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Subject: Dr.Reddy's Labs RDY Date: 9/18/2004 5:49 PM
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Dr. Reddy's Labs is an Indian company with a substantial part of operations conducted there and most of the assets located in India. The Indian government controls the economy and India has enjoyed a liberalization and deregulation that has favorably impacted business. Witness the most recent turmoil when a party came to power that was considered more conservative and less favorable to business--the market swooned. Ms. Ghandi did eventually step aside and the economy regained momentum.Any investment in India must take into account the position of the current government on further privatization and liberalization of business.

The other consideration regarding Indian business is the possibility of natural disasters and the pressure of dense population. Main facilities are located in the Hyderabad area. This region has experienced earthquakes, floods and droughts in the past and has experienced droughts in recent years. In the event of a drought so serious that the drinking water in the region is limited, the government would cut the supply of water to all industries including RDY facilities and this would adversely affect production capabilities, reduce the volume of products manufactured and reduce revenues. These are things not normally considered when dealing with a US based corporation. Water and drought are very real concerns in parts of India. Water is controlled by the government.

Wage costs in India have historically been significantly lower than wage costs in
developed countries and have been one of their competitive strengths. However, wage increases in India may prevent them from sustaining this competitive advantage and may negatively affect profit margins. The low cost advantage of a country like India is what has made outsourcing so profitable. There may come a time when this low wage advantage disappears.

Dr. Reddy's Laboratories Limited was incorporated in India in 1956, by its promoter, Dr. K. Anji Reddy as a Private Limited Company on February 24, 1984. They converted to a Public Limited Company in November 1985 and listed on the Indian Stock Exchanges in August 1986 and on the New York Stock Exchange on April 11, 2001. They haven't been readily available to US investors for long.

The Business

They originally concentrated the business on the manufacturer of active pharmaceutical ingredients (API); first for Indian consumption and then as an export. RDY now exports to 70 countries.

The formulations operations began in 1987, and gradually grew into formulations of a large number of new products. The main difference between active pharmaceutical ingredients, formulations and generics is the form in which they are produced and the way they are packaged. While active pharmaceutical ingredients are distributed in bulk, formulations and generics are packaged in individual doses for consumption by the patient. They began to export formulations in 1992, mainly to Russia and other countries of the former Soviet Union. They currently market formulations in over 38 countries.
Branded formulations accounted for 38.0% of revenues in fiscal 2003.

Recent acquisitions

Between November 1999 and January 2000, RDY acquired a 87.1% equity stake in American Remedies Limited, a publicly traded Indian pharmaceutical company primarily engaged in domestic manufacturing and marketing of formulations and active pharmaceutical ingredients for allopathic and natural products. The cash consideration paid was Rs.896.9 million (U.S.$19.5 million). On October 26, 2001, they acquired the balance of the shares (12.9% interest)

In February 2001, they completed a merger with Cheminor Drugs Limited a publicly traded Indian pharmaceutical company engaged in the manufacture of active
pharmaceutical ingredients, intermediates and generic formulations.Approximately 5.1 million equity shares of the company were issued to the Cheminor shareholders.

The generics segment started operations in the second half of fiscal 2001, with its primary focus on the regulated markets of the United States and Europe. This segment accounted for 23.7% of revenues in fiscal 2003--up from 2.1% in 2001 As of March 31, 2003, they had 11 Abbreviated New Drug Applications approved by the U.S. FDA and 23 ANDAs were pending approval.

In 2002,they acquired BMS Laboratories Limited, a U.K.-based generics company (now Dr. Reddy's Laboratories (EU) Ltd.) for 9.16 million pounds sterling. BMS Laboratories and its subsidiary, Meridian Healthcare (UK) are now Dr. Reddy's Laboratories (UK) Ltd.). Of the 9.16 million, 2.82 million pounds sterling is a promissory notes payable over a period of 4-1/2 years, which includes contingent consideration of 1.00 million pounds sterling.

Strategy and growth

Over the next few years, RDY intends to become an integrated, global, mid-sized pharmaceutical company. They will focus on a global, discovery-led pharmaceutical approach and less on the bulk sales and generics. They have already started to implement the strategy by almost doubling R&D. This has eaten away at net and earnings per share and may in part account for the nearly halving of the price per share. They are pushing into biotech.

They are leveraging the scale and the strengths built into the core businesses of active pharmaceutical ingredients and intermediates(which has been very profitable), formulations and generics(profitable as of 2002 where it made up an increased percentage of revenue) to provide a platform for continued growth. Over the next 5-7 years, they plan to grow these businesses to strengthen the cash flows necessary to support the discovery-led expansion.

This may prove to be a risky strategy--drug discovery is a long, costly process. They may destroy the business that was so profitable to venture into areas that are highly risky. Biotech is known for its tendency to consume huge amounts of cash with very little return.

Percentages of each segment's contributions to revenue
Formulations 38%
Active pharmaceutical ingredients and intermediates 35.1%
Generics 23.7%
Diagnostics 2.4%
Other 0.8%
Formulations and generics account for almost 62% of the business now.

Formulations sales percentage by country
India 62.7%
Russia 24.2
Brazil 0.1
Venezuela 0.9
Vietnam 0.9
Sri Lanka 0.7
Myanmar 0.7
Trinidad 0.4
Others 9.4

India is the largest market. In India and Russia they sell their branded formulations. In the US and other developed nations, they sell generics not the Reddy branded drugs.

Active pharmaceutical ingredients(bulk) by country
India 27.6%
Bangladesh 1.4
Other emerging nations 24.9%
US 37.8%
Europe 7.3%
Japan 0.9%

Generics Segment

Generics operations started in the second half of fiscal 2001. Generic products are marketed principally in North America (United States and Canada) and the United Kingdom. Growth in the generic pharmaceutical industry has been driven by the increased market acceptance of generic drugs, as well as the number of brand drugs for which patent terms and/or other market exclusivities have expired or been determined to be invalid.

RDY has recently been involved in patent disputes for Lamisil(Novartis) and Plavix(Sanofi and BMY). It lost both.

This segment accounted for 23.7% of total revenues for fiscal 2003. It is becoming an increasingly larger percentage of revenue. Revenues from sales of fluoxetine(Prozac) accounted for 41.8% of total revenues in this segment in fiscal 2003. Significant product launches in fiscal 2003 included tizanidine in the United States and omeprazole in the United Kingdom.
 
Product Fiscal 2003 Revenues % Total


(in millions)

Fluoxetine capsules U.S.$ 37.6 41.8%
Ranitidine tablets 4.7 5.3
Oxaprozin tablets 0.2 0.2
Famotidine tablets 3.6 3.9
Ranitidine capsules 4.1 4.6
Omeprazole Capsules 6.0 6.6
Tizanidine tablets 16.4 18.2


This is after approximately one year in the generics business in the US
The sold a lot of Prozac(fluoxetine)which is now slowing
The formulation best sellers in India are very different and consist mostly of pain
medications, GI drugs and antibiotics.

Diagnostics, critical care and biotech


2001 2002 2003

Division Revenues % Total Revenues % Total Revenues % Total

(in (in (in millions)
millions) millions)
Critical Care Rs. 194.1 56.7% Rs. 230.2 53.7% Rs. 235.5 U.S.$ 4.9 55.0%
Diagnostics 148.1 43.3 161.4 37.6 136.8 2.9 31.9
Biotechnology -- -- 37.5 8.7 55.9 1.2 13.1


Total Rs. 342.2 100.0% Rs. 429.1 100.0% 428.2 U.S.$ 9 100.0%


Diagnostics and critical care are sold mostly in Russia and India
Key diagnostic product is Fast Forward HcG Velocit, a pregnancy detection kit.

The critical care business accounted for 55% of the segment's revenues in fiscal 2003. It includes mainly cancer drugs. Since its inception in fiscal 1999, this business has grown at a compound annual growth rate of 78%.

In biotech, they intend to provide therapeutic products and diagnostic proteins using recombinant DNA. We are also in the process of developing our capabilities in molecular biology, cell culture, fermentation, downstream processing and hybridoma technology. They are one of the few Indian companies that have capabilities in the manufacture of biotechnological products--DNA cloning and bacterial and yeast fermentation to protein isolation and purification.

In July 2001, they launched their first biotechnology product, Grastim, a human
granulocyte colony-stimulating factor(promotes growth of white blood cells). Sales of Grastim for fiscal 2003 were Rs.55.86 million.

Drug discovery

As part of research and development strategy, they established Reddy U.S. Therapeutics in Atlanta, Georgia. By setting up a research facility in the United States,they have better access to research scientists in the United States. RDY has plans to continue spending in R&D for developing novel drugs. They focus on new drug discovery and development in the areas of diabetes, cancer, bacterial infections, cardiovascular and metabolic disorders. The compounds currently under development include:
 

Compound Therapeutic Area Development Status
DRF 2593 Diabetes Phase II completed
DRF 4158 Metabolic disorders Preclinical completed
DRF 4832 Metabolic disorders Late preclinical
DRF 1042 Cancer Phase I completed
DRF 1644 Cancer Preclinical completed
DRF 11057 Bacterial infections Preclinical
DRF 10945 Metabolic disorders/Dyslipidemia Preclinical
RUS 3108 Cardiovascular Preclinical

I include this to show all stages of development are very early and there is nothing close to marketability. They are going to have to pour R&D dollars into these projects for years. And the other business segments are going to foot the bill. Can they grow in profitability while waiting for R&D to produce results? Luckily, R&D for generics and API, is growing faster than R&D for biotech. The API and generics sectors are where their core competency lies and it would be suicide to abandon them.Research and
development costs increased by 85.4% primarily due to an expansion of activities in the generics and API segments and increased research and development projects in the drug discovery segment during fiscal 2003. Research and development costs in generics and API together increased by 163.1% Research and development costs in drug
discovery increased by 13.8%.

Income statement ratios

Annual

2003 2002 2001 2000 1999
gross margins 53% 57% 59% 48% 40%
operating margins 10% 18% 30% 14% 11%
net margins 12% 19% 30% 7% 4%
growth revenue 11% 9% 51% 38% --
growth gross 5% 5% 86% 62% --
growth operating -35% -36% 239% 73% --
growth net -27% -31% 560% 164% --
growth COGS 19% 14% 20% 21% --
growth SGA 29% 39% 30% 65% --
growth EPS diluted -27% -31% 450% 162% --
growth EPS operations -27% -31% 451% 162% --
inventory/COGS 32% 35% 32% 33% 35%
R&D change 41% 89% 46% 45% --
tax rate 3% 12% 3% 22% 30%

**RDY has a total of 123 brands--17 brands ranked either first or second in terms of sales in India in their respective product categories.

**Sales of formulations in India grew 16.3% in fiscal 2003 as against the industry
average of 5.6%. Russia is the largest export market in this segment and sales of
formulations accounted for 21.7% and 24.2% of our revenues in the formulations
segment in fiscal 2002 and 2003, respectively.

**Revenues increased by 8.7% to Rs.18,069.8 million in fiscal 2003 from Rs.16,622.7 million in fiscal 2002, primarily due to an increase in revenues from active
pharmaceutical ingredients and formulations.

**Sales to North America declined 3.1% to Rs.5,852.6 million in fiscal 2003 from Rs.6,037.2 million in fiscal 2002 primarily due to a decline in both volume of sales and prices of fluoxetine 40 mg capsules, which in turn was attributable to increased competition following expiration of the 180-day marketing exclusivity on January 29, 2002. The Prozac generic was the biggest reason for the huge increase in revenue in 2002 and by 2003, had declined significantly. They went up dramatically in 2002 and again 2004. The 2002 increase was certainly in response to the amazing growth in revenue. The increase in 2004 is a mystery. Earnings were up slightly but not
spectacular. They are no at almost the 52 week low and a two year low.

**Sales to Russia and other former Soviet Union countries increased by 29.6% in fiscal 2003 primarily due to an increase in both volume and sales price of formulations.

**Sales to Europe increased in 2003 by 79.4% primarily due to our acquisition of Dr. Reddy's Laboratories (EU) Limited (formerly BMS Laboratories Limited) and Dr. Reddy's Laboratories (UK) Limited (formerly Meridian Healthcare Limited)

**Sales in India constituted 62.7% of total formulations sales in fiscal 2003 and 66.2% in fiscal 2002. Sales of formulations in India increased by 7.8% in fiscal 2003. The overall increase in revenues was primarily the result of increases in both volume of sales and average prices of branded formulations: Nise(nimesulide), Gaity(gatifloxacin), Clamp(amoxycillin and clavulanate) , Stamlo Beta(amlodipine and atenolol), Omez(omeprazole) and Stamlo(amlodipine besylate).

** Revenues from new products introduced in fiscal 2003 amounted to Rs.140.1 million. The major contributors were Elina(amizolastine), Mintop Forte (minoxidil), and Dynapres (tamsulosin.) They continue to bring out branded formulations for mainly India. This is an important vehicle for growth--withou it they are dead in the water if R&D keeps increasing.

**Sales outside India increased by 25.2% --Russia constituted 65.0% of formulation sales outside India in fiscal 2003 and 64.3% in fiscal 2002. Russia is an important market and RDY believes that stability and strengthening economy have helped. You might wonder what the current terrorist attacks in Russia might do to the market.

**Active Pharmaceutical Ingredients and Intermediates were 35.1% of total revenues from this segment, compared to 31.5% in fiscal 2002. This segment(the original business) is growing slowly. Sales in North America increased by 53.7% and sales in India decreased slightly.

**Generics in 2003,were 23.7% of total revenue compared to 27.2% in fiscal 2002. The decline was primarily the result of a decrease in revenues from fluoxetine 40 mg capsules due to increased competition and reduction of prices following expiry of the 180-day exclusivity for sales in the United States on January 29, 2002.

**Sales in biotech increased by 49.1% due to an increase in sales of Grastim

**High margin items increasing sales in API helped lower cogs.

**Selling, general and administrative expenditures as a percentage of total
revenues was 27.8% in fiscal 2003, compared to 22.1% in fiscal 2002. This increase was largely due to an increase in legal and consultancy fees, software training and development, employee cost, marketing expenses and traveling expenses. Employee costs increased by 37.6% primarily due to an increased number of employees, including key recruitments at senior levels, and also due to an increase in the payment of performance bonuses.

** Marketing expenses increased by 12.8% due to an increase in commission on export revenues and increases in bad debt expenses, special campaigns, journal advertisement and business promotion expenses and clearing and forwarding agents servicing
expenses.

**Legal and consultancy expenses increased due to product patent filings and litigation expenses relating to various patent challenges as well as ANDA related submissions and corporate special projects.

Quarterly income statement ratios

June 04 March 04 Dec 03 Sep 03
growth revenue 117% -7% -4% 12%
growth gross income 6% -7% -8% 10%
growth EBIT 153% -138% -35% 15%
growth net income 9% -73% -36% 18%
growth EPS 7% -72% -37% 17%
gross margin 51% 2% 52% 54%
gross operating 3% -6% 14% 21%
gross net 3% 3% 12% 17%
growth COGS 10% -8% 0% 13%
growth SGA -21% 34% 5% 0%

The June quarter showed significant improvement over the March 04 quarter.
Revenue for quarter up from 04 same quarter
Russia continues growth in branded products

Net and operating compare poorly due to 61% increase in R&D.Investments in R&D increased by 61% to Rs 525 million from Rs 326 million in Q1FY04. As a %, R&D spend is at 10% of total revenues as against 7% in Q1 FY04. Of this, the Company invested 55% in drug discovery primarily on the ongoing clinical development of DRF 10945 in Canada. Still preclinical and is a medication for cholesterol/triglycerides. Continued heavy investment here is not guaranteed to pay off and is a long way from market.

RDY had increased forex losses(foreign exchange) that negatively impacted operating income. There was a gain in the same quarter 04.
Growth negatively impacted by decreasing generics sales --mainly loss of Prozac


Balance sheet ratios

Annual

2003 2002 2001 2000 1999
current ratio 3.4 3.6 2.2 -- --
quick ratio 0.95 2.34 2.16 0.10 0.13
AR growth 3% -5% 59% 37% --
DSO 68.2 73.5 84.1 79.9 80.3
inventory days 118.4 129.4 116.6 122.0 126
growth in payables 40% 50% 65% -23% --
growth in inventory 9% 27% 14% 17% --
CCC 93.8 124.2 140.8 158.4 137.8
tax rate 3% 12% 3% 22% 30%
ROE 12% 18% 32% 14% 6%
ROA 9% 15% 26% 6% 3%
ROIC 9% 15% 31% 13% 7%
debt/equity 2.4% 1.8% 1.0% 75.4% 83.8%
debt/capital 2% 2% 1% 43% 46%
book value 5.9 5.3 4.3 1.7 1.8
cash/share $1.24 $2.06 $1.45 $0.16 $0.23
NC WC 155.7 25.2 -45.9 -44.2 -46
change in NC WC 130.5 71.1 -1.7 1.8 -46
payable days outstanding 92.8 78.6 59.9 43.5 68.5

Nice balance sheet generally. Returns on capital and equity poor as net and op inc fall. R&D is expensed and this is hurting performance as it has yet to pay off and they have lost exclusivity of Prozac which was the main engine of growth in 2001-2002. ROE and ROIC were good in 2002 and it demonstrates the power of one good high revenue product. They need another homerun. RDY tried to get Plavix and Lamisil which would have been huge, but they lost.
Low debt and fair amounts of cash
DSO and inventory compare favorably with TEVA--in fact are better.
Growth in AR and DSO are not exceeding growth in revenue.

Credit is generally extended only to customers after they have established a satisfactory history of payment. The credit ratings of these customers are based on turnover, payment track record and the number of the customers' branches or pharmacies and are reviewed on a quarterly basis

Inventory turns and accounts receivables

The active pharmaceutical ingredients and intermediates business involves
long lead times in ordering and procuring raw materials and a long credit
period on sale of the final product. They purposely maintain high levels of stock to compensate for the long order replenishment cycle.
On average, they store the raw materials for no longer than six months before
using them in the manufacturing process. Cash flow statement ratios

Cash flow statement ratios

2003 2002 2001 2000 1999
growth in operating cash flow -8% -6% 651% -2% --
operating cash/revenue 20% 24% 28% 6% 8%
operating cash/net income 162% 128% 95% 83% 225%
operating cash/debt+interest 9.4 21.97 167.8 0.2 0.2
growth capex 53% 8% 193% 69%
capex/operating cash 62% 37% 32% 82% 47%
free cash flow 33.1 59.6 68.5 2.4 7.2
common shares 76.5 76.5 76.52 63.18 52.97
free cash flow/share $0.43 $0.78 $0.90 $0.04 $0.14

**Free cash flow positive
**Capex covered by operating cash flow
**Operating cash flow decreasing with respect to revenue--mostly due to inventory increase(explained below)
**Deb decreasing
**Net cash provided by operating activities decreased slightly in 2003 Net cash provided by operating activities consisted primarily of net income,depreciation and amortization and changes in working capital.

**During fiscal 2003, cash inflow increased due to improved collection in active pharmaceutical ingredients and intermediates and formulations segments, resulting in a decrease in accounts receivable, compared to an increase for fiscal 2002. The increase in fiscal 2002 was primarily due to the increase in revenues.

**During fiscal 2003, cash outflow increased due to an increase in inventories as compared to 2002, primarily due to an increase in business operations and product pipeline. The government of India announced that a Value Added Tax was being considered for implementation in April 2003. Due to uncertainty as to whether India would implement the VAT, or the effect of such tax system on businesses, we had higher inventories of finished goods in the formulations segment. In April 2003, the government of India decided not to implement the VAT.

**Trade accounts payable increased primarily due to an increase in material creditors.

**Cash used by investment activities was Rs.1,954.7 million in fiscal 2003, primarily accounted for by expenditures in property, plant and equipment, and cash paid for the acquisition of BMS Laboratories Ltd. and Merdian Healthcare (UK) Ltd.

**Cash used by investment activities was Rs.1,532.9 million in fiscal 2002, primarily due to expenditures in property, plant and equipment and intangibles. Expenditures on intangibles were mainly related to acquisition of Group Pharma brands, for marketing know-how and purchase of Nectar brands.
Capex grew in 2003

**Net cash used by financing activities for fiscal 2003 was Rs.153.0 million, primarily due to dividend payments.

Cash flow from financing activities for fiscal 2002 was Rs.1,421.8 million, primarily due to proceeds from issuances of ADSs. This was offset to some extent by repayment of short-term loans and long term loans and by dividend payments. The principal repayments were with respect to debentures, foreign currency loans and rupee term loans prior to their contractual maturities.

Growth

In emerging markets, the key focus markets are China, Brazil and other countries of the former Soviet Union, including Kazakhstan, Uzbekistan, Ukraine and Belarus, where they have a sales force to promote products. In several of these emerging markets, they market and distribute through local agents. They also have representative offices in several of these countries. In China they market through their equity investee, Kunshan Rotam Reddy Pharmaceuticals Co. Ltd. ("KRRP"). As of March 31, 2003, they hold a 51% equity interest in KRRP. Currently, RDY markets five products and has 15 products pending registration. They have 75 marketing representatives in China covering hospitals. As reported by Boston Consulting Group in their July 2002 report titled "Opportunities for Action in Health Care".

China's pharmaceutical market size was approximately U.S.$15.74 billion in 2002, registering a growth of 10.24%.

By 2010, China is expected to emerge as the fifth largest pharmaceutical market in the world, with revenue of over U.S.$24 billion.

Driving this growth is China's rapid economic development and its recent accession into the World Trade Organization.


In Brazil, RDY has established a wholly-owned subsidiary, Dr. Reddy's Farmaceutica do Brasil Ltda., to market our branded products.

In developed markets, the principal markets are North America, Europe and Japan. In the United States, over the next five years, a large number of products are expected to come off patent, providing significant opportunity for the active pharmaceutical ingredients business. They have been actively involved in the marketing of active pharmaceutical ingredients andintermediates in the United States for over a decade. They can sell active pharmaceutical ingredients in the United States only after submission of a drug master file ("DMF"). Any drug for which an ANDA is being filed must have a drug master file in place with respect to a particular supplier supplying the underlying active pharmaceutical ingredient. For European markets, they obtain a European DMF and, where applicable, a certificate of suitability or certificate of European Pharmacopoeia. They had 11 Abbreviated New Drug Applications approved by the U.S. FDA and 23 ANDAs were pending approval.

They currently have over 40 DMFs on file in the United States. For each of these, they are either already supplying the product or are waiting to supply the product when it comes off patent.

Insider ownership

Directors, together with members of their immediate families, in the aggregate,
beneficially approximately 26.02% of issued shares.


Competitors

Active Pharmaceutical Ingredients(API)

The API business in India is a mature business and hence intensely competitive. The business is highly fragmented with numerous small players, as there are cheaply available technologies and low investment requirements. Main competitors in India are Aurobindo Pharma Limited, Ranbaxy Laboratories Limited, Sun Pharmaceuticals Limited, Zydus Cadila Limited, Hetero Drugs Limited, Divi's Laboratories, Matrix Laboratories and Biocon India Limited.

Main competitors in the export market are Teva Pharmaceutical Industries Limited, Ranbaxy Laboratories Limited, Shasun Chemicals Limited and Cipla Limited.

Formulations

They compete with different companies in different countries, depending upon
therapeutic and product categories, and within each category upon dosage
strengths and drug delivery. According to Operations Research Group, they are the sixth largest formulation manufacturer in India, with a market share of 2.8% for fiscal 2003. Of the top ten participants in the Indian formulations market, three are multinational corporations and the rest are Indian corporations. The top five competitors in the Indian market are Glaxo SmithKline Pharmaceuticals Limited, Cipla Limited, Ranbaxy Laboratories Limited, Nicholas Piramal India Limited and Sun Pharmaceuticals Industries Limited.

In the export markets, they compete with local companies, multinational corporations and players from other emerging markets. In Russia and in most of the export markets, the company has products that occupy a niche between the less expensive localproducts and the more expensive products of the multinational corporations.

Debt

Principal Amount Annual Interest Rate

------------------- ---------------------
(in millions)
Debt
Working capital loans Rs. 146.3 U.S.$ 3.1 10.5%
Long term loan (including current portion) 184.7 3.9 2 %* to 12%

----- ---
Total Rs. 331.0 U.S.$ 7.0

Low debt levels but interest rates are not favorable.

Insider transactions

Here are some things that are troubling--interest-free loans to employees and transactions with companies owned by family members. If these things were found on the financial statements of US corporations, it would raise an immediate red flag. I am unsure how this type of business arrangement is regarded in India. I have several emails to the company and a finance professor to see what the attitude is in India. I know from Damodaran's lectures, that these kinds of arrangements with family members are standard operating procedure in India. Should it bias us? They have operated for decades like this.

Loans to Employees

We provide loans to employees who are not executive officers or directors to meet specified exigencies. These loans are all interest free and are repayable over fixed periods ranging from one month to eight years. As of March 31, 2001 and 2002, there were Rs.41.5 million (U.S.$0.9 million) and Rs.69.4 million (U.S.$1.4 million) in loans outstanding to employees. As of March 31, 2003, there were Rs.63.2 million (U.S.$1.3 million) in loans outstanding to employees.

Is it possible that because of the low wage structure in India, this service is a “perk” given to employees to keep them in the company rather than looking for better paying jobs? It is not extended to management.

The second unusual business practice we don't normally tolerate in US companies is giving business to family members. The room for abuse is large. Giving business to family members limits the company's use of competitive bids for contracts and it is more likely to overpay for services. It is hard to know if this is happening to RDY.


Dr. Reddy's Holdings Private Limited

Dr. Reddy's Holdings Private Limited is 100.0% owned by Dr. K. Anji Reddy and his family and is engaged in the business of manufacturing active pharmaceutical ingredients. It holds approximately 22.80% of our shares. In fiscal 2001, 2002 and 2003, we purchased products from Dr. Reddy's Holdings in the amount of, Rs. 3.1 million (U.S.$0.1 million), Rs.11.9 million (U.S.$0.2 million) and Rs.37.3 million (U.S.$ 0.8 million) respectively. In fiscal 2003, we sold products to Dr. Reddy's Holdings Private Limited in the amount of Rs.0.8 million (U.S.$0.02 million).

This particular company is more like a wholly owned subsidiary

AR Chloride

AR Chloride is a partnership firm in which the sister-in-law of our chairman, Dr. Anji Reddy, is a partner. The firm undertakes processing of raw materials and intermediates for us. In fiscal 2001, 2002 and 2003, we purchased Rs. 3.7 million (U.S.$0.1 million), Rs.3.9 million (U.S.$0.1 million) and Rs.7.1 million (U.S.$ 0.15 million) worth of
processing services from them.


Expenditures are in the neighborhood of $100,000 per year. If this is all they spend on processing, it doesn't seem like a high expense. However, just what does processing entail? Actually working with the chemicals or something as simple as putting them in bags?

S.R. Enterprises

S.R. Enterprises is a partnership firm in which the sister-in-law of our chairman, Dr. Anji Reddy, is a partner. This firm is engaged in the business of transportation and undertakes transport of raw materials and finished goods for us. In fiscal 2001, 2002 and 2003, we spent Rs.0.02 million (U.S.$364.0), Rs.4.5 million (U.S.$92,156) and Rs.4.3 million (U.S.$ 0.1 million)respectively on transportation services from S.R.
Enterprises.


Transport where? To the airport? The train station? Overseas? To local Indian
distributors? Details are too sketchy to make a judgment on the need for this service. I intend to pose these questions to the co.

Diana Hotels Limited

Dr. K. Anji Reddy, Mr. G.V. Prasad and Mr. Satish Reddy Kallam are directors of Diana Hotels Limited. In fiscal 2001, 2002 and 2003 we spent Rs. 7.7 million (U.S.$0.2 million) Rs.5.7 million (U.S.$0.1 million) and Rs.7.1 million (U.S.$0.15 million) respectively on hotel services from Diana Hotels.

Why? For travels around India on business? Vacations? To put up clients visiting for meetings?

Employee loans

Certain employee loans amounting to Rs.7,000 and Rs.Nil as of March 31, 2002 and 2003, respectively, do not have any fixed repayment terms.
As of March 31, 2003, the required repayments of employee loans, other than those that do not have any fixed repayment terms, granted for purchase of vehicles and property are given below:

Repayable in the year ending March 31:



(In
thousands)
2004 Rs. 22,863
2005 14,836
2006 12,807
2007 8,220
2008 3,905
Thereafter 599

------
Rs. 63,230

------


That is $1.4 million in US currency. I have deducted this amount from EPS in the DCF.

Options

The options grants and outstanding are small compared to US corporations.They represent a total dilution 0.01% rounded up.I did not enter them into calculations.The dilution is negligible. There are some very interesting differences in Indian business models. They do not hesitate to give business to family and they loan money to employees, but the options are not abused and management may cash in on some related party business transactions, but they don't take big options grants and management doesn't take loans. It is as if the company is run for the benefit of employees and family.

Outstanding 543,871 -- -- --

-----------
Exercisable 69,500 Rs. 997.13 Rs. 997.13 47
-----------

Weighted average grant date fair values for options granted during the years ended March 31, 2002 and March 31, 2003 are Rs.418.2 and Rs.404.5 respectively.

DCF

The cost to the company from loans is 2¢ per share

ROE*retention ratio= 49% including R&D
ROE*retention ratio=38% without R&D

These growth rates are unrealistic and the product of huge increases in working capital. The company has actually been decreasing EPS.
I used 10% growth for 5 years and 3% in stable growth.
Beta was 1
cost of equity 9.7%
Capex exceeds depreciation 1005 in stable growth
Capex, depreciation working capital increase at the same rate as earnings

No deduction for options
The value for the company $5.06

If you were to take R&D as a capital expense and remove it is an operating expense,the value of RDY is $14.16.

This company is not a clear cut case for a buy. I tend to not want to include the R&D expense as operating expense and see it clearly as investment in the future. In RDY's case, they are attempting to completely alter the course of the company from a small purveyor of chemicals to a competitive global pharmaceutical company.

They have a catalog of successful active pharmaceuticals to provide revenue and provide raw materials for their own drug manufacture. This vertical integration helps lower cost. They also have successful formulations. Before the transition to heavy R&D spending and working capital increases, they were a fairly profitable corporation. Betting on them to successfully make the transition is far from a sure thing. At least they have a stream of revenue to pay for R&D and experience in the drug formulation business. The question remains, can they make R&D pay off?They have no drugs in discovery nearing marketability and this will be a long endeavor.

Before investing I would like to see them start to balance their expenditures and income and return to decent growth. They have been declining yoy and for the last two quarters. Undoubtedly, that is why the price has been nearly halved in the last year. At the current price of $17 they are something of a gamble.

I like the company and like their aggressive pursuit of generic candidates. If they win some litigation and can add a blockbuster to their stable as they did with Prozac, I would be more inclined to buy. They are after Plavix and Lamisil--two big sellers. If they win one of these and the price isn't too steep, a buy would be in order.
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