March 31, 2017

Q&A: Divi’s Laboratories Limited has a section dedicated to answering queries of readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. I have responded to these queries as replies to their comments.

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  • Divi’s Laboratories Limited

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer


It is advised to read the following two articles before understanding the below query in its right perspective:

Dear Vijay,

Thank you for your quick response. I am still curious and want to highlight some of my thoughts.

You are right, it is not right to say upfront that the high working capital days are a moat for any given company.

As you rightly mentioned API is a sort of commodity business with no major price differentiation. However, in case of Divi’s Laboratories Limited there are two things to be considered.

First, if we look at the Annual reports (FY16 – Pg no. 50) and other company documents, we understand the company derives around 50% of its total revenue from Custom Synthesis business (CRAMS).

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

In custom synthesis business it is involved in throughout the drug development stages i.e. the discovery and development stages. The company is involved in the research for these drugs ranging from the initial stage of the drug to development stage till drug is fully developed.

Drug Development Stages

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

Right from the development of a molecule at the innovator’s end till the expiry of the drug, Divi’s Laboratories Limited helps its customers in each stage.

It is worth noting, this business requires good chemical skills and long-standing relationships with the customers (sensitive information of the customers is to be shared). Needless to mention this is a high margin business.

Food for thoughts: 
  1. This may also lead to the company to manufacture patented products once the patent is commercialised. Again high margin products.
  2. Major CRAMs business in the India tend to rely on high debt to fund their capex. And cash flow generation is not sufficient to back the expansions as the general characteristic in the CRAMS business is high working capital requirements. Below is the excerpt of Suven Life Science (Engaged in the Crams business):

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

Second, in the API business, Divi’s Laboratories Limited manufactures very complex APIs which command better margins. Further, it has a clear standout strategy of not entering the territory of the innovator and violates patent norms. This has helped the company to have very strong relationships with its clients.

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

The business model of the company is driven by complex chemistry and long-standing relationships with its clients. The high margins CRAMS business comprises around 50% of the total revenue, to an extent explains the high margins.

It is widely accepted that when operating margins are very high in a competitive business there may be a cash of numbers being cooked. The best one can do to decipher that is a thorough analysis of Cash Flows and Quality of earnings.

The concern regarding the high working capital (generally a sign of Shenanigan) is worth if it badly impacts the overall cash generation of the business.

I have tried to look at some numbers to see the impact of the high working capital on the Divi’s Laboratories Limited overall cash flow generation.

Table 1: Cash Flow: Strong cash generation

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

So if we look into it:

  • CFF is Negative – This means company has been paying dividends, repaying debt (good sign)
  • CFI is Negative – This means company has been investing back into the business at a very high re-investment rate (good sign)
  •  NCFO positive – The operating business is generating good cash in spite of high working capital requirements. (a very good sign)
  • Over the period of 10 years company has been able to generate way more cash than it has invested. And positive free cash flows for a long period of time are something cannot be ignored. 

Any financial gimmick in the majority of the cases would be reflected in the cash flows. However, in the case of the Divi’s Laboratories Limited cash flows are very strong and support the argument that high realization covers up the high working capital requirements.

Table 2: Cash Flow from Operations:

If we look at the generation of the cash flow from Operations (CFO) the most critical part of the cash flow is the changes in the working capital changes. Let us call cash flow from operations before working capital changes as ‘Gross Cash Flow from Operations’ (GCFO) and cash flow from operations after working capital changes as ‘Net Cash Flow from Operations’ (NCFO).

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

As a shorthand, while providing working capital loans/auditing the books of accounts, we use NCFO as a % of GCFO. This number essentially signifies the quantum of the working capital requirement in the business. In a trading business, it is expected to be 100%. And in the case of a manufacturing company, anything above 60% is considered reasonable.

The 60% goes with the assumption that 40% is stuck in the working capital requirements, which is reasonable.

Since Divi’s Laboratories Limited is a manufacturing company and aggregate NCFO as a percentage of GCFO for last 10 years has been 64%, which shows the amount of money stuck in the working capital is within the acceptable limits and gives a little scope to the company to cook its book.

Table 3: Operating Cash flow Vs Profits

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

Table 4: Earnings to cash conversion: OCF (post tax)/ (PAT+Depriciation- Other Income)

One of the metric to look at the quality of the earnings is to see the earnings to cash conversion ratio.

Answer to reader's query on Divi’s Laboratories Limited, a Hyderabad based Indian Pharmaceutical Manufacturer

The ratio is better if closer to 100%. In the case of Divi’s Laboratories Limited, it has been very robust and stood at 80% if we look at the aggregate data of last 10 years.

Thus, the cash flow seems to be very strong. As we know any fraud/cooking of the books generally gets reflected in the cash flows, it is very difficult to establish that the company might be cooking the books.

Thanks for your valuable time. Request you to correct me if I am missing out something.

Thanks & Regards

Simple Thinking

Author’s Response


Many thanks for providing your valuable inputs.

We appreciate the hard work that you have put in while preparing your write up by calculating various financial/cash flow parameters and taking out relevant information from other documents like the annual report and doing the peer comparison.

You are right that most of the cases of accounting manipulations revolve around dressing up the financials so that the companies can appease various stakeholders like lenders (to take more debt) or equity shareholders (to get high share price, esp. true in case of companies run by professionals where significant part of wealth of management is locked in ESOPs). In the case of Divi's the financials reflect a good cash flow position, which despite high working capital needs, is able to spare ample cash in the hands of the company.

As far as the complexity of products and the association with the customers through all stages of the life cycle, which are leading to higher margins, we believe that currently, the word of the management is the only available source of information. Let's hope that what they have stated in the annual report about various policies in the annual report is being followed on the ground as well.

The first most test of the same is the current FDA issue being faced by the company. Let's hope the company gets out of it soon and focus on delivering value to its stakeholders (customers as well as shareholders).

All the best for your investing journey!


Dr. Vijay Malik

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