EUR 850.00 For Business Accounts Only

Morningstar | CSPC Reports in Line Earnings, but Policy Concerns Remain, FVE Lowered to HKD 17.8. See Updated Analyst Note from 19 Mar 2019

CSPC’s earnings were in line, with revenue growth and margins on top of our full-year estimates. While this year’s Group Purchasing Organization pilot (GPO, or “4+7 policy” as it is known in China) and other drug price reforms weigh on the drugmaker’s stock price, at this time we do not think these policy concerns will significantly affect CSPC’s profitability over the next two years. However, we revise our fair value estimate downwards from HKD 19.9 to HKD 17.8, since the new policy environment suggests a more competitive environment than we previously expected, especially in in the mid-term time horizon. We maintain our narrow moat rating.

Revenue for fiscal 2018 grew 36%, which is just below our estimate of 38%. Operating margins, when calculated using COS, SG&A and R&D costs only, were 20%, or 2.6% lower than fiscal 2017. While gross margins improved 6%, which reflects improving product mix, this was offset by a 6% increase in SG&A and 2% increase in R&D costs (expressed as a percentage of revenue). Sales and marketing costs have increased due to the launch of new products like Keaili (albumin-bound paclitaxel), as well as management’s decision to proactively take over sales and marketing that were previously delegated to third parties.

We have lowered our operating margin assumptions to reflect a more competitive landscape. While we previously expected CSPC’s new drugs and pipeline to improve its profitability, we now believe that the drug pricing reform will decrease the profitability of its generics business and the copycat drugs in its “innovative” portfolio, thus keeping margins stable in the mid-term. Our fair value estimate falls from HKD 19.9 to HKD 17.8 as a result. Nonetheless, we still project the company to generate high returns on invested capital due to its portfolio of differentiated drugs and pipeline prospects, as well as its strong manufacturing capabilities of certain APIs and preparations.

The current policies to watch out for include the next GPO, which will likely occur in the second half of this year, the adjuvant drug list which is intended to limit the overuse of drugs that lack clinical effectiveness, and the implementation of Diagnostics Related Groups, or DRGs, as a way to cap drug reimbursements. All of these policies are essentially cost controls by limiting drug prices, drug usage, and reimbursement rates. However, based on publications released over the past couple of months clarifying the direction of these policies, we reaffirm our belief that CSPC’s near-term revenue and profitability over the next two years will be minimally affected.

Overall, we believe that CSPC is well-positioned for the future regulatory environment, due to its differentiated portfolio and high quality generics manufacturing. The stock currently trades at a 17% discount to our new fair value estimate. We believe the large fall in stock price represents an attractive long-term buying opportunity, and while the recent wave of policy news has been less negative than the second half of 2018, there is still lot of potential for headline surprises.