www.morganmarkets.com Asia Pacific Equity Research 15 October 2011 China Healthcare Shattered landscape; hope and opportunity Healthcare Sean Wu AC (852) 2800-8538 [email protected]J.P. Morgan Securities (Asia Pacific) Limited See page 144 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. One-year China & APxJ Healthcare Source: Bloomberg Three-month China & APxJ Healthcare Source: Bloomberg -50% -40% -30% -20% -10% 0% 10% 20% Oct -10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul -11 Aug-11 Sep-11 MSCI China H APxJ Healthcare MCSI China Healthcare -35.0% -30.0% -25.0% -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 1-Jul 1-Aug 1-Sep MSCI China H APxJ Healthcare MSCI China Healthcare Sell-off creating buying opportunities: The MSCI China healthcare index (down 13.5% in the past three months and 28% YTD) is trading at the lowest multiples since mid-2009, with many counters offering enticing valuations when set against the growth prospects, in our view. We believe the sentiment has been too negative given that the secular growth of healthcare industry looks intact and it is in the government’s interest to strengthen, not weaken, the domestic players. We are confident that many healthcare companies can withstand short-term negative macro headwinds and emerge with growth outlooks intact. We believe the recent sell-off has created some attractive buying opportunities. Fundamentals for long-term growth look strong - underpinned by ageing population, rising disposable income, increasing government healthcare expenditure, and expanding insurance coverage: Annual drug sales are expected to grow nearly 20% annually for the next 5-10 years and China will become the third-largest drug market in 2011 and No.2 by 2020, according to IMS China. The use of medical devices will continue to expand given low penetration levels. Increased government spending will benefit all healthcare subsectors as we foresee total healthcare spending as a proportion of GDP rising from 5% today to about 10% by 2020, growing at a CAGR of 18%, roughly twice that of nominal GDP growth for next 10 years. We prefer devices over drugs because of price cut overhang: We see continued short-term pricing pressure on pharmaceuticals as we expect the recent Fujian type of drug-tendering to possibly be repeated in other provinces. With rising raw material costs and labor inflation, and price-cuts taking full effect in 2H11 for many drugs, consensus profit projection for many drug companies could be at risk. Hence, in the short term, we prefer medical device players to drug names for lower regulatory risks. Stock picks: Buy Sino Biopharma for 54% upside potential, Sinopharm for 46% upside, and Mindray for 29% upside. Those are leaders of their respective subsectors that possess sustainable competitive advantages to keep them strong for years to come. We recommend selling China Shineway due to its continued downside earnings risk from EDL drug cuts. We are Overweight on Weigao, Sihuan, and Concord Medical Services, and Neutral on United Labs and MicroPort. China healthcare coverage universe Company Name Code Price (PT) MCAP US$m Vol US$m 1W Chg 3M Chg 11E P/E (x) 12E P/E (x) 11E EV/ EBITDA 11E ROE (%) P/B (x) 11E Yld (%) ND/E (%) CHINA SHINEWAY (UW) 2877 HK 11.5 (12) 1,223 5.6 24.2 (16.1) 9.8 9.0 5.0 22.8 3.6 1.8 (76.1) CONCORD MEDICAL (OW) CCM US 3.19 (4.6) 151 0.1 3.2 (21.3) 6.3 4.7 2.6 8.5 0.9 0.0 (23.8) MICROPORT (N) 853 HK 4.7 (5.5) 868 1.2 9.3 (5.1) 20.0 15.9 11.1 12.9 3.0 0.0 (44.3) MINDRAY (OW) MR US 24.8 (32) 2,857 12.6 2.6 (7.3) 17.1 14.5 10.7 16.4 2.6 1.2 (47.6) SHANDONG WEIGAO (OW) 1066 HK 9.2 (11.5) 5,311 5.4 15.8 (16.1) 30.1 22.5 23.2 23.8 7.6 1.0 (44.8) SIHUAN (OW) 460 HK 3.14 (4.9) 1,847 4.2 18.5 (1.9) 15.5 12.1 9.1 12.2 2.9 0.0 (54.0) SINO-BIOPHARM (OW) 1177 HK 2.28 (3.5) 1,444 2.4 4.6 (14.9) 20.1 17.0 7.4 15.1 3.6 2.8 (42.0) SINOPHARM (OW) 1099 HK 20.6 (30) 6,362 15.2 4.8 (11.0) 21.1 14.6 10.4 14.7 4.5 0.8 (22.8) UNITED LAB (N) 3933 HK 6.46 (7.5) 1,078 3.5 16.2 (25.0) 6.7 4.6 5.1 22.7 3.2 2.6 34.1 Source: Bloomberg, J.P. Morgan estimates. Prices as of close 13 October 2011.
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www.morganmarkets.com
Asia Pacific Equity Research15 October 2011
China HealthcareShattered landscape; hope and opportunity
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
One-year China & APxJ Healthcare
Source: Bloomberg
Three-month China & APxJ Healthcare
Source: Bloomberg
-50%
-40%
-30%
-20%
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MSCI China H
APxJ Healthcare
MCSI China Healthcare
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1-Jul 1-Aug 1-Sep
MSCI China H
APxJ Healthcare
MSCI China Healthcare
Sell-off creating buying opportunities: The MSCI China healthcare index(down 13.5% in the past three months and 28% YTD) is trading at the lowest multiples since mid-2009, with many counters offering enticing valuations when set against the growth prospects, in our view. We believe the sentiment has been too negative given that the secular growth of healthcare industry looks intact and it is in the government’s interest to strengthen, not weaken, the domestic players. We are confident that many healthcare companies can withstand short-term negative macro headwinds and emerge with growth outlooks intact. We believe the recent sell-off has created some attractive buying opportunities.
Fundamentals for long-term growth look strong - underpinned byageing population, rising disposable income, increasing government healthcare expenditure, and expanding insurance coverage: Annual drugsales are expected to grow nearly 20% annually for the next 5-10 years and China will become the third-largest drug market in 2011 and No.2 by 2020, according to IMS China. The use of medical devices will continue to expand given low penetration levels. Increased government spending will benefit all healthcare subsectors as we foresee total healthcare spending as a proportionof GDP rising from 5% today to about 10% by 2020, growing at a CAGR of 18%, roughly twice that of nominal GDP growth for next 10 years.
We prefer devices over drugs because of price cut overhang: We see continued short-term pricing pressure on pharmaceuticals as we expect the recent Fujian type of drug-tendering to possibly be repeated in other provinces. With rising raw material costs and labor inflation, and price-cutstaking full effect in 2H11 for many drugs, consensus profit projection for many drug companies could be at risk. Hence, in the short term, we prefer medical device players to drug names for lower regulatory risks.
Stock picks: Buy Sino Biopharma for 54% upside potential, Sinopharm for 46% upside, and Mindray for 29% upside. Those are leaders of their respective subsectors that possess sustainable competitive advantages to keep them strong for years to come. We recommend selling China Shinewaydue to its continued downside earnings risk from EDL drug cuts. We are Overweight on Weigao, Sihuan, and Concord Medical Services, and Neutral on United Labs and MicroPort.
There has never been a more tumultuous period for healthcare stocks than the third quarter of 2011. Clearly, the overall market has not done well, but is not the healthcare industry a defensive sector, resistant to the business cycle? We believe this might still hold true, but Chinese healthcare stocks have done badly owing to some specific issues pertinent to this industry. During 3Q11, the MSCI China healthcare index fell by 23%, while the China’s A-share drug index and MSCI APxJ healthcare index fell by about 10% and 15%, respectively. Given the relatively better performance by the A-share drug companies, the H-share China healthcare names have apparently suffered disproportionally more. Among our coverage space, The United Labs performed the worst, with a 3-month decline of about 50%, while Mindray managed to perform relatively well but still dropped by 16%. While the current macro-environment does appear to be difficult for the healthcare industry and some level of stock pull-back is understandable and healthy in light of excessive valuation for some companies, we believe that the recent carnage suffered by healthcare stocks have nonetheless created very attractive buying opportunities for many of our companies. We believe the sentiments have been too negative. China’shealthcare industry remains a secular growth story and, over the long term, healthcare stocks are bound to outperform the general market, in our opinion. Our top picks are Sino Biopharmaceutical, Sinopharm, and Mindray.
Figure 1: Healthcare stocks took a beating in 3Q11%
Source: Bloomberg; J.P. Morgan Estimates; Prices are as of the close of 11 October 2011.
Why the underperformance
Macrowinds currently blowing the wrong way
The National Development and Reform Commission (NDRC) has announced three rounds of price cuts recently, first for the essential drugs, then for antibiotics and circulatory system drugs earlier this year, which resulted in ~20% cut at retail reference levels. The tendering of drugs on the essential drug list (EDL) at the provincial levels has resulted in 40%-plus price cuts for some drugs and many major brands have been completely shut out from the EDL catalogue of certain provinces. The Anhui model of EDL tendering, conducted mostly on price, is especially controversial. It has resulted in very severe price cuts, compared to a more balanced approach taken by the Shanghai government, which has considered both quality and price for tendering. Unfortunately, the Anhui model appears to be winning, as more and more provinces adopt its approach. Expectations for further price cuts of drugs have severely hampered the drug companies’ stock performance. Even for medical devices, there are expectations that dramatic price cuts may be forthcoming,following the rounds of tendering organized by the local governments. Nonetheless, we remain steadfast that the regulatory risks for the medical-device/equipment sector are much lower than those for the drug companies.
Table 2: Recent NDRL Cuts of Retail Ceiling Prices
Date No. of Drugs Price Cut Drug Categories Involved
Dec-10 17 12% 17 categories of EDL drugsFeb-11 162 21% 162 anti-infective and circulatory system drugsAug-11 82 14% Hormonal and endocrine system drugs
Source: NDRC
Short-term pain may persist, especially for drug names
Whatever damage the Anhui model has done to the prices of EDL drugs, we think the Fujian model of non-EDL drug tendering could likely do worse for the overall
drug prices. First, the Fujian model intends to dramatically cut down the categories of drugs that companies can bid in. For each category, there may be only 2-3 winners, which significantly lowers the number of winning companies. Finally, the price difference among drugs in the same category cannot be more than 30% and the winning bid price for lower-quality class cannot be any higher than the higher class, which would likely make certain drugs enjoying independent pricing power sure losers if the producers of these drugs want to maintain premium prices in other provinces. While companies can complain about the quality/price trade-off for the Anhui model, there are no legitimate complaints, according to our assessment, about the Fujian model, especially about limiting drug categories. We see a high likelihood that the Fujian model may be duplicated in other provinces in the future rounds of drug tendering. This would likely spell bad news for many companies. According to estimates by some industry experts, more than 50% of tender winners that occupied top-100 ranks in terms of sales in the Guangdong province for 2010 might be completely shut out of Fujian.
Why would the sector recover
Valuation has become more attractive
With MSCI China Healthcare Index down by 23% over the last three months till October 1, we believe the overall healthcare sector valuation has become more attractive. The index is currently trading at about 21x forward P/E, unseen since 2009. Comparatively, this also allows the healthcare sector to be in a more favorable position compared with other Chinese sectors given the healthcare sector’s strong growth ahead.
Figure 2: Forward P/E of MSCI China Healthcare Index
Fundamentals of the healthcare industry stay strong
We believe the healthcare industry will continue to grow at a robust pace for the next 5-10 years because of favorable demographics and government support for expanding insurance coverage. With expanding insurance coverage and rising disposable income, an aging population is bound to demand more and more quality medical services. We expect healthcare spending in China to grow 15-20% each year over the next ten years and healthcare expenditure as a portion of GDP should reach approximately 10% by 2020 from the current level of ~5%. Furthermore, the government is encouraging consolidation within each healthcare subsector, meaning that the leading players should be able to achieve top-line growth of over 25% a year.
Remain positive in the longer term
Even with tough macro headwinds, the healthcare industry output for 1H11 grew Y/Y by 27.9% to Rmb714.6bn, with the output of chemical drug APIs, finished dosages, Chinese patent medicines, and biologic products growing Y/Y by 25.4%, 23.4%, 32%, and 25.4%, respectively. The drug-manufacturing industry’s industrial value-added output increased by 16.8% Y/Y in 1H11. Hence, despite a challenging environment, the overall industry has managed to maintain a very healthy growth. We firmly believe that the Chinese government will need a healthy healthcare industry with players generating decent profits in order to fulfill its goal to provide quality medical services to the population at affordable prices. If companies continue to make losses by selling drugs, they will either stop selling drugs or exit businesses altogether, making some drugs unavailable to patients. In order to make the essential drugs available to its people, the government might be forced to raise prices in order to attract domestic manufacturers or import drugs at even higher prices. Hence, there is a balance between price cuts and drug supply. In addition, if the government wants to achieve its goal of upgrading the healthcare industry to be more competitive globally, it would need the leading companies to generate profits to fund R&D for innovative product development. We think the current downturn could have the potential to rid the industry of weak players so that strong players with consolidated market positions might eventually emerge.
Building R&D capabilities key to sustainable margins
In the longer term, we believe only companies that have strong R&D capabilities and a pipeline of products would thrive. New-product launches are key to sustainable healthy margins in the future, which are under constant attack these days with rounds of government price cuts, labor and raw-material inflation. Some companies might acquire new products through acquisitions to build product portfolios in lieu of in-house R&D. In our coverage space, we believe Sihuan, Sino Biopharma have strong R&D capabilities that deserve special investor attention. The other companies with strong R&D capabilities are Jiangsu Hengrui (600276 CH, Not covered), and Simcere (SCR US, Not Covered).
Channel consolidation to benefit leading distributors
Local governments are cutting drug prices in order to make drugs more affordable. Those price cuts are carried out in light of the perception that there is a huge gap between ex-factory prices and retail prices for some drugs with too much value lost to distributors, or drug sales organizations, which do not provide much value added.Price cuts may force channel reshuffling, forcing business model changes as we see more and more manufacturers internalizing sales and marketing by adopting direct sales model while using distributors as pure logistics organizers. National level distributors, such as Sinopharm and Shanghai Pharmaceuticals, are not drug sales
organizations and are less susceptible to cleaning up the channels. Since the Chinese government plans to support the emergence of 1-3 distributors with sales of above Rmb100bn and 20-plus local distributors with sales of above Rmb10bn by 2015 as a part of 12th five-year plan, we believe the consolidation of drug distribution industry would pick up and view consolidators with successful track-record of integration as ultimate winners.
Stock investment views
Currently, we have nine Chinese healthcare companies under coverage. None escaped the sharp downturn in 3Q11. Particularly hard hit was The United Labs, whose shares were down 50% in 3Q11, followed by Shineway, whose shares fell by 42%. We think there are good reasons, while not totally justifiable, for the two companies to fall a lot because of the disproportionally high exposure of The United Labs to antibiotics and Shineway to EDL sales. We believe the retreat of The United Labs shares has created a good buying opportunity, while Shineway no longer looks over-valued at current levels. On the other hand, Mindray shares and Sinopharm shares have not suffered as much for good reasons. They are industry leaders,shouldering the tough macro environment well and thus deserve premium pricing, in our view. We have summarized individual stock views below.
highWhat’s in the price Potential recovery drivers
CHINA SHINEWAY
2877 HK -61.9%
Very large EDL exposure; Qing Kai Ling Sales affected greatly; the company lost EDL tendering in multiple
provinces; GM to go down further
EDL exposure may be over-estimated; non-injections perform really well and may pick
up the slack
CONCORD MEDICAL
CCM US -57.0% Continued doubt with business model; overall bad performance by China ADRs
Diversifying into hospitals; Financial performance may get better recognition
MICROPORT SCIENTIFIC
853 HK -45.8% Stent price cut overhang; Lepu’s Nano may take away a large trunk of
market share
Stent price cut may be less than expected; Nano should not take away too much market
share yet Firehawk success would fundamentally change
MicroPort
MINDRAY MEDICAL
MR US -21.2% overall business slowdown, particularly China
business; Unimpressive new product launch
China business rebounding and may show continuing strength in 3Q, 4Q earnings;
New products may show progress
SHANDONG WEIGAO
1066 HK -27.3%
Stent price cut pressure; Doubt with dialysis business take-off; Doubt with super-strong growth sustainable? Valuation very high
Weigao may find a reputable partner for dialysis center business;
Good deal terms with JW Medical divesture Unabated growth momentum
SIHUAN 460 HK -49.0% Sales slowdown of Kelinao/Anjieli; CCV price cut; Too many acquisitions too quickly
Oudimei appears to be taking over from Kelinao as key driver;
Dupromise acquisition works fine so far; CCV price cut better than expected
SINO BIOPHARMACEUTICAL
1177 HK -32.5% Continued SG&A deleveraging; sales may slow down; Management focus or lack of it
Sales have shown continued strength; Expenses being controlled better; Good acquisitions may complement growth; Strong performance by new products
SINOPHARM 1099 HK -38.8%
Price cut may affect gross margin; Integration may be more difficult than expected; Competition for acquisitions may be getting fierce Organic growth under-estimated
Relative resistant to EDL drug price cut; Business tied to overall sales but not any
particular drugs; Sales continue being strong with solid organic
growth complemented with acquisitions; Positions best with widest network and
experience for acquisitions
UNITED LABORATORIES
3933 HK -63.4%
Antibiotics price cut + restriction of use; Doubt with Insulin uptake; Price cut of antibiotics on bulk medicine
businesses
May be able to handle price cut better with individual pricing for some antibiotics in place;
Use of its main antibiotics products unrestricted so sales impact may be less than market expectations;
Improved enzyme-method for Amoxicillin bulk medicine production may improve profitability
Source: J.P. Morgan; All prices are as of close of October 14 for HK-listed stocks and Oct.13 close for US-listed stocks
Sino Biopharmaceutical – 1177 HK: We believe Sino Biopharma is among the best all-around Chinese pharmaceutical companies, as it features a balanced portfolio with 14 or more blockbuster drugs by next year. It operates an unrivaled hepatitis franchise with 20% market share, and its CCV franchise is among the strongest with 75% of market share of alprostidil, a top-5 drug in China. SBP boasts an enviable track record of M&A and integration successes and is poised to make additional acquisitions, which, combined with its industry-leading R&D pipeline, should sustain SBP’s strong top-line growth well into the future. While many investors dislike SBP’s holding-company structure and its involvement in apparently non-core business, SBP is a rare HKeX Main Board listed firm that reports quarterly results and pays a quarterly dividend, which we believe provides visibility and reduces investment risk. We reiterate OW rating and believe it should be a core holding for investors seeking investment opportunities in the booming healthcare industry.
Sino Biopharma shares have dropped by 14% in past three months, but have managed to outperform Hang Seng China Enterprise Index by 16%. The stock is currently trading at 17.4x 2012E EPS. We believe that the stock’s decline may have been due to the investors’ concerns about continued SG&A deleveraging and apprehension about management’s lack of focus. We believe Sino Biopharma shares will perform when the market recovers, as the company has shown continued strength with its products sales, apparently shouldering price cuts better than most competitors. We are pleased with the company's expense controlling efforts as shown in 1H11 results. The key drivers for the company going forward are: 1) Good acquisitions to complement growth; and 2) Strong performance by new products.
Sinopharm – 1099 HK: Sinopharm is the largest medical product distributor that operates the widest network covering 159 prefecture-level cities in 30 provinces, positioning the company in the best place for further consolidation of the distribution industry. Although sales growth will eventually slow down, as acquisitions result in business canalization, we believe this is a ‘consolidation first, leveraging second’story. Leveraging would eventually materialize after Sinopharm builds up sufficient scale and network reach. We believe the recent pull back in the stock has establisheda very attractive buying opportunity. Sinopharm is among our three top picks in the healthcare space.
Sinopharm shares have dropped by 23% over the past three months but have managed to outperform the Hang Seng China Enterprise Index by 7%. The stock is currently trading at 21x 2012E EPS. We believe the stock’s decline may have been due to the investors’ concern about the impact of EDL and NDRL drug price cuts on the company's sales and margins. In addition, investors might have become more pessimistic about the company's ability to extract SG&A leverage with the new acquisitions. Finally, investors may start discounting Sinopharm's scarcity value post-IPO of Shanghai Pharmaceutical. We believe Sinopharm shares will perform well when the market recovers and re-rating of healthcare stocks starts. First, 1H11 results highlighted Sinopharm’s ability to continue performing even under today's tough macro-environment, with its 48% Y/Y growth in total revenue apparentlyreassuring investors and driving the stock to outperform the HSCEI index by 20% in the last month. The company has been able to deal with price cuts by shifting product mix and sales mix towards more direct sales to hospitals. We believe investors will eventually appreciate that the company is well-positioned to leverageits nationwide distribution network for additional businesses and acquisitions. The key drivers for the company going forward are: 1) M&A success; 2) receding price
pressures; and 3) financial results showing SG&A leveraging and finance cost in control.
Mindray Medical: Mindray is a leading global medical equipment company with deep roots in China and deriving more than half of its revenue abroad. The key products include patient monitors and life-support systems, in-vitro diagnostic products and medical imaging. While we are forecasting only a modest EPS CAGR of 14% for next 3 years (2011- 2013), we still believe the stock price (15.5x 2012EEPS) is undervalued. We think Mindray, as a predominant market leader in China, deserves a premium valuation. The company’s diversified product mix and balanced sales contribution from China and ex-China greatly reduce investment risks. Its strong R&D capabilities and wide sales network should sustain the company’s growth for many years to come, in our view.
Mindray shares, while down 21 % from 52-week high, have performed relatively well over the past three months and managed to post a gain of 12.3% relative to Hang Seng Mainland Enterprise Index. Mindray shares have underperformed theoverall China healthcare sector in past couple years as investors appear to view Mindray more and more like a global medical equipment company with its days of year-after-year strong sales growth behind it. Instead of being a China company with strong sales growth momentum, Mindray's China sales actually dragged down the company's growth in the past couple of years. However, we do see value in Mindray as a global player hailing from China. The company still maintains a cost advantage against most MNCs and its R&D capabilities, brand recognition and quality perception are second to none among domestic medical equipment makers. We see continued strengthening of China business and the launch of new products as key drivers for share performance.
China Shineway 2877 HK: Shineway is the largest TCM injection and soft-capsule modernized Chinese medicine manufacturer, in terms of both sales volume and production capacity. The company has more than 15 years of experience in the production of TCM injection – a relative new development in the TCM field. TCM injections have been controversial and many people do not believe in the safety of TCM injections. However, the Chinese government has been very supportive of the development of TCM injections as a way to lower drug costs, while fostering modernization of TCMs, a national pride. The company's two leading TCM injections, Shineway-branded Qing Kai Ling and Shenmai injections are among the best-known TCM injections and have occupied the No.1 and No.2 market positionsin their respective categories. Shineway enjoys much higher gross margins than its peers, who are engaged in producing common generics.
Shineway shares have traded down by 61% in the past 12 months and dropped by more than one third in the past three months. We think the dramatic retreat of Shineway shares was mainly due to the company’s disproportionally high exposure to EDL price cuts. In 2010, the two injection products included in the EDL, Shenmai injection and Qing Kai Ling injection, roughly accounted for 50% of the company’s total sales. The initial enthusiasm about having two drugs on the EDL has been replaced with a nightmare of relentless price cuts. Furthermore, Shineway has lost EDL tendering in several major provinces, where they may only supply drugs through non-tender channels. We do not see EDL pain to cease anytime soon, andhence investors should look elsewhere within the healthcare space for better values
YTD 1M 3M 12M
Absolute (%) -6.7 -2.0 -8.0 -20.8
Relative (%) 16.1 -0.3 12.3 5.5
Source: Bloomberg.
OW, PT – US$32, 19x 2012e EPSKey drivers: Continued China sales
without overhangs of price cuts of key products and continued weak financial performance for some time.
Concord Medical Services – CCM US: Concord is the largest operator of third-party radiotherapy and diagnostic imaging centers in China with approximately 20% market share. Concord has developed beneficial relationships with partner hospitals. As of June 30, 2011, Concord operated 125 centers across 46 major cities in China. The company’s network centers employ hundred of surgeons and medical staff, who can learn from each other by attending semi-annual conference, and surgeons can compare notes with treatment options for difficult cases, for which Concord is maintaining a database. Concord's network of centers also offer training for staff to be placed in new centers, facilitating the ramp-up of new centers. The company has been moving aggressively into the private hospital services space. In January 2011, Concord announced that it was acquiring 52% interest of the entire Chang’an Hospital, which has 1,100 beds. Although the deal has faced delays, it should close by the year-end of 2011. Separately, Concord has entered into a 70:30 JV agreement with the Oncology Hospital of Zhongshan Medical University to establish a 400-bed specialty hospital in Guangzhou for cancer diagnosis and treatment. The JV hospitalis expected to open to treat patients in 2013. Concord is developing an independent Proton Beam therapy center with a partner that is slated for opening in 2012-2013. As the government opens up hospital services for private investment, we believe Concord is moving into a very lucrative space, whereby it can serve well-off patients and enjoy more leeway with flexible pricing for high-end services
Concord shares have declined 58.8% since the beginning of this year and 28% in the past three months. We believe the continued weakness of CCM shares mainly reflects: 1) accounting scandals associated with US-listed Chinese companies in general; and 2) continued doubts by the US investors on the sustainability of Concord’s lease-and-management business model. We view the first reason as unfairand the second largely misplaced. After all, Concord’s financials are audited by E&Y professionals, directly supervised by the regional practice head. Most of Concord’s centers are quite profitable and its longstanding relationship (6 centers) with the reputable Navy General Hospital in Beijing validates the demand for third-party radiotherapy and diagnostic centers. Although we do not see many major catalysts in the near term that will drive tremendous upside, we believe trading at 7.2x 2011EEPADS and 5.8x 2012E EPS, Concord shares are certainly undervalued in light of the company’s growth potential. Low liquidity notwithstanding, we think this company offers a good opportunity for investors participate in the tremendousgrowth potential of China private hospital space.
MicroPort Scientific – 853 HK: Unlike other healthcare markets, the stent market is dominated by three domestic players, MicroPort, Lepu, and JW Medical, a joint venture of Shandong Weigao and Biosensor of Singapore. MicroPort pioneered the market in China and has been industry leader for several years. Even after strong growth in the past few years, the PCI penetration rate is still low, leaving further room for continued growth ahead. We expect MicroPort to maintain its current leadership position (29% share in 2009) for a few more years, while staking its future on the success of its Firehawk stents in clinical trials, which may enable it to launch a high-end stent competing with MNC stents for the global markets. Meanwhile, MicroPort is diversifying into orthopedic market, diabetic infusion pumps, and cardiac ablation catheters. The success of other business segments may relieve MicroPort’s over-reliance on a single stent product (Firebird II) as of now.
Over the past twelve months, MicroPort declined by 53%, underperforming the HSCEI index by 24%. The stock was down by 22% over the past three months alongwith the market and other healthcare names. We believe some level of pullback in MicroPort shares is understandable given its sky-high valuation attached to the company based on investor enthusiasm about a potential Shandong Weigao because both are strong players in the stent space. However, the severity of the pullback has surprised us. We think there are some key concerns about MicroPort, including: 1) the looming price cuts of stents; 2) the competition of Lepu’s Nano™ stent againstFirebird II; and 3) MNC competition pressure. However, we recommend investors stay on the sideline, and wait for more clarity on the level of stent price cuts. We also see risks with the company’s efforts to diversify away from its core competence area.On the other hand, we see tremendous upside in MicroPort shares if the clinical trials of Firehawk are successful.
Sihuan Pharmaceutical – 460 HK: Sihuan is a leading provider of cardio-cerebral drugs used in major hospitals for the emergency treatment of strokes and other cardio-cerebral diseases. Sihuan has ranked No.1 for CCV sales since 2007, featuring Kelinao as the best-selling drug among all products procured by hospitals. The acquisition of Dupromise boosted Sihuan's market share to 9% for 1H11, as compared with 7.8% for 1H10. Sihuan’s portfolio features products for three out of five most-frequently prescribed CCV molecules in China. With low market share for edaravone and GM1, Sihuan is poised to grab more significant market shares for those products. Although we are concerned about a growth slowdown inKelinao/Anjieli, given the poor 1H11 results, we are encouraged by the initial sales performance of Oudimei. The strong performance was substantiated by the hospitalpurchases data compiled by IMS. We expect Sihuan to maintain its strong growth momentum as we see potential for sales recovery of Kelinao and Anjieli. Our Dec12 price target is HK$4.9.
Sihuan shares debuted on the Hong Kong stock exchange last October at HK$4.60. Since reaching the post-IPO high of HK$6.19, the price has been cut by an half, and the shares are currently trading at less than 12.7x our 2012E EPS. This is probably uncalled for, in our view, in light of its historically strong financial performance, its leadership position in cardio-cerebral medicine and the ability to develop related new products to boost growth better than most peers and its growth potential. We think the weakness in Sihuan shares are probably caused by three factors: 1) slowdown of Kelinao/Anjieli sales; 2) potential price cuts for CCV drugs; and 3) concerns about the absorption of all these new acquisitions post-IPO. We believe Sihuan’s shares are likely to rebound as: 1) Oudimei appears to have the potential to take over Kelinao as the key driver for continued growth; 2) Kelinao and Anjieli’s sales are likely to rebound after the removal of reimbursement restrictions; and 3) the new acquisitions appear to be complementary to the company's business and will drive future growth.
YTD 1M 3M 12M
Absolute (%) -53.7 0.8 -27.3 -42.8
Relative (%) -22.5 16.0 2.7 -13.7
Source: Bloomberg.
OW, PT – HK$4.9, 21x 2012E EPSKey drivers: Rebounding of Kelinao/Anjieli business; Continued
Shandong Weigao – 1066 HK: Over the years, Weigao has built up a vast sales and distribution network that is critical for the success as a medical consumable company. While Becton-Dickinson, Weigao’s main MNC competitor for high-end consumables, relies on distributors for product sales, Weigao uses its own sales force, and hence it gains more control of end-user hospital market. Weigao’s products usually enjoy a price premium versus its domestic peers and they are positively perceived by large hospitals that evaluate medical products on both price and quality. Compared to the medical equipment makers, whose products generally have a replacement cycle lasting several years that may be prolonged under tough economic conditions, Weigao’s products are mostly disposable consumables thatpatients rely on daily and are largely non-discretionary, which we view as a distinct advantage with Weigao’s business model. Weigao’s stock has been trading at a very hefty forward PE of 30-40x for quite long. However, one can hardly find any large Chinese healthcare companies growing their sales 30-40% year after year for so long. Hence, we believe as long as Weigao can keep such robust pace of growth, its shares will continue to trade at a premium.
Weigao’s stock has traded down 24% year-to-date and down 25.6% in the past threemonths. While the CFO announced the resignation during the company’s 1H11 earnings call, we do not think it was anything related to the financials or the stock performance. We think the weakness may have been caused by the following four factors: 1) pressure from stent price-cuts; 2) doubts about the take-off of the dialysis business; 3) doubts about the sustaining power of the company’s hyper-strong growth enjoyed for the past few years; and 4) high valuation. Even after the pullback, Weigao’s shares are still trading at 25x 2012E EPS, which might not look cheap. However, if investors believe that Weigao can continue to grow as strongly as it has done in previous years, we think the recent pullback of Weigao shares actually offersan opportunity for the investors to add to their existing positions or to establish new positions. Some key catalysts that could drive Weigao’s share performance include: 1) successful rollout of pilot dialysis centers; 2) favorable terms for JW Medical divestures; and 3) strong quarterly earnings results.
The United Laboratories – 3933 HK: We continue to like The United Laboratories (TUL) for its strong antibiotics franchise that features well-established brand names. The company’s low-cost 6-APA facility in Mongolia has a distinct competitive edge. Its enzyme process for amoxicillin production is likely to expand segment marginsfor the bulk medicines. Nevertheless, we believe TUL shares will continue being under pressure as the market digests the full impact of antibiotics price cuts and restriction of use on the company’s short term financial performance. Hence, we rate TUL at Neutral.
TUL shares have fallen by 64% year-to-date and 46% in 3Q11, making them by far the worst performer among our coverage space. There is no question that TUL is facing some difficulties specific to the company and the company has reported 1H11 results, with segmental profits declining across all the three business segments. We believe the recent decline in TUL shares has been due to the concerns about the restrictions on antibiotics use on top of the price cuts in antibiotics. Management may have worked too hard on curbing investor enthusiasm on the market potential and sales ramp-up of insulin products. In addition to 6-APA average selling price trend, key drivers for TUL include: 1) the sales performance of antibiotics in face of price cuts and restriction of use; 2) sales ramp up of insulin products; and 3) the impact of enzyme process on the profitability of bulk medicines businesses.
UNITED LABORATORIES 3933 HK N OW HK$7.5 HK$22.0 -65.9% 0.416 0.961 -56.7% 0.630 1.411 -55.4%
Source: Bloomberg, J.P. Morgan estimates.
Valuation Analysis and Price Targets
DCF - our primary valuation methodology
We have derived our Dec-12 price targets for our covered companies mostly based on discounted cash flow (DCF) analysis of our base-case financial projections for the individual company. For all our DCF analyses, we generally assume a market risk premium of 6.0% and a risk-free rate of 4.2% (common yield on 10-year government notes in China). The beta values are based on Bloomberg adjusted beta figures calibrated by our own assessments of the reliability of cash flow forecasts. We derivecost of equity according to the capital asset pricing model (CAPM). The weighted cost of capital (WACC) is calculated based on the debt to capital ratio, cost of equity and interest rate of debt. We estimate free cash flow until 2015 and assume a terminal growth rate of 3-6%, based on the annual growth rate expected in 2015 and the nature of the healthcare subsector.
P/E Valuation – mainly used as a sanity check
Although we believe each company has its own intrinsic value as determined by properly structured DCF analysis, the stock of a company must also be evaluated in the context of its peers. We routinely compare P/E as if the price target is achieved to see how the company would be traded compared to peers to assess the likelihood of achievement of the PT.
Risks to our price target
We routinely perform sensitivity analysis of our price target based on different assumptions of terminal growth rate and WACC, two of the most subjective factors affecting valuations, in our opinion. Although we are trying to determine the price target with about one-year horizon, we see long-term prospects to have different impact on short-term performances and hence, we also test our price target versus multiple negative or positive surprises that may affect the price targets.
Fundamentals driving industry growth to remain intact
Despite the recent negative macro headwinds, we believe the secular growth story of the China healthcare industry remains in place. In China, healthcare expenditure is just less than 5% of the GDP compared with over 10% for many developed nations. In recent years, there have been debates in both China and the US about healthcare spending and reforms. In the US, the reforms intend to curb excessive healthcare spending that accounts for ~16% of the GDP, while in China, the new Healthcare Reform aims to increase healthcare spending as a proportion of GDP and allocate resources more optimally. The Chinese are demanding the government to increase healthcare spending and pay for a higher percentage of their healthcare costs. We expect the government to continue to invest heavily in building up healthcare infrastructure and subsidize the expansion of healthcare insurance coverage to eventually get all Chinese citizens covered by some form of health insurance by 2020. In addition, with the rising disposable income, the Chinese are becoming more health-conscious and willing to spend out-of-pocket money even to treat minor illnesses. Finally, the population is fast aging and consequently cancer, chronic illnesses, Alzheimer’s, and other aging-related illnesses are become more prevalent.
Figure 3: Chinese have consistently under-spent on healthcare, while the economy has been growing at an unprecedented pace
Source: OECD, Chinese government websites.
Although the healthcare stocks have undergone a painful de-rating this year due to all kinds of negative headlines, we think that all the underlying fundamentals that drove the healthcare industry growth of ~18% for the past six years remain intact. We believe that the sheer size of the population and the propensity of Chinese to take care of their elders could offer ample opportunities for the healthcare industry to continue its huge growth in the next 10-15 years. Hence, while we are cautious in the short term, especially on drug companies, we remain extremely positive on the long term prospects of the industry.
-
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
% GDP (1980) % GDP (1990) % GDP (2000) % GDP (2009)
Healthcare names under-represented in the public market
Healthcare in aggregate is one of the largest sectors in the U.S. economy and its aggregate market capitalization is approximately 10% of the entire stock market capitalization. In contrast, China does not have any healthcare stock with a market cap of over US$10bn and the total market capitalization of all public-traded healthcare companies is about 4.2% of all the listed companies, as per Bloomberg estimates. Post-healthcare reform, we believe that many strong companies will emerge that will be attractive to investors. Companies with strong R&D capabilities and sales network should be long-term winners, in our view. We expect healthcare companies as an aggregate will eventually account for more and more of the Chinese market capitalization, and take their rightful place in the market, given their importance to the economy as a whole, i.e. healthcare spending will eventually account for ~10% of the GDP by 2020.
Table 5: Chinese under-capitalized healthcare companies compared with global peers
# of Public Companies
HC Market Cap ($bn)
Average Market Cap ($mn)
Total Market Cap ($bn)
HC % of Total
China 238 4,790.0 840.3 200.0 4.2%
US 1,001 14,770.0 1,468.5 1,470.0 10.0%
India 189 1,210.0 305.2 57.7 4.8%
Japan 148 3,670.0 1,526.3 225.9 6.2%
UK 97 2,510.0 1,824.9 177.0 7.1%
Source: Bloomberg; Priced on Sep.23, 2011
Low spending per-capita drives superior growth
As Table 6 shows, the spending per-capita on healthcare in China is less than 2% of that in the US in 2006, according to the World Health Organization. The growth rate is nearly double that of most countries, but we note that even at this growth rate, the spending per-capita would still be well below 5% of that in the US by 2015.
Table 6: Low per-capita healthcare spending even after growing the fastest among select peers
Total in 2006 (US$bn)
Per Capita ($)2001
Per Capita ($)2006
01-06 CAGR (%)
China 121.5 50.0 92.0 13.0
Spain 105.2 1,596.0 2,387.0 8.4
Japan 355.0 2,609.0 2,626.0 0.1
Italy 175.0 2,358.0 3,002.0 4.9
UK 215.0 2,478.0 3,552.0 7.5
Canada 123.9 2,853.0 3,799.0 5.9
Germany 318.0 3,537.0 3,870.0 1.8
France 262.0 3,227.0 4,278.0 5.8
US 2,010.0 4,915.0 6,714.0 6.4
Source: WHO.
More prosperity to accelerate healthcare spending – rising income leading toheightened health awareness
Along with GDP growth, disposable income of Chinese has also been rising very fast in recent years. Consumers have raised their awareness of public health, increasing focus on disease prevention, general wellness, and the early diagnosis of medicalconditions. According to the China Statistical Yearbook, from 2000 to 2007, average spending on healthcare and medical services increased from approximately 6.4% to 7.0% of household expenditure for urban households and from approximately 6.8% to 7.6% for rural households. This in part reflects growing health awareness in the
PRC. The substantial growth in disposable income of urban residents combined with the increase of awareness of public health and focus on disease prevention and general wellness would lead to greater demand for pharmaceuticals and healthcare-related products.
Figure 4: Rising disposal income propelling out-of-pocket spending on healthcare
Source: Statistics Bureau; J.P. Morgan estimates.
We believe the rising prosperity of China should accelerate the spending on healthcare, especially in rural areas. Since 2000, the annual growth in total healthcare expenditure in China is approximately 15%, which is higher than the rate of GDP growth but well below some of the growth rates in other sectors, such as investment in infrastructure and power. We believe the government has refocused on providing better healthcare services to the people and the next stage of growth would be driven by spending on rural healthcare. Currently, the healthcare spending per-capita in rural areas is only 23% of that for urban residences (MOH).
Figure 5: Healthcare spending rising but staying relative stable and low as a percentage of GDP
Figure 6: Rural versus city spending (Rmb ‘bn) suggests considerable room to grow as Rural Co-op insurance takes off
Source: Ministry of Health
Population continues to age, regardless of government policies
The latest data from the China National Committee on Aging shows that the number of people over 60 years reached 167mn or 12.5% of the total population in 2009, with rapid Y/Y growth of 4.5%, the highest during the past four years. According to a UN projection, by 2050, over 400 million or nearly 33% of Chinese population will be over 60 years of age. Population aging is clearly the direct result of government’s one-child policy, but it is also the result of people living longer life. Unfortunately, people who live longer tend to also see more illness. For example, cancer and Alzheimer’s diseases are not the diseases of the young. More and more elderly are also developing chronic diseases, such as hypertension and diabetes because of lifestyle changes. With more people getting older and living longer, the demand for healthcare services will increase tremendously along the way. Since the Chinese have the propensity to take care of the elderly people and many people feel morally compelled to spend as much as they can to keep their parents alive, this part of inelastic demand is expected to last well in the future. Currently, the elderly already consume more than half of all drugs sold in China. That share should clearly increase with the population ageing.
Figure 7: Life expectancy at birth for Chinese to double to 80
Source: United Nations.
Figure 8: China's ageing population puts extra demand on healthcare
Chronic diseases becoming epidemic in China – substantial untapped market
With the population aging and lifestyle changing to diets containing more fat and calories, chronic diseases have reached epidemic proportions. From 1993 to 2005, patients with ischemic stroke increased by 251.3%, cancer by 111.5%, hypertension 387.2%, diabetes 482.9%, and heart diseases 82.4%. Clearly, the burden for treating chronic diseases has clearly outpaced the growth of GDP. In the old days, the Chinese might have chosen to live with chronic diseases and pushed off treatment as late as possible. Nowadays, as they become more health-conscious, many people are electing to get treatment. As there is normally no cure for chronic diseases and all that the doctors can do is slow down the disease progression, the treatment for chronic diseases is routinely long term and very costly. Manufacturers of medicines for chronic diseases stand to benefit greatly from these demographic changes. This is the reason why we like United Labs and Sino Biopharmaceutical particularly well. United Labs has the potential to be a prominent domestic supplier with its comprehensive portfolio of insulin products, which were launched recently to the market. Sino Biopharmaceutical is by far the most-dominant player in the lucrative hepatitis space. China has one-third of the world’s patients with chronic hepatitis B.patients, with hepatitis B patients routinely taking anti-viral products for more than one year daily to keep viral breakthrough under control.
Increased government portion of total healthcare expenditure a major force behind industry growth
In the 1980s, the proportion of healthcare costs paid by the government or government-related entities (including insurance) was in excess of 80%. The government under-invested in the healthcare area in the early reform years, with individuals losing jobs from state-owned enterprises that provided full healthcare benefits and moving to private sectors that provided much-less generous healthcare coverage. By 2000, the individual contribution to healthcare spending reached a high of nearly 60%. In the following decades, the government looked to alleviate the burden of individuals and the payment from government sources and social spending increased to about 60% in 2008, with individuals still paying 40% of the cost of healthcare. The trend to greater government subsidies and insurance reimbursements should raise the affordability and the demand for healthcare in China. The main reasons are expanded health insurance coverage through three new public insurance schemes: 1) Urban Workers’ Medical Insurance Scheme launched in 1999; 2) the New Rural Cooperative Health Insurance Scheme launched in 2003; and 3) the Urban Residents Basic Medical Insurance launched in 2007. The Rural Cooperative Scheme offers insurance coverage for rural population for the first time and it is reimbursing patients up to 40% of out-patient services costs, including drugs. The Urban Resident Program ensures children, elderly, and college students to receive some form of insurance, with patients more generally reimbursed by the governments than the rural program. By year 2020, the government aims to have universal coverage of all its population. We believe that, with more government subsidies to the rural and urban resident schemes, many more people will elect to purchase insurances and opt to receive treatment for diseases people use to tolerate or even die of. This fundamental driver behind industry growth is clearly unperturbed by the recent negative macro headwinds.
Healthcare Reform brings opportunities and challenges
The government released the New Healthcare Reform plan and associated three-year execution plan in April 2009. It also appropriated Rmb850bn for the implementation of the plan for 2009-11, although it remains unclear whether the entire fund would be incremental to baseline spending or a mix of both. According to IMS estimates, the government spent about 98% of its budgeted Rmb850bn in the initial two years and would invest Rmb284bn more to implement the Reform. The Reform efforts intend to achieve five key goals to be accomplished by 2011:
1) To further expand medical insurance coverage and to increase the medical insurance participation rate
2) To set up a national essential drug system3) To establish an extensive public health system4) To provide equal public health services in both rural and urban
areas5) To pilot the reform of state-owned hospitals
The No.1 goal is undoubtedly positive for the industry. The government subsidy for rural co-op insurance scheme has increased per head from Rmb40 to Rmb120 in 2011. Even with the government spending only a quarter of the Rmb850bn for expanding insurance coverage, Rmb200bn extra insurance will be largely spent on drug purchases, benefiting the drug distribution and manufacturing industries. The No. 3 goal clearly favors vaccine developers and medical equipment companies developing diagnostic machines. The No.4 goal involves building up local community health centers and rural medical facilities that are supposed to divert traffic away from large urban hospitals, which is clearly beneficial to the low-end medical equipment and consumable makers because those hospitals will need to be equipped with basic medical equipment and operate with daily consumable for patients. On the other hand, the build-up of local healthcare facilities appears to be detrimental to drugstore operators. As far as the No.5 goal is concerned, the reform of state-owned hospitals will take much longer time than three years and its impact should be minimal in the near term. The hospital reform may open the door to the establishment of more private hospitals and privatization of some hospitals, which could benefit medical service players, such as Concord Medical and Chindex (CHDX US, Not Rated).
Industry players initially had high expectations with the implementation of the EDL as they saw opportunities with vastly expanding sales volume to rural areas, the so-called third terminal. However, the EDL has turned out to be the most controversial part of the New Healthcare Reform and nightmarish for companies such as Shineway which depend heavily on sales of EDL drugs.
Anhui model – can we do away with the EDL?
By way of reference, the EDL includes 307 most commonly used drugs deemed essential by the government, two-thirds chemical drugs and one-third TCMs. The Anhui-based tender model was developed and used in Anhui Province last year as a means of controlling the prices of essential drugs. On top of the 307 drugs listed on the national EDL, Anhui government added 277 drugs to the list and subjected them to provincial-level EDL tendering. All the hospitals and clinics below county-level stock only those EDL drugs. The bidders were asked to submit two envelopes – one showing adequate GMP certification and one showing the bid price. Under the Anhui system, those producers offering the lowest prices in a bidding contest were awarded contracts to manufacture the stipulated medicines, given that most of the bidders could fulfill the requirements of the other envelop in which a manufacturer submitted manufacture certificate. Otherwise, they would not be in the business. The Anhui model was highly controversial because of the large price cuts that resulted from the
tendering, with an average of 40% price cut. In addition, some reputable providers of EDL drugs, such as Shineway for Qing Kai Ling TCM injection, were completely shut out of Anhui EDL tendering, making their products unavailable to patients through the regular channels.
Some experts estimated that the prices offered by some small drug manufacturers were so low that they would not even cover the production costs. Hence, some experts have been openly concerned that many manufacturers may be compelled to supply low-quality products in order to be profitable. The widely reported (e.g. Xinhua News) manufacturing issues identified with low-price manufacturer,Shuzhong Pharmaceutical, which is based in Sichuan Province and has won many EDL bids in Anhui, appeared to confirm this concern. However, conversations withAnhui officials from the tender office indicate that they remain steadfast with their approach. Local government officials seeking to build political capital have copied the Anhui model to achieve the highest magnitude of price cuts. Even the wealthy Guangdong province’s EDL tendering was mostly modeled after the Anhui model.
Given the news flow surrounding the Anhui Model of EDL tendering and its potential adverse effects on drug quality (too low) and supply (shortage), many are now looking at the central government for remedy. It has been widely circulated (e.g. Yangcheng Evening News) that the NDRC may establish a unified pricing mechanism this year for the EDL drugs and the initial focus will be on 50 or so drugs provided each by a single manufacturer or drugs that have been in the market with established efficacies and stable prices over many years. It is stipulated that the bidders will compete mainly on qualities now that the prices are fixed. The questions remain on how one evaluates qualities, as unlike prices, they are quite subjective.
NDRL drug price cuts – yet more to come
The implementation of the 2009 version of the NDRL is supposed to make drugs more affordable for patients, hence expanding the drug sales volume, as the list contains 14% more number of drugs than in the 2004 version with many popular drugs moving from Class-B to Class-A, which is reimbursable from 80-90%, with some completely reimbursable. However, it is almost inevitable that drugs will see price cuts if they are included in the NDRL as the government, the ultimate payer, seeks to control medical costs. In fact, the government has already cut prices twice this year, first for antibiotics and circulatory system drugs in February. It cut the prices of drugs for the hormonal/endocrine drugs in August 2011. For both batches, the price cuts were about 20%. Additional price cuts may be forthcoming for oncology drugs, CCV drugs, and other drugs. However, the timeline appears to be stretching further out. The cut in retail ceiling prices may not hit manufacturers directly if the prevailing tendering prices are well under the ceiling prices. Non-EDL drug tendering, which sets the hospital purchase prices, on the other hand, will almost certainly affect ex-manufacturing prices directly.
Fujian model – NDRL tendering causing fear among manufacturers
The Fujian government is conducting tendering for non-EDL drugs included in the government’s provincial drug reimbursement list. As per the plan released by the Fujian government, the tendering will dramatically reduce the number of formulations that drug manufacturers can bid to 20. As a reference, for drug tenders conducted in 2010 in Henan, Hebei, Zhejiang, and Guangdong, there were 127, 75, 64, and 47 drug classes for manufacturers to bid on, respectively. In the Fujian model, a formulation category may not be further subdivided into categories, while this was allowed in other provinces. There may be only 2-3 winners for any quality class, which, combined with fewer categories to bid in, significantly lowers the number of
winning companies. For example, cefaclor (头孢克洛) products are divided into four classes, according to the qualities of manufacturers to tender their bids: 1) Highest-
quality capsules – 1 bid and 1 winner; 2) Capsules, 1 bid and 1 winner; 3) Capsules, tablets, tablets covered with thin film, and dispersible pills, all treated as group (oral) for bidding - 11 bidders, 3 potential winners; and 4) Same four formulations as 3), still one group, 4 bidders and 2 winners. There are potentially only seven winners, compared to 20 in Guangdong.
Table 8: Fujian Non-EDL Tender Cutting down Winning Bids Dramatically
Last tender
Formulation Categories
Dosage Forms
Quality Classes
Potential Winning Bids
TotalWinning Bids
Henan 2010 127 2 4 2.5 2,540
Hebei 2010 75 2 4 2.5 1,500
Zhejiang 2010 64 2 4 2.5 1,280
Guangdong 2009 47 2 4 2.5 940
Fijian 2011 20 1 5 2.5 250
2009 NDRL 19
Source: Fujian Government; JP Morgan Estimates; * Numbers fro Dosage Forms, Quality Classes, and Potential Winning Bids are
illustrations according to normal practice. For Fujian, no separation of dosage forms into different bidding categories.
Furthermore, the price difference among drugs in the same quality class cannot be more than 30%, and the winning bid price for lower-quality class cannot be any higher than the higher class, which makes certain drugs enjoying independent pricing power sure losers if the manufacturers of those drugs want to maintain premium prices in other provinces. While companies can complain about the quality/price trade-off for the Anhui model, we see no legitimate complaints about the Fujian model, especially for the aspects of limiting drug categories to 20. For the 2009 version of NDRL, only 19 formulations were listed. According to the estimates by some industry experts, more than 50% of tender winners that occupied top-100 ranks in term of sales in Guangdong province for 2010 may be completely shut out of the Fujian model. Previously, the Fujian government has also issued two-invoice rules for the sales of drugs in Fujian. The plan further stipulates that the markup between ex-manufacturing prices and hospital purchase prices can be only in the range of 5-8%, effectively shutting down the indirect sales model that tenders to offer much higher channel markup than allowable range. We see high likelihood that Fujian model may be duplicated in other provinces in the future rounds of drug tendering. If the model is adopted widely, fewer companies will have a slice of the pie, which could potentially force out some weak players as there appears to be no recourse.
However, there might be some positives going forward. Sino Biopharma’s Runzhong is likely to win the Fujian tender, with Jiangsu CTTQ accepting a ~15% price cut, squeezing out Bristol Myers-Squibb, which owned an 80% market share in 2010, according to Sino Biopharmaceutical. Given the weak domestic competition, Sino Biopharma is likely to more than make up the price cuts with market-share gain in Fujian. Similar situations might exist for other drugs. Hence, MNCs may fare very poorly in the Fujian model of tendering.
Supply/Demand conundrum must be solved – companies will adapt
Clearly, the drug industry is facing tremendous pressure from rounds of price cuts,with more to come. However, we would like to remind investors that the industry has faced similar pressure before and it is still standing strong. In fact, prior to recent rounds of NDRL price cuts, the government had conducted about 26 rounds of price adjustments, with only once involving upward price adjustments since 1994. Microeconomics dedicates that there is always a balance between demand and supply, which is determined by price. The government cannot continue cutting prices without affecting drug supply. When manufacturers realize that no profits can be made from producing certain products, they will stop producing them. In fact, one
study found that, for 1,500 essential drugs defined by the SFDA previously, prior to the release of the new EDL, a third of them were not available in the Beijing market. Of the products not available in Beijing, about 30% were no longer even being produced. Herein lies the conundrum – pricing essential medicines too low may cause medicine shortages and force patients to choose more expensive alternatives, which would negate the purpose of setting low prices for essential medicines. In order to make the essential drugs available to its people, the government might be then forced to raise prices in order to attract domestic manufacturers or import drugs at even higher prices. It is a possibility that the NDRC may install uniform price nationwide for certain EDL drugs, as mentioned earlier, to prevent the running to bottom competitions that have provinces compete against each other to see who can cut EDL drug prices by the largest amount, which may cause quality problems or supply shortage. Other alternatives may also emerge, including a wider adoption of Shanghai Model, which values a balance between prices and qualities for EDL tendering, a distinct minority as of now.
In addition, if the government wants to achieve its goal to upgrade the healthcare industry to be more competitive globally, it will need China’s leading companies to generate decent profits in order to fund R&D for innovative product development. We think the current downturn could have the potential to rid the industry of weak players so that strong players with consolidated market positions might eventually emerge.
Finally, over the long term, companies can adapt to new pricing schemes with cost-structure changes. Manufacturers can improve cost efficiency by adopting new manufacturing processes or improving labor productivity. The government may also be able to keep costs down for manufacturers by implementing rigorous monitors of raw material costs, which sometimes may be subject to price gouging and offering subsidies for producing certain products.
Recent Guangdong drug price adjustments contained some good news, though it is not necessarily a trend
The price bureau of Guangdong recently announced price adjustments for products included in the provincial drug reimbursement list that would be implemented on October 1. Although the adjustments included lowering retail ceiling prices for ampillicin and other drugs in Guangdong, so that they would be in line with the NDRC price cuts, the adjustments actually had some surprising price increases as well. For example, the retail ceiling prices for alprostadil and Cattle Encephalon
Glycoside and Ignotin Injection (脑苷肌肽) will be raised by 15% and 35%, respectively. Given that Guangdong is among the largest drug market in China, we believe this should be good news for Sihuan, which sells both drugs, and Sino Biopharma, which holds the largest market share for alprostadil in China. Furthermore, this could be an indication that some rationality might be coming back in the government’s decision process regarding drug pricing.
The Pharmaceuticals subsector is by far the largest subsector within China Healthcare. It has been and will continue to be sensitive to the government policy decisions, as government spending is responsible for a large share of total healthcare expenditure. Given the uncertainties in the current pharmaceutical environment and low visibility for any future price cuts, we are cautious about the industry’s short-term prospect. We believe that policy risks are particularly acute for pharmaceutical companies and investors might need to hold a long-term view in order to handle the day-to-day volatilities. We think that investors should not ignore the subsector as we are confident that many strong companies will emerge stronger post-Healthcare Reform.
Figure 11: Historical projected size of the Chinese pharmaceutical market (2005–2009)
Source: IMS Report
The drug market in China has grown rapidly in recent years. According to IMS China, total sales of the Chinese pharmaceutical market grew from Rmb107.2 billion in 2005 to Rmb243.9 billion in 2009, representing a CAGR of 22.8%. Growth has been partly driven by the favorable macro environment in terms of GDP growth and an increase in healthcare expenditure in the region. As a result of increasing urbanization, disposable income and health awareness, aging population and the prevalence of chronic health problems, and government initiatives relating to the healthcare industry, the market is projected to continue to experience a significant growth rate in the future. IMS estimates the Chinese pharmaceutical market will become the world’s third-largest pharmaceutical market by 2011, up from its number-five ranking in 2009, and the size of the Chinese market will reach Rmb691.3 billion by 2014, representing a CAGR of 23.2% from 2009 to 2014.
Figure 12: Hospital sales to continue growing at a robust paceRmb 'bn
Source: IMS China.
Fragmentation of the PRC pharmaceutical industry
The pharmaceutical industry in China is highly fragmented and competitive, with over 3,600 manufacturers in 2009, according to IMS. The top 20 companies accounted for 25% of total 2008 pharmaceutical sales in China, compared to 68% in Japan, 74% in the US and 78% in the UK. Even the largest company has only about 2% market share in China. Seventy percent of manufacturers generate annual sales less than Rmb50mn. No Chinese pharmaceutical company makes the top-50 list of global pharmaceutical company in terms of total sales as domestic drug makers generally lack the scale to compete effectively against global players. In theory, Chinese drug industry should undergo a dramatic consolidation in order to extract efficiency and allow large players to achieve scale to compete with global players. New policy initiatives, such as raised standard of new GMP and EDL tendering, all appear to favor industry consolidation. In reality, it has been difficult for the industry to get rid of weak players for the following reasons:
New GMP may not be sufficient: The new GMP standards are supposed to get rid of a number of weak manufacturers with limited financial resources as it takes an average of Rmb10mn to upgrade facilities and purchase software to bring manufacturing facilities in compliance. However, as a matter of supporting local employment, local governments routinely extend a helping hand with bank loans for facility upgrading and, as provincial governments are responsible for GMP certification, many manufacturers are expected to be squeezed by the new standard.
Weak players might need to shut down rather than be acquired: It is difficult for thriving companies to buy weak pharmaceutical assets. They might not be able to dismiss employees for fear of social unrest. Meanwhile, it may be costly to upgrade manufacturing facilities of weak players. Most small Chinese pharmaceutical companies operate in the low-end segments with many producing duplicate generic products of little differentiation. Those companies compete aggressively on pricing and spend heavily on sales and marketing, resulting in very small profit margins and little room for error. It makes no sense to acquire many such companies.
Price may be too high: While some domestic companies with quality assets may be willing to sell, the asking prices may be too high. Until recently, the solid performance by new IPOs in Hong Kong and domestic A-share markets, especially the Shenzhen GEM board, resulted in many potential sellers demanding sky-high valuation.
We believe industry consolidation should eventually occur to some extent, but the process may be much longer than expected. We understand that local governments might have incentives to bring about consolidation of local assets through direct government intervention. For example, the Shanghai government has facilitated the consolidation of numerous manufacturing and distributions assets into the creation of new Shanghai Pharmaceutical (2067 HK, 601607 CH, Not Rated). Willing players have been able to acquire quality assets. In late-2010, Sihuan was able to acquire Dupromise for a contingent cash payment of Rmb2.4bn, about 120x trailing 12-month PE and 12x forward PE if the profit goal attained.
Heavily regulated industry – new GMP and Pharmacopedia
All drug companies must receive GMP certificates in order to be in the business of drug manufacturing. While the manufacturing standards for Chinese drug companies lag developed countries, such as the EU and US, they are nonetheless improving. In March 2011, the Chinese government started implementing the latest GMP standards, which are quite similar to the EU standards. The standards entail industry-wide expenditure of Rmb30-50bn, averaging about Rmb6-10mn per company – clearly a burden to the industry. In October 2010, a new edition of “Chinese Pharmacopeia”took effect. This Pharmacopedia features more varieties of medication and raises standards for their dispensing to the public. Forty percent of the drugs in the new edition are new types. The new edition also contains improvement on some 70% of existing medication. Government officials expect the new Pharmacopeia to enhance safety in the use of drugs, promote international competitive power for domestic medical and drug products, and accelerate structural adjustment of the country's drug industry. The Pharmacopedia appears to favor companies, which have advanced technology and quality control. Hence, it may encourage more pharmaceutical groups to pay closer attention to R&D and invest more on technological innovations. While new regulations could help the entire industry down the road by improving quality standards and competitiveness against global players, companies must spend money to bring their products to comply with new standards, including label revisions, etc.
Drug prices subjected to NDRC controls and local-tendering pressures
Since the government pays a lion’s share of drug expenses for patients covered under Urban Workers’ Program, drug prices are strictly controlled in China. Retail prices of pharmaceutical products that qualify for the program and are included in the Drug Catalogue of the National Basic Medical Insurance Scheme are heavily regulated to ease the burden of medical expenses on society and ensure the implementation of the medical insurance scheme. The NDRC has historically been in charge of setting reference retail ceiling for drugs included in the national drug reimbursement list. The prices are set based on three considerations: 1) manufacturers’ self-reported production cost; 2) wholesaler spread, which is set by the government; and 3) prices of comparable products in the market. The provincial development and reform commissions are responsible for the pricing of prescription medicines that are supplementary to the local health insurance medicine list and all OTC drugs on the list. Drugs on the national list are divided into two classes. Class-A drugs automatically qualify for the regional reimbursable list, whereas the list of Class-B drugs is subject to modification by provincial authorities. Since 1997, the NDRC has issued guidelines on medicine pricing on at least 28 occasions and all but once involving significant price cuts. Although the government sets retail ceiling prices for drugs, the hospital purchase prices are set through local competitive tendering, which ultimately determines ex-factory prices for manufacturers after the distributors take a cut. Local governments normally conduct tendering once a year with some twice a year. The tendering, while setting prices for the drugs, does not specify the amount of
27 Feb-11 162 21% 162 anti-infective and circulatory system drugs
28 Aug-11 82 14% Hormonal and endocrine system drugs
Source: NDRC & MOH.
Generic vs. innovative drugs
The pharmaceutical market in China has been dominated by generic drugs, which are drugs that have the same active ingredients and are considered equivalent to an innovative drug. Innovative drugs refer to drugs that have active ingredients that are new-chemical or biochemical entities. Innovative drugs only make up a small portion of the China pharmaceutical market. Most domestic pharmaceutical companies in China manufacture and sell generic drugs, while drugs sold by multinational pharmaceutical companies in China are mostly innovative drugs, including off-patent sold by original developers, such as entecavir by BMS. Branded innovative drugs aregenerally referred to as the originator drug, when the generic drug equivalents become available. Based on IMS data, since 2005, generic drugs have accounted forover 70% of the PRC pharmaceutical market, in terms of hospital purchases, and from 2005 to 2009, the generic drug market grew by a CAGR of 24.0%, outpacing the CAGR of 19.8% for the innovative-drugs market during the same period.
First-to-market generic drugs vs. Branded generic drugs vs. Common Generics
According to IMS, in China, approximately 72% of generic drugs are marketed under specific brand names, rather than generic molecule names. Pharmaceutical companies that sell branded generic drugs generally offer sales-and-marketing support for their products, which help the companies build up brand recognition. Branded generic drugs mainly compete on the basis of brand recognition. IMS predicts that most of the growth in the China pharmaceutical market will continue to come from branded generic drugs manufactured and sold by established local companies, although the demand for innovative drugs from multinational companies has been increasing in the country’s leading urban centers. Branding generics is quite unique for the Chinese market. In the developed markets, once a drug goes off-patent, all generics will be referred with chemical names and identified by manufacturers only for product places, while only the originator will continue to have a unique brand. Generally speaking, generics are considered indistinguishable from each other in terms of efficacy and safety profiles. In China, because of the food-and-drug safety issues and varying standards of quality control by manufacturers, the public has been much more brand-conscious. That is also why the originators normally continue maintaining a large market share even after patent expiration because people think the MNC originators produce drugs of higher qualities and efficacies compared to domestic generics. In addition, generic substitution is very uncommon in China.
The first generic drug to emerge in Chinese market is called first-to-market (FTM)generic. FTM generics used to be entitled to patent or administrative protection in China that allowed a company to have marketing exclusivity against other generics for five years. The government continues allowing premium pricing for FTM generics over other competing generic drugs to encourage innovation in the pharmaceutical industry, which may also save government money. The earlier the FTM generics are brought to the market, the sooner the government can start saving money as the originators, which will normally set the prices still much higher against FTM generics. As a further incentive, reimbursement under China medical insurance programs do not differentiate between first-to-market generic drugs and other competing generic drugs as well. These practices allow sales volume of FTM generic drugs in China to continue to grow even after the introduction of competing generic equivalents as a part of the memo drafted by the government in last June, the company specified different price-cutting schedules for FTM and follow-on generics. It seeks to strip branding for any generics coming to the market as the fourth or later generics.
According to IMS, the top-five pharmaceutical drugs by therapeutic area in 2009, in terms of hospital purchases, were:
(i) Systemic anti-infective drugs;(ii) Alimentary tract and metabolism drugs;(iii) Cardiovascular system drugs;(iv) Antineoplastic and immunomodulating agents; and(v) Nervous system drugs.
On an aggregate basis, these five therapeutic areas accounted for approximately 68.3% of the Chinese pharmaceutical market in 2009.
Each of the above top-ten therapeutic areas is forecast by IMS to continue to grow at a CAGR of over 20% from 2009 to 2014. The following table sets forth certain historical and forecast information on the PRC market size for the top-ten therapeutic areas.
Founded in 1971 and based in Taizhou, Jiangsu Province, Yangzijiang Pharma is one of the largest Chinese pharmaceutical companies and a top-5 since 1997. Yangzijiang has over 8000 employees and 7 subsidiaries all over China. It has exported APIs, Finished Drug Products and TCMs to many countries and regions, including EU, Hong Kong, and others. The company’s Solid Dosage Workshop has been issued the Certificate of EMEA GMP.
Jiangsu Hengrui (600276 CH, Not Rated)
Jiangsu Hengrui Medicine, together with its subsidiaries, is engaged in the manufacture and distribution of pharmaceutical tablets, injections, and raw materials primarily in China. Hengrui is the undisputed domestic leader of China’s oncology market, a relatively less-crowded but very lucrative drug segment that enjoys much higher GM. In addition to oncology, the company also provides cardiovascular, anesthetic, and endocrine drugs. Generally regarded as one of the most innovative companies in China, Hengrui has invested heavily to build up strong R&D capabilities and a respectable product and pipeline. Jiangsu Hengrui Medicine Co., Ltd. was founded in 1970 and is based in Lianyungang, Jiangsu Province.
Zhejiang Hisun Pharmaceutical Co., Ltd. (600267 CH, Not Rated)
Zhejiang Hisun Pharmaceutical is principally engaged in the manufacture and distribution of pharmaceuticals. Its products include antineoplastic drugs, cardiovascular drugs, anti-infection drugs, endocrine control drugs, anti-parasite drugs, as well as animal remedies. Hisun distributes its products under the brand name of HISUN in domestic markets and to overseas markets. Hisun is one of the largest API manufacturers in China and a major supplier to global MNCs, such as Pfizer. As of December 31, 2010, Hisun had seven major subsidiaries and associates, which are involved in the production of pharmaceuticals, technology research and the manufacture of containers.
Shanghai Fosun Pharmaceutical (Group) Co., Ltd (600196 CH, Not Rated)
Shanghai Fosun Pharmaceutical is a China-based company engaged in R&D, manufacture, distribution and retailing of medical products. Its principal products are:pharmaceuticals for malarias, such as Artesunate Tablets; pharmaceuticals for liver inflammations, such as Atomolan; pharmaceuticals for gynecological diseases, such as Huahong Tablets, as well as pharmaceuticals for diabetes, such as insulin injection. Fosun also supplies pharmaceuticals for cardiovascular diseases, antineoplastic drugs, pharmaceuticals for sick disease, pediatrics drugs and gastrointestinal tract drugs, among others. The company also operates regular chain drug stores. It distributes its products primarily in domestic and overseas markets. The company owns about 34% of Sinopharm, the largest medical product distributor in China.
Simcere Pharmaceuticals (SCR US, Not Rated)
Simcere, based in Nanjing, Jiangsu Province, is a NYSE-listed Chinese pharmaceutical company that is mostly engaged in the manufacture and sales of first-to-market generics. It also markets a rare-patented oncology drug developed in China for the treatment of non-small cell lung cancer. It has the largest market of edaravone products in China. The company has built a strong sales network and has undertaken many acquisitions in recent years.
Medical equipment is what doctors employ to facilitate diagnostics and treatment. Medical devices, on the other hand, are implanted inside the human body for disease management. In China, as both involve technology and hardware, they are routinely treated as a single sub-sector of the healthcare industry.
Low penetration rate suggests plenty room for growth ahead
The penetration rate of common medical equipment in Chinese hospitals and implantation rate of medical devices in humans remain relatively low compared to the developed medical markets. Although the hospital beds per 1,000 people have increased steadily in China and surpassed that in the US recently (4.06 per 1,000 people in China as of 2009 and 3.10 per 1,000 people in the US as of 2008), many low-tier hospitals are severely under-equipped. The penetration rate of even the basic patient monitor (monitor holdings/number of beds in medical institutions) remainslow. In 2009, while 20% of beds were equipped with medical monitors in China, the penetration rate in the US was 80%. The use of implantable medical devices remains very low as well. For orthopedic implants, the implantation rate for trauma, joints, and spine was 2.7%, 0.4%, and 1.0% in China vs. 21.9%, 43.0%, and 3.8% in the US, respectively, according to the estimates from Frost & Sullivan. Overall, the sales of medical devices/consumables are about 30% of the drug sales in China, compared with 40-50% in the US. Local companies have only about 30% market share in China. Hence, this subsector has considerable more room to grow, compared with the drug sector.
More favorable government regulation and continued government support make the sector preferred in the near term
We believe that the medical devices sector offers the best investment opportunity within the China healthcare space in the near term because of its sustainable domestic and international growth and competitiveness with MNCs. Medical devices have a shorter development time than drugs and the requirement for R&D investment is much lower as well. The regulatory risk is also lower. Since it is difficult to standardize medical devices/equipment, the NDRC has not attempted to set retail reference prices for them. Since the government spends far less on medical devices than drugs, the incentives for price control is also much lower. In November 2010,the Chinese government announced its intention to upgrade all county-level hospitals within five years and its plans to invest a total of Rmb36 billion in supporting 2,176 county-level hospitals across the country over the next three years. A significant portion of the government spending for county-level hospitals is expected to be in the form of direct funding in lieu of centralized tender purchases, which should benefit non-tender sales. This should be good news for companies like Mindray as it can compete for non-tender sales on quality/price tradeoff rather than mainly on price, which tends to drive down prices.
Thanks to the favorable regulatory environment and low capital investment, some Chinese medical device companies have become very competitive with MNCs, especially in the lower-tier markets. Generally speaking, Chinese medical device players are more competitive in the global market than their drug peers from China. The medical devices exports have been growing at 25-30% in the recent years. China is expected to overtake Japan in the near future to become the second-largest global medical device market. The output was about Rmb100bn in 2010, accounting for 5%
of the global market. By 2050, the market share should reach 25%, according to the estimates by China Chamber of Commerce of Medicines & Health Products Importers & Exporters.
Key success factors in Medical Devices
Strong in-house R&D: Mindray is by far the most established and profitable domestic medical equipment maker due to its ability to upgrade products and launch new products. This is possible because it has an R&D staff of more than 1,000 developing most of its products in house. Mindray’s spending on R&D is budgeted at about 10% of sales, making it one of the largest research budgets among medical devices companies in China. Mindray has a good track record when it comes to securing approval to sell its products in international markets and we expect the company to leverage this experience when it comes to selling other high-end products in international markets. The large R&D spending relative to domestic peers keeps Mindray ahead of other low-cost local competitors. The company has also become more aggressive with protecting its intellectual properties.
Wide distribution network: Most domestic and international equipment/devicemakers sell their products primarily through distributors to reach the end markets, with small amount of sales going directly to hospitals, clinics, government agencies, ODM customers, and OEM customers. Mindray works with more than 2,000 distributors in China with 1200 exclusive distributors. However, third-party distributors are sometimes not able to launch new products or build a strong brand. Therefore, Mindray directly employs 1000 direct sales and sales-support personnel in China and in international markets in order to push new products. Shandong Weigao, on the other hand, has established a strong direct sales force targeting high-end hospitals. The company’s 1,000-plus sales staff has presence in 110 cities based out off 22 sales offices as of Jun 30, 2011. Weigao’s market reach offers it a sustainable competitive advantage versus its competitors.
New products required for growth and to sustain margins: The ability to develop and market new products is the key criteria for achieving and sustaining high margins. The shelf life of new products in this segment is quite short. Successful products are mimicked rather quickly through reverse engineering and margins would fall unless the company has a strong brand and can continue to launch new products. New products introduced by Mindray in 2009 and 2010 include anesthesia equipment, incubators digital radiography. It launched a 360Mhz MRI this year. We expect Mindray to launch super-conductor MRI equipment over in 2012 or 2013.
Key subsectors: The device/equipment sector can be roughly segregated into four sub-segments, namely medical equipment, medical consumable, cardiac implants and orthopedic implants.
Medical consumable: needles, syringes, and etc. - Shandong Weigao, Becton Dickson.
Medical equipment: patient monitors, ultrasound, MRIs, CT – GE, Phillips, Mindray, Edan, Sonoscape, etc.
Cardiac implants: stents, pacemakers – Weigao, Lepu, MicroPort, Boston Scientific, and Abbott
Local government tendering looming for high-end medical products: The Ministry of Health (MOH) conducted a centralized procurement of high-end medical devices in 2008, which resulted in about 15% price cut for the products with both domestic companies and MNCs winning solid shares. The tendering was projected to occur at least biannually, but has not occurred since then because of the bad feedback from local levels. After months of delays, Beijing government has been asked to go first to conduct provincial-level tendering of high-end medical consumable, such as stents, catheters, etc. Managements of some companies under our coverage are expecting a 20-30% price cut according to their private communications with thegovernment officials, while a more optimistic estimate is about 10%. The price cut is within the range of market expectation. It will not be shouldered by manufacturers alone. Distributors will be asked for their share as there is normally a substantial markup between ex-factory prices and retail prices. We believe the local hospitals will retain power to purchase regular medical consumables, while the provincial governments take over tendering for high-price products.
Selected medical equipment/devices companies in China
Trauson Holdings (325 HK, Not Rated)
Trauson is a leading maker of orthopedic products with No.1 market share in China for trauma-related products and No.3 for spine related products. The company plansto leverage its industry leadership position and rely on its established distributor network into new products (joints) and also new export markets (US, EU) in the future. Its key to success is the brand name and the network of highly trained sales professionals built up over 20 years of operations. All of the products are developed by in-house R&D staff and sold through over 500 distributors to over 2500 hospitals in China. A key area of growth is that 70% of the demand for trauma orthopedic devices is due to car accidents. There are twice as many autos on the road in 2011 compared to 2007 and more car accidents unfortunately would come along with more cars on the road.
Biosensors Int’l Group (BIG.SP; Not Rated)
Biosensors International Group Ltd. develops, manufactures, and commercializes medical devices used in interventional cardiology and critical-care procedures. The company operates in four segments: drug-eluting stents, interventional cardiology, critical care, and licensing revenue. The critical-care segment supplies catheter systems and related accessories used during surgery and intensive care treatment and monitoring. Biosensor has a 50% joint venture called JW Medical Systems with Weigao to manufacturer and sell stents in China.
Mingyuan Medical (233.HK; Not Rated)
Mingyuan Medical is engaged in the provision of medicare solutions for the early detection and prevention of diseases, particularly in China. The company focuses on the development and application of advanced biotech screening and diagnostic solutions for early detection and prevention of diseases, including cancer. It operates through two divisions: protein chips and hospital operations. The protein chips division manufactures and trades protein chips and related equipments. The company also manages the Shanghai Woman and Child Healthcare Hospital of Hong-Kou District, Shanghai.
Golden Meditech is China’s largest supplier of the Autologous Blood Recovery System (ABRS) used in hospital operating theaters with a market share of more than80%, according to the company. The size of Golden Meditech’s installed equipment base, which dominates the market, is now leading to increased sales of consumable chambers for the ABRS, which are produced exclusively by the company. Golden Meditech also operates cord blood centers in Beijing and Guangzhou.
China Medical Technologies (CMED US; Not Rated)
CMED is an established industry leader in the Chinese in-vitro diagnostics (IVD) market, one of the fastest-growing segments in the sector. CMED has transformed itself from an equipment maker to an IVD company. The company employsmolecular diagnostic technologies, including fluorescent in situ hybridization (FISH) and surface plasmon resonance (SPR), and enhanced chemiluminescence immunoassay (ECLIA), an immunodiagnostic technology in the development, manufacturing, and distribution of diagnostic products for the detection of various cancers, diseases, and disorders, as well as companion diagnostic tests for targeted cancer drugs.
Table 12: Major Chinese Medical Devices Companies and Their Valuations (Most Medical Devices names with market cap above $100mn)
In China, in addition to the chemical drugs, TCMs are also a very important part of treatment algorithm. For many diseases, physicians actually combine TCMs with chemical drugs. Chinese government has promulgated policies in support of TCM industry, both for national pride and for practical reasons of controlling medical cost. TCM is the bright spot within China’s pharmaceuticals industry. The modernization of TCM and development of TCM injections as key tools to control viral infections and cardiovascular diseases have fostered the emergence of some strong TCM companies, such as Tianjin Tasly and China Shineway. Meanwhile, major brands,such as Dong-E E-Jiao and Yunnan Baiyao, have sustainable brand recognitions unrivaled by any chemical-drugs maker in China.
Favorably perceived by the public and strongly supported by the government policies
TCM has a long history with deep roots in China. Unlike some elitists, the Chinese people do not question the effectiveness of TCMs, while generally holding the belief that TCMs are safer than Western medicines. Hence, given a treatment choice between TCMs and chemical drugs, many people opt for TCMs. As the Chinese government considers TCM as part of national heritage, it has instituted policies and regulations to protect the industry. One-third of the drugs included in the 2009Essential Drug List are TCMs, which are 100% reimbursable. A total of 2,688 hospitals were designated TCM hospitals in 2008, with more to open as a part of the focus of the new Healthcare Reform to build up local health communities. Recent drug price cuts have largely spared TCM drugs.
TCM is one of the fastest-growing healthcare segments
The TCM market has expanded rapidly. From 2002 to 2010, TCMs (excludingChinese herbal products) accounted for roughly 20% of all healthcare industry output in China, which encompassed chemical drugs, TCM, biotech, and medical devices and managed to grow at a CAGR of 22% during these eight years. Meanwhile, Chemical-drug-finished products’ share of total output dropped from 25%+ to below 20% by 2010. Although the price cuts in EDL drugs have caused major problems for the drug companies, we believe that the cuts are less a problem for TCM manufacturers than chemical-drug producers. TCMs normally have a very low manufacturing cost compared with chemical drugs. In addition, many TCMs on the EDL are unique drugs that enjoy much-stronger pricing power, which make local governments less inclined to cut price too low to make those popular drugs unavailable in those areas. We think that the TCM market should shoulder this price-cutting pressure better than the chemical drugs. And given the recent easing of raw material price pressure, this sector should be overall better-positioned for continued strong growth.
Drawbacks of investing in TCM companies
Although TCMs are quite popular in China, they are not as well-regarded in many developed drug markets, because the efficacies of TCMs are based on empirical evidence rather than results from vigorously designed clinical trials. Thus, the export market for TCMs is quite limited. While TCMs have been perceived as safer to chemical drugs, which routinely carry bad side effects, the advent of TCM injections may have changed this perception a bit. As there have been a number of incidences
involving TCM injections, the government has carried out re-validation for some TCM injections. The stigma with TCM injections may hurt companies, such as Shineway, which has maintained a strong track record of safety for its products. Finally, as many TCMs are based on naturally growing herbs, land shortage and adverse climate situations have caused raw material costs to skyrocket in the recent years. The government has put out some tough policies against raw -material hoarding and price gouging. There are indications that TCM raw material price pressure may be finally easing. The average prices of TCM raw materials have dropped by 9.73% sequentially in August 2011, according to the Department of Commerce. There may be more room to drop, when the raw material trades pick upafter a slow summer.
Figure 14: The healthy growth of TCM output in recent yearsRmb billion
Yunnan Baiyao Group (000538.SZ)Yunnan Baiyao is engaged in the R&D, manufacture and marketing of traditional Chinese medicines and other related products, including toothpaste. The company’s Baiyao is one of only two TCMs in China that enjoys Class 1 protection.
Guangzhou Pharma (0874.HK; 600332.SS)GPC is a holding company with subsidiaries engaged in manufacturing and selling of traditional Chinese medicines, herbal teas, and related products. Its distribution JV with Alliance Boots is the largest in Southern China. It has multiple well-known TCM brands and it has two unique products, Xiao Ke Wan and Hua Tuo Zai Zao Wan, included in the EDL.
Tong Ren Tang Technologies (8069.HK; Not Rated)Tong Ren Tang, together with its parent holding company, Beijing Tongrentang, is the largest Chinese medicine manufacturer in China. The company currently produces and sells more than one hundred different types of products. The company’s main products include Liu Wei Di Huang pills, Gan Mao Qing Re granules for cold and flu, and Niu Huang Jie Du tablets.
Buchang Group (Private)Buchang Group, established in 1993 and headquartered in Xi’an Shaanxi Province, is one of the largest Chinese company that involves itself in the manufacture and sales of products for the treatment of gynecological diseases, cancer, and cardio-cerebrovascular disease, among others. The main product, Buchang Naoxintong capsule, indicated for the prevention and treatment of cardio-cerebral vascular diseases and for the relief of palpitation and restoration of pulse, won the golden medal on 42nd World Invention Exhibition in Brussels of Belgium. Other productsinclude Buchang Wenxin Granule, a sole Chinese herb medicine for the treatment ofcoronary heart disease and arrhythmia, Buchang Delisheng Capsule, an oncology product, and Buchang Kangfuyan capsule, Gongliuxiao Capsule and Xiaoru Sanjie Capsule, all gynecology products. The company also markets OTC products, including Buchang Jiangugai, Buchang Beijia, and Buchang Xiangju Capsule. Buchang operates a University, two hospitals, 10 separate departments, 10 pharmaceutical manufacturers, including Xianyang Buchang Pharmaceutical and Shandong Buchang Pharmaceutical. Buchang is a rare TCM company that holds multiple patents resulted from its continuous heavy investments in R&D.
Market growth driven by low base in healthcare spending
We expect the pharmaceutical distribution industry to achieve an annual sales growth of 20% until 2015, fuelled by China’s current low spending per-capita on pharmaceutical products and the government’s push to foster greater access to healthcare by the population through the construction of more modern hospitals, expanding of medical insurance coverage and privatization of healthcare enterprises. As a percentage of per-capita GDP, the total healthcare spending in China is about 5%, not even one-third of ~16% in the US, which has fewer than a quarter of Chinese population. Even with a 20% annual growth rate in healthcare spending, and thus pharmaceutical sales, we expect the per-capita spending on healthcare to reach just 7% of GDP by 2015.
Figure 15: Pharmaceutical sales in China
Source: Business Monitor International, J.P. Morgan estimates.
Figure 16: Rising market concentration in China
Source: Company data, J.P. Morgan estimates.
Industry consolidation to continue
The drug distribution industry in China is currently highly fragmented with approximately 15,000 pharmaceutical distributors holding GSP certificates. The three largest distributors accounted for about ~20% of the total industry revenue in 2010, compared with the three largest US players holding 90% market share and the three largest UK distributors with 73%. Putting this in a historical perspective, the top-3 held only 13% of the total market share. Hence, the market has clearly been consolidating. We believe the implementation of the Essential Drug List and the likely adoption of two-invoice distribution rule (one by the manufacturer and one by a distributor) will drive further industry consolidation. The government also favors continued industry consolidation. It is its stated goal to support the emergence of 1-3 distributors with sales above Rmb100bn and 20-plus local distributors with sales above Rmb10bn by 2015 as a part of 12th 5-year plan. However, we think industry consolidation may not come easy. First, the low-hanging fruits are mostly gone – the parent company of Sinopharm has largely completed asset injections and large local distributors willing to sell are largely picked up. Second, prices may rise because of fierce competition among the top-3 players. And finally, it may not be easy tointegrate the assets.
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3 largest suppliers market share Sinopharm market share
Large-scale distributors are not contract sales organizations
In China, drug manufacturers operate with two business models for selling drugs to end-customers – hospitals and retail drugstores. They either sell directly to hospitals, facilitated by visits paid by their own sales people. Alternatively, they may retain contract sales organizations (CSO), also routinely called distributors, to sell to hospitals and other terminals indirectly. With the second business model, manufacturers normally do not file a large sales force. They rely on sales people retained by CSOs to make the sales. Current sales channel cleaning up, aimed to reduce markup between ex-factory prices and hospital purchase prices, and two-invoice system directly hit the second business model, which are forcing business model changes. The manufacturers with indirect sales model may try to internalize the sales force or try to reimburse the CSOs for sales & marketing costs aftercharging much higher ex-factory prices, which involve complex tax issues and concerns with timely and legal reimbursement by the manufacturers. Thus, the independent CSOs with not much scale are the ones now on the edge of losing business. Although some CSOs may also provide logistic services, large-scale distributors, such as Sinopharm and Shanghai Pharmaceuticals, are not CSOs. They only provide distribution services to the manufacturers by storing and moving their products to the hospitals or drugstores. As they take fixed points from manufacturers, they should be a lot more resistant to the channel-cleaning efforts. When drug prices get cut, the distributors may take a smaller cut of each item delivered but if sales volume expands, they may come out better off after all. The loss of CSOs may actually be the gain for distributors as they may now be able to pick up distribution services business left behind by small CSOs going out of business.
Figure 17: Direct sales vs. indirect sales; distributors vs. CSOs
Source: J.P. Morgan; numbers used for illustration only.
Hospitals
Manufacturers - Direct sales, high-ex-factory price, low channel markup, high GM, high SG&A ratio, low OPM & NPM
Manufacturers – Indirect sales,
low-ex-factory price, high channel markup, low GM, low SG&A ratio,
high OPM & NPM
Distributors(Logistics Handling, take 5-8 points of
Drug retailers – by far the clear losers of Healthcare Reform
We view that the mom-and-pop drugstores and drugstore chains are clearly indentified losers of this round of Healthcare Reform. As the communities start building up healthcare centers offering EDL drugs with no markup, more and more traffic of patients, who are used to going to drugstores for self-treating, is expected to be diverted to hospitals, where they receive proper diagnosis and obtain cheap drugs from hospital pharmacies that may be reimbursable. OTC drugs, on the other hand,are largely paid by patients on the own. Furthermore, rounds of price cuts haveseverely depressed gross margins retailers can charge. In some instances, drug retail reference prices have been cut by the NDRC to be under prevailing prices at drugstores, making it highly unlikely for the drugstores to make any money out of them. Finally, the restriction on antibiotics use and strict enforcement against selling antibiotics without prescriptions should hit drugstores hard as antibiotics abuse has been quite common until recently. Many drugstore chains have attempted to change business models by carrying more consumer products. However, with so many street-corner stores running 24 hours a day, there is little reason for customers to visit drugstores to pick up personal care items. By the way, rising rental cost and strict zoning rules are also running against drugstores with regard to business expansion and cost controlling. The only bright spot one can see from the Healthcare Reform may be the eventual separation of pharmacies from hospitals, which may not happen for years to come, while the government is gingerly carrying out pilot public hospital reform.
Selected companies with extensive drug-distribution businesses
China National Medicines Corporation Ltd (600511 CH, Not Rated)China National Medicines is principally engaged in the distribution and provision of logistics services of pharmaceuticals. The company primarily focuses on the wholesale of Chinese patent drugs, chemical preparation, chemical bulk drugs, antibiotics, biochemical products, biological products, stupefacient, first-class psychotropic substances, second-class psychotropic substances and vaccine, among others, as well as the distribution of health foods. It operates its businesses primarily in domestic markets, with Huainan, Anhui province, and Beijing as its major markets. The company was 44% owned by Sinopharm, which nonetheless consolidates China National Medicines Corporation with its financial reporting as a matter of effective control.
Jointown Pharmaceutical Group Co Ltd (600998 CH, Not Rated)Jointown Pharmaceutical is principally engaged in the wholesaling and regular chain retailing of pharmaceuticals and medical equipment. It operates businesses primarily through the wholesaling of pharmaceuticals and medical equipment, which deals with western drugs, Chinese patent medicines, Chinese medicine tea, Chinese medicine materials, medical equipment, healthcare products and cosmetics, among others; regular chain-retailing business, which involves in the operation of regular chain and chartered drugstores; pharmaceutical production, research and development, which offers antibiotic series, diabetes series and cardio-cerebral vascular series products, as well as other value-added services, including logistics management information system and other value-added services. Jointown is top-3 ranked nationally and the only pure-private enterprise, but not a legacy state-own distributor. It specializes in distributing to the third terminal, i.e. the rural market,with fast-moving logistics handling.
Nepstar (NPD US, Not Rated)NPD operates a chain of retail drug stores throughout the country. The company sells prescription, OTC and TCM medicines and is relatively strong in the Southern region near Shenzhen, its headquarters. Napster stores provide customers with professional and convenient pharmacy services and a variety of other merchandise, including OTC drugs, nutritional supplements, herbal products, personal care products, family care products, as well as convenience products including consumable, seasonal and promotional items.
Historically, the Chinese government has paid special attention to immunization. Even during the most difficult times, such as of the Cultural Revolution, children received free immunization, such as vaccines for smallpox, chickenpox, mumps, etc. The government has expanded the free immunization from six vaccines to 14 in 2007, bringing about a solid growth in vaccine sales in the recent years. The Chinese vaccines market has been growing at a 15% per annum for the past few years, outpacing global growth of ~12%. We expect the growth to accelerate given the government’s emphasis on preventative medicines and the buildup of the public health system.
Although the Chinese vaccine industry is recovering from the negative headlines,associated with vaccine procurement and accidents in the Shanxi Province last year, there are five major reasons in support of our view that the vaccine market will continue with its robust growth in China:
1. There were more than 16mn newborns in China last year with a birth rate of 12.4% and, although this is predicted to drop, the country’s large population should ensure a sizeable market for children’s vaccines.
2. Awareness of the importance of vaccinations is rising in China. The outbreak of H1N1 in 2009 brings home the importance of immunization, which may directly improve immunization for seasonal flu – a severely under-developed vaccine market segment in China.
3. The vaccines market has received a boost from the Chinese government with the new Healthcare Reform putting much of its emphasis on preventative medicines. The increase in funding provides the whole industry with a strong confidence and good environment for further development.
4. New technologies for vaccine development, including viral-like particle technology and DNA vaccines, and new products, such as GARDASILfor HPV, are emerging. They bring new life into vaccine development and encourage local Chinese companies to develop cheaper versions of blockbuster vaccines, such as Prevnar of Pfizer. Think SinoVac.
5. Local Chinese companies showed strong R&D capabilities by producing the first effective vaccines against H1N1 in 2009. Guangzhou Pharma is developing therapeutic DNA vaccines against hepatitis B, while Chongqing Brewery is in advanced stage development of therapeutic synthetic peptide vaccine against hepatitis B.
China is already the largest market for conventional vaccines. We estimate the total market for vaccines to reach Rmb8bn by 2020.
China National Biotech Group (CNBG, private)There are six institutes of Biological Products and one public company (Beijing Tiantan Biological Product, 600161 CH, Not Rated) under the umbrella of China National Biotech Group (CNBG). CNBG was merged into China NationalPharmaceutical Group (CNPG), the parent company of Sinopharm (1099.HK), as a part of the central government’s efforts to trim the number of SOEs under its direct control in 2009. The SOE vaccine makers generate large amounts of vaccine products, mainly covered by the EPI, and as a group it has a 95% market share of the products sold for the EPI program. The group of companies also exports products to > 30 countries and it accounted for about 2% of the global vaccine market in 2009.
SinoVac (SVA US, not rated)SinoVac Biotech Ltd., based in Beijing, is a fully integrated biopharmaceutical company that focuses on the R&D, manufacture and commercialization of vaccines for human use. It has developed a portfolio of leading vaccine products, including vaccines against hepatitis A, hepatitis B and influenza viruses. Sinovac is in the early stage development of vaccines for head, foot, and mouth diseases and pneumococcal conjugate vaccines, which are among the top revenue grosser for Pfizer.
Hualan Biological Engineering (002007 CH, not rated)Hualan Biological Engineering is principally engaged in the R&D, manufacture and sale of blood products and vaccine products. It mainly provides human albumin, intravenous gammaglobulin, influenza vaccines and other products. Hualan is the largest seasonal flu vaccine maker in China.
Walvax Biotechnology (300142 CH, not rated)Walvax Biotechnology (云南沃森生物) is principally engaged in the R&D, production and distribution of human vaccine products. It primarily supplies haemophilus influenzae B vaccines, which are applied in the prevention of meningitis, pneumonia, septicemia, cellulitis, arthritis and pharyngitis caused by Hib, as well as group A and group C meningococcal polysaccharide vaccines, which are applied in the prevention of diseases caused by group A and group C meningococcal polysaccharide, such as cerebrospinal meningitis and septicemia.
Table 15: Major Chinese Biological Companies and Their Valuations (Most biological companies with market cap above $100mn)
Company Name CodePrice (TP)
MCAP US$MM
Vol US$mn
1M Chg
3M Chg
YTD Chg (%)
11e PE (x)
12e PE (x)
EPS CAGR (10_12e)
PEG '11E
PEG '12E
EV (US$mn)
EV/Sales ('11E)
3SBIO INC-ADR (NR) SSRX US 10.3 225.0 0.7 (20.3) (43.0) (32.1) 14.1 10.7 31.4% 0.4 0.3 279.0 12.3BEIJING TIAN-A (NR) 600161 CH 16.4 1,326.0 7.6 (8.1) (4.8) (28.0) 40.0 34.2 22.2% 1.8 1.5 1,508.4 7.1CHANGCHUN HIGH-A (NR) 000661 CH 38.2 786.7 3.2 (14.6) (25.1) (37.2) 40.2 32.4 49.8% 0.8 0.6 1,018.1 4.7CHENGZHI CO-A (NR) 000990 CH 10.0 465.4 5.4 (7.5) (5.0) (28.4) na na na na na 574.2CK LIFE SCIENCES (NR) 775 HK 0.3 395.2 0.1 (14.7) (33.3) (38.1) na na na na na 544.9HUA HAN BIO-PHAR (NR) 587 HK 1.4 353.6 0.6 (17.0) (38.8) (44.3) 6.0 4.4 6.2% 1.0 0.7 382.2 1.5HUALAN BIOLOGI-A (NR) 002007 CH 22.4 2,024.5 16.6 (13.8) (37.4) (53.3) 19.4 18.0 17.3% 1.1 1.0 2,955.6 15.1LEE'S PHARM (NR) 950 HK 2.6 153.8 0.1 (3.4) (14.1) (28.3) 15.0 11.1 27.8% 0.5 0.4 164.0 3.6SHENZ NEPTUNUS-A (NR) 000078 CH 7.6 780.9 5.5 (9.4) (22.3) (36.0) na na na na na 1,216.2SHENZHEN HEPAL-A (NR) 002399 CH 28.7 3,604.7 4.6 (6.6) (23.9) (57.7) 27.9 23.5 -11.7% (2.4) (2.0) 7,754.5 13.5SINOVAC BIOTECH (NR) SVA US 2.2 121.0 0.6 (2.2) (26.2) (50.9) 22.2 88.8 na na na 122.6 10.1TIANJIN CHASE-A (NR) 300026 CH 24.3 575.9 1.8 (8.3) (13.8) (18.4) 24.8 17.8 42.3% 0.6 0.4 602.7 7.7TIANJIN RINGPU-A (NR) 300119 CH 20.9 486.1 3.9 (11.6) (8.4) (39.7) na na na na na 366.9TONGHUA DONGBA-A (NR) 600867 CH 8.6 1,047.0 7.8 (2.2) (6.6) (20.2) na na na na na 1,057.9UNITED GENE HIGH (NR) 399 HK 0.1 154.7 0.1 (22.7) (33.1) (24.4) na na na na na 198.2WALVAX BIOTECH-A (NR) 300142 CH 53.7 1,264.1 4.0 (13.0) (6.6) (39.2) 35.2 25.2 26.4% 1.3 1.0 1,758.6 24.4Biologicals Average 860.3 3.9 (11.0) (21.4) (36.0) 24.5 26.6 23.5% 0.6 0.5 1,281.5 10.0
Source: * J.P. Morgan estimates. Bloomberg estimates for other non rated companies. Share prices as of 5 Oct 2011.
Company DataShares O/S (mn) 827Market cap (Rmb mn) 7,586Market cap ($ mn) 1,193Price (HK$) 11.22Date Of Price 14 Oct 11Free float (%) 27.4%3-mth trading volume (mn) 53-mth trading value (HK$ mn) 413-mth trading value ($ mn) 5HSI 18,758Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
5
15
25
HK$
Oct-10 Jan-11 Apr-11 Jul-11 Oct-11
Price Performance
2877.HK share price (HK$)HSI (rebased)
Poor performance likely to continue; assuming coverage with UW and Dec-12 PT of HK$12: Shineway’s share price has been hit hard due to its high dependence on EDL drugs, which are experiencing relentless pricing pressure. Although we believe price-only EDL tendering cannot last forever, it could take time for EDL prices to recover. At current levels, the shares may find support due to a strong cash position (=HK$3/share) and high dividend yield (4%). However, we believe there is better value elsewhere within the healthcare space without similar overhangs; hence, we keep the UW rating.
EDL tendering hitting hard: Shineway’s 1H11 results showed a significant decline in Qing Kai Ling’s sales due to the losing of some provincial EDL tenders. Shineway has lost EDL tendering in Shandong, Sichuan, Anhui, and Fujian among others, which has clearly affected Qing Kai Ling sales. The gradual rollout of the newly-reduced tender prices should figure more prominently in the next few quarters and could put pressure on prices for non-tender channel sales as well. Hence, we forecast gross margins to decline further. We believe the trend has risk of turning worse until a forecast recovery by 2013, owing to NDRC’s unified EDL pricing.
Shineway, the TCM injection leader, could see better days ahead: Given the concerns about Anhui’s model EDL tendering, the NDRC is reportedly formulating a plan to set up unified nationwide pricing for EDL drugs. This could result in tendering based on quality alone, which could be a relief for Shineway as the company’s products are well known for superior quality. Meanwhile, Shineway’s non-EDL drugs appear to be doing well with new product sales ramping up strongly. Finally, losing EDL tendering does not mean the drug is completely out of local markets. Shineway could still generate a considerable amount of sales through non-tender channels.
Valuation and risks. Our DCF-based Dec-12 PT of HK$12 implies 2012E P/E of 11.6x. In our view, margin pressure for Shineway is greater than that of its peers due to its portfolio of cheaper products and its above-average margins. Key risks include a sooner-than-expected EDL drug price rebound.
Company description P&L sensitivity metrics EBIT EPS
FY11E impact (%) impact (%)
Shineway is one of the largest Chinese medicine manufacturers of injection-based and soft capsule medicines in China, in terms of volume. Shineway focuses on prescription medicines in three major forms—injection, soft capsule, and granule. All of the products are sold under the Shineway brands and developed mainly by the in-house R&D team.
Chinese herbs
Impact of each 5 percentage increase -3.3% -3.0%
Selling cost
Impact of each 5 percentage points increase -2.5% -2.3%
Demand for products under EDL
Impact of each 5 percentage points increase 3.2% 3.0%
GM: 1% Increase
Impact of each 1% increase 2.6% 2.4%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 price target of HK$12 is based on DCF methodology. Based on our analysis of the current macro dynamics, we lower our terminal growth assumption from 6% to 4%, but this does not include new products that could offer more long-term growth.
Our Dec-12 PT (previously Dec-11) of HK$12 (previously HK$22) implies a forward P/E of 11.6x (FY12E). Key upside risks are a more-than-expected sales volume increase after EDL implementation and earlier-than-expected implementation of unified pricing for EDL providing an unexpected relief for Shineway.
EDL tendering hurts Shineway particularly hard: While Shineway’s overall revenue grew 12% Y/Y in 1H11, sales of injection products rose only 3.9% and accounted for 56.5% of the total sales, compared with 60.9% in 1H10. Given that Shen Mai injection recorded sales growth of 29.9% in 1H11, the Y/Y decline of Qing Kai Ling sales caused by losing some provincial EDL bids must be quite severe, in our view. Shineway has lost EDL tendering in Shandong, Sichuan, Anhui, and Fujian among others, which clearly has affected its Qing Kai Ling sales. The gradual implementation of new reduced tender prices will figure more prominently in the next few quarters and could put pressure on prices for non-tender channel sales as well. Hence, we forecast GM to come down further.
Safety issues could emerge: As mentioned earlier, there have been multiple incidences involving the use of TCM injections. Although Shineway’s products have not been pointed for any of them, it does not mean it will not happen in the future. If Shineway’s products show major adverse side effects in the future, the damage to the company’s reputation and short-term sales could be considerable, in our view.
Substitutes from chemical drugs: Shineway’s drugs are used mainly in the treatment of cardiovascular diseases and viral infections, for which a number of chemical drugs are available. Further incidences associated with TCM injections could change the prescription behavior more inclined to chemical drugs. If better and more effective chemical drug alternatives emerge, Shineway’s sales could also suffer.
Positive share price drivers, upside risks to our view
The largest market leader of TCM injection: Shineway is the largest TCM injection and soft capsule modernized Chinese medicine manufacturer in terms of both sales volume and production capacity. The company has more than 15 years of experience in the production of TCM injection, which is a relatively new development in the TCM field. TCM injections have been controversial and many people do not believe in the safety of TCM injections. A number of incidents, including death, have been reported with the use of TCM injections but none have involved Shineway, highlighting the company's unbroken track record of product safety. The company's two leading TCM injections, Shineway branded Qing Kai Ling and Shenmai injections, are among the best known TCM injections and occupied the No.1 and No.2 market positions in their respective categories.
TCM injection supported by a favorable government policy: Notwithstanding the controversies surrounding the safety of TCM injections, the Chinese government has been very supportive of the development of TCM injections as a way to lower drug cost while fostering the modernization of TCMs, a national pride. The support is highlighted by the inclusion of eight different TCM injections, including Qing Kai Ling and Shenmai, into the EDL list. The total TCM injection market is estimated to be around Rmb20 billion and Shineway is one of the undisputed market leaders.
Anti-viral and anti-cancer activities of TCM injections could be under-appreciated: Shineway’s Qing Kai Ling injection is an anti-viral medicine for the treatment of viral diseases, including respiratory tract infection, viral hepatitis, cerebral hemorrhage and cerebral thrombosis. Like many other TCM, Qing Kai Ling’s anti-viral activities may be genuine and under-appreciated. Patients who
contract the flu caused by viral infection are normally advised to drink a lot of water and sent home in the West. In China, people routinely seek active treatment for theflu and numerous TCMs, including Ban Lan Gen 板藍根, has demonstrated strong anti-viral activities. After all, Tamiflu (oseltamivir), well regarded as the most effective anti-viral drug for flu, is made from Chinese star anise, an ancient cooking spice that is also used in TCM. Qing Kai Ling has actually demonstrated strong adjuvant therapeutic efficacy in a well-controlled 130-patient study in children with viral pneumonia, for which Western medicines are largely ineffective.
Government may come to the rescue: Given the controversies surrounding the Anhui Model of drug tendering that is based exclusively on price, manufacturers are looking at the central government for remedies as the local governments are unlikely to proactively move away from price-based EDL tendering due to budget constraints.Quality issues do emerge mostly associated with price-based tendering and EDL drugs become unavailable because of low price, we believe the MOH and NDRC could be compelled to intervene. The NDRC is reportedly putting together a plan to set unified nationwide prices for EDL drugs, so the tendering will occur only to determine the winning bids based on quality and the ability to supply products. If that happens, Shineway would definitely breathe a sigh of relief. Shineway's products are known for the quality and it certainly has sufficient production capacity to fulfill drug demand. If the unified price is not set very low, Shineway could finally get to enjoy the sales volume expansion expected from the drugs' inclusion into the EDL list.
Figure 19: Shineway—Historical overall GM and injections GM
Source: Company reports.
High gross margins of TCM injections: Shineway’s injection products have historically carried gross margins close to 80%, roughly in line with those seen with originator or first-to-market generic chemical drugs. Overall, Shineway has maintained gross margins higher than 70% for the past few years, much healthier than most drug companies in China, being TCM or chemical drug manufacturers. The good profitability of the company has allowed it to invest in R&D to build a strong product pipeline and in SG&A efforts to build up brand recognition of the company. It has also invested heavily to expand and upgrade its manufacturing facilities, which should position Shineway well for a business recovery.
Our Dec-12 price target is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.2, based on Bloomberg estimates. Accordingly, we assume a WACC of 11.4%. We estimate free cash flow until 2015 and assume a terminal growth rate of 4.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 1.5% and a maximum of 4.5%, depending on the nature of the industry and the level of maturity in China.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
We expect sales CAGR of 10% with -1% CAGR for net profit
Gross margins to decline: We expect Shineway’s GM to decline steadily over the next few years because of the pricing cut for injections and its product mix features more lower GM products.
We forecast lower operating margins in 2011 and 2012 but could stay well above 30%, still healthy for a pharmaceutical company. We estimate a significant amount of SG&A could be fixed cost and could not be cut quickly in response to a revenue shortfall. Over the long term, the lower GM could spill over to lower OPM, and it could see a slight decline in outer years and reach around 32% by 2015.
Figure 20: Shineway— Margin trends
Source: Company reports, J.P. Morgan estimates.
Revisions to our model: Given the unexpected tough situations faced by Shineway which resulted in substantial revenue decline in Qing Kai Ling sales, we lower our revenue forecasts for both 2011 and 2012 significantly. We also forecast about 3ppt drop in GM. Considering the top line and lower GM estimates together, we cut our EPS estimates by 4.6% and 17.5% for 2011 and 2012, respectively.
China Shineway Pharmaceutical Group Limited: Summary of FinancialsIncome Statement Cash flow statementRmb in millions, year end Dec FY09 FY10 FY11E FY12E FY13E Rmb in millions, year end Dec FY09 FY10 FY11E FY12E FY13E
Company DataShares O/S (mn) 47Market cap ($ mn) 156Market cap ($ mn) 156Price ($) 3.28Date Of Price 13 Oct 11Free float (%) 32.8%3-mth trading volume (mn) 27,105,500,0003-mth trading value ($ mn) 82,671,775,0003-mth trading value ($ mn) 82,672S&P500 1,207Exchange Rate 1.00Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
3
5
7
9
$
Oct-10 Jan-11 Apr-11 Jul-11 Oct-11
Price Performance
CCM share price ($)S&P500 (rebased)
Misunderstood business model offers upside: We believe the persistingweakness of Concord shares mainly reflects: 1) accounting scandals associated with Chinese ADRs and 2) continued investor doubts on the sustainability of Concord’s lease and management business model. We view the first reason as unfair and the second largely misplaced. Most of Concord’s centers are quite profitable and its longstanding relationship with the reputable Navy General Hospital in Beijing validates the demand for third-party radiotherapy and diagnostic centers. In addition, Concord ismoving aggressively into the lucrative private-hospitals sector. Hence, we believe Concord’s shares at current levels (7.2x 2011E EPS) are attractive. Therefore, we rate Concord at OW with Dec-12 PT of US$6.4
Moving aggressively into the private-hospitals space: In Jan-11, Concord announced the acquisition of a 52% stake in 1,100-bed Chang’an Hospital. Although the deal has faced delays, it should close by the year end of 2011. Separately, Concord has entered into a 70/30 JV agreement with the Oncology Hospital of Zhongshan Medical University to establish a 400-bed specialty hospital in Guangzhou for cancer diagnosis and treatment. The JV hospital is expected to commence operations in 2013. Concord is developing an independent Proton Beam therapy center with a partner that is slated for opening during 2012-2013. As the Chinese government opens up hospital services for private investment, we believe Concord is moving into a very lucrative space, whereby it can serve well-off patients and enjoy more leeway with flexible pricing for high-end services.
Valuation, Price Target, and risks: With net cash (~$56mn) covering about one-third of its market cap and strong cash flow generating capability, we believe that Concord is significantly undervalued at the current level in light of its growth potential. Our Dec-12 PT of US$6.4 is derived from DCF analysis. Key downside risks to our PT and investment thesis include: regulatory measures that squeeze pricing of healthcare services and slower-than-expected pace of acquisition of new-hospital contracts.
Company Description P&L sensitivity metrics EBIT EPS
impact (%) impact (%)
Concord Medical Services was incorporated in Nov-07 to hold the cancer treatment centers operated by the Aohua Group, which has been developing cancer medical centers in China for over ten years. In 2008, Concord acquired China Medstar. Currently, Concord is the largest private operator of cancer clinics in China.
Number of centers added in 2010
Impact of 5 new centers 3.1% 4.3%
Patient fees
Impact of each 1 percentage points change 1.9% 2.7%
Profit share percentage
Impact of each 1 percentage points change 2.4% 3.4%
GM
Impact of each 100bps increase 1.5% 2.1%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 price target of US$6.4 is based on DCF analysis. Our DCF valuation is based on the assumptions below. We have adopted a very conservative assumption of terminal free cash flow growth of only 2%.
Revenue mix (2010A)
Risk-free rate: 4.20%Market risk premium: 6.00%Beta: 1.50Cost of equity 13.2%
Terminal “g”: 2.00%
Source: Company report
Our price target (Dec-12) of US$6.4 implies a P/E of 11.2x (FY12E). The key risks to our price target and investment thesis include regulatory measures that could squeeze pricing of healthcare services, a slower-than-expected pace of acquisitions of new-hospital contracts, and the unstable government policies regarding private hospitals.
EPS: J.P. Morgan vs consensus (US$)
J. P. Morgan Consensus
FY11E 0.45 na
FY12E 0.56 na
FY13E 0.67 na
Source: J.P. Morgan estimates.
Cancer center revenuesManagement ServicesHospitalOthers
Leader in a fast-growing market: Concord is the largest operator of private cancer radiotherapy and diagnostic imaging centers in China. Frost & Sullivan estimates that new cancer cases in China will increase at a 2.6% CAGR between 2008 and 2015 versus a 1.5% rate in the US, thanks to environmental factors and improving diagnostic tools that identify additional cases of cancer. The penetration ofradiotherapy equipment in China is very low, with the linear accelerator penetration rate being 0.7 machines per million people, versus 9.5 machines per million people in the US. According to Frost & Sullivan’s estimates, the annual growth in the number of radiotherapy cancer equipment units in China can reach 22-23% from 2008 to 2015. Even at this growth rate, the penetration rate for cancer therapy equipment in China should still be less than 20% of the US by 2015. According to the estimates of Frost & Sullivan, third-party radiotherapy and diagnostic centers currently account for 7% of all such services performed and it may go up to 10% by 2015, creating significant opportunity for Concord, currently the strongest player in this niche market segment. The government is emphasizing prevention and early diagnosis of the disease as a part of the new Healthcare Reform, which should open the door for more independent-managed diagnostic imaging machines.
Hospital build-up creating demand for capital equipment: Since the beginning of 2009, the government has embarked on a program to construct new hospitals and improve the level of healthcare for the population. However, the focus on capital spending, combined with credit tightening, has resulted in more subdued expenditure on healthcare by the government as well as public hospitals. Instead of purchasing capital equipment with large investment and uncertain return, hospitals routinely prefer to add more hospital beds, so they can charge for more with inpatient services, which also improves the chances of upgrading to high-tier hospitals that come with a lot of more prestige as the hospitals move up the tier ladder. This creates the opportunity for Concord to fill in the investment gap and establish third-party centers in those hospitals to expand the options of medical services.
Established reputation and the largest network of centers make Concord the preferred partner for new centers: Concord has developed beneficial relationships with the partner hospitals. The company is very well-known among cancer treatment community and the undisputed market leader as a third-party provider of leasing and management services for radiotherapy and diagnostic imaging centers with a 21% share in third-party medical services as of 2008. As of June 30, 2011, Concord operated 125 centers across 46 major cities in China. The company's network centers employ hundreds of surgeons and medical staff that can learn from each other by attending semi-annual conferences and surgeons can compare notes on treatment options for difficult cases, for which Concord maintains a database. Concord's network of centers also offer training to the staff to be placed in new centers, facilitating the ramp-up of new centers.
Moving aggressively into private-hospital space: In Jan-11, Concord announced that it was acquiring a 52% stake in Chang’an Hospital, which has 1,100 beds. Although the deal has faced delays, it should be closed by the end of 2011. Separately, Concord has entered into a 70:30 JV agreement with the Oncology Hospital of Zhongshan Medical University to establish a 400-bed specialty hospital
in Guangzhou for cancer diagnosis and treatment. The JV hospital is expected to commence operations in 2013. Concord is developing an independent Proton Beam therapy center with a partner that is slated for opening during 2012-2013. As the government opens up hospital services for private investment, we believe Concord is moving into a very lucrative space, whereby it can serve well-off patients and enjoy more leeway with flexible pricing for high-end services. We understand that the company is in active discussions with multiple parties for establishing additional private hospitals in major cities. Given the trouble people have with receiving medical services from public hospitals, which feature long queues and less-than-friendly medical staff, we see great potential for private medical services to take off should the government make the services received from private hospitals more readily reimbursable.
Stock buyback to lessen downward pressure: Concord announced recently that it plans to buy back up to US$20 million of its American depositary shares. At the current price of $3.16, we calculate the total buyback could involve 6.3mn shares out of 47.5 million shares outstanding. As we believe that the shares are undervalued, given the company’s strong cash position and growth potential, the buyback should be quite a prudent thing to do, which of course also further decreases the liquidity of the stock. On the other hand, the low liquidity means that the opportunistic share purchase by the company from the open market could serve as a strong deterrent to the further downward spiral of CCM shares.
Negative share price drivers and risks to our thesis
Regulatory uncertainty: The majority of Concord’s cancer clinics operate within non-profit public hospitals in China. Concord generates return on its investment using a lease contract that is variable and based on patient revenues rather than a fixed payment. As it is already prohibited by the MOH to establish hospitals within hospitals, the appropriateness of this arrangement with the hospitals is subject to interpretations and could be subject to regulatory oversight in the future. Further amendments may be required in the contract agreements in order to pass regulations. The pay-for-performance system operating at Concord’s centers may be regarded unfavorably.
Lease renewal is not automatic: Concord has a number of centers that are approaching the late stage of contract lives, and hence the company is sharing less and less of the profit generated because most contracts specify that Concord will receive lower share of center profits on a sliding scale. Hospital partners may elect not to renew contracts if they can find financial resources to replace equipment on their own or if they think they can make more profit by operating those centers on their own. We understand that Concord has a good track record of renewing centers, but still view contract renewal as a key concern.
Returns from new clinics could fall: The business is capital-intensive and the investment return on the equipment is dependent upon the ability of Concord to maintain high utilization of its equipment. Major cities have already reached the saturation point for gamma-knife radiotherapy units and diagnostic imaging machines. Good locations for setting up profitable centers may become harder and harder to come by, intensifying competition. If Concord runs out of large hospitals to establish new centers and enters into agreements with smaller hospitals with an aim to achieve its goal of having 200 centers under management by the year end of 2012,
the utilization rates of equipment might fall because of lower patient flow. Concord may find it more and more difficult to find good projects that offer good returns.
Pricing pressure with medical services: Pricing is determined by the provincial government. The key authorities are the provincial ministry of health, provincial pricing bureau and provincial government. The key criterion is to maintain a level of pricing that ensures sufficient equipment to treat the number of expected patients. Longer term, as the number of equipment rises in China and the need to attract capital for new equipment recedes, we might see more pressure for the government to lower rates in order to improve the affordability for the patients.
Operating private oncology hospitals has risks: Setting up independent oncology centers and private hospitals requires high capital expenditure, e.g., Rmb620mn for the Beijing Proton Medical Center. Although Concord had bank credit lines of RMB2.1 billion (US$329 million) as of June 30, 2011, of which RMB71.3 million(US$11.0 million) were drawn down, the company might likely need to tap the capital market to raise funds for its expansion, especially in the light of high interest rates demanded by the banks. Given the company’s current stock valuation, we believe this route appears not to be very attractive. Hence, there is likelihood that Concord might face a cash crunch in an effort to expand private-hospitals business. In addition, the company lacks experience in operating independent centers and private hospitals, including in the areas of staffing and government relations. Furthermore, behavioral changes from public hospitals as a result of competition from private hospitals might make private hospitals less attractive to patients than before if public hospitals can raise their service standards.
The largest operator of third-party radiotherapy and diagnostic imaging centers in China with well-established reputation.
The company has historically been able to partner with large Class 3 hospitals and attract the best doctors by offering better packages and working environment than government-operated hospitals.
Strong track record in signing new centers through its brand recognition and reputation for improving the operating efficiency and sales revenue of its clinics.
High entry barriers once a center is signed, since these are 8-10-year contractual relationships with very little opportunity for the terms and conditions to be amended.
Weaknesses
The nature of the business is competitive and there are a number of operators that compete for new hospital projects.
The price of patient treatments is set by the provincial government and the ministry of health, and there is relatively little transparency on how the prices are set.
The business is capital-intensive and the investment return on the equipment is dependent upon the ability of Concord to sustain a high utilization on its equipment.
There could be greater competition for patients as more non-profit and for profit hospitals add radiotherapy equipment in China.
Opportunities
Strong demand for radiotherapy cancer treatment in China should increase the number of patients for Concord centers.
Government budget constraints could encourage more hospitals to seek private partners for their cancer clinics.
Concord may be invited by its hospital partners to operate centers for other illnesses that require modern equipment
Concord could acquire smaller private operators and lift their efficiency and profitability.
Private hospitals open a new area for the company to diversify its business
Threats
The renewals of cancer clinic contracts could be uncertain and the profit share of Concord may be impacted if there is competition during contract renewals.
New technologies make the equipment at Concord obsolete and require expensive upgrades.
The company is dependent on a limited number of key doctors that can move to other hospitals and jeopardize the sales and profitability of Concord.
The ownership structure could come under regulatory scrutiny as the typical partners of Concord are non-profit hospitals.
Our price target of US$6.4 is based on DCF analysis
Our Dec-12 price target of US$6.4 is based on DCF analysis and on our revised financial forecasts for the base case. We assume a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.5, which is higher than the average beta of 0.8-1.0 for relatively defensive hospital service companies, but is appropriate given the relatively new business model and high variability of cash flow forecasts – we are essentially applying a VC (ventral capital) discount here. Accordingly, we assume a WACC of 11.5%. We estimate free cash flow for Concord until 2015 and assume a terminal growth rate of 2.0%, which we believe as extremely conservative. We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
At our price target of $6.4, Concord would be trading at 14x and 11x our 2011E and 2012E EPS estimates, respectively. This sanity check makes us believe that this price target is achievable in light of the company’s strong EPS growth potential – 26.0% Y/Y in 2012E and 22.7% in 2013E.
We expect a sales CAGR of 37% between 2010 and 2013E
We expect a sales CAGR of 37% from 2010 to 2013E, based on the current rate of center additions and expected contribution from hospitals starting in 2012. Although management has admitted that Concord may not be able to achieve the goal of opening 25-30 centers in 2011 as part of the company’s 2Q11 earnings release, the company did reconfirm full-year revenue guidance of Rmb480-520mn, which excludes any potential contribution from Chang'an Hospital.
Figure 21: Concord Medical Services: Sales mix$ in millions
Source: Company reports and J.P. Morgan estimates.
For a fast-growing company like Concord that demands large ongoing capital expenditures to fund its expansion, we think EBIDTA margins and growth are some key measures for the company as a way to show its overall cash-generating capabilities from the operations. Concord has a high EBITDA margin of 85.3% for 2008PF (pro-forma, with MedStar included), since all of the operating costs for the cancer centers are not included in the sales revenue of Concord. Instead, Concord only includes the company’s share of center net profits in its top-line revenue. The EBITDA margins trended lower from 85.3% in 2008PF to 76.7% in 2010. We expect the margins to go down further as the company enters into hospital management business, whereby the operating-expense ratios are much higher.
Figure 22: Concord Medical Services: Sales growth and EBITDA margin
Source: Company reports and J.P. Morgan estimates.
We estimate Concord’s net profit to grow at a CAGR of 20.6% from 2010 to 2013E. The growth rate is lower than the revenue growth spanning the same period because of the impact of higher general and administration costs after the company's listing and lower profit margins from the hospitals business.
Historically, Concord required a significant amount of capital to expand its network of service centers. Over the next few years, Concord would need to invest in new businesses, such as hospital management, as well as a potentially large investment in a proton-bean treatment center in Beijing. Concord currently has cash position of approximately US$65mn. After the company spends US$20mn to buy back shares and Rmb200mn to close the transaction to buy a 53% stake in Chang'an Hospitals, plus additional funds needed for the opening of centers, we estimate Concord will probably need to significantly draw down its Rmb2.1bn credit facility to continue funding its business expansion.
Company DataShares O/S (mn) 1,441Market cap (Rmb mn) 5,547Market cap ($ mn) 869Price (HK$) 4.69Date Of Price 14 Oct 11Free float (%) 47.1%3mth Avg daily volume 1,853,837.003M - Avg daily Value (HK$ mn)
7.36
3M - Avg daily Value (USD) ($ mn)
0.95
HSCEI 9,585Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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0853.HK share price (HK$)HSCEI (rebased)
R&D-based stent maker diversifying into orthopedic and EP; assume coverage with an N rating and a PT of HK$5.5: Unlike other healthcare markets, the Chinese stent market is dominated by three domestic players. MicroPort pioneered the market and has been the leader for several years. MicroPort is diversifying into the orthopedic market, diabetic infusion pumps, and cardiac ablation catheters. While we like management's R&D focus and see good potential of Firehawk, the looming stent price cut and intensifying stent competition keep us on the sidelines for now.
Benefitting from strong industry growth: Even after the strong growth in the past few years, PCI penetration rate is still low, leaving further room for continued growth. We expect MicroPort to maintain its current leadership position (29% share in 2009) for a few more years, while Lepu ramps upNano stent sales, which we expect will take a while. We think MicroPort’s future is strongly linked to the success of Firehawk in the clinical trials, which may enable it to launch a high-end stent competing with MNC stents for the global markets.
Price cut looming, but likely not crippling: Industry sources suggest new rounds of stent tendering will be conducted at provincial levels with Beijing, quickly followed by Shanghai and Zhejiang, most likely in 4Q11. Based on informal communications with Beijing tendering authorities, MicroPort is expecting a price cut of ~20%, largely in line with previous expectation of 15-20%. As the price cut will be shouldered by both stent makers and distributors, given the product’s high gross margin, this level of price cut may be tolerable as it affects GM by about 2-3 ppt, in our opinion.
Valuation, price target, and risk analysis: MicroPort is trading at 18.7x our 2011E EPS. Our DCF-based Dec-12 price target of HK$5.5 implies a FY12E P/E of 18.3x, which we think is reasonable for a China healthcare company with strong growth ahead. Key risks are government regulations on the pricing of stents and any delay in launch of new stents product “Firehawk”.
Company Description P&L sensitivity metrics (11E) EBIT EPS
impact (%) impact (%)
Listed in Sep-10, MicroPort is the leading provider of drug-eluting cardiac stents in China with 29% market share as reported in 2009. The company developed a series of drug-eluting stents in house, starting in 1998 and began manufacturing in 2000. MicroPort's products are now being used in over 1,100 hospitals throughout China.
Utilization rates
Impact of 1% increase 0.9% 1.1%
Stents (ASP)
Impact of 1% increase 1.9% 2.4%
Non-stents business
Impact of 1% increase 0.6% 0.8%
GM
Impact of each 100bps increase 2.2% 2.2%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 price target of HK$5.5 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth of 5% (the high-end of the 3-6% growth rate used for Chinese healthcare companies).
Revenue mix (2011E)
DCF assumptions
Risk-free rate: 4.20%Market risk premium: 6.00%Beta: 1.20Cost of equity 11.4%
Terminal “g”: 5.00%
Source: J.P. Morgan estimates
Our Dec-12, DCF-derived price target of HK$5.5 implies a forward P/E of 18.3x (FY12E). Our price target is based on two assumption changes: (1) lower terminal growth to 5%; and (2) increase beta to 1.20. The key downside risks to our price target are the government regulations on the pricing of stents and the delay of commercialization of a new stent product, named “Firehawk”. On the other hand, the upside risk to our PT include: less severe price cut for stents and stronger than expected performance by orthopedic and other segments.
Still-large potential for PCI cases to increase – stent market to continue growing: Percutaneous coronary interventions (PCI) are procedures, such as balloon angioplasty or stenting, used to open narrowed coronary arteries. Despite the continued robust growth 25-30% of PCI cases in China over the past few years, there is still considerable room for further growth. In 2009, there were about 240,000 cases of PCI performed in China, while an approximately 600,000 PCI cases are performed annually in the US. Given that the US has only one quarter of China's population, we see substantial room for PCI cases to go up in next few years due to the aging population and associated coronary artery diseases. It is estimated that on average, a PCI involves 1.45 stents, 96% of which are drug-eluting stents. In addition to the overall low penetration of PCI vs. CABG (coronary artery bypass surgery) in China, PCI cases have been concentrated in the developed coastal areas. Hence, we see an untapped market for PCI and stents.
Figure 23: PCI cases have grown at 25-30% in last few years'000
Source: MOH Online Registry.
Figure 24: Total revenue of China's coronary stent market (based on retail prices charged by hospitals)
Proven R&D capabilities: MicroPort has 170 R&D engineers, and approximately 81 of them possess masters or doctorate degrees, as of March 2010. The company offers 18 products, all of which were developed internally (except for La Fenice, which was acquired externally). MicroPort also has an additional 28 products in various stages of development. The company has received a total of 52 patents in China, including 13 invention patents, 38 utility model patents and one design patent, and two patents in the European Union. In addition, the company has 83 patent applications pending in China and 11 patent applications pending in the United States, the European Union and Japan. It also has 25 applications for priority dates pending under the Patent Cooperation Treaty.
Heavy investment in R&D to pay off handsomely with Firehawk: MicroPort has historically spent close to 15% of its total revenue on R&D, twice as much as most of Chinese drug and medical devices companies. The company developed Firebird II in house, making it very competitive with foreign brands. The company will continue investing in R&D to support clinical trials of Firehawk, and other promising pipeline products.
In May-11, MicroPort achieved full enrollment of 510 patients for a Target I randomized controlled trial that has enlisted 16 top-tier national clinical trial centers to evaluate the safety, efficacy and delivery system of Firehawk for the treatment of coronary artery diseases. The primary endpoint is in-stent late lumen loss after 9 months of stent implantation and the secondary endpoint is in-stent percent diameter stenosis. As a show of confidence, this trial is based on non-inferior assumption vs. Xience V DES, requiring both endpoints to reach statistical significance. We think the company’s heavy investment may be validated with the success of this trial, which may launch the product into global markets for stents.
Figure 25: Heavy R&D Investment should eventually pay offRmb '000
Source: Company data, J.P. Morgan estimates.
Comprehensive distribution network: In line with market practice, MicroPort sellsall of its products to distributors, who then resell the products to hospitals. MicroPort had 147 domestic and international distributors as of March 2010, all of whom are independent distributors, except for MP B.V. and a few international distributors who are affiliates of Otsuka Pharmaceutical. The company does not have management control over these independent distributors.
Plunging into the orthopedic market through an acquisition: MicroPort recently disclosed that it had entered into an agreement to purchase a Suzhou-based orthopedic company for Rmb110mn. The target has 11 product series covering trauma, spine, and associated instruments. Based on 2010 revenue of Rmb22mn and net profit of Rmb9mn, MicroPort is paying a trailing P/B of 5x and P/E of 12.2x, which is not a pricey deal in our view. This acquisition should complement the company's existing rudimentary orthopedic business well. Clearly, as orthopedic implantation rates in China are very low compared to those in the US, the market potential of orthopedic implants is huge. If MicroPort can manage to compete effectively against the three major domestic companies – Shandong Weigao, Kanghui, and Trauson – we think the company could significantly downsize its portfolio risk of over-reliance on stent products, which are facing intensive price-cutting pressure.
Figure 26: MicroPort: 2008 orthopedic implantation rate – China vs. US
Source: Frost Sullivan
Negative share price drivers and risks to our thesis
Price cuts looming: Industry sources indicate new rounds of stent tendering will be conducted at provincial levels, with Beijing going first, quickly followed by Shanghai and Zhejiang, most likely occurring in 4Q11. Based on informal communications with Beijing tendering authorities, MicroPort is expecting a price cut of ~20%, largely in line with the previous expectation of 15-20%. From historical precedents, a price cut at the average selling price to hospitals should result in similar magnitude of price cut at ex-factory levels. However, stent makers may negotiate with distributors for lower share of price cut by offering better credit terms or better deals on stent accessories. Overall, MicroPort management expects a 15-20% price cut to trim 2-3ppt off gross margins, which should be manageable in light of high overall gross margins. However, management may have underestimated the impact of price cuts on its businesses, especially the distributors’ incentives to strongly promote their products.
Stents have been subject to recall: There have been a number of recalls of medical devices in the US, highlighting the risk of investing in medical devices companies. On the FDA website: http://www.fda.gov/MedicalDevices/Safety/RecallsCorrectionsRemovals/ListofRecalls/default.htm, numerous instances of medical device recalls are listed. In the past ten
years, products from Boston Scientific have been subjected to recall in eight different occasions. In addition, there have been some issues regarding the safety of implanting drug-eluting stents, especially in cases of off-label use. Although large-scale recalls of stents have not occurred in China to our knowledge, it does not mean they will not occur in the future. Recall would be very costly for a company’s near-term profitability with reputation damage even harder to repair.
Competition with international players, which have greater resources:MicroPort works in a highly competitive market, which is significantly affected by the introduction of new products and price reductions by industry participants. Its competitors, such as Johnson and Johnson (11.6% market share as of 2009), Medtronic (7.7% market share) and Boston Scientific Corporation (2.9%), have substantially greater resources and are capable of developing more-effective products or offer their products at lower prices, which could materially impact the business of MicroPort. With JNJ exiting the market and BSX treading water, domestic players might be able to breathe easier. Abbott's XIENCE and XIENCE nano lines of stentshave demonstrated superior efficacy and safety profiles in clinical trials. Since XIENCE missed the centralized tendering of high-value medical consumable conducted in 2008 by the MOH, Abbott is forced to push the product province-by-province through negotiations. After the next rounds of provincial-level tendering, XIENCE may not only take the market share away from fellow MNC products, but could also become a threat to the market position of local products as well.
Figure 27: Market share in 2009
CompanyPercentage (%) in the coronary stent
market in China
MicroPort Scientific Corporation 28.9Beijing Lepu Medical Device, Inc. 23.5Shandong JW Medical Systems Limited 22Johnson and Johnson (through its Cordis subsidiary) 11.6Medtronic, Inc. 7.7Dalian Yinyi Biomaterials Development Co., Ltd. 3.2Boston Scientific Corporation 2.9Others 0.3
Source: Frost & Sullivan.
Foray into other product fields may not necessarily be successful: We understand MicroPort’s desire to diversify away from stents business and become a full-fledged medical device company. However, the dynamics of the orthopedic market is quite different from stents, as the ortho market is much more dominated by MNCs. Meanwhile, three local players – Shandong Weigao, Trauson, and Kanghui – have cultivated the market for years with very well-established distribution network. There is no guarantee that MicroPort will find significant successes in fields outside of its core business of stents.
Pipeline failure or delays in obtaining regulatory approvals for Firehawk:Although Firehawk has shown preliminary efficacies and potential in small clinical trials so far, there is no guarantee that it can show non-inferiority to XIENICE in large-scale clinical trials. Even if the product demonstrates strong efficacy in clinical trials, there is no guarantee the SFDA will approve it promptly. The Chinese government has been increasing the level of regulatory control over the medical-device industry in recent years, and the SFDA approval process now takes a longer time to complete than before. Thus, any failure to obtain approval of significant delay of approval could significantly impact MicroPort’s commercial success of Firehawk.
Strong in-house R&D capabilities responsible for developing most of the products in the market
Strong product pipeline featuring Firehawk that may be competitive with MNC brands
Relatively high technology entry barrier
Dedicated founder with years of experience in the field
Weaknesses
Low pricing power with the government setting prices through tendering processes
Products subject to pricing pressure constantly
Retaining a coherent core group of management has been a problem
Limited financial resources compared with the global medical-device makers
Opportunities
PCI cases performed in China still lower compared with the developed stent markets
Exit of JNJ from stent business offering opening to well-positioned domestic players
Firehawk, if successful in showing non-inferiority to XIENCE, may become the launch pad for MicroPort to enter the developed markets
Electrophysiology and orthopedics offer significant market opportunities for MicroPort to diversify away from the highly regulated stent business
Threats
MNCs may become more aggressive in competing for the market share in China
New technology and products may make MicroPort’s products obsolete
XIENCE may be much more successful than expected after next rounds of tendering
Lepu’s Nano could be very successful
Delays in obtaining regulatory approvals. The company depends on the approval of new products in order to sustain its growth, which is higher than the pharmaceutical industry. SFDA approval process now takes a longer time to complete than before.
Our Dec-12 price target is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.2 (the beta from Bloomberg of 0.82 is probably unreliable given the short trading history), which we believe is commensurate with the nature of its business. Accordingly, we assume a WACC of 10.8%. We estimate free cash flow until 2015 and assume a terminal growth rate of 5.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 3% and a maximum of 6%, depending on the nature of the industry and the level of maturity in China.
We also analyze the DCF price sensitivity to WACC and the terminal multiple.
We expect a net profit CAGR of 16.7% during 2010-13E
MicroPort achieved a sales CAGR of 22.5% between 2008 and 2010, roughly in line with the industry growth, which means that the company has not been able to take market share away from its competitors. We expect a 17.6% Y/Y growth in 2011 sales as we figure in the company’s voluntary price cut of 5% implemented earlier this year.
Figure 28: MicroPort—Revenue mix
Source: Company data, J.P. Morgan estimates.
Figure 29: MicroPort —Cost breakdown
Source: Company data; J.P. Morgan estimates.
MicroPort’s gross margins were up at 86.1% in 2009 from 81.9% in 2008, mainly because 2008 was negatively impacted by the uncertain economy. The gross margin went further up to 86.5% in 2010, but we expect the gross margin to trend down because of price pressure on stents and the company’s expansion of businesses into areas with lower gross margins. MicroPort has been able to cut its SG&A expenses as a proportion of sales from 32.4% in 2007 to 27.3% in 2010, and we expect this ratio to fluctuate around current levels depending on the company’s product-launch efforts. MicroPort has been investing around 13-15% for R&D, among the highest in the healthcare industry. We actually expect the ratio to go up slightly, going forward, as the company continues the clinical trials of Firehawk.
Figure 30: MicroPort: Trends of profit margins and expense ratios
Source: Company reports and J.P. Morgan estimates.
557.1 721.8 841.2 1,004.3
1,153.3 1,321.2
1,455.2
- -6.0
9.0
20.0
25.0
30.0
3.7 5.9 5.9
8.9 17.8
35.6 71.3
- - 5.0 35.0 52.5 70.9 92.1
80%
85%
90%
95%
100%
2009 2010 2011E 2012E 2013E 2014E 2015E
Vascular devices EP Devices Diabetes Devices Orthopedic Devices
MicroPort achieved a net profit CAGR of 33% between 2007 and 2010, due to a combination of sales growth and lower SG&A costs. We expect the CAGR growth in net profits over 2010 to 2013E to moderate to 16%, as the company faces stent price cuts and invests in R&D. For next three years, we see the EPS to grow at a CAGR of 10.3% as the lower amount of shares outstanding used to calculate 2010 EPS increased the baseline EPS figure.
Historically, MicroPort’s profitable business has generated sufficient cash to fund capital expenditure from 2007 through 2009. We expect MicroPort to remain in a net cash position after the company raised over Rmb1.4bn in its IPO in Sep-10 and that should provide sufficient cash to invest in new non-stents products as well as to develop and commercialize the new third-generation "Firehawk" stent.
Company DataShares O/S (mn) 85Market cap ($ mn) 2,105Market cap ($ mn) 2,105Price ($) 24.62Date Of Price 13 Oct 11Free float (%) 81.3%3-mth trading volume (mn) 13-mth trading value ($ mn) 163-mth trading value ($ mn) 16HSCEI 9,803Exchange Rate 1.00Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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MR share price ($)HSCEI (rebased)
Global strength, diversified product portfolio = premium valuation; assuming coverage with OW, Dec-12 PT $32 (Dec-11 PT $40.00 previously):Mindray Medical (MR) is a leading global medical equipment firm with deep roots in China but derives >50% of its revenue from abroad. Its key products include patient monitors, in-vitro diagnostic products, and medical imaging. While we forecast only a modest EPS CAGR of 14% for the next three years, we still believe the stock price (14.0x 2012E EPADS) is undervalued. We believe MR’s diversified product mix and balanced sales contribution from China and ex-China significantly reduce investment risks. MR’s strong R&D capabilities and wide sales network should propel it into a sustainable growth path well into the future.
Solid 1H bodes well for 2H11: MR reported total 2Q sales of $217.3MM(+21.2%Y/Y). Signaling the progress with sales force restructuring, MR recorded strong China sales of $97MM (+25.3% Y/Y), largely driven by the pickup of non-tender sales. International sales grew 18.5% Y/Y, driven mostly by the strong performance in emerging markets (Eastern Europe and CIS >40%, and Asia Pacific >30%). MR maintained the strong momentum in developed markets with double-digit growth in 2Q11. After reporting 1H Y/Y sales of +22.5%, MR has guided for >16% sales growth for 2011 and >10% non-GAAP profit growth. These appear conservative but we caution that 2H10 could be a difficult comparison with sales growth of 16.7% H/H.
New products and acquisitions to sustain MR’s growth momentum:Earlier this year, MR acquired two small domestic firms to expand the product offerings to target the booming low-end market. MR introduced 10 new products across divisions in 2010, including a 360MHz MRI, and it is on course to launch 7-10 new products for both high- and low-end markets in 2011. Other key 2011 priorities are to establish infrastructure across geographies to drive long-term growth.
MR currently trades at 14.0x FY12E P/E; our DCF-based Dec-12 PT of $32 implies a FY12E P/E of 18x. Although our P/E target isn’t low vs. its peers, we believe the premium is reasonable, given MR’s market leadership in medical devices and proven track record in new product development. Akey risk to our PT is the sustainability of the domestic market recovery.
Company description P&L sensitivity metrics EBIT EPS
FY11E impact (%) impact (%)
Mindray is China’s largest exporter of medical devices and the most profitable medical device manufacturer in China. It is based in Shenzhen, develops new products in-house and assembles most of its products in two factories in Shenzhen. Key products include patient monitors and life support, in-vitro diagnostic products and medical imaging.
Growth in export sales
Impact of each 5 percentage increase 5.9% 5.1%
Change in Selling costs
Impact of each 5 percentage increase 4.3% 3.8%
Change in manufacturing costs
Impact of each 5 percentage increase 10.2% 8.9%
GM: 1% Increase
Impact of each 1% increase 4.7% 4.2%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 price target of $32 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth rate of 5% (the middle of the 3% to 6% growth rate used for health care stocks).
Our PT (Dec-12, DCF-derived) of US$32 implies a P/BV of 2.6x (FY12E) and P/E of 18x (FY12E). We have not factored in new acquisitions in our price target. Key risks to our price target are that the recovery of the domestic market might not be sustainable, and that tender sales for new hospitals might be lower than we expect.
Global company hailing from China - Cost Advantage
Although Mindray is in a true sense a global medical equipment company with the majority of sales derived from overseas, it conducts much of its manufacturing and R&D operations in China. Hence, the company has lower labor and R&D costs than global medical device companies. Although Mindray lacks cutting-edge medical technologies such as CT and high-end MRI, we believe the quality of its mid- to low-end products is comparable with that of multinationals. Mindray’s devices are typically priced at ~30% discount to similar models from multinationals, making those products very competitive in emerging markets, which underlines the company’s strong growth there. In China, MR’s market share has surpassed that ofglobal brands for several major products, although the company’s penetration into top-tier hospitals remains low.
Global presence lowers domestic exposure to low-end price-based competition
Mindray is the best-known domestic brand in China with leading market share across all categories of its products. Its market dominance, comprehensive product offering, and premium brand image enable it to command a premium price of 20%+ versus local competitors. However, the company does not compete with its rivals for market share in low-end markets as the company would rather make more sales through exports. Mindray has cultivated the emerging markets of Eastern European, CIS, Middle East, and Latin America for several years now. This allows the company to use exports to offset the loss of low-end and low-margin business to domestic competitors.
A key beneficiary of government investment to build up local healthcare facilities
As part of the government’s healthcare reform, the company intends to build up a wide network of local healthcare facilities, including rural clinics and urban community health centers to control excessive patient flow to top-tier hospitals in major cities. As those facilities need to be equipped with patient beds, monitors, and diagnostic equipment, we believe Mindray stands to benefit significantly by selling equipment offering favorable quality/price trade-off against MNCs and domestic competitors. In November 2010, the Chinese government announced its intention to upgrade all county-level hospitals within five years and its plan to invest a total of Rmb36 billion in supporting 2,176 county-level hospitals across the country over the next three years. A significant portion of the government spending for county-level hospitals is expected to be in the form of direct funding in lieu of centralized tender purchases, which should benefit non-tender sales. This should be good news for companies such as Mindray as it can compete for non-tender sales on quality/price tradeoff rather than mainly on price, which tends to drive down prices.
China sales could be turning a corner
Ever since Mindray’s China sales growth dipped into negative territory in 2Q09, China sales growth has been recovering steadily. By 2Q11, growth was restored to 25.3%, which should be outpacing the overall industry growth for medical device/equipment at ~20%. We believe this suggests that the company's sales channel/sales force restructuring could be bearing fruit. Combined with opportunistic
acquisitions, we expect MR to maintain growing the China business at 20%+ for the next several years.
Figure 31: Mindray—China sales appear to be picking up momentumUS$ in millions
Source: Company reports.
Negative share price drivers and risks to our thesis
Rising labor and material cost and Rmb appreciation put pressure on margins
Inflation and labor costs have been on the rise in recent years. In particular, with rising labor costs, China is losing its advantage as a low-cost provider of manufacturing labor, which also raises the overall cost for Mindray with most of its staff and R&D personnel residing in China. Moreover, with the majority of sales coming from ex-China markets, while the company’s cost is mostly denominated in Rmb, Rmb appreciation, left largely unhedged by Mindray, could negatively impact its operating margins.
Competition is becoming fiercerWe have visited the biannual China Medical Equipment Fair several times and each time we see more and more small companies featuring their own fancy monitors and ultrasound equipment. As medical equipment has a relatively short development time, low regulatory hurdles, and low capital requirements, we expect more Chinese medical device companies to enter the market. This will make the low-end equipment market ever more crowded. Mindray has been able to leverage its R&D capabilities to keep upgrading its products and to move away from low-end market penetration. On the other hand, Mindray appears also to be facing increasing pressure from MNCs. Philips has acquired Goldway to enhance its market reach while GE has been openly contemplating its market entry strategies to move into lower-tier markets where Mindray is the strongest.
Emerging market uncertainties and slow growth of business in developed markets
In the first half of 2011 there was major turmoil in Middle East and North Africa, which does not appear to have significantly impaired Mindray's businesses in thatregion. If more turmoil arises, there is no guarantee that Mindray will not see material negative impact. Ever since Mindray acquired Datascope's patient monitoring business and became the No.3 overall global supplier, its business has been much more tied to the performance in developed markets, where growth is much slower.
Our Dec-12 price target of $32 is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.0, based on Bloomberg data. Accordingly, we assume a WACC of 12.2%, which is relatively high, just to be conservative. We estimate free cash flow until 2015 and assume a terminal growth rate of 5.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 3% and a maximum of 6%, depending on the nature of the industry and the level of maturity in China.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple. At our price target of US$32, Mindray would be trading at 18x our 2012 EPS estimate, which we believe is reasonable given its China market leadership, strong global presence, and its historical track record of launching products to fuel further growth.
We expect EPS CAGR of 13.8% over the next three years
As Mindray derives majority of its sales from overseas, its business should actually be much less affected by the current negative macro headwind in China that has caused us to lower our estimates for many of our covered companies substantially. We revise our model only slightly to incorporate the reported 2Q11 results and bring our full-year estimates roughly in line with management guidance.
We forecast sales CAGR of 18.2% for the next three years over the span of 2010-13E and foresee China growth again to overtake international sales growth. Based on reported results so far for 2011, we raise our GM estimate for 2011 to 56.3% but lower our GM estimate for 2012 to 55.3% because of labor inflation and potential sales from new equipment which normally carry a lower GM. We expect Mindray to budget about 35% of total sales for SG&A, but expect a bit of leverage with rising sales.
We expect EPS to record CAGR of 13.8% over the next three years and EPADS growth of 11.1% Y/Y for 2011.
We keep our capital expenditure forecast unchanged, in line with management guidance.
Leading brand recognition and quality perception enable the company to enjoy premium pricing vs. local competitors.
Low prices and cost efficiency allow the company to compete aggressively with global medical equipment companies for market share.
Strong R&D capabilities allow the company to keep launching new products.
Global presence lowers competitive pressure from low-end domestic manufacturers.
Weaknesses
Technologically, Mindray is still not as strong as MNC competitors, so it cannot compete effectively for a lion’s share of business from large tier-1 hospitals.
Lack of price advantage to compete for tender businesses from rural clinics and community health centers.
The patient monitor business is becoming mature in developed markets.
Opportunities
Government investment of Rmb36B to build local hospitals and rural clinics offer significant market opportunities for non-tender sales.
Significant market opportunities exist for CT and MRI that cater to low-end hospitals.
Cross-selling still feasible in the US for Mindray’s patient monitor products.
Austerity measures in European countries could hit spending on healthcare and increase the demand for medical equipment offering favorable quality/price trade-off.
Threats
Competition from MNCs for middle-tier markets.
Local players could go after Mindray with low-pricing strategies.
The government may put more strict quotes for medical equipment purchase in order to control cost.
Labor and raw material cost inflation could severely impact the company’s profitability and its ability togenerate cash to fund R&D.
Political turmoil may spill over and affect Mindray’s businesses in some countries.
Company DataShares O/S (mn) 1,884Market cap (Rmb mn) 13,599Market cap ($ mn) 2,138Price (HK$) 8.83Date Of Price 14 Oct 11Free float (%) 82.9%3-mth trading volume (mn) 53-mth trading value (HK$ mn) 453-mth trading value ($ mn) 6MSCI-Cnx 5,419Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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A solid consumable player deserving premium valuation; assuming coverage with OW and Dec-12 PT of HK$11.5: Compared to medical equipment makers whose products generally have a replacement cycle lasting several years and could be prolonged under difficult economic conditions, Weigao’s products are mostly disposable consumables which are largely nondiscretionary, offering Weigao a distinct advantage. Weigao’s stock has been trading at a very high forward P/E of 30x-40x for last 2-3 years, which we think is justifiable as it has recorded sales growth of 30%-40% for such a long period. We view the recent pull back in Weigao’s share price as an attractive buying opportunity.
Strong brands and unrivaled sales reach underpin long-term growth: Weigao’s vast sales and distribution network is critical for success as a medical consumable player. While Becton-Dickinson, Weigao’s main MNC competitor for high-end consumable, relies on distributors, Weigao uses its own sales force; hence, it gains more control over the end-user hospital market. Weigao’s products usually enjoy a price premium versus domestic peers, and they arepositively perceived by large hospitals that evaluate medical products on both price and quality.
Hemodialysis consumable key to long-term growth: Currently, China has only 100,000 patients on hemodialysis vs. 300k-400k in the US. We expect expanding insurance coverage, plus uplift in the annual reimbursement limit, to drive up hemodialysis penetration and consumable use. Weigao has obtained the only license to operate independent dialysis centers and it plans to start the pilot run of a handful of centers. We believe Weigao’s business model could become extremely lucrative by operating those centers as government-subsidized non-profit clinics while making profit through selling consumables.
Valuation, price target, and risks: Our DCF-based price target of HK$11.5(Dec-12) implies a P/E of 33x 2012E EPS. We have not factored in any new acquisitions into our price target. Key risks to our PT and investment thesis include a severe price cut for medical supplies, worsening cash collection cycle, and a setback in setting up the dialysis business.
Company description P&L sensitivity metrics EBIT EPS
FY11E impact (%) impact (%)
Weigao was established in 1998 in Shandong province and has grown to be one of the leading domestic suppliers of hospital medical consumable products in China. With over 110 different product types and over 2,000 specifications, Weigao offers international quality needles, blood bags, orthopedic and blood purification products at competitive prices relative to imports.
No blood purification growth in 2011
- assumes 2011 sales = 2010 sales -7.1% -5.8%
No new product introduction for 2011
- only organic growth from existing products -8.7% -9.0%
Selling expenses
Impact of each 5 percentage points increase -10.8% -10.2%
GM: 1% Increase
Impact of each 1% increase 3.8% 3.1%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 PT of HK 11.5 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth of 5.5% (the high end of the 3%-6% growth rate used for healthcare stocks).
Revenue mix (2011E)
Risk free rate: 4.20%
Market risk premium: 6.00%
Beta: 0.71
Wacc 8.43%
Terminal “g”: 5.50%
Source: Company reports, J.P. Morgan estimates.
Our PT (Dec-12, DCF-derived) of HK$11.5 implies P/E of 33x (FY12E). We have not factored in new acquisitions into our price target. Key risks to our price target and investment thesis includeregulatory measures on pricing of healthcare supplies, persistent difficulty with cash collection resulting in bad debt write-off and discounting, and more competition from international players establishing low-cost plants in China.
Sales consistently growing by 30+%, unprecedented for a large established healthcare company: Since 2005 Weigao has consistently managed to improve its topline revenue by more than 30%, except for 2009. In 2009, sales of Weigao Orthopedic decreased by 27.1% due to transfer pricing adjustment made after the establishment of the distribution JV with Medtronic. Otherwise, Y/Y growth should undoubtedly have been 30% as well. This consistent strong top-line growth is the main reason, in our view, for investors assuming a premium valuation for Weigao’s shares. In addition, Weigao’s gross margins have also risen consistently year after year until reaching 55.2% in 2010. Although we expect the GM to trend down slightly this year because of higher expected sales of low-end consumable as a proportion of total sales, we expect Weigao to maintain healthy gross margins going forward, which should provide room for the company to undertake aggressive sales and marketing efforts to promote its products.
Figure 32: Shandong Weigao—An impressive record of consistent strong top-line growthRmb in millions
Source: Company reports, J.P. Morgan estimates.
Strong brands and unrivaled sales network reach: We believe that a wide sales network is a key success factor for a medical device company. Over the years, Weigao has built a sales and distribution network that is well regarded in the Chinese medical community. The company sells its products primarily to hospitals through its direct sales force of 1,035 as of June 30, 2011, up from around 750 in 2008. The company maintains 22 sales offices and 23 customer centers throughout China with its sales people having presence in 110 cities. While Becton-Dickinson, Weigao’s main MNC competitor for high-end consumable, relies on distributors for product sales, Weigao uses its own sales force; hence, it has more control over the end-user hospital market. Weigao’s products usually enjoy a price premium versus its domestic peers and they are positively perceived by large hospitals that evaluate medical products on both price and quality.
Weakness in the network reach in the low-tier market could offer upside opportunities: While Weigao enjoys an 81.3% penetration rate for the ~1,200 top-tier Class-3 hospitals, it has only ~25% penetration into the ~6.600 mid-tier hospitals and single digit penetration in lower-tier hospitals. We understand that Weigao is selling to some of those uncovered hospitals through 1,062 distributors but we
believe substantial market opportunities still exist if the company could strengthen its market reach, at least to mid-tier hospitals through its own direct sales force as those hospitals demand better quality medical consumable products. According to management, Weigao has actively sought to acquire a company to build up its market reach to low-tier hospitals but has not pulled the trigger as the ask price has been too high.
Dialysis consumable to be the next big thing driving Weigao growth: Weigao has moved aggressively into the business of supplying dialysis consumable to dialysis centers. Weigao started the blood purification consumable business in 2005 and has seen its sales growing +100% for the past few years. The sales of blood purification dialysis consumables grew by a healthy 47.5% in 1H11. The dialysis consumableswas mostly imported before Weigao launched its products, initially of the variety of rinsing fluid. The company launched dialyzer in 2009/2010 and it has seen steady but not significant pickup in dialyzer sales. We believe the JV with Nikkiso for the manufacturing and distribution of Nikkiso technology based dialysis machines could fundamentally strengthen Weigao's consumable business. Although Nikkiso’s dialysis machines are well perceived, their market penetration has been low because of lack of vigorous market efforts. With Weigao in control of the JV, it should leverage its strong network of sales people to push Nikkiso’s products and its consumables along the way. The dialysis business will likely be greatly bolstered if Weigao could successfully establish its independent dialysis center business in China, in our view.
The dialysis market to experience huge growth: There are about 1.5 million people in China who live with end-stage renal diseases (ESRD), according to estimates from the MOH. This represents a market opportunity of Rmb120 billion at Rmb80,000 annually. ESRD used to mainly result from nephritis but more and more ESRD develops as secondary to diabetes, which is becoming epidemic in China. About 300,000 patients with ESRD develop uremia and are in need of hemodialysis. Unfortunately, hemodialysis is prohibitively expensive for people without adequate insurance and 90% of patients with uremia die of it. Currently only about 100,000patients are on hemodialysis in China versus 300,000-400,000 estimated in the US. Weigao aims to launch a full portfolio of dialysis consumable to serve quality and inexpensive products to this population in need of desperate care. As Weigao could likely lower the overall cost of hemodialysis, it might be able to convince more and more local governments to cover an increasing share of the cost of dialysis care. Hence, we believe as a domestic pioneer of dialysis consumable products, Weigao stands to benefit significantly from the potentially huge growth of the dialysis market in China in the next few years.
The Biosensors deal could finally close in the near future: We understand Weigao is finalizing a deal with Biosensor to transfer its ownership in JW Medial to Biosensor for a stake of Biosensor and cash. This transaction should close by year-end 2011. Given the pricing pressure on stents and tense relationship between Weigao management and JW Medical management, we believe Weigao may be better off if it divests its interest. As a reminder, its share of profit from JW Medical declined about 14% in 1H11, a major drag on the company’s overall profitability.
Negative share price drivers and risks to our thesis
Previous JVs have proven to be unhappy marriages: While Weigao reported 33% Y/Y growth for its 2Q11 operating profits, net profit growth of 21% lagged far behind due to the weak results from three key JVs. We expect the swap of Weigao’s
stent JV stake with a stake in Biosensor will come through in 2H11 but do not foresee Medtronic buying out its minority share in the orthopedic sales JV according to our discussions with management; hence, the Medtronic JV could continue being a drag on the company’s overall financial performance. Due to the issues related to managing minority interest in JVs, Weigao has opted for a majority stake in its dialysis JV with Nikkiso and for any future JVs with more control.
A stent price cut looming: We understand that MOH has largely given up its efforts for the centralized procurement of high value medical consumable after the initial round conducted in 2008 was not so well received. Instead, it has assigned the Beijing government to conduct the first provincial tendering, to be followed closely by Shanghai and Zhejiang. The tendering should complete its course by year-end 2010. While the expectation is for stent price to be cut by 15%-20%, if the price cut reaches 30%, it would be very negative for stent makers. Although Weigao is in the process of divesting its interest in JW Medical to Biosensor, it would still hold a significant stake in Biosensor afterwards. Any effect on Biosensor’s business would show up on Weigao’s book indirectly thereafter, in our view.
Large capex need for dialysis centers would mean dilutive financing: Weigao would require significant amount of capital investment to roll out dialysis centers. The company may need to tap the capital market repeatedly to raise cash to fund the build-up and initial operations of those centers, which could be dilutive to current shareholders.
Chronic cash collection problem: As Weigao makes most of its sales directly to hospitals, long account receivable days have been a chronic problem. A couple of years ago, Weigao tried to improve cash collection by limiting supplies of low-end consumable to hospitals but the hospitals did not accept it. Generally speaking, hospitals have very strong bargaining power with suppliers and they always see better use of cash than paying suppliers promptly. With Weigao expanding sales, we expect increasing need for working capital, which could lead to very high finance cost, given the current tight monetary policy of the Chinese government. We have presented a sensitivity analysis of free cash flow to days of sales outstanding on Table 1. Clearly, if the AR days were to lengthen for a month for any of next three years, FCF for that particular year will become zero.
Table 30: Weigao - Sensitivity of Free Cash Flow to AR Days
Our Dec-12 price target of HK$11.5 is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 0.71, based on Bloomberg adjusted data. Accordingly, we assume a WACC of 8.43%. We estimate free cash flow until 2015 and assume a terminal growth rate of 6.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 3% and a maximum of 6%, depending on the nature of the industry and the level of maturity in China. Given Weigao’s strong growth momentum, we believe 6% terminal growth rate is justifiable.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
We expect EPS to grow about 14-15% for next two years
Since 2005, Weigao has consistently managed to grow its top line by more than 30%, except for 2009. In 2009, sales of Weigao Orthopedic decreased by 27.1% due to transfer pricing adjustment made after the establishment of the distribution JV with Medtronic. Otherwise, Y/Y growth should undoubtedly have been 30% as well. This significantly consistent strong top-line growth is the main reason for investors assuming a premium valuation to Weigao shares. In addition, Weigao’s gross margins have also risen consistently year after year until reaching 55.2% in 2010. Although we expect GM to trend down slightly this year because of higher expected sales of low-end consumable as a proportion of total sales, we expect Weigao to maintain healthy gross margins going forward, which should provide room for the company to undertake aggressive sales and marketing efforts to promote its products.
Figure 33: Weigao—Sales and GM forecastsRmb in millions
Source: Company reports, J.P. Morgan estimates.
Figure 34: Weigao—Composition of sales for 2010
Source: Company reports, J.P. Morgan.
Revision to our model: As earlier we have been too optimistic about dialysis sales ramp-up, we cut our revenue forecasts for FY11 and FY12. We also lower our GM estimate slightly as we expect low-end medical consumables will represent a larger portion of total sales than we previously expected. Net/net, we lower our EPSestimate for 2011 and 2012 by 14.4% and 14.7%, respectively.
Table 33: Revisions to our model
Rmb in millions
New Old Change
FY11E FY12E FY11E FY12E FY11E FY12E
Turnover 3,253 4,364 3,306 4,616 -1.6% -5.4%
Gross profit 1,743 2,331 1,799 2,474 -3.1% -5.8%
EBIT 855 1,169 932 1,308 -8.2% -10.6%
Net profit 955 1,297 1,116 1,521 -14.4% -14.7%
EPS (CNY) 0.215 0.287 0.251 0.336 -14.4% -14.7%
Gross margins 53.6% 53.4% 54.4% 53.6% -0.8% -0.2%
Source: Company data, J.P. Morgan estimates. Note: Earnings revision made due to assumption of coverage.
For the next few years we expect Weigao to continue budgeting about 30% for SG&A with an overall small trend for leveraging. Net margins should also trend down slightly with gross margins declining due to more than expected leveraging of SG&A. By 2015, we expect Weigao to have net margins of slightly above 20%.
Figure 35: Weigao—Margin forecasts
Source: Company reports, J.P. Morgan estimates.
Weigao has been experiencing some difficulty in cash collection problems because of strong bargaining power of hospitals and Weigao’s reliance on direct sales to hospitals. We are forecasting AR days of about 140 days for the next few years. However, were the company's AR days to lengthen by a month in any year of next three, we estimate the free cash flow for that year would be completely wiped out.
Company DataShares O/S (mn) 5,175Market cap (Rmb mn) 12,989Market cap ($ mn) 2,042Price (HK$) 3.07Date Of Price 14 Oct 11Free float (%) 25.9%3mth Avg daily volume 13.693M - Avg daily Value (HK$ mn)
42.21
3M - Avg daily Value (USD) ($ mn)
5.45
HSCEI 9,803Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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Assuming coverage with OW rating and Dec-12 PT of HK$4.9: Sihuan is a leading provider of cardio-cerebral drugs used in major hospitals in China for the emergency treatment of stroke and other cardio-cerebral diseases. Although we are concerned about the Kelinao/Anjieli growth slowdown given poor 1H results, we are encouraged by initial sales performance of Oudimei. The strong performance was substantiated by the hospital purchases data compiled by IMS. We expect Sihuan to maintain itsstrong growth momentum as we foresee the potential for a sales recovery for Kelinao and Anjieli.
Predominant position in CCV reinforced by Dupromise acquisition: Sihuan has been ranked No.1 for CCV sales since 2007, featuring Kelinao as the best selling drug among all products procured by hospitals. The acquisition of Dupromise boosted Sihuan's market share to 9% for 1H11 vs. 7.8% in 1H10. Sihuan’s portfolio features products for three out of five most frequently prescribed CCV molecules in China. With low market share for edaravone and GM1, we believe Sihuan is poised to gain significant market share for these products.
A distinctive distribution platform: Sihuan relies exclusively on 2,000 external distributors for product sales. At an average of five sales people per distributor, essentially 10,000 sales people are engaged in the promotion and selling of its products. Sihuan’s strength resides in its ability to identify productive distributors. This is probably the reason why it was able to build up its current scale in less than 10 years. However, this sales model involves Sihuan pricing its products at significant discounts to hospital purchase prices. As the government is determined to control channel markup, Sihuan will start booking key products at small discounts to hospital prices while reimbursing distributors indirectly for their expenses, which could be confusing in interpreting Sihuan’s financial results.
Valuation, PT and risks: Our DCF-based PT (Dec-12) of HK$4.9 implies a FY12E P/E of 21x. Key downside risks to our PT are government regulations on the pricing of drugs, lower-than-expected Kelinao sales recovery, and the timing of commercialization of new products.
Company description P&L sensitivity metrics (FY10E) EBIT EPS
impact (%) impact (%)
Founded in 2001, Sihuan Pharmaceutical (Sihuan) is a leading pharmaceutical company with the largest cardio-cerebral vascular drug franchise in China in terms of market share, accounting for approximately 7.5% of the market in 2010. Sihuan has a distribution network covering close to 10,000 hospitals, including 70% of Class 3 hospitals,through over 2,000 distributors in all 31 provinces.
Kelinao ASP
Impact of 5% increase 4.0% 3.6%
Kelinao (volume)
Impact of 5% increase 3.2% 2.9%
Other cardio-cerebral (ASPs)
Impact of 5% increase 1.8% 2.0%
GM
Impact of each 100bps increase 1.7% 1.6%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 PT of HK$4.9 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth of 6% (the high-end of the 3%-6% growth rate used for healthcare companies).
Source: Company, J.P. Morgan estimates. Source: J.P. Morgan estimates
Our PT (Dec-12, DCF-derived) of HK$4.9 implies a forward P/E of 21x (FY12E). Key downside risks to our price target are government regulations on the pricing of drugs and the timing of commercialization of new products.
A leading cardio-cerebral vascular drug company in China. Recent acquisitions have boosted Sihuan’s CCV portfolio to include 37 drugs. Sihuan has consistently maintained the No.1 position in market share of CCV drugs in China since 2007, ahead of leading MNCs such as Sanofi-Aventis and Pfizer. Sihuan markets three out of the top five most prescribed CCV medicines in China. In particular, Kelinao and Anjieli have collectively ranked first among all drugs sold in hospitals in China every year since 2007. However, the company has only recently started marketing GM1 and distributing edaravone products for a third party. The current low market share means significant growth opportunities for Sihuan based on its success in selling products to the same end users. Sihuan has acquired a GM1 manufacturer that has its own API facility, which should resolve the company's raw material supply constraints, positioning Sihuan to be competitive with Shandong Qilu for a significant market share of the largest molecule class of CCV drugs in China. In addition, Sihuan also markets the No.1 selling (58% market share) ligustrazine injectables for the treatment of ischemic CCV diseases related to insufficient blood supply to the brain, and the No.2 selling (22.4% market share) cerebroprotein hydrolysate for the treatment of traumatic brain injury.
Figure 36: Sihuan—Revenue mix
Source: Company data; J.P. Morgan estimates.
Figure 37: Sihuan—Sales growth and gross margins
Source: Company data. J.P. Morgan estimates.
Increasing demand for cardio-cerebral vascular drugs: According to the MOH’s Fourth National Survey on the PRC’s Healthcare Services, the total diagnosed cases of cardio-cerebral vascular diseases increased from 37 million in 1993 to 114 million in 2008. Cardio-cerebral vascular diseases have been a major cause of death in the PRC. According to the MOH, cardio-cerebral vascular diseases were responsible for over 40% of deaths caused by diseases in the PRC in 2009, and cerebrovascular and cardiovascular diseases were ranked number two and three, respectively, as the leading causes of death in the same year. The CAGR of the CCV drug market was 24.1% between 2005 and 2009, with 2009 market size estimated to be around Rmb28 billion, according to IMS. IMS forecasts that the CCV market will record 25.8% CAGR between 2009 and 2014, representing one of the fastest growing segments of the Chinese drug industry. As the market leader of the segment, Sihuan stands to benefit greatly from the overall robust growth, in our view.
Oudimei acquisition to further strengthen the CCV portfolio
Late last year Sihuan acquired all equity interests held by JASB Holding Limited in
Dupromise, with Oudimei (歐迪美) (Cerebroside-Kinin Injection) as one of three
major products. Cerbroside-Kinin, branded as Kailuoxin (凯洛欣), once outsold Kelinao after its approval in 2003 and achieved sales close to Rmb300 million in 2005 before it was temporarily taken off the market. Audimei has demonstrated efficacy to improve the metabolism of heart and brain tissues, facilitate the growth, differentiation and regeneration of brain neurons, and improve cerebral blood flow and cerebral metabolic functions. Hence, it has the potential to be widely used in treating dysfunction caused by myocardial and brain diseases. Given Sihuan’s strength in distributing CCV products, we are significantly upbeat about Oudimei’s market potential. The strong sales of Oudimei (Rmb334 million) in 1H11 appears to confirm our positive view of its market potential. Oudimei is a proprietary drug with patent protection up to 2025, which should alleviate concerns about Kelinao losing patent protection ahead of schedule while continued sales ramp up of Oudimei should lower the company’s overreliance on the sale of cinepazide products, in our view.
Kelinao/Anjieli could recover to some extent: Although total sales of CCV drugs grew by 122.5% Y/Y in 1H11, it was mainly driven by the newly acquired Oudimei (Rmb344 million in 1H11 vs. nil in 1H10). We are concerned about the sudden sales slowdown of cinepazide products, which only recorded an aggregate Y/Y growth of 8.5% (Kelinao: 3.6% and Anjieli: 26.8%) in 1H11. The slow growth is largely attributable to the restriction on reimbursement for cinepazide to work-related injury and Raynaud's disease as specified in the 2009 NDRL list, which became widely effective nationwide in 1H11. Hospital pharmacy destocking in anticipation of price cuts could be another reason. As a reminder, cinepazide was reimbursed without those restrictions by 27 provincial DRLs previously. Sihuan has successfully negotiated with 14 provincial authorities to remove such restrictions and will try to lift the restriction in other provinces as well. We estimate sales of these two products could well pick up in 2H11 and 2012 to Y/Y growth of 10%-20% when there are fewer restrictions. The price cut in Kelinao/Anjieli could fall only by a manageable 5%-10%, in our view.
An established distribution network to confer key competitive advantage for the sale of CCV drugs: Sihuan has established an extensive nationwide distribution network covering close to 10,000 hospitals through over 2,000 distributors in all 31 provinces in China. Leverage is a key feature of this indirect sales distribution model, as Sihuan is effectively commanding a sales force of 10,000, with five sales people per distributor. No Chinese pharmaceutical company can keep a sales force of 10,000 in-house as it will be prohibitively costly and highly inefficient. We believe Sihuancan leverage the same distribution model to ramp up sales for Aogan (a GM1 product) and Qingtong (an edaravone product), along with Oudimei and Kelinao.
Pipeline of new products to boost growth: Sihuan has two R&D teams of 289employees as of June 30, 2011, one focusing on innovative R&D and one on branded generics, especially first-to-market generics. Sihuan has a pipeline of over 30 product candidates, including 10 drugs that are in various stages of development. Majority of these pharmaceutical products under development are new drugs, i.e. innovative or first-to-market generic drugs. The new drugs span a variety of products that include illnesses that are related to the company’s current product offerings such as drugs for circulatory system disorders but also new areas such as respiratory and epilepsy-related diseases.
Dupromise acquisition likely to be closed at the agreed upon price: Based on the strong performance of Oudimei in the first half, Dupromise generated a net profit of close to Rmb90 million, according to Sihuan management. Hence, we believe it is on
course to generate a full-year profit of Rmb200 million, on which the transaction is conditioned to be closed at Rmb2.4 billion. Clearly, the recent retail ceiling price in Guangdong is encouraging. Investors had strong doubts whether Dupromise could record a net profit of Rmb200 million in 2011 given that the company’s net profit was about Rmb20mn in 2010. We believe strong 1H11 validates management's decision to purchase Dupromise.
Negative share price drivers and risks to our thesis
Competition with international players which have greater resources: Sihuan works in a highly competitive market, which is significantly affected by the introduction of new products and price reductions by industry participants. Its competitors from international pharmaceutical companies have larger research budgets and stronger international research capabilities. These international giants are adding more resources in China in terms of research and development and also distribution capabilities. Many of them could lower the prices of their products in order to more effectively compete with the lower-priced products from Sihuan.
Efficacy of its key products remains empirical: Of all the three CCV classes Sihuan is producing, none is available in the US and many other developed markets. Their success in China is partly due to the dire need for the effective treatment for ischemic stroke, which is much more prevalent in China than in the US. Patients and relatives are willing to pay for probable, not necessarily definite, benefits to a debilitating illness. Although there is empirical evidence to support the efficacies of edaravone, cinepazide, and GM1 for the treatment and prevention of stroke, the efficacies have not been confirmed by clinical trials featuring vigorous statistical plan to assess the use of those drugs. In addition, cinepazide was previously withdrawn from the European market for safety concerns. Although the product has been reformulated in China by Sihuan quite different indications, doubts linger thatadverse effects may arise in future with more and more patients receiving treatment.
Pipeline setback and delays in obtaining regulatory approvals: Although Sihuan has historically been successful with its R&D efforts, there is no guarantee that the company will continue being successful. Pipeline failure, especially with products with high promise, could result in negative perception about the company’s ability to continue growing strongly. Even if products can withstand clinical trials, the SFDA may not approve products and take much longer than expected time to review applications. Sihuan depends on the approval of new products in order to sustain its above-industry average growth. The SFDA approval process now takes longer time to complete than before. Sihuan could fail to obtain approval or face delay in securing approval for its products, resulting in commercial loss, in our view.
The market leadership for cardio-cerebral drugs used in major hospitals for the emergency treatment of strokes and other cardio-cerebral illnesses.
The largest market share in the CCV drug market each year since 2007 and had a market share of 7.4% in 2009, highlighting the company’s strong distribution network.
Patent protection into 2020’s for two key products—Oudimei and Kelinao.
An extensive nationwide distribution network covering close to 10,000 hospitals through over 2,000 distributors in all 31 provinces in China.
Management team is made up of seasoned veterans, many of whom have over 20 years experience in the pharmaceutical area—the medical background of the two co-founders confers credibility when dealing with physicians and surgeons.
Weaknesses
The anti-infective drugs market to become more competitive. For example, several of Sihuan’s anti-infective drugs, namely Kanglixin, Xiboao, Aolang and Anjiejian, experienced a decrease in their wholesale prices of 3.9%-14.2% in the past three years, mainly attributable to intense competition.
The over-reliance on the sales of Kelinao and Anjieli, its cinepazide maleate products. In 2009, the revenue derived from the sale of Kelinao and Anjieli represented 57.3% of total revenue. Oudimei is expected to alleviate this problem.
The indirect sales model does not allow much to control the end-user market as the direct sales model.
Opportunities
Vast market opportunities—Sihuan has 44 products covering the top five medical therapeutic areas in China: anti-infective, metabolism, cardiovascular system, oncology and nervous system. The aggregate market size of products in these five therapeutic areas amounted to Rmb166.4 billion in 2009, accounting for approximately 81.8% of the overall pharmaceutical market in China. These top five areas are projected to continue to grow rapidly and reach Rmb466.8 billion by 2014, representing a CAGR of 22.9% from 2009.
Qu’Ao, the CNS drug for cardio-cerebral vascular diseases, ranked second in the cerebroprotein hydrolysate market in China in 2009. Sihuan also launched Aogan and Qingtong in 2008 and 2009, respectively, and since then the company has been quickly gaining market share in their respective markets.
Kelinao and Anjieli are currently used mainly in two departments—neurology and neurosurgery. According to management, cinepazide can find use in about 10 departments because of the versatility of the drug class.
Threats
Competition with international players which have greater resources. Sihuan competes in a highly competitive market, which is significantly affected by the introduction of new products and price reductions by industry participants.
Sihuan’s products are subject to price controls and it doesnot have full discretion over the pricing of its products.
Delays in obtaining regulatory approvals. The company depends on the approval of new products in order to sustain its growth, which is higher than the pharmaceutical industry. The SFDA approval process now takes longer to complete than before.
Our Dec-12 price target of HK$4.90 is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.0 (consistent with other healthcare companies of similar market share.). Accordingly, we assume a WACC of 10.3%. We estimate free cash flow until 2015 and assume a terminal growth rate of 6.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 1.5% and a maximum of 4.5%, depending on the nature of the industry and the level of maturity in China.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
We expect net profit CAGR of 31% and EPS CAGR of 20%between 2010 and 2013E
Booking sales differently may result in confusion: Sihuan confirmed it would start booking sales of major products such as Kelinao at a minor discount to hospital purchase prices, as if Sihuna is operating a direct sales model. Distributors will be reimbursed for the sales and marketing efforts and the payment to distributors will berecorded as a part of the distribution cost by Sihuan. Hence, 2H11 and 2012 saleswill see dramatic Y/Y growth while distribution cost should rise significantly. GM should also be up but both OPM and NPM could record a sharp decrease. This could make Y/Y comparison quite difficult but should have no bearing on Sihuan’s bottomline performance, in our view.
Table 37: Sihuan—Confusing revenue rebooking to have no economic impact
Old New CommentsHospital purchase price 400 400Sihuan ex-factory price 100 372Cost of Sales 30 30GM 70% 92%G&A 10 10Distribution Cost 10 282 272 reimbursed to distributorsOperating profit 50 50Operating margin 50.0% 13.4%
Source: J.P. Morgan estimates.
Revisions to our models: As Sihuan will start booking revenue for Kelinao/Anjieli differently in 2H11, we raise our revenue forecast substantially by 40% for 2011 and 75% for 2012, respectively. Along the way, we also raise our forecasts for distribution cost accordingly. In fact, as we trim our growth forecast for cinepazide products, net/net, we cut our 2011 and 2012 EPS estimates by 5.1% and 7.6%, respectively.
Source: Company data, J.P. Morgan estimates. Note: Estimate revisions due to assumption of coverage.
Between 2007 and 2010, Sihuan recorded sales CAGR of 54% due to a rise in demand for Kelinao and other cardio-cerebral drugs as their use in China as a domestic substitute for foreign brands rose in popularity. We estimate sales growth of 142.7% for 2011 because of the strong performance of acquired products which did not show up in 2010 results and rebooking of Kelinao and Anjieli sales in 2H11. We further expect sales to grow by 61% in 2012 as the growth is artificially boosted by the full rebooking of 2012 revenue compared with the partially rebooked 2011 revenue.
Figure 38: Sihuan—Revenue and gross margins forecastsRmb in millions
Source: Company reports, J.P. Morgan estimates.
Sihuan’s gross margins steadily dropped from 79% in 2007 to 72% by 2010 due to the introduction of some new products with lower margins. As the company starts rebooking revenue at smaller discounts to hospital purchase prices, we expect the overall 2011 GM to rise to 80%, and slowly go down because of the expected price cuts for some of the products expected down the road.
Figure 39: Sihuan—Forecasts of expense ratios and profit margins
Source: Company reports, J.P. Morgan estimates.
As mentioned earlier, we expect the distribution expense ratio to go up substantially as the company rebooks revenue. Economically, we believe Sihuan will maintain operating profit and net profit; hence, the margins should rise as a part of revenue rebooking, since margins will be derived based on a larger revenue base as denominators. Overall, we expect net profit to grow at a CAGR of 31% and EPS at 20% for the next three years. The difference between net profit CAGR and EPS CAGR is attributable to smaller share counts used to calculate EPS for 2010 (the IPO was in October 2010) than for other years.
Historically, Sihuan’s profitable business has generated sufficient cash to fund capital expenditure from 2007 through 2009. The company continued to be cash flow positive for 2010. We factor in the payment and the contribution for Dupromise in our estimates and this acquisition could be financed from existing cash and cash flow of Sihuan.
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Company DataShares O/S (mn) 4,941Market cap (HK$ mn) 10,921Market cap ($ mn) 1,404Price (HK$) 2.21Date Of Price 14 Oct 11Free float (%) 45.1%3mth Avg daily volume 5.983M - Avg daily Value (HK$ mn)
13.83
3M - Avg daily Value (USD) ($ mn)
1.73
HSCEI 9,803Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
2.0
2.5
3.0
3.5
4.0
HK$
Sep-10 Dec-10 Mar-11 Jun-11 Sep-11
Price Performance
1177.HK share price (HK$)HSCEI (rebased)
Assume coverage with an OW rating, Dec-12 PT of HK$3.50, top pick in the sector: We believe Sino Biopharmaceutical (SBP) is one of the premier all-around biopharmaceutical companies in China as it is likely to have a balanced portfolio with 14 or more blockbuster drugs by next year. SBP boasts an enviable track record of successful M&As and integration and is poised to make more acquisitions, which combined with its industry-leading R&D pipeline, should help sustain its strong top-line growth well in the future, in our view.
A strong product portfolio and R&D pipeline: SBP operates the No.1 hepatitis franchise with 20% market share. It also has the No.1 position for alprostadil, a Top-5 drug in China, with 75% market share. Highlighting SBP’s marketing prowess, its biapenem sales rose by 330% to HK$102MM in 1H11, while 1H11 sales of renzhong were at HK$193MM. Keep in mind the product was not launched until March 2010. SBP has several newly-launched products and a strong product pipeline, including raltitrexed and Kaifen patch, which have the potential to become blockbuster drugs with total sales of over Rmb100MM, in our view.
Clearly benefiting from the 2009 NDRL implementation: SBP focuses on the manufacturing and sale of proprietary or first-to-market generics. These products enjoy premium pricing while being less susceptible to price cuts. For 2Q11, sales of Tianqingganmei/Mingzheng grew by 96%/7.6%. Given Ganmei’s large sales base in and flattish sales of Mingzheng in recent quarters, SBP is clearly benefiting from their inclusion in 2009 NDRL.
Valuation, price target, risks: SBP is currently trading at 17.4x 2012E P/E, while it targets 30% top-line growth and 15%-20% recurring EPS growth. Thus, we believe the stock is currently undervalued. Our DCF-based Dec-12 PT of HK$3.5 implies 27.5x FY12E P/E. Key risks to our PT are the timing of commercialization of new drugs and pricing pressure from regulators.
Company description P&L sensitivity metrics (FY11E) EBIT EPS
impact (%) impact (%)
Sino Biopharmaceutical (SB) produces medicines in two core therapeutic categories: cardio cerebral diseases and hepatitis. The company is extending its development efforts to oncology, analgesics and respiratory medicines in order to meet the increasing demand frommedical practitioners and patients.
Hepatitis sales (base case 19%)
Impact of 5% increase 2.2% 1.1%
Cardio-Cerebral sales (base case 27%)
Impact of 5% increase 1.5% 0.8%
Selling expenses (base case 41%)
Impact of 1% points inc 1.8% 0.9%
GM
Impact of each 1.0% increase 4.4% 7.0%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur PT of HK$3.50 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth of 5% (the high end of the 3%-6% growth rate used for healthcare companies).
Our PT (Dec-12, DCF-derived) of HK$3.5(previously Dec-11, HK$3.6) implies a forward P/E of 27.5x (FY12E). Key risks to our PT are the timing of the commercialization of new drugs and pricing pressure from regulators.
A leader in hepatitis and cardio-cerebral medicines: SBP produces medicines in two core therapeutic categories: hepatitis and cardio cerebral diseases. According to a WHO survey, 300-400 million people worldwide are afflicted with chronic hepatitis B, with 1/3 residing in China—130 million carriers of the hepatitis B virus (HBV) and 30 million chronically infected. Viral hepatitis has consistently been ranked as a top infectious disease. About 1.4 million people contracted viral hepatitis in 2008 and 2009, resulting in the death of ~1,000 in each year. About 300,000 people die from HBV-related illness annually in China, including 180,000 with hepatocellular carcinoma (HCC). Unlike hepatitis C which is difficult to treat but can be cured, it is easier to suppress viral breakthrough in patients with hepatitis B but there is no cure that can completely eradicate HBV. The treatment cycle for hepatitis B can last for one-to-two years, which creates a very attractive and captivated market for drug makers.
Unique ability to manage product life-cycle fortifying hepatitis franchise: SBP produces two types of agents commonly used for hepatitis B treatment, anti-viral agents and hepatic protecting traditional Chinese medicines. SBP’s liver-protecting TCMs are extracted from licorice, for which the company has patent protection. SBP is one of the few Chinese companies that is able to manage the product life cycle well. Upon the expiry of the patent for Ganlixin, the company developed an enteric slow-release version of the drug (Tianqingganping) to prolong the patent life of itskey products. SBP also developed Tianqingganmei as an isomer of Ganlixin which allowed it to claim composition-of-matter chemical patent, which will last for 20 years. For anti-viral products, SBP is mainly engaged in developing and sales of first-to-market generics. The company has held the largest market share of adefovir for several years, outselling the originator GSK by a significant margin. Given the strong performance of Ruzhong in 1H11, SBP has clearly managed to stay very competitive with BMS for entercavir products. Finally, SBP is developing tenofovir, a generic version of anti-viral that GSK is seeking to market in China.
A solid pipeline and M&A positioning for future growth: SBP has historically spent 5%-8% of annual sales in R&D, and it has built a strong R&D pipeline,launching six-seven products each year, propelling strong future revenue growth. It launched Runzhong™ (entecavir dispersible tablets) for chronic hepatitis B in March 2010 and became the first local Chinese company to launch entecavir to the Chinese market, after only Bristol-Myers Squibb, the originator of the product. In its second year in the market, sales of Runzhong reached HK$193 million in 1H11 and are well on track to reach HK$400 million for full year 2011, a significant feat for a Chinese company, in our view. SBP is poised to launch Kaifen patch and pronase powder for endoscopy enhancement, both having strong potential to become blockbuster drugs.
SBP has demonstrated a solid record of successful M&As. The capability of identifying candidates and integrating the acquired businesses should, we believe,position the company for future growth in a consolidating industry. The company acquired Shanghai Tong Yong Pharmaceutical to gain a foothold in the booming dermatology market and it is closing a transaction to acquire an orthopedic specialty hospital in Shaoyang, Hunan, according to management.
Clearly benefiting from the implementation of 2009 NDRL: 2Q11 sales of Tianqingganmei and Mingzheng grew by 96% and 7.6%, respectively. Given Ganmei’s large sales basis in 1H10 and flattish sales performance of Mingzheng in recent quarters, SBP is clearly benefiting from their respective inclusion in 2009 NDRL. Even with the controversial Fujian drug-tendering, Kaishi and Mingzheng prices are expected to be cut by about 20%, while Renzhong could see a more modest 15% cut. While SBP sees price cut for Renzhong, Bristol Myers-Squibb is expected to lose Fujian tender for its entecavir, which had 80% market share in 2010. Hence, with no competition from BMS’s entecavir, the sales volume increase of Renzhong should more than make up for the price cut. We believe SBP’s key attraction is that it sells mainly innovative drugs or first-to-market generics. These drugs are less susceptible to price cuts from tendering as competition is not as fierce as for common generics. Recently alprostidil (Kaishi) witnessed a 15% increase in the retail ceiling price in Guangdong, which should benefit the company’s sales in one of the largest Chinese pharmaceutical markets.
Little exposure to EDL: SBP does not generate much revenue from EDL drugs, which shields it well from aggressive price cuts seen in EDL drugs in the Anhui province. Hence, SBP recorded a significant 1H11 total revenue growth of +40.8%Y/Y, outpacing management’s full-year guidance of ~30%.
Quarterly reporting and dividend provide visibility and reduced risk: Many investors dislike SBP’s holding company structure and its involvement in apparently non-core businesses. However, SBP is a rare HKEX Main Board listed company that reports quarterly results and pays a quarterly dividend, which we believe provides visibility and reduces investment risk.
Negative share price drivers and risks to our thesis
Risks from changes in drug pricing and other regulations: SBP has seen a 15% cut in the retail ceiling price of its key product, Kaishi. Going forward, there could likely be price cuts for its hepatitis and oncology drugs as well. Any severer-than-expected price cuts could result in the stock’s underperformance, in our view.
Competition from domestic and international firms: There are a number of existing and potential producers of hepatitis, cardio-cerebral and other drugs that could put pressure on margins for older products. SBP, we believe, would need to constantly launch new improved products in order to maintain relatively high gross margins. MNCs could become more aggressive in defending their anti-viral products, while domestic players could challenge SBP by offering extremely low prices.
Pipeline failure: Drug development is inherently risky. A drug can fail during clinical trial, or the clinical trial data could not be strong enough for SFDA to approve the product. As an R&D focused company, SBP’s stock performance may be subject to volatility caused by pipeline progress or failure. Even if a drug enters the market, its commercial success is far from guaranteed.
Coal-to-Olefin JV and other unrelated transactions: In 2006, SBP, through its wholly-owned subsidiary, Chia Tai Refined Chemical Industry Limited, entered into an agreement to establish a joint venture engaging in the refining of coal to olefin products in Yulin City, Shaanxi Province. The project has not secured approvals from multiple layers of local authorities and has a high probability of not taking off. Late last year, SBP also participated in the purchase of a parcel of land in Beijing. These and other activities unrelated to the company's core drug manufacturing business have raised concerns among investors about management’s focus or lack of it. Such activities could occur again and they could be perceived negatively.
Table 40: Products newly included in 2009 NDRL (HK$ mn)
Our Dec-12 price target is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.2, slightly higher than Bloomberg adjusted beta of 1.1, as we see additional risk for Chinese companies listed on a foreign exchange. Accordingly, we assume a WACC of 11.4%. We estimate free cash flow for SBP until 2015 and assume a terminal growth rate of 5.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period) subject to a minimum of 3% and a maximum of 6%, depending on the nature of the industry and the level of maturity in China.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
Over the past five years, SBP has traded at a forward P/E range of as high as 80x to as low as 12x. Our price target implies a forward P/E of 27.5x, well within the range of the historical norm. We note that SBP was mainly a hepatitis drug maker until2007 and has since branched out to many more new medicines. The larger drug portfolio and the upcoming pipeline of drugs may justify a higher P/E for SBP than the pre- 2007 levels, in our view.
While others are suffering, SBP had strong 1H results
SBP reported total revenue of HK$2,707 million (+40.8%Y/Y) for 1H11, significantly outpacing management’s full-year guidance of ~30%. Net profit grew by 15% Y/Y, even after investing 60% in R&D. For 1H11, while gross margins were 30bp below our estimates, operating margins were actually 120bp higher. Hence, we are encouraged by management’s efforts to rein in operating expense. While SBP’s hepatitis franchise had a mediocre 2010, it generated outstanding results for a second quarter in a row, with revenue growth of 45% Y/Y. Meanwhile, Kaishi sales recorded Y/Y sales growth of 27.2% for 1H11, even with a ~15% cut in the retail ceiling price in 1Q11. We believe SBP is well on the path to record revenue growth of ~30%, while its 15%-20% net profit growth target is also quite attainable.
Results in 2010 represent a skewed comparison
SBP recorded sales CAGR of 66.9% from 2007 to 2009 due to capacity expansion and the ramping up of sales of relatively new blockbuster hepatitis drugs such as Mingzheng, Tianqingganmei and the Kaishi cardio-cerebral drug. SBP also entered into new fields such as analgesic and oncology during this period to further drive sales growth. The company’s top-line grew by 26%, relatively low compared to the previous year due to the underperformance by the hepatitis franchise. Meanwhile, it managed to grow its net profit and EPS by 43% and 33%, respectively, which were skewed by an investment gain of about HK$182 million. Excluding the gain and associated tax expense, SBP would have managed an EPS growth of -0.6%, making 2010 quite a forgettable year for it.
Going forward, we estimate SBP will record sales CAGR of 28.4% between 2010 and 2012 due to the ongoing growth in the existing key lines of hepatitis, cerebral cardio oncology and analgesic drugs, supplemented with the acquisition of Shanghai Tong Yong and Shaoyang Orthopedic Hospital.
Figure 42: SB—Sales growth and gross margins
Source: Company data, J.P. Morgan estimates.
Figure 43: SB—Cost breakdown (FY11E)
Source: Company data, J.P. Morgan estimates.
SB’s gross margins have steadily remained above 80% from 2005 to 2010 and we expect a lower GPM of 78.2% for FY11 to factor in rising competition and government pressure to lower prices. The key to stable margins is the introduction of new drugs every year that tend to offset the maturing drugs that are subject to greater competition. SBP has seen SG&A expenses as a proportion of sales steadily climbing from 51.5% in 2008 to 54.3% in 2010 and a deleveraging that has caused EPS growth to significantly underperform top-line growth. We expect SBP to slowly gain
leverage and forecast SG&A ratio to drop by about 50bp to 53.8% in 2011 and drop 30bp more to 53.5% in 2012. Net/net, we estimate SBP to generate EPS ofHK$0.110 and HK$0.127 for 2011 and 2012, which represents Y/Y growth of -5.6% and 15.4%, respectively. Excluding the investment gain impact in 2010, we estimate EPS growth in 2011 to be about 26.5%. However, our estimate for 2011 could certainly have overestimated the impact of the investment gain on 2010 EPS. We believe our EPS of HK$0.110 (for FY11) should be achievable as it recorded HK$4.46 for 1H11.
We forecast SBP’s working capital needs based on the recorded results of 2010, which showed a significant jump from HK$178mn in 2008 and HK$31mn in 2009 to HK$686mn in 2011, due to a large sum of investment in tradable securities, which was classified as part of operating cash flow under HK financial reporting. Hence, the forecasts may well be too high and err on the conservative side, which negatively impact the valuation.
Historically, SB’s profitable business has generated sufficient cash to fund its capital expenditure and dividends for 2007 through 2009. SBP had a net cash position at the end of 2010 with a placement in June 2010 replenishing its cash position even more and giving it ample financing for organic or acquisitive growth.
Table 43: Sino Biopharmaceutical—Changes to our models
HK$MM, except for EPS
New Old Change
FY11E FY12E FY11E FY12E FY11E FY12E
Turnover 5,429 6,741 5,507 6,816 -1.4% -1.1%
Gross profit 4,245 5,165 4,334 5,257 -2.1% -1.7%
EBIT 1,123 1,295 1,157 1,363 -2.9% -5.0%
Net profit 547 631 563 664 -2.9% -5.0%
EPS (HK$) 0.110 0.127 0.114 0.134 -2.9% -5.0%
Gross margins 78.2% 76.6% 78.7% 77.1% -0.5% -0.5%
Source: Company reports, J.P. Morgan estimates. Earnings revisions made due to assumption of coverage.
Company DataShares O/S (mn) 828Market Cap (Rmb mn) 35,600.99Market Cap ($ mn) 5372.31Price (HK$) 19.74Date Of Price 14 Oct 11Free float (%) 26.1%3-mth trading volume (mn) 133-mth trading value (HK$ mn) 1033-mth trading value (US$) ($ mn)
13
HSCEI 9,803Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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HK$
Sep-10 Dec-10 Mar-11 Jun-11 Sep-11
Price Performance
1099.HK share price (HK$)HSCEI (rebased)
Top distributor offers significant value; assuming coverage with OW rating and Dec-12 PT of HK$30 (previously HK$35 to Dec-11): Sinopharm is the largest Chinese drug distributor with unrivaled nationwide reach. Its wide network positions the company well for further consolidation, in our view. We believe this is a consolidation-first, leveraging-second story, and leveraging will eventually materialize after Sinopharm builds up sufficient scale and network reach. We believe recent share pullback has established an attractive buying opportunity and place Sinopharm among our top-3 picks under our coverage.
Benefiting from secular growth: Sinopharm is not a contract sales company; hence it is not susceptible to sales channel cleansing. Price cuts should eventually result in increased sales volume and we expect total drug sales to grow further by around 20% in the next few years, driven by favorable government policies and demographics. The long-term secular growth story remains intact, in our opinion, and we expect Sinopharm to benefit from the growth trend.
Largest network—a distinct advantage: As the only drug distributor owned by the Chinese Central Government until China Resources started rolling up distribution assets recently, Sinopharm is in a unique position to influence government policies, in our view. Sinopharm should benefit from the favorable policies which support industry consolidation and the emergence of 1-3 distributors with sales above Rmb100B. Having the largest network should enable it to win a high share of business from manufacturers seeking scale and to obtain more exclusive distribution rights for premium imported drugs.
Valuation, price target, risks: Sinopharm trades at 21x 2012E EPS. While not exactly cheap, we think Sinopharm deserves a price premium to its peers given its scale, market leadership and competitive advantages. Our DCF-based Dec-12 PT of HK$30 implies CY12E P/E of 32x, well within the historical P/E trading range, and supported by accelerating earnings growth in prospect. Key risks include: (1) unexpected industry-wide slowdown; (2) acquisitions becoming prohibitively expensive; and (3) finance cost stays high for longer than expected.
Company description P&L sensitivity metrics EBIT EPS
FY11E impact (%) impact (%)
Sinopharm was established in 2003 and is the largest pharmaceutical distributor in China with approximately 11%-12% market share. China National Pharmaceutical Group (CNPG), along with Fosun Pharmaceutical, indirectly owns 65.52% share of Sinopharm through Sinopharm Industrial Investment, and CNPG owns 0.12% directly. Products are sold directly to hospitals or through local third-party distributors. Sinopharm also has small operations of drug retailing and manufacturing businesses.
Chinese herbs
Impact of each 5 percentage increase 3.9% 7.6%
Selling cost
Impact of each 5 percentage points increase 3.9% 9.1%
Demand for products under EDL
Impact of each 5 percentage points increase 2.7% 6.3%
GM: 1% Increase
Impact of each 1% increase 2.8% 8.2%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 price target of HK$30 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth rate of 5% (the high end of the 3% to 6% growth rate used for health care stocks).
Our PT (Dec-12, DCF-derived) of HK$30 implies CY12E P/E of 32x. Key risks to our rating and PT include a slower pace of acquisition of new distributors and a faster pickup in sales volume arising from the implementation of the Essential Drug List, resulting in low points taken by Sinopharm because of low profitability to manufacturers who would ask for shared sacrifice of profits from distributors. In addition, we see risks with: (1) unexpected industry-wide slowdown; (2) acquisitions becoming prohibitively expensive; and (3) finance cost stays high for longer than expected.
Market growth driven by low base in healthcare spending
We expect the pharmaceutical distribution industry to achieve an annual sales growth of 20% until 2015, fuelled by China’s current low spending per capita on pharmaceutical products and the government’s push to foster greater access to healthcare by the population through the construction of more modern hospitals, lifting of medical insurance coverage and privatization of healthcare enterprises. In 2006, the spending per capita on healthcare was approximately US$92 per person year according to the World Health Organization, or just 1.5% of that of the US. In 2010, per capital spending on healthcare rose to about US$230, still representing only a small fraction of that in the US. As a percentage of per capital GDP, the total healthcare spending in China is about 5% or roughly a third of the proportion in the US. Even with a 20% annual growth rate in healthcare spending, and thus pharmaceutical sales, we expect the per capita spending on healthcare to reach just 7% of GDP by 2015.
Figure 44: Sinopharm—Hospital sales of drugs in China
Source: IMS China.
Figure 45: Sinopharm—Rising market concentration in China
Source: Company data, J.P. Morgan estimates.
Economies of scale comes from the largest distributor status
Sinopharm is the undisputed industry leader in the Chinese pharmaceutical distribution industry in terms of both market share and geographical reach of its distribution network. Compared to its main rivals, Sinopharm is particularly strong in inland areas where business is growing much faster than the coastal region because of a lower base and migrants' staying home. The company’s broad geographic and market coverage make it an ideal partner for drug manufacturers seeking to quickly expand the market reach of their products. In addition, Sinopharm has one of the broadest product portfolios, including drugs and medical devices, to serve large hospitals increasingly looking to stock a wider variety of drugs. Unlike China Resources Medications, Sinopharm has cultivated the market for some years and it has established strong relationships with customers and suppliers. We believe the company is favored by many customers and suppliers because of its unique ability to provide comprehensive logistics and advanced value-added supply chain services and infrastructure.
Valued-added services distinguish Sinopharm from competitors
On top of its capability to distribute the widest portfolio of products to hospitals and other customers, Sinopharm offers advanced logistics services such as supply chain consulting, inventory tracking, and other related services to its suppliers and customers. By offering such value-added services unavailable from most small distributors, Sinopharm enables its customers and suppliers to streamline and increase the efficiency of their business while receiving all relevant services in a package from one vendor. The ability to offer value-added logistics services furtherstrengthens Sinopharm’s relationship with its suppliers and customers, which is a key competitive advantage for Sinopharm to maintain its relatively high bargaining power with suppliers, in our opinion.
Strong 1H11 shows the resilience of Sinopharm’s business
For investors who expect revenue growth to slow because of drug price cuts, Sinopharm’s 1H11 results should come as a relief as it reported Y/Y top-line growth of 52%, leaving it on course to record revenue of Rmb100 billion for full-year 2011. Facing relentless government price cutting pressure, Sinopharm was able to maintain a stable GM due to a distribution mix shift towards more direct sales to hospitals.
1 + 1 may not equal 2 but not necessarily always smaller: A section of the market appears to have become concerned about the organic growth of Sinopharm and to think it may not sustain above-industry-level growth once the acquisition pace slows down. We are not nearly so concerned in this regard. As a tier-1 nationwide drug distributor, it inevitably runs into former customers when it makes so many acquisitions. When recording revenue, the sales of Sinopharm made to those customers will be eliminated as internal transfer post-acquisition while they were recorded as sales on its book previously, which would lead to under-estimation of organic growth if one calculates Y/Y growth by simply taking away sales generated by the acquired companies without adding back the sales internally to the newly acquired. We believe the acquisitions should result in higher sales and operating leverage eventually. First, smaller distributors normally do not have the extensive product portfolio Sinopharm can distribute to its clients. By equipping the distributors with more popular products and improving its warehouse utilization, Sinopharm should make those distributors more competitive with their respective local competitors and improve cost efficiency. Furthermore, Sinopharm could improve efficiency by consolidating warehouse operations and install state-of-the-art software for inventory tracking, which should result in cot-saving down the road.
Negative share price drivers and risks to our thesis
Regulatory control over pharmaceutical products
The pharmaceutical industry is among the most regulated in China. As the ultimate player, the government is strongly biased to regulate the volume and profit from the sale of drugs by hospitals to patients. Sinopharm is indirectly impacted by many of the new rules and regulations under the ongoing healthcare reforms and this is a risk to the company’s operations, in our view. The government has cut drug prices repeatedly in recent years, including two rounds of price cuts for drugs included in the 2009 NDRL list this year. These price cuts, while they do not affect Sinopharm directly, may reduce the points (% of sales to hospitals) that Sinopharm can demand from the manufacturers for arranging the logistics of delivery. Sinopharm may receive by distributing products as manufacturers, facing lower gross margins with top-line price cut, could ask Sinopharm to shoulder some of the pain. So far Sinopharm has been able to maintain relatively stable gross margins by shifting the
product mix distributed and by shifting the sales mix to featuring more direct sales to hospitals.
High finance cost a near-term major concern
While Sinopharm’s operating profit for 1H11 was 15% above our estimate, net profitavailable to common shareholders was 7% below, largely due to the higher interest expense. Sinopharm’s finance cost for 1H11 increased by 227.6% from Rmb105million in 1H10 to Rmb344 million. Given its significant need for bank loan to finance its appetite for acquisition and current high interest rate due to China’s tightening lending policy, we are concerned that finance cost may continue bleeding the company’s earnings in the near future. We believe that the cash that Sinopharm raised through the H-share placement in May 2011 and bonds raised recently should somewhat alleviate the financing burden.
Lack of coverage in rural areas
As a former national level distributor selling to provincial level distributors, Sinopharm lacks an extensive rural network. The company has historically been a Level 1 distributor selling products to other distributors, which, in turn, sell the products to lower level distributors or end users—large hospitals (Terminal 1) or drugstores (Terminal 2). However, it does not have a presence in rural clinics and urban community health centers (Terminal 3). The Chinese government has been investing heavily in building up rural clinics and urban community health centers, where drug sales have been experiencing the highest uptick. We have no doubt that sales of generics to the third terminal will become increasingly important. Sinopharm has been trying to expand its distribution coverage through acquisitions of local distributors but has faced resistance from those distributors, which enjoy good business dealing with local health communities. In addition, it may be more difficult to integrate the businesses of these small distributors.
Our Dec-12 price target is based on a DCF valuation that assumes a market premium of 6.0% and risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.0 (from Bloomberg) which only reflects a short trading history. Normally pharmaceutical distribution is a stable business and leading US distributors have a lower beta of 0.8, leaving some valuation upside surprises, should Sinopharm proves to be as stable as global peers after a longer period of trading history. Accordingly, we assume WACC of 11.7%. We estimate free cash flow for Sinopharm until 2015 and assume a terminal growth rate of 5.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 3% and a maximum of 6% depending on the nature of the industry and the level of maturity in China. We use 5% as we believe a faster growing industry and a low penetration should allow for strong long term growth.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
Table 46: Sinopharm—Base-case DCF analysis indicates an equity value per share of HK$36
DCF Parameters AssumptionsLiabilities as a % of EV 20% Terminal growth 5.0%WACC 11.7% Risk-free rate 4.2%
Market risk 6.0%Enterprise NPV (10E-16E)
71,393 Beta 1.00
+ Net cash (debt), current 4,623 Cost of debt 6.2%- Minorities (Market value) (16,897)+/- Other items 0 Implied exit P/E multiple (x) 26.7x= Equity value 59,119 / Number of shares 2,400
= Equity value per share (HK$) 30.0
Source: Company data, J.P. Morgan estimates.
Table 47: Sinopharm—Sensitivity analysis based on WACC and perpetual terminal growth rate
We expect sales CAGR of 29% and EPS CAGR of 25% between 2010-2013E
Sinopharm recorded sales CAGR of 30.6% from 2007 to 2010, mainly due to the overall growth of the pharmaceutical market of approximately 20% as well as market share gain contributing another 5%-10% annual growth. We estimate Sinopharm will achieve sales CAGR of 29% between 2010 and 2013 due to the expected stable growth of 20% per year for the pharmaceutical distribution industry as well as market share gain fuelled by additional funding arising from the late 2009 IPO and placement earlier this year.
Figure 46: Sinopharm—Sales growth and gross margins
Source: Company data, J.P. Morgan estimates.
Figure 47: Sinopharm—Cost breakdown (2011E)
Source: Company data, J.P. Morgan estimates.
Sinopharm’s gross margins declined from 8.4% in 2006 to 7.9% in 2008 but recovered to 8.4% for both 2009 and 2010. Given the overall pricing pressure, we expect GM to go down to about 8.1% in 2011 and stay stable for a few years.
Sinopharm has been able to control and trim its SG&A expenses as a percentage of sales from 6.4% in 2006 to 4.9% in 2009. The SG&A ratio went up to 5.1% in 2010. As the company’s 1H11 ratio declined by 6bp to 4.49% in 1H11, we forecast the ratio of SG&A over sales to fall to 4.7% in 2011. We expect a slow but steady SG&A leverage from 2012 onwards.
We estimate that Sinopharm’s EPS will increase at a CAGR of 25% between 2010 and 2013. Historically, Sinopharm’s profitable business generated sufficient cash to fund capital expenditure until its IPO in September 2009. The company has significantly quickened its pace of M&As and capital expenditure after the IPO. Sinopharm had cash and cash equivalent of about Rmb10 billion as of June 30, 2011, which should be sufficient to fund the acquisition of numerous smaller regional distribution companies, for e.g., local distributors. Over a period of time, as the top 3 to 5 leading distributors gain market share in China, we believe that other smaller national distributors that are not performing as well would increasingly find it difficult to secure new drug distribution contracts and would likely becomeacquisition targets of large firms.
The company is the largest distributor of pharmaceutical products in China and looks well positioned to gain market share from smaller distributors through above-industry organic growth and acquisitions.
The company has historically been able to maintain above-industry average gross margins.
The company is able to leverage its resources to offer valued-added logistic services unavailable from resources-strapped small distributors.
The country’s largest portfolio to meet demand from customers and widest network coverage to satisfy the needs of manufacturers to grow business nationwide.
The management team is made up of seasoned veterans, many of whom have over 20 years’ experience in the pharmaceutical area.
Owned by the largest state-owned pharmaceutical group, CNPGC, and Shanghai Fosun Pharmaceuticals, a major private drug maker. This enhances credibility, and the stature of Sinopharm could lead to greater access to hospitals.
Weaknesses
Very low net margins of around 2% do not offer much room for errors.
The market is fragmented and subject to competition from numerous distributors all selling different drugs to same hospitals that Sinopharm services.
The business is working-capital intensive and a fast-growing company tends to tie up bulk of its cash flows in rising inventories and receivables balances.
The company is dependent on a number of key suppliers, all of which may opt to use smaller distributors if they offer better terms.
Nearly 50% of the sales rely on non-exclusive third-party distribution channels for smaller clinics and more rural regions.
Opportunities
Strong demand for pharmaceutical products and low per capita spending on healthcare should lead to a long period of annual growth in the vicinity of 20%.
As the largest distributor with a 12% market share, it is in a good position to grab a significantly higher market share, in our view. In developed markets, the top three players typically command a 60%-80% market share.
Higher volume should allow Sinopharm to use existing facilities better and may lift GM and OPM.
The company has a strong presence in the distribution of pharmaceuticals but has not generated significant business from medical devices and medical consumables space which offer upside, building on the relationship with its hospital customers.
Numerous M&A opportunities in the distribution industry with many small distributors that maybe available at reasonable valuations.
Threats
There are a number of other strong distributors and many of them are working with international drug distribution companies and this may pose a threat to the long term growth prospects of the company.
The implementation risk of moving from developed tier one cities to smaller cities is quite significant, in our view.
The government has historically controlled the price of drugs and discouraged hospitals from making excessive sales and profits from this area. These controls have a great impact on the relationship between hospitals and distributors.
The aggressive rolling up of distribution assets by China Resources may mean higher acquisition prices for Sinopharm.
The successful IPO of Shanghai Pharmaceutical on the Hong Kong Stock Exchange allows it to gain financial resources to compete with Sinopharm while cutting into the investor base of Sinopharm.
Company DataShares O/S (mn) 1,302Market cap (HK$ mn) 8,082Market cap ($ mn) 1,039Price (HK$) 6.21Date Of Price 14 Oct 11Free float (%) 34.2%3-mth trading volume (mn) 53-mth trading value (HK$ mn) 333-mth trading value ($ mn) 4HSI 18,758Exchange Rate 7.78Fiscal Year End Dec
See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
4
8
12
16
20
HK$
Sep-10 Dec-10 Mar-11 Jun-11 Sep-11
Price Performance
3933.HK share price (HK$)HSI (rebased)
A long-term winner; we assume coverage with N rating and Dec-12 PT of HK$7.5: We continue to like TUL in the long term for its strong antibiotics franchise that features well established brand names and think its low-cost 6-APA facility in Mongolia is a distinct competitive edge. We believe the market potential of newly-launched insulin products could beunder-appreciated. However, we believe TUL shares will continue being under pressure as the market digests the full impact of antibiotics price cuts and restriction of use on the company’s short term financial performance.
Not expecting sharp share rebound after recent significant pullback: We believe recently TUL’s share price has sharply declined due to concerns over restrictions on the use of antibiotics on top of the antibiotics price cut. Management seems to have pushed hard to retain investor enthusiasm on the market potential and sales ramp-up of insulin products. We believe there are still significant obstacles to a sharp share rebound as we foresee weak performance in the 2H11 after the price cuts are implemented in more provinces and the restriction of antibiotics use takes effect. Insulin sales ramp up, in our view, will not come fast enough to provide a jolt to the share performance.
Insulin—a key to future growth: According to management, so far the launch of insulin products has been smooth. Insulin sales ramp-up is expected to be slow but sales should become important growth/profit driver in the future, in our view. We foresee good growth potential for a low-cost domestic insulin maker in China. We believe that while a significant earnings contribution would not be likely until FY13, the insulin market should be much more lucrative for TUL vs. the mature antibiotics market. Patient investors would be rewarded when TUL makes significant inroad into the insulin market, in our opinion.
Valuation, PT and risks: Our DCF-based PT of HK$7.5 implies CY12E P/E of 11.9x. Key risks to our PT include regulatory steps on the pricing of healthcare supplies and any slower-than-expected sales ramp-up of newly launched insulin products.
Company description P&L sensitivity metrics EBIT EPS
FY11E impact (%) impact (%)
The United Laboratories (TUL) was founded in 1990 and is the largest 6-APA producer in the world. The company has developed a wide range of products, which include finished products, bulk medicine and intermediate products and has adopted a vertically integrated production and operation model. In 2009, 78% of the company’s revenue was generated from the operations in China, with the rest from overseas.
Antibiotics
Impact of 5% increase (w. no change in costs) 11.6% 12.0%
Selling cost
Impact of 5% increase (w. 50% pass through ) 1.8% 1.8%
Demand for products under EDL
Impact of 5% points inc (w. 50% pass through ) 0.8% 0.8%
GM
Impact of each 100bps increase 5.1% 5.5%
Source: J.P. Morgan estimates.
Price target and valuation analysisOur Dec-12 PT of HK$7.5 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth of 4% (the low end of the 3% to 6% growth rate used for healthcare stocks).
Our PT (Dec-12, DCF-derived) of HK$7.5 implies a forward P/E of 11.9x (FY12E). Key upside risks to our PT and investment thesis include lower than expected impact from antibiotics price cut and restriction of use, and better than expected sales ramp up of insulin. Conversely, worse impact from antibiotics price cut and restriction of use, slower than expected insulin sales ramp up would be the downside risks to the PT.
Unrivaled strength with a vertically integrated antibiotics business: TUL’s fully-integrated manufacturing value chain features intermediates, bulk medicines (APIs), and finished products. Since 2006, it has been producing in-house intermediates for penicillin class antibiotics. The company processes 6-APA intermediates into amoxicillin bulk medicines, which could be further processed into finished products. The company’s vertically integrated business allows for stable supply for its finished product franchise, fine-tuning production according to market demand for intermediates, bulk medicines, and finished products. These offer the company a distinct advantage in a highly competitive commodity business. As the company owns about 60% of China’s 6-APA capacity with lower-than-average product cost, it is more competitive in terms of pricing.
Significant brand recognition; premium pricing for amoxicillin and amplicilin: The government has granted five of TUL’s finished products the status of ‘high quality, high price’ under which the price ceiling for TUL's antibiotics can be substantially higher than the standard ceiling prices for similar products. We believe the government’s recognition confers legitimacy to TUL’s claim of superior quality for its products and enables it to bid for higher tendering prices as well. Amoxin, TUL’s brand for amoxicillin, is among the best recognized medicine brands in China. Although the company’s ceiling prices were cut late last year alongside many other drugs with individual pricing power, it is encouraging that the government allows TUL’s antibiotics to retain individual pricing power, which should allow the company to outsell competitors with higher price and quality. It is widely known that low-price common generics, normally the ones with highest prices, sell best in China because hospitals get better markup. In addition, since 60% of TUL’s antibiotics medicines are classified as non-restricted categories, the impact of government restriction should not place much a constraint. We expect sales to recover once hospitals gain clarification on the restrictive measures. Furthermore, the restrictive use of high-price new generation antibiotics could promote the sale of non-restricted antibiotics.
Table 48: Individual pricing for TUL’s antibiotics
Rmb
Drug Formulation Dosage form Package sizeIndividual
pricingRegular
ceiling pricePremium
Amoxicillin
Granule 125mg 12 packs 8.4 4.8 75%
Capsules250mg 24 tablets 13.7 7.4 85%
500mg 24 tablets 23.3 12.6 85%
Ampicillin Capsules250mg 24 tablets 14.0 5.7 146%
500mg 24 tablets 23.8
Source: Company reports.
Enzyme process to help the bulk medicine business: In 1H11 TUL became the second company in the world to establish an enzymatic process for the production of amoxicillin bulk medicines which are more cost effective, efficient, and environment-friendly. Once the demand for bulk amoxicillin recovers, TUL should be well positioned to provide bulk medicines at flexible and competitive prices with an expanded production capacity supporting sales volume growth.
Insulin represents a substantial market opportunity: According to a study published in the New England Journal of Medicine in March 2010, people with diabetes and pre-diabetic conditions had been vastly underestimated. In contrast to an earlier estimate of 43.2 million, currently 50 million men and 42 million women are estimated to have diabetes while 16% more have pre-diabetic conditions in China. With the population aging and lifestyle changes leading to higher incidence of diabetes, the numbers will certainly rise further, in our view. Although a vast array of medicines has been developed for the management of diabetes, insulin remains one of the most important therapies. The current market value for recombinant human insulin is estimated to be around Rmb5 billion and is expected to grow by approximately 20%-30% annually, according to IMS China. The human recombinant insulin market has been dominated by Novo Nordisk, Eli Lilly, and Sanofi-aventis, although Tonghua Dongbao has been in the market for years but failed to carve out a significant market share. While Wanbang, a subsidiary of Fosun Pharmaceutical, has the license to produce human insulin, its main strength is animal-derived insulin (80% market share), which is listed in the NDRL as Class A product. Since there is clear market demand for insulin products offering a good tradeoff between quality and price, we believe TUL has the market reach of top-tier hospitals and financial resources to make a significant inroad into the market. We believe the company is capable of garnering a market share of 10%-15% within five years after the product launch.
Negative share price drivers and risks to our thesis
A price cut could have more severe-than-expected impact on sales: We expect TUL’s antibiotics sales to recover as 60% are non-restricted. However, sales volume may not recover as the restriction on antibiotics use could encourage physicians to seek alternatives such as TCMs vs. antibiotics.
The insulin market could be difficult to crack: MNCs would undercut TUL’s market entry with pricing and promotions that make TUL’s insulin products less attractive for hospitals. TUL’s sales team might not be able to promote insulin products effectively given many of them are transferred from the antibiotics team.
Excess capacity leads to low utilization and margin erosion: We believe as TUL and other antibiotics manufacturers have expanded capacity in recent years, there is excess capacity of 6-APA globally since the demand for 6-APA has only risen gradually. For TUL to grow its business and make full utilization of expanding capacity, it might need to gain market share from others. If others undertake dramatic price cuts to defend market share, TUL’s 6-APA franchise could suffer.
Overreliance on commodity business: Two-third of TUL’s three business lines is commodity business. The prices of 6-APA and 7-ACA fluctuate greatly with the rise in exports and domestic demand from other manufacturers. While 6-APA prices have stayed close to historical low but have been relatively stable, 7-ACA prices have dropped significantly in 1H11. Further erosion of 7-ACA and the downward movement of 6-APA prices could, we believe, put pressure on TUL’s profitability.
Large amount of short-term debt: TUL carries short-term debts amounted to more than HK$2bn due to the company's heavy capital expenditure for building up Inner Mongolia facility. Given the current tight PRC credit policies, the company may incur substantially high interest expenses or find it more difficult to roll over its short-term debts.
Our Dec-12 price target is based on a DCF valuation that assumes a market risk premium of 6.0% and risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 0.90, based on Bloomberg data. Accordingly, we assume a WACC of 11.6%, for which we have added a 2% premium as TUL trades in its non-native market. We estimate free cash flow until 2015 and assume a terminal growth rate of 4.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 1.5% and a maximum of 4.5%, depending on the nature of the industry and the level of maturity in China.
We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
We expect EPS to decline then recover—bumpy road ahead
After recording a 73% Y/Y growth in earnings in 2010 because of favorable commodity prices and cost efficiency with high capacity utilization of its Inner Mongolia 6-APA facility, TUL experienced earnings decline of 36.4% in 1H11. In 1H11, all three segments showed some level of revenue growth as the sales (including inter-segment sales) of intermediate products, bulk medicines and finished products grew Y/Y by 19.1%, 1.7% and 10.1%, respectively. Unfortunately, revenue growth was not accompanied by profit growth as the segmental profit of intermediate products, bulk medicines and finished products declined by 12.2%, 65.9% and 12.7%, respectively. Given 1H11 results and as we foresee further room for GM to decline because of pricing pressure and raw material inflation, we forecast sharply lower estimates for 2011 and 2012, as summarized in Table 4.
In 1H11, GM declined by 500bp Y/Y because of rising raw material cost and labor inflation, in addition to a price cut for 7-ACA and finished products. For 2H11, with raw material price and labor cost inflation, management guided GM to decline further compared with 1H11. Hence, we cut our GM forecast for 2011 and 2012 by 3.8ppt and 6.4ppt, respectively.
Source: Company reports, J.P. Morgan estimates. Note: Earnings revision due to assumption of coverage.
As sales growth slows down, we forecast a higher percentage of SG&A of total sales as part of the expenses is fixed. We forecast the selling expense ratio to rise from 14.4% in 2010 to 16.9% in 2011 and slightly decline to 15.9% in 2012. The administrative cost as a percentage of sales could also rise from 5.5% in 2010 to 7.5% in 2011, then decline to 6.7% in 2012 and trend down thereafter as we foresee SG&A leveraging with growth.
We expect the EPS to decline by 47% to HK$0.416 in 2011 but grow by 51.3% in 2012 because of lower basis and the expected recovery of the bulk medicine business and profitability due to the utilization of enzyme process from amoxicillin production.
As the company expanded capacity and generated significant revenue growth, both inventory and account receivable increased significantly in 2010, resulting in large tied up of working capital. We think the situation should improve in next few years. We keep our capital expenditure forecast unchanged. We expect TUL to have a negative free cash flow of HK$43 million in 2011 but record a positive cash flow of HK$136 million in 2012.
The scale—TUL is one of the largest producers of antibiotics products in China and the largest producer of 6-APA in the world.
A vertically integrated production and operation model—full control over the production of intermediate, API, and finished dosage form of amoxicillin.
Management team is made up of seasoned veterans with many possessing over 20 years experience in the pharmaceutical area and staying with the company for a long time.
Independent pricing of amoxicillin and ampicillin with superior quality perception.
A wide network for product distribution.
Low-cost advantage with its Inner Mongolia product facility confers competitive edge.
Weaknesses
Under the healthcare reform, the government has put major focus on developing healthcare services in rural areas, where TUL does not have a strong presence with its relatively high-end and higher priced products compared to its competitors such as China Pharmaceutical.
TUL may not compete well in rural areas compared to larger cities.
Low entry barriers and intense competition for antibiotics.There are hundreds of antibiotics producers in China.
Lack of pricing power for the commodity business.
Opportunities
The newly launched insulin products have the potential of becoming a new growth catalyst for TUL. There are more than 100 million diabetic patients in China which pose significant demand for recombinant human insulin every year.
High demand for lysine eye drops and compound chondroitin sulfate eye drops is high.
Expanding the healthcare insurance coverage creates additional demand for essential drugs such as amoxicillin.
The adoption of the enzyme process for amoxicillin bulk medicine should make the company more competitive with flexible pricing.
Threats
EDL tendering may shut TUL’s more expensive antibiotics off certain markets.
Prices of 6-APA and 7-ACA have been volatile in thepast and these could cause earnings uncertainty.
The restriction on antibiotics use may affect the overall use of all kinds of antibiotics, even those in unrestricted categories.
Domestic competitors could undercut TUL’s insulin business with better products or very low prices.
Companies Recommended in This Report (all prices in this report as of market close on 14 October 2011, unless otherwise indicated)China Shineway Pharmaceutical Group Limited (2877.HK/HK$11.22/Underweight), Concord Medical Services Holdings Limited (CCM/$3.28[13 October 2011]/Overweight), MicroPort Scientific Corp (0853.HK/HK$4.69/Neutral), Mindray Medical (MR/$24.62[13 October 2011]/Overweight), Shandong Weigao Group Medical Polymer Co. Ltd. (1066.HK/HK$8.83/Overweight), Sihuan Pharmaceutical Holdings (0460.HK/HK$3.07/Overweight), Sino Biopharmaceutical (1177.HK/HK$2.21/Overweight), Sinopharm (1099.HK/HK$19.74/Overweight), The United Laboratories (3933.HK/HK$6.21/Neutral)
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Country and Region Specific Disclosures U.K. and European Economic Area (EEA): Unless specified to the contrary, issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment research issued by JPMSL has been prepared in accordance with JPMSL's policies for managing conflicts of interest arising as a result of
publication and distribution of investment research. Many European regulators require a firm to establish, implement and maintain such a policy. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL does not issue or distribute this material to "retail clients". The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms "wholesale client" and "retail client" have the meanings given to them in section 761G of the Corporations Act 2001. Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd., Frankfurt Branch and J.P.Morgan Chase Bank, N.A., Frankfurt Branch which are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for Persons Licensed by or Registered withthe Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivative warrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan, Type II Financial Instruments Firms Association and Japan Securities Investment Advisers Association. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.
General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst's involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.
"Other Disclosures" last revised September 30, 2011.
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