Capex Formula

Murali K. Divi, Founder, Chairman and Managing Director of Hyderabad-based Divi's Laboratories, is known for his ability to spot business opportunities and for his love of chemistry. He has built a company that has carved out a space for itself in the field of custom synthesis of active pharmaceutical ingredients (APIs) and intermediates for global companies. In some cases, such as Naproxen Sodium (an anti-inflammatory drug) and Dextromethorphan (a cough suppressant), it is a dominant supplier.

These, and a combination of other factors, have helped the company weather the turbulent times that pharma companies have been facing, especially those in India - pricing pressure in markets such as the US, a move towards lower prices in India and policy uncertainty. To top it all, developments in China have created supply disruptions.

"The API manufacturing space in India had been experiencing stiff competition from China for the past few decades. However, China has had several disruptions in manufacturing and supply of these materials owing to pollution and other operational concerns," says Aditya Khemka, AVP, Equity Investments (Healthcare), DSP Investment Managers. Due to the disruption, he says, many large global customers are looking to either entirely switch to or add an alternative source apart from China. "Indian API production is more or less at par with China in terms of cost and most Indian API manufacturing companies have embarked on aggressive capital expenditure plans to meet the demand. Given that global customers would continue to look to diversify from China as a source of raw material, Indian companies that are able to meet this demand should continue to do well," adds Khemka.

There are other elements to consider, too. Analysts often refer to the hypertension drug Valsartan, which was recalled globally because of contaminated APIs supplied from China. Divi's was a beneficiary in this case as supply disruptions from China led global pharma majors to look for other sources. So, it is not surprising that Divi's has been investing aggressively in expanding its manufacturing capacity.

At the company's 29th Annual General Meeting in August 2019, Divi told shareholders: "In view of the series of accidents in chemical plants in China and environment-related issues, there has been an impact of shortage of starting materials and raw materials for the pharmaceutical industry in India, Europe and rest of the world. The industry needs preparedness to meet the challenges of supply constraints of these starting materials as well as APIs." Several formulation companies, he reminded, were totally dependent on APIs and advanced intermediates from China. "Due to non-availability of these materials, these formulation companies faced disruption in operations and consequent erosion of profits. Several customers have been approaching us for support for supply of APIs. Divi's is already backward integrated in many products like Naproxen, Dextromethorphan, etc." Not just that, he said, the company had "taken up backward integration programmes for all its major products to reduce dependency on Chinese raw materials. While doing so, the company has chalked out plans for building future chemistry blocks with efficient and modern technology with automation."

A senior executive of a rival company, who did not wish to be named, pointed to the move by Divi's to invest in expanding capacity and talking of a capex of around Rs 1,700 crore by the end of this year. "This would help the company be better prepared to fill in when supply disruptions occur in the market."

When most companies are taking time to resolve issues with the US drug regulator, Divi's achieved successful closure of audits by the US FDA (US Food and Drug Administration) for its unit-II at Visakhapatnam in 2017/18 and got it inspected by the drug regulator in June 2019 without any observations.

Therefore, notwithstanding a relatively weak second quarter this year, Deepak Malik, an analyst at Edelweiss, says, "Over the past three years, what stands out, other than getting the import alert lifted, is its ability to consistently deliver double-digit growth both in top line and earnings; talk of a strong 30 per cent RoC (return on capital); apart from not having debt on the books and yet aggressively making capex investments."

At the AGM, he did not miss to add: "While most of the companies in India and elsewhere are cash-strapped and have significant debts, Divi's is investing in capex programmes with its own cash surpluses." The question now is how it executes the capacity expansion and monetises it.