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Morningstar | CSPC 3Q Earnings Broadly in Line with our Expectations, FVE Lowered to 19.9 per Share. See Updated Analyst Note from 19 Nov 2018

CSPC Pharmaceutical Group Ltd, or CSPC, released third-quarter earnings that were broadly in line with our expectations. We are also revisiting our model’s growth rate and margin assumptions to incorporate what we know so far about the centralized procurement. We revise our fair value estimate downwards to HKD 19.9 per share and maintain our narrow moat rating.

The results are very close to our estimates for key metrics, including revenue growth, operating margins, and R&D spend. Despite the market’s bearish reaction, we view the results as continuing the strong growth story over the past two years. Revenue for the three quarters has grown 41.4% year over year, while operating profit margins have only declined modestly from 23% to 20.2%, since the increase in SG&A and R&D has been mostly offset by increases in gross margins due to better manufacturing processes and price increases. The innovative drug segment, which constitutes about 50% of revenue and is the most important driver of growth and margin expansion, shows signs of moderating its steep growth trajectory, but still grew 6% from the second quarter.

We have revisited our model to account for new expectations on centralized procurement, revising our fair value estimate from HKD 21 to HKD 19.9, primarily due to lower operating margin assumptions. Since Sept. 11, when news first came out about the joint tendering pilot program for hospitals in 11 cities, the China’s National Health Insurance Bureau, or NHIB, has expressed a strong desire to vastly expand the future scope of the program. Next year, we expect more generic drugs to be included beyond the 33 included on this year’s list. Furthermore, by 2020, NHIB intends to expand the program nationwide. Even if nationwide implementation is delayed, the bidding results of the pilot programs will still likely serve as reference prices across China’s provinces.

By implementing centralized procurement nationwide, NHIB intends to reduce the profit margins for generic drugs, forcing drugmakers to outperform by virtue of their innovative drug pipelines rather than the strength of their sales networks. However, the pace of Generic Consistency Evaluations, or GCEs, will be a short-term hurdle for large-scale implementation. Drugmakers’ progress in bioequivalence testing has been much slower than the government’s original deadline, and joint tendering is not effective at lowering prices when fewer than two generics makers have passed the required GCEs. Additionally, there are still unresolved questions about the implementation of the pilot program which will take time to work through. Finally, we expect that hospitals and drugmakers will push back, and make the case for a more gradual, less disruptive implementation.

We agree with management’s assessment that the near-term impact on CSPC will be small for the next two years, since the company has minimal exposure to the 33 drugs on this year’s list. Additionally, as a relative newcomer, much of its generics portfolio consists of drugs where CSPC currently has small market share, and actually stands a chance of increasing volumes by winning some tenders. However, on a longer time horizon, we expect that nationwide implementation of centralized procurement will lower CSPC’s gross margins, although this will be partially offset by a decrease in SG&A costs. Lower operating margin assumptions are the primary cause for our lower fair value estimate.

The stock currently trades at a 15% discount to our fair value estimate. For investors looking to buy, we continue to stress that the environment remains volatile for Chinese drugmakers due to uncertainty on government policy.