February 21, 2017

Analysis: Divi's Laboratories Limited

www.drvijaymalik.com has a dedicated section for investment & stock specific queries of readers: “Ask Your Queries”. Over time, readers have asked queries about multiple stocks in this section. Answers to these queries have been done post preliminary analysis of the stocks under consideration. Such analysis has been found helpful by readers.

“Analysis” series is an attempt to summarize & share with all the readers, the key questions and their answers, which have featured on “Ask Your Queries” section. The primary aim of this new feature is to share the knowledge with all the readers of the website.

The current section of this series, “Analysis” covers Divi’s Laboratories Limited, a Hyderabad-based Indian pharmaceutical manufacturer, which focuses on making active pharmaceutical ingredients (API) and intermediates as primary business activities.
Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


Divi’s Laboratories Limited

 

(BSE: 532488, NSE: DIVISLAB)
Industry: Pharmaceuticals

Reader’s Query

Divi’s Laboratories Limited (DLL), established in 1990 by Dr Murli K Divi., is a Hyderabad, Telangana (India) based company involved in the production of Active Pharma Ingredients (APIs) & Intermediates. Divi’s Laboratories Limited is listed on both Bombay Stock Exchange and National Stock Exchange in India. 

Current Market Price (INR)
BSE (February 20, 2017)
756.95
Market Capitalization (INR Cr./10 million)
Full
20,094.64
Free Float
9,645.43



FINANCIAL ANALYSIS



A) Analysis of Profit And Loss Statement (P&L):


Sales Growth & Profitability: 

(INR Cr./10 million)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
CAGR
2007-16
Sales (A)
724
1033
1191
929
1315
1845
2129
2514
3084
3721
20%
Operating profit (B)
246
417
490
412
505
696
823
1,020
1,163
1,399
21%
Operating profit margin (B/A)
34%
40%
41%
44%
38%
38%
39%
41%
38%
38%

Net profit after tax (C)
192
354
424
344
436
546
611
792
847
1108
22%
Net profit margin (C/A)
26%
34%
36%
37%
33%
30%
29%
31%
27%
30%


We can see that over last 10 years (2007-16), DLL has increased its sales at a healthy rate of 20% per annum. It has been able to maintain its operating & net profit margins (OPM & NPM) at healthy levels of 34-38% and 26-30% respectively. When we would compare NPM of Divi’s Laboratories Limited with its peers later in business analysis, we would realize that Divi’s Laboratories Limited has one of the best profitability margins in the industry.

Tax Rate:

2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Tax rate
15%
8%
7%
11%
9%
21%
23%
22%
21%
19%

The general corporate tax rate applicable in India is 30%. However, Divi’s Laboratories Limited has some of its manufacturing facilities in SEZ, which have a subsidized tax rate. Hence, Divi’s Laboratories Limited’s effective tax rate is lower than 30%

Interest Coverage:

(INR Cr./10 million)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Operating profit (A)
246
417
490
412
505
696
823
1,020
1,163
1,399
Interest Expense (B)
11
14
8
5
3
5
5
3
3
4
Interest Coverage (A/B)
23
29
59
80
151
148
155
330
430
337

Divi’s Laboratories Limited has been maintaining its leverage levels within comfortable levels of serviceability. Interest coverage ratio has always been very healthy. This is a sign of a healthy company. 

B) Analysis of Balance Sheet (B/S):


Debt to Equity ratio (D/E, Leverage):

(INR Cr./10 million)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Total Debt (D)
154
86
53
33
23
55
33
18
27
42
Total Equity (E)
542
874
1,262
1,542
1,828
2,175
2,553
3,034
3,562
4,350
D/E
0.3
0.1
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0

Debt to equity ratio of Divi’s Laboratories Limited has been almost 0, which shows that Divi’s Laboratories Limited has always been almost debt free 

C) Analysis of Cash Flow Statement (CF): 



(INR Cr./10 million)
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
Cash from Operating Activity (CFO)
        190
       302
       301
       368
       326
       334
       483
           558
           822
       1,032
Cash from Investing Activity (CFI)
(158)
(235)
(217)
(317)
(222)
(204)
(254)
(305)
(521)
(413)
Cash from Financing Activity (CFF)
(35)
(65)
(82)
(48)
(104)
(131)
(231)
(249)
(303)
(624)
Net Cash Flow (CFO+CFI+CFF)
(3)
2
1
3
(0)
(1)
(2)
5
(1)
(5)
Cash & Eq. at the end of year
17
13
13
13
13
22
35
36
57
58

We can see that Divi’s Laboratories Limited has been consistently generating cash from its operations and using it for capital expenditure.


NCF is lower than cash at end of year also a lot of cash inflow is happening from financing activity– what does that signify?

Cumulative PAT vs. cumulative CFO:

(INR Cr./10 million)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Total
Net Profit after tax (A)
192
354
424
344
436
546
611
792
847
1,108
5,653
Other Income (B)
14
14
23
31
29
66
49
84
43
94
446
Interest [C]
11
10
7
3
2
5
3
3
3
3
49
Adjusted Profit (A-B+C)
189
350
409
316
409
485
565
711
807
1,017
5,257
Cash from Operating Activity (CFO) (D)
190
302
301
368
326
334
483
558
822
1,032
4,716

If we compare the cumulative PAT and CFO for last 10 years (2007-16), we realize that company has collected cash less than its profits. It indicates that the company’s profits are stuck in receivables & inventory – Is this a cause for concern?

Conclusion:

After analysis of financials of Divi’s Laboratories Limited for last 10 years (2007-16), we realize that it is growing at a healthy growth rate while maintaining good profitability margins. Divi’s Laboratories Limited is able to increase its sale by capacity expansion without overly leveraging its balance sheet, as it has been using cash generating from operations to pay off its lenders. The company is in a comfortable debt-servicing situation, which is reflected by its healthy interest coverage ratio. However, rising inventories and receivables is a concern that needs to be investigated into.



BUSINESS ANALYSIS



Comparison with Industry Peers:

S.No.
Name
Sales Growth (2007-16)
NPM
D/E
P/E
Mar Cap
CMP


%
%


Rs. Cr.
Rs.
1
Sun Pharma Inds.
33.24%
25%
0.27
19.8
 155,778
647.25
2
Lupin
24.24%
17%
0.65
23.87
    67,363
1,492.00
3
Aurobindo Pharma
23.21%
15%
0.67
17.51
    40,067
684.7
4
Cadila Health.
20.88%
15%
0.46
27.4
    37,372
365.05
5
Torrent Pharma.
19.95%
21%
0.7
17.57
    22,241
1,314.30
6
Divi's Lab.
19.94%
27%
0.01
18.08
    20,185
760.35
7
Dr Reddy's Labs
10.42%
8%
0.29
48.38
    52,115
3,144.55

We see that Divi’s Laboratories Limited has outperformed most of its peers over last 10 years (2007-16) without compromising on its profit margins. Its net profit margin (NPM) is one of the best in the industry. As discussed during financial analysis, we can notice that Divi’s Laboratories Limited is one of the most conservatively financed companies in its industries, which is reflected by a comparison of its D/E ratio with its peers. Although its peers also have very low D/E ratio

The increase in Production Capacity and Sales:


2009
2016
CAGR
2009-16
Production capacity (MT)
4,000
8,809
12%
Revenue per MT*
2,976,400
4,224,464
5%
Total sales (INR Cr./10 Million)
      1,191
      3,721
18%
* derived by dividing sales by production capacity

The above table indicates that the sales growth achieved by Divi’s Laboratories Limited over last 7 years has been contributed equally by product price increase (measured by revenue per MT,) and increased quantity of product sold (measured by production capacity). This is a good sign that Divi’s Laboratories Limited is not relying solely on product price increases to achieve sales growth but also expanding its reach in markets by selling higher quantities.

Conversion of Sales Growth into Profits:

(INR Cr./10 million)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
CAGR
2007-16
Sales (A)
724
1033
1191
929
1315
1845
2129
2514
3084
3721
20%
Net profit after tax (C)
192
354
424
344
436
546
611
792
847
1108
22%
Net profit margin (C/A)
26%
34%
36%
37%
33%
30%
29%
31%
27%
30%


We can see that though the profit margin has been fluctuating over the years, it has still been able to maintain it at respectable levels of 27-30%.

Conversion of Profits into Cash:

 (INR Cr./10 million)
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Total
PAT
192
354
424
344
436
546
611
792
847
1,108
5,653
CFO
190
302
301
368
326
334
483
558
822
1,032
4,716

The above table reflects that the profits of Divi’s Laboratories Limited are being stuck in the receivables and inventory. This is not a good sign and needs to be investigated.

Creation of Value for Shareholders from the Profits Retained By the Company:

  (INR Cr./10 million)
2007-16
Total retained profits of last 10 years (A)
4,196
Total increase in market capitalization in 10 years (B)
15,464
Value created per INR of retained profits (B/A)
3.69

We can see that the company passed the test of creating at least one INR of market value generation for its shareholders for each INR profits retained by it over last 10 years.

Conclusion:

Upon testing Divi’s Laboratories Limited at all the 5 parameters to judge the business performance, it has passed on 4 of the five parameters. It has demand for its products in the market that it is able to tap by selling higher quantities and able to pass on the increase in its costs as higher prices to its customers. The cash generated is being utilized productively in capacity expansion and debt reduction and it has created equivalent market value for its shareholders. Its profits are being stuck in receivables & inventory and are realized as cash.



VALUATION ANALYSIS



I have used the framework provided in the article: How to do Valuation Analysis of a Company to analyse Divi’s Laboratories Limited’s share market data for determining whether it is available at attractive valuations.

Price to Earnings Ratio (P/E Ratio):

S.No.
Name
P/E
PEG
Sales Growth (2007-16)
NPM
D/E




%
%

1
Sun Pharma. Inds.
19.8
0.84
33.24%
25%
0.27
2
Lupin
23.87
1.13
24.24%
17%
0.65
3
Aurobindo Pharma
17.51
0.62
23.21%
15%
0.67
4
Cadila Health.
27.4
1.68
20.88%
15%
0.46
5
Torrent Pharma.
17.57
0.38
19.95%
21%
0.7
6
Divi's Lab.
18.08
0.88
19.94%
27%
0.01
7
Dr Reddy's Labs
48.38
2.42
10.42%
8%
0.29

At February 5, 2017, Divi’s Laboratories Limited is available at a P/E ratio of 18.08, which is cheap when compared with its peers. If we see the whole package of conservatively financed growth rate while keeping healthy profitability margins, Divi’s Laboratories Limited comes out to be a clear winner among its peers.

P/E to Growth Ratio (PEG Ratio):

If we compare the PEG ratio in the above table, we come to the same conclusion that Divi’s Laboratories Limited presents a case of healthy growth, which is available cheaply in the market. This is a one of the desirable quality of an investment worthy stock.

Earnings Yield (EY) and Margin of Safety (MoS):

At P/E ratio of 18.08, Divi’s Laboratories Limited provides an earnings yield of 5.5%. If we compare it to the 10-year government securities (G-Sec) yields, which are currently in the range of 7.0-7.25%, then we realize that, as per Benjamin Graham’s teachings, Divi’s Laboratories Limited margin of safety is not adequate for the investors. If we give the benefit of FCF and SSGR then the current P/E is already at the max range an investor should enter into the stock.


Dividend Yield (DY):

Divi’s Laboratories Limited paid a dividend of INR 10 for FY2015-16. At the current price (February 5, 2017) of INR 760, it provides a yield of 1.32%.

Conclusion:

After doing the valuation analysis of Divi’s Laboratories Limited and comparing it with its peers, we realize that Divi’s Laboratories Limited provides an opportunity of investing in a conservatively financed consistent growth story with healthy profitability margins at slightly risky prices when compared to its peers as Divi’s Laboratories Limited doesn’t provide a healthy margin of safety for its shareholders.



MANAGEMENT ANALYSIS



Background Check of Promoters & Independent Directors:

Divi’s Laboratories Limited is promoted by Dr Murali K Divi, who holds a doctorate degree in Pharmaceutical Sciences. He plays an active role in the management of Divi’s Laboratories Limited. He has extensive experience of over 30 years in the Active pharmaceutical ingredients industry. The board consists of eight directors. Three out of the four executive directors are of promoter’s group besides four independent directors.

Web search about Dr. Divi and other directors did not reveal any negative information.

Management Succession Plans and the Salary being paid to Potential Successors:

Dr Murali K Divi has introduced his son into the board of directors. Mr. Kiran S. Divi was inducted in FY2001 in the board as directors. Dr Murali K Divi is currently about 65 years of age and Mr Kiran S Divi is aged 40 years and has been working as Director Operations since last 16 years.


Salary of Promoters vs. Net Profits:

I have analysed total remuneration being paid to the director from promoter family viz-a-viz net profit of Divi’s Laboratories Limited:

(INR Cr./10 million)
2012
2013
2014
2015
2016
Net Profit after tax (A)
          545.97
          611.42
       791.72
       847.06
    1,107.69
Remuneration of Murali K Divi
            23.15
            26.46
         33.39
         35.41
         44.99
Mr Ramana
            11.89
            13.71
         17.18
         18.20
         22.99
Kiran S Divi
              8.08
              9.45
         11.77
         12.44
         15.63
Total Remuneration (B)
            43.12
            49.62
         62.34
         66.05
         83.61
(B/A)
7.9%
8.1%
7.9%
7.8%
7.5%

The above table reflects that the remuneration of directors of promoter’s family has in line with the profits of Divi’s Laboratories Limited. Is there a benchmark % that the director’s remunerations be?

Project Execution Skills:

Divi’s Laboratories Limited promoters & managers have increased its production capacity from about 4000 MT in 2009 to 8809 MT in 2016. This reflects that the promoters and management have good project execution skills. This experience would be useful for further capacity expansion projects that would be essential for future growth.

Consistent Increase in Dividend Payments:

(INR Cr./10 million)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
CAGR
Net Profit after tax (A)
192
354
424
344
436
546
611
792
847
1,108
22%
Dividend Payout (B)
13
26
39
79
133
173
199
265
265
265
40%

We can see from the above table that as net profits of the company have increased over the years, the dividend paid by Divi’s Laboratories Limited to its shareholders has also increased. In fact, dividend payout has increased at a higher rate than profits. In 2015 Divi’s Laboratories Limited also gave a 1:1 bonus issue. This pattern indicates that the company is rewarding its shareholders by sharing the outcome of its growth over the years. This is one of the signs of a shareholder friendly management.

Promoter Shareholding and Insider's Buying Pattern:

Current shareholding of promoters in the company is 52.06% (February 5, 2017).

Foreign Institutional Investors (FII) Holding:

Divi’s Laboratories Limited has 19.57% FII shareholding at Mar 31, 2016. 

Conclusion:

After analyzing the management of Divi’s Laboratories Limited, we can notice that it has a competent management, which cares about shareholder’s interests and believes in company’s future. Dr Divi seems to have put in place a succession plan, which would enable the next generation to take over the company by the time he retires from the day-to-day management of Divi’s Laboratories Limited.



Query & Concerns: 
  • P/E is already higher then and hence margin of safety is not there even after adjusting it for FCF & SSGR factor.
  • Salary increment to staff and directors seems to be too high, higher than sales growth.
  • Is there a benchmark Ratio of remuneration of each Director to median remuneration of employees
  • Director's remuneration vis a vis Net Profit is it as per benchmark or is higher?
  • A lot of MF have reduced their holding in the company though not very significantly in FY 15-16, FII already hold 19.5%, is there upside left in this stock?
  • One promoter Nilima Motaparti holds 20.34% shares, couldn’t find out about her
  • OPM% is dropping year on year, it could be linked to company's pricing power. How do we find out the reasons for this?
  • The tax rate is less than the corporate rate which could be because 2 of the plants are in SEZ, how can this be confirmed?
  • CFO in most of the years is lesser than PAT. How to find out the reasons for the same?
  • Debt is negligible but on the rise for last 2 years. Should that be a cause for concern?

Regards,

Mukesh Mansukhani


Author’s Response


Hi Mukesh,

Thanks for sharing your analysis of Divi’s Laboratories Limited with the author and readers of the website. We appreciate the hard-work put in by you in the analysis.

We have noticed that the above analysis is based on standalone financial performance of Divi’s Laboratories Limited. The company has two subsidiaries that are based out of the USA and Europe, which currently have a minor scale of operations as compared to the main entity Divi’s Laboratories Limited. Therefore, standalone financials form the bulk of the overall financial position of the company.

However, it is preferable that while analysing any company, the investor should take a view about the entire entity including its subsidiaries if any, so that she is aware of the complete financial and performance picture of the company. Therefore, we always advise that investor should focus on the consolidated financial position of the company.

Therefore, while analysing the performance of last 10 years for Divi’s Laboratories Limited, we have analysed the consolidated financial performance of the company.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


Divi’s Laboratories Limited, as mentioned by you, has been growing its sales at a good pace of 18-20% year on year for last 10 years (FY2007-16). The growth rate has been very good until now. The company seems to have been increasing its manufacturing capacity continuously, which is evident from the consistent year on year capital expenditure (Capex) of about ₹250-300 cr. being done by Divi’s Laboratories Limited for last 5 financial years (FY2011-16)

Even for the current financial year (FY2017), as per the press release dated February 4, 2017, by Divi’s Laboratories Limited for December 2016 quarterly results, the company has stated that it has done about ₹180 cr. of capex in 9M-FY2017. It has also communicated that at December 31, 2016, about ₹400 cr. worth of capital work in progress has been incurred, which is expected to lead to the growth in coming years.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


The company has been expanding its capacity on a continuous basis and in such a scenario, the project execution skill of the management to complete the ongoing projects within reasonable time & costs becomes a key differentiating factor between the companies. Completing the projects on time as projected, is essential as otherwise, there is a risk of the company losing out on the customer orders as well as an increase in costs due to increasing labour costs, increasing raw material costs in inflationary scenarios etc.

While communicating with the shareholders, in the FY2016 annual report, Divi’s Laboratories Limited has informed the stakeholders that its ongoing capital expansion should get completed and the plant gets operational within FY2017.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis



As per the above-mentioned press release, the plant is yet to get completed for about 2 months in the financial year to spare. It is advised that the investor should focus on the communications from the company as well as other reports like management interviews, equity research reports from brokerages and try to track the progress of ongoing capital expansion projects.

The credit rating agency CARE Limited, in its report for Divi’s Laboratories Limited in October 2016, has highlighted the timely project completion as one of the key rating sensitivities.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis



An investor would notice that CARE Limited has highlighted that Divi’s Laboratories Limited has a product concentration risk with top few products constituting the bulk of the sales.

When an investor analyses the annual report of Divi’s Laboratories Limited for FY2016, then she gets to know that the top 5 products constitute about 43% of the total revenue. We believe that product concentration might not be a challenge if the company is a market leader in the products and the management has been dealing in those products since long and has built in formidable expertise in the products.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


On the face of it, the sole parameter of the revenue share of 43% from top 5 products does not seem too high a risk if the company is able to handle the associated factors well.

As on date, the company seems to be doing well in protecting its profitability as it has been able to maintain healthy profitability margins.

An investor would notice that over the years, the operating profit margins (OPM) of Divi’s Laboratories Limited, have been continuously in the range of 37-40%, which is higher than the profitability margins shown by other similar sized (by market capitalization) Indian pharmaceutical players: like Torrent Pharmaceuticals Limited (Mcap: ₹21,330 cr), GlaxoSmithKline Pharmaceuticals Limited (Mcap: ₹22,600 cr), Ajanta Pharma Limited (Mcap: ₹15,350 cr), Natco Pharma Limited (Mcap: ₹13,300 cr) and Biocon Limited (Mcap: ₹22,500 cr) etc.

The chart below compares the operating profit margins of the above-mentioned companies for past 10 years (FY2007-16):

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


The above chart shows that the OPM of Divi’s Laboratories Limited is substantially higher than its similarly sized peers (by market capitalization). OPM of most of other players is within the range of 20-25%, whereas the OPM of Divi’s Laboratories Limited is about 37-40%.

On the face of it, such profitability margins are very good and it indicates that the company might be enjoying very good relationships with its buyers, which are primarily large global pharmaceutical players, which use the API and intermediaries supplied by Divi’s Laboratories Limited into branded generics.

An investor would notice that Divi’s Laboratories Limited is primarily an active pharmaceuticals ingredients (API) and intermediaries manufacturer, which for pharmaceutical industry can be compared to the outsourced auto-ancillaries business in the automobiles industry. It is a common perception that in the supply chain, usually the OEM retains the highest margins and squeezes out the profitability margins out of the vendors.

In the case of pharmaceutical space, the analogy can be thought as the case of players like Divi’s being the vendors and the players selling branded generics as the OEM players.

However, the investor would notice that the OPM of Divi’s Laboratories Limited is also significantly higher than the players, which are into branded generics.

The following chart compares the OPM of Divi’s Laboratories Limited with key branded generic players like Cadila Healthcare, Cipla Limited, Aurobindo Pharma Limited and FDC Limited:

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


The investor would notice that the OPM of most of the players in the branded generics space like Cadila, Cipla, Aurobindo, FDC etc. is in the range of 20-25%, which is significantly lower than the profitability margin enjoyed by Divi’s Laboratories Limited.

It is advised that the investor should dig deeper into advantages that Divi’s Laboratories Limited has as compared to its peers, which are allowing it to have superior margins over the peers. It is expected that higher margins attract higher competition, which in turn leads to lowering of profitability margins for the players going ahead.

Divi’s Laboratories Limited has been enjoying a net profit margin of about 27-30% over the years, which seems very good. In fact, the NPM of Divi’s Laboratories Limited is higher than the OPM of many of its peers.

Such performance warrants deeps study into the sources of competitive advantages by the investor.


The tax payout ratio of Divi’s Laboratories Limited is slightly lower than the corporate tax rate in India, which as rightly mentioned by you, seems to be due to the SEZ units and export nature of the business of the company, which enjoys concessional tax rates by the Govt.

Operating efficiency parameters of Divi’s Laboratories Limited reflect that the net fixed assets turnover (NFAT) has been within the range of 2.4 to 2.8 over the years. It indicates that the company has been able to improve the utilization levels of its previously done capital expenditure as it has continued to invest in fresh capacity on an ongoing basis.

Working capital efficiency parameters of Divi’s Laboratories Limited and its comparison with similar sized (by market capitalization) pharma peers reflect that Divi’s Laboratories Limited has lower inventory turnover when compared to its peers.

The below chart compares the inventory turnover ratio (ITR) of Divi’s Laboratories Limited with Torrent Pharmaceuticals Limited (Mcap: ₹21,330 cr), GlaxoSmithKline Pharmaceuticals Limited (Mcap: ₹22,600 cr), Ajanta Pharma Limited (Mcap: ₹15,350 cr), Natco Pharma Limited (Mcap: ₹13,300 cr) and Biocon Limited (Mcap: ₹22,500 cr).

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


We notice that the inventory turnover ratio (ITR) of Divi’s Laboratories Limited has been consistently lower than its above-stated peers.

Similarly, when we measure the working capital cycle of Divi’s Laboratories Limited in a number of days and compare it with its above-stated peers, then the investor notices that its working capital days are higher than the peers.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


(Working capital days have been calculated as receivables day + inventory days. We exclude payables days in our analysis as long payable days might be due to liquidity crunch with the company rather than its negotiating power with vendors). Inventory Days = 365/inventory turnover ratio.

The above analysis indicates that the working capital management of Divi’s Laboratories Limited can be improved when compared to the performance of its peers. The same concern has been highlighted by CARE Limited in its credit rating rationale for the company in October 2016:

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


The working capital assessment of the company over the years indicates that the funds have been stuck in the receivables and inventory over the years, which has resulted in the cumulative CFO being less than cumulative PAT over last 10 years (FY2007-16).

Over FY2007-16, Divi’s Laboratories Limited reported a cumulative PAT of ₹5,592 cr. whereas over the same period, the company had the cumulative CFO of ₹4,711 cr.

An investor should keep a watch on the operating efficiency parameters especially inventory utilization going ahead to ascertain whether the company is able to improve its working capital utilization going ahead. It is advised that the investor should do her own analysis in arriving at conclusions in such cases and not rely on management statements as managements are known to defend their decision irrespective of the final outcome.


Self-Sustainable Growth Rate (SSGR):


The investor would notice that Divi’s Laboratories Limited has an SSGR of about 40-43% over the years, which is significantly higher than the sales growth rate of 18-20% being achieved by the company in the past.


Even after adjusting for the factor of funds being consumed in the working capital (cCFO/cPAT) = 0.84 (4711/5592), it becomes evident that the company should be able to support a growth of about 30-32% (SSGR 40-43% * 0.84) without the requirement of additional funds for growth.

The analysis of debt levels of Divi’s Laboratories Limited over last 10 years (FY2007-16) indicates that the debt of Divi’s Laboratories Limited has decreased from ₹154 cr. in FY2007 to ₹42 cr. in FY2016.

The reduction in debt over the years with sustained sales growth indicates that the company is able to generate surplus funds over and above the requirements of the company. This assessment of SSGR gets substantiated when the investor analyses the free cash flow (FCF) position of Divi’s Laboratories Limited.

An investor would notice that Divi’s Laboratories Limited has generated ₹4,711 cr. from cash flow from operations (CFO) over last 10 years (FY2007-16) whereas it has spent ₹1,957 cr as capital expenditure over the same period resulting in a free cash flow (FCF) of ₹2,754 cr.

The presence of significant amount of FCF has ensured that the company has been able to reduce its debt levels despite stretched working capital cycle and ongoing capex. Moreover, the company has utilized the free cash to pay dividends to shareholders of about ₹1,458 cr and it still has about ₹874 cr. with itself as cash and investments.

SSGR and FCF are two of the main pillars of assessing the margin of safety in the business model of any company.


This strong cash flow position with optimal utilization of fixed assets has ensured that the company could increase its dividend payouts to shareholders with increasing profits.

Such performance has been taken positively by the market and the market has rewarded the company and its shareholders handsomely over the past years.

The company could achieve an increase in market capitalization of about ₹16,500 cr. over FY2007-16 versus the earnings retained and not distributed to shareholders of about ₹4,100 cr. indicating that a market value of about ₹4 has been created by the company for its shareholders for each ₹1 of earnings retained by it over the years.

You have mentioned that the salaries of three of the key management personnel:
  • Mr. Murali Divi (₹45 cr),
  • Mr. N.V. Ramana (₹23 cr) and
  • Mr. Kiran Divi (₹15.5 cr)

sums up to about ₹83.5 cr. per annum, which is about 7.5% of the PAT of Divi’s Laboratories Limited for FY2016 (₹1,112 cr).

We have noticed that the salary of promoters being about 2-5% over the years is an average across industries, which includes a fixed salary component and about 2% of commission on the profits generated by the company.

The above remunerations though not exorbitant from the perspective of the percentage of net profits, seem high from absolute level perspective.

We suggest that the investor should look the management assessment of Divi’s Laboratories Limited both from the aspect of remuneration as well as an interesting observation, which gets highlighted when the investor analyses various exchange filings done by Divi’s Laboratories Limited over last year.

On August 31, 2016, Divi’s Laboratories Limited wrote to stock exchanges while denying that there has been any import alert against its facilities:

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


In the letter, Divi’s Laboratories Limited explained that the apparent import ban by USFDA resulting due to the company refusing to let the regulators inspect the facility, which is being highlighted in the media does not pertain to it but to some other company by the name of “M/s Divi’s Pharmaceuticals Private Limited”

However, when the investor analyses the annual report of Divi’s Laboratories Limited for FY2016, then she notices that M/s Divi’s Pharmaceuticals Private Limited is an associate company of Divi’s Laboratories Limited where the key management personnel have significant influence.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


This is further evidenced when the investor tries to search for the directors of Divi’s Pharmaceuticals Private Limited. As per the corporate database Zaubacorp, the directors of Divi’s Pharmaceuticals Private Limited include Mr. Murali Divi and Mr. N.V. Ramana.

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis

Two things become evident from this observation:
  1. The promoters might have other businesses in their personal capacity, which might be competing with Divi’s Laboratories Limited in the same markets as the facility owned by Divi’s Pharmaceuticals Private Limited controlled by Mr. Divi and Mr. Ramana is being assessed by USFDA, indicating that Divi’s Pharmaceuticals Private Limited might also either be already exporting drugs/pharmaceutical products to US markets or is planning to do the same.
  2. Despite payment of significant salaries of ₹45 cr. to Mr. Divi and ₹23 cr. to Mr. Ramana, the promoters are not devoting their 100% professional calibre to Divi’s Laboratories Limited and might be running personal competing businesses on the parallel.


An investor should also be cautious about the recent issues faced by the company related to observations highlighted by brokerage Emkay Global in the USFDA inspection of its facilities in recent months. As per media reports, USFDA has among other things highlighted the inaccuracy/falsification of data by the company. The following extract from the BSE website indicates the clarifications sought by it from the company in this regard:

Analysis Divi’s Laboratories Limited Equity research report, Hyderabad, active pharmaceutical ingredients, API, intermediates, Dr Vijay Malik, Dr Stock, Management analysis


Divi’s Laboratories Limited has given general responses to BSE without detailing the actual observations/alerts highlighted by USFDA.

The observation of falsification of data, if true, assumes very high significance as it directly questions the integrity of the management and the corporate governance structure and practices at the company.

In the past, there have been many cases where Indian companies in the pharmaceutical field have been found guilty of data manipulation to get the regulatory approvals. 

Among such cases, the investors would remember recent cases of GVK Biosciences being accused of manipulating clinical trials data in September 2014, which resulted in the suspension of approvals of multiple drugs in Europe, which were based on the clinical data of research/studies done by GVK Biosciences.

Another such case, which has been consistently highlighted is of Ranbaxy, which has also been accused of and pleaded guilty to similar charges by USFDA.

It is advised that the investors should be cautious and keep the above issue in mind while making any investment decision about Divi’s Laboratories Limited.


Let us now address the specific concerns highlighted by you in the write-up:

1) NCF is lower than cash at end of year also a lot of cash inflow is happening from financing activity– what does that signify?

Net cash flow (NCF) is the net change in the cash experienced by the company during a year. NCF is the sum of CFO, CFI and CFF.

Cash at the end of the year is the sum of cash at the start of the year (which is same as the cash at the end of previous year) and the NCF during the year.

The cash flow data indicates that in all the years during FY2007-16, Divi’s Laboratories Limited has witnessed positive CFO and negative CFI and negative CFF. This means that the company received funds from operations (CFO) and used these funds to make investments in plant & machinery, mutual funds etc. (CFI) and to pay dividends to shareholders, repayment of debt etc. (CFF).


2) A lot of MF have reduced their holding in the company though not very significantly in FY 15-16, FII already hold 19.5%, is there upside left in this stock?

We do not recommend taking investment decisions based on actions of Mutual Funds and other institutional investors as many times such institutions have to sell stocks to meet redemption requests from their subscribers. Their sell decisions might not be based on changing fundamentals of the investee company.

We do not have any view about the future stock price movement of Divi’s Laboratories Limited

3) One promoter Nilima Motaparti holds 20.34% shares, couldn’t find out about her.

In case the details about any promoter are not available in the public domain, then the investor may approach the company related to her queries if she has any.

4) OPM% is dropping year on year, it could be linked to company's pricing power. How do we find out the reasons for this?

The decline in OPM might be a result of declining power of any company over its suppliers. The analysis of the company above deals the comparative aspects of the OPM of the company with its peers. We suggest that the investor should look deeper into it by getting in touch with the company, its vendors, suppliers, competitors etc. by doing primary research.

5) The tax rate is less than the corporate rate which could be because 2 of the plants are in SEZ, how can this be confirmed?

An investor may get the confirmation from the company by contacting the investor relationship officer assigned by the company.

6) Debt is negligible but on the rise for last 2 years. Should that be a cause for concern?

As mentioned by you, the debt levels are low when compared to the overall cash position of the company and should be a cause of grave concern if the provided information by the company in its financial statements is correct.

Divi’s Laboratories Limited is currently available at a P/E ratio of about 17-18, which does not offer any margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.

However, as discussed above, the reported financial numbers of Divi’s Laboratories Limited seems to have a good margin of safety in terms of its business as reflected by good SSGR and FCF position.

You may read more about estimating the margin of safety in the target investment in the following article:


Overall, Divi’s Laboratories Limited seems to be a company growing at a descent pace of 18-20%, with good profitability margins. However, the profitability margins of the company seem significantly higher when compared with its peers. The company seems to have been managing its cash positions well with optimal utilization of its capital investments and has been able to meet its entire capex requirement from its internal accruals.

The company has been facing higher working capital cycle than its peers and it remains to be seen whether the company is able to improve the same in future. However, good cash flow position of the company has ensured that the despite higher working capital cycle, the company has been able to avoid debt burden.

The company management seems to be taking high salaries but might not be devoting full attention to company’s business. It might be that the promoters are running parallel competing businesses in their personal capacity.

The recent news about the probability of USFDA detecting falsification of data by the company are significant and the investor should dig deeper and monitor the developments around it as it questions the integrity and corporate governance levels at the company and promoter level.


These are my views about Divi’s Laboratories Limited. However, you should do your own analysis before taking any investment related decision about Divi’s Laboratories Limited.

You may use the following steps to analyse the company: "How to do Detailed Analysis of a Company"

Hope it helps!

Regards,

P.S:



DISCLAIMER


Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:



Currently, I do not own stocks of the companies mentioned above in my portfolio.