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Morningstar | Shanghai Pharmaceutical’s Earnings in Line, Interest Expenses Warrant a Watchful Eye

Shanghai Pharmaceuticals Holding Co, or SPH, announced third-quarter results that for the most part were on top of our expectations. We maintain our fair value estimate of HKD 24.0 per share, or a 2018 adjusted P/E of 14 times and an enterprise value/EBITDA of 8 times. We believe the H-share market is pricing this company at approximately a 30% discount to our evaluation.

After adjusting for our estimates of the integration of Cardinal Health’s China operations, revenue is flat to the same period last year, which is a slight improvement from last quarter. Like other distributors, SPH appears to be recovering from the negative impact of the Two Invoice Policy at the start of this year, although its manufacturing segment’s growth has stalled. Operating margins (including research and development costs) are 3.93%, in line with our projection of 4.01%. Net income is approximately 10% higher than our estimates after adjusting for Cardinal Health’s integration, primary due to one-off effects and an unusually low income tax expense of 9% booked for the third quarter.

Interest expense deserves special mention, since it nearly doubled compared with the previous quarter despite only an 8% increase in borrowings. This implies a large increase in financing rates that SPH’s competitors avoided by refinancing with ultrashort debt.  While concerning, we believe its financing situation should be manageable. After the debt burden taken on after the acquisition of Cardinal, SPH’s debt/equity ratio is 66% and net debt/equity ratio is 29%, which is in line with its peers. With CNY 13 billion of net debt and 2.3 billion of annualized operating cashflow, a large state-owned SOE like SPH should be able to weather the storm.

While SPH does not have the same opportunities for growth and margin expansion that other large distributors enjoy, we believe the market has been overly bearish on its prospects, and this is an attractive stock to own in the long term at current valuations. While we do not foresee a near-term correction, over time, the earnings story should convince the market that the price is too low.