Why the street is positive on Divi’s Labs

Hyderabad-based Divi’s Labs is around a fresh 52 week high. In fact, the stock has outperformed most of its pharma peers in 2018, gaining 25 percent versus the Nifty Pharma index up 5 to 6 percent. And it seems the street expects the outperformance to continue.

For example, brokerage Phillip Capital in its latest note upgraded its rating on the stock to a ‘Buy; call hiking its target price to Rs 1,550 with an FY20E EPS hike of 5 percent. However, while prospects for Divi’s Labs seem to be bright now, one would have not thought the same in December 2016 or through most of 2017.

In December 7, 2016, Divi’s Labs informed the exchanges about an inspection at the company’s main unit located at Vishakapatnam, their Unit 2 facility.

The US Food and Drug Administration (FDA) had issued five observations to the plant. Five observations didn’t seem much especially for a company such as Divi’s that had a largely unblemished record, when it came to regulatory issues.

This confidence reflected in the stock, which held on to levels of around 1100 for the next few days. But this resilience only lasted till the details of the observations surfaced.

On December 23, 2016, the stock in one swoop corrected to close at 861, a 22 percent correction in one day and a 25 percent correction from the time the news of the inspection surfaced i.e. on the December 7.

The street feared the observations, which included lack of proper controls and inaccurate falsified documentation. The news worsened as Divi’s got slapped with an import alert three months later.

As expected, the correction extended with Divi’s falling below Rs 550 by May 2017. That meant an over 50 percent correction from the pre-USFDA inspection levels in December 2016.

Unit 2 was Divi’s Labs main facility shipping to the US. Fears of a prolonged regulatory issue such as those seen with Ranbaxy or Wockhardt loomed. That combined with the risk of other regulators taking cue from the FDA and an inspection still pending at their only other plant – Unit 1 also remained.

But, that was not to be. Divi’s Labs seemed to in fact set an example of a quick and efficient resolution. The green shoots seemed to emerge a few weeks after receiving the import alert in March itself.

The FDA exempted a few products from the facility. This fresh set of exempted products was in addition to 10 that were exempted earlier. That meant Divi’s Labs could continue manufacturing and supplying these products to the US, albeit probably with more regulations.

In July, the FDA lifted the 99-32, one of the two clauses under which an import alert was issued.

In July-August 2017, Unit 2 was also inspected by Irish and Slovenian regulators. The inspection was a general inspection, which was successful with no critical observations. This was another confidence boost for Divi’s.

However, the biggest surprise of them all was a USFDA re-inspection of the Unit 2 facility in September 2017, less than a year of an import alert being issued.

The FDA was satisfied with the company’s remediation. The import alert was lifted in November 2017 and was moving to close the warning letter issued to Unit 2.

Divi’s Labs managed to solve an import alert on its main facility in less than a year. Yes, this resolution might have been a one off case, but Divi’s Labs was out of the woods. This confidence reflected in the stock. The stock rallied back to its pre-regulatory issues levels of 1,100 by Jan 2018 and has now extended the rally to over 1,300.

One of the reasons for this confidence on the stock is probably the company re-earning its past reputation of good compliance.

Besides resolving the import alert, Divi’s, for example, solved six fresh observations issued to Unit 2 facility, which was issued in September 2017. Divi’s managed to remediate the problems and received an Establishment Inspection Report for the facility in November 2017.

Unit 2 also got the green light from the Japanese and Australian authorities in October and November 2017. The risk from a Unit 1 plant inspection also doesn’t remain. The USFDA inspected Unit 1 in May 2018 with no observations, giving the unit a go ahead.

FY18 was a washout year for Divi’s Labs. Earnings were impacted due to the import alert and subsequent remediation at its Unit 2 facility.

The company ended FY18 with revenue falling 6 percent to Rs 3,837 crore, EBITDA (Earnings before interest, taxes, depreciation, and amortisation) falling 13 percent, margins correcting to 32.6 percent against 35.4 percent in FY17 and profit falling 17 percent to around Rs 870 crore.

But the street is confident about the future and believe earnings should pick up. Q1 for example, was a quarter of normalised operations, i.e. not impacted by ongoing remediation or audits by the US FDA.

In Q1FY19, the company recorded a revenue growth of 21 percent to Rs 955 crore, EBITDA spiking 44 percent to Rs 352 crore and margins recovering to 35 percent against 30 percent in Q1FY18 with a profit of Rs 266 crore. The earnings per share (EPS) for Q1FY19 itself was Rs 10 against Rs 6.65 a year ago and Rs 32 for the whole of FY18.

Divi’s Labs generated around 60-70 percent of its sales from regulated markets, US and Europe. Despite price pressure and vendor consolidation impacting US market, the company says it’s confident.

Divi’s Labs believes that the company plays a ‘complementary’ and ‘non conflicting’ role with their customers. And their product portfolio combined with the long standing relationships with customers, make them the vendor of choice.

Lastly, analysts believe the API (active pharmaceutical ingredient) supply disruption in China will also be an opportunity for Divi’s. Currently, China is the lead supplier of APIs globally and in India. China supplies 20 percent API’s globally and 70-80 percent of India’s requirements.

However, many Chinese suppliers are shutting capacities due to environmental concerns. This has resulted in supply-chain problems, shortages of some APIs and a consequent spikes in prices.

Analysts expect these supply disruptions to be a multiyear opportunity for Divis. Analysts believe this is when the company can leverage its long term partnerships to remain a supplier of choice and acquire new clients.

Divi’s is currently looking at alternatives to ensure continuing supply. Besides that, they are evaluating backward integration for starting materials.

Divi’s is also looking at capex to take advantage of the opportunities. They believe there are some patents of products, which could be expiring soon.

The to capitalise on these opportunities, the company is investing Rs 400 crore in a brownfield expansion at its SEZ in Vishakapatnam. Analysts also expect the company’s Rs 700 crore Kakinada greenfield plant that has been stuck with environmental and land hurdles getting the go ahead soon.