Analysing Divi's Laboratories with Dr Tanmay Motiwala

Introducing Dr Tanmay Motiwala - a man with a passion for paediatric surgery and a keen eye for the world of investments. When it comes to the world of stocks, Dr Motiwala is no ordinary investor. He combines his medical knowledge and analytical skills to make informed decisions in the market, and one of his top picks is none other than Divi's Laboratories. So, join us as we dive into the world of Divi's Laboratories with Dr Tanmay Motiwala, with his unique approach and expertise.

The pharmaceutical industry involves sourcing raw materials to produce Key Starting Materials (KSM), which are processed to create Active Pharmaceutical Ingredients (APIs). APIs are used to create finished dosage forms like tablets, capsules, and injections that are packaged and distributed to healthcare providers and patients. 

Each stage of production requires stringent quality control measures and regulatory approvals to ensure the safety and efficacy of the medications. The pharma industry is constantly evolving, with advancements in technology and innovation leading to new discoveries and treatments for various diseases.

One of the words that is often thrown around when talking about the pharmaceutical industry is API. What is API?

Active Pharmaceutical Ingredients (APIs) are the crucial chemical substances found in medications that produce the desired therapeutic effect. In simpler terms, APIs are the active components that make a medication work.

For instance, aspirin, like Reckitt Benckiser’s Disprin, contains the API acetylsalicylic acid. This compound is responsible for aspirin's pain-relieving, fever-reducing, and anti-inflammatory effects. Without acetylsalicylic acid, aspirin would not be effective in treating these conditions.

In summary, APIs are like the "secret sauce" that produces the desired effect in a medication. They are the primary components that create the intended healing effects and are indispensable to the medication's efficacy.

Breaking down the Pharma Industry

Before getting into a specific company, it is important to understand how the pharma industry works, its dynamics, and what are the key components. The pharma industry can be broken down into two processes.

1. Drug development (CRAMS & CDMO): This involves the entire drug development process, from drug discovery, preclinical trials, and clinical trials to regulatory approvals and commercialisation. Both innovator companies and generic drug manufacturers may use the services of CDMOs and CRAMS providers to develop and manufacture drugs.

2. Drug management (CROs): This encompasses a range of services related to the management of drugs after they have been approved and commercialised, including life cycle management, regulatory compliance, pharmacovigilance, and medical writing. CROs can also provide services related to clinical trial management and data analytics during the drug development process. Para 4 filing is a specific type of legal challenge related to the approval of generic drugs, and CROs may be involved in this process as well. Overall, CROs play a critical role in the ongoing management of drugs throughout their life cycle, both for innovators and generic drug manufacturers.

In the last few years, contract manufacturing has become more and more viable for big pharma companies.

Divi's Laboratories is a contract manufacturer (CMO) that primarily focuses on providing contract manufacturing services for active pharmaceutical ingredients (APIs) and intermediates to pharmaceutical companies. Divi's Laboratories can be considered a CDMO in the sense that they provide contract development and manufacturing services for their customers. However, Divi's Laboratories' primary focus is on manufacturing APIs, whereas a broader CDMO may provide a wider range of services, including drug product formulation and packaging. Therefore, Divi's Laboratories can be categorised more specifically as an API-focused CMO. With a market presence in 95 countries and approximately 14,000 employees, Divis Laboratories is one of the leading pharmaceutical companies in the world.

One of the things that sets Divis Laboratories apart from its competitors is its extensive product portfolio. The company offers 122 products across various therapeutic areas, including leading generic APIs, nutraceutical ingredients, and custom synthesis of APIs and intermediates for global companies. In fact, the company derives approximately 47% of total revenues from its top 5 products, with Naproxen (an anti-inflammatory drug) contributing approximately 18% of total sales during FY20. Divis Laboratories is one of the leading suppliers of this drug, making it a major player in the pharmaceutical industry.

Divi’s Labs: Business Verticals

When we look at Divi’s, we can classify the business into three arms:
1. Generic APIs: This vertical basically includes the generic molecules made by the company with 30 APIs, plus 10 in the development stage. Divi’s makes it to the top 2 API manufacturers for 18 out of the 30 molecules that they make across the world. This is how Divi’s operates; they pick an API, learn how to make it efficiently, and then they go on to scale it. 

2. Custom Synthesis:  This refers to the process of synthesising or manufacturing a specific chemical compound or molecule according to a customer's specific requirements. 12 out of 20 big pharma companies in the world are associated with Divi’s.

3. Nutraceuticals: Nutraceuticals are a class of products that are derived from food sources and are purported to offer health benefits beyond basic nutritional value. These products are frequently marketed as dietary supplements and can contain a variety of natural substances, including vitamins, minerals, and herbs.

The revenue mix has changed a little from FY20 to Q2 of FY23. The custom synthesis accounted for 41% in FY20, which increased to 48%, along with an increase in generics’ contribution from 51% to 52%. Generics contribute more towards the top line, and custom synthesis is where the margins are more.

Another key factor that makes Divis Laboratories stand out is its strong presence in international markets. The company derives approximately 85% of total revenues from exports, with Europe being the largest market at 47% of revenues. The revenue share of America has gone down from 33% in FY17 to 23% in FY20, while the revenue share of Europe has gone up from 40% to 47% in the same timeframe, implicating larger growth from its European business. 

But Divis Laboratories isn't just focused on its current success. The company is also dedicated to research and development, with 3 R&D facilities near its manufacturing locations. These centres are involved in the development of processes for both new compounds and the improvement of processes for compounds on the market. The company spent approximately 38 crores towards R&D in FY20, which demonstrates its commitment to staying ahead of the curve in the constantly evolving pharmaceutical industry.

Speaking of manufacturing, Divis Laboratories has two manufacturing locations at Bhuvanagiri, Telangana, and Visakhapatnam, Andhra Pradesh. These two locations house six different manufacturing units with diverse operations. But the company isn't content to rest on its laurels - it has started the construction of a new manufacturing facility in Kakinada, Andhra Pradesh, in December 2020. The company will invest approximately ₹1,500 crores from internal accruals, and the operations are likely to commence within 12-18 months for phase-1 of the project. 

Finally, Divis Laboratories has two wholly-owned subsidiaries: Divis Laboratories (USA) Inc and Divi's Laboratories Europe AG in Switzerland. These subsidiaries are engaged in the marketing/distribution of nutraceutical products to provide greater reach to customers within these regions. In FY20, the subsidiaries brought in ₹319 crores (6%) of revenues for the company, further expanding its reach and impact.

Understanding Con-Calls of Divi’s Labs

Upon examining the con-calls of API manufacturing companies, one would often hear that the high cost of raw materials in China is negatively affecting their profit margins. The majority of companies in the industry import key starting materials (KSMs) and intermediates, and due to various factors, including the COVID-19 pandemic, Chinese manufacturers have been stocking up on inventory.

This has created pressure on supply and demand, leading to price increases outside of China. Unfortunately, price manipulation is common in this space. Many companies are dependent on China for their imports, which creates a risk for their supply chain. 

To combat this dependency problem, some players, such as Laurus Lab, have started making APIs and formulations. This move may be viewed as a risk factor for major players in the formulation space. However, Divi's is a pure API play and has no intention of entering into the formulation market. And often talks about being backwards integrated. 

The global medicine market is expected to reach $1.8 trillion in total market size in 2026, with emerging countries leading the growth due to increased access to medicines and healthcare. The API market is also expected to grow at a 6% CAGR from $222 billion to $353 billion by 2030, with India being preferred over China for API exports due to geopolitical situations and demand to reduce dependence on China. The Indian pharma industry is valued at $49 billion in FY22, with exports reaching $23.3 billion. India is becoming a preferred destination for high-value and complex APIs, with significant FDIs and investments in R&D. With many CAPEX planned for backward integration to API/KSM and capacity expansion, India is expected to continue growing as a reliable supplier for the pharmaceutical industry.

The “China Factor” in the API industry

According to the graph above, the cost of manufacturing APIs is significantly cheaper in China compared to India. In India, raw materials, electricity and other expenses are greater than China by 25-30%,20% and 30%, respectively. However, India has an advantage in terms of labour cost, which is 1.8 times lower than China.

The pandemic has led to fluctuations in prices and has highlighted the importance of self-sufficiency in the manufacturing process. Many companies, including those in India, have realised the significance of automation and the need to reduce reliance on other countries. Consequently, governments have launched initiatives to encourage self-sufficiency, such as China's "Plus One Strategy," which has also been implemented in other sectors. These initiatives aim to reduce dependence on any one country and diversify supply chains to mitigate risks.

We can also see higher production capacity for select APIs in China as the overall production cost is very low. It is estimated that Chinese manufacturers make around 40% of all APIs used worldwide.

Changing Perspective with the China Plus One Strategy

The global COVID-19 pandemic has caused major disruptions in supply chains, particularly in the manufacturing sector. In response, companies have started adopting the “China Plus One” strategy to diversify their operations beyond China, reducing their dependence on a single market. This approach is particularly relevant in the context of the API industry, where raw material prices are high in China and supply chain risks are high.

India, with its growing API industry and favourable government policies, has emerged as an attractive alternative for companies looking to diversify their operations. The Government of India has launched various initiatives to boost local manufacturing, including the "Make in India" campaign, which is aimed at increasing the competitiveness of the Indian API industry.

The Indian API industry also has several advantages over China, including lower labour costs and a large pool of skilled labour. As more companies look to set up operations in India to reduce their dependence on China, the Indian API industry is likely to benefit from increased investment and growth opportunities.

The China Plus One Strategy is expected to boost the growth of the Indian API industry and provide new opportunities for domestic players to expand their operations. It is also likely to lead to greater collaboration between Indian and foreign companies, as well as the development of new partnerships and joint ventures.

The China Plus One Strategy is an important trend in the global API industry, and India is well-positioned to benefit from it. As companies look to diversify their operations and reduce their dependence on China, the Indian API industry is likely to see increased investment, growth, and new opportunities for domestic players to expand their operations.

Tanmay’s MOAT Analysis of Divi’s Laboratories

Investors often look for companies where the promoters have "skin in the game," meaning they have a significant stake in the company's success. In the case of this particular company, the promoters hold a 51.9% stake, indicating their strong belief in the company's potential.

Furthermore, the company has an experienced leader in Kiran Divi, who has a proven track record in the business. This leadership is a further sign of the company's potential for growth and success.

But what really sets this company apart is their commitment to green chemistry and economies of scale. By implementing backward integration and sustainable practices, not only are they reducing their environmental impact but also positioning themselves for long-term success in a market that is increasingly focused on sustainability.

The company has set a benchmark in the API industry with its fast track project, delivering hundreds of tons in just one year, which is a first in the sector's history. Furthermore, Divi's Laboratories does not compete with its clients, which sets it apart from competitors like Laurus Labs. 

Not competing with the clients makes the Divi’s stand out from the likes of Laurus Labs.

Most of the big pharma companies, 12 out of 20 are clients of Divi’s.

Company’s forte of APIs mostly include drugs that require long term use and where the company will be able to sustain economies of scale and also keep revisiting old processes to improve them. 

Opportunities that Tanmay sees ahead for Divi’s

Upcoming opportunity size of ~US$20 Billion in molecules going off-patent over FY 23-25.

According to Tanmay's analysis, Divi's Laboratories has identified six key areas for growth during their con-calls, which include established generics, existing generics, new generics, Sartan APIs, Contrast Media, and Custom Synthesis. By focusing on diversifying its portfolio across these areas, the company can increase its revenue potential and maintain a competitive edge in the pharmaceutical industry.

Additionally, Divi's Laboratories is actively progressing on its Kakinada greenfield project, which has a planned outlay of ₹1000 crores - ₹2000 crores. The project aims to enhance the company's manufacturing capabilities and expand its production capacity to meet the growing demand for its products. Overall, these growth engines and expansion plans position Divi's Laboratories for long-term success and growth in the industry.

A quick peer comparison on Ticker shows how well the company stacks up with other players. The ROE and the ROCE seem to dominate other players. This is also a good tell-tale sign that the company is using its resources efficiently and that there is some moat that the company has around its business that keeps the other players at bay. Also, the interest coverage ratio stands high enough to make investors feel safe.

Threat to Divi’s Labs

When analysing a company, it is essential to consider both positive and negative aspects before making any investment decisions. Tanmay, therefore, believes that investors should look for antithesis pointers to get a well-rounded view of the company's position in the market. In the case of Divi's Laboratories, the risk of concentrated products is a potential concern, as almost 20% of the revenue comes from Naproxen, and another 7% comes from Gabapentin.

Furthermore, the anticipated drop in the prices of Sitagliptin, an anti-diabetic drug, after going off-patent this year, may have a significant impact on the company's revenues. In addition, the company faced compliance issues with the USFDA in FY18, indicating a possibility of future risk.

Moreover, the company's margins were temporarily affected in Q1FY23 due to increased raw material prices. Shipping costs, coal and electricity prices, generator costs, and the price of lithium, a catalyst used in most reactions, have seen significant increases in price as well. While the management has assured investors that they have addressed these concerns, they may still pose a risk in the future.

Lastly, the Kakinada greenfield project still awaits final clearance from the state government, leaving room for potential delays in its implementation. Considering all these antithesis pointers will help investors decide whether to take a position in Divi's Laboratories.

The Bottom Line

Divi's Laboratories is a fast-growing pharmaceutical company that has demonstrated exceptional performance in terms of revenue growth, profitability, and efficiency. The company's strong focus on R&D, commitment to quality, and its ability to consistently deliver innovative products to its customers has set it apart in the highly competitive pharmaceutical industry. Divi's has also been expanding its manufacturing capabilities, with a number of new plants under construction, which is expected to significantly increase its capacity and allow it to meet growing demand.

With its strong financial performance, focus on innovation and quality, expanding manufacturing capabilities, and diversified product portfolio, Divi's Laboratories is a company worth watching for in the pharmaceutical industry.