Why is CR Sanjiu being shorted?

It's that time of year again when the temperature difference between morning and evening is significant, making it easy for those working overtime to catch a cold. Recently, I've often been running to the pharmacy to stock up in advance to avoid long queues later. However, I mistakenly remembered the timing; the days of queuing to buy medicine and hoarding supplies are long gone, and the special peak period for pharmaceutical companies' performance has also passed.

Due to the high base in 2023, we indeed need to rationally view this year's year-on-year decline in pharmaceutical companies' performance. However, before the third-quarter reports were released, all Chinese medicine stocks plummeted. Upon closer inspection, it turned out that Anhui's centralized procurement had "no regard for rules" and was the first to include OTC brands like Ganmaoling, Shuanghuanglian, and Xiaor Lung Heat Cough and Asthma.

The iron-fisted measures directly hit the deep water zone, and what was once difficult to standardize is no longer a get-out-of-jail-free card for traditional Chinese medicine in centralized procurement. The long-stable CR Sanjiu took the lead in this wave of plummeting stocks, with its market value evaporating by over 10 billion in just four days.

As a super blockbuster product, if 999 Ganmaoling is included in centralized procurement, it will undoubtedly have a significant impact on the company's performance, causing panic in the secondary market, leading to widespread selling.

Unlike other pharmaceutical companies, after a significant acquisition of TASLY, the company's immediate and long-term concerns have increased, and these worries are enough to justify a bearish outlook on CR Sanjiu.

1. Immediate Concerns

The primary principle of medicine is always to treat illness.

Most of the OTC brands included in Anhui's centralized procurement this time share a few common characteristics: they are commonly kept at home, have sales scales exceeding 100 million, and have brand premiums. The policy's starting point is to bring these widely used medicines back to their primary principle.

On September 9, after the release of the "Anhui Province 2024 Traditional Chinese Medicine Centralized Procurement Document (Draft for Comments)," all pharmaceutical stocks became startled, and stock prices plummeted. CR Sanjiu was particularly hard hit, with its market value evaporating by 10 billion in just four days.

The market's reaction was so intense, which is closely related to the industry status of 999 Ganmaoling. In 2023, CR Sanjiu's sales of Ganmaoling granules exceeded 3 billion, maintaining its position as the top-selling traditional Chinese medicine for colds. In terms of performance, this single product accounted for 12% of the company's total sales revenue from physical pharmacies in cities, making it an undeniable core blockbuster.

According to the selection rules for this centralized procurement, for non-exclusive varieties in Directory One, if there are more than two companies applying, the price reduction must reach at least 50%. Ganmaoling happens to be a non-exclusive variety with many production batches. Besides CR Sanjiu, companies like Baiyunshan, Yiling, and Kewang Pharmaceutical also have it.

Therefore, if CR Sanjiu's Ganmaoling truly participates in centralized procurement, the price reduction must be at least 50%. This would undoubtedly be a devastating blow to the company's profits.

Such a ruthless price reduction has prompted the management to quickly come out and reassure: the 999 brand Ganmaoling is a non-medical insurance variety, focusing on the outpatient market, with strong brand power, and has not actively sold in the inpatient market, so the impact is extremely limited However, according to Jefferies' research report, there may be 24 suppliers of 999 Cold Medicine Granules in Anhui. As the first province to apply pressure, the price reduction pressure for the product in the Anhui market is relatively high. Currently, although national centralized procurement does not cover OTC traditional Chinese medicine, if policies continue to expand in the future, CR Sanjiu will ultimately need to balance price and market share.

In addition, Anhui will closely monitor non-selected products and occasionally announce that you have not actively participated in centralized procurement. As a state-owned enterprise, CR Sanjiu has not played the role of a leader; how can other smaller players respect you? How can consumers view you?

Although its brand position cannot be shaken in the short term, the advantage of autonomous pricing power will also weaken, as the larger the price difference with products participating in centralized procurement, the more unfavorable it is for the company's development.

Moreover, the series of industry policies issued in recent years not only affect the brand side of OTC but also deeply impact the competitive landscape on the sales side.

In the first quarter of this year, the average daily order volume of retail pharmacies nationwide was not much different from the same period last year, but the average transaction price dropped significantly year-on-year, leading to a noticeable decrease in overall sales.

In addition to the impact of the traditional off-season, changes in consumer demand and frequent major policies have also posed greater challenges to the pharmaceutical retail industry. In terms of market competition, the rapid growth in the number of pharmacies has led to a price war in the industry, while the rise of channels such as O2O and B2C has also diverted customers, causing the market share of physical pharmacies to continuously decline.

The chaotic channel situation has led to a significant increase in CR Sanjiu's accounts receivable. Before a stable pattern is formed in the downstream channel market share, which continues to decentralize, the asset quality of CR Sanjiu will inevitably be affected.

More importantly, after breaking through 3 billion yuan for the first time in 2022, the sales of Sanjiu Cold Medicine in 2023 only increased by 1.8% year-on-year to 3.079 billion yuan. In the same period, the sales scale of Baiyunshan's Xiao Chai Hu Granules in China's three major terminals and six major markets increased by 20.69% year-on-year, surpassing 1.6 billion yuan.

Market demand still exists, but compared to the smaller base of competing products, the demand growth for 999 Cold Medicine has become very limited.

Regarding the centralized procurement in Anhui, it is still uncertain whether companies will participate, and it is impossible to accurately judge whether the policy will be widely adopted nationwide or if external channels will follow suit in large numbers; we can only wait for the dust to settle.

However, it is a fact that the growth of demand in the large product market is limited, and the transformation of sales channels has increased the adverse impact on asset quality, which is enough to alert investors.

In terms of future development, the recent significant acquisition of a controlling stake in TASLY has increased the development potential of CR Sanjiu, but it has also brought considerable long-term concerns.

II. Long-term Concerns

Before the performance announcement, a centralized procurement document caused the company's market value to evaporate by over 10 billion. Even after announcing relatively bright performance, CR Sanjiu was unable to completely reverse the downward trend.

In the first three quarters of this year, the company achieved operating revenue of 19.740 billion yuan (+6.08%) and a net profit attributable to the parent company of 2.960 billion yuan (+23.19%). However, looking solely at Q3, the net profit attributable to the parent company fell sharply on a quarter-on-quarter basis.

The pressure on quarterly profits is mainly due to strengthening brand building, continuous quality improvement, and increased investment in research and innovation. The number of products with sales exceeding 100 million has increased from 21 in 2017 to 39 in 2023, indicating that there are still many areas where the company needs to spend money.

In the third quarter of this year, sales expenses alone amounted to 4.75 billion yuan, accounting for about one-quarter of total revenue. After the significant acquisition of TASLY, the expenditures have increased even more.

In August of this year, CR Sanjiu acquired a 28% stake in TASLY for a total transfer price of 6.212 billion yuan, becoming its controlling shareholder. TASLY is a well-known traditional Chinese medicine company in the prescription drug field, and its exclusive dosage form, Compound Danshen Dripping Pills, still ranks first in the traditional Chinese medicine market for ischemic heart disease today.

Additionally, as a private traditional Chinese medicine enterprise established for 30 years, TASLY has a well-established channel layout in hospitals, which complements CR Sanjiu's relatively OTC-focused channels, creating a synergistic effect.

However, before acquiring TASLY, CR Sanjiu itself also had a prescription drug business, which, along with CHC self-medication, constituted its two core businesses. Although the proportion is not as large as CHC, prescription drugs were once the company's profit driver, with gross margins reaching over 80% at their peak.

However, after the normalization of centralized procurement, the company's main prescription drugs have been included in the centralized procurement, and with provinces gradually following up on price adjustments, there is price pressure on products, forcing the prescription drug business to face a decline in both profits and growth. The company's gross profit margin has also begun to rely on CHC.

It is hard to say whether this situation will be repeated at TASLY. Even if the marginal impact of existing prescription drugs has basically bottomed out, there is still a possibility of this hidden danger resurfacing after the acquisition of TASLY.

From the current operational status, TASLY's quality is not considered excellent. Just looking at the changes in net profit attributable to the parent company from 2021 to 2023, the company has been unable to achieve stable profitability. The latest performance continues to decline; in the first three quarters of this year, operating income was 6.463 billion yuan, a year-on-year decrease of 1.66%; net profit attributable to the parent company was 842 million yuan, a year-on-year decrease of 18.41%.

As an exclusive dosage form, Compound Danshen Dripping Pills have long occupied a significant market in Tianjin. Therefore, although it won the bid for the Guangdong Alliance centralized procurement with a 15% price reduction in 2022, the impact on the company's gross profit margin is not significant since national centralized procurement has not yet been fully rolled out.

However, after being controlled by China Resources, there is significant incremental and imaginative potential nationwide, but it also needs to consider the price pressure after the nationwide rollout of centralized procurement prices.

In May of this year, it was reported that the online price of Buchang Brain Heart Tong was reduced, revealing a trend that exclusive traditional Chinese medicine varieties may also be included in medical insurance cost control, and TASLY's Compound Danshen Dripping Pills also appeared in the recent price adjustment document from Inner Mongolia. The negative impact from the policy side has clearly not fully materialized.

After the equity transaction, the extent of the synergy between the two companies is still unknown, but if more provinces gradually follow up on centralized procurement price adjustments, Compound Danshen Dripping Pills will also face price pressure, and the gross profit margin will be at risk of decline.

Numerous immediate concerns and long-term worries have made the development prospects of CR Sanjiu increasingly unclear.

Core products face risks from centralized procurement, slowing growth risks, and shrinking price increase potential. The equity transfer with TASLY was paid in cash by CR Sanjiu, resulting in a cash outflow of 6.2 billion yuan, which has reduced the company's free cash position to 3.3 billion yuan. This is also a further decrease in freely disposable funds after the increase in accounts receivable.

In the face of so many uncertainties, the current dividend yield of CR Sanjiu has not provided investors with sufficient margin of safety.

3. Insufficient Dividends

In terms of valuation methods, the non-innovative drug enterprise attributes, and the performance of profit growth exceeding revenue growth, CR Sanjiu can be valued based on its dividend yield.

Currently, with a dividend yield of less than 3%, CR Sanjiu does not rank among its peers.

According to the earnings forecast provided by WanLian Securities, in 2024, CR Sanjiu's net profit attributable to the parent company is expected to reach approximately 3.4 billion yuan, which translates to about 17 times PE based on the current market capitalization, falling within the valuation central range of the past 10 years.

However, considering the above analysis, there is a risk of compression in the company's profit margins, and the current valuation basically does not take potential risks into account. The divergence between profit expectations and valuation could entirely serve as a reason for a bearish outlook on CR Sanjiu.

From a personal investment preference perspective, pursuing a 4% dividend yield in traditional Chinese medicine investments seems completely reasonable to me. This implies that if the company maintains a high dividend payout ratio of about 50% as it did in 2023, the corresponding PE should be 12.5, indicating significant downward potential compared to the current valuation level.

Of course, valuation is to some extent a purely personal artistic endeavor; different people have different opinions, and the above is for reference only.

Conclusion

As the leading OTC brand in traditional Chinese medicine, CR Sanjiu's product profitability is stable, and the capital management capabilities of the CR Group's management team are well recognized. The "999" brand is also widely acclaimed. This moat, built over time, is not easily shaken.

However, it is also important to understand that the previous price increase has little relation to the current intrinsic value. Continuously emphasizing the competitive barrier of brand OTC self-pricing power seems somewhat overly path-dependent. The industry in which the company operates is greatly influenced by policies, and this risk cannot be ignored.

For CR Sanjiu, which has little opportunity for valuation enhancement, its dividend payout level deserves investors' attention. Based on the current valuation, there is not much investment attractiveness