Positive fundamentals not fully priced in
Er-kang is benefitting from tightening regulation in adjuvants given its marketleadership, and its starch capsule business also has strong prospects. Neither factor isfully priced in, in our view. Trading at just 39x 2016E PE, Er-kang's current valuation isnear the historical mean but below the sector average of 74x. We think this overlypessimistic valuation reflects concern that slower pharmaceutical manufacturingindustry growth will affect its pharmaceutical adjuvants business, along with failure toanticipate the potential boost to earnings from next-gen adjuvants and starch capsules.
Adjuvants: Beneficiary of higher industry concentration, strong next-gen sales
In contrast with the more mature US/European markets, China's adjuvant sector isfragmented. It is also still far from saturated. Many brand-name drugs are set to losepatent protection in the next three years, which will likely drive rapid growth in thehigh-end generics market while spurring demand for next-gen adjuvants. Helped byrising industry concentration and strong sales of next-gen products, we expectadjuvants to post revenue growth of 11.2%/9.3%/6.9% in 2016/17/18, with a 7.81%gross profit CAGR.
Starch capsules: Set to be main earnings growth driver in next 3 years
The company is the world's only pharmaceutical adjuvant maker to commercializestarch capsules. It has built up a complete value chain which uses the cassava plant as araw material and integrates core production technologies. The company currentlymarkets its starch capsules under three main models: 1) self-use (used in Er-kang's ownproducts); 2) sales via the internet; and 3) export. We estimate that starch capsulescould capture market share worth at least ~Rmb14bn from traditional gelatin capsules.With expansion in the self-use and export categories, we forecast its starch capsulerevenue to grow 200%/80%/50% and contribute 26%/36%/44% of gross profit in2016/17/18, with a 64% gross profit CAGR.
Valuation: Rmb39.26 price target; maintain Buy rating
Our new Rmb39.26 price target is derived using DCF (WACC 7.6%). We maintain ourBuy rating.
