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Morningstar | CR Pharma's Full-Year Results in Line, but Less Impressive Than 1H; Debt Levels Rise. See Updated Analyst Note from 22 Mar 2019

Narrow-moat CR Pharma reported 2018 earnings that were in line with expectations, but showed slower growth and lower margins than in the first half. We have lowered our fair value estimate to HKD 12.50 per share from HKD 13.20 due to minor tweaks in our margin assumptions.

Full-year results were largely in line with our expectations, with revenue growth of 11.9% and operating margins of 5.4% (when calculated using cost of sales, selling, general, and administrative, and other expenses). Despite a better-than-expected interim report, the second half did not exhibit the same pace of growth or margin expansion. While gross profit margins continued to improve, with 2018’s result improving 200 basis points compared with 2017, this was offset by a similar increase in SG&A costs, leaving operating margins almost unchanged from last year. We still expect margins to improve modestly next year, since we believe the improvements in gross margins are high-quality gains, reflecting a better product mix in drug manufacturing and expansion into more profitable regions in drug distribution. On the other hand, we think the rise in SG&A costs is likely to be more short term, due to temporary marketing promotions that could subside more quickly.

We are lowering our fair value estimate to HKD 12.50, which implies a 21.6 adjusted price/earnings ratio. This is primarily due to a slightly lower assumption on our midcycle operating margins. CR Pharma’s drugmaking segment mostly sells traditional Chinese medicine and over-the-counter drugs, but it still has some exposure to China’s cost-control policies due to its prescription drugmaker subsidiary CR Double Crane. Additionally, we think drug distribution in the long run is likely to see lower margins as China implements more centralized procurement, which is a lower-margin business for drug distributors.

CR Pharma’s retail segment is also likely to see lower margins as it continues to focus on its direct-to-patient franchise, a high-growth but low-margin business.

The company’s net debt grew by HKD 11 billion in order to finance a few acquisitions, which in turn caused financing costs to rise 44% year over year. Financing costs were 2.0% of revenue in the second half of 2018, compared with 1.3% for all of 2017, which represents a significant increase for a company whose operating margins are only 5.5% in fiscal 2018. Net debt rose from 36% of equity in 2017 to 57% in 2018. While we believe the leverage and financing costs are still manageable, we are keeping a close eye on these metrics.

We continue to view CR Pharma as a defensive stock that is relatively insulated from China’s recent cost-cutting policies. Sentiment has improved considerably from the end of 2017, and the stock currently trades at a 10% discount to our fair value estimate.