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Morningstar | Sinopharm's Earnings Rebound From 1Q, but Concerns Remain Over Financing Costs

Sinopharm announced interim results that were in line with our expectations and substantially better than the poor first-quarter results. However, rising finance costs and increasing accounts receivable days continue to be a major concern for the company. We maintain our fair value estimate of HKD 36 per share, which implies 2018 adjusted price/earnings of 20.5 and enterprise value/EBITDA of 6.9.

Gross margins improved dramatically from last quarter, rising 150 basis points from 7.9% to 9.4%, bringing the six-month level in line with our annual projection. The increase is due to the higher proportion of direct sales in Sinopharm’s distribution business, which has better margins than indirect sales. While we had expected to see such an improvement due to China’s implementation of the two-invoice policy, we originally predicted it would take another quarter or two and are pleasantly surprised it has shown up in the second quarter's results. Next quarter’s results will provide an important indicator of how much of this margin improvement is permanent.

The gross margin improvement was partially offset by increases in selling, general, and administrative and finance costs. SG&A expenses rose from 4.2% to 4.6% quarter over quarter, since Sinopharm must spend more money on sales and rent to build new direct sales channels with hospitals that were previously served via indirect sales. We expect SG&A costs to decline once these channels are established. Finance costs continued to trend upwards at a fast pace, rising from 1.0% to 1.4% of revenue quarter over quarter, and are likely to remain a key concern for investors.

Overall, the improving gross margins give us confidence that Sinopharm has rebounded from its poor first-quarter results, when SG&A and finance costs rose without a commensurate rise in gross margins. However, we expect the financial burden from hospitals’ long accounts receivable days to weigh on investors' minds.

Overall credit conditions in China have eased recently, and we do not expect the group’s borrowing rates to rise further. However, accounts receivable days has risen dramatically from 99 as of Dec. 31, 2017, to 128 as of June 30, 2018. This is a reflection of the poor cash flow situation at many Chinese hospitals, the group’s main customers, and we do not expect this situation to improve in the near term. Therefore, we expect Sinopharm to face continued pressure to factor its receivables and borrow from debt markets, which will keep its finance costs at historical highs.