Buy Dr Reddy Labs: Merrill Lynch

Broking house, Merrill Lynch has maintained buy rating on Dr Reddys Laboratories.

Merrill Lynch report on Dr Reddys Laboratories:

In-line 3Q; Strong growth continues:

DRL’s 200% growth in 3Q net profit (Rs 1.8 billion) on back of Rs 15.4 billion revenues (162% growth YoY) are in line with MLe. Reiterate Buy (PO: Rs 1059 per share) given improving base business, reasonable valuations and catalysts. Risks: research failure, higher generic pricing pressure, and acquisition challenges.

3Q performance highlights:

3Q highlights include - (a) Underlying 38% revenue growth excluding impact of acquisitions and authorized generic sales (USD 77 million) (USD 134 million); (b) 230bp sequential increase in gross margin to 43% driven by base business (c) Betapharm gross margin remained higher at 56% vs 58% in 2Q; and (d) strong profit growth despite amortization charge of Rs 330 million.

Core business to drive FY08E; possible upsides as well:

DRL emphasized on continuing core business strength in FY08E as well with possibility of one-time upsides. MLe FY08E base revenue and PAT growth is 20% and 19% respectively. Further, products that could drive upside include 1) Aciphex (USD 1.1 billion; ulcer); 2) Avelox (USD 261 milion; sinusitis) 3) Risperdal-M (USD 71 million; schizophrenia) and 4) Tequin (USD 53 million; sinusitis).

Management conference call highlights:

1) Generic Zofran market share now at 55% (USD5 million revenues) 2) Balaglitazone (diabetes) progress to Phase III trials expected only over next 12 months (vs earlier mid’07 expectation 3) While 4Q will witness significant generic Zofran benefits, management cautioned on high R&D spend and soft base revenues.

Price Objective Basis & Risk:

We value DRL’s core business at Rs903/sh on comparative P/E valuation (20x on FY08E EPS; in-line with the sector average). Our valuation of DRL’s research pipeline (Balaglitazone; Phase III entry) on NPV methodology is Rs156 per share, suggesting an overall fair value of Rs1059 per share.

Risks to PO. Risk of failure of Balaglitazone, challenge to gain size in US generic space, higher than expected US generic pricing pressure, acquisition and domestic market challenges.