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Morningstar | Shanghai Pharmaceuticals Posts Strong 1Q Growth in Distribution; H-Shares Remain Undervalued

Narrow-moat Shanghai Pharmaceuticals, or SPH, posted solid first-quarter results, with its distribution segment modestly outperforming our expectations. This was partially tempered by a contraction in gross margins. Our fair value estimates are unchanged at HKD 22.5 per H-share and CNY 19.5 per A-share. While the A-shares are in line with our fair value, the H-shares trade at a 28% discount, and we believe they offer attractive long-term value for patient investors.

Revenue grew to CNY 46 billion, which modestly outperformed our expectations. In particular, the distribution segment grew 10% sequentially, which is faster than our estimate of 4% for the full year and indicates the business has recovered from the slow pace during 2018. Management attributed the growth to consolidation trends caused by the two-invoice policy, medical device distribution, and imported products (SPH is the largest agent for imported drugs in China). We believe regional consolidation tends to fluctuate, but the latter two effects are likely to be continuing trends, and we have revised our forecast for this year’s distribution revenue, up to 8% from 4%.

The top-line beat was partially offset by lower gross margins, which fell 60 basis points compared with the first quarter of 2018. According to management, this was primarily because of price pressures in its drug manufacturing segment, whereas the margins in the distribution segment were unchanged. We continue to forecast declining margins over the next few years because of the expansion of China’s GPO policy, and more sales of high-growth but low-margin imported drugs in its product mix (such as PD-1 and PD-L1 checkpoint inhibitors, which are likely to have a rapid uptake in China during 2019).

We made minor changes to our model, including the aforementioned change in the 2019 revenue forecast. However, our fair value estimates remain unchanged at HKD 22.5 per H-share and CNY 19.5 per A-share. Despite its undifferentiated drug manufacturing segment and slower growth than peers in its distribution segment, in our view SPH’s H-shares remain an attractive long-term buy.