Divi’s Laboratories: Under observation

The company’s intent to resolve regulatory issues at the earliest is a positive

Investors in Divi’s Laboratories got a hard knock last month after the company announced that it received an import alert from the US drug regulator Food and Drug Administration (FDA) for its manufacturing facility Unit-2 at Visakhapatnam. Earlier in December 2016, the company’s facility was inspected by the US FDA and subsequently five observations were made in Form 483. The stock has shed over 45 per cent since mid-December 2016.

The current price seems to factor in all the negatives, given that the impact of this move is limited to about 5 per cent of revenue, according to the management. At the current price, the stock trades at about 16 times its 2018-19 estimated earnings, implying an over 20 per cent discount to its historical average. Given the steep price correction and the company’s track record of not having had any regulatory issues in the past, and the intent to resolve the ongoing issues at the earliest, investors may continue to hold the stock.

Factors in favour

While the concerns around the FDA issues are valid, there are three key factors that should play out in favour of Divi’s. First, the revenue impact on account of the issue at Unit-2 may be limited to 5 per cent according to the management. The US accounts for a third of the company’s overall revenue. Unit-2 accounts for about two thirds of Divi’s revenue. The total revenue to the US market from that facility is estimated to be about 22 per cent. However, given that about 10 key products have been exempted from the ban, the overall revenue impact is pegged at 5 per cent. The management has indicated that the company, along with its key customers, plans to make a requisition to the FDA to exempt a few more products from the ban.

Second, the current facility has been inspected by FDA nearly six times in the past and has not had any major observation. The management seems determined to take necessary action to bring the plant back into compliance. It has indicated that it is already working with consultants and experts to take necessary remedial action.

Also, given the issues with the Government with respect to its new facility at Kakinada, the company is augmenting capacity of existing facilities. It has spent ₹400 crore in 2016-17 across Unit-1 and Unit-2 for augmenting capacities. The company is in the process of setting up two additional production blocks in Unit-1 at Visakhapatnam at an estimated ₹175 crore. It plans to spend ₹25 crore in the current fiscal for increasing capacity at Unit-2.

Finally, Divi’s being the custom synthesis partner to many innovators, is the sole/lead supplier of critical active ingredients to innovators. The FDA has already exempted about 10 drugs manufactured in Unit-2 from the import ban. While the elongated approval timelines lately is a concern, the company being a lead supplier for several critical drugs, may be in a relatively better position compared to other formulation players who are currently facing regulatory heat.

Key concerns

However, answers to three key concerns will be critical to the stock’s performance. The first is the probability of inspection of the company’s Unit-1 by the US FDA in the light of the issues at Unit-2. The management has indicated its preparedness for such inspection.

Second, delay in approval of Unit-2 will be detrimental to growth in the US market. The management is still unclear about the reason for the import alert and, hence, needs to wait for communication from the FDA to decide on the next steps.

Third, inspection of Unit-2 by other regulatory agencies, particularly EU and the UK authorities will need to be closely monitored, given that the company derives 40 per cent of its revenue from the EU region.

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