Shanghai Pharmaceutical: From Shanghai to a national pharmaceutical business leader

Shanghai Pharmaceutical is one of the few pharmaceutical distribution companies in China that has successfully moved from the region to the whole country. It is a rare pharmaceutical group in the domestic pharmaceutical industry and commercial ranking in the top three in the country. Its development process can basically be divided into 4 stages and 3 key points. The company's revenue CAGR for 2004-2022 was 18.6%, of which the 2005-2009, 2010-2011, 2012-2018, and 2019-2022 revenue CAGR were 16.0%, 67.5%, 16.4%, and 13.4%, respectively. In 2010, the company completed a comprehensive business layout in the pharmaceutical industry and commercial side through the merger of Shangshi Pharmaceutical and Chinese and Western Pharmaceuticals, the acquisition of 100% shares in CITIC Pharmaceutical Industry (later Xinhai, Shanghai Pharmaceutical Science Park) in 2011, and the completion of the merger and acquisition of Kantler's China business in 2018. It has rapidly grown from a regional distribution enterprise to a national pharmaceutical business leader within more than ten years. In 2022, the company achieved total operating revenue of 231,981 billion yuan (yoy +7.5%), with distribution business accounting for 88.7% of total revenue and retail business accounting for 3.6% of total revenue; industrial revenue accounting for 11.5%, and internal business offsetting accounting for -4.2%.

Pharmaceutical business: Benefiting from increased concentration and acceleration, service expansion and provision of growth elasticity. Starting in 2023, the concentration of pharmaceutical distribution will increase or accelerate, and leaders will benefit even more. From a policy perspective, policies such as the two-ticket system in 2017 drove the concentration of the pharmaceutical distribution industry to accelerate; since 2021, the policy side of the pharmaceutical distribution industry has gradually been refined and sinking, putting higher demands on the professionalization capabilities of distribution service providers; in 2023, medical reform was further deepened, direct health insurance payments were gradually promoted, and the “two-ticket system” may gradually transition to a “one-ticket system”, and industry clearance is expected to accelerate. According to historical data from the review, the number of pharmaceutical wholesalers nationwide has remained at 13,000-14,000 since 2014, and the overall clearance rate of the industry has been slow. Looking at a horizontal comparison, there were only 36 national pharmaceutical wholesalers in the US in 2019, while in 2018 there were only about 100 in Japan. Meanwhile, in 2018, the US pharmaceutical wholesale industry's CR3 revenue accounted for about 96% of the total pharmaceutical market size during the same period; the Japanese pharmaceutical wholesale industry's CR4 accounted for about 74%; however, in 2021, the domestic pharmaceutical wholesale industry's CR4 was only 44%, and there is still plenty of room for concentration to increase.

Since 2017, the increase in CR4 in the domestic pharmaceutical distribution industry has been significantly higher than CR100. Currently, leaders and the industry as a whole have shown differentiation. At the same time, in 2020-2022, the court-side account period was generally extended or exacerbated the pattern of differentiation in the industry, and the concentration of leaders increased even more clearly. We believe that the increase in industry concentration may be mainly driven by leaders. In the short term, we look at leading capital advantages, and long-term industrial structure optimization, scale, and channel advantages.

Judging from changes in current assets and the history of mergers and acquisitions, the expansion of the pharmaceutical business sector in Shanghai is accelerating. Shanghai Pharmaceutical is one of the few distribution companies in the country that has successfully moved from the region to the whole country. Behind it, it shows its high current asset turnover efficiency, operational integration capabilities, and strategic foresight. We believe these capabilities can support it to seize a new window of concentration increase and accelerate scale expansion. Specifically, we will analyze and demonstrate from the two perspectives of the company's accounts receivable turnover ratio, balance ratio, and capital reserve:

The company's historical accounts receivable turnover efficiency is high, and it is clear that short-term medical recovery and long-term repayment structural improvements support the acceleration of its accounts receivable turnover rate. The company's historical accounts receivable turnover efficiency is high. We think this aspect is related to the company's own strong credit management capabilities and strong scale and channel advantages on the purchasing side. On the other hand, it is also related to the fact that its key coverage areas are mainly in regional central cities such as Shanghai and Beijing, where the operating resilience and standardization of large public hospitals is relatively good. In the short term, after the recovery of diagnosis and treatment, the company's downstream hospital repayment improvement trend is relatively clear, and short-term performance may be more flexible; in the long run, if the country's hospital repayment rights are gradually handed over to health insurance management agencies, the repayment period is expected to greatly release the company's 78.8 billion accounts receivable and bills receivable (up to the 2023 Interim Report) to support the accelerated expansion of scale.

The company's historical balance ratio is relatively low, and the capital reserves on hand are more abundant, and the potential for increased concentration to accelerate window expansion is stronger. The company has continued to carry out large-scale strategic mergers and acquisitions over the past ten years, but historically, the company's balance ratio has basically been at the lowest level compared to the industry level. On the one hand, this shows the company's good capital utilization efficiency. On the other hand, it shows that the company's financial leverage still has a lot of room to improve to support the acceleration of scale expansion. Since 2018, the company's financing intensity has increased markedly. Looking at a horizontal comparison, the company's reserves are currently relatively more abundant, and the company may have taken the lead in entering a window of accelerated financing and capital advance; furthermore, under low financing costs and relatively low leverage, the company's future capital scale still has a lot of room for improvement. Therefore, we believe that in the current window where concentration increases and accelerates and working capital turnover improves, the company may have higher expansion potential.

Resumption: The ability behind continuous mergers and acquisitions is the ability to make strategic decisions and integrate operations. In 2010-2022, the company carried out continuous mergers and acquisitions expansion, breaking the stable competitive pattern with increased concentration through a series of “high-premium” strategic acquisitions. Looking at the time point, one of the company's two key acquisitions occurred during the window period after the new medical reform in 2009, and the other occurred during the period of dramatic changes in the industry after the two-vote system was rolled out and collection began in 2017. Under the influence of two major mergers and acquisitions, the company achieved relatively rapid growth in key windows of industry change. Judging from internal operating efficiency, Kendler's net interest rate in 2019 rapidly increased from 0.65% before it was acquired to 1.3% in 2020, and by 2021, net interest rate had risen to 2%, and the integration efficiency exceeded expectations. With the company's layout in Southeast Asia starting in 2021, we believe the company's future expansion path is clear: seize the increase in national concentration and accelerate a new window of acceleration, and gradually open up international regional expansion.

Businesses such as innovation, imported drugs, equipment, and hospital supplies supply chain services (SPD) have brought great growth elasticity.

① Innovation and full-life cycle service of commercialization of imported drugs is the most prominent ability of Shanghai Pharmaceutical's commercial part, and may show greater flexibility after recovery in diagnosis and treatment; ② The domestic device distribution business pattern is relatively more scattered, while differences in the pace of policies and industry cycles such as device consumables collection and drug collection may support Shanghai's pharmaceutical device distribution business to maintain a high growth rate for the next 3 years. ③ Information management systems such as SPD will continue to advance medical reform and accelerate development, leading distribution companies will have a stronger cost advantage.

Pharmaceutical industry: The layout is tiered, and it is entering a period of release

In 2022, Shanghai Pharmaceutical ranked first in the country in terms of revenue volume and R&D investment in the industrial sector.

The company produces about 700 varieties of traditional Chinese medicines and chemical drugs all year round. In the context of large external policy changes such as collection and generic drug consistency evaluation in 2017, the company gathered and cultivated 60 key varieties, and empowered the industrial sector through its leading edge in commercialization capabilities to achieve stable high profitability and continued rapid growth.

Innovative drugs: The innovative drug sector will gradually enter a harvest period after 7 years of high investment or in the second half of 2023. A total of 5 products are in clinical phase III, and 3 new Class I drugs will soon be marketed (X842, reflux esophagitis indication; I001, hypertension indication; I008-A, chronic abnormal immune indication for AIDS). In the short term, we expect the company's three new drugs to be released more quickly on a broad basis and on a better commercial basis.

Traditional Chinese Medicine: Large variety strategies and rich stock potential varieties may support continued high growth in the traditional Chinese medicine sector. Shanghai Pharmaceutical brings together 8 core traditional Chinese medicine companies, has many confidential traditional Chinese medicine recipes and more than 10 billion varieties. We believe that in line with the company's commercial advantages, the strategy for cultivating large varieties of traditional Chinese medicine has already paid off. The rich reserves of large varieties have yet to be cultivated and re-developed, and the sector's performance is expected to continue to grow rapidly.

Generic Pharmaceuticals: Steady growth is supported by a large variety of exclusive products, rich overrated stocks, and continuous investment in development of new 3 and 4 types of generic drugs.

Rare diseases: Shanghai Pharmaceutical is one of the companies with the most rare disease drug approvals in China. As of 2022, the company has 21 varieties, involving 34 rare diseases; among them, SRD4610, which is used to treat amyotrophic lateral sclerosis, is expected to be approved for listing after completing phase II clinical trials.

Profit forecasting and valuation

We believe that the company is a pharmaceutical distribution leader benefiting from increased industry concentration and acceleration windows, while at the same time, innovative commercial business and industrial product echelons continue to be released or brought about greater growth flexibility. We expect the company to achieve operating income of 2630.7/2968.7/333.51 billion yuan in 2023-2025, an increase of 13.4%/12.9%/12.3% over the previous year; net profit of 57.2/66.4/7.8 billion yuan, a year-on-year increase of 1.9%/16.1%/17.4%. The corresponding EPS is 1.55/1.79/2.11 yuan/share, and the current price corresponds to 12 times the closing price PE on August 31, 2023. Considering the company's multiple benefits as a distribution leader in the context of accelerated medical reform, its strong ability to utilize capital, and the scarcity of innovative commercial and industrial drug businesses, it has a certain valuation premium, and is covered for the first time with a “increase in holdings” rating.

Risk warning

The accelerated liquidation of the industry has led to the risk of short-term fluctuations in upstream and downstream operations; the risk of R&D progress falling short of expectations; and the risk of financial leverage.