DIVIS LABS - STOCK STORY

Background
 Established in 1990 by Dr Murali K Divi, currently assisted by his son Kiran Divi
 Promoter shareholding 52% (no pledge), DIIs 20%, FIIs 20%, Others 8%
 Pharma company into manufacturing of APIs and custom synthesis business

Main Products/Segments
1. Two key segments
a. Custom Synthesis c. 42% in FY 19 – CRAMS offtake from global pharma innovator companies
i. Collaboration at molecule development stage & supporting the innovators throughout lifecycle of molecule
ii. No presence in formulations, gives comfort to the customers on Divis playing a completely non-conflicting
role
iii. Established relationship over many years with top 10 global pharma innovators/giants
b. Generic APIs c. 50% in FY 19
i. Manufacturing and supply of generic APIs and intermediates of matured chemicals to global markets
ii. Two key generics make up 26% of Divis revenues – Naproxen (pain management) & Dextromethorphan
(cough suppressant) with Divis having c. 70% of global market. Other recent products - Levetiracetam (70 %
market share) and Gabapentin.
iii. Strategy of limited no of molecules with significant market share, gives them global leadership position and
making them a critical supplier (as was evident in US FDA issues elaborated later)
c. Neutraceuticals: c. 8% in FY 19
i. One of the world's leading producers of Carotenoids
ii. Product portfolio includes a Beta Carotene, Astaxanthin, Lycopene, Canthaxahnthin, Lutein, Vitamins (A, D3,
D2, E Acetate and A Palmitate)
iii. Supplies to all the major food, dietary supplement and feed manufacturers around the world
d. Non infringing patent policy: Clear strategy of respecting Patents & focus on patent expired molecules, or custom
synthesis for innovator cos, no risk of patent infringement.
i. This strategy (which is different from that adopted by other players in the market) has really worked well
for Divis especially from a custom synthesis business perspective. A big pharma company as customer
would not want to share confidential details about a molecule with another company which is also into
generics formulations.

Segment wise Sales are presented below:

Business Segments Fy09 Fy10 Fy11 Fy12 Fy13 Fy14 Fy15 Fy16 Fy17 Fy18 Fy19 10yr 7yr 5yr 3yr 1yr
Custom Synthesis 558 445 610 892 1,027 1,187 1,428 1,665 1,826 1,688 2,060 14% 13% 12% 7% 22%
Generic API 602 460 635 885 1,022 1,211 1,505 1,921 1,992 1,899 2,438 15% 16% 15% 8% 28%
Neutraceuticals - 36 62 81 91 127 171 183 239 250 381 - 25% 25% 28% 52%

2. Manufacturing plants – 4 across 2 sites

Plant name Location Production Area (in Details
blocks acres)
Unit 1 API plant Telangana 12 500  13 production blocks with 362 reactors
totalling 1744 m3
 DC SEZ unit (expansion recently completed cost
c. Rs 600 crs)*
Unit 2 (exports) Near Vizag 23 490  Export oriented unit (8 production blocks) 192
(AP) reactors totalling 1622.55m3
 SEZ unit (9 blocks) with 420 reactors totalling
3053.4m3
 DSN SEZ (5 blocks) with 254 reactors totalling
2389 m3
 DCV SEZ unit (expansion recently completed
cost c. Rs 600 crs)#
They announced a large capacity expansion program of Rs 1700 crs in Sep’18 (equivalent to existing fixed asset base of the
company) driven by environmental shutdown in China, which included:
1. #DCV SEZ unit at Unit 2 at cost of Rs 600 crs – Commenced operations in March 20 to semi-regulated markets.
2. *DC SEZ unit at Unit 1 at cost of Rs 600 crs - Commenced operations for sale to semi-regulated markets on Feb 5, 2020
until validation batches for the regulated market from this facility are completed.
3. Debottlenecking of existing plants at both Unit 1 and 2 -cost c. Rs 300 crs
4. Augmentation of waste treatment infra at Unit 2 – Cost Rs 190 crs

They have also a greenfield project planned in Kakinada over 670 acres. Environment clearance was obtained in April’19
(http://environmentclearance.nic.in/writereaddata/Form-1A/EC/041020191408_2014_Divi_Letter.PDF)
Other clearances were pending as of the last update.

Main Markets/Customers
% FY 14 FY 15 FY 16 FY 17 FY 18 FY 19
America 44% 38% 32% 33% 29% 27%
Europe 37% 35% 43% 40% 44% 46%
India 9% 13% 12% 13% 13% 12%
Asia excl India 6% 10% 11% 12% 9% 12%
RoW 4% 4% 2% 2% 5% 3%
Domestic Sales 9% 13% 12% 13% 13% 12%
Export Sales 91% 87% 88% 87% 87% 88%
Main customers are top 10 pharma companies across the world.

Bullish Viewpoints
 To benefit from two structural business dynamics, namely:
(1) robust pharma‐outsourcing opportunity (emerging out of drug‐pricing challenges, declining productivity/yield in drug
discovery)
(2) Supply disruption in China - (due to environmental concerns, now coronavirus) leading to higher pressure on diversification
of supplier base – this is likely to shift demand to India
 Strong R&D capabilities reflected by the company– develops products with complex chemistry
 Low cost due to large plants and economies of scale
o Reasonable gross margins on account of global market leadership in few key APIs thereby having limited competition
(unlike generics cos).
o High operating margins due to economies of scale – one of the key reasons being low employee cost – which at
Divis is c. 9%-10% (lately c. 11% due to new plant expenses which are not contributing to sales) compared to c. 26%
at Syngene, c. 21% at Jubilant Life etc.
 Global leadership - in few products, making the company position strong and critical from a global perspective (this helped in
resolving US FDA issues, see below) and also gives pricing power evident in high EBITDA margins
 Long relationship with customers playing complementary and non-conflicting role (with no presence in formulations) – This
helps the customer from a confidentiality perspective
 Large capacity (capex spends c. INR 1700 crs over last 3 years, which will double fixed asset base) coming upstream starting
now and within next 12 months – has been funded from accruals, no debt
 Backward integration benefits - EBITDA margin to improve going forward due to backward integration benefits (this will also
help in reducing China dependence for key raw material)
 Management is usually ahead of the curve – started backward integration to mitigate the China API risk way back in 2017/18
 Strong RoCE at 28%, RoE at 21% despite significant capex (which is yet to yield results)
 Financials (summarized in Annexure – 1) reflect long track record of profit delivery, industry-leading EBITDA margins of 35-
40%, debt-free balance sheet, a superior asset-turnover ratio, consistent cash flows (being invested in capex) and consistent
working capital cycle. Cash on Balance sheet as of Sep-19 was c. 1100 crs – sufficiently liquid to tide over the current
coronavirus crisis.

Bearish Viewpoints
 Regulatory risk - US FDA/others
 o In Dec 2016 Unit 2 got Form 483 observations (this plant accounted for 70% of sales then) followed by import alert
in March 2017
o Important to note that they got exemptions for key products, which were perceived as critical (as this could lead to
major shortages in the market) – Eventual decline in top-line was not much due to these exceptions.
o All issues were rectified in record time of 10 months by Sep’17 and EIR issued (unprecedented in global pharma
industry) – explains the support it receives from US FDA and global innovator companies given criticality of products.
o US FDA continues to be a key risk going forward.
 Highly capital and working capital intensive – Not so much of an issue as RoE is still satisfactory c. 20%
 Portfolio concentration is significant - Top 5 products contribute 47% of sales & top 5 customers contribute 37%
 Succession risk - Murali Divi is 68 years old and is assisted by his son Kiran Divi who has been involved in the business for 15+
years and is currently the CEO. But will Kiran be as strategic as his father – is unknown and remains a risk.

Interesting Viewpoints/Things to keep in mind

 Recent US FDA inspections - Unit 1 cleared in Nov’19 and Unit 2 inspected in Jan 20 – No issues reported.
 Divis does not gain from rupee depreciation as it is passes on the benefit to the customer
 Operating leverage will kick in as capacity utilisation on new capex increases – For example evident in employee cost trend
FY 14 FY 15 FY 16 FY 17 FY 18 FY 19
Total employee costs Rs crs 225 283 357 500 456 531
Employee cost as % of sales 8.7% 9.0% 9.2% 12.1% 11.4% 10.4%
No of employees (absolute) 7362 8721 9481 9,735 10,762 11,847

Barriers to Entry
 Complex R&D skills
 Sticky customer relationships – not easy to change suppliers in custom synthesis business or in API business
 Large capex requirements

Business Model
Already explained under various heads.

Valuation Model
 Peak asset turnover based on history is c. 3x
 Total fixed assets Sep’19 c. INR 3200 crs, potential peak turnover c. INR 9600 crs at EBITDA Margin of c. 40% = INR 3840 crs
(Operating leverage will kick in, margins should be sustainable)
 Less: Depreciation c. INR 250 crs
 Other income & Interest: Nil
 PBT c. INR 3600 crs
 PAT @ 75% = INR 2700 crs, EPS c. 103

Worst case
 At P/E c. 30x (based on Divis’s average PE over last 5-7 years), Price Rs 3100 over say next 3 years thereby giving CAGR of c.
10%
This scenario assumes significant discount to PE – at c. 30x as compared to current PE of c. 50x.

Optimistic case
 While PE multiple of c. 30x seems reasonable based on average PE over last 5-7 years, there has been significant increase in
PE levels across sectors (for sector leaders with good management) over last 2 years on account of low interest rates and
thus last 5-7 years trend may not correctly reflect the current scenario.
 I feel, in the optimistic scenario, PE can sustain at c. 50x levels for Divis Labs due to higher earnings growth, higher free cash
flow (due to lower capex) and higher RoE going forward (since half the fixed assets currently weren’t contributing to profits).
Given the China issues (earlier on account of environment issues and now corona virus), there is a reasonable chance that
pharma API/CRAMS sector becomes the leader of the next bull market, which if it happens, can help Divis maintain the PE to
c.50x levels. In this case, Price will be 103*50= Rs 5150 which is c. 30% CAGR from here.
Current Market/Industry Trends
 China supply disruptions is a multi‐year business opportunity
 China is the world’s leading producer (over 2,000 APIs) &exporter of APIs by volume, accounting for almost
20% of total global API output.
 India is also dependent upon China for 65% of the country’s API/intermediates requirement - API prices on the rise due to
coronavirus – an added advantage for largely integrated players like Divis Labs

Key opportunities for next few years:

 Contract manufacturing business continues to have a long runway
 Replacing China partly in API space (with complete backward integration) should play out over next few years. Post
coronavirus, the world would want to diversify their supply chain to other countries outside China. This could help API
players in India (aided by the govt initiative to expand API capacity). However, it will be important for API players to be not
dependent upon China in anyway eg. KSM also, and would require API players to set up capacities for the same.

Corporate Governance Scan

1. Divis Labs had missed reporting one of the points in the Import letter, which was corrected by a revised filing the next
day, seemed like an error. All US FDA issues were reported timely.
2. Auditor has been changed to PWC since 2018 (earlier local auditor) which is a good sign
3. There were income tax raids in Feb’19 – no negative findings reported.
4. Promoter remuneration is high at c. 6-8% of PAT
INR m FY 16 FY 17 FY 18 FY 19
Promoter remuneration 616 646 557 1,096
PAT 11,260 10,600 8,770 13,530
Remuneration as % of PAT 5.5% 6.1% 6.4% 8.1%
In FY 17 / FY 18 when company was impacted by US FDA, promoters took remuneration cuts / marginal increase in
remuneration in line with other employees (though not reflecting in % terms due to addition of another promoter on BoD
in FY 18). However overall remuneration is high at 8.1% in FY 19.

Forensic Scan/Red Flags

1. One of the clauses in the import letter in 2017/18 was related to refusal by the Company for FDA inspection – which is a
bit surprizing.

Disclosure(s)
Invested
 Annexure – 1: Financial summary

INR crs FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 FY 17 FY 18 FY 19 Trailing

Sales 1,317 1,864 2,145 2,532 3,115 3,776 4,064 3,891 4,946 5,272
Operating Profit 501 691 816 1,018 1,173 1,422 1,449 1,269 1,873 1,788
Operating profit % 38% 37% 38% 40% 38% 38% 36% 33% 38% 34%
PAT 429 533 602 773 852 1,126 1,060 877 1,353 1,280
PAT margin % 33% 29% 28% 31% 27% 30% 26% 23% 27% 24%
EPS 8.1 10.0 11.3 14.6 16.0 21.2 26.6 33.0 51.0 48.2
P/E ratio 41.7 38.1 43.5 46.9 55.7 46.6 23.4 33.0 33.4 44.5
Balance Sheet
Total debt 23 55 33 18 27 42 36 63 106
Net Worth 1,797 2,132 2,501 2,963 3,495 4,293 5,357 5,925 6,957
Fixed assets 694 920 1,212 1,366 1,527 1,703 2,003 2,116 2,580 Large capex
Inventory days 159 133 142 134 136 117 119 127 131
Debtor days 101 97 87 104 87 85 81 95 86 Stable cycle
Cash flows (CF)
Operating CF 327 338 480 557 826 1,038 1,150 776 954 Strong Op CF
Investing CF -221 -204 -255 -305 -521 -406 -1,140 -478 -685 funding capex
Financing CF -104 -131 -231 -249 -303 -631 2 -314 -246
Net CF 1 3 -5 3 3 0 13 -17 23
Return ratios
RoE 24% 25% 24% 26% 24% 26% 20% 15% 19% High returns, scope
RoCE 28% 34% 33% 36% 33% 36% 29% 22% 29% to increase

TRENDS: 10 YEARS 7 YEARS 5 YEARS 3 YEARS

Sales CAGR 20.2% 15.0% 14.3% 9.4%
Avg OPM % 37.1% 36.9% 36.3% 35.6%
PAT CAGR 16.6% 14.2% 11.8% 6.3%
Price to Earning 41.8 40.9 39.4 33.6