DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. U.S. Disclosure: Credit Suisse 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. 23 June 2011 Asia Pacific/China Equity Research Major Pharmaceuticals Shanghai Pharmaceuticals Holding Co. (2607.HK / 2607 HK) INITIATION High growth, without sacrificing margins Shanghai Pharmaceuticals (Shanghai Pharma) is among the largest integrated pharmaceutical companies in China, with leading positions in both pharma products and distribution markets. Its key business divisions are pharma: (1) manufacturing; (2) distribution and supply chain solutions; and (3) retail. ■ Vertical integration and broad offerings diversify risks. Amid current market concerns about drug price cuts, we believe Shanghai Pharma stands out as a leader with much lower policy risk compared with peers. With its broad product offerings, the impact of price cuts should likely be minimal. By vertically integrating the manufacture, distribution and retailing of its products, it should benefit from potential cross-selling opportunities, as well as diversify potential risks in particular parts of the industry value chain. ■ Facilities relocation is a near-term catalyst. We expect Shanghai Pharma to sign an agreement with the Shanghai government this year to relocate its multiple downtown plants to a consolidated location. Beside the land prices- related one-time gain, we also expect this to reduce Shanghai Pharmas staff costs and improve manufacturing efficiency. ■ Acquisitions on track. The company is committed to making acquisitions without sacrificing margins. We expect more drug distribution acquisitions this year, and drug manufacturing acquisitions shortly thereafter. ■ Initiate with OUTPERFORM. With improving operating margins, we expect core profits to grow by 33% and 51% in 2011E and 2012E, respectively. Our target price of HK$24.3 is based on 20x 2012E core earnings. ■ Key investment risks: (1) operational risks; (2) risks from competition; (3) policy risks; (4) acquisition risks; (5) orders risks; (6) product risks; (7) elimination or changes to incentives; and (8) key personnel risks. Share price performance 20 21 22 23 24 Jun-11 96 98 100 102 Price (LHS) Rebased Rel (RHS) The price relative chart measures performance against the MSCI China Free index which closed at 63.7 on 21/06/11 On 21/06/11 the spot exchange rate was HK$7.79/US$1 Performance over 1M 3M 12M Absolute (%) Relative (%) Financial and valuation metrics Year 12/10A 12/11E 12/12E 12/13E Revenue (Rmb mn) 37,381.6 52,694.3 67,602.4 83,195.1 EBITDA (Rmb mn) 2,417.4 3,062.8 4,437.3 5,991.6 EBIT (Rmb mn) 2,038.4 2,611.8 3,870.3 5,314.7 Net income (Rmb mn) 1,350.8 1,802.6 2,715.0 3,630.5 EPS (CS adj.) (Rmb) 0.50 0.67 1.01 1.35 Change from previous EPS (%) n.a. Consensus EPS (Rmb) n.a. 0.77 0.91 1.22 EPS growth (%) 81.0 33.5 50.6 33.7 P/E (x) 33.5 25.1 16.7 12.5 Dividend yield (%) 0.70 0.45 0.55 0.75 EV/EBITDA (x) 4.5 2.0 1.4 0.8 P/B (x) 5.0 2.2 1.9 1.7 ROE (%) 15.5 12.0 12.2 14.5 Net debt/equity (%) Net cash Net cash Net cash Net cash Source: Company data, Thomson Reuters, Credit Suisse estimates Rating OUTPERFORM* [V] Price (22 Jun 11, HK$) 20.35 Target price (HK$) 24.30„ Chg to TP (%) 20.0 Market cap. (HK$ mn) 14,795.4 Enterprise value (Rmb mn) 6,268 Number of shares (mn) 730.64 Free float (%) 85.72 52-week price range 22.95 - 20.25 *Stock ratings are relative to the relevant country benchmark. „Target price is for 12 months. [V] = Stock considered volatile (see Disclosure Appendix). Research Analysts Jinsong Du 852 2101 6589 [email protected]Lefei Sun 852 2101 7658 [email protected]Duo Chen 852 2101 7350 [email protected]
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DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. U.S. Disclosure: Credit Suisse 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.
High growth, without sacrificing margins Shanghai Pharmaceuticals (Shanghai Pharma) is among the largest integrated pharmaceutical companies in China, with leading positions in both pharma products and distribution markets. Its key business divisions are pharma: (1) manufacturing; (2) distribution and supply chain solutions; and (3) retail.
■ Vertical integration and broad offerings diversify risks. Amid current market concerns about drug price cuts, we believe Shanghai Pharma stands out as a leader with much lower policy risk compared with peers. With its broad product offerings, the impact of price cuts should likely be minimal. By vertically integrating the manufacture, distribution and retailing of its products, it should benefit from potential cross-selling opportunities, as well as diversify potential risks in particular parts of the industry value chain.
■ Facilities relocation is a near-term catalyst. We expect Shanghai Pharma to sign an agreement with the Shanghai government this year to relocate its multiple downtown plants to a consolidated location. Beside the land prices-related one-time gain, we also expect this to reduce Shanghai Pharma�s staff costs and improve manufacturing efficiency.
■ Acquisitions on track. The company is committed to making acquisitions without sacrificing margins. We expect more drug distribution acquisitions this year, and drug manufacturing acquisitions shortly thereafter.
■ Initiate with OUTPERFORM. With improving operating margins, we expect core profits to grow by 33% and 51% in 2011E and 2012E, respectively. Our target price of HK$24.3 is based on 20x 2012E core earnings.
■ Key investment risks: (1) operational risks; (2) risks from competition; (3) policy risks; (4) acquisition risks; (5) orders risks; (6) product risks; (7) elimination or changes to incentives; and (8) key personnel risks.
Share price performance
2021222324
Jun-119698100102
Price (LHS) Rebased Rel (RHS)
The price relative chart measures performance against the MSCI China Free index which closed at 63.7 on 21/06/11 On 21/06/11 the spot exchange rate was HK$7.79/US$1
Source: Company data, Thomson Reuters, Credit Suisse estimates
Rating OUTPERFORM* [V] Price (22 Jun 11, HK$) 20.35 Target price (HK$) 24.30¹ Chg to TP (%) 20.0 Market cap. (HK$ mn) 14,795.4 Enterprise value (Rmb mn) 6,268 Number of shares (mn) 730.64 Free float (%) 85.72 52-week price range 22.95 - 20.25 *Stock ratings are relative to the relevant country benchmark. ¹Target price is for 12 months. [V] = Stock considered volatile (see Disclosure Appendix).
High growth, without sacrificing margins According to Shanghai Pharma�s management, it is one of the largest integrated pharma companies in China. Based on NFS data, the company is among the top manufacturers of pharma products. Besides manufacturing, it is also one of the largest distributors and retailers of pharma products in China, primarily focusing on eastern China, with further expansion plans in southern and northern China regions.
Manufacturing turnaround Given China�s highly fragmented pharma industry, Shanghai Pharma�s 1.3% market share already makes it the third-largest player in the arena, according to NFS. The company manufactures and markets a broad range of pharma products, spanning chemical drugs, modern Chinese medicines, bio-pharma products and various other pharma products, including approximately 70% of the drugs on the National List of Essential Drugs. The majority of Shanghai Pharma products are prescription drugs, targeting major therapeutic markets such as the cardiovascular system, alimentary tract and metabolism, central nervous system, anti-infectives for systemic use and antineoplastic and immuno-modulating agents. We believe Shanghai Pharma is well positioned to capture the rising demand for pharma products in China. Based on the historical numbers supplied by NFS, the Chinese pharma product market grew from Rmb313 bn in 2005 to Rmb619 bn in 2009 � a CAGR of 18.6% for the period. NFS forecasts the industry could grow to over Rmb1.7 tn by 2014, implying a five-year CAGR of 22.4%.
Distribution�s focus is on high-margin regions According to management, Shanghai Pharma is among the very few major integrated pharma companies in China. Besides a sizeable pharma business, it is also the second-largest distributor of pharma products in China in terms of revenue, according to NFS. The company operates a national distribution network that comprises 41 subsidiaries and branches, as well as 32 logistics centres and warehouses located strategically across its key regional markets in eastern, northern and southern China. These three regional markets are essential to the distribution business, as they account for 67% of China�s entire pharma distribution market in terms of sales, according to NFS. Shanghai Pharma continues to strengthen its foothold in these markets by making strategic, bolt-on acquisitions rather than engaging in an aggressive nationwide expansion. The pending acquisition of CITIC Pharma, a leading pharmaceutical distributor in Beijing, should help Shanghai Pharma expand its operations and market share in northern China.
Earnings forecasts and valuation With improving operating margins, we expect Shanghai Pharma� core profits to grow by 33% and 51% in 2011E and 2012E, respectively. Our target price of HK$24.3 is based on 20x 2012E core earnings.
Key risks The key risks include: (1) operational risks; (2) risks from competition; (3) policy risks; (4) acquisition risks; (5) orders risks; (6) product risks; (7) elimination or changes to incentives; and (8) key personnel risks.
The company manufactures and markets a broad range of pharma products, spanning chemical drugs, modern Chinese medicines, bio-pharma products and various other pharma products.
Shanghai Pharma is the second-largest distributor of pharma products in China in terms of revenue.
We expect Shanghai Pharma� core profits to grow by 33% and 51% in 2011E and 2012E, respectively.
Manufacturing turnaround Shanghai Pharma is one of the largest integrated pharma companies in China in addition to being one of the country�s top manufacturers of pharma products. Besides drug manufacturing, the company is also among the largest distributors and retailers of pharma products in China, with its primary focus on eastern, southern and northern China.
China�s pharma industry is highly fragmented with over 5,300 active participants, according to NFS. Despite controlling only 1.3% of the market, Shanghai Pharma is the third-largest company in this business, according to NFS.
Shanghai Pharma�s pharma division is engaged in research and development, manufacture and marketing of an extensive range of pharma products. These range from chemical drugs, modern Chinese medicines, bio-pharma products, other pharma products as well as non-pharma products such as medical devices. According to management, its product portfolio includes approximately 70% drugs on the National List of Essential Drugs. The majority of its products are prescription drugs.
Shanghai Pharma focuses primarily on key therapeutic areas it believes to have significant current market demand as well as future market growth potential. These include areas such as the cardiovascular system, alimentary tract and metabolism, the central nervous system, anti-infectives for systemic use and antineoplastic and immuno-modulating agents. These five markets collectively accounted for approximately 76% of the total sales in 2009 for the chemicals and bio-pharma drugs market, based on NFS numbers.
As of December 2010, the pharma division manufactured over 950 pharma products. The division focuses primarily on 53 major products, which accounted for 50.6% of the division�s total revenue in 2010. Shanghai Pharma is expected to increase the number of major products by another six. These will include four antibiotics products, following the pending acquisitions of Shanghai New Asiatic and Shanghai Huakang from their controlling shareholders. According to management, the �major products� category gross margin is much higher compared to other drugs.
Through its PRC GMP-certified production facilities�some of which are also certified pursuant to the United States cGMP standards or the European Union�s GMP standards�Shanghai Pharma manufactures and sells a number of branded products. These include the well-known trademarks recognised by the PRC trademark authority, such as Sine (信谊), Leishi (雷氏), Longhu (龙虎), Qingchunbao (青春宝), Huqingyutang (胡庆余堂) and Cangsong (苍松).
A highly favourable industry China is one of the world�s fastest-growing economies and its healthcare industry, in turn, is one of the country�s fastest-growing sectors. According to the China Health Statistics Yearbook 2010, total healthcare spending in China grew from Rmb866.0 bn in 2005 to Rmb1,720.5 bn in 2009 � equivalent to a four-year CAGR of 18.7%. The solid growth was driven by a number of favourable socioeconomic factors, such as the rapid growth of China�s GDP, disposable income, life expectancy and age of population, increased urbanisation, rise in healthcare awareness, adoption of the healthcare reform plan as well as other support measures provided by the government. Supported by these, NFS estimates, China�s total healthcare spending will reach Rmb3,265.1 bn by 2014, which represents a 2009-14 CAGR of 13.7%.
Shanghai Pharma focuses primarily on key therapeutic areas it believes to have significant current market demand as well as future market growth potential.
Along with China�s significant GDP growth, the country�s population has experienced rapid growth of disposable income in both urban and rural areas. This rising disposable income is expected to contribute to the total healthcare spending in the future.
Figure 11: Rising disposable income per capita for the urban population
20%Rural disposable income per capita YoY chg (%) - RHS
8.2% CAGR
Source: NFS
Ageing population
The overall growth of China�s population is expected to drive up demand for healthcare products and services in the coming years. Based on the National Bureau of Statistics, China�s population grew from 1,307.6 mn in 2005 to 1,334.7 mn in 2009 and the number is expected to reach 1,368.8 mn by 2014. The increase in life expectancy, however, grew from 68.6 years in 1990 to 73.0 years in 2005. There is also a rise in the prevalence of diseases associated with increased life expectancy, such as cardiovascular diseases, metabolic diseases, cancer and arthritis, according to NFS. In terms of aging, NFS estimates the population aged 60 or above would likely reach 15.1% in 2014, or 206.8 mn, a rise from only 12.5% in 2009. Given these statistics, demand for healthcare is bound to increase.
Figure 13: An ageing population will likely help drive healthcare demand
Government initiatives and spending on healthcare The Chinese government has been very supportive of the healthcare industry. As part of the Eleventh Five-Year Plan, it has worked on improving the overall affordability and accessibility of healthcare products and services. Initiatives included the building of new hospitals, research centres, healthcare facilities, enacting healthcare reforms, improving healthcare standards as well as increasing healthcare subsidies.
As part of its recently proposed Twelfth Five-Year Plan, the government intends to make more healthcare resources available to the rural population and suburban communities. In particular, it is aiming to improve the social medical insurance programme, increase the number of benefits under it, continue to implement the essential drugs programme in addition to increasing the number of community healthcare centres and clinics.
Adoption of the National List of Essential Drugs
Historically, the government has controlled the cost of drugs mainly through the National Medical Insurance Drugs Catalogue programme, which contains a list of drugs that are reimbursable under the China social medical insurance. This allows the government to set a maximum retail price/ fixed retail price at which a drug can be sold. To further control the price of drugs, the government has adopted the National List of Essential Drugs, which also helps to streamline channels of distribution.
Under the National List of Essential Drugs programme, the centralised tender and bidding process for all purchases of listed essential drugs by public hospitals and healthcare centres or clinics is conducted at the provincial level. These measures are expected to result in a significant increase in the usage and demand for essential drugs.
Pharma industry: Land of the large According to NFS, China�s pharma industry is highly fragmented with over 5,300 participants, of which more than 3,500 are drug companies and more than 1,100 are active pharma ingredients manufacturers. No single participant controls more than 2% market share according to the same source.
Squeezing out the small
As regulatory standards are benchmarked to higher levels, such as those relating to GMP and environmental protection, smaller pharma companies will likely have to face significantly higher costs and difficulties in terms of compliance. This may force the smaller companies to either leave the market or merge with others to enhance overall economies of scale.
The ongoing healthcare reforms, such as the promotion of the National List of Essential Drugs, are intended to minimise costs for patients. As a result, this should create pressure on pharma companies that lack scale. On the other hand, larger pharma companies are generally more likely to prosper versus their smaller counterparts, given they usually have significantly better economies of scale, product portfolios, drug pipelines as well as more robust distribution networks.
Broad product lines in specialised markets Shanghai Pharma is the third-largest pharma manufacturer in China in terms of 2009 revenue, according to NFS. The pharma division has grown steadily over the past couple of years. We expect growth to accelerate from 2011 and onwards, driven by solid organic growth, concentration on key markets as well as through acquisitions.
As of December 2010, the pharma division manufactured over 950 pharma products, including 492 chemical drugs, 313 modern Chinese medicines and 24 bio-pharma products. Within these, 601 were prescription drugs while 505 were included in the National Medical Insurance Drugs Catalogue and 215 were part of the National List of Essential Drugs.
Shanghai Pharma targets major therapeutic markets such as the cardiovascular system, alimentary tract and metabolism, the central nervous system, anti-infectives for systemic use and antineoplastic and immuno-modulating agents. These five markets collectively accounted for approximately 76% of total sales of the chemical and bio-pharma drugs market during 2009, based on NFS numbers. According to the 2009 data from the NFS, the top five therapeutic markets accounted for 78.5% of the Rmb410 bn market. According to NFS, the total value of the China pharma industry could reach over Rmb1.7 tn by 2014, from only Rmb619 bn in 2009. This implies a five-year CAGR of 22.4%.
Figure 16: Chemicals and bio-pharma therapeutic markets breakdown Implied market Top 5 focus of % of size in 2009 Shanghai Therapeutic area total sales (Rmb mn) Pharma Anti-infectives for systemic use 23.9 98.0 Yes Antineoplastic and immuno-modulating agents 17.7 72.6 Yes Cardiovascular system 13.3 54.4 Yes Alimentary tract and metabolism 12.7 52.3 Yes Blood and blood-forming organs 10.9 44.6 Nervous system 8.4 34.6 Yes Various 3.2 13.2 Musculo-skeletal system 2.9 11.8 Respiratory system 2.5 10.3 System hormonal preparations (ex-sex hormones) 1.9 7.6 Others 2.6 10.8 Total chemical and bio-pharma drug sales 100.0 410.3
Source: NFS, company data
Figure 17: 2011E Pharma revenue breakdown
Chemical drugs43%
Modern Chinese drugs32%
Biopharmaceutical drugs
9%
Other pharmaceutical drugs9%Non-pharmaceutical
products7%
Source: Credit Suisse estimates
Chemical drugs Chemical drugs are medical drugs whose active ingredients are manufactured using chemical compounds. Therefore, the drugs contain no plant, animal or mineral derivatives.
Sales of chemical drugs have been relatively strong, growing 15.9% in 2009 and 13.2% in 2010. As of December 2010, chemical drugs are the largest contributor to the pharma business, accounting for 33.9% of total revenue. Going forward, with the amalgamation of New Shanghai Asiatic�s portfolio and other potential acquisitions, we believe contribution from chemical drugs should reach over 40% of total revenue.
Figure 19: Select major chemical drug products portfolio D evelo ped N at io nal
w/ external Obtained Expirat io n List o f
D evelo ped research thro ugh date o f A dmin. P rescrip- OT C N M ID (4) Essentia l
P ro duct name M ajo r usage by co . partners acquisit io n patent pro tect io n tio n drug drug C atalo g D rugsCompound Dihydralazine Sulfate tablet Cardiovascular system Yes - - - - Yes - No No
Tobramycin eye drop Sensory organs Yes - - M ar 2023 - Yes - Yes No
Raceanisodamide eye drop Sensory organs Yes - - - - Yes - Yes No
Levonorgestrel tabletGenito-urinary systemand sex Hormones Yes - - - - - Yes No No
Isotretino in so ft capsule Dermatologicals Yes - - - - Yes - Yes No
(1) M ajor chemical drug products and antibiotics that each generated over Rmb100 mn in revenue for 2009. (2) Indicates major products of antibio tics business.
(3) Exclusive licenses granted by third party. (4) NM ID = National M edical Insurance Drugs.
Modern Chinese medicine Modern Chinese medicine, according to Shanghai Pharma�s management, consists of medical drugs based on traditional Chinese medicine (TCM) formulae and manufactured in modern dispensing forms, such as injections, capsules and tablets.
Sale of modern Chinese medicines has been slow in the last couple of years, recording a growth of 4.3% in 2009 and 1.6% in 2010. For 2008, 2009 and 2010, modern Chinese medicines accounted for 36.7%, 35.8% and 33%, respectively, of the pharma manufacturing division�s net revenue.
As of December 2010, the company had 18 State Protected Chinese Medicine products, such as Kugan Chongji, Shenxiangsuhewan and Shengmai capsule, and eight State Confidential Chinese Medicine products, such as Liushenwan, Xinhuang tablet and Babaodan.
Figure 20: Market value of China�s modern Chinese medicines
Liushen WanHeat-clearing anddetoxifying Yes - - - Apr 2013 Yes - No No
Kangshuailaotablet(1 Others Yes - - - - - Yes No No
Qingliang series(1) Others Yes - -Aug 2019 & Jun 2020 - - Yes No No
(1) M ajor modern Chinese medicine products that each generated over Rmb100 mn in revenue for 2009. (2) NM ID = National M edical Insurance Drugs.
Source: Company data
Bio-pharma products Bio-pharma products are defined as medicinal drugs manufactured using biotechnological means or biological processes.
Revenue from bio-pharma products has been growing at a rapid pace in the last few years. Revenue from this segment reached Rmb819 mn and Rmb1.08 bn, respectively, in 2009 and 2010. This represented an increase of 30.7% in 2009 and 31.5% for 2010. Bio-pharma products revenue accounted for 13.3% of 2010 total pharma sales. As of December 2010, Shanghai Pharma produced 24 bio-pharma products.
%Biopharmaceutical & chemical drugs YoY chg (%) - RHS
2009-2014E CAGR = 22.5%
Source: NFS
Other pharma products Besides core chemical, modern Chinese medicine and bio-pharma products, Shanghai Pharma also manufactures and sells Chinese herbal medicines as well as active pharma ingredients. Revenue from other pharma products reached Rmb813 mn for 2009 and Rmb919 mn for 2010, representing a decrease of 12.7% in 2009 and an increase of 13% for 2010. As of 2010, this segment accounted for 11.4% of total pharma revenue.
Acquisition of antibiotics business In December 2010, Shanghai Pharma entered into an agreement to acquire a 96.9% equity interest in Shanghai New Asiatic and a 100% equity interest in Shanghai Huakang from Shanghai Pharmaceutical (Group). The total cash consideration is approximately Rmb1.49 bin, subject to final approval by the relevant regulatory authorities. Shanghai New Asiatic primarily manufactures, sells and packages chemicals and antibiotics. The remaining 3.1% of Shanghai New Asiatic is to be held by Shanghai Pudong New District Caolu Investment Management Co. Limited.
The acquisition is expected to be final in the first half of 2011and should immediately contribute to revenue for the chemical drugs segment. We believe this acquisition will likely act as a near-term growth driver for Shanghai Pharma in addition to further expanding the company�s product offering. According to management, the acquisition should add four additional major products to its current portfolio of 53.
Unique quality in pharma manufacturing Shanghai Pharma follows stringent quality control standards and procedures and has obtained the necessary PRC GMP certifications for all its manufacturing facilities. Some of them are even certified pursuant to the cGMP standards of the United States or the European Union. Such quality and safety standards and procedures include many features that are not required or specified in the China GMP standards, such as a quality control manual that sets forth management commitment to quality control targets and a comprehensive quality control system with procedures for quality inspection and audit.
As a result, global pharma companies have recognised Shanghai Pharma�s pharma manufacturing capabilities and have chosen the company as an active pharma ingredients supplier for their major products. In 2005, Shanghai Pharma became the first company in China to obtain the licence to manufacture both the active ingredients and the product form of Tamiflu® from Hoffmann-La Roche Limited.
Solid JV partners Shanghai Pharma has established a number of joint ventures, which accounted for 23.9%, 14.5% and 13.0% of the company�s 2008, 2009 and 2010 profit before income tax, respectively. The company�s current joint ventures include Shanghai Squibb, Shanghai Roche, Shanghai Ajinomoto Amino Acid, Shanghai Leiyunshang Pharmaceutical North District, Shanghai Tsumura among others. However, we identify the two we believe are the more prominent contributors.
Shanghai Squibb
Formed in 1982 for an initial joint venture term of 50 years, Shanghai Pharma currently owns 30% equity interest. Bristol-Myers Squibb and China National Pharmaceutical Foreign Trade Corp own 60% and 10%, respectively.
The joint venture was formed to manufacture over thirty pharma products and one active pharma ingredient, all of which are primarily sold within China. Major products from this JV include Baraclude, Glucophage, Theragen, Bufferin Cold, Monopril, Maxipime, Captoril, Velosef and Pravachol. In 2008, 2009 and 2010, Shanghai Squibb�s attributable profit to the company was Rmb77.6 mn, Rmb105.2 mn and Rmb89.6 mn, respectively.
Shanghai Roche
Established in 1994, for an initial joint venture term of 50 years, Shanghai Pharma currently owns 30% equity interest. Roche holds the remaining 70%.
Shanghai Pharma is responsible for the joint venture�s overall business operation, including securing licences and approval from relevant authorities and for liaison with banks and providers. Roche, on the other hand, is responsible for supporting the joint venture by securing equipment and materials from overseas. The joint venture�s current major offerings include MabThera, Xeloda, Herceptin and CellCept. In 2008, 2009 and 2010, its net profit attributable to Shanghai Pharma was Rmb96.9 mn, Rmb101.7 mn and Rmb120.4 mn, respectively.
Strong research & development capabilities Research and development (R&D) is a critical process for sustaining a pharma company�s long-term growth. As one of the largest and leading pharma companies within China, Shanghai Pharma puts significant effort into its R&D capabilities. In 2008, 2009 and 2010,
The acquisition is expected to be final in the first half of 2011and should immediately contribute to revenue for the chemical drugs segment
the company incurred R&D-related expenses of Rmb229 mn, Rmb259 mn and Rmb286 mn, respectively. This represented approximately 3.3-3.5% of total pharma revenue during 2008-10.
Shanghai Pharma currently places significant R&D emphasis on these key areas:
■ Innovative drug research. Identifying innovative drugs that can address major unmet medical needs through independent research efforts as well as by collaborating with external research partners such as research institutes, universities and other pharma companies.
■ Generic drug development. To develop first-to-market generic drugs in major therapeutic areas such as the cardiovascular system, alimentary tract and metabolism, the central nervous system, anti-infectives for systemic use and antineoplastic and immuno-modulating agents.
■ Product improvement. To improve quality standards as well as discover new usage and/or refining the production process of the company�s existing products.
■ International registration. To increase the value of existing products by ensuring that their quality meets required international standards and by conducting required clinical trials and tests.
As of December 2010, the company had 205 research programmes, including 24 innovative drug research programmes, 118 generic drug development programmes, 53 product improvement programmes and 10 international registration programmes. The research programmes include 45 on the cardiovascular system, 23 on antineoplastic and immuno-modulating agents, 17 on anti-infectives for systemic use, 11 on the alimentary tract and metabolism and 23 on the central nervous system. According to management, the company held 305 patents as of December 2010.
Since 2004, Shanghai Pharma has developed 54 new products that have obtained Certificates of New Medicine, including four innovative drugs, three first-to-market generic drugs as well as eight first three-to-market generic drugs. In addition, the company has also developed a pipeline of 33 drug candidates as of December 2010. This should help sustain long-term growth through constant, steady product launches. Of the 33 drugs, 27 are in various stages of clinical trials while six are pending approval to enter clinical trial.
Figure 24 presents a select list of key drug candidates under development:
Figure 24: Selected key drug candidates in the pipeline Selected drug candidates Drug type Stage NoteHigh Aff inity Etanercept Biopharmaceutical Completing pre-clinical studies Treatment of rheumatoid arthritis and(高親和力 Etanercept) ankylosing spondylitis. Modif ied version of
Etancercept . Collaborating w ith Fudan-Zhangjiang.
rhLTα28-171 Biopharmaceutical Phase II clinical trial Treatment of cancer. Collaborating w ith(重組人淋巴毒素α衍生物) Fudan-Zhangjiang.Deuteporfin (多替泊芬) Chemical Approved for clinical trials Treatment of cancer. Collaborating w ith
Fudan-Zhangjiang.Liposomal Vincristine Chemical Approved for clinical trials Formulation of vincristine, a generic(LVCR, 硫酸長春碱脂質體) chemotherapy agent, but more effective and
less toxic. Collaborating w ith Fudan-Zhangjiang.
LLTD-8 (雷藤舒) Chemical Phase I clinical trial Treatment of rheumatoid arthritis. Structurallymodif ied version of triptolide . Research show sthat LLTD-8 maintains triptolide's eff icacybut w ith reduced toxicity. Collaborating w ithShanghai Institute of Materia Medica.
Huaiguojian for injection Modern Chinese Phase II clinical trial Treatment of viral myocarditis caused by (槐果碱注射液) medicine coxsackievirus B. Collaborating w ith Shanghai
Renji Hospital. Thalidomide (沙利度胺) Biopharmaceutical Phase I clinical trial for Existing product for treatment of chronic
ankylosing spondylitis. inf lammation and autoimmune skin diseases.Currently under research for multiple myelomaand ankylosing spondylitis.
Zhengganqinhuang tablet Modern Chinese Completing phase III clinical trial Treatment of hepatitis. Has demonstrated ability(正肝清黃片) medicine Expects SFDA approval for to treat hepatitis w ithout signif icant adverse
manufacture & sale in 2013 effects. Developed new manufacturing processemploying new extraction and separationtechnologies.
Source: Company data
Major in-house R&D team
With 550 R&D personnel, Shanghai Pharma believes it has one of the largest R&D teams in the industry. Of this headcount, 20% have Masters or higher degrees in medical, pharma and other related fields. The company�s Vice President of R&D, Mr Jiang Yuanying, currently has over 20 years of pharma R&D experience and is a professor of pharmacology at the Second Military Medical University. According to management, the company�s solid R&D capabilities have been well recognised by a number of government-sponsored drug R&D programmes. In 2008, 2009 and 2010, the company was awarded grants under these programmes to the tune of Rmb4.1 mn, Rmb26.8 mn and Rmb76.1 mn (of which Rmb34.5 mn has been granted but not yet received), respectively.
Shanghai Pharma conducts R&D activities through three segments: (1) Central Research Institute; (2) research and technology centres managed by the company�s manufacturing subsidiaries; and (3) production site laboratories and pilot plants. Each tier of the R&D team has its own distinct focus, but it frequently works together with other teams in the project initiation process to avoid the overlap of effort. The company has also commenced R&D collaborative initiatives to further increase collaboration among these R&D teams to share expertise and knowledge on specific issues.
The company�s R&D facilities include the National Engineering and Research Centre for TCM and Shanghai Institute of Materia Medica, which are their own certified enterprise technical centres and 13 provincially or municipally certified enterprise technical centres.
Collaboration with external research partners
Besides its own in-house R&D efforts, Shanghai Pharma also maintains collaborative relationships with national and international research partners to jointly develop new products. The types of collaborative arrangements range from specific technical services and consultancy to long-term collaboration.
Research partners in China include institutions and universities such as Shanghai Institute of Materia Medica, Shanghai Jiao Tong University, Zhejiang University, Jilin University, China Pharmaceutical University as well as the Shenyang Pharmaceutical Industry. In addition, the company has been collaborating on innovative drug discovery and development with Mitsubishi Tanabe Pharma Corporation, which is the company�s international research partner, since 2004.
As of December 2010, Shanghai Pharma has long-term collaboration agreements with eight external research partners conducting research for potential pharma products in therapeutic areas such as the cardiovascular system, cancer, metabolism, nerve system and immuno-modulating agents.
The key benefits of jointly developing a drug may vary between drugs. However, in general, key benefits include:
■ shared risks;
■ increasing the chances of developing a commercially-viable product through expertise from the two (or more) parties;
■ pulling together resources, such as facilities, instruments, information support, personnel and others.
Relocation ahead, strategic move Shanghai Pharma is in the final stage of negotiations with the Shanghai Pudong government regarding its plant relocation. This will be a strategic long-term positive catalyst if completed smoothly as it would ensure the following:
■ Consolidate most manufacturing facilities in a centralised location and discontinue non-operating facilities to optimise utilisation and upgrade facilities.
■ Valuation gain from land acquisitions.
■ The company would be able to optimise labour force (such as reduce the manufacturing force to half) and potentially increase operating margin.
We expect Shanghai Pharma to sign an agreement with the Shanghai government within this year to relocate its multiple downtown plants to a consolidated location.
Distribution�s focus is on high-margin regions Shanghai Pharma is one of the largest integrated pharma companies in China. Besides its leadership in the manufacture of pharma products, the company is a major distributor and retailer of pharma products in the country. Currently, there are only a small number of integrated pharma groups with significant operations in both pharma and distribution.
Shanghai Pharma is the second-largest distributor of pharma products in China in terms of revenue, according to NFS. The company operates a national distribution network that comprises of 41 subsidiaries and branches, as well as 32 logistic centres and warehouses located strategically across its key regional markets in eastern, northern and southern China.
Focusing on the most lucrative regions Shanghai Pharma�s distribution business is primarily focused in three regional markets: eastern, northern and southern China. According to NFS, these three regions collectively account for approximately 67% of the entire China pharma distribution market in terms of 2009 sales. Eastern China is the most affluent in terms of GDP per capita and is the most populous region in China. NFS estimates that this market alone accounts for 39.1% of the China pharma distribution business based on 2009 sales figures.
Figure 25: Shanghai Pharma is the second-largest pharma distributor
Figure 26: Eastern, northern and southern China � Shanghai Pharma�s key distribution markets Eastern China: 39.1%Northern China: 15.7%Central China: 12.4%Southern China: 12.1%Southwestern China: 10.7%Northeastern China: 5.3%Northwestern China: 4.6%
Source: Company data, Credit Suisse research
According to NFS, among the seven regions, eastern China has the highest GDP per capita. GDP per capita in the area increased from approximately Rmb20,183 in 2005 to over Rmb35,127 in 2009, representing a CAGR of 14.9% for the period. In addition, according to NFS�s statistics, Shanghai Pharma is currently the number one distributor of pharma products in eastern China with an 11% market share, ahead of the 7% controlled by Nanjing Pharmaceutical and 6.4% by Sinopharm.
Staying focused; diversification is not a priority The three regions that Shanghai Pharma focuses on, namely eastern, northern and southern China, are very populous and highly developed regions. From the company�s perspective, given the higher disposable income relative to other regions, it is an appropriate strategy to remain focused on these regions. In addition, given the company�s existing infrastructure and the location of its logistic centres and warehouses, a diversification towards other regions would make very little sense.
Shanghai Pharma has leading market share in eastern China and will likely continue to focus on it while also building up its presence in northern and southern China. According to the company, these attributes are likely to help the firm maintain solid profit margins, whereas rapid expansion into other regions without adequate infrastructure support may actually have the opposite effect.
Shanghai Pharma distinguishes itself as a pharma products distributor in part through the value-added services that it provides to both its suppliers and customers. Some of these include:
Shanghai Pharma focuses on the eastern, northern and southern China, which are very populous and highly developed regions
■ Terminal solutions: Assisting in setting up barcode systems to track and manage inventory.
■ Client relationship management: Receiving and processing customer and supplier feedback.
■ Specialised logistic services: Cold storage and transportation services.
■ Customer hotline: Providing 24-hour assistance in preparing adverse drug effect reports.
■ Business intelligence systems: Gathering and analysing Shanghai Pharma�s own operational data such as inventory level and sales information, which is valuable for suppliers.
■ Vendor-managed information system: Assisting suppliers to monitor customers� inventory levels, among other things.
Through the above, the company has been successful in retaining customers.
Quality network, quality drugs Shanghai Pharma�s distribution division is the company�s largest revenue contributor. Based on the company�s 2010 figures, revenue from the distribution business was over Rmb28.3 bn, accounting for 76% of the company�s total turnover. Some key reasons for the company�s success include: (1) continuous focus on its key markets and (2) the ability to source high-quality items.
Currently, the pharma distribution and supply solutions business generates the majority of its revenue from sales of high-end pharma products. According to management, these products include imported medicines as well as medicines manufactured by local China subsidiaries of international pharma companies.
Shanghai Pharma also specialises in distributing products directly to hospitals and other medical institutions, which includes community healthcare centres and clinics. In general, direct distribution to hospitals and medical institutions carries higher profit margins than sales to other distributors. The company sells its products to over 7,600 hospitals and other medical institutions in the country, including 229 (or 63.8%) Class III hospitals and 879 (or 55.7%) Class II hospitals in eastern China. However, in order to extend its reach to customers throughout China, Shanghai Pharma also sells to other distributors. In 2008, 2009 and 2010, the percentage of direct sales within the distribution business has been relatively stable at 62.8%, 63.9% and 61.9%, respectively.
Extending the network Management notes that the long-term success of the distribution and supply chain solutions business depends significantly on its ability to constantly improve as well as extend the existing distribution network. To achieve this, the company has made selective acquisitions to strengthen its leadership in eastern China while consolidating its overall leadership in the country.
In July 2010, Shanghai Pharma acquired a 49% interest in Fujian Pharmaceutical, which operates a pharma distribution network across the Fujian province. A month later, Shanghai Pharma took a 51% equity interest in Guangzhou Z.S.Y., a leading pharma distributor in Guangzhou. In November 2010, Shanghai Pharma took a 52.24% stake in Beijing Aixin Weiye, which is a pharma distributor in Beijing. In December 2010, the company further consolidated its leadership position in eastern China through Tai Zhou Medicine and Yutiancheng. From Shanghai Pharma�s perspective, these acquisitions will further extend the company�s reach in its three key regions.
Most recently, Shanghai Pharma has acquired CITIC Pharma, a major Beijing-based pharma distributor. According to management, this acquisition should allow Shanghai Pharma to significantly expand its market share in northern China.
Figure 27: Solid growth from the distribution business
0
20,000
40,000
60,000
80,000
2008 2009 2010 2011E 2012E 2013E
Rmb mn
0
15
30
45
60%Distribution revenue YoY chg (RHS)
Source: Company data, Credit Suisse estimates
Significant product portfolio As of December 2010, Shanghai Pharma distributed in excess of 18,600 pharma and healthcare products ranging from prescription medicines, over-the-counter medicines, personal care products to various medical supplies. According to management, the company focuses more on high-end pharma products, primarily consisting of imported medicines and those manufactured by local subsidiaries of international pharma companies. Management explains that these products allow it to enhance operational efficiency largely due to the high price-to-volume ratio, better marketing and the demand for such products.
Currently, the distribution business sources its products from over 2,600 international as well as domestic pharma companies. Besides Tier-3 suppliers, the division also helps distribute products from the company�s pharma business. Management aims to better integrate the pharma and distribution businesses, going forward.
Shanghai Pharma acquired CITIC Pharma to significantly expand its market share in northern China.
Figure 29: Major healthcare and medical supplies products manufactured by Shanghai Pharma Approximate no.
Product category of products Major productsMedical supplies 2,600 Implantable pacemaker, Bone plates, Pen needles, Disposable surgical maskCosmetics 100 Pearl lotion, Johnson�s Baby body oil, Mentholatum Mint ointment, Liushen body pow derHealthcare food 80 Yinghuang Ginseng tablet, Jinpai f ish oil
Retail: Small, but not forgotten Besides pharma manufacturing and distribution, Shanghai Pharma is also engaged in the retail of pharma products. Its retail network spans nine provinces, municipalities and autonomous regions in China. As of December 2010, the company�s retail network consisted of 1,682 retail pharmacies, of which 1,187 were directly-operated retail pharmacies (363 operated through jointly-controlled entities) while the remaining 495 were franchises. According to NFS, Shanghai Pharma had the largest pharmacy retail chain during 2009. Management adds that Shanghai Pharma�s typical retail pharmacy customers are primarily urban residents living in China�s major cities.
Figure 30: Shanghai Pharma distribution coverage Directly Region operated Franchise Total Eastern China region Shanghai 436 323 759 Jiangxi* 363 363 Zhejiang 60 15 75 Shandong 86 86 Jiangsu 78 9 87 Anhui 42 4 46 Other regions 0 Inner Mongolia 60 144 204 Guizhou 40 40 Guangdong 22 22 Total 1,187 495 1,682 * Operated through jointly owned entity.
Source: Company data
The retail business offers over 10,000 types of products. The drugs carried in the stores are generally medicines most frequently purchased/ used by customers. Overall, the retail division sells three lines of products: (1) prescription medicines, (2) over-the-counter medicines and (3) non-pharma products. Prescription medicines
The company offers a wide range of prescription medicines, amounting to 22 of the 23 currently available classes of prescription medicines. Only prescriptions ordered by physicians and other licensed healthcare service providers will be accepted by the Shanghai Pharma retail division. Over-the-counter medicines
Shanghai Pharma currently offers 62 classes of over-the-counter drugs for treatment of common diseases as well as 36 classes of modern Chinese medicines. Non-pharma products The retail division has 152 types of personal healthcare products available at this stage. These include a variety of healthcare supplements, vitamins, minerals, dietary products, skin care products, hair growth products, beauty products and cosmetics.
Strategic acquisition: CITIC Pharma Shanghai Pharma�s bold acquisition of CITIC Pharma is a strategic move towards the northern China region and supplements finding new growth drivers. Shanghai Pharma continues to expand the distribution network in the PRC by both organic and inorganic approaches. This fits well with Shanghai Pharma�s strategic focus on affluent regions within China since Shanghai Pharma has already been the long-standing leader in its home base eastern China. Northern China is a lucrative and strategically important area. In April 2011, Shanghai Pharma acquired CHS, whose main asset is its wholly owned subsidiary CITIC Pharma, a leading pharma distributor in Beijing in terms of revenue in 2009. The addition of CITIC Pharma will significantly expand Shanghai Pharma�s operations and market share in northern China.
What is CITIC Pharma?
CITIC Pharma was formed in 1993 and grew rapidly in recent years after a series of private equity investments strengthened its growth. According to CAPC, CITIC Pharma was the eighteenth largest distributor of pharma and healthcare products in the PRC in terms of revenue in 2009. As of 31 December 2010, CITIC Pharma distributed over 5,000 types of pharma and healthcare products, a majority of which were high-end pharma products, primarily comprising imported medicines and those manufactured by subsidiaries of international pharma companies in the PRC. In 2010, CITIC Pharma�s direct sales to hospitals accounted for approximately 51% of its revenue. CITIC Pharma also distributes a select portfolio of imported vaccines, as well as medical devices from international medical devices manufacturers or their subsidiaries in the PRC. CITIC Pharma conducts its pharma distribution operations through nine warehouses located in Beijing, Nanjing, Shanghai, Hangzhou, Henan and Hainan. The primary function of the warehouses is to process and store the products received from suppliers and to distribute them when ordered by customers.
CITIC Pharma has an attractive financial profile. It achieved a ten-year track record of consistent over 30% revenue CAGR, significantly outpacing peers. In terms of 2008 sales growth, it was ranked second among China pharma distributors in terms of size. In 2008, 2009 and 2010, CHS�s revenues were Rmb3,214.4 mn, Rmb4,343.4 mn and Rmb6,111.9 mn, respectively, and its profits after taxation were Rmb71.4 mn, Rmb93.6 mn and Rmb131.7 mn, respectively, in the same periods.
Figure 31: CITIC Pharma�s revenue trend
3,214
4,343
6,112
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2,000
3,000
4,000
5,000
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2008 2009 2010
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Rev enue
CAGR: 38%
Source: Company data
CITIC Pharma achieved a ten-year track record of consistent over 30% revenue CAGR, significantly outpacing peers.
Figure 34: CITIC Pharma has a high growth momentum
153.10%
38.90%
35.80%
33.10%
26.00%
25.80%
24.20%
24.00%
22.10%
21.20%
Sichuan secco Aaron Pharmaceutical
CITIC Pharmaceutical
Yunnan Pharmaceutical
Harbin Pharmaceutical
Shanghai Pharmaceutical
Hebei Dongsheg Yinghua Pharmaceutical
China Pharmaceutical
Zhejiang Intmedic Pharmaceutical
Beijing Pharmaceutical
Lerentang Pharmaceutical
Chinese pharmaceutical distributors in terms of 2008 sales growth
Source: CAPC
CITIC Pharma offers Shanghai Pharma a strategic home base in Beijing
CITIC Pharma is a top three pharma distributor in the attractive Beijing hospital market, which was lacking in the territory covered by Shanghai Pharma. It distributes products to over 400 hospitals, including all Class III hospitals and 103 Class II hospitals in Beijing. It strategically focuses on the medium- to high-end market and collaborates with reputable multinational companies. It maintains close relationships with 20 of the top 25 supplier multinational pharma manufacturers in China, with 70% of its revenues from quality products coming from MNCs. It is the foremost distributor in the Beijing top-tier hospital market with rich experience and outstanding competence in rendering quality service to mid-to-large hospitals.
Figure 35: Top five cities in annual healthcare expenditure per capita
Figure 36: CITIC Pharma partners with top multinationals and top hospital
Source: Company data
Strategic addition of new growth drivers in vaccine and medical device
Another highlight for CITIC Pharma is its addition of new growth drivers in the vaccine and medical device distribution business. CITIC Pharma covers three business areas: pharma, vaccines and medical devices. CITIC Pharma is a pioneer pharma distributor in China to engage in MNC�s vaccine distribution and has recently also been engaged in the medical devices business. Currently, it is ranked as the number two national vaccine distributor covering Centres for Disease Control at all levels including those of provinces, cities and counties. After integration with Shanghai Pharma�s national network, the vaccine and medical device distribution business could expand further , leveraging CITIC Pharma�s existing relationship and expertise. This will likely be another two corner stone growth drivers for Shanghai Pharma.
On the other hand, as part of its pharma, vaccines and medical devices distribution operations, CITIC Pharma offers a broad range of logistics and value-added services to its customers, such as import services, third-party logistics services and information technology solutions. CITIC Pharma is equipped with an advanced IT infrastructure and robust operating platform that can offer better synergy to Shanghai Pharma. In fact, CITIC Pharma is the first pharma distributor in China to deploy SAP�s MySap system. Its well-established logistic management, quality control systems are acknowledged by major multinational pharma companies.
Earnings forecasts and valuation We project Shanghai Pharma�s core profit to reach Rmb1.8 bn for 2011, representing an increase of 33% YoY. Our forecasts also suggest earnings to reach Rmb2.7 bn for 2012, suggesting core profit to increase 51% YoY. We believe companies such as Harbin Pharmaceutical Group and Sinopharm Group are the key comparables to Shanghai Pharma, given their similar exposure to the China healthcare market.
Earnings growth driven by strategic acquisitions Shanghai Pharma�s revenue has been growing steadily at 14-20% over the last two years, thanks to the increasing revenue from the distribution business. However, we forecast revenue growth to accelerate to 41% and 28% for 2011 and 2012, respectively. The significantly higher growth rates are driven by: (1) improving organic growth from existing businesses and (2) contributions from recently-acquired companies.
In our view, the pharma and distribution businesses will continue to be Shanghai Pharma�s key earnings contributors in the long term. Besides organic growth, we believe these two divisions will continue to expand through acquisitions in the future.
Pharma: acquiring growth
The pharma manufacturing division has a large portfolio of drugs, along with a steady pipeline of candidates, in our view. We believe the chemical drugs, modern Chinese medicines as well as bio-pharma drugs will continue to act as key drivers going forward, benefitting from overall rising demand for pharma products. In addition, as mentioned earlier, regulatory standards are likely to be benchmarked towards higher levels forwarding the future, which will likely to drive out smaller pharma players given higher compliance and cost requirements. In our view, such an event is likely to redirect market share to pharma companies with large economies of scale. Therefore, we believe Shanghai Pharma�s revenue growth from manufacturing should outpace the industry�s average of 20-25% over the next three years.
Besides organic growth, Shanghai Pharma has adopted an acquisition strategy to drive growth. The buyout of Shanghai Asiatic and Shanghai Huakang, primarily engaged in the manufacture of antibiotic products, should help expand Shanghai Pharma�s product portfolio and immediately add to the top-line growth. After the recent buyouts, we expect the company to perform further bolt-on acquisitions in 2011 and 2012, which should help the pharma segment deliver 28% revenue growth in 2011 and by nearly 35% for 2012.
Distribution: casting its net(work) strategically
Shanghai Pharma has one of the most extensive distribution networks in China. Despite its size, the company has limited its businesses to eastern China, northern China and southern China. As discussed earlier, these markets offer greater revenue opportunities relative to other regions within the country. Therefore, we believe Shanghai Pharma�s strategy to focus on these regions is sensible as it allows the company to allocate resources within a smaller area to maximise its scale, efficiency and profitability.
We project organic top line growth for the distribution business to be in excess of 20% over the next two years. However, through the various acquisitions in 2010 and 2011, especially with the integration of CITIC Pharma, we estimate revenue growth may reach 46% for this year. We expect the company to perform further acquisitions in the future, but unlike some of its key competitors, Shanghai Pharma is unlikely to acquire targets to expand geographically. In our view, management is likely to focus on acquisition opportunities that can enhance its leadership positions in its three key geographic regions. For 2012, we estimate distribution revenue to grow 28% on the back of solid organic growth along with additional contributions from newly acquired targets.
We project Shanghai Pharma�s core profit to reach Rmb1.8 bn for 2011, and Rmb2.7 bn for 2012
Shanghai Pharma is committed to making acquisitions without sacrificing margins.
Equity value range With improving operating margins, we expect Shanghai Pharma�s core profits to grow by 33% and 51% in 2011E and 2012E, respectively. Our target price of HK$24.3 is based on 20x the 2012E core earnings.
There are a number of China healthcare companies. The majority of healthcare companies are pharma manufacturers while some are distributors. In our view, the closest comparables in the comps include Harbin Pharmaceutical Group and Sinopharm Group. Our key comparables consist of three groups of companies:
Based on our calculations, we estimate Shanghai Pharma�s core profit to reach Rmb1.8 bn for 2011 and Rmb2.7 bn for 2012. We consider it reasonable to refer to the valuation of the comps below, given the similarity of their exposure to the China healthcare market, despite some differences in product offerings and growth profile.
We believe P/E is an appropriate valuation methodology to be applied to Shanghai Pharma�s equity valuation range. In our view, Shanghai Pharma deserves a valuation premium compared to the general comps. We believe a P/E at 20x the 2012E core profit would be an appropriate valuation.
Key risks We highlight the following potential key risk factors related to Shanghai Pharma:
■ Operational risks. Shanghai Pharma�s success is subject to significant operational risks, including management�s ability to implement its business strategies and be compliant with laws and regulations. We believe any delays or failure to successfully implement its expansion strategies could result in delay or loss in revenue, an increase in financing costs and weakening of the company�s overall financial condition.
■ Competition risks. The company directly competes with a number of competitors. For pharma manufacturing, its key competitors include Harbin Pharmaceutical Group Co., Limited and Shijiazhuang Pharmaceutical Group Co., Limited along with numerous others. At the distribution level, Shanghai Pharma�s key competitors are Sinopharm Group Co., Limited and China Resources Medications Group Limited. For the retail business, it competes with Sinopharm Group Co., Limited as well as with China Nepstar Chain Drugstore Limited.
■ Policy risks. A substantial portion of the company�s pharma products are subject to price controls in China. Further, changes to the existing products already on the Medical Insurance Drugs Catalogue could materially affect demand for the company�s products, and, in turn, its profitability and outlook.
■ Acquisition risks. Part of Shanghai Pharma�s growth strategy is to acquire existing pharma manufacturers as well as pharma distributors and/or retailers. We believe there is a chance that the company may be unable to identify suitable acquisition targets or complete acquisitions at commercially acceptable terms or prices. In addition, the company may be unable to integrate the acquired target smoothly and/or the acquired target may not perform as well as expected.
■ Orders risks. In 2008, 2009 and 2010, the majority of the company�s revenue derived from hospitals as well as other medical institutions in China. There is a risk that Shanghai Pharma may fail to win the statutory tender process. If this happens, the company would not be able to sell its products to them, which would severely affect its revenue and profitability.
■ Product risks. Pharma manufacturing is a major profit contributor for the company. Its success relies on enhancing existing products as well as developing new ones. However, the development of new drugs is time consuming and costly and generally has a low rate of successful commercialisation. In addition, if a drug is alleged to be unsafe, the company may have to recall its products. We believe this may materially affect the company�s financial conditions and reputation.
■ Elimination or changes to incentives. The government has provided various benefits to Shanghai Pharma through reduced income tax as well as grants. For 2008, 2009 and 2010, the company received Rmb109.1 mn, Rmb73.8 mn and Rmb136.1 mn, respectively, in government grants. This equates to 16%, 6% and 10% of the company�s 2008, 2009 and 2010 net earnings. Should the grants be eliminated or changed, we believe the company�s profitability would be materially affected.
■ Key personnel risks. Shanghai Pharma�s success depends heavily on the continued service of its senior management team as well as key personnel from the R&D and sales and marketing departments.
■ Other risks. We believe the company may also be exposed to other risks, in addition to those mentioned above.
Operational risks Shanghai Pharma�s success is subject to significant operational risks, including management�s ability to implement its business strategies and be compliant with laws and regulations. We believe that any delays or failure to successfully implement its expansion strategies could result in delay or loss in revenue, an increase in financing costs and weakening of the company�s overall financial condition.
The company operates in a fast growing, highly competitive industry. Management is expected to implement a number of well-thought-out strategies in order to maintain or improve its market share. However, we believe such implementation is not without risks as they must also take into consideration the strict laws and regulations relating to the healthcare industry.
Further, it is important for the company to implement its business strategies on time and in a cost-effective manner. We believe any delays or failure to successfully implement its expansion strategies could result in delay or loss in revenue, increase the cost of financing and weaken the overall financial condition of the company.
Competition risks The healthcare industry is highly competitive. Shanghai Pharma competes with a number of large, national and regional manufacturers, distributors and retailers of pharma and healthcare products. In addition, the company competes with a number of smaller, local participants across these areas. Besides domestic competitors, the company also competes with the domestic operations of the foreign pharma products manufacturers and distributors.
The pharma manufacturing segment is highly fragmented, with no company controlling more than 2% of the market. The company�s key competitors include Harbin Pharmaceutical Group Co., Limited and Shijiazhuang Pharmaceutical Group Co., Limited along with numerous others.
At the distribution level, Shanghai Pharma�s key competitors are Sinopharm Group Co., Limited and China Resources Medications Group Limited. For the retail business, it competes with Sinopharm Group Co., Limited as well as with China Nepstar Chain Drugstore Limited.
Policy risks In our view, besides the company�s operational strength, its overall profitability is also subject to policy risks. A substantial portion of the company�s pharma products are subject to price controls (primarily those listed in the Medical Insurance Drugs Catalogue), in the form of fixed retail prices or retail price ceilings. This limits the company�s ability to increase prices of these products.
There is no direct control over the prices at which pharma manufacturers must sell their products to distributors or hospitals. However, we believe the revenue and profitability of manufacturers can affected if the government reduces the fixed retail prices or retail price ceilings applicable to Shanghai Pharma products, as the company may have to reduce its prices when it sells to its distributors.
The commercial success of Shanghai Pharma products is substantially dependent on whether reimbursement is available to the hospitals ordering such drugs for their patients. Should the company�s products be removed from the Medical Insurance Drugs Catalogue, we believe it could have a material effect on the company�s business operations and prospects.
Acquisition risks Part of Shanghai Pharma�s growth strategy is to acquire existing pharma manufacturers as well as pharma distributors and/or retailers. We believe that there is a chance that the company may be unable to identify suitable acquisition targets or complete acquisitions at commercially acceptable terms or prices. In addition, the company may be unable to integrate the acquired target smoothly and/or the acquired target may not perform as well as expected. Shanghai Pharma intends to make strategic acquisitions to further expand its business operations. However, as the industry consolidates, we believe it will become increasingly difficult to identify suitable targets. Even if a suitable target is identified, the required bidding price, along with the terms and conditions, may not be favourable for Shanghai Pharma. Should the company overpay for such acquisitions, it may have a negative impact on the firm�s financial condition. Even if Shanghai Pharma manages to make an acquisition at a reasonable price, the company will likely continue to suffer from integration risks. In our view, the combined business operations may pose difficulties for management given the larger operational scale, whether it is the number of products or greater geographical reach. Further, if the company is unable to retain the existing management team of the acquired targets, it could lead to a diversion of resources and management attention from Shanghai Pharma�s existing businesses. We believe integrating businesses requires a significant amount of effort and skill. There is a risk that the combined entities may have less synergy than initially expected. In addition, the acquired target may not perform as well as expected. Should this happen, we believe impairment costs may accrue, which could hurt the company�s earnings as well as its financial condition.
Orders risks In 2008, 2009 and 2010, the majority of the company�s revenue derived from hospitals as well as other medical institutions in China. The purchase of pharma products by government-owned or government-controlled hospitals is generally subject to the annual statutory tender process, which is conducted by local governments. With the recent introduction of a more centralised statutory tender system for basic drugs, competition among suppliers is likely to intensify, putting downward pressure on prices. Given increased competition, we believe Shanghai Pharma may fail to win the statutory tender processes should its selling prices not be competitive enough and/or its product quality, amongst other variables, fails to meet the required standards. As a result, the company�s revenue and profitability could be severely compressed.
Product risks Pharma manufacturing is a major profit contributor for the company. Its success relies on enhancing existing products as well as developing new ones. However, the development of new drugs is a time-consuming process. In addition, the development process can be very costly and there is no guarantee that the product candidate will end up becoming a commercial product. A drug candidate that appears promising at the early stages of development could end up failing at a later stage. The key reasons why drug candidates fail to reach the market include (but are not limited to):
■ failure to demonstrate safety and efficacy in pre-clinical and clinical trials;
■ failure to obtain approvals for intended use from relevant regulatory bodies such as the SFDA;
■ inability to manufacture and commercialise sufficient quantity of the product to make it economically viable; and
■ lack of patent rights and/ or inability to acquire or license such rights at commercially reasonable terms.
Besides the failure to obtain approvals, a delay in the development process can also affect the company�s future revenue and profitability.
Further, even if a product has been approved, the company is not without risks. According to management, Shanghai Pharma does not have any liability insurance. The company is therefore exposed to a number of risks, including manufacturing, packaging, marketing and distribution of pharma and healthcare products, inadequate labelling of warnings, misleading disclosures and unintentional distribution of counterfeit drugs.
If there are allegations that the company�s products are unsafe, the company may have to recall its products from the market. Any claims against the company, whether with or without merit, are likely to affect overall demand for the company�s products, and hence the profitability and reputation of the firm.
Elimination or changes to incentives The government has provided various benefits to Shanghai Pharma through reduced income tax as well as grants. As Shanghai Pharma is considered part of the �high-and-new technology enterprises�, some of the company�s subsidiaries are entitled to preferential income tax rates of 15% (versus the statutory income tax rate of 25%). However, the government could decide to modify/ cancel such incentives at any time.
For 2008, 2009 and 2010, the company received Rmb109.1 mn, Rmb73.8 mn and Rmb136.1 mn, respectively, in government grants. This equates to 16%, 6% and 10% of the company�s 2008, 2009 and 2010 net earnings. Should the grants be eliminated or changed, we believe the company�s profitability could be materially affected.
Key personnel risks Shanghai Pharma�s success depends heavily on the continued service from its highly experienced senior management team, which is led by the Chairperson, Mr Lu Mingfang. Besides the senior management team, the company also relies on key personnel from the R&D and sales and marketing departments.
The company�s R&D team is very important for the development and commercialisation of products in the pharma manufacturing business. In addition, the overall success of the distribution of drugs is dependent on sales and marketing personnel.
The ability to attract and retain such staff may require Shanghai Pharma to offer higher monetary incentives, hence operating expenses. However, in our view, the loss of such employees could affect the company�s future development, especially if it is unable to find suitable replacements.
Other risks We believe the company may also be exposed to other risks, in addition to those previously mentioned. These include:
■ macroeconomic risks, which may affect the overall demand of certain drugs;
■ shortage of raw materials used in the manufacture of pharma products;
■ infringement of intellectual property rights of third parties;
■ disruptions to the company�s information technology systems;
■ disruptions to the company�s pharma storage and supply chain network.
Companies Mentioned (Price as of 22 Jun 11) Shanghai Pharmaceutical (Group) Co. (2607.HK, HK$20.35, OUTPERFORM [V], TP HK$24.3) Sinopharm Group Co (1099.HK, HK$26.50, OUTPERFORM, TP HK$40.00) For other companies mentioned, please see Figure 40 on page 33.
Disclosure Appendix Important Global Disclosures Jinsong Du, Lefei Sun & Duo Chen each certify, with respect to the companies or securities that he or she analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. See the Companies Mentioned section for full company names. 3-Year Price, Target Price and Rating Change History Chart for 2607.HK 2607.HK Closing
The analyst(s) responsible for preparing this research report received compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities. Analysts� stock ratings are defined as follows: Outperform (O): The stock�s total return is expected to outperform the relevant benchmark* by at least 10-15% (or more, depending on perceived risk) over the next 12 months. Neutral (N): The stock�s total return is expected to be in line with the relevant benchmark* (range of ±10-15%) over the next 12 months. Underperform (U): The stock�s total return is expected to underperform the relevant benchmark* by 10-15% or more over the next 12 months. *Relevant benchmark by region: As of 29th May 2009, Australia, New Zealand, U.S. and Canadian ratings are based on (1) a stock�s absolute total return potential to its current share price and (2) the relative attractiveness of a stock�s total return potential within an analyst�s coverage universe**, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. Some U.S. and Canadian ratings may fall outside the absolute total return ranges defined above, depending on market conditions and industry factors. For Latin American, Japanese, and non-Japan Asia stocks, ratings are based on a stock�s total return relative to the average total return of the relevant country or regional benchmark; for European stocks, ratings are based on a stock�s total return relative to the analyst's coverage universe**. For Australian and New Zealand stocks a 22% and a 12% threshold replace the 10-15% level in the Outperform and Underperform stock
rating definitions, respectively, subject to analysts� perceived risk. The 22% and 12% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively, subject to analysts� perceived risk. **An analyst's coverage universe consists of all companies covered by the analyst within the relevant sector. Restricted (R): In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Volatility Indicator [V]: A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.
Analysts� coverage universe weightings are distinct from analysts� stock ratings and are based on the expected performance of an analyst�s coverage universe* versus the relevant broad market benchmark**: Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. *An analyst�s coverage universe consists of all companies covered by the analyst within the relevant sector. **The broad market benchmark is based on the expected return of the local market index (e.g., the S&P 500 in the U.S.) over the next 12 months. Credit Suisse�s distribution of stock ratings (and banking clients) is:
Global Ratings Distribution Outperform/Buy* 47% (62% banking clients) Neutral/Hold* 40% (56% banking clients) Underperform/Sell* 10% (50% banking clients) Restricted 3%
*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors.
Credit Suisse�s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein. Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: http://www.csfb.com/research-and-analytics/disclaimer/managing_conflicts_disclaimer.html Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties. See the Companies Mentioned section for full company names. Price Target: (12 months) for (2607.HK) Method: Our target price of HK$24.3 is based on 20x 2012E core profit of Rmb1.01 (HK$1.22) Risks: Key risks include (1) operational risks; (2) risks from competition; (3) policy risks; (4) acquisition risks; (5) orders risks; (6) product risks; (7) elimination or changes to incentives; and (8) key personnel risks. Price Target: (12 months) for (1099.HK) Method: China's integrated distributors are trading at various price to earnings (P/E) multiples but similar price to sales (P/S) multiples. Our target price of HK$40 for Sinopharm Group is based on 0.9x FY11E total sales, the average of its peer group. Risks: Key investment risks and risks to our HK$40.00 target price for Sinopharm Group include: (1) working capital commitments, (2) margin pressure for its side businesses, such as drug stores. Please refer to the firm's disclosure website at www.credit-suisse.com/researchdisclosures for the definitions of abbreviations typically used in the target price method and risk sections.
See the Companies Mentioned section for full company names. The subject company (1099.HK) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (1099.HK) within the past 12 months. Credit Suisse has managed or co-managed a public offering of securities for the subject company (1099.HK) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (1099.HK) within the past 12 months. Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (1099.HK) within the next 3 months. Important Regional Disclosures Singapore recipients should contact a Singapore financial adviser for any matters arising from this research report. The analyst(s) involved in the preparation of this report have not visited the material operations of the subject company (2607.HK, 1099.HK) within the past 12 months. Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares.
Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit http://www.csfb.com/legal_terms/canada_research_policy.shtml. As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report. Principal is not guaranteed in the case of equities because equity prices are variable. Commission is the commission rate or the amount agreed with a customer when setting up an account or at anytime after that. To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. � Jinsong Du, non-U.S. analyst, is a research analyst employed by Credit Suisse (Hong Kong) Limited. � Lefei Sun, non-U.S. analyst, is a research analyst employed by Credit Suisse (Hong Kong) Limited. � Duo Chen, non-U.S. analyst, is a research analyst employed by Credit Suisse (Hong Kong) Limited. Taiwanese Disclosures: Reports written by Taiwan-based analysts on non-Taiwan listed companies are not considered recommendations to buy or sell securities under Taiwan Stock Exchange Operational Regulations Governing Securities Firms Recommending Trades in Securities to Customers. For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at www.credit-suisse.com/researchdisclosures or call +1 (877) 291-2683. Disclaimers continue on next page.
23 June 2011Asia Pacific/ChinaEquity Research
HC0049
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