Dr Reddy Laboratories Ltd RDY (XNYS)

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1 Morningstar Equity Analyst Report Report as of 06 Nov 2015 Page 1 of 10 Morningstar Pillars Analyst Quantitative Economic Moat Narrow Narrow Valuation QQ Overvalued Uncertainty High Low Financial Health Strong Source: Morningstar Equity Research Quantitative Valuation IND d Current 5-Yr Avg Sector Country Price/Quant Fair Value Price/Earnings Forward P/E Price/Cash Flow Price/Free Cash Flow Dividend Yield % Source: Morningstar Bulls Say ODr. Reddy's ability to launch difficult-tomanufacture drugs with limited competition, such as Arixtra and Allegra, builds the company's presence in developed markets without sacrificing profitability. OIn the U.S. and Russia, Dr. Reddy has grown quickly in over-the-counter generics, which is an attractive segment of the market with slightly higher barriers to entry than conventional retail pharmacy drugs. ODr. Reddy's strong brand presence in emerging markets provides high-growth opportunities with less price competition than typically seen in developed markets. Bears Say RDY Undervalued Fairly Valued Overvalued ODr. Reddy should face greater competition in its emerging-market strongholds, such as Russia and India, as numerous competitors look to expand operations in these markets. OAlthough it markets four biosimilars in India and other emerging markets, Dr. Reddy likely won't be introducing these products to the U.S. and European markets anytime soon because of higher regulatory, manufacturing, and intellectual property barriers. OThough Dr. Reddy has surpassed other Indian generic manufacturers in entering the U.S. drug market, it still lacks the prowess of its larger global competitors. Dr. Reddy's Labs Receives FDA Warning on API Plants; Maintaining Fair Value Estimate for Now Michael Waterhouse, Analyst, 24 July 2015 Investment Thesis Dr. Reddy's low-cost manufacturing and emerging-market exposure add up to attractive growth prospects. Dr. Reddy has a well-established brand in many emerging markets where rising disposable income, a fragmented customer base, and lower generic drug utilization rates offer attractive growth opportunities. Since many global drug markets lack a consolidated and efficient drug distribution infrastructure, generic drug manufacturers generally sell most of their product frequently called branded generics to independent pharmacies and physicians in these areas. Brand recognition generally supports customer loyalty and more stable prices, but governments can intervene with mandated pricing or tender-based bidding. Besides its own brand recognitions, Dr. Reddy has global distribution agreements with AstraZeneca and GlaxoSmithKline. Market share gains in the large U.S. and European drug markets also offer attractive growth opportunities for Dr. Reddy. The company has racked up a handful of successful drug launches, but its manufacturing scale, research capabilities, distribution networks, and legal acumen still lag larger competitors, in our view. While we do expect its low-cost operating structure will sustain market share gains, Dr. Reddy's shift into the more commodified developed markets may eventually erode the firm s lofty returns on capital. Management hopes to develop more complex manufacturing capabilities in market segments where limited competition supports stronger pricing power and higher profitability. Dr. Reddy has made relatively strong inroads into generic over-the-counter products and has also launched four biosimilars near generic equivalents of biotech drugs in India and other emerging markets. However, we think U.S. and European approval for Dr. Reddy's biosimilars remains highly improbable in the near future due to the more stringent approval criteria in these regions. Management initiated a partnership with Merck KGaA to bolster its biosimilars program in Michael Waterhouse, Analyst, 06 November 2015 Analyst Note The U.S. Food and Drug Administration issued a warning letter on three of Dr. Reddy s Indian facilities, including its Miryalaguda- and Srikakulam-based API facilities and an oncology formulation manufacturing plant in Duvvada. We plan on maintaining our fair value estimate until more definitive details on the nature of the noncompliance is released. The company is still reeling from the aftermath of previous FDA concerns on its Srikakulam facility in 2014, which resulted in delayed U.S. product approvals and accounts for roughly 10%-12% of total revenue. At the least, we anticipate an increase in remediation costs as the company takes the necessary steps to bring its facility up to FDA compliance. Although we're concerned by Dr. Reddy's ongoing regulatory issues, we believe the company can maintain its narrow economic moat as it resolves these conflicts. This news follows a string of other FDA observations and warnings on Indian generic drug manufacturers, including Ranbaxy Laboratories whose plants were ultimately banned for production by the FDA. Subject to the severity of the FDA warning letter, the impact could be materially damaging if production is limited. However, without more clarity, we can expect a wide range of outcomes that do not necessarily include cutbacks in production. The manufacturing of Dr. Reddy s generic version of Nexium (esomeprazole), a highly anticipated win for the company, was fortunately transferred out of the Srikakulam facility to another location earlier this year to gain FDA approval and is unlikely to be affected. Investors can expect upcoming volatility as more details are released, and we reiterate Dr. Reddy s high uncertainty rating. We will continue to keep an eye out for forthcoming details on the situation. Economic Moat Michael Waterhouse, Analyst, 24 July 2015 Low-cost operations form the cornerstone of Dr. Reddy's narrow moat. With its operations in India, Dr. Reddy enjoys low-cost labor and a low tax base. Additionally, the company owns vertically integrated active pharmaceutical ingredient manufacturing capabilities, which allow it to save considerably on raw-material costs. Not only can Dr. Reddy aggressively price its products as a result of its lower-cost structure, but also these cost-saving measures allow the firm to maintain some of the highest profit margins in the generics industry. The company also has

2 Morningstar Equity Analyst Report Page 2 of 10 Close Competitors Currency (Mil) Market Cap TTM Sales Operating Margin TTM/PE Novartis AG NVS USD 216,302 50, Teva Pharmaceutical Industries Ltd TEVA USD 51,904 19, Mylan NV MYL USD 22,025 9, Hikma Pharmaceuticals PLC HIK GBX 4,009 1, relatively strong brand recognition among physicians and pharmacists in many of the emerging markets where it operates. Although these branded generics lack patent protection, they generally enjoy more favorable pricing among a loyal customer base. Valuation Michael Waterhouse, Analyst, 24 July 2015 We're raising our fair value estimate for Dr. Reddy's Laboratories to $51 per share from $47 primarily based on cash flows realized since our last update. We use an exchange rate of approximately INR per $1 as of July. Our fair value estimate implies a price/earnings ratio of approximately 21 and an enterprise value/ebitda of 14. We expect average revenue growth of nearly 11% through We model U.S. generic revenue growth of approximately 15% on generic launches and ongoing market share gains. We also continue to forecast double-digit generic sales in India, Russia, and other emerging markets thanks to rising personal incomes and increased utilization of generic drugs. We expect Dr. Reddy's woes with its Betapharm acquisition in Germany will damp growth to the mid-single digits in Europe during the next few years. Our forecast culminates in mid-single-digit growth in the active pharmaceutical ingredients segment and low-double-digit growth in the proprietary pharmaceuticals segment through We expect that gross margins can remain above 55% thanks to new launches of higher-margin products and the growing contribution from the firm's higher-margin generic drug sales. Although Dr. Reddy's product shift will continue to bolster gross margins, we expect the company's developed market generics segments and the heavily commodified API operations will face greater pricing pressure toward the end of the patent cliff. We also imagine additional marketing costs to maintain market share in Dr. Reddy's emerging markets combined with higher research costs for biosimilars will keep operating margin near 20%. Regardless, our operating margin forecast results in returns on capital near 20% through We estimate Dr. Reddy's cost of equity at 10%. Risk Michael Waterhouse, Analyst, 24 July 2015 The company's drug-specific strategy places a higher degree of success on limited product launches. As such, product recalls represent modest setbacks since the company's product portfolio lacks the diversity of its larger competitors. Dr. Reddy's faced some limited product recalls in 2009 and 2014, as well as a year-long import ban on its Mexican manufacturing facility in While Dr. Reddy has successfully overcome these challenges so far, the company's foray into Europe has been more painful. The company extended its reach into Europe through the 2006 acquisition of Betapharm, a German generic manufacturer, for about $570 million. Soon thereafter, Betapharm's revenue crumbled as the German market shifted to a partial tender-based market system. Betapharm's losses have forced Dr. Reddy to take significant write-offs on its assets. As a result, we d be skeptical of any future potential international acquisitions. Also, Dr. Reddy's brand recognition is likely to face stronger competition in the coming years as larger players with greater financial resources hope to expand and diversify operations in the faster growing emerging markets. Management Michael Waterhouse, Analyst, 24 July 2015 We give Dr. Reddy average marks for shareholder stewardship. For the most part, Dr. Reddy's capital allocation decisions appear on par with its peers in the industry, but the company's acquisition of Betapharm as part of its planned European expansion was a large misstep. We'd be skeptical of any big future international acquisitions. Aside from the black eye of Betapharm, management has done a good job of expanding into other global generics markets and establishing the firm as a major global competitor. As one potential risk to outside shareholders, Dr. Reddy remains a family-run organization. Satish Reddy inherited the role of board chairman in 2014 from his father and company founder, K. Anji Reddy. Satish previously worked as COO and managing director of the company. Abhijit Mukherjee took over as the company's COO in the same year, bringing many years of previous leadership experience at the firm. Meanwhile, G.V. Prasad, a son-in-law to founder K. Anji Reddy, is the company's

3 Morningstar Equity Analyst Report Page 3 of 10 co-chairman and CEO. The Reddy family and other insiders own nearly 25% of the shares outstanding. Nepotism and family ownership of a large block of shares have the potential to put outside investors at greater risk of misaligned interests. We like that management takes a very modest paycheck, by developed-country standards, and doesn't seem overly concerned about earnings per share targets and other short-term metrics.

4 Morningstar Equity Analyst Report Page 4 of 10 Analyst Notes Archive Dr. Reddy's Labs Receives FDA Warning on API Plants; Maintaining Fair Value Estimate for Now Michael Waterhouse, Analyst, 06 November 2015 The U.S. Food and Drug Administration issued a warning letter on three of Dr. Reddy s Indian facilities, including its Miryalaguda- and Srikakulam-based API facilities and an oncology formulation manufacturing plant in Duvvada. We plan on maintaining our fair value estimate until more definitive details on the nature of the noncompliance is released. The company is still reeling from the aftermath of previous FDA concerns on its Srikakulam facility in 2014, which resulted in delayed U.S. product approvals and accounts for roughly 10%-12% of total revenue. At the least, we anticipate an increase in remediation costs as the company takes the necessary steps to bring its facility up to FDA compliance. Although we're concerned by Dr. Reddy's ongoing regulatory issues, we believe the company can maintain its narrow economic moat as it resolves these conflicts. This news follows a string of other FDA observations and warnings on Indian generic drug manufacturers, including Ranbaxy Laboratories whose plants were ultimately banned for production by the FDA. Subject to the severity of the FDA warning letter, the impact could be materially damaging if production is limited. However, without more clarity, we can expect a wide range of outcomes that do not necessarily include cutbacks in production. The manufacturing of Dr. Reddy s generic version of Nexium (esomeprazole), a highly anticipated win for the company, was fortunately transferred out of the Srikakulam facility to another location earlier this year to gain FDA approval and is unlikely to be affected. Investors can expect upcoming volatility as more details are released, and we reiterate Dr. Reddy s high uncertainty rating. We will continue to keep an eye out for forthcoming details on the situation. Dr. Reddy's Posts Robust Second-Quarter Results Michael Waterhouse, Analyst, 29 October 2015 Strong second-quarter results, propelled by a European turnaround and consistent delivery by the U.S and Indian generic drug markets, revealed that Dr. Reddy s Laboratories is primed for a solid fiscal year. Year-over-year total revenue grew by 11%, driven by a 13.5% growth in the generics segment amid currency headwinds. The company s quarterly performance was in tune with our expectations, and we do not foresee changes to our fair value estimate. Dr. Reddy's also saw notable margin expansion, deepening support for our narrow economic moat rating. We believe Dr. Reddy s diversification across product lines and geographic regions helped carry the firm through some mishaps in other business areas during the quarter. The North American generics segment saw revenue increase by 30% within our expectations and largely due to an easy comparison to last year. Venezuela remains a sore point for management and major headway has likely yet to materialize. Meanwhile, the pharmaceutical services and active ingredients revenue fell 7% to last year s comparable, even though profitability seemed to improve in this segment. The company is still feeling the impact of U.S. Food and Drug Administration observations placed on its Srikakulam API facility last fall, which has delayed several product approvals. The Russian business posted healthy volume growth, resulting in 11% constant currency top-line growth, but foreign exchange effects more than offset the gain. Dr. Reddy's Strong Fundamentals Overcome Russian Weakness in 1Q Results Michael Waterhouse, Analyst, 30 July 2015 While Dr. Reddy s first-quarter revenue growth experienced a slowdown mainly due to currency effects in Russia, solid results from the European, Indian, and U.S. generic markets, along with favorable product mix, amounted to 14% growth in profits compared with a year prior. The company posted overall results largely in line with our expectations, and we do not anticipate changes to our fair value estimate. Despite the lackluster results from Russia, Dr. Reddy s fundamental business remains strong and reaffirms our narrow moat rating. The struggling Russian ruble continued to have a material impact on Dr. Reddy s top line, but slightly better than expected profitability should enable Dr. Reddy to stay on track with our forecast. Instability in Russia resulted in a 20% year-over-year decline in Dr. Reddy s emerging-market generic drug revenue, which is likely to continue to depress near-term results. Dr. Reddy saw strong growth in the European and Indian markets, thanks to new product launches, which pulled the quarter s results to a favorable position. Interestingly, the revenue from the U.S. generics market experienced a 14% increase from fiscal year 2015,

5 Morningstar Equity Analyst Report Page 5 of 10 exclusively driven by market share gains for existing small molecule products as there were no new launches this quarter, signaling Dr. Reddy s sustainable advantage in the space. The pharmaceutical services and active ingredients segment also reported sales that were nearly level to results last year. launch new products and builds out its proprietary products segment, and we don't expect expenses to significantly deviate from our expectations going forward. Thanks to the firm s margin gains supplemented by ongoing efficiency initiatives and a conscious shift to higher-margin products, we believe Dr. Reddy is poised for further growth. R&D expenditure marginally increased to 11.7% of total revenue from 11% in fiscal year 2015, which is within our expectations, as the firm attempts to build out its complex generics, biosimilars, and proprietary products. Dr. Reddy Delivers Strong Results, Ramps Up R&D Michael Waterhouse, Analyst, 13 May 2015 Dr. Reddy s Laboratories released fourth-quarter results mostly in line with our expectations. Unfavorable foreign exchange rates remain a near-term concern, although fundamental gains in revenue more than offset any negative effects, driven by new product expansion and a healthy generics business. We maintain our fair value estimate and reaffirm our narrow moat and stable moat trend ratings. Fourth-quarter top-line growth was affected by volatile currency rates in key geographic regions, most notably in Russia, but we don't foresee any dramatic change in our growth forecasts thanks to mostly stable underlying performance across Dr. Reddy's segments. Despite these currency pressures, Dr. Reddy delivered overall revenue growth of 11%, mainly bolstered by its global generics business, which accounts for 80% of sales. The growth was led by new product launches in the U.S., including Habitrol, a transdermal nicotine patch system. Venezuelan revenue offset the troubles brewing with the Russian ruble, evening out emerging-market growth. Meanwhile, the pharmaceutical services and active ingredients segment saw more revenue stability, increasing by 12% compared to a year prior. Regulatory run-ins concerning an API manufacturing plant will likely remain a short-term struggle. Operating margin slipped in the fourth quarter from last year thanks to currency effects and some nonrecurring operating charges. Higher investment in R&D will continue to trend as the company scales its efforts to

6 Quantitative Equity Report Release Date: 06 November 2015 Reporting Currency: INR Trading Currency: USD Page 1 of 1 Page 6 of 10 Dr Reddy Laboratories Ltd ADR RDY Last Close Quantitative Fair Value Estimate Market Cap (Mil) Sector Industry Country of Domicile ,117.4 d Healthcare Drug Manufacturers - Specialty & Generic Dr Reddy Laboratories Ltd together with its subsidiaries is engaged in manufacturing of pharmaceutical products. It operates through three segments; Pharmaceutical Services & Active Ingredients, Global Generics and Proprietary Products. Quantitative Scores Scores All Rel Sector Rel Country Quantitative Moat Narrow Valuation Overvalued Quantitative Uncertainty Low Financial Health Strong IND d RDY Undervalued Fairly Valued Overvalued Valuation Current 5-Yr Avg Sector Country Price/Quant Fair Value Price/Earnings Forward P/E Price/Cash Flow Price/Free Cash Flow Dividend Yield % Price/Book Price/Sales Profitability Current 5-Yr Avg Sector Country Return on Equity % Return on Assets % Revenue/Employee (Mil) Quantitative Moat Financial Health Current 5-Yr Avg Sector Score Country Distance to Default Solvency Score Assets/Equity Long-Term Debt/Equity Price Versus Quantitative Fair Value Quantitative Fair Value Estimate Total Return IND India Sales/Share Forecast Range Forcasted Price Dividend Split Momentum: Standard Deviation: Wk Yr Total Return % / Market (Morningstar US Index) Dividend Yield % Price/Earnings Price/Revenue Undervalued Fairly Valued Overvalued 806 Monthly Volume (Thousand Shares) Liquidity: High TTM Financials (Fiscal Year in Mil) 74,693 96, , , , ,603 Revenue % Change 12,629 18,252 21,112 26,032 26,286 30,316 Operating Income % Change 11,040 14,262 16,777 21,512 22,179 24,410 Net Income 8,009 16,150 13,317 19,463 25,033 29,083 Operating Cash Flow -11,606-8,462-7,336-10,627-15,327-15,906 Capital Spending -3,597 7,688 5,981 8,836 9,706 13,177 Free Cash Flow % Sales EPS % Change Free Cash Flow/Share Dividends/Share Book Value/Share 169, , , , , ,558 Shares Outstanding (K) Profitability Return on Equity % Return on Assets % Net Margin % Asset Turnover Financial Leverage Gross Margin % Operating Margin % 5,316 16,335 12,625 20,740 14,307 10,631 Long-Term Debt 45,990 57,444 73,085 90, , ,499 Total Equity Fixed Asset Turns Growth Per Share 1-Year 3-Year 5-Year 10-Year Revenue % Operating Income % Earnings % Dividends % Book Value % Stock Total Return % Quarterly Revenue & EPS Revenue (Bil) Jun Sep Dec Mar Total Earnings Per Share () Revenue Growth Year On Year % Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. To order reprints, call To license the research, call ß

7 Morningstar Equity Analyst Report Page 7 of 10 Morningstar Equity Research Methodology Fundamental Analysis At Morningstar, we believe buying shares of superior businesses at a discount and allowing them to compound over time is the surest way to create wealth in the stock market. The long-term fundamentals of businesses, such as cash flow, competition, economic cycles, and stewardship, are our primary focus. Occasionally, this approach causes our recommendations to appear out of step with the market, but willingness to be contrarian is an important source of outperformance and a benefit of Morningstar s independence. Our analysts conduct primary research to inform our views on each firm s moat, fair value and uncertainty. Fundamental Analysis Economic Moat Rating Economic Moat Fair Value Estimate Uncertainty Assessment QQQQQ QQQQ QQQ QQ Q Star Rating The economic moat concept is a cornerstone of Morningstar s investment philosophy and is used to distinguish high-quality companies with sustainable competitive advantages. An economic moat is a structural feature that allows a firm to sustain excess returns over a long period of time. Without a moat, a company s profits are more susceptible to competition. Companies with narrow moats are likely to achieve normalized excess returns beyond 10 years while wide-moat companies are likely to sustain excess returns beyond 20 years. The longer a firm generates economic profits, the higher its intrinsic value. We believe lower-quality no-moat companies will see their returns gravitate toward the firm s cost of capital more quickly than companies with moats will. We have identified five sources of economic moats: intangible assets, switching costs, network effect, cost advantage, and efficient scale. Fair Value Estimate Our analyst-driven fair value estimate is based primarily on Morningstar s proprietary three-stage discounted cash flow model. We also use a variety of supplementary fundamental methods to triangulate a company s worth, such as sum-of-the-parts, multiples, and yields, among others. We re looking well beyond next quarter to determine the cash-generating ability of a company s assets because we believe the market price of a security will migrate toward the firm s intrinsic value over time. Economic moats are not only an important sorting mechanism for quality in our framework, but the designation also directly contributes to our estimate of a company s intrinsic value through sustained excess returns on invested capital. Uncertainty Rating The Morningstar Uncertainty Rating demonstrates our assessment of a firm s cash flow predictability, or valuation risk. From this rating, we determine appropriate margins of safety: The higher the uncertainty, the wider the margin of safety around our fair value estimate before our recommendations are triggered. Our uncertainty ratings are low, medium, high, very high, and extreme. With each uncertainty rating is a corresponding set of price/fair value ratios that drive our recommendations: Lower price/fair value ratios (<1.0) lead to positive recommendations, while higher price/fair value Economic Moat COM PETITIVE FORCES WIDE NARROW NONE COMPANY PROFITABILITY Moat Sources: Intangible Assets Switching Costs Network Effect Cost Advantage Efficient Scale

8 Morningstar Equity Analyst Report Page 8 of 10 Morningstar Equity Research Methodology ratios (>1.0) lead to negative recommendations. In very rare cases, the fair value estimate for a firm is so unpredictable that a margin of safety cannot be properly estimated. For these firms, we use a rating of extreme. Very high and extreme uncertainty companies tend to have higher risk and volatility. Quantitatively Driven Valuations To complement our analysts work, we produce Quantitative Ratings for a much larger universe of companies. These ratings are generated by statistical models that are meant to divine the relationships between Morningstar s analyst-driven ratings and key financial data points. Consequently, our quantitative ratings are directly analogous to our analyst-driven ratings. Quantitative Fair Value Estimate (QFVE): The QFVE is analogous to Morningstar s fair value estimate for stocks. It represents the per-share value of the equity of a company. The QFVE is displayed in the same currency as the company s last close price. Valuation: The valuation is based on the ratio of a company s quantitative fair value estimate to its last close price. Quantitative Uncertainty: This rating describes our level of uncertainty about the accuracy of our quantitative fair value estimate. In this way it is analogous to Morningstar s fair value uncertainty ratings. Understanding Differences Between Analyst and Quantitative Valuations If our analyst-driven ratings did not sometimes differ from our quantitative ratings, there would be little value in producing both. Differences occur because our quantitative ratings are essentially a highly sophisticated analysis of the analyst-driven ratings of comparable companies. If a company is unique and has few comparable companies, the quantitative model will have more trouble assigning correct ratings, while an analyst will have an easier time recognizing the true characteristics of the company. On the other hand, the quantitative models incorporate new data efficiently and consistently. Empirically, we find quantitative ratings and analyst-driven ratings to be equally powerful predictors of future performance. When the analystdriven rating and the quantitative rating agree, we find the ratings to be much more predictive than when they differ. In this way, they provide an excellent second opinion for each other. When the ratings differ, it may be wise to follow the analyst s rating for a truly unique company with its own special situation, and follow the quantitative rating when a company has several reasonable comparable companies and relevant information is flowing at a rapid pace. Quantitative Economic Moat: The quantitative moat rating is analogous to Morningstar s analyst-driven economic moat rating in that both are meant to describe the strength of a firm s competitive position. Uncertainty Rating Price/Fair Value % 95% 135% 105% 110% 80% 90% 70% 155% 85% 115% 60% 175% 80% Low Medium High Very High Uncertainty Rating 125% 50% Q QQ QQQ QQQQ QQQQQ

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