Market report- Dr. Reddy’s Labs and JSW Energy

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  1. DR REDDY’S LABS: Ex-US trends favorable, cost-cut benefits visible

–      PSAI/EM/EU drive growth: Adjusting for one-time income of INR7.2b as license fee for two brands, sales increased 7.5% YoY to INR40.8b (our estimate: INR41.9b) in 2QFY20, led by PSAI (+18% YoY), EMs (+10% YoY) and Europe (+44% YoY), partly offset by muted growth in the US (flat YoY). For 1HFY20, sales/EBITDA increased 5% YoY to INR79b/INR15.7b, while PAT was down 12% YoY to INR8.5b.

–      Cost measures offset adverse mix impact, drive margins: Adjusting for the sale of brands and voluntary recall of Ranitidine from the US market, the gross margin shrank ~350bp YoY to 51.5%, mainly due to price erosion in the US base business and higher cost of revenue in PSAI. However, controlled SG&A expense (-290bp YoY), adjusting for impairment and one-offs, and lower R&D spend (-180bp YoY) drove 130bp YoY expansion in the EBITDA margin to 20.8% (our estimate: 20.0%). EBITDA thus came in line with our estimate at INR8.5b. Further, DRRD recognized deferred tax asset (INR5.2b) related to MAT credit. Adj. PAT declined 20% YoY to INR4b (in-line).

–      Key concall takeaways: (1) DRRD received complete response letter (CRL) from the USFDA on g-Nuvaring and g-Copaxone. It would file response for the same over the next few months. (2) Company expects USFDA inspection at CTO-6 in near future. (3) Adverse impact of nationwide recall of Ranitidine from the US is fully factored in 2Q. (4) While 2Q US sales were impacted by product recall and logistics issues, DRRD guided for normalization 3Q onward. (5) R&D spend guided at USD200-240m for FY20.

–      Valuation view: We cut our FY20/21 EPS estimate by 11%/3% to INR107/INR126 to factor in product recalls/associated expenses, deferred key approvals and the delayed pick-up in the gross margin. We continue valuing DRRD at 20x 12M forward earnings to arrive at a TP of INR2,590 (prior: INR2,620). DRRD has been progressing well in terms of revenue growth across markets, except the US, and cost reduction initiatives are also fructifying to an extent. However, we maintain our Neutral rating as the current valuation adequately factors in the aforementioned positives.

(DRRD IN, Mkt Cap USD6.5b, CMP INR2755, TP INR2590, 6% Downside, Neutral)

  1. JSW ENERGY: Lower fuel cost, higher hydro gen. aid earnings; Visibility on earnings improving; Maintain Neutral

JSW Energy’s (JSWE) EBITDA increased 9% YoY to INR9.4b (our estimate: INR9.8b) in 2QFY20, led by lower fuel cost and strong hydro generation, partly offset by the impact from the new CERC norms. PBT grew 21% YoY to INR4.8b on the back of a decline in finance cost (-12% YoY), while adj. PAT was up ~12% YoY to INR3.5b (our estimate: INR3.7b).

–       Standalone generation was up ~1% YoY to 2.5BU. Realization was down 12% YoY (-INR0.6/kWh) to INR4.37/kWh. Fuel cost declined ~19% YoY (-INR0.7/kWh) to INR3.12/kWh. In our view, this was driven by some benefit from the lag between the decline in fuel cost and tariff in Ratnagiri Maharashtra PPA. Volumes from Telangana PPA (300MW from 1st July) were low. However, tariff related to the back down has not been recognized.

–       Hydro’s generation was ~9% higher YoY and helped offset the impact from the new CERC norms. Hydro EBITDA declined 3% YoY to INR4.9b (7% beat).

–       EBITDA at JSW Barmer was up 22% YoY to INR2.7b, as the previous year had an impact of INR0.5b related to certain tariff true ups.

–       JSWE noted that it is yet to elect for a switch to the new tax regime. However, there are certain benefits, which it expects its subsidiaries to accrue given the lower MAT rate.

1HFY20 performance: Consol. EBITDA increased 7% YoY. PBT/PAT was higher by 23/10% YoY on account of lowering interest costs. Operating cash flows post taxes declined 1% YoY to INR9.6b. Capex was at INR0.6b, while FCF stood at INR9.0b.

Visibility improving, but capital allocation remains the key; Maintain Neutral

–       Around 80% of JSWE’s 4.4GW capacity is under long-term PPAs and generate predictable cash flows. Another ~7% could soon get tied up under group captive, further de-risking cash flows. Further ~7% is L1 under a 300MW contract of three years. It has also secured short-term contracts for ~300MW open capacity at attractive prices and is benefiting from the recent fall in global thermal coal prices. As these contracts fructify, it will de-risk earnings.

–       Given its strong balance sheet, JSWE can also benefit from the consolidation in the generation sector. JSW noted that it is under discussions for acquiring GMR Kamalanga (1,050MW) and has received CoC approval for Ind Barath Utkal (700MW). However, successful closure and further details related to these deals are awaited which will determine value creation. Maintain Neutral with a target price of INR76.

(JSW IN, Mkt Cap USD1.6b, CMP INR70, TP INR76, 8% Upside, Neutral)