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Morningstar | China to audit 77 drugmakers, government likely to speed up pricing reform

On the morning of June 4 2019, China’s Ministry of Finance, or MOF, announced it and the Medical Insurance Administration will jointly audit the accounting practices of 77 drugmakers during June and July. The stocks of Chinese drugmakers have fallen sharply following the news as the market braces for more policy uncertainty.

Among our coverage, the list includes narrow-moat Shanghai Pharmaceuticals, CR Sanjiu (a listed subsidiary of narrow-moat CR Pharmaceuticals), and one unlisted subsidiary of narrow-moat CSPC Pharmaceuticals. Our fair values remain unchanged

Ostensibly, the catalyst is the accounting scandal at Kangmei Pharmaceutical, a large Shanghai-listed supplier of traditional Chinese medicines. After restating its 2017 financial results by CNY 29.9 billion ($4.4 billion), it was investigated by the China Securities Regulatory Commission, or CSRC, which found it had fabricated its financials from 2016 to 2018. On May 17, CSRC said Kangmei used fake bank deposit slips to overstate cash, forged documents for non-existent business activities, and transferred company funds to related parties to trade in its own stock.

MOF claims the list of 77 drugmakers to be audited was chosen at random. It includes 27 A-shares, including large respected companies such as Hengrui, alongside numerous unlisted firms. It also includes the local divisions of three foreign drugmakers: Sanofi, Eli Lilly, and Bristol-Myers Squibb.

Beyond investigating alleged fraud, the government seems especially interested in how much of the companies’ costs it claims are being used for alleged kickbacks. Generic drugs still have unusually high gross margins, even in highly competitive products. Despite numerous government policies to remove misaligned incentives, we believe kickbacks plague the supply chain. We also believe that increasing the scale and scope of the Group Purchasing Organization, or GPO, is the most powerful policy tool the government has to reform generic drug pricing.

Barring news of any alleged fraudulent accounting, we think the most likely outcome of the audit will be more political ammunition for the central government to expand the GPO on a faster timeline. Local governments and drugmakers have been pushing back against a quick national implementation of the GPO. We think if the GPO finds any hard evidence of widespread kickbacks, it will give the central government more ability to speed up reform.

Our fair values remain unchanged at this time, since our models already factor in a fairly quick implementation of the GPO. However, the unexpected announcement reinforces our view that 2019 will be fraught with policy headline risk. Our top pick in Chinese healthcare is the H-share of narrow moat Shanghai Pharmaceuticals, which trades at a 33% discount to our fair value, and is also near the 52-week lows. While we think the sector offers long-term value, we advise investors to be cautious and pick entry points carefully.