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Morningstar | Initiating coverage of CSPC with Narrow Moat Rating, FVE of HKD 21.0 per Share. See Updated Analyst Note from 21 Aug 2018

We initiate coverage on CSPC Pharmaceutical Group, or CSPC, with a narrow moat rating and a fair value estimate of HKD 21.0 per share, implying a 2018 adjusted P/E of 39 times and an enterprise value/EBITDA of 25 times.

CSPC is one of the largest drugmakers in China, and has a diversified portfolio that includes innovative drugs, common generic drugs, and bulk drugs. The group operates in a high-growth industry, and enjoys positive tailwinds from government policy designed to push out smaller players, and benefit companies such as CSPC that make relatively high-quality generics, first- or second-to-market generics of expensive foreign-branded drugs, and improved preparations of existing drugs.

The group derives its narrow moat from intangible assets, in the form of patents and regulatory protection. The value of these intangibles is heavily dependent on government regulations, but based on the policy direction that has been outlined through 2030, we believe they will likely allow CSPC to generate returns in excess of its cost of capital for at least the next 10 years.

As with all Chinese drugmakers, there is considerable uncertainty on the firm's future pipeline. CSPC only recently started focusing heavily on R&D, so it doesn't have the same track record as its peers, and its market share in large molecules is insignificant. However, management has strategically focused on developing drugs in therapeutic areas that do not have much overlap with peers. It has also had early success in developing and marketing chemotherapy drugs, a major contributor of revenue growth in CSPC's portfolio.

Recent earnings reports have been supportive of the stock's growth story, and its price has outperformed many of its peers in Chinese healthcare. However, like most other Chinese industries, this sector has been jarred by fears of a trade war, although most drugmakers (including CSPC) should not be materially affected beyond foreign exchange adjustments. There have also been serious scandals at small healthcare companies, which has also caused ripples in China's healthcare stocks, but we believe these incidents should reinforce the government's policy direction of favoring large companies over small ones, therefore benefiting CSPC.

The market is currently pricing CSPC at a 17% discount to our fair value estimate. As a high-growth company operating in a sector dominated by government policy and headlines, this stock has shown considerable volatility which may provide attractive points of entry.