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Morningstar | CSPC reports In-Line Earnings for an Uneventful Quarter, FVE Lowered to HKD 17.40. See Updated Analyst Note from 22 May 2019

Narrow-moat CSPC had another in-line quarter, with no surprises in revenue or margins. Unlike last quarter, this period did not have any negative policy surprises, and we think it is unlikely 2019 earnings will be seriously affected by the latest changes.

Because of the new timing assumptions for NBP’s loss of exclusivity, we are revising our fair value to HKD 17.40 per share from HKD 17.80. However, our thesis is unchanged, and we think CSPC is undervalued by the market, even after considering the negative effect of the new policy environment on mid-term forecasts.

Revenue this quarter grew 25.6% year on year, which is in-line with our expectations. Growth was driven by its "innovative" drug portfolio, balanced by slow growth in common generics. Its flagship drug NBP (butylphthalide, acute ischemic stroke) grew 32.1% year on year, driven by the fast uptake in its injection format, which allows delivery to patients who have difficulty swallowing. Additionally, its "me-better" oncology franchise continued to grow quickly, increasing 208% year on year because of drugs such as Duomeisu (liposomal doxorubicin, chemotherapy), Jinyouli (pegylated rhG-CSF, chemo-induced neutropenia and so on), and Keaili (albumin-bound paclitaxel, chemotherapy).

Operating margins, when calculated with COS, SG&A, and R&D costs, were 24%, or 60bp lower than first-quarter 2018. This earnings report continues the trend of better gross margins, which improved 570 basis points from first quarter 2018, being offset by higher SG&A and R&D costs, which increased 380 and 240 basis points respectively.

We view the R&D increases as positive news, as it shows management’s commitment to improving its pipeline. This quarter, CSPC’s R&D expenditure was 10.9% of its finished drug revenue, which is a marked improvement from 4.5% in fiscal 2016. It still lags Hengrui, which spent 15.3% of fiscal 2018’s revenue on R&D, but it is in line with Sino Biopharmaceuticals, which spent 10% in the same period.

We have made a number of tweaks to our drug revenue forecasts, and revise our fair value down by 2.3%, to HKD 17.40 per share from HKD 17.80. The most significant change is our revision to NBP’s revenue projections. We now assume revenue will drop in 2023 instead of 2024 because of a loss of exclusivity (CSPC’s patents expire in June 2022 for injections, and December 2023 for capsules). We originally believed Chinese competitors would be slow to challenge CSPC’s patents, but now that China’s large drugmakers are rapidly improving their R&D capabilities, we have reconsidered this assumption.

As with all Chinese healthcare stocks, the market is watching policy announcements closely, particularly the effect of the first Group Purchasing Organization, or GPO, on next quarter’s revenue, the next GPO drug list later in 2019, the adjuvant drug list, and how diagnostics related groups, or DRG’s, will be implemented. We continue to believe CSPC’s portfolio will not see any material effects from these policies over the next two years, and that CSPC is well positioned for the future regulatory environment.