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Morningstar | Shanghai Pharmaceuticals Faces Increasing Margin Pressure; FVE Lowered to HKD 22.5 Per H-Share. See Updated Analyst Note from 03 Apr 2019

Shanghai Pharmaceutical announced annual results that were in line with our expectations, with organic revenue growth and net profit on top of our full-year estimates. However, core operating margins and profit fell below our expectations due to higher SG&A costs. We lower our fair value estimate to HKD 22.5 per H-share from HKD 24.0 and CNY 19.5 per A-share from CNY 21.0. The H-shares trade at a 23% discount to our fair value estimate.

The company reported annual revenue of CNY 159.1 billion, up 21.6% from last year. After removing the effects of its purchase of Cardinal Health, organic growth was 6.1%, which is in line with our original estimate of 6.2%. Drug manufacturing and retail pharmacy segments were key growth drivers, with both growing close to 30% year on year. On the other hand, drug distribution is the largest segment, and its organic growth (excluding Cardinal) was only 2.6% year on year, which is in line with our expectations given its limited expansion into regional markets compared with its peers. Drug manufacturing continues to benefit from improving its product mix, targeting high-end generics, and innovative drugs, and the trend will likely continue for the next few years. However, this may be offset by the government’s centralized procurement policy, depending on how it develops.

Core operating margins (including only COS and SG&A) were 3.4%, which is below our expectation of 3.7%. We believe this is due to higher-than-expected SG&A costs in the manufacturing segment, which are likely to remain elevated as the company continues to work on expanding its sales footprint.

We are lowering our fair value estimate to HKD 22.5 per H-share from HKD 24.0 and CNY 19.5 per A-share from CNY 21.0. This is due to a slightly more pessimistic outlook on SG&A costs and operating margins. Despite its more limited business opportunities relative to peers, we believe the H-shares remain cheap, trading at more than a 20% discount to our fair value estimate.

Cardinal’s integration appears to be going well. Prior to its purchase, Cardinal’s net margins were only 0.5%. Management intends to improve this to 1%-1.5% within a couple of years, and this year ended at 0.9%, which is an encouraging indication of integration progress.

Net finance costs remain under control at 0.8% of revenue, which is only a modest increase from 2017’s level of 0.6%. Since the company is more focused on developed regions relative to its peers, it is not as exposed to the long accounts receivable days from struggling hospitals. While its debt-to-equity ratio shot up to 68% from 42% due to its acquisition of Cardinal, cash remains plentiful and net debt to equity is quite manageable at 28%.