities as was the case when it started commercial operations in the early nineties. Thus, it has filed just 41 odd DMFs (38 approved) with the USFDA and does not want to increase its count drastically. It has also received a certificate of suitability (COS) from the European Directorate for 12 products. To enter the custom synthesis space in the nineties, the company made its own case to the innovators, which, until then, were relying on services provided by major players such as BASF, Degussa, etc. As these players grew and became as big as the innovators themselves, companies like DLL, on account of their capabilities and commitment towards the strict IP regime, started getting assignments. DLL currently owns three manufacturing facilities — one in Nalgonda near Hyderabad and two in Vishakhapatnam. It is in the process of setting up its fourth manufacturing facility in Vishakhapatnam, which is expected to commence production in the current fiscal. DLL owns four research centres with functional focus across all verticals. The company operates predominantly in exports markets, which contribute ~90% to overall revenues.

Exhibit 2: DMFs filed with USFDA

28

32

3738

41

25272931333537394143

FY07 FY08 FY09 FY10 FY11

Nos

Source: Company, ICICIdirect.com Research

Exhibit 3: CoS with Europe

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10 10 10

12

0

2

4

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8

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14


Nos

Source: Company, ICICIdirect.com Research; Certificate of suitability (CoS)

Share holding pattern (Q2FY12)

Shareholder Holding (%)Promoter 52.2Institutional Investors 27.9Other Investors 10.0General Public 9.9

Promoters and FII & MFs holding trend (%)

52.2 52.2 52.2 52.2 52.2

29.4 28.9 29.1 27.7 27.9

0.0

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20.0

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60.0

Q2FY11 Q3FY11 Q4FY11 Q1FY12 Q2FY12Promoter FIIs & MFs

700045

700045

700045



Exhibit 4: Geographical break-up (FY11)

ROW 5%

North America44%

India8%

Far East 9%

Europe30%

Asia4%


Exhibit 5: Top 5 client’s revenues (%)

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48

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52


(%)


Exhibit 6: Largest product contribution to revenues

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22


(%)


Exhibit 7: Top 5 products contribution to revenues

60 6061

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62


(%)


Exhibit 8: Sales grows 16.1% in FY07-11

724

1,033

1,203

947

1,319

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1,400


(| c

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Source: Company, ICICIdirect.com Research; sales includes other operating income

Exhibit 9: Trends in EBITDA margins

34.0

40.441.8

45.3

38.6

30.032.034.036.038.040.042.044.046.048.0


(%)




Exhibit 10: Divi’s Laboratories business structure (FY11 sales break up)

Divi's Laboratories (100%)

Genric APIs & Intermediates, Carotenoids (50%)

Custom Synthesis & Peptides (50%)

Generic APIs & Intermediates (45%)

Carotenoids (5%) Custom Synthesis (47%) Peptides (3%)


Exhibit 11: Pharma Product Life cycle

Life cycle of pharmaceutical product


Patent Filing

Regulatory Approval

End of Patent Protection

Drug Discovery

Drug Development

Generic APIs

Custom synthesis

Identifying/discovering new molecule

Pre clinical/Phase I, Phase IIa, Phase IIb & Phase III

Commercial launch

Generics entering



Investment Rationale After a difficult period of 18-24 months, the global CRAMS industry is in a recovery mode. We believe the de-stocking phase at the MNC client’s end is almost complete. The revival in the CRAMS industry would benefit low cost manufacturing destination like India and China. DLL has established a strong relationship with leading pharma MNCs by strict adherence to the IP regime and focus on intermediates and APIs. Flexibility at the manufacturing facilities gives the company an edge over its peers. It can alter the production taking into account the market dynamics as was visible during the tough times of FY10. In spite of the capital intensive nature of the business, DLL has consistently brought down its debts over the last five years to negligible levels despite almost doubling the gross block. With the revival in CRAMS fortunes globally on account of the pause of de-stocking, we believe the company is well placed to cater to the requirements of MNCs in a more dynamic JIT environment. We expect total sales (including other operating income) to grow at a CAGR of 20.7% to | 1922 between FY11 and FY13E driven by strong growth in the Carotenoids and generic APIs segment. With the industry scenario becoming favourable for CRAMS players on account of the impending patent cliff and drying output in the R&D pipeline, we expect players like DLL with negligible leverage and required scalability to perform above industry average. DLL is a leading player in certain APIs such as Naproxen and Dextromethorphan Hydrobromide. DLL holds ~ 70% market share in both these APIs and revenues from these APIs account for 29% of total sales. As these two products are matured, we do not expect much pricing pressure and incremental competition. We expect sales from generic API and intermediates (excluding Carotenoids) to grow at a CAGR of 21.4% to | 871 crore between FY11 and FY13E. In custom synthesis (CS), the company will continue to work on select assignments and register strong EBITDA margins on account of its expertise in chiral chemistry and peptides. We expect sales from CS to grow at a CAGR of ~14% to | 843 crore between FY11 and FY13E. Carotenoids will also be the key growth trigger for the company as it wants to penetrate a tough market dominated by MNCs. On a smaller base, we expect sales from Carotenoids to grow at a CAGR of 74% to | 188 crore between FY11 and FY13E. Exhibit 12: Sales break-up trend

584

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Generic APIs Custom Synthesis Carotenoids

Source: Company, ICICIdirect.com Research; A; Assumption

DLL is committed towards strict IP regime

CRAMS industry witnessing recovery

DLL is a global leader in APIs like Naproxen and

Dextromethorphan Hydrobromide

Custom synthesis business is EBITDA accretive



Generic API to see healthy growth on the back of revival DLL manufactures generic APIs and intermediates for both generic and innovator companies. The company concentrates on a few niche APIs, which normally fetch better margins and where competition is low. So far, it has filed 41 DMFs with the US Food & Drug Administration (USFDA) and 12 DMFs with the European Directorate for the Quality of Medicine & Healthcare (EDQM). This shows that the company is focusing only on a small basket of niche products. Generic APIs account for nearly 50% of total sales in FY11. The global slowdown in FY09-10 also impacted DLL’s generic API business. During the turmoil, majority of the customers opted for lean inventory management, which resulted in a decline in sales for FY10. The management has indicated that the de-stocking at its customers end is almost over. The key generic APIs of DLL are Naproxen, Dextromethorphan Hydrobromide, Lopamidol and Phenylephrine. The company enjoys more than 70% market share across the globe in APIs like Naproxen and Dextromethorphan Hydrobromide. With a commanding market share, the company is better positioned to fetch better realisations. Since both these APIs are already mature, we do not expect a more intense pricing scenario to develop in future on account of fewer competitors. Naproxen is a non-steroidal anti-inflammatory drug (NSAID) used in the treatment of arthritis, spondylitis and other inflammatory conditions. Its DMF was approved by both USFDA and by EDQM. Beside Naproxen, the company has also received approvals for Naproxen Sodium and its intermediate (DL Naproxen). Around 20% of DLL’s total revenues came from Naproxen in FY11. Other players, which manufacture Naproxen API, are Roche, Teva, Albemarle, Farchemia and Dr Reddy’s Laboratories. Dextromethorphan Hydrobromide is another API in which the company enjoys more than 70% global market share. Around 9% of the total revenues come from this API. It is a cough suppressant, which is widely used as the main ingredient in the formulation of cough syrups and tablets. DLL also manufacture methoxymorphenane, a key ingredient for Dextromethorphan. Other players, which manufacture this API, are Roche, Dr Reddy’s Laboratories and Wockhardt. Exhibit 13: Addition of products to its generic API and intermediates portfolio

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DLL concentrates on few niche generic APIs

Sales and profits in FY10 were impacted due to inventory

correction at customers

DLL enjoys more than 70% of market share in Naproxen

and Dextromethorphan Hydrobromide

Around 20% of revenues come from Naproxen in FY11

Around 9% of revenues come from Dextromethorphan

Hydrobromide in FY11



DLL has added eight generic APIs and intermediates to the product portfolio in the last fiscal. The company is currently marketing 36 generic APIs while another five are ready for marketing. It has identified around 25 APIs, which are under development. Despite concentration of revenues, the company is growing at a healthy rate (10 year sales CAGR of ~21%) as other big players, be they Roche, Teva or Dr Reddy’s have other aspirations. We expect sales from generic API and advanced intermediates (excluding Carotenoids) to grow at a CAGR of 21.4% to | 871 crore between FY11 and FY13E. Exhibit 14: Generic APIs business to grow at a CAGR of 21% in FY11-13E

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Generic APIs

Source: Company, ICICIdirect.com Research; A: Assumptions

Carotenoids to emerge as new niche Revenues from generic APIs & intermediate segment also include sales from Carotenoids. Around 5% of total revenues (~| 62 crore) came from Carotenoids in FY11. Carotenoids are colouring matters or pigments, which are naturally present in many plants, flowers, fruits and vegetables. Carotenoids are important in human nutrition as a source of vitamin and as a preventive agent against cancer and heart diseases. The protective effects of Carotenoids against serious disorders such as cancer, heart disease and degenerative eye disease have been recognised and have stimulated research into the role of Carotenoids as antioxidants and as regulators of the immune response system. In addition, Carotenoids add colour to foods and beverages and are ingredients for chemicals responsible for the flavour of foods. The global market size of Carotenoids is ~US$1 billion. This is expected to grow to US$1.2 billion by 2015E. Although the growth prospects for Carotenoids remain at a low scale, only a few players occupy the market space. The leading players BASF and DSM together hold ~60% of market share. Broad types of Carotenoids include Beta-carotene, Astaxanthin, Canathaxanthin and Lutien. Beta-carotene is the most well known of the Carotenoids and is extracted from carrots, beetroots, sweet potatoes, etc. It is the largest product segment in Carotenoids with ~40% of total market size. Beta carotene plays a major role as a contributor of Vitamin A in human diets. Canathaxanthin is the fastest growing Carotenoid globally and the preferred colouring agent for imparting red coloration to egg yolks as well as for providing red background colour in shrimp and fish. Astaxanthin is chemically synthesised, though Astaxanthin products derived from algae are rapidly penetrating the market as antioxidant enriched supplements, due to associated health benefits.

Eight generic APIs and intermediates were added to the

portfolio in FY11

Top Five Generic APIs API Therapeutic Naproxen Anti InflammatoryDextromethorphan Hydrobromide Anti CoughPhenylephrine Hydrochloride Anti CoughLevodopa CNSNabumetone Anti Inflammatory

Products under development API Therapeutic segmentAliskiren Hemifumarate Anti HypertensiveAtazanavir Anti RetroviralsAtorvastatin Anti Cholesterol Bazedoxifene Anti Inflammatory Chlophedianol HCL Anti Cough Fesoterodine Fumarate Anti Muscarinic Fondaparinux Anti-Thrombotic Saxagliptin Anti Diabetic Selectracetam Anti-ConvulsantValgaciclovir Anti Viral

Carotenoids are colouring agents

Global market size of Carotenoids is US$1 billion

Beta Carotene accounts for ~40% of total market size



As the natural availability of these Carotenoids is limited and extracting them from natural sources finds low yields involving high volume of inputs, these are being produced synthetically with the same efficacy. Carotenoids produced through chemical synthesis are dominating the global Carotenoids market. DLL has developed various types of Carotenoids like Astaxanthin, beta carotene, Canathaxanthin, Apocarotenal, Lutein, lycopene and Vitamin D3. The management has indicated that sales from Carotenoids will reach | 250 crore by FY13 from | 62 crore in the current fiscal. We expect sales from Carotenoids to grow at a CAGR of 74% to | 188 crore between FY11 and FY13E. By FY13E, we expect sales from Carotenoids to account for ~10% of total revenues. Exhibit 15: Carotenoids drive growth

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Carotenoids


Overall, generic APIs including Carotenoids are expected to grow at a CAGR of 27% to | 1059 crore between FY11 and FY13E.

Custom synthesis to provide cushion A major portion of MNC pharma’s drug development spend (~80%) is allocated to contract research. Contract research encompasses drug discovery services, pre-clinical and clinical trials and custom synthesis (CS), i.e. manufacturing compounds on a small scale for clinical trials. In custom synthesis (CS), DLL has a presence in all stages of preclinical and clinical trials. Normally, innovators outsource very small quantity of production at these stages. These are top end services and DLL charges a hefty premium for these services. Once the client gets confidence at the pre-clinical stage, he will normally consider DLL for the next phase i.e. clinical trials for stages 1 to 3. On account of the flexibility and capability that the company possesses in manufacturing, it is in a position to cater to the client’s requirements after the commercial launch as well. Outsourcing volumes at these stages generally scale up from grams to kilograms. Thus, DLL can be a partner throughout the product development life cycle. On account of this, DLL enjoys one of the highest recalls by big pharma MNCs as preferred supplier. Several MNC clients audit its facilities regularly in the course of the custom manufacture of their products. This transparency in operation has resulted in increased confidence, trust and business between Divis and its clients. Almost 20 among top 25 global MNC majors are customers of the company.

DLL has developed various types of Carotenoids like

Astaxanthin, beta carotene, Canthaxanthin, Apocarotenal,

Lutein, lycopene and Vitamin D3

Almost 20 among top 25 global MNC majors are

customers of the company



DLL owns four R&D centres, two pilot plants and three large scale manufacturing facilities with approval from various regulatory bodies. This kind of infrastructure helps the company to alter the scale as per requirements. On account of strict adherence to customer’s IP related protocols, it has become a trusted partner for custom synthesis, process development and mass manufacturing of the customer's own discovery product. DLL undertakes complete and acceptable validation of processes. It also offers its analytical and process expertise for generating reliable data for regulatory agencies and its documentation expertise for preparing draft DMFs, CoS, etc. for regulatory submissions. DLL has a major presence in CS unlike other CRAMS players in India, which are mainly API and intermediate suppliers. In CS, DLL has a presence across major therapies. Exhibit 16: Addition of products to its custom synthesis portfolio

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Another aspect that works in favour of DLL other than adherence to IP sanctity is its desistance from entering into formulations. The company has just confined itself to supply of intermediates and APIs. Also, it does not have any intention of entering drug discovery services. Although margins are very high in CS (gross margins in the range of 60-90%), it is not a volume driven business. The CS business, over and above being EBITDA accretive, also acts as a cushion in difficult times especially when the generic API business faces a slowdown on account of inventory de-stocking at the client’s end as was visible during FY10 and H1FY11. In CS, the company follows a service-based fee model and charges a hefty sum, which also covers R&D expenditure. DLL possesses an army of highly qualified R&D personnel who have the ability to understand the complex molecular requirement and also suggest scope for further improvement. R&D for CS is included in the manufacturing expenses and not clubbed with normal R&D. There is no direct relationship between raw materials and end product cost that DLL charges. We expect CS to grow at a CAGR of 13.7% to | 843 crore between FY11 and FY13E.

DLL has a presence across major therapies

No plans for entering into formulations also benefits the

company in getting orders from MNCs

DLL charges a hefty premium as it manufactures a lower

quantity



Exhibit 17: Custom synthesis to grow at a CAGR of 13.7% in FY11-13E

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Strong operating cash flow The company generated free cash flow of ~ | 350 crore despite a slowdown in the business in FY10. In FY11, it generated free cash flow of | 242 crore on the back of higher capex spend for greenfield and brownfield expansions. The company normally invests cash into liquid mutual funds. At the end of FY11, the investment in SBI liquid mutual funds was | 526 crore or | 41 cash per share. We expect the cash per share to increase to | 71 by FY13E (after considering 7.5% of return from existing cash). Exhibit 18: Cash per share trend

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Capex DLL is setting up its fourth manufacturing facility at its SEZ at an investment of | 200 crore. In FY11, it spent around | 74 crore and expects to spend the remaining amount in the current fiscal. The facility was commissioned in June 2011 for a pilot run and commercial operations will commence in the current fiscal itself. Total capex for the current fiscal would be around | 160 crore including maintenance capex.

The cash per share is expected to increase from | 41 in

FY11 to | 71 in FY13E

Capex for FY12 would be around | 160 crore



Financials Total operating income to grow at 20.7% CAGR in FY11-13E We expect total operating income to grow at a CAGR of 20.7% to | 1922 crore between FY11 and FY13E, driven by strong growth in generic APIs including Carotenoids. Generic APIs including Carotenoids are expected to grow at a CAGR of 27% to | 1059 crore between FY11 and FY13E. Growth will also be supported by a steady growth in custom synthesis (CAGR of ~13.7% between FY11 and 13E). Exhibit 19: Sales growth to be mainly driven by generic APIs and Carotenoids

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EBITDA margins to be around 37% The company’s EBITDA margins are expected to be under pressure on the back of commissioning of the new manufacturing facility and increase in the employee strength for both R&D & manufacturing teams. We expect EBITDA margins to decline from 38.6% in FY11 to 37% in FY12E and FY13E. We expect EBITDA to grow at a CAGR of 18.4% to | 713 crore in FY11-13E. Exhibit 20: Trends in EBITDA and EBTIDA margins

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EBITDA EBITDA Margins


Sales from Generic API including Carotenoids are expected

to grow at a CAGR of 27% between FY11 and FY13E

EBITDA to grow at a CAGR of 18.4% in FY11-13E



Higher depreciation & taxation to limit growth in net profit With the commissioning of the new facility and increase in the tax rate, net profit growth will be restricted for some time. The tax exemption scheme for the EOU unit hit the sunset clause on March 31, 2011. The second facility, which was commissioned in 2006, will be eligible for exemption of 50% of export profits from April 2011. Also, the implementation of MAT for SEZ facilities will increase the taxation rate. We expect net profit to grow at a CAGR of 13.1% to | 557 crore in FY11-13E. Exhibit 21: Trends in net profit & net profit margins

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Return ratios to remain healthy With improved profitability and incremental asset-turnover ratio, we expect DLL to continue to generate high return ratios between FY11 and FY13E. RoCE is expected to sustain at ~25% level. Exhibit 22: Return ratio trend

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Net profit to grow at a CAGR of 13.1% in FY11-13E



Risk & concerns

Higher product concentration Around 29% of revenues come from the supply of two generic APIs Naproxen and Dextromethorphan Hydrobromide. Any change in prospects of these APIs may impact revenues and profits.

Appreciation of rupee may hit margins Exports accounted for nearly 92% of the company’s revenues for FY11. Of this, ~75% come from advanced countries like the US and EU. A significant appreciation of the rupee vis-à-vis the US dollar may impact margins.

Revenues & profits may be lumpy The revenues and profits can be lumpy sometimes depending on the successful development of new products and as per customer request to defer the shipment. Consolidation at client end may hamper future orders In the last two or three years, there has been heightened M&A activity across the global pharma space. Consolidation at the client’s end may hamper future order flow if the acquirer has different priorities.



Valuation DLL was one of the few Indian CRAMS players identified by MNCs quite early thanks to its capability and strict adherence to the sanctity of the IP regime. Over the years, it has consolidated its position by growing at a CAGR of ~22% between FY02 and FY11. Due to a slowdown in the overall CRAMS industry and rapid de-stocking at the customers end, DLL’s financial were impacted in FY10 and the first half of FY11. As the de-stocking phase is almost complete, the company is looking forward to decent YoY sales growth, going ahead. Since it is catering to both innovator and generic requirements almost equally, we believe the company is well poised to grow at a decent rate. The management has indicated that the company has no intention to move into formulations and compete with its own clients. DLL is currently trading at 17.6x FY13E EPS of | 42. We have valued the stock at 18x FY13E EPS of | 42, arriving at a value of | 756. With its virtual debt-free status, cash (liquid investments) of ~| 525 crore, healthy EBITDA margins in the range of ~35-40% and revival in the CRAMS space, we believe the valuation is justified. Exhibit 23: One-year forward PE Graph

0100200300400500600700800900

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Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11

(|)

Price 19.0x 22.0x 17x 15x


Exhibit 24: One-year forward EV/EBITDA

0

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Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11

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EV 19.6x 17.6x 14.5x 12.5x


Exhibit 25: Peer valuation (FY13E)

Mcap (|cr) EV/Sales (x) EV/EBITDA(x) P/BV RoCE (%) RoNW (%)Divi's Laboratories 9770 4.6 12.4 3.9 25.1 22.4Dishman Pharma 369 1.1 5.42 0.4 7.8 9Jubilant Life sciences 2932 1.3 6.26 1.1 12 15.8

Source: Bloomberg, ICICIdirect.com Research



Exhibit 26: Profit & loss account (| crore)

(Year-end March) FY09 FY10 FY11 FY12E FY13ESales 1,203.5 946.7 1,318.5 1,640.4 1,922.4 Growth (%) 14.9 (21.3) 39.3 24.4 17.2 Total Operating Expenditure 700.2 517.4 809.5 1,031.7 1,209.0 Raw Material Expenses 443.6 296.0 521.2 646.3 759.3 Employee Expenses 61.9 68.5 80.5 111.9 132.4 Marketing Expenses 78.7 71.7 102.1 133.4 163.4 Administrative Expenses 116.0 81.3 105.7 140.1 153.8 EBITDA 503.3 429.2 509.1 608.7 713.4 Growth (%) 18.9 (14.7) 18.6 19.6 17.2 Depreciation 47.8 51.5 53.4 68.1 81.7 Interest 7.2 2.8 2.2 2.6 2.6 Other Income 10.1 13.3 25.5 40.9 50.0 PBT 458.3 388.3 479.0 578.9 679.1 Total Tax 33.9 44.1 43.5 108.6 122.2 PAT 424.4 344.2 435.6 470.3 556.8 Growth (%) 19.9 (18.9) 26.5 8.0 18.4 EPS 32.0 25.9 32.8 35.5 42.0

Source: Company, ICICIdirect.com Research; Sales includes other income from operations

Exhibit 27: Balance sheet (| crore)

(Year-end March) FY09 FY10 FY11 FY12E FY13EEquity Capital 13.0 26.4 26.5 26.5 26.5 Reserve and Surplus 1,248.8 1,515.6 1,801.5 2,085.6 2,456.2 Total Shareholders funds 1,261.8 1,542.1 1,828.0 2,112.1 2,482.7 Secured Loan 49.5 29.8 20.2 30.2 25.2 Unsecured Loan 3.1 3.0 2.9 7.9 7.9 Total Debt 52.6 32.8 23.0 38.0 33.0 Deferred Tax Liability 48.6 51.9 54.9 59.9 64.9 Source of Funds 1,363.0 1,626.8 1,906.0 2,210.0 2,580.6 Total Gross Block 782.5 832.7 885.3 1,159.7 1,209.7 Less: Acc Depreciation 192.8 243.0 295.6 363.7 445.4 Net Block 589.7 589.7 589.7 796.0 764.3 Capital WIP 19.5 23.8 129.3 15.0 15.0 Total Fixed Assets 609.2 613.4 719.1 811.0 779.3 Liquid Investments 172.4 441.9 528.5 578.5 878.5 Inventory 395.9 479.6 543.1 693.7 713.6 Debtors 283.5 234.4 395.0 463.8 547.3 Loans and Advances 99.3 104.1 109.5 148.4 155.9 Other Current Assets 0.3 0.3 0.3 0.0 0.4 Cash 12.8 13.8 12.8 2.8 68.7 Total Current Assets 791.9 832.2 1,060.6 1,308.7 1,485.8 Creditors 161.6 164.2 240.3 287.1 312.7 Provisions 48.9 96.4 161.8 201.0 250.2 Total Current Liabilities 210.5 260.7 402.1 488.1 562.9 Net Current Assets 581.4 571.5 658.5 820.6 922.9 Application of Funds 1,363.0 1,626.8 1,906.0 2,210.0 2,580.6




Exhibit 28: Cash flow statement (Year-end March) FY09 FY10 FY11 FY12E FY13EProfit after Tax 424.4 344.2 435.6 470.3 556.8Depreciation 47.8 51.5 53.4 68.1 81.7(inc)/dec in Current Assets -212.1 -39.3 -229.5 -258.1 -111.2inc/(dec) in Current Assets 16.2 50.2 141.5 85.9 74.8CF From Operations 276.4 406.5 400.9 366.2 602.2Liquid Investments -116.2 -269.5 -86.6 -50.0 -300.0(Purchase)/Sale of Fixed Assets -97.0 -55.7 -159.0 -160.0 -50.0Deferred Tax Liability 7.3 3.3 3.0 5.0 5.0CF from investing Activities -206.0 -321.8 -242.6 -205.0 -345.0inc/(dec) in Equity Capital 0.0 13.5 0.1 0.0 0.0inc/(dec) in Sec Loan -33.4 -19.7 -9.7 10.0 -5.0inc/(dec) in Unsec Loan 0.0 -0.1 -0.1 5.0 0.0Dividend & Dividend tax -45.6 -92.5 -154.1 -186.2 -186.2Adjustment in ESOOP 2.1 -16.2 -3.2 0.0 0.0inc/(dec) in Sec Pre Account 6.8 32.5 7.6 0.0 0.0CF from financing activities -70.1 -83.7 -159.4 -171.2 -191.2Net Cash flow 0.3 1.0 -1.1 -10.0 65.9Cash and Cash Equivalent at the beg 12.6 12.8 13.8 12.8 2.8Closing Cash 12.8 13.8 12.8 2.8 68.7


Exhibit 29: DuPont analysis (%)

FY09 FY10 FY11 FY12E FY13EPAT/PBT 92.6 88.6 90.9 81.2 82.0 PBT/EBIT 100.6 102.8 105.1 107.1 107.5 EBIT/Sales 38.3 40.7 34.9 33.5 33.2 Sales/Asset 87.3 57.1 68.5 72.9 73.7 Asset/Equity 108.0 105.5 104.3 104.6 103.9 ROE 33.6 22.3 23.8 22.3 22.4


Exhibit 30: Free cash flow

FY09 FY10 FY11 FY12E FY13ENet Profit 424.4 344.2 435.6 470.3 556.8Depreciation 47.8 51.5 53.4 68.1 81.7Change in working capital -195.9 10.9 -88.0 -172.2 -36.4Capex -97.0 -55.7 -159.0 -160.0 -50.0Total 179.3 350.8 241.9 206.2 552.2




Exhibit 31: Key ratios (Year-end March) FY09 FY10 FY11 FY12E FY13EPer Share Data (|)EPS 32.0 25.9 32.8 35.5 42.0 Cash EPS 35.6 29.8 36.9 40.6 48.1 BV 95.1 116.3 137.8 159.2 187.2 DPS 6.0 6.0 10.0 12.0 12.0 Cash Per Share 14.0 34.4 40.8 43.8 71.4 Operating Ratios (%)EBITDA / Total Operating Income 41.8 45.3 38.6 37.1 37.1 PBT / Total Operating income 38.1 41.0 36.3 35.3 35.3 PAT / Total Operating Income 35.3 36.4 33.0 28.7 29.0 Return Ratios (%)RoE 33.6 22.3 23.8 22.3 22.4 RoCE 34.7 24.0 24.6 25.1 25.1 RoIC 31.2 20.8 21.9 19.9 20.6

FY09 FY10 FY11 FY12E FY13EValuation Ratios (x times)P/E 23.1 28.4 22.5 20.8 17.6 EV / EBITDA 19.2 21.8 18.2 15.2 12.4 Price to Book Value 7.8 6.3 5.4 4.6 3.9 EV/Total Operating income 8.0 9.9 7.0 5.6 4.6 Mcap/Total Operating income 8.1 10.3 7.4 6.0 5.1 Total Operating income/Equity 1.0 0.6 0.7 0.8 0.8 Turnover RatiosInventory Turnover 3.5 2.1 2.6 2.6 2.7 Asset turnover 1.0 0.6 0.7 0.8 0.8 Debtors Turnover Ratio 4.2 4.0 3.3 3.5 3.5

Creditors Turnover Ratio 7.4 5.7 5.4 5.6 6.1 Solvency RatiosDebt/EBITDA 0.10 0.08 0.05 0.06 0.05 Debt / Equity 0.04 0.02 0.01 0.02 0.01 Current Ratio 3.8 3.2 2.6 2.7 2.6 Quick Ratio 3.7 3.1 2.6 2.7 2.5




CRAMS Industry dynamics Contract research and manufacturing services (CRAMS) is the term used for outsourcing of either research services or manufacturing activities (intermediates, APIs or formulations) to third-party for cost plus mark-up. In case of a formulations deal, there may be some royalty sharing agreement. Contract manufacturing requires upfront investments for building up requisite facilities and is capital intensive in nature thereby requiring long-term assured supply contracts in order to recoup its investments. The global CRAMS market is estimated to be around ~US$75 billion in 2011. Contract manufacturing (CMO) consists of ~65% of the CRAMS market while the rest consists of contract research (CRO), which includes drug discovery, clinical trials (preclinical and clinical) and custom synthesis (CS). The Indian CRAMS market is estimated to be around ~US$4 billion, ~60% of which consists of CRM while the rest is CRO. Countries in Eastern Europe and Latin America have been the traditional markets for a major part of outsourcing. For the last seven or eight years, the trend is gradually shifting to Asia and particularly to countries like India, China, Taiwan and Singapore. Higher employee costs, drain of talented scientists and graduates, geo-political turmoil and environmental issues are some of the reasons for a gradual shifting of the CRAMS base out of these regions. Another reason cited by industry players is the shift of focus by established CRAMS players of the past such as BASF, Degussa (Evonik-Degussa), Lonza, etc. These companies started focusing on more lucrative businesses such as speciality chemicals, performance polymers, engineering thermoplastics, etc. On account of their size, they earned better bargaining powers vis-à-vis the innovator. Consider the case of BASF, whose turnover for CY10 stood at ~US$90 billion, higher than any Tier I pharma MNC. Although the potential for Indian CRAMS players remains positive, they faced tough times during FY10 and the first half of FY11. The financial meltdown in 2008-09 took a toll on global pharma MNCs as well. They started inventory rationalisation by aggressive de-stocking, the effect of which was felt in FY10. Industry players have indicated that the de-stocking exercise of their clients is more or less over, the effect of which was visible in the last two quarters. Going ahead, we expect most of the MNC clients to confine to JIT inventory procurement. This move, on the one hand will facilitate better inventory management while, on the other hand, only players with established deep rooted relationship with clients will survive in the long run. This, in fact, will create high entry barriers. The global pharma outsourcing market grew at ~14% CAGR from US$44 billion in FY07 to US$75 billion in FY11. Fuelled by mounting healthcare costs in developed economies and decreasing profitability of pharma companies (due to patent expiry of several blockbuster drugs), the outsourcing trend is likely to continue. Here, we take into account the fact that drugs worth US$97 billion are expected to go off patent between 2011and 2015 in the US compared to USS$73 billion during 2006-10 forcing innovators to look for various alternatives such as cost control and introduction of generics to their portfolio.

CRAMS is capital intensive industry

India’s CRAMS market estimated around US$ 4 billion

MNC players to follow JIT inventory procurement

Drugs worth US$97 billion are set to go off patent between

2011 and 2015



Most of the innovators are also bracing for the period 2015-2020 in which they are planning aggressive product launches to make good the lost market during the patent meltdown. Innovator companies are likely to outsource more as they focus on their core competencies of molecular R&D and brand building. Pressure due to declining R&D productivity, increased generic competition, patent expiries, increasing cost of drug development and fewer blockbuster drugs is likely to force them to outsource more in the coming years. A large portion of this outsourcing business is likely to be sourced from Asia (mainly India and China). India is especially rapidly gaining a reputation as a preferred destination for outsourcing pharmaceutical product manufacturing and R&D services due to factors such as 1) highest number of USFDA approved facilities outside the US, 2) lower setting up costs for a regulatory compliant plant (40-50% of setting up cost in the west), 3) vast talent pool of chemistry/pharmacy graduates and doctorates, 4) labour cost arbitrage as these qualified technocrats cost just 50-60% of the cost structure in advanced markets, 5) higher share of regulatory filing (DMFs as well as ANDAs) and lastly 6) improved adherence to the IP regime post signing the TRIPS agreement. In spite of all these favourable factors, India’s share in the global outsourcing market remains low at ~5% in FY11 although it has improved from 2.5% in FY07.

India has highest USFDA approved facilities outside US



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Pankaj Pandey Head – Research [email protected]

ICICIdirect.com Research Desk, ICICI Securities Limited, 1st Floor, Akruti Trade Centre, Road No 7, MIDC Andheri (East) Mumbai – 400 093

[email protected]

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