Divis Lab was hit by US FDA import alert recently. To be sure its 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.”
You should not indiscriminately buy on the way down. You need 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?
Potential Revenue Impact on Divis Lab
It is widely reported that the current unit under inspection contributes 20% of U.S. revenue for the firm. Some APIs are exempted from this ban for now. Considering that 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. However since they may not immediately be able to export these exempted APIs through third party, their statements must be taken with a pinch of salt.
CASCADING EFFECTS
Apart from the impact of current USFDA ban one must take into account the possibility of cascading effects due to:
a. It is possible that other facilities of the company are brought under inspection. This is because some of the comments in the 483 point to company officials being already aware of the issues. 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. However if that is not the case revenues may face further fall.
b. Other regulators (say EU/ U.K) may carry out their own inspections as well which may further dent 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. Here we are assuming that resolution of FDA issues won’t take more than 2-3 years.
Reconciling charts with about ‘fundamentals’ of Divis Lab
Now lets look at the monthly stock chart of Divi’s lab:
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 from here it would be factoring an even bigger de-growth and/or longer recovery period. This is of course only a rough gauge of value assigned by the market. Other scenarios are more optimistic and indicate that 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?
If that is the case it would mean significantly lower prices than the current price. But if that is unlikely then it could be a value buy.
Now let’s see how elliott wave theory helps us in devising a strategy that takes into account the uncertainty associated with the stock.
Navigating Risks Using Elliott Wave Theory
The chart shows a tentative long term labeling as per Elliott Wave Theory for Divis Lab. If this labeling is correct the price of 482 won’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 looks like 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. Place stop loss just below 482 (20-25% risk).
If the prices in fact head to 482 it would mean markets are pricing in a bigger de-growth. This means either new adverse news would have hit the counter already or it may be on the way. In this case the company is like to grapple with these issues for a couple of years. Then we expect the stock price to 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. I may make an investment in the stock after 5 days of publishing the report as per SEBI regulations.
