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Can Divis Lab USFDA alert be a contrarian opportunity?

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USFDA import alert hit Divis Lab stock few days back. To be sure its a pretty serious but the famous Seth Klarman once said:

“You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.”

But this strategy of buying on the way down is not meant to be used indiscriminately. One needs to be confident that a turnaround in business is likely. In situation like the one Divis Lab is in currently how does one make a judgement on its future prospects.

It is widely reported that the current unit under inspection contributes 20% of U.S. revenue for the firm.  Given that some APIs are exempted for now, and since in at least one of them the company is a market leader. The direct revenue impact may be less than 20%. Divis’ management in a recent concall said that they expect only a 5% impact on revenue. But considering that they may not immediately be able to export these exempted APIs through third party (as has been witnessed with other pharma companies). Their statements must be taken with a pinch of salt.

But apart from the impact of current USFDA ban one must take into account the possibility of cascading effects due to:

a. Other facilities of the company being brought under inspection (considering some of the comments from FDA in the 483 point to company officials being already aware of the issues with respect to quality). Here is the original 483 from the FDA website. Considering the nature of these findings, if other facilities are not brought into inspection that may in itself be a positive development as their might not be further dampening of revenue. But if that is not the case revenues may face further fall.

b. Other regulators (say EU/ U.K) waking up to carry out their own inspections as well which may result in further fall in revenues.

c. Effect on the company’s ability to introduce new products. If there is no sustainable damage to its ability due to this particular case then the growth from these products may provide some cushion to the company in the next 2-3 years ( assuming that it is the best case scenario for this issue to be resolved as of now).

Now lets look at the monthly stock chart of Divi’s lab:

Divis Lab FDA

Around its peak price around Aug ‘2016 markets were pricing 20-25% growth. The company last traded at its current price of 610 around june 14. That is 642 sales in jun ’14 v/s dec ’16 quarter sales of 976.50 and 167.93 june net profit v/s dec net profit of 268.32. That is about 35-40% de-growth in numbers.

So essentially in June 14 the price of around 600 was pricing in those numbers + 20% growth
So the question is what is today’s price pricing in?
a. better numbers than the ones in june 14 + further de-growth or
b. same numbers as in june 14 + flat or lower growth.

Either way it seems the current price may be factoring in a fall of more than 15-20% in revenues/ profits (closer to 30-40% or more). If the prices fall further it would be factoring an even bigger de-growth and/or longer recovery period.This is of course not accurate but only a rough gauge of value being assigned by the market. Other scenarios would be more optimistic and will only indicate that at the current price the stock is undervalued.

The fact is in the current scenario, analysis of past financial numbers is incomplete without considering these more qualitative factors. But the ultimate question to answer is this: Is it possible that the company will face a scenario of say 60-70% de-growth due to cascading effect of these factors? As that would mean significantly lower prices than the current price. But if that is unlikely then it could be a value buy.

But can elliott wave theory help us devise a strategy that takes into account the uncertainty associated with the stock?

I have shown a tentative long term labeling as per Elliott Wave Theory for Divis Lab. If this labeling is correct the price of 482 shouldn’t be violated. Wave 4 is an expanded flat correction and the fall from August 2016 peak is part of the C wave (within wave 4). This fall has a five wave structure which seems to be working in a 5th wave. The prices are also approaching a crucial long term trend line. Although it remains to be seen if it holds. One should probably look to enter if the prices bounce off after testing the trendline. The stop loss can be placed just below 482 (20-25% risk).

If the prices in fact head to 482. It would actually signify markets pricing in a bigger de-growth and either new adverse news would have hit the counter already or may be on the way. In which case the company will likely be grappling with these issues for a couple of years and the stock may go into a slumber for some time.

If however the prices manage to go over 711 (March 21 high), either substantial time would have passed (which would mean probability of some of the cascading effects materializing would have subsided) or we may see some +ve news hitting the counter (or on the way). Either way one can add to the position as we get more clarity on some of these points.

Considering the various qualitative uncertainties surrounding the stock this is probably a good way to play this contrarian call.

Disclosure: I currently don’t have any investment in this stock. Though I may make an investment in the stock after 5 days of publishing the report as per SEBI regulations.

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