[DR. REDDY'S LOGO]
DR. REDDY'S LABORATORIES LTD.
7-1-27 Ameerpet
Hyderabad 500 016 India
Tel: 91 40 373 1946
Fax: 91 40 373 1955
www.drreddys.com
March 1, 2006
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
Washington, D.C. 20549
United States of America
Re: Dr. Reddy's Laboratories Limited
Form 20-F for Fiscal Year Ended March 31, 2005
Letter from Securities and Exchange Commission
dated February 2, 2006
File No. 001-15182
----------------------------------------------
Dear Mr. Rosenberg:
This letter is sent to you in reference to your letter dated February 2, 2006
requesting information in connection with Dr. Reddy's Laboratories Limited's
Form 20-F for the fiscal year ended March 31, 2005. We set forth below our
responses to your letter. For your convenience, your requests for supplemental
information have been restated below in italics.
FORM 20-F FOR FISCAL YEAR ENDED MARCH 31, 2005
GENERAL
1. We reference the comment letter issued to you by our Office of Global
Security Risk on September 30, 2005 regarding certain business
interests and contracts in countries that have been identified as state
sponsors of terrorism and note that you have not yet responded to those
comments. We request that you respond to the comments issued in that
letter under separate cover.
Response: We submitted a detailed reply to this letter on February 10, 2006, a
copy of which is attached.
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
CRITICAL ACCOUNTING POLICIES
ACCOUNTING ESTIMATES, PAGE 49
2. We acknowledge your revenue recognition policy as noted herein and
within your "Summary of Significant Accounting Policies" in the
accompanying notes to your consolidated financial statements. We
believe that your disclosure related to estimates of items that reduce
your gross revenue, namely sales returns, could be defined and
improved. Please provide us with the following information in a
disclosure-type format:
a). The effect that could result from using assumptions that are
reasonably likely to occur to estimate sales returns other than
those upon which your current recorded estimate is based. For
example, please provide a range of reasonably likely amounts or
another type of sensitivity analysis.
b). Factors, other than historical trends, that you utilize to
estimate your sales returns accrual, such as levels of inventory
in the distribution channels; estimated remaining product shelf
life; price changes from competitors and introductions of new or
generic competing products.
c). To the extent that the information you consider in b. is
quantifiable, discuss both quantitative and qualitative factors
and the extent of availability and your use of information from
external sources; for example, end-customer demand data compared
to inventory levels. In discussing your estimate of product
returns, provide additional information regarding the total amount
of product in sales dollars that could potentially be returned as
of the most recent balance sheet date, disaggregated by expiration
period.
Response: The Staff's comments are duly noted. In future filings we will expand
our discussions in the critical accounting policies section of the Management's
Discussion and Analysis of Financial Condition and Results of Operations
regarding estimates for sales return allowance based on the Staff's comments.
We account for sales returns in accordance with SFAS 48 by establishing an
accrual in an amount equal to our estimate of sales recorded for which the
related products are expected to be returned. In 2005, 2004 and 2003, allowances
for sales returns were INR 105.2 million,
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 3
INR 169.5 million and INR 193.2 million, respectively, which represented 0.55%,
0.84% and 1.07% of our net sales for these years.
We deal in various products and operate in various markets and our estimate is
determined primarily by our experience in these markets for our products. For
returns of established products, we determine an estimate of the sales returns
accrual primarily based on historical experience regarding sales returns, but we
also consider other factors that could impact sales returns to the extent
relevant in our business. With respect to new products that we introduce, they
are either extensions of an existing line of products or in a generally
therapeutic category where we have historical experience. Our new product
launches have historically been in therapeutic categories where established
products exist and are sold either by our competitors or us. We have not yet
introduced any products in any new therapeutic category where the acceptance of
such products is not known. Therefore, we believe that the amount of sales
returns for our newly launched products are not significantly different from
current products marketed by our competitors or us. Consequently, we do not
expect sales returns for new products to be significantly different than
expected sales returns of current products. Further, we evaluate the sales
returns of all of our products at the end of each reporting period and necessary
adjustments, if any, are made. However, to date, no significant revision has
been determined to be necessary.
Other factors that we consider in our estimate of sales returns include levels
of inventory in the distribution channel, estimated shelf life, product
discontinuances, price changes of competitive products, introductions of generic
products and introductions of competitive new products to the extent each of
them has an impact on our business and markets. We consider all of these factors
and adjust our accrual to reflect actual experience.
We have provided below in a disclosure type format the factors that we consider
in estimating sales returns. In respect of certain markets, we consider the
level of inventory in the distribution channel and determine whether an
adjustment to our sales return accrual is appropriate. For example, if the level
of inventory in the distribution channel increases, we analyze the reasons for
the increase and if the reasons indicate that sales returns will be larger than
expected, we adjust the sales returns accrual. Further, the products and markets
in which we operate have a rapid distribution cycle and therefore products are
sold to the ultimate customer within a very short period of time. As a result,
the impact of changes in levels of inventory in the distribution channel
historically has not caused any material changes in our return estimates.
Further, we have not had any significant product recalls / discontinuances
within our product portfolio, which could potentially require us to make
material changes to our estimates.
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 4
o End-customer demand: Due to the nature of our business, our API (Active
Pharmaceuticals Ingredients) sales cycle is linked to the end customer
demand of our customers (large pharmaceutical companies). These customers
provide us with firm sale orders. These sales are generally not returnable
other than for quality defects. In our Branded Formulation segment, our
distributor inventory holding in India (our key market) is less than 30
days. This is reflected in day's sales outstanding for receivables which
historically have been less than 30 days. This results in a rather quick
inventory turnover and cash conversion cycle and thus product returns have
not been significant in this large segment.
o Price change from competitors / New product launch: This is generally only
applicable to our U.S. Generics business, which for the fiscal year ended
March 31, 2005 was 11.45% of our total revenues. We believe that we have a
significant cost and competitive advantage as an Indian Generic producer
which makes us less vulnerable to the risks of price changes from
competitors and new product launches. In our Formulations and API segments,
most of the key countries in which we market and sell our products did not,
until recently, follow a regulated patent regime which created an open
market situation for product launches by large pharmaceutical companies
even as products were patent protected in regulated markets such as the
United States and the United Kingdom. The impact of new products introduced
or products going off patent in relation to our existing products was
therefore already factored into our historical analysis of returns, and the
number of products sold and sales quantities in our chosen markets were
very large.
o Product Shelf Life: Most of our products have a shelf life ranging from 12
to 36 months. As explained above, due to quick inventory turnover, cash
conversion cycles and firm orders from our pharmaceutical company
customers, the incidence of sales returns on account of product shelf life
is relatively low. Further, due to a large volume of relatively homogeneous
transactions, we believe that we are able to estimate future returns with
reasonable accuracy.
To summarize, factors such as level of inventory in the distribution channel,
end customer demand, price change from competitors and new product launches have
not significantly impacted our sales returns. Our accrual for sales returns
adequately reflects the impact of these factors, to the extent relevant, and
product shelf life and quality defects as explained above.
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 5
e).1 We note your presentation, in Note 22, of the roll-forwards of your sales
returns allowance for the financial statement periods presented. Please
supplement those roll-forwards with the following:
o current provision related to sales made in current period;
o current provision related to sales made in prior periods;
o actual returns or credits in current period related to sales made in
current period; and
o actual returns or credits in current period related to sales made in
prior periods.
Response: The Staff's comment is duly noted. The supplemental data has been
provided below:
- ----------------------------------------------------------------------------------------------------------------------------
AMOUNT IN RS. `000
- ----------------------------------------------------------------------------------------------------------------------------
2005 2004 2003
- ----------------------------------------------------------------------------------------------------------------------------
PARTICULARS
- ----------------------------------------------------------------------------------------------------------------------------
Current provision related to sales made in * * *
current period
- ----------------------------------------------------------------------------------------------------------------------------
Current provision related to sales made in prior * * *
periods
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL
- ----------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------
Actual returns or credits in current period 76,249 56,371 63,775
related to sales made in current period
- ----------------------------------------------------------------------------------------------------------------------------
Actual returns or credits in current period 33,792 102,247 125,325
related to sales made in prior period
- ----------------------------------------------------------------------------------------------------------------------------
TOTAL 110,041 158,618 189,100
- ----------------------------------------------------------------------------------------------------------------------------
* Our accrual for sales returns estimates are re-evaluated at the reporting
date and includes both current periods and previous periods. Therefore,
these are not separately identifiable.
Historically, our sales returns trend due to the various factors identified
above has ranged from 0.52% to 1.04% over the past five years, with an average
during such period of approximately 0.69% of gross sales. This range of
percentages would have the effect of an approximately USD 1 million reduction or
increase in our gross sales, which we believe will not change our sales return
estimates materially.
- ----------
1 We note that your letter does not contain a paragraph 2.d).
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 6
f). Finally, include information regarding the amount of and reason for period
to period fluctuations within your statement of operations with respect to
your sales returns allowance. Please address the effect that changes in
your estimates with respect to your sales returns allowance had on your
revenues and operations for the applicable periods.
Response: The Staff's comment is duly noted. We evaluate allowance for the sales
returns of all our products at the end of each reporting period and necessary
adjustments, if any, are made. However, to date, no significant revision has
been determined to be necessary. The period to period variation was primarily on
account of a change in our sales base and actual sales returns out of current
year sales, which were accounted for through this sales return allowance
account.
REVENUE RECOGNITION, PAGE 50
3. We note that you recognize amounts related to non-refundable up-front
license fees over the development period associated with the underlying
agreements, in proportion to the milestones earned under those
agreements. Please provide us with additional information that supports
this treatment, in particular with respect to the Novartis agreement,
as it seems that you do not recognize revenue in correlation with
services performed under the license agreements. Please consider and
reference the applicable provisions of SAB No. 104, Topic 13A, in your
response.
Response: The Staff's comment is duly noted. We refer you to comments 25 through
29 of the Staff comment letter dated January 12, 2001 in reference to our
Registration Statement on Form F-1 submitted to the Securities and Exchange
Commission on a confidential basis on September 29, 2000 and our response dated
May 21, 2003 to your letter dated May 7, 2003. Specifically, we refer you to our
response to comment number 28 in our counsel's letter of January 29, 2001, which
discussed in relation to the Novo Nordisk contracts how deferred license fees
are systematically recognized into income, and where we explained:
"Upfront license fees are amortized over the development period.
Milestone payments are recognized when earned as we have no future
obligations or continuing involvement pursuant to the License
Agreement. Upfront license fees are recognized when the milestone
payments are earned, in the proportion that the amount of each
milestone earned bears to the total milestone amounts agreed upon in
the License Agreement. The calculation is done as follows:
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 7
milestone payments received X total upfront fees
---------------------------
total expected milestone payments to be received
The upfront license fees are amortized over the development period in proportion
to the milestone payments received, as we believe that the milestone payments
are a fair representation of the progress made in the development of these
molecules.
The milestone payments during the development period increase as the risk
involved decreases. We believe that the milestone payments are a fair
representation of the extent of progress made in the development of these
molecules which may not spread evenly over the development period. We therefore
amortize the up-front license fees over the development period in proportion to
the milestone payments received.
A similar comment was received from the Staff on May 7, 2003 to which we
responded on May 21, 2003 explaining that we have continued with the accounting
treatment discussed with the Staff on a confidential basis. Our accounting
policy has not changed since that time.
We considered the specific facts and circumstances to determine the accounting
treatment for the Novartis contract and based on an evaluation of the contract,
we believe that we had continuing involvement in the research and development
phase of the molecule. We could not establish sufficient objective evidence to
separate the up-front fees from the milestone payments. Further, the ongoing
services being delivered to Novartis were essential to the customer (Novartis)
who received the expected benefits of the up-front payments and, as a result,
both were assessed as an integral package. We therefore needed to apply a
systematic and rational method to spread all of the upfront and milestone
payments over the development period.
We believe that the current method of accounting is in line with the Staff's
views in the Staff Accounting Bulletin 104 (SAB 104), Topic 13.A.3 (f) Non
Refundable fees, and best reflects the economic substance in the Novartis
transaction since May 2001, when the Novartis License Agreement was executed.
On May 30, 2004, the development was discontinued by Novartis and there were no
further obligations for either party under the License Agreement as confirmed by
Novartis. As a result, the upfront non-refundable license fee included under
"Deferred revenue" in the balance sheet was recognized as revenue during the
fiscal year ended March 31, 2005.
Subsequent to our discussions with the SEC staff in 2001 and our response dated
May 21, 2003 to your letter dated May 7 2003, there have been no further
developments in this matter.
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 8
As originally discussed with the Staff, we have continued to apply the same
accounting treatment to the up-front license fees which are deferred on a
systematic basis in proportion to the milestones. Further, as explained in Note
2(f) to our consolidated financial statements for the fiscal year ended March
31, 2005, page F-10, since the development activity with Novartis was terminated
by Novartis, the corresponding amount of deferred revenue was recognized in the
income statement in the fiscal year ended March 31, 2005.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. INVESTMENT IN AFFILIATE, PAGE F-23
4. Please provide us with your analysis according to the provisions of FIN
46R, particularly paragraph 5, in order to clarify your determination
that you do not need to consolidate Kunsham Rotam Reddy Pharmaceuticals
Co. Ltd.
Response: We have invested in China through a joint venture structure that we
originated in 2001. Our evaluation of the structure of Kunshan Rotam Reddy
Pharmaceuticals Co. Ltd. ("Reddy Kunshan") in accordance with the provisions of
FIN 46R "Consolidation of Variable Interest Entities" was primarily driven by
the governing documents of the joint venture, specifically the joint venture
agreement with Kunshan Double-Crane Pharmaceutical Co. Ltd. and Canada Rotam
Enterprises Company Ltd., of the British Virgin Islands. In accordance with this
agreement, the Board of Directors of Reddy Kunshan is comprised of seven
directors, of which three directors are our representatives. Under the terms of
the agreement, all decisions with respect to significant operating and financing
activities have to be taken after obtaining the majority approval of at least
five of the seven directors of the Board. Therefore, applying the consensus
reached in EITF 96-16, which provides that majority-owned investees should not
be consolidated when the minority has substantive rights that provide the
minority shareholder with the right to effectively participate in significant
decisions that would be expected to be related to the investee's ordinary course
of business, the investment had been accounted for under the equity method as
the minority shareholders have the ability to participate significantly in
operating decisions. The equity participation of 51.2% by Dr. Reddy's, 1.75% by
Kunshan Double-Crane Pharmaceutical Co. Ltd., a public sector enterprise in the
People's Republic of China, and 47.05% by Canada Rotam Enterprises Company Ltd.,
entitles the equity holders to participate in the profits and losses in
proportion to their economic interests. According to the terms and conditions of
the joint venture agreement, these interests do not carry variable interests. On
the effective date of application of FIN 46R, we evaluated whether the
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 9
equity interests met the definition of GAAP equity at risk based on the factors
outlined in Paragraph 5 of FIN 46R.
We believe that Paragraph 5.a of FIN 46R does not apply as the equity investment
at risk in Kunshan Rotam was more than 10% of the entity's total assets at the
time of our involvement with the entity and therefore is considered sufficient
to permit the entity to finance its activities without subordinated financial
support and thus does not qualify as a variable interest entity.
As a group, the holders of the equity investment at risk do not lack any one of
the three characteristics of a controlling financial interest as described in
paragraph 5.b of FIN 46R.
Further the equity investors as a group do not carry voting rights that are
disproportionate to their obligations to absorb the expected losses of the
entity and their rights to receive the expected residual returns of the entity
and therefore paragraph 5.c also does not apply to Kunshan Rotam.
Considering these factors, and also the fact that there has not been any
subsequent event that requires a re-evaluation under paragraph 7 of FIN 46R, we
believe that Kunshan Rotam Reddy Pharmaceuticals Limited is not a variable
interest entity in accordance with FIN 46R and therefore we have not
consolidated it.
16. RESEARCH AND DEVELOPMENT ARRANGEMENT, PAGE F-26
5. We note that you received an up-front payment of Rs. 985.4 million
($22.5 million U.S.) pursuant to your joint development and
commercialization agreement with I-VEN Pharma Capital Limited and that
you recognized Rs. 96.2 million ($2.2 million U.S.) of that up-front
payment as a credit to research and development expense for the period
ended March 31, 2005. Please provide us with additional information, in
a disclosure-type format, that supports your accounting treatment
related to this up-front payment; in particular the reason you did not
defer it and recognize it as revenue over the period you are committed
to perform research and development. Please reference the applicable
authoritative literature.
Response: During the fiscal year ended March 31, 2005, we entered into a joint
development and commercialization agreement with I-VEN Pharma Capital Limited
("I-VEN"). As per the terms of the agreement, I-VEN will fund up to fifty
percent of the project costs (development, registration and legal costs) related
to these products and the USFDA filings made by us for the United States of
America market. The terms of the arrangement do not require us to repay the
funds or purchase I-VEN's interest in the event of the failure of the
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 10
research and development. However, upon successful commercialization of these
products, we are required to pay I-VEN a royalty on net sales for a period of 5
years for each product. The first tranche of funds advanced by I-VEN of
Rs.985,388,000 was received on March 28, 2005. I-VEN has an option to further
invest USD 33.5 million (Rs.1,465,458,000) by March 31, 2006.
We evaluated facts and circumstances relating to the I-VEN funding arrangement
and determined that it does not meet the criteria of a sales transaction as per
SAB No. 104 since risks and rewards of product or service ownership are not
transferred. The ownership of all assets continues to rest with us. The
arrangement did not meet any of the criteria mentioned in paragraph 5 through 9
of SFAS No. 68, "Research and Development Arrangement".
This is because of the following:
o The arrangement is in the nature of a research and development project with
both partners sharing equal risks related to the outcome of the research
and the participation of I-VEN was to facilitate a faster
commercialization.
o As per paragraph 10 of SFAS No. 68, we have undertaken an obligation to
perform contractual services, i.e., to make product filings with the U.S.
FDA and deal with patent challenges in respect of certain Paragraph III and
IV filings. There is no obligation to refund any amounts to I-VEN
regardless of the outcome of the research and development activity.
We then evaluated if the entire amount of the up-front payment received of Rs.
985.4 million (USD 22.5 million) should be recognized as a credit to income
statement and concluded that since certain product filing milestones linked to
the product portfolio have been completed, a proportionate amount linked to the
completion should be recognized as a credit to research and development cost.
As per the joint development and commercialization agreement with I-VEN, we have
calculated the payment applicable to each of the Para III and Para IV filings,
which is approximately USD 0.9 million and USD 1.3 million, respectively.
During the fiscal year ended March 31, 2005, we completed one Paragraph III
filing and one Para IV filing pursuant to the agreement, for which we have taken
a proportionate amount of Rs. 96.2 million (USD 2.2 million) as a credit to
research and development cost.
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 11
23. OTHER (EXPENSE)/INCOME, NET, PAGE F-33
6. We note that you recorded the loss of Rs. 58.4 million related to your
sale of 51% of your formerly wholly owned interest in Compact Electric
Limited in "other income" in the statement of operations for the year
ended March 31, 2004. Please provide us with additional information
that supports your accounting treatment of presenting the amount
outside of operating income/loss and address your consideration of SFAS
No. 144, particularly paragraph 45. In addition, please clarify to us
what is included in the "other" line item and why it is appropriate to
include it outside of operating income/ loss. Clarify the reasons for
the differences between the presentation of operating income/ loss in
the annual report to shareholders and the presentation in your Form
20-F.
Response: The Staff's comment is duly noted. We believe that since Compact is a
component of our company, paragraph 45 of SFAS 144 does not apply. Also, we have
observed that there is diversity in practice regarding the classification of
gains and losses with respect to sales of majority-owned businesses. We also
note that this amount was not material to our results for the fiscal year ended
March 31, 2004. The amount reported as a loss in the fiscal year ended March 31,
2005 relates to our 49% holding which is properly classified.
The "Other" line is primarily comprised of sale of discarded (spent) chemicals,
scrap sales insurance claims received and excess liabilities written back as per
our accounting policy. In future filings we will disclose material items in the
"Other" line separately.
Certain items were presented as "Other operating income, net" in the annual
report to the stockholders for the fiscal year ended March 31, 2005 which were
erroneously presented in the annual report and subsequently corrected in the
Form 20-F. Accordingly, these items were reclassified under "Other
(expense)/income, net" in the consolidated financial statements presented in the
Form 20-F and appropriately disclosed in our filing.
We acknowledge that:
o our company is responsible for the adequacy and accuracy of the
disclosure in our SEC filings;
o staff comments or changes to disclosure in response to staff comments
do not foreclose the Commission from taking any action with respect to
our SEC filings; and
Jim B. Rosenberg
Senior Assistant Chief Accountant
Securities and Exchange Commission
March 1, 2006
Page 12
o our company may not assert staff comments as a defense in any
proceeding initiated by the Commission or any person under the federal
securities laws of the United States.
Should you have any concerns or questions, please call me at the number listed
above.
Respectfully submitted,
Dr. Reddy's Laboratories Limited
By: /s/ V. S. Vasudevan
----------------------------
V. S. VASUDEVAN
CHIEF FINANCIAL OFFICER