Dr. Reddy's Laboratories: Hold

Recommendation: Hold

Sanjiv Shankaran

IF THERE is a lesson that pharmaceutical companies can draw from Dr. Reddy's, probably it is `Go West'! People in the pharmaceutical industry have a litany of complaints: The domestic market's slowdown, stifling regulations and so on. In this setting, Dr. Reddy's got the industry to sit up last week when it announced a remarkable financial performance in the second quarter of this year (2001-02) with sales in the US firing healthy growth.

A look at the financial statement for the second quarter (July-September) of 2001-02 gives one an idea of the growth. Sales logged Rs 467 crore, a jump of 92 per cent over the corresponding previous period. Net profit grew almost three-fold to Rs 143 crore.

US generics: The engine of growth

In the July-September quarter of 2001-02, Dr. Reddy's US generic market sales were about 36 per cent of total sales. The generic market's contribution to the operating profit was 61 per cent of total operating profit for the quarter. Appropriately, the performance driver was fluoxetine, an antidote to depression.

The US generic market -- drugs that lose the monopoly provided to innovator through patents -- has excited Indian companies no end. Simply put, manufacturing at Indian cost for US prices will offer enormous returns. But this lucrative market has many hurdles and just a handful of companies seem to have the capability to succeed.

To get an idea of the importance of the US generic market for Dr. Reddy's, consider its performance in the crucial domestic formulations (drugs in dosage form) market. During the second quarter of this fiscal, Dr. Reddy's formulations growth was 7 per cent over the corresponding previous period. The growth rate for the company and the overall market is unlikely to increase significantly in the near future.

Fluoxetine: A high risk, high reward strategy

The US generic market is not cut-and-dried. It is complex with the best returns going to companies that take the biggest risk and have the wherewithal to succeed. Dr. Reddy's notable performance in the second quarter of this year came on the heels of the significant success in the generic market for fluoxetine. The second quarter performance begs the question: Can the trend continue?

To answer this, it may be necessary to understand the risks in Dr. Reddy's strategy. In just two months, the company racked up a turnover of Rs 163 crore in fluoxetine. It has a six-month monopoly in the 40 mg tablet because of a Para IV filing -- technical classification for the most sophisticated generic challenge. The current monopoly should run for another four months and that should make for quite a staggering return.

The flip side of a Para IV filing strategy is the high level of risk involved. Higher cost in launching the drug is one. Another key aspect is that a generic challenger such as Dr. Reddy's must have a well-crafted strategy. The returns for the patent-holder are so great and the legal loopholes so many that the generic challenger needs a watertight case to be successful.

Fluoxetine's patent challenge by Dr. Reddy's had a few unique features. The fortunes in the patent challenge case fluctuated wildly because it was taken up thrice by different courts in the US between January 1999 and May 2001. And on each occasion, the judgment seemed to focus on a different issue, thereby leading one to believe that there may a high level of subjectivity in patent challenge cases.

Take Dr. Reddy's patent challenge for another blockbuster, omeprazole (brand name Prilosec). Prima facie, Prilosec's owner, AstraZeneca seems to have been more successful than Eli Lilly in defending its patent. Recently, the company managed to get the generic launch delayed provoking one of the generic challengers to accuse AstraZeneca of resorting to smokescreens to protect its monopoly.

The delay because of the legal challenges means the cost of launching the generic omeprazole goes up. Given the way the Prozac case was interpreted so differently, one can never be sure about the way the omeprazole case will go. Even if it comes off patent and Dr. Reddy's finally is the among the first to be allowed entry into the omeprazole market, the returns may be far lower than Prozac. For the record, Dr. Reddy's is confident about its position in omeprazole.

Another danger that lurks is that even in the case of Prozac, a US-based company, AAI Pharmaceuticals, has challenged the generic entry in the case of fluoxetine. Dr. Reddy's appears confident of its position. But investors have to exercise caution because Ivax, a generic company, had its successful generic launch of an anti-cancer drug, Taxol, questioned by a US appeals court.

Even if the generic challenger makes the right moves, there seems to a bit of uncertainty associated with the whole legal process of the generic challenge. In the case of Taxol, the US court has said the US Food and Drug Administration's approval was ``arbitrary and capricious''. Not a comforting thought when one tries to gauge the likely returns for Dr. Reddy's.

Research pipelines and their value

Dr. Reddy's tangible success in basic research -- thought almost impossible a few years ago -- has contributed significantly to the high equity valuation. The second quarter income included Rs 23.5 crore from success in basic research.

The high cost of basic research in pharmaceuticals and the low probability of commercial success is critical in trying to gauge the value of Dr. Reddy's research pipeline. The company has proved that it can carry out research at a cost lower than that incurred by Western pharmaceutical companies. And an anti-diabetes compound, DRF 2725, has entered Phase III clinical trials abroad.

Dr. Reddy's inflow of milestone payments for compounds licensed out for clinical trials is impressive, but unpredictable. If any compound in the research pipeline crosses all hurdles and reaches the final stage, the returns will be enormous; far more than anything the company has got thus far. But the problem lies in trying to gauge the likely return from the company's pipeline, something for which there is no precedent in India.

A cautious way out may be to value the company highly for its overall R&D strength and the positive spillover of the same. Trying to gauge the income that is likely to flow in from the company's basic research exercise is fraught with danger for most, at the moment.

Dr. Reddy's is much more than generics and basic research. The company has a notable track record in bulk drugs (chemical ingredients for formulations), formulations and contract research. But the trigger for a significant move in its share price is likely to come from success or failure -- or perceptions of the same -- in generics and basic research.

The stock trades around Rs 1,060, about 20 times its annualised earnings per share (EPS) for this financial year. The valuation is among the highest in the pharmaceutical sector, but fair in the wake of recent developments. Given the growing interest in pharmaceutical stocks and buzz about them, Dr. Reddy's could see a rally from the current level. But that may not be good enough for a long-term investor to commit money because the risk associated with its strategy (generics and basic research) leaves it vulnerable to a quick downgrade in its valuation.

The shareholders may consider staying invested for a while longer because the buzz about the company can push the share price a little higher. Fresh investment at the moment may not be prudent because the associated risk appears too high.