PremiumShares of Dr Reddy’s Laboratories Ltd have risen about 140% in the past three years and are trading at all-time highs. Returns of Sun Pharmaceuticals Industries Ltd are much more modest at 22% in the same period, and in fact, the stock trades over 40% lower compared to its all-time high in mid-2015.
Analysts at Jefferies India Pvt. Ltd point out that the stark contrast in the share performance could be owing to the huge difference in the way return ratios of the two firms have moved over the past few years. In FY17, for instance, Sun Pharma had a return on capital employed (RoCE) of 16%, double that of Dr Reddy’s.
But, in FY21, there was a role reversal of sorts, with Dr Reddy’s boasting of a return ratio of 17%, compared to a much lower RoCE of 11% for Sun Pharma.
Performance of Indian pharma firms had bottomed out in the FY17-FY18 period owing to pricing pressures in the US generics market. “After hitting rock-bottom in FY17, Dr Reddy’s RoCE has improved consistently while Sun’s RoCE has stagnated," said Jefferies’ analysts in a recent report.
The changed dynamics in the US market meant Indian companies charted a new approach to drive growth there. The focus shifted towards niche limited competition products and wider product ranges to sustain the growth momentum.
Sun Pharma aimed at growing its speciality product range, but it also involved higher investments on product development followed by launches. What’s more, the firm’s US unit Taro, which used to be a significant growth driver, has continued to face pressure on growth. Its dermatology product range faces significant pricing challenges. Taro’s earnings before interest, taxes, depreciation, and amortization (Ebitda) has been down 68% over the last five years.
Dr Reddy’s, on the other hand, has focused on limited competition niche product launches in the US such as injectables. The firm also divested some of its less profitable or loss-making proprietary product business in the US.
Key factors behind the divergence of return ratios remain the varied performance in the US generics business, say analysts. Revenue growth rates have been higher at Reddy’s owing to this. Also, the amount of capital employed by Sun Pharma is far higher for the same amount of revenue/profit.
Both firms, though, have similar profit margins. “Sun Pharma is banking on specialty to improve its return profile, but a full-scale specialty business will still deliver RoCE below Dr Reddy’s current levels," said analysts at Jefferies.
Further, to reduce dependence on the US, Dr Reddy’s has increased focus on the domestic market and other key emerging markets. The pharma market in China also opens opportunities for Dr Reddy’s. The firm already has a presence in China, giving it an early mover advantage. In the domestic market, Dr Reddy’s acquisition of the Wockhardt portfolio is aiding growth. The company is also getting a boost in sales from its existing covid treatment franchise including products such as remdesivir, while it is launching Sputnik vaccine and other products.
Going forward, Jefferies estimates broadly similar earnings growth rates for the two firms. For Dr Reddy’s, they estimate 9.8% Ebitda CAGR in FY21-23 driven by growth across geographies. For Sun Pharma, they estimate 8.2% Ebitda CAGR over FY21-23, driven by growth in US specialty and recovery in Taro. But for the share performance to converge, Sun Pharma would need to do better at improving its return ratios.
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