Could there be a scarier company in the world than Dr. Reddy's Laboratories (NYSE:RDY)? Dr. Reddy's is a generic drug manufacturer, which is a tough business to start with. But there's more. It's an Indian drug maker with an empty pipeline and a strategy that leaves it with the occasional blistering by Wall Street, or its Mumbai equivalent.

Almost three-quarters of the company's drug applications in the U.S. involve challenges of existing patents by other companies. This is pretty simple: Dr. Reddy's files for the right to market a drug in countries where an existing company has a dramatically similar product already on the market. Earlier this month, Dr. Reddy's lost in a court decision that blocked it from offering its own version of Pfizer's (NYSE:PFE) hypertension drug Norvasc, which has nearly $2 billion in annual revenues. The setback sent Dr. Reddy's stock down more that 18%, scotching more than $400 million in market capitalization.

This may seem like bad news, and for one simple reason: It is. The company was so confident that it would have a positive outcome on the case that it had already set up infrastructure in the U.S. to offer its amlodepine maleate (AmVaz) hypertension drug, which was to be the company's first specialty drug offering.

Drugs and lawyers
Dr. Reddy's has a booming business in pharmaceutical ingredient development and branded medications that it sells throughout the developing world. Its largest market is India, though, its sales in Russia and in China are growing even faster. In 1999, the company had revenues of $138 million; in 2002, it topped $380 million, a growth of more than 175% over the period. Revenues per share have increased over that time period from $2.13 to $5.00. Dr. Reddy's failed to make a profit in 1999, but in 2003 it earned $74 million, or $0.97 per share.

So, when the company's market cap gets blitzed for $400 million on the loss of a drug that was worth $200 million, I get interested. Could we have a Hidden Gem in Dr. Reddy's? It has a great deal going for it, though, the company's patent-assault approach for generic drugs is high risk. Dr. Reddy's has been named in patent-infringement suits by Pfizer, GlaxoSmithKline (NYSE:GSK), Aventis (NYSE:AVE), aaiPharma (NASDAQ:AAII), Sanofi-Synthelabo (NYSE:SNY), Eli Lilly (NYSE:LLY), Albany Molecular Research (NASDAQ:AMRI), UCB, and others. After losing the Pfizer suit, Dr. Reddy's CEO, G.V. Prasad, noted that the company would continue to seek opportunities to compete with existing drugs where it believed that existing patents offered opportunities. Naturally, this does not exactly endear Dr. Reddy's to the big drug development companies.

Mr. Prasad said that the company was altering its strategy to some extent, looking for places to enter the generic market in the U.S. without risk of legal action against it. This is a lower-risk way to enter the market, but there is little chance that the company could find an opportunity that offers the potential for revenues that grappling a Norvasc would. That's just the nature of that particular beast.

Labor for less
Dr. Reddy's has the majority of its drug production and research facilities in India. Similar to other industries, this means that its cost per employee is substantially lower than it would be in the U.S. In 2003, Dr. Reddy's generated little more than $70,000 per employee in revenue. This would not be enough to keep the lights on anywhere in the developed world.

While compensation expenses and salaries for highly educated professionals in India have been rising along with demand, they are still a fraction of those in the West. This gives Dr. Reddy's an enormous opportunity. While manufacturing costs are fairly minimal components of drug company expenditures, research and development spending can be substantial.

But it's Dr. Reddy's ability to develop drugs and drug ingredients and intermediaries at a lower cost that leads me to believe that, in spite of its recent problems in the U.S., this company has the ingredients to be a long-term winner. Interestingly, even as Dr. Reddy's prepares to assault the neighboring Chinese pharmaceutical market, estimated to be about $16 billion, its home market of India is under pressure by cheaper Chinese imports.

Dr. Reddy's has a market capitalization exceeding $1.8 billion, but it also has $153 million in unencumbered cash and minimal debt. Its capital expenditures in the last three years have been substantial as Dr. Reddy's has built out its businesses in the U.S., China, and India. Even so, it generated $60 million in free cash flow in 2003, giving the company a price-to-free cash flow ratio of about 26. That's not exactly cheap, but it doesn't have much in the way of excitement from potential victories in its patent battles built in. This strategy of grappling patents is lower probability/higher reward than what is employed by most companies addressing the generic market in the U.S. Even without any real victories here, though, Dr. Reddy's still has plenty of potential for lollapalooza growth.

The company's low-cost development capabilities, if they continue to gain sophistication, have the potential to give the big drug makers fits. Dr. Reddy's willingness to come after their big cash flow drugs with competing "copycat" products means that it runs the risk of doing so without a friend in the business.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann knows the feeling. He doesn't own any of the companies mentioned here. He does own a Mexican wrestling mask he got in Nogales. Please see his profile for a complete list of holdings.