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Morningstar | Initiating Coverage of SPH With Narrow Moat Rating, FVE of HKD 24.00 per Share

We initiate coverage on Shanghai Pharmaceuticals Holding Co Ltd, or SPH (HK: 2607, SSE: 601607) with a narrow moat rating and a fair value estimate of HKD 24.00 per share. This implies a 2018 adjusted P/E of 14 times and an enterprise value/EBITDA ratio of 8 times. The market is currently pricing SPH at a 27% discount to our fair value estimate.

SPH is a top three drug distributor in China and is vertically integrated with a large drugmaking segment and a retail distribution franchise. The large scale of its distribution segment affords it a cost advantage in providing logistics and high value-added services. Additionally, it has not been as adversely affected by recent policy changes, owing to its product mix and geographical concentration in affluent Eastern China.

However, at the same time, its opportunities for growth and margin expansion are more limited than the other large distributors. Additionally, we do not believe the drug making segment is competitive; over the past five years, it has underperformed peers in revenue growth, operating margins, and pipeline generation. These concerns have weighed on the stock price, and SPH usually trades at a substantially lower P/E compared with other distributors with national scale, namely Sinopharm, CR Pharma, and Jointown.

Despite these weaknesses, we believe market concerns are overdone, and this stock offers good value. While net income growth has lagged peers in the recent past, we forecast that this situation will turn around and will be more in line in the coming years. Chinese healthcare stocks have been suffering a bout of bearish sentiment recently, so we recommend that investors bear this in mind when choosing entry points in this sector. However, we believe this is an attractive stock to own long-term.