JPM Report

Asia Pacific Equity Research
15 October 2011
China Healthcare
Shattered landscape; hope and opportunity
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 governments 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 CHINA SHINEWAY (UW) CONCORD MEDICAL (OW) MICROPORT (N) MINDRAY (OW) SHANDONG WEIGAO (OW) SIHUAN (OW) SINO-BIOPHARM (OW) SINOPHARM (OW) UNITED LAB (N) Code 2877 HK CCM US 853 HK MR US 1066 HK 460 HK 1177 HK 1099 HK 3933 HK Price (PT) 11.5 (12) 3.19 (4.6) 4.7 (5.5) 24.8 (32) 9.2 (11.5) 3.14 (4.9) 2.28 (3.5) 20.6 (30) 6.46 (7.5) MCAP US$m 1,223 151 868 2,857 5,311 1,847 1,444 6,362 1,078 Vol US$m 5.6 0.1 1.2 12.6 5.4 4.2 2.4 15.2 3.5 1W Chg 24.2 3.2 9.3 2.6 15.8 18.5 4.6 4.8 16.2 3M Chg (16.1) (21.3) (5.1) (7.3) (16.1) (1.9) (14.9) (11.0) (25.0) 11E P/E (x) 9.8 6.3 20.0 17.1 30.1 15.5 20.1 21.1 6.7 12E P/E (x) 9.0 4.7 15.9 14.5 22.5 12.1 17.0 14.6 4.6 11E EV/ EBITDA 5.0 2.6 11.1 10.7 23.2 9.1 7.4 10.4 5.1 11E ROE (%) 22.8 8.5 12.9 16.4 23.8 12.2 15.1 14.7 22.7 P/B (x) 3.6 0.9 3.0 2.6 7.6 2.9 3.6 4.5 3.2 11E Yld (%) 1.8 0.0 0.0 1.2 1.0 0.0 2.8 0.8 2.6 ND/E (%) (76.1) (23.8) (44.3) (47.6) (44.8) (54.0) (42.0) (22.8) 34.1
Healthcare Sean Wu
AC
(852) 2800-8538 sean.wu@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited
One-year China & APxJ Healthcare

20% 10% 0% -10% -20% -30% -40% -50%
Nov-10 Dec-10
Feb-11 Mar-11
Aug-11
Apr-11 May-11
MSCI China H APxJ Healthcare MCSI China Healthcare
Source: Bloomberg
Three-month China & APxJ Healthcare

5.0% 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% -35.0% 1-Jul 1-Aug 1-Sep
MSCI China H APxJ Healthcare MSCI China Healthcare
Source: Bloomberg
Source: Bloomberg, J.P. Morgan estimates. Prices as of close 13 October 2011.
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. www.morganmarkets.com
Sep-11
Oct-10
Jan-11
Jun-11 Jul-11
Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com
Asia Pacific Equity Research 15 October 2011
Table of Contents
Investment summary................................................................3
Poor performance creates opportunity......................................................................3 Why the underperformance .....................................................................................4 Why would the sector recover .................................................................................5 Stock investment views ...........................................................................................7 Valuation Analysis and Price Targets.....................................................................14
Healthcare a major pillar industry......................................15

Fundamentals driving industry growth to remain intact ..........................................15
Chemical-Drugs/APIs .............................................................27
Pharmaceutical demand by therapeutic area ...........................................................32 Selected chemical drug companies in China...........................................................33
Medical Equipment/Devices ..................................................36

Key success factors in Medical Devices.................................................................37 Selected medical equipment/devices companies in China.......................................38
Traditional Chinese Medicines ..............................................40

Selected Pharmaceutical and TCM companies .......................................................42
Medical Distribution/Retailing ...............................................44

Selected companies with extensive drug-distribution businesses.............................48
Chinese Vaccine Market ........................................................50

Selected companies in the vaccine space................................................................51
Companies
China Shineway Pharmaceutical Group Limited ....................................................54 Concord Medical Services Holdings Limited .........................................................63 MicroPort Scientific Corp......................................................................................74 Mindray Medical...................................................................................................85 Shandong Weigao Group Medical Polymer Co. Ltd. ..............................................93 Sihuan Pharmaceutical Holdings ......................................................................... 104 Sino Biopharmaceutical....................................................................................... 115 Sinopharm .......................................................................................................... 127 The United Laboratories...................................................................................... 136
Investment summary
Poor performance creates opportunity
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 Chinas 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. Chinas healthcare 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
%
10.0%
0.0%
-10.0%
-20.0%
-30.0%
-40.0%
-50.0%
-60.0% 7/5/2011 7/12/2011 7/19/2011 7/26/2011 2877 HK 1066 HK 3933 HK
8/2/2011
8/9/2011 8/16/2011 8/23/2011 8/30/2011 853 HK 1177 HK MSCI APxJ Healthcare
9/6/2011 9/13/2011 9/20/2011 9/27/2011 MR US 1099 HK MSCI China Healthcare
CCM US 460 HK A-share Drug Index
Source: Bloomberg
Table 1: Summary of performance of companies against sector and regional healthcare companies
Company Name Covered Companies CHINA SHINEWAY (UW)* CONCORD MEDICAL (OW)* MICROPORT (N)* MINDRAY (OW)* SHANDONG WEIGAO (OW)* SIHUAN (OW)* SINO-BIOPHARM (OW)* SINOPHARM (OW)* UNITED LAB (N)* Coverage Universe Average Distribution Average Chemical Drugs Average TCM Average Medical Devices Average Biologicals Average HK/China Average Taiwan Average Korea Average India Average AU/NZ Average Singapore Average ASEAN Average Code 2877 HK CCM US 853 HK MR US 1066 HK 460 HK 1177 HK 1099 HK 3933 HK Price MCAP Vol (TP) US$MM US$mn 10.3 (12) 3.1 (6.4) 4.6 (5.5) 24 (32) 9.2 (12) 2.9 (4.9) 2.2 (3.5) 20.8 (30) 6.2 (7.5) 1,098.7 18.6 844.2 2,811.9 5,291.3 1,908.3 1,396.8 6,405.5 1,035.1 2,312.3 1,762.9 841.4 1,257.4 573.8 860.3 1,059.2 235.0 478.4 1,326.8 1,878.2 631.8 594.4 5.2 0.0 1.3 11.3 5.5 4.4 2.3 16.2 3.2 5.5 8.5 4.0 5.6 2.6 3.9 4.9 0.8 7.3 2.1 8.9 0.7 0.6 1M Chg 4.1 (5.3) 28.1 (2.8) 4.3 (3.3) 4.3 11.3 1.1 4.7 (7.9) (10.2) (9.4) (12.7) (11.0) (10.2) (8.6) 2.2 (3.2) 1.2 (0.6) 0.1 3M YTD Chg 11e PE 12e EPS CAGR Chg (%) (x) PE (x) (10_12e) (25.0) (24.7) (6.7) (9.2) (16.4) (14.0) (15.7) (15.7) (28.3) (17.3) (17.0) (14.8) (14.3) (16.5) (21.4) (16.8) (18.0) 5.5 (9.9) (11.0) (7.5) 0.1 (52.7) (56.8) (38.2) (6.4) (16.2) (47.5) (22.0) (22.9) (60.5) (35.9) (27.3) (20.7) (21.0) (6.5) (36.0) (22.3) (17.5) 20.1 (11.1) (0.3) (2.9) 12.3 9.2 6.7 18.2 16.7 35.0 14.8 29.1 26.8 14.9 19.0 29.0 27.6 25.4 26.6 24.5 26.6 25.8 89.3 16.6 26.3 20.6 14.8 9.8 5.3 15.2 14.5 26.3 11.9 25.2 22.0 9.8 15.6 23.3 20.0 20.3 19.8 26.6 22.0 15.1 16.0 14.2 15.1 16.7 13.3 -6.6% 19.6% 11.6% 12.9% 24.3% 23.2% 4.4% 21.8% -10.2% 11.2% 20.6% 41.3% 26.2% 37.3% 23.5% 29.8% 22.1% 36.3% 28.9% 7.8% 30.9% 8.1% PEG PEG EV EV/Sales '11E '12E (US$mn) ('11E) (1.4) (1.5) 0.3 0.3 1.6 1.3 1.3 1.1 1.4 1.1 0.6 0.5 6.7 5.8 1.2 1.0 (1.5) (1.0) 1.1 1.0 2.1 1.7 1.1 0.8 1.5 1.2 0.9 0.7 0.6 0.5 1.2 1.0 0.9 0.7 (0.8) (1.3) 0.5 0.4 1.1 1.2 1.4 1.2 2.1 1.9 1,090.4 20.9 974.1 1,970.0 5,175.0 2,458.1 1,546.4 7,336.6 2,256.5 2,536.4 1,249.5 1,180.4 1,378.9 2,207.1 1,281.5 1,459.5 284.6 403.8 1,514.7 2,319.4 495.8 622.0 3.1 2.3 2.5 2.4 10.1 6.2 2.2 0.5 2.6 3.5 1.0 5.9 9.1 47.4 10.0 14.7 21.9 9.8 10.1 53.2 2.9 4.5
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 Dec-10 Feb-11 Aug-11
Source: NDRC
No. of Drugs 17 162 82
Price Cut 12% 21% 14%
Drug Categories Involved 17 categories of EDL drugs 162 anti-infective and circulatory system drugs Hormonal and endocrine system drugs
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
4
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 sectors strong growth ahead.
Figure 2: Forward P/E of MSCI China Healthcare Index
50 45 40 35 30 25 20 15 10 5 0
Forward P/E
Source: Bloomberg
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 industrys 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 inhouse 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
6
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.
Table 3: Stock performance and drivers

Company Ticker % off 52-wk high Whats in the price CONCORD MEDICAL CCM US -57.0% Very large EDL exposure; Qing Kai Ling Sales affected greatly; the company lost EDL tendering in multiple provinces; GM to go down further Continued doubt with business model; overall bad performance by China ADRs Potential recovery drivers
CHINA SHINEWAY
2877 HK
-61.9%
EDL exposure may be over-estimated; non-injections perform really well and may pick up the slack
Diversifying into hospitals; Financial performance may get better recognition Stent price cut may be less than expected; Nano should not take away too much market share yet Firehawk success would fundamentally change MicroPort China business rebounding and may show continuing strength in 3Q, 4Q earnings; New products may show progress
MICROPORT SCIENTIFIC
853 HK
-45.8%
Stent price cut overhang; Lepus Nano may take away a large trunk of market share
MINDRAY MEDICAL
MR US -21.2%
overall business slowdown, particularly China business; Unimpressive new product launch
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 BIOPHARMACEU TICAL
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 8
Price Performance
4.0 3.5 HK$ 3.0 2.5 2.0
Sep-10 Dec-10 Mar-11 Jun-11 Sep-11
1177.HK share price (HK$) HSCEI (rebased)
YTD Absolute (%) Relative (%) Source: Bloomberg. -27.3 3.9
1M -12.5 2.7
3M -14.3 15.7
12M -34.2 -5.1
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 SBPs strong top-line growth well into the future. While many investors dislike SBPs 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 stocks decline may have been due to the investors concerns about continued SG&A deleveraging and apprehension about managements 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 established a 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 stocks 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 Sinopharms ability to continue performing even under today's tough macro-environment, with its 48% Y/Y growth in total revenue apparently reassuring 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 leverage its nationwide distribution network for additional businesses and acquisitions. The key drivers for the company going forward are: 1) M&A success; 2) receding price
9
OW, PT HK$3.5, 27.6x 2012E EPS Key drivers: sales of new products; Tide listing
Price Performance
35 HK$ 25 15
1M 4.7 19.9
3M -22.7 7.3
12M -37.9 -8.8
OW, PT HK$30, 32.0x 2012e EPS Key drivers: SG&A leveraging; M&A
pressures; and 3) financial results showing SG&A leveraging and finance cost in control.
Price Performance
34 30 $ 26 22 18
Oct-10 Jan-11 Apr-11 Jul-11 Oct-11
MR share price ($) HSCEI (rebased)
YTD Absolute (%) Relative (%) -6.7 16.1
1M -2.0 -0.3
3M -8.0 12.3
12M -20.8 5.5
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 2012E EPS) is undervalued. We think Mindray, as a predominant market leader in China, deserves a premium valuation. The companys 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 companys 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 the overall 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 positions in 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 companys 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 companys 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, and hence investors should look elsewhere within the healthcare space for better values
Source: Bloomberg.
OW, PT US$32, 19x 2012e EPS Key drivers: Continued China sales strength; M&A; and new product launch
Price Performance
25 HK$ 15 5
2877.HK share price (HK$) HSI (rebased)
YTD Absolute (%) Relative (%) -56.8 -33.7
1M -6.8 4.1
3M -35.7 -13.6
12M -61.1 -37.4
Source: Bloomberg.
UW, PT HK$12, 11.6x 2012e EPS Key drivers: EDL price pressure; NDRC policy of unified pricing
10
without overhangs of price cuts of key products and continued weak financial performance for some time.
Price Performance
9 7 $ 5 3
CCM share price ($) S&P500 (rebased)
1M -16.8 -10.4
3M -28.1 -10.2
12M -56.0 -52.7
Source: Bloomberg.
OW, PT US$6.4, 14x 2012e EPS Key drivers: Closing of Changan Hospital acquisition; Strong quarterly results; and M&A deal for centers
Concord Medical Services CCM US: Concord is the largest operator of thirdparty 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 companys 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 Changan 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 hospital is 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 Concords lease-and-management business model. We view the first reason as unfair and the second largely misplaced. After all, Concords financials are audited by E&Y professionals, directly supervised by the regional practice head. Most of Concords 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 2011E EPADS and 5.8x 2012E EPS, Concord shares are certainly undervalued in light of the companys growth potential. Low liquidity notwithstanding, we think this company offers a good opportunity for investors participate in the tremendous growth 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 MicroPorts over-reliance on a single stent product (Firebird II) as of now.
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Price Performance
9 HK$ 7 5 3

YTD Absolute (%) Relative (%) -48.8 -17.0 1M -0.5 14.7 3M -22.2 7.8% 12M -53.3 -24.2
Source: Bloomberg.
N, PT HK$5.5, 19x 2012e EPS Key drivers: Firehawk clinical progress; stent price cut; ramp up of ortho business
Over the past twelve months, MicroPort declined by 53%, underperforming the HSCEI index by 24%. The stock was down by 22% over the past three months along with the market and other healthcare names. We believe some level of pullback in MicroPort shares is understandable given its sky-high valuation attached to the company based on investor enthusiasm about a potential Shandong Weigao because both are strong players in the stent space. However, the severity of the pullback has surprised us. We think there are some key concerns about MicroPort, including: 1) the looming price cuts of stents; 2) the competition of Lepus Nano stent against Firebird II; and 3) MNC competition pressure. However, we recommend investors stay on the sideline, and wait for more clarity on the level of stent price cuts. We also see risks with the companys efforts to diversify away from its core competence area. On the other hand, we see tremendous upside in MicroPort shares if the clinical trials of Firehawk are successful.
Price Performance
6.5 5.5 HK$ 4.5 3.5 2.5
1M 0.8 16.0
3M -27.3 2.7
12M -42.8 -13.7
Source: Bloomberg.
OW, PT HK$4.9, 21x 2012E EPS Key drivers: Rebounding of Kelinao/Anjieli business; Continued strength of Oudimei.
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. Sihuans 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 in Kelinao/Anjieli, given the poor 1H11 results, we are encouraged by the initial sales performance of Oudimei. The strong performance was substantiated by the hospital purchases 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$6.19, the price has been cut by an half, and the shares are currently trading at less than 12.7x our 2012E EPS. This is probably uncalled for, in our view, in light of its historically strong financial performance, its leadership position in cardio-cerebral medicine and the ability to develop related new products to boost growth better than most peers and its growth potential. We think the weakness in Sihuan shares are probably caused by three factors: 1) slowdown of Kelinao/Anjieli sales; 2) potential price cuts for CCV drugs; and 3) concerns about the absorption of all these new acquisitions post-IPO. We believe Sihuans shares are likely to rebound as: 1) Oudimei appears to have the potential to take over Kelinao as the key driver for continued growth; 2) Kelinao and Anjielis sales are likely to rebound after the removal of reimbursement restrictions; and 3) the new acquisitions appear to be complementary to the company's business and will drive future growth.
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Price Performance
13 11 HK$ 9 7
1066.HK share price (HK$) MSCI-Cnx (rebased)
1M -7.5 6.0
3M -25.6 -2.9
12M -21.2 3.9
OW, PT HK$11.5, 33x 2012e EPS Key drivers: rollout of pilot dialysis centers; favorable terms for JW Medical divesture; unabated growth momentum
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, Weigaos 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. Weigaos 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, Weigaos products are mostly disposable consumables that patients rely on daily and are largely non-discretionary, which we view as a distinct advantage with Weigaos business model. Weigaos 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. Weigaos stock has traded down 24% year-to-date and down 25.6% in the past three months. While the CFO announced the resignation during the companys 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 companys hyper-strong growth enjoyed for the past few years; and 4) high valuation. Even after the pullback, Weigaos 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 offers an opportunity for the investors to add to their existing positions or to establish new positions. Some key catalysts that could drive Weigaos 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 companys low-cost 6-APA facility in Mongolia has a distinct competitive edge. Its enzyme process for amoxicillin production is likely to expand segment margins for 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 companys 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.
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Price Performance
20 16 HK$ 12 8 4
1M -20.1 -9.0
3M -45.9 -24.9
12M -64.8 -42.7
Source: Bloomberg.
N, PT HK$7.5, 11.9x 2012E EPS Key drivers: 6-APA price: recovery of bulk medicine business; sales ramp up of insulin products
Table 4: Summary of Changes to Our EPS Estimates, Ratings, and 12-month Price Targets for Companies Under coverage
Company Name CHINA SHINEWAY CONCORD MEDICAL (OW)* MICROPORT SCIENTIFIC MINDRAY MEDICAL SHANDONG WEIGAO SIHUAN SINO BIOPHARMACEUTICAL SINOPHARM UNITED LABORATORIES Code 2877 HK CCM US 853 HK MR US 1066 HK 460 HK 1177 HK 1099 HK 3933 HK Rating New UW OW N OW OW OW OW OW N Prior UW OW OW OW OW OW OW OW OW New HK$12.0 US$6.4 HK$5.5 US$32.0 HK$12.0 HK$4.9 HK$3.5 HK$30.0 HK$7.5 Price Target Prior HK$22.0 US$7.0 HK$7.2 US$40.0 HK$15.0 HK$7.4 HK$3.6 HK$35.0 HK$22.0 Change -45.5% -8.6% -23.6% -20.0% -20.0% -33.8% -2.8% -14.3% -65.9% New 0.922 0.51 0.206 1.63 0.215 0.158 0.110 0.635 0.416 2011E EPS Prior 0.967 0.46 0.193 1.62 0.251 0.167 0.114 0.803 0.961 Change -4.6% -10.8% 6.8% 0.7% -14.4% -5.1% -2.9% -20.9% -56.7% New 0.863 0.68 0.245 1.86 0.287 0.198 0.127 0.774 0.630 2012E EPS Prior 1.046 0.56 0.242 1.88 0.336 0.214 0.134 1.157 1.411 Change -17.5% -17.8% 1.3% -1.2% -14.7% -7.6% -5.0% -33.1% -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 derive cost 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.
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Healthcare a major pillar industry

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, Alzheimers, 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
20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 -
% GDP (1980)
Source: OECD, Chinese government websites.
% GDP (1990)
% GDP (2000)
% GDP (2009)
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.
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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$10bn and the total market capitalization of all public-traded healthcare companies is about 4.2% of all the listed companies, as per Bloomberg estimates. Post-healthcare reform, we believe that many strong companies will emerge that will be attractive to investors. Companies with strong R&D capabilities and sales network should be long-term winners, in our view. We expect healthcare companies as an aggregate will eventually account for more and more of the Chinese market capitalization, and take their rightful place in the market, given their importance to the economy as a whole, i.e. healthcare spending will eventually account for ~10% of the GDP by 2020.
Table 5: Chinese under-capitalized healthcare companies compared with global peers
# of Public Companies 238 1,001 189 148 97 HC Market Cap ($bn) 4,790.0 14,770.0 1,210.0 3,670.0 2,510.0 Average Market Cap ($mn) 840.3 1,468.5 305.2 1,526.3 1,824.9 Total Market Cap ($bn) 200.0 1,470.0 57.7 225.9 177.0 HC % of Total 4.2% 10.0% 4.8% 6.2% 7.1%
China US India Japan UK
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$bn) China Spain Japan Italy UK Canada Germany France US
Source: WHO.
Per Capita ($) 2001 50.0 1,596.0 2,609.0 2,358.0 2,478.0 2,853.0 3,537.0 3,227.0 4,915.0
Per Capita ($) 2006 92.0 2,387.0 2,626.0 3,002.0 3,552.0 3,799.0 3,870.0 4,278.0 6,714.0
01-06 CAGR (%) 13.0 8.4 0.1 4.9 7.5 5.9 1.8 5.8 6.4
121.5 105.2 355.0 175.0 215.0 123.9 318.0 262.0 2,010.0
More prosperity to accelerate healthcare spending rising income leading to heightened 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 medical conditions. 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
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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 healthcarerelated products.
Figure 4: Rising disposal income propelling out-of-pocket spending on healthcare
30000 20000 10000 0 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 -10000 -20000 -30000 GDP per Capita (Rmb)
Source: Statistics Bureau; J.P. Morgan estimates.
40% 30% 20% 10% 0% -10% -20% -30% -40% Per Capita Real GDP
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
1,900.0 Healthcare Spending % of GDP Y/Y Growth 1,980.0 35%
1,700.0
30% 1,611.9 1,453.5 25%
1,500.0
1,300.0 1,157.4 1,100.0 866.0 759.0 700.0 458.7 502.6 658.4 579.0 984.3
20%
15%
900.0
10%
500.0 319.7 300.0 367.9
5%
404.8
0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: CEIC, MOH, and other Government Websites
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Figure 6: Rural versus city spending (Rmb bn) suggests considerable room to grow as Rural Co-op insurance takes off
1200 1000 800 600 400 200 0 1990 1995 2000 2001 2002 2003 2004 2005 2006 2007 City
Source: Ministry of Health
Rural
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 governments 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 Alzheimers 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
90.0 80.0 70.0 60.0 50.0 40.0 30.0 1950-1955 1955-1960 1960-1965 1965-1970 1970-1975 1975-1980 1980-1985 1985-1990 1990-1995 1995-2000 2000-2005 2005-2010 2010-2015 2015-2020 2020-2025 2025-2030 2030-2035 2035-2040 2040-2045 2045-2050
Source: UN, 2009. Source: United Nations. 18
Figure 8: China's ageing population puts extra demand on healthcare
Life Expectancy at Birth

Life Expectancy at Birth
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 worlds 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.
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Figure 9: Personal contribution to healthcare spending declining - still quite a lion's share
100% 80% 60% 40% 20% 117 121 80 2001 154 91 2002 271 301 334 368 407 452 485 510 588
179 112 2003 Government
223 129 2004 Social
259 155 2005 Personal
321 178 2006
389 258 2007
507 359 2008
71 0% 2000
Source: Source: CEIC and J.P. Morgan estimates.
Figure 10: % of public spending on healthcare by Chinese government still below World average
%
100.00
80.00
60.00
40.00
20.00
0.00 2001 2002 2003 2004 2005 2006 2007 2008 2009
World
Source: The World Bank.
China
India
Japan
United Kingdom
United States
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Table 7: Three different insurance schemes dramatically to expand insurance coverage greatly
Basic Medical Insurance System Launch Date Qualified Individuals Participation 1999 Urban workers Mandatory 2010: 237 mm (~100%) New Rural Cooperative Health Care System 2003 Rural residents Voluntary 2009: 833 mm (94%) Urban Residents' Basic Medical Insurance 2007 Urban non-workers (Students, elderly, etc) Voluntary 2010: 195 mn
900 800 700 600 500 400

Covered Population
300 200 100 0 2005 2006 2007 2008 2009 2010
New Rural Cooperative Health Care System Basic Medical Insurance System
Source: MOH, NDRC, and MOHRSS; Left axis shows people insured in millions
Urban Residents' Basic Medical Insurance
Coverage Plan
Basic medications, hospitalization, in-patient expenses
Hospitalization and in-patient expenses Maximum reimbursement rate: 75% Max: Rmb60,000 (depending on region)
Hospitalization and major illness
Premium payer breakdown
Employer: 6% of employee's salary & up to 4% of supplementary insurance Employee: 2% of salary
Central government: Rmb60/person/year Local government: Rmb60/person/year Individual: Rmb30/person/year (varies among different regions)
Individual contribution varies among children, elderly, handicapped, etc Government: Rmb120/person/year (varies among regions)
Government spending
2006: Rmb130 billion
2008: Cumulatively up to Rmb85mn
2007: Rmb7 billion
Key Ministries Involved
Ministry of Human Resources & Social Security Ministry of finance Ministry of health SFDA
Department of Rural Health Management of Ministry of Health Ministry of Finance
Ministry of Human Resources & Social Security Ministry of Finance Ministry of Health, NDRC
Source: Chinese government websites.
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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) 2) 3) 4) 5) To further expand medical insurance coverage and to increase the medical insurance participation rate To set up a national essential drug system To establish an extensive public health system To provide equal public health services in both rural and urban areas 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 socalled 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
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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 with Anhui 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 provinces 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 governments 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 () products are divided into four classes, according to the qualities of manufacturers to tender their bids: 1) Highest23
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 2010 2010 2010 2009 2011 Formulation Categories 127 75 64 47 20 19 Dosage Forms 2 2 2 2 1 Quality Classes 4 4 4 4 5 Potential Winning Bids 2.5 2.5 2.5 2.5 2.5 Total Winning Bids 2,540 1,500 1,280 940 250
Henan Hebei Zhejiang Guangdong Fijian 2009 NDRL
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 58%, 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 Biopharmas 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
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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 Chinas 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 coststructure 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 () 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 governments decision process regarding drug pricing.
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Table 9: Asian Healthcare Comparison

Company Name Covered Companies CHINA SHINEWAY (UW)* CONCORD MEDICAL (OW)* MICROPORT (N)* MINDRAY (OW)* SHANDONG WEIGAO (OW)* SIHUAN (OW)* SINO-BIOPHARM (OW)* SINOPHARM (OW)* UNITED LAB (N)* Average CHINA NATIONAL-A (NR) CHINA NEPSTA-ADR (NR) JOINTOWN PHARM-A (NR) SHANGHAI PHARM-H (NR) SHENZ ACCORD-A (NR) Distribution Average CHINA MEDICAL SY (NR) CHINA PHARMACEUT (NR) HARBIN PHARMA-A (NR) JIANGSU HENGRU-A (NR) NORTH CHINA PHAR (NR) SHANGHAI FOSUN-A (NR) SIMCERE PHAR-ADR (NR) ZHEJIANG HISUN-A (NR) ZHEJIANG HUAHAI (NR) Chemical Drugs Average BEIJING TONGRE-A (NR) CHINA RESOURCE-A (NR) GUANGZHOU PHAR-H (NR) JIANGZHONG PHM-A (NR) KANGMEI PHARMA-A (NR) LIJUN INTL PHARM (NR) SHANDONG DONG-A (NR) TIANJIN TASLY-A (NR) YUNNAN BAIYAO-A (NR) TCM Average CHINA KANGHU-ADR (NR) CHINA MEDIC-ADR (NR) EDAN INSTRUMEN-A (NR) LEPU MEDICAL-A (NR) MINGYUAN MEDICA (NR) SHINVA MEDICAL-A (NR) TRAUSON HOLDINGS (NR) Medical Devices Average AIER EYE HSPTL-A (NR) CHINA CORD BLOOD (NR) CHINA RENJI MED (NR) Hospital Services Average 3SBIO INC-ADR (NR) BEIJING TIAN-A (NR) HUA HAN BIO-PHAR (NR) HUALAN BIOLOGI-A (NR) LEE'S PHARM (NR) SINOVAC BIOTECH (NR) TONGHUA DONGBA-A (NR) WALVAX BIOTECH-A (NR) Biologicals Average SHANGPHARMA-ADR (NR) WUXI PHARMAT-ADR (NR) CRO Average Code 2877 HK CCM US 853 HK MR US 1066 HK 460 HK 1177 HK 1099 HK 3933 HK 600511 CH NPD US 600998 CH 2607 HK 000028 CH 867 HK 1093 HK 600664 CH 600276 CH 600812 CH 600196 CH SCR US 600267 CH 600521 CH 600085 CH 000999 CH 874 HK 600750 CH 600518 CH 2005 HK 000423 CH 600535 CH 000538 CH KH US CMED US 300206 CH 300003 CH 233 HK 600587 CH 325 HK 300015 CH CO US 648 HK SSRX US 600161 CH 587 HK 002007 CH 950 HK SVA US 600867 CH 300142 CH SHP US WX US Price MCAP Vol (TP) US$MM US$mn 10.3 (12) 3.1 (6.4) 4.6 (5.5) 24 (32) 9.2 (12) 2.9 (4.9) 2.2 (3.5) 20.8 (30) 6.2 (7.5) 15.6 2.2 11.9 14.3 25.2 5.4 1.8 9.4 29.3 8.5 9.6 8.8 32.5 14.0 13.2 18.3 4.7 23.6 14.0 0.8 41.5 40.4 55.6 19.3 4.9 24.9 15.7 0.3 28.2 2.0 22.3 2.9 0.1 10.3 16.4 1.4 22.4 2.6 2.2 8.6 53.7 8.1 11.6 1,098.7 18.6 844.2 2,811.9 5,291.3 1,908.3 1,396.8 6,405.5 1,035.1 2,312.3 1,174.6 230.6 2,644.7 5,695.0 1,015.8 1,350.0 1,119.0 349.9 2,378.0 5,166.3 1,376.2 2,870.6 469.9 2,674.5 1,184.4 1,954.3 2,702.0 2,814.4 1,226.8 1,151.8 4,824.7 235.6 4,257.2 3,275.7 6,054.6 2,949.2 441.0 156.8 389.8 1,993.2 153.8 593.4 197.0 560.7 1,496.9 216.6 104.4 606.0 225.0 1,326.0 353.6 2,024.5 153.8 121.0 1,047.0 1,264.1 814.4 151.8 820.8 486.3 5.2 0.0 1.3 11.3 5.5 4.4 2.3 16.2 3.2 5.5 12.6 0.1 6.2 3.7 2.0 6.3 0.4 1.1 13.0 9.8 10.0 8.9 0.5 3.9 3.7 5.7 14.0 7.5 0.7 4.4 21.2 0.3 18.1 10.9 9.1 9.6 1.8 1.1 1.9 3.1 0.2 2.8 0.2 1.6 4.8 0.1 1.6 0.7 7.6 0.6 16.6 0.1 0.6 7.8 4.0 4.7 0.1 4.1 2.1 1M Chg 4.1 (5.3) 28.1 (2.8) 4.3 (3.3) 4.3 11.3 1.1 4.7 (8.8) (12.9) 6.9 (14.7) (7.6) (4.9) (3.4) (19.1) (1.6) (3.1) (12.3) (5.4) (9.2) (11.7) (11.5) (8.6) (13.8) (9.6) (25.7) (9.0) (9.2) (23.5) (6.4) (5.2) (7.8) (12.2) 0.6 (4.0) (10.2) (15.8) (22.4) (11.5) (26.2) (12.8) (7.0) (6.1) (4.4) (20.3) (8.1) (17.0) (13.8) (3.4) (2.2) (2.2) (13.0) (10.0) (4.2) (7.5) (5.9) 3M YTD Chg 11e PE 12e EPS CAGR Chg (%) (x) PE (x) (10_12e) (25.0) (24.7) (6.7) (9.2) (16.4) (14.0) (15.7) (15.7) (28.3) (17.3) (5.5) (26.2) (2.3) (28.5) (8.4) (11.3) (10.1) (51.4) (23.1) (7.0) (29.8) (15.6) (12.1) (16.1) (6.7) (19.1) (19.5) (1.7) (36.2) (5.3) (0.1) (48.6) (4.2) (3.7) (6.9) (14.0) (14.3) (37.6) (20.1) (19.2) (44.3) (14.6) (37.5) (26.8) 6.5 (11.7) (1.7) (43.0) (4.8) (38.8) (37.4) (14.1) (26.2) (6.6) (6.6) (22.2) (26.1) (31.7) (28.9) (52.7) (56.8) (38.2) (6.4) (16.2) (47.5) (22.0) (22.9) (60.5) (35.9) (36.3) (37.9) (17.7) na (23.2) (30.6) (7.5) (56.7) (43.9) (26.1) (45.7) (28.0) (22.9) (15.2) 11.6 (26.0) (2.7) (27.1) (63.5) (33.8) (16.2) (65.9) (18.3) 0.7 (7.8) (26.1) 4.3 (56.8) (42.2) (72.4) 0.7 (44.2) (35.1) (18.9) (26.9) (15.2) (32.1) (28.0) (44.3) (53.3) (28.3) (50.9) (20.2) (39.2) (37.0) (29.2) (28.4) (28.8) 9.2 6.7 18.2 16.7 35.0 14.8 29.1 26.8 14.9 19.0 na 35.8 34.4 15.4 21.8 35.1 17.0 5.1 11.8 35.2 40.6 15.3 15.9 33.0 32.4 22.9 39.8 18.6 9.3 27.8 27.4 6.6 27.4 32.2 31.5 24.5 25.0 2.8 25.9 23.9 9.8 36.5 9.5 19.1 49.0 12.3 na 30.6 14.1 40.0 6.0 19.4 15.0 22.2 na 35.2 21.7 8.4 10.3 9.4 9.8 5.3 15.2 14.5 26.3 11.9 25.2 22.0 9.8 15.6 na 29.6 26.3 12.7 16.9 27.9 12.9 4.8 10.0 27.8 23.7 13.7 14.1 24.1 25.1 17.4 32.9 15.0 8.0 19.9 20.3 5.5 21.3 25.9 24.2 19.2 19.9 2.4 18.3 18.6 8.7 25.1 8.1 14.4 33.4 10.1 na 21.8 10.7 34.2 4.4 18.0 11.1 88.8 na 25.2 27.5 7.1 9.0 8.1 -6.6% 19.6% 11.6% 12.9% 24.3% 23.2% 4.4% 21.8% -10.2% 11.2% na 11.8% 29.4% 15.2% 19.1% 20.6% 48.5% -2.1% 15.7% 21.6% 155.2% 6.4% 15.4% 22.5% 34.8% 35.3% 14.2% 20.2% 15.1% 25.0% 25.3% 13.6% 32.3% 13.6% 22.9% 20.2% 39.2% 68.5% 24.1% 29.1% 15.9% 34.0% 11.6% 31.8% 54.2% 9.9% na 32.1% 31.4% 22.2% 6.2% 17.3% 27.8% na na 26.4% 21.9% 27.6% 14.6% 21.1% PEG PEG EV '11E '12E (US$mn) (1.4) (1.5) 1,090.4 0.3 0.3 20.9 1.6 1.3 974.1 1.3 1.1 1,970.0 1.4 1.1 5,175.0 0.6 0.5 2,458.1 6.7 5.8 1,546.4 1.2 1.0 7,336.6 (1.5) (1.0) 2,256.5 1.1 1.0 2,536.4 na na 1,057.2 3.0 2.5 107.5 1.2 0.9 3,518.8 1.0 0.8 1.1 0.9 1,078.9 2.1 1.7 1,561.2 0.3 0.3 124.2 (2.4) (2.3) 965.0 0.8 0.6 3,759.5 1.6 1.3 5,152.8 0.3 0.2 2,664.8 2.4 2.2 3,751.2 1.0 0.9 3,869.9 1.5 1.1 3,245.2 0.9 0.7 1,249.3 0.7 0.5 2,753.5 2.8 2.3 2,739.6 0.9 0.7 2,569.5 0.6 0.5 669.2 1.1 0.8 1,126.3 1.1 0.8 3,974.2 0.5 0.4 509.8 0.8 0.7 3,978.4 2.4 1.9 3,396.5 1.4 1.1 6,021.8 1.3 1.0 2,776.1 0.6 0.5 20,321.5 0.0 0.0 2,709.2 1.1 0.8 0.8 0.6 3,298.1 0.6 0.5 182.4 1.1 0.7 673.7 0.8 0.7 218.1 0.7 0.6 4,567.2 0.9 0.6 1,741.7 1.2 1.0 156.0 na na 113.6 1.1 0.8 670.5 0.4 0.3 279.0 1.8 1.5 1,508.4 1.0 0.7 382.2 1.1 1.0 2,955.6 0.5 0.4 164.0 na na 122.6 na na 1,057.9 1.3 1.0 1,758.6 1.0 0.8 1,028.5 0.3 0.3 154.4 0.7 0.6 1,115.2 0.5 0.4 634.8 EV/Sales ('11E) 3.1 2.3 2.5 2.4 10.1 6.2 2.2 0.5 2.6 3.5 0.9 1.1 0.9 0.4 1.0 4.4 0.9 1.7 26.9 3.8 6.5 3.8 4.7 6.6 3.7 13.8 2.1 12.9 5.2 1.8 31.3 3.8 14.0 9.8 262.0 73.2 132.2 6.8 12.6 8.7 82.6 8.5 10.7 9.6 12.3 7.1 1.5 15.1 3.6 10.1 24.4 10.6 5.3 10.9 8.1
Source: * J.P. Morgan estimates. Bloomberg estimates for other non rated companies. Share prices as of 11 Oct 2011.
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Chemical-Drugs/APIs
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 industrys shortterm 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 (20052009)
Hospital purchase (Rmb MM) 300000 250000 200000 150000 100000 50000 0 2005 2006 2007 2008 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 worlds 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.
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Figure 12: Hospital sales to continue growing at a robust pace

Rmb 'bn
400.0 35.0%
350.0
30.0%
300.0 25.0% 250.0 20.0% 200.0 15.0% 150.0 10.0% 100.0 5.0%
50.0
1998 1999 2000 2001 2002 2003 2004 2005 Sales 2006 2007 2008e 2009e 2010e 2011e 2012e 2013e Y/Y Growth
0.0%
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.
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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 12month 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 lions 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
29
drugs to be purchased. Manufacturers or their agents must make the sales so that the drugs get prescribed by physicians.
Table 10: While inflation is running amok, drug prices have been cut 28 times since 1997
# 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 Date Dec-97 Apr-98 Apr-99 Jun-99 Aug-99 Jan-00 Jun-00 Oct-00 Apr-01 Jul-01 Dec-01 Dec-02 Jan-03 Sep-03 Jun-04 Jul-04 Oct-05 Jun-06 Aug-06 Nov-06 Jan-07 Feb-07 Apr-07 May-07 Dec-07 Dec-10 Feb-11 Aug-11 No. of Drugs 47 38 21 150 2 12 9 21 69 49 383 199 267 107 24 18 22 67 99 32 10 278 240 260 26 17 162 82 60% 23% 30% 15% 20% 15% 20% 19% Raising price floor 12% 21% 14% 30% Price Cut 15% 10% 20% 5% 15% 10% 15% 20% 20% 15% 20% 15% 14% Drug Categories Involved 15 Antibiotics / 32 Biotech Heat Clearing Cephalosporins Imported drugs: Cefuoxime, etc. Biological: Defibrase, etc. Biotech drugs: Human (Serum) Albumin, etc. Cefradine, etc. Ampicillin, etc. Anti-infective drugs TCM oncology, circulation system, CNS Chemical drugs TCM TCM Anti-infective drugs Drugs with Independent Pricing Anti-infective drugs Chemotherapies Anti-microbials Oncology TCM Cardiovascular Internal TCM Specialist TCM Chemical drugs Low-cost Drugs 17 categories of EDL drugs 162 anti-infective and circulatory system drugs 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 are generally referred to as the originator drug, when the generic drug equivalents become available. Based on IMS data, since 2005, generic drugs have accounted for over 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.
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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 countrys 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.
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Pharmaceutical demand by therapeutic area

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.
Figure 13: Top ten therapeutic areas (2009)
Dermatologicals 1% Genito-Urinary Tract and Sex Hormones 1% Musculo-Skeletal System 2% Respiratory System 2% Antineoplastic and Immunomodulating Agents 10% Others 21% General Anti-infectives, Systemic 26%
Alimentary Tract and Metabolism 13%
Blood and Blood Forming Organs 5%
Cardiovascular System 12%
Nervous System 7%
Source: IMS Report
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Selected chemical drug companies in China

Yangzijiang Pharmaceutical Group Co Ltd (Private) 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 companys 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 Chinas 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 firstto-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.
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Table 11: Major Chinese Chemical Drug Companies and Their Valuations (Most major pharma with Market Cap above $100mn)
Company Name Code Price MCAP Vol (TP) US$MM US$mn 2.9 (4.9) 1,908.3 2.2 (3.5) 1,396.8 6.2 (7.5) 1,035.1 7.7 9.1 19.1 0.5 29.3 5.4 1.8 28.2 41.6 20.9 67.5 2.3 0.5 6.7 21.6 22.4 9.6 11.6 23.9 16.5 21.3 9.4 10.9 24.5 10.8 6.6 24.8 9.1 18.6 275.0 35.0 13.4 11.0 29.3 13.7 19.3 7.9 8.9 7.3 13.1 0.8 7.4 23.4 8.5 9.9 7.2 12.6 5.2 6.1 6.3 6.7 9.6 11.6 23.6 11.8 15.2 27.0 32.1 315.2 218.3 1,712.7 254.5 172.1 1,119.0 349.9 589.2 861.7 601.1 137.9 233.9 136.8 319.9 338.8 632.1 2,870.6 850.5 929.7 516.4 936.3 2,378.0 992.3 413.6 340.6 434.8 1,687.1 359.7 537.4 221.3 549.0 262.5 1,553.3 5,166.3 250.5 709.8 195.3 703.6 1,508.5 812.4 305.1 407.9 366.9 1,376.2 518.3 656.3 420.5 403.4 141.2 574.7 358.9 2,870.6 324.0 974.9 534.4 319.8 610.7 1,828.1 4.4 2.3 3.2 3.1 0.8 4.7 0.1 2.7 0.4 1.1 1.2 1.2 3.6 0.1 0.3 2.4 0.7 2.3 8.9 5.6 5.9 2.8 2.6 13.0 2.0 12.7 3.0 1.9 2.2 3.6 14.8 3.1 1.1 2.8 9.8 5.2 1.7 3.2 5.6 4.3 0.2 0.0 4.9 1.9 10.0 5.3 3.7 1.2 0.2 5.0 4.2 1.2 8.9 1.4 4.0 3.6 16.2 1.2 5.1 1M Chg (3.3) 4.3 1.1 (4.2) (10.4) (21.1) (1.0) (11.4) (3.4) (19.1) (6.1) (8.5) 6.0 na (5.8) (27.3) (0.3) (10.4) (7.6) (5.4) (14.9) (8.3) (12.9) (15.2) (1.6) (4.4) (16.8) (13.0) (12.7) (9.8) (11.4) na (19.7) (6.2) (7.6) (11.9) (3.1) (12.1) (5.1) (30.1) 3.0 (7.5) (17.7) (9.1) (13.7) (8.3) (12.3) (19.9) (13.8) (9.9) (17.2) (6.2) (11.8) (2.6) (5.4) (12.6) (8.1) (12.8) (24.4) (12.4) (13.0) 3M Chg (14.0) (15.7) (28.3) (16.4) (17.3) (22.3) 35.6 (19.9) (10.1) (51.4) (8.6) (9.6) (5.8) na (10.6) (25.0) (9.6) (9.4) (15.8) (15.6) (22.4) 6.9 (12.2) (12.7) (23.1) (13.1) na (17.2) (16.6) (5.8) (22.4) na (38.5) (1.2) (11.8) (20.2) (7.0) (14.5) 3.1 (26.2) (1.5) (21.3) (35.4) (27.3) (20.1) (2.9) (29.8) (38.7) (27.5) (16.5) (31.1) (0.2) (23.8) (10.0) (15.6) (0.6) (11.8) (11.6) na (16.2) (9.9) YTD Chg (%) (47.5) (22.0) (60.5) (22.8) (27.6) (32.3) 2.1 (11.4) (7.5) (56.7) 14.4 (35.4) (22.5) (10.0) (33.1) (24.3) (28.0) (32.2) (19.3) (58.6) (44.2) (43.9) (20.8) (15.3) (33.3) (24.6) (19.8) (45.0) (33.6) (14.3) (26.1) (22.7) (18.2) (15.2) (18.7) (34.1) (53.0) (31.3) (22.4) (45.7) (42.2) (28.8) (32.9) (46.3) 0.3 (26.0) (12.5) (28.0) (1.4) (24.6) (37.9) (28.2) 11e EPS 12e PE CAGR PE (x) (x) (10_12e) 14.8 29.1 14.9 35.1 32.5 18.1 11.1 na 17.0 5.1 na na 43.9 na 8.2 na na na 19.4 15.3 19.5 45.2 22.2 21.7 11.8 na 23.2 na 20.6 25.7 41.4 30.8 na 41.3 21.3 na 35.2 na 41.7 na 19.8 11.3 6.5 na 26.5 36.8 40.6 13.6 na 31.4 na na na na 15.3 na 33.9 24.7 36.0 25.5 24.1 11.9 25.2 9.8 27.6 23.4 14.5 na na 12.9 4.8 na na 32.9 na 6.7 na na na 15.2 13.7 15.2 23.7 na 15.8 10.0 na 16.9 na 6.7 20.5 24.6 21.3 na 26.8 15.7 na 27.8 na 30.3 na 15.9 9.3 5.6 na 13.0 28.5 23.7 7.8 na 23.2 na na na na 13.7 na 24.2 18.8 26.8 17.3 18.3 23.2% 4.4% -10.2% 48.2% 18.0% 19.6% na na 48.5% -2.1% na na 62.9% na 13.9% na na na 41.9% 6.4% 21.9% 35.4% na 46.5% 15.7% na 39.6% na 263.8% 22.0% 144.3% 34.9% na 36.5% 48.9% na 21.6% na 39.8% na 14.2% 29.4% 16.1% na 234.7% 37.2% 155.2% na na 12.1% na na na na 6.4% na 43.7% 28.3% 8.8% 35.5% 33.6% PEG '11E 0.6 6.7 (1.5) 0.7 1.8 0.9 na na 0.3 (2.4) na na 0.7 na 0.6 na na na 0.5 2.4 0.9 1.3 na 0.5 0.8 na 0.6 na 0.1 1.2 0.3 0.9 na 1.1 0.4 na 1.6 na 1.0 na 1.4 0.4 0.4 na 0.1 1.0 0.3 na na 2.6 na na na na 2.4 na 0.8 0.9 4.1 0.7 0.7 PEG EV EV/Sale '12E (US$mn) s ('11E) 0.5 5.8 (1.0) 0.6 1.3 0.7 na na 0.3 (2.3) na na 0.5 na 0.5 na na na 0.4 2.2 0.7 0.7 na 0.3 0.6 na 0.4 na 0.0 0.9 0.2 0.6 na 0.7 0.3 na 1.3 na 0.8 na 1.1 0.3 0.3 na 0.1 0.8 0.2 na na 1.9 na na na na 2.2 na 0.6 0.7 3.1 0.5 0.5 2,458.1 1,546.4 2,256.5 411.3 256.4 2,173.1 1,022.4 577.7 124.2 965.0 950.0 520.2 239.1 228.2 390.3 445.1 680.4 3,751.2 1,181.3 793.2 1,026.3 1,449.1 3,759.5 1,178.7 424.8 706.7 1,827.0 491.7 574.1 330.1 2,699.5 5,152.8 282.0 875.3 248.2 609.7 1,998.1 1,316.9 2,229.3 523.2 411.3 2,664.8 1,009.8 972.1 552.6 432.4 141.4 850.5 462.7 3,751.2 363.5 1,175.9 628.4 2,434.6 6.2 2.2 2.6 1.6 8.8 2.4 1.9 4.4 0.9 5.6 1.4
Covered Compaies SIHUAN (OW)* 460 HK SINO-BIOPHARM (OW)* 1177 HK UNITED LAB (N)* 3933 HK Non-covered Chemical Drug Names ANHUI FENGYUAN P (NR) 000153 CH BEIJING BEILU-A (NR) 300016 CH BEIJING DOUBLE-A (NR) 600062 CH C & O PHARMCEUTI (NR) COPT SP CATHAY INTL HLDG (NR) CTI LN CHINA MEDICAL SY (NR) 867 HK CHINA PHARMACEUT (NR) 1093 HK CHONGQING FUAN-A (NR) 300194 CH CHONGQING HUAP-A (NR) 002004 CH CHONGQING LUMM-A (NR) 300006 CH COLAND HOLDINGS (NR) 4144 TT DAWNRAYS PHARMAC NR) 2348 HK EXTRAWELL PHARM (NR) 858 HK GINWA ENTERP-A (NR) 600080 CH GUANGDONG TAIA-A (NR) 002433 CH GUANGDONG ZHON-A (NR) 002317 CH SHANGHAI FOSUN-A (NR) 600196 CH GUANGZHOU BAIY-A (NR) 000522 CH HAINAN HAIYAO-A (NR) 000566 CH HAINAN HONZ-A (NR) 300086 CH HARBIN GLORIA-A (NR) 002437 CH HARBIN PHARMA-A (NR) 600664 CH HARBIN PHARMACEU (NR) 600829 CH HEBEI CHANGSHA-A (NR) 300255 CH HENAN LINGRUI-A (NR) 600285 CH HENAN TOPFOND-A (NR) 600253 CH HUADONG MEDICI-A (NR) 000963 CH HUBEI GUANGJI-A (NR) 000952 CH HUNAN ER-KANG -A (NR) 300267 CH HUTCHISON CHINA (NR) HCM LN HYBIO PHARMACE-A (NR) 300199 CH INNER MONGOLIA-A (NR) 300049 CH INNER MONGOLIA-A (NR) 600277 CH JIANGSU HENGRU-A (NR) 600276 CH JIANGSU LIANHU-A (NR) 600513 CH JIANGSU NHWA -A (NR) 002262 CH JILIN PHARMACE-A (NR) 000545 CH JINLING PHARM-A (NR) 000919 CH JOINCARE PHARM-A (NR) 600380 CH LIVZON PHARMAC-B (NR) 200513 CH LUYE PHARMA GROU (NR) LUYE SP MERRO PHARMACE-A (NR) 600297 CH NANTONG JINGHU-A (NR) 002349 CH NORTH CHINA PHAR (NR) 600812 CH NORTHEAST PHAR-A (NR) 000597 CH PKU INTERNATIO-A (NR) 000788 CH QINGDAO HUAREN-A (NR) 300110 CH SD LUOXIN PHAR-H (NR) 8058 HK SHANDONG JINTA-A (NR) 600385 CH SHANDONG LUK-A (NR) 600789 CH SHANDONG XINHU-A (NR) 000756 CH SHANGHAI FOSUN-A (NR) 600196 CH SHANGHAI FUREN-A (NR) 600781 CH SHANGHAI KAIBA-A (NR) 300039 CH SHANGHAI MODER-A (NR) 600420 CH SHANXI C&Y PHA-A (NR) 300254 CH SHANXI ZHENDON-A (NR) 300158 CH SHENZHEN SALUB-A (NR) 002294 CH
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3.8 1.9 6.6 12.0 1.7
1.1 1.8 7.5 26.9 11.2 6.0
1.1 8.5
3.8 8.9 2.3 10.1
Company Name SHIJIAZHUANG Y-A (NR) SICHUAN DIKANG-A (NR) SICHUAN KELUN-A (NR) SIMCERE PHAR-ADR (NR) SOUTHWEST PHAR-A (NR) STAIDSON BEIJI-A (NR) TIANJIN LISHEN-A (NR) TIANJIN TIANYA-A (NR) TONGHUA GOLD-A (NR) TOPSUN SCIENCE-A (NR) UNISPLENDOUR G-A (NR) WINTEAM PARMACEU (NR) WUHAN GUOYAO-A (NR) WUHAN HUMANWEL-A (NR) ZHEJIANG HISOA-A (NR) ZHEJIANG HISUN-A (NR) ZHEJIANG HUAHAI (NR) ZHEJIANG JINGX-A (NR) ZHEJIANG MEDI-A (NR) ZHEJIANG XIAN-A (NR) ZHEJIANG YATAI-A (NR) ZHEJIANG ZHEN-A (NR) Chemical Drugs Average
Code 002603 CH 600466 CH 002422 CH SCR US 600666 CH 300204 CH 002393 CH 600488 CH 000766 CH 600771 CH 000590 CH 570 HK 600421 CH 600079 CH 002099 CH 600267 CH 600521 CH 002020 CH 600216 CH 002332 CH 002370 CH 000705 CH
Price MCAP Vol (TP) US$MM US$mn 36.4 7.6 57.5 8.8 8.4 44.7 37.5 7.0 6.8 8.6 10.6 1.1 6.2 21.0 19.6 32.5 14.0 19.2 25.9 12.1 10.1 11.1 2,426.5 520.6 4,330.6 469.9 380.0 467.5 1,071.7 595.2 476.8 327.7 338.8 256.6 189.6 1,621.5 495.9 2,674.5 1,184.4 305.8 1,829.0 646.9 321.6 217.2 841.4 11.2 9.6 6.5 0.5 3.9 2.7 5.8 2.5 7.0 4.8 2.7 0.0 5.0 8.1 1.7 3.9 3.7 1.2 9.0 2.5 1.2 2.6 4.0
1M Chg (6.2) (15.5) (8.9) (9.2) (11.2) 0.4 (3.1) (6.3) (12.4) (6.5) (13.5) (5.1) (11.5) (3.2) (14.5) (11.7) (11.5) (11.4) (11.9) (6.7) (11.9) (17.7) (10.2)
3M Chg na (35.4) (8.9) (12.1) (16.2) 12.6 (12.8) (14.4) (12.9) (18.3) (17.9) (17.6) (12.3) (15.9) (16.1) (6.7) (5.6) (25.5) (9.9) (23.7) (22.7) (14.8)
YTD Chg (%) 93.6 (26.7) (22.9) 11.9 (23.6) (20.7) (11.3) 13.5 (30.3) (8.9) 2.0 (17.6) (17.0) (15.2) 11.6 10.2 (18.7) (38.0) (17.5) (7.1) (20.7)
11e EPS 12e PE CAGR PE (x) (x) (10_12e) 34.7 26.6 20.7% na na na 41.7 27.7 16.0% 15.9 14.1 15.4% na na na 35.0 23.9 27.5% na na na 31.8 24.1 29.3% na na na na na na 29.0 19.7 20.8% na na na na na na 33.0 25.6 24.3% 24.5 17.4 38.4% 33.0 24.1 22.5% 32.4 25.1 34.8% 101.1 60.0 21.1% 8.9 8.2 10.8% 26.3 20.1 30.9% 32.4 27.9 28.6% na na na 27.6 20.0 41.3%
PEG '11E 1.7 na 2.6 1.0 na 1.3 na 1.1 na na 1.4 na na 1.4 0.6 1.5 0.9 4.8 0.8 0.8 1.1 na 1.1
PEG EV EV/Sale '12E (US$mn) s ('11E) 1.3 na 1.7 0.9 na 0.9 na 0.8 na na 0.9 na na 1.1 0.5 1.1 0.7 2.8 0.8 0.7 1.0 na 0.8 783.7 5,454.3 3,869.9 517.7 1,116.9 816.5 577.5 510.3 406.5 326.8 189.5 1,843.7 602.4 3,245.2 1,249.3 369.0 2,002.7 1,036.2 344.0 280.1 1,180.4
6.5
7.1 20.7 3.0 3.8 4.7 2.6 4.6 5.9
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Medical Equipment/Devices
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) remains low. 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%
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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. Mindrays 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/device makers 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 companys 1,000-plus sales staff has presence in 110 cities based out off 22 sales offices as of Jun 30, 2011. Weigaos 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. Orthopedic implants: trauma, spine, hip/knee implants Trauson, Weigao, Kanghui, Medtronic, Synthes/JNJ.
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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 the government 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 plans to 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 Intl 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.
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Golden Meditech (801 HK; Not Rated) Golden Meditech is Chinas largest supplier of the Autologous Blood Recovery System (ABRS) used in hospital operating theaters with a market share of more than 80%, according to the company. The size of Golden Meditechs 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 employs molecular 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 $100mn)
Company Name Covered Companies MICROPORT (N)* MINDRAY (OW)* SHANDONG WEIGAO (OW)* Non-covered Devices Names ANDON HEALTH C-A (NR) BEIJING WANDON-A (NR) CHINA KANGHU-ADR (NR) CHINA MEDIC-ADR (NR) EDAN INSTRUMEN-A (NR) GOLDEN MEDITECH (NR) GUANGDONG BIOL-A (NR) GUANGZHOU IMPR-A (NR) JIANGSU YUYUE-A (NR) LEPU MEDICAL-A (NR) MINGYUAN MEDICA (NR) SHANDONG PHAR-A (NR) SHANGHAI KEHUA-A (NR) SHANGHAI TOFFL-A (NR) SHENZHEN GLORY-A (NR) SHINVA MEDICAL-A (NR) TOPCHOICE MEDI-A (NR) TRAUSON HOLDINGS (NR) VITAL GROUP HOLD (NR) ZHEJIANG D.A.-A (NR) Medical Devices Average Code 853 HK MR US 1066 HK 002432 CH 600055 CH KH US CMED US 300206 CH 801 HK 300246 CH 300030 CH 002223 CH 300003 CH 233 HK 600529 CH 002022 CH 300171 CH 002551 CH 600587 CH 600763 CH 325 HK 1164 HK 300244 CH Price MCAP Vol (TP) US$MM US$mn 4.6 (5.5) 844.2 24 (32) 2,811.9 9.2 (12) 5,291.3 11.3 440.3 13.4 453.6 19.3 441.0 4.9 156.8 24.9 389.8 0.9 239.4 35.0 222.8 10.7 248.6 24.4 1,563.7 15.7 1,993.2 0.3 153.8 12.6 508.3 11.4 876.4 42.0 1,054.3 25.4 489.1 28.2 593.4 18.7 469.5 2.0 197.0 1.0 411.1 44.7 358.4 573.8 1.3 11.3 5.5 6.4 1.7 1.8 1.1 1.9 0.1 7.9 1.3 3.0 3.1 0.2 3.4 6.0 3.0 3.1 2.8 2.4 0.2 0.9 12.0 2.6 1M Chg 3M Chg YTD Chg (%) 11e PE 12e (x) PE (x) 18.2 16.7 35.0 44.4 48.6 25.0 2.8 25.9 9.6 33.1 34.1 38.0 23.9 9.8 17.2 20.8 30.8 25.9 36.5 42.0 9.5 na 50.1 26.6 15.2 14.5 26.3 32.3 37.8 19.9 2.4 18.3 7.9 23.7 24.8 26.3 18.6 8.7 15.2 16.8 22.5 18.3 25.1 29.4 8.1 na 36.1 19.8 EPS CAGR (10_12e) 11.6% 12.9% 24.3% 78.4% 25.5% 39.2% 68.5% 24.1% 71.3% 15.9% 48.8% 52.2% 29.1% 15.9% 15.1% 20.1% 25.1% 66.3% 34.0% 29.7% 11.6% na 17.9% 37.3% PEG PEG EV EV/Sales '11E '12E (US$mn) ('11E) 1.6 1.3 1.4 0.6 1.9 0.6 0.0 1.1 0.1 2.1 0.7 0.7 0.8 0.6 1.1 1.0 1.2 0.4 1.1 1.4 0.8 na 2.8 0.9 1.3 1.1 1.1 974.1 1,970.0 5,175.0 2.5 2.4 10.1 6.5 4.1 262.0 73.2 8.3 6.6 55.7 132.2 6.8 31.6 12.6 8.0 8.7 47.4
28.1 (6.7) (38.2) (2.8) (9.2) (6.4) 4.3 (16.4) (16.2) (23.4) (7.7) 0.6 (4.0) (10.2) (19.5) (24.1) (10.6) (7.2) (15.8) (22.4) (9.0) (11.9) (7.5) (12.8) (11.5) (6.4) (26.2) (11.1) (16.5) (12.7) (3.1) (3.3) (14.3) (37.6) (20.1) (30.0) na (9.7) (4.5) (19.2) (44.3) (3.5) (14.5) (3.8) (18.0) (14.6) 4.7 (37.5) (24.4) na (16.5) (30.5) (16.0) 4.3 (56.8) (37.7) (29.5) (22.6) (42.2) (72.4) (25.2) (35.5) 0.7 (6.6) (44.2) 317.4 (6.5)
0.4 553.9 1.5 453.6 0.5 20,321.5 0.0 2,709.2 0.8 0.1 213.5 1.5 0.5 295.3 0.5 1,973.8 0.6 3,298.1 0.5 182.4 1.0 557.6 0.8 965.3 0.9 0.3 0.7 673.7 1.0 398.1 0.7 218.1 na 292.5 2.0 0.7 2,207.1
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Traditional Chinese Medicines

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 Chinas 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 2009 Essential 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 (excluding Chinese 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 pricecutting 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
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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 up after a slow summer.
Figure 14: The healthy growth of TCM output in recent years
Rmb billion
250 200 150 100 50 0 2002 2003 2004 2005 2006 2007 2008 2009 TCM Y/Y
40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%
Chemical: Drugs
Source: CEIC
TCM: Medicine
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Selected Pharmaceutical and TCM companies

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 companys 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 companys 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 Xian 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 cardiocerebrovascular 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 products include Buchang Wenxin Granule, a sole Chinese herb medicine for the treatment of coronary 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.
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Table 13: Major TCM Companies and Their Valuations (Most of TCM companies with market cap above $100mn)
Company Name Covered Compaies CHINA SHINEWAY (UW)* Non-covered TCM Names BEIJING TONGRE-A (NR) CHINA RESOURCE-A (NR) CHONGQING TAIJ-A (NR) GANSU DUYIWEI-A (NR) GUANGDONG JIAY-A (NR) GUANGXI WUZHOU-A (NR) GUANGZHOU PHAR-H (NR) GUILIN SANJIN -A (NR) GUIZHOU BAILIN-A (NR) GUIZHOU XINBAN-A (NR) GUIZHOU YIBAI-A (NR) HANGZHOU TIAN-MU (NR) HENAN TALOPH-A (NR) HUNAN HANSEN-A (NR) JIANGSU KANION-A (NR) JIANGZHONG PHM-A (NR) JILIN AODONG M-A (NR) JILIN JIAN YIS-A (NR) JIUZHITANG CO -A (NR) KANGMEI PHARMA-A (NR) KUNMING PHARM -A (NR) LIJUN INTL PHARM (NR) MAYINGLONG PHA-A (NR) QINGHAI GELAT-A (NR) RENHE PHARMACY-A (NR) SHANDONG DONG-A (NR) SHANDONG WOHUA-A (NR) SICHUAN JOINT-A (NR) SP PHARMACEUTI-A (NR) TIANJIN TASLY-A (NR) TIANJIN ZHONGX-A (NR) TIBET CHEEZHEN-A (NR) TIBET RHODIOLA-A (NR) TONG REN TANG-H (NR) WUHAN JIANMIN -A (NR) XIANGXUE PHARM-A (NR) YABAO PHARMACE-A (NR) YUNNAN BAIYAO-A (NR) ZHANGZHOU PIENTZ (NR) ZHEJIANG CONBA-A (NR) ZHEJIANG JOLLY-A (NR) ZHUZHOU QIANJI-A (NR) TCM Average Code 2877 HK 600085 CH 000999 CH 600129 CH 002219 CH 002198 CH 600252 CH 874 HK 002275 CH 002424 CH 002390 CH 600594 CH 600671 CH 600222 CH 002412 CH 600557 CH 600750 CH 000623 CH 002566 CH 000989 CH 600518 CH 600422 CH 2005 HK 600993 CH 000606 CH 000650 CH 000423 CH 002107 CH 000809 CH 600869 CH 600535 CH 600329 CH 002287 CH 600211 CH 1666 HK 600976 CH 300147 CH 600351 CH 000538 CH 600436 CH 600572 CH 300181 CH 600479 CH Price MCAP Vol (TP) US$MM US$mn 10.3 (12) 1,098.7 13.2 18.3 6.9 13.4 10.0 12.8 4.7 13.8 15.8 13.6 16.3 9.9 5.7 21.9 14.3 23.6 26.9 33.0 10.1 14.0 13.7 0.8 17.0 6.5 13.2 41.5 11.7 21.8 22.1 40.4 9.2 18.1 12.0 7.2 15.1 11.3 6.3 55.6 62.0 10.0 21.8 12.0 2,702.0 2,814.4 464.7 785.8 320.3 2,190.2 1,226.8 1,272.9 1,165.8 369.0 903.5 188.7 369.4 507.7 951.3 1,151.8 2,900.8 571.7 471.0 4,824.7 672.7 235.6 881.5 413.3 1,304.9 4,257.2 300.7 391.8 1,481.0 3,275.7 887.0 1,150.7 274.0 341.9 364.0 436.4 624.5 6,054.6 1,360.6 1,102.5 273.4 573.7 1,257.4 5.2 14.0 7.5 2.7 3.0 0.8 35.8 0.7 1.1 3.9 1.7 2.0 1.3 3.1 6.7 4.4 4.4 18.9 2.3 2.0 21.2 5.1 0.3 2.0 5.0 4.8 18.1 1.2 2.5 4.2 10.9 1.9 1.1 1.9 0.6 2.8 1.8 2.7 9.1 3.8 10.2 2.7 3.7 5.6 1M Chg 4.1 (13.8) (9.6) (11.9) (15.2) (8.6) (11.5) (25.7) (5.2) (14.6) (9.7) (7.7) (7.7) (7.6) (8.1) (9.5) (9.0) (4.7) (6.2) (10.0) (9.2) (5.9) (23.5) (9.6) (10.9) (7.4) (6.4) (5.0) (8.2) (5.2) (5.2) (16.0) (5.3) (9.6) (7.9) (10.6) (10.2) (7.4) (7.8) (5.3) (11.6) (5.9) (5.7) (9.4) 3M Chg (25.0) (19.5) (1.7) (21.5) (21.3) (18.4) (32.0) (36.2) (16.2) (24.1) (12.0) (19.2) (10.3) (17.2) (1.0) (4.0) (5.3) (10.6) (0.9) (15.1) (0.1) 0.7 (48.6) (12.4) (28.2) (15.4) (4.2) (2.6) (17.4) (16.6) (3.7) (24.7) (12.5) (20.7) (4.3) (27.7) (14.7) (15.8) (6.9) (5.7) (29.1) 0.5 (2.8) (14.3) YTD Chg (%) (52.7) (2.7) (27.1) (29.0) 5.7 (26.4) (27.7) (63.5) (27.7) (8.2) (35.5) (17.1) (27.1) (22.2) (10.4) (23.0) (33.8) (5.2) na (29.7) (16.2) (0.5) (65.9) (25.6) (19.0) (13.3) (18.3) (15.4) 40.3 (14.0) 0.7 (35.8) (26.4) (31.7) (6.5) (32.7) (37.2) (36.1) (7.8) (13.9) na na (33.3) (21.0) 11e EPS 12e PEG PEG EV EV/Sales PE CAGR PE (x) '11E '12E (US$mn) ('11E) (x) (10_12e) 9.2 39.8 18.6 23.9 na na 17.2 9.3 na 23.4 40.7 21.9 na na 43.7 24.2 27.8 11.9 35.1 12.9 27.4 32.2 6.6 29.1 na 26.1 27.4 na na 17.0 32.2 17.7 43.0 na 13.9 25.6 22.6 13.7 31.5 37.8 23.1 31.0 29.5 25.4 9.8 32.9 15.0 19.8 na na 13.3 8.0 na 16.5 28.3 16.5 na na 37.4 19.0 19.9 13.1 28.0 17.7 20.3 22.8 5.5 23.0 na 20.0 21.3 na na 12.6 25.9 13.9 36.9 na 11.0 19.8 18.2 10.0 24.2 30.3 19.2 25.0 22.7 20.3 -6.6% (1.4) (1.5) 14.2% 20.2% na na na 30.7% 15.1% na 57.9% 42.6% 29.2% na na 11.6% 28.7% 25.0% 12.0% 5.5% 7.3% 25.3% 31.3% 13.6% 32.2% na 27.7% 32.3% na na 22.2% 13.6% 26.6% 8.0% na 28.5% 22.2% 23.7% 113.3% 22.9% 14.7% 20.3% 12.5% 46.5% 26.2% 2.8 0.9 na na na 0.6 0.6 na 0.4 1.0 0.7 na na 3.8 0.8 1.1 1.0 6.4 1.8 1.1 1.0 0.5 0.9 na 0.9 0.8 na na 0.8 2.4 0.7 5.4 na 0.5 1.2 1.0 0.1 1.4 2.6 1.1 2.5 0.6 1.5 2.3 0.7 na na na 0.4 0.5 na 0.3 0.7 0.6 na na 3.2 0.7 0.8 1.1 5.1 2.4 0.8 0.7 0.4 0.7 na 0.7 0.7 na na 0.6 1.9 0.5 4.6 na 0.4 0.9 0.8 0.1 1.1 2.1 0.9 2.0 0.5 1.2 1,090.4 2,739.6 2,569.5 1,044.8 1,004.7 342.8 3,290.6 669.2 1,609.0 1,196.1 499.0 1,035.6 224.2 452.6 471.3 986.3 1,126.3 3,135.9 417.0 3,974.2 582.6 509.8 933.7 625.9 1,375.0 3,978.4 263.0 459.2 2,214.9 3,396.5 591.6 1,467.8 347.3 281.2 454.8 574.0 816.7 6,021.8 1,361.9 1,543.0 569.3 1,378.9 3.1 3.7 13.8 1.0 66.6 2.1 8.4 8.7 3.5 6.9 13.8 12.9 16.1 2.1 5.2 7.0 1.8 4.1 4.8 31.3 1.1 3.8
1.2 1.6 5.0 14.0 8.1 4.5 3.1 9.1
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Medical Distribution/Retailing
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 Chinas current low spending per-capita on pharmaceutical products and the governments 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
50 40 30 20 10 0 2004 2005 2006 2007 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015E 30% 25% 20% 15% 10% 5% 0%
Figure 16: Rising market concentration in China

40% 30% 20% 10% 0% 2004 2005 2006 2007 2008 2009E 2010E 2011E 2012E 2013E 2014E 2015E
Pharma sales (US$bn)

Source: Business Monitor International, J.P. Morgan estimates.
Y/Y (%)
3 largest suppliers market share

Source: Company data, J.P. Morgan estimates.
Sinopharm market share
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 to integrate the assets.
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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 twoinvoice 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 after charging 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
Manufacturers - Direct sales, high-exfactory price, low channel markup, high GM, high SG&A ratio, low OPM & NPM Drugs Manufacturers Indirect sales, low-ex-factory price, high channel markup, low GM, low SG&A ratio, high OPM & NPM Drugs
500 Sales people making sales to hospitals
Distributors (Logistics Handling, take 5-8 points of sales to hospitals)
Distributors (Contract Selling, incur Sales & Marketing Cost)
Make delivery on sales secured by sales people
5 Sales people making sales to hospitals
Hospitals
Source: J.P. Morgan; numbers used for illustration only.
45
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 have severely 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.
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Figure 18: Drug distribution process in China

Sourced from Domestic Suppliers Imported from Foreign Suppliers Quarantine and Quality Inspection Free Trade Zone Warehousing
Procured Products to Pass Quality Inspection & Monitoring
Quality Inspection
Customs Clearance
Products stored in GSP-compliant Warehouse, Quality Ensured throughout Storage Period
Warehousing Receiving Customer orders Arranging Delivery
Drugs delivered to customers
Hospitals (Based on Tender Price)
Other Distribution Market (Market Price)
Retail Pramacy (Market Price )
Source: Chinese Association of Pharmaceutical Commerce; J.P. Morgan.
47
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.
48
Table 14: Major Chinese Distributors and Their Valuations (Most distributors with market cap above $100mn)
Company Name Code Price MCAP Vol (TP) US$MM US$mn 20.8 (30) 6,405.5 15.6 2.2 6.6 11.9 5.2 14.2 14.3 25.2 13.3 1,174.6 230.6 283.4 2,644.7 570.1 5,674.1 5,695.0 1,015.8 1,019.6 1,762.9 16.2 12.6 0.1 2.3 6.2 8.4 21.7 3.7 2.0 0.3 8.5 1M Chg 3M Chg YTD Chg (%) 11e EPS 12e PE CAGR PE (x) (x) (10_12e) 26.8 na 35.8 na 34.4 na 16.7 15.4 21.8 9.4 29.0 22.0 na 29.6 na 26.3 na 14.1 12.7 16.9 7.3 23.3 21.8% na 11.8% na 29.4% na na 15.2% 19.1% 28.2% 20.6% PEG '11E 1.2 na 3.0 na 1.2 na na 1.0 1.1 0.3 2.1 PEG EV EV/Sales '12E (US$mn) ('11E) 1.0 na 2.5 na 0.9 na na 0.8 0.9 0.3 1.7 7,336.6 1,057.2 107.5 412.6 3,518.8 1,151.4 1,078.9 1,364.4 1,249.5 0.5 0.9 1.1 0.9
Covered Company SINOPHARM (OW)* 1099 HK Non-Covered Distribution Names CHINA NATIONAL-A (NR) 600511 CH CHINA NEPSTA-ADR (NR) NPD US CHONGQING TONG-A (NR) 000591 CH JOINTOWN PHARM-A (NR) 600998 CH NANJING PHARMA-A (NR) 600713 CH SHANG PHARM -A (NR) 601607 CH SHANGHAI PHARM-H (NR) 2607 HK SHENZ ACCORD-A (NR) 000028 CH SHENZ ACCORD-B (NR) 200028 CH Distribution Average
11.3 (15.7) (22.9) (8.8) (12.9) (13.5) 6.9 (14.1) (5.2) (14.7) (7.6) (24.0) (7.9) (5.5) (26.2) (18.0) (2.3) (33.2) (16.7) (28.5) (8.4) (39.2) (17.0) (36.3) (37.9) (25.1) (17.7) (12.1) (34.5) na (23.2) (43.4) (27.3)
0.4 0.7 1.0
49
Chinese Vaccine Market

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 governments 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 countrys large population should ensure a sizeable market for childrens vaccines. 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. 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. 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. 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.
2.
3.
4.
5.
China is already the largest market for conventional vaccines. We estimate the total market for vaccines to reach Rmb8bn by 2020.
50
Selected companies in the vaccine space

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 National Pharmaceutical Group (CNPG), the parent company of Sinopharm (1099.HK), as a part of the central governments 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 () 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 $100mn)
Company Name 3SBIO INC-ADR (NR) BEIJING TIAN-A (NR) CHANGCHUN HIGH-A (NR) CHENGZHI CO-A (NR) CK LIFE SCIENCES (NR) HUA HAN BIO-PHAR (NR) HUALAN BIOLOGI-A (NR) LEE'S PHARM (NR) SHENZ NEPTUNUS-A (NR) SHENZHEN HEPAL-A (NR) SINOVAC BIOTECH (NR) TIANJIN CHASE-A (NR) TIANJIN RINGPU-A (NR) TONGHUA DONGBA-A (NR) UNITED GENE HIGH (NR) WALVAX BIOTECH-A (NR) Biologicals Average Code SSRX US 600161 CH 000661 CH 000990 CH 775 HK 587 HK 002007 CH 950 HK 000078 CH 002399 CH SVA US 300026 CH 300119 CH 600867 CH 399 HK 300142 CH Price (TP) 10.3 16.4 38.2 10.0 0.3 1.4 22.4 2.6 7.6 28.7 2.2 24.3 20.9 8.6 0.1 53.7 MCAP Vol 1M 3M YTD 11e 12e EPS CAGR PEG US$MM US$mn Chg Chg Chg (%) PE (x) PE (x) (10_12e) '11E 225.0 0.7 (20.3) (43.0) (32.1) 14.1 10.7 31.4% 0.4 1,326.0 7.6 (8.1) (4.8) (28.0) 40.0 34.2 22.2% 1.8 786.7 3.2 (14.6) (25.1) (37.2) 40.2 32.4 49.8% 0.8 465.4 5.4 (7.5) (5.0) (28.4) na na na na 395.2 0.1 (14.7) (33.3) (38.1) na na na na 353.6 0.6 (17.0) (38.8) (44.3) 6.0 4.4 6.2% 1.0 2,024.5 16.6 (13.8) (37.4) (53.3) 19.4 18.0 17.3% 1.1 153.8 0.1 (3.4) (14.1) (28.3) 15.0 11.1 27.8% 0.5 780.9 5.5 (9.4) (22.3) (36.0) na na na na 3,604.7 4.6 (6.6) (23.9) (57.7) 27.9 23.5 -11.7% (2.4) 121.0 0.6 (2.2) (26.2) (50.9) 22.2 88.8 na na 575.9 1.8 (8.3) (13.8) (18.4) 24.8 17.8 42.3% 0.6 486.1 3.9 (11.6) (8.4) (39.7) na na na na 1,047.0 7.8 (2.2) (6.6) (20.2) na na na na 154.7 0.1 (22.7) (33.1) (24.4) na na na na 1,264.1 4.0 (13.0) (6.6) (39.2) 35.2 25.2 26.4% 1.3 860.3 3.9 (11.0) (21.4) (36.0) 24.5 26.6 23.5% 0.6 PEG EV EV/Sales '12E (US$mn) ('11E) 0.3 279.0 12.3 1.5 1,508.4 7.1 0.6 1,018.1 4.7 na 574.2 na 544.9 0.7 382.2 1.5 1.0 2,955.6 15.1 0.4 164.0 3.6 na 1,216.2 (2.0) 7,754.5 13.5 na 122.6 10.1 0.4 602.7 7.7 na 366.9 na 1,057.9 na 198.2 1.0 1,758.6 24.4 0.5 1,281.5 10.0
51
52
Companies
53

15 October 2011
China Shineway Pharmaceutical Group Limited

Getting Worse Before Getting Better - Retain UW
Poor performance likely to continue; assuming coverage with UW and Dec12 PT of HK$12: Shineways 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: Shineways 1H11 results showed a significant decline in Qing Kai Lings 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 nontender 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 NDRCs unified EDL pricing. Shineway, the TCM injection leader, could see better days ahead: Given the concerns about Anhuis 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 companys products are well known for superior quality. Meanwhile, Shineways 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.
China Shineway Pharmaceutical Group Limited (Reuters: 2877.HK, Bloomberg: 2877 HK) Rmb in mn, year-end Dec FY09A FY10A FY11E FY12E FY13E Revenue (Rmb mn) 1,633 2,038 2,217 2,332 2,703 Net Profit (Rmb mn) 767.2 821.7 762.8 713.8 802.2 EPS (Rmb) 0.93 0.99 0.92 0.86 0.97 DPS (Rmb) 0.37 0.40 0.28 0.26 0.29 Revenue growth (%) 28.1% 24.8% 8.7% 5.2% 15.9% EPS growth (%) 92.6% 7.1% -7.2% -6.4% 12.4% ROCE 29.3% 31.7% 24.9% 19.9% 19.9% ROE 31.6% 27.6% 21.8% 17.8% 17.7% P/E (x) 9.9 9.2 9.9 10.6 9.5 P/BV (x) 2.8 2.3 2.0 1.8 1.6 EV/EBITDA (x) 7.9 5.8 5.9 5.9 5.0 Dividend Yield 4.0% 4.4% 3.0% 2.8% 3.2%
Source: Company data, Bloomberg, J.P. Morgan estimates.
Underweight
2877.HK, 2877 HK Price: HK$11.22
Price Target: HK$12.00

Previous: HK$22.00
China Healthcare Sean Wu

AC

Price Performance
25 HK$ 15 5
Abs Rel
YTD -56.8% -33.7%
1m -6.8% 4.1%
3m -35.7% -13.6%
12m -61.1% -37.4%
Company Data Shares O/S (mn) Market cap (Rmb mn) Market cap ($ mn) Price (HK$) Date Of Price Free float (%) 3-mth trading volume (mn) 3-mth trading value (HK$ mn) 3-mth trading value ($ mn) HSI Exchange Rate Fiscal Year End
827 7,586 1,193 11.22 14 Oct 11 27.4% 5 41 5 18,758 7.78 Dec
Company description
P&L sensitivity metrics

FY11E Chinese herbs Impact of each 5 percentage increase Selling cost Impact of each 5 percentage points increase Demand for products under EDL Impact of each 5 percentage points increase GM: 1% Increase Impact of each 1% increase
Source: J.P. Morgan estimates.
EBIT impact (%) -3.3% -2.5% 3.2% 2.6%
EPS impact (%) -3.0% -2.3% 3.0% 2.4%
Shineway is one of the largest Chinese medicine manufacturers of injectionbased and soft capsule medicines in China, in terms of volume. Shineway focuses on prescription medicines in three major formsinjection, soft capsule, and granule. All of the products are sold under the Shineway brands and developed mainly by the in-house R&D team.
Price target and valuation analysis
Our 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.
Revenue mix (2010A)
Granules 16% Soft capsules 19%
Others 2%
Injection 63%
Risk-free rate: Market risk premium: Beta: Cost of equity Terminal g:
4.20% 6.00% 1.20 11.4% 4.00%
Source: Company reports.
EPS: J.P. Morgan vs. consensus

Rmb FY10A FY11E FY12E J.P. Morgan 0.990 0.922 0.863 Consensus 0.990 0.993 1.124
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.
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Investment summary
Negative share price drivers
EDL tendering hurts Shineway particularly hard: While Shineways 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 Shineways products have not been pointed for any of them, it does not mean it will not happen in the future. If Shineways products show major adverse side effects in the future, the damage to the companys reputation and short-term sales could be considerable, in our view. Substitutes from chemical drugs: Shineways 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, Shineways 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 underappreciated: Shineways 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 Lings anti-viral activities may be genuine and under-appreciated. Patients who
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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 the flu and numerous TCMs, including Ban Lan Gen , 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: ShinewayHistorical overall GM and injections GM
90% 80% 70% 60% 50% 40% 2005 2006 2007 2008 2009 2010
Average GM
Injections GM
High gross margins of TCM injections: Shineways 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.
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Valuation and share price analysis

DCF valuation at HK$12
Our Dec-12 price target is based on a DCF valuation that assumes a market risk premium of 6.0% and a risk-free rate of 4.2% (yield on 10-year government notes in China). We assume a beta of 1.2, based on Bloomberg estimates. Accordingly, we assume a WACC of 11.4%. We estimate free cash flow until 2015 and assume a terminal growth rate of 4.0%. The terminal growth is based on the annual growth rate expected in 2015 (the final year of the estimate period), subject to a minimum of 1.5% and a maximum of 4.5%, depending on the nature of the industry and the level of maturity in China. We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
Table 16: ShinewayBase-case DCF analysis
HK$MM Cash flow estimates Sales EBIT NOPAT Capex, net Depreciation Change in working capital Free CF (excl. non-core)) DCF Parameters Liabilities as a % of EV WACC Enterprise NPV (10E-16E) + Net cash (debt), current - Minorities (Market value) +/- Other items = Equity value / Number of shares = Equity value per share (HK$)
Source Company data, J.P. Morgan estimates.
2007 1,013 426 366 (93) 32 (78) 228
2008 1,275 575 490 (84) 36 (142) 300 0% 11.4% 8,660 2,326 0 0 8,660 827 12.0
2009 1,633 712 596 (128) 45 313 826
2010E 2,038 944 819 (459) 87 (181) 266
2011E 2,217 869 720 (620) 138 (16) 223
2012E 2,332 799 654 (540) 195 (80) 230
2013E 2,703 903 748 (200) 217 (427) 338 4.0% 4.2% 6.0% 1.20 6.2% 11x
2014E 3,108 1,017 843 (230) 217 (140) 689
2015E 3,417 1,101 913 (253) 220 (140) 741
Assumptions Terminal growth Risk-free rate Market risk Beta Cost of debt Implied exit P/E multiple (x)
Table 17: ShinewaySensitivity analysis based on WACC and perpetual terminal growth rate
11.3 9.9% 10.4% 10.9% 11.4% 11.9% 12.4% 12.9% 3% 12.7 11.8 11.0 10.4 9.8 9.2 8.7 3% 13.5 12.5 11.6 10.9 10.2 9.6 9.1 3.5% 14.3 13.2 12.3 11.4 10.7 10.0 9.4 Terminal growth rate 4.0% 4.5% 5.0% 15.4 16.6 18.1 14.1 15.1 16.3 13.0 13.8 14.8 12.0 12.8 13.6 11.2 11.8 12.6 10.5 11.0 11.6 9.8 10.3 10.8 5.5% 19.9 17.8 16.0 14.6 13.4 12.3 11.4
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WACC
Financial analysis
We expect sales CAGR of 10% with -1% CAGR for net profit
Gross margins to decline: We expect Shineways 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
80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2005 2006 2007 2008 2009 SG&A 2010 2011E 2012E 2013E 2014E 2015E Net margin
Gross Margin
EBIT margin
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.
Table 18: China ShinewayRevisions to our model
Rmb in millions New Year to Dec (RmbMM) Turnover Gross profit EBIT Net profit EPS Gross margin FY11E 2,217 1,443 869 763 0.922 65.1% FY12E 2,332 1,452 799 714 0.863 62.3% FY11E 2,351 1,594 939 800 0.967 67.8% Old FY12E 2,747 1,796 1,021 865 1.046 65.4% FY11E -5.7% -9.4% -7.4% -4.6% -4.6% -2.7% Change FY12E -15.1% -19.2% -21.7% -17.5% -17.5% -3.1%
Source: Company reports, J.P. Morgan estimates. Note: Earnings revision made due to assumption of coverage.
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Table 19: China ShinewayRevenue forecasts Rmb in millions

Total turnover y-y growth Injections % of sales y-y growth Soft capsules % of sales y-y growth Granules % of sales y-y growth Other formulations % of sales y-y growth Injections Shen Mai Injection - Vol change - ASP change Qing Kai Ling injection - Vol change - ASP change Shu Xie Ning injection - Vol change - ASP change Other - Vol change - ASP change Total YoY Weighted average vol change Soft Capsules Wu Fu Xin Nao Qing soft capsule - Vol change - ASP change Huo Xiang Zheng Qi soft capsule - Vol change - ASP change Qing Kai Ling soft capsule - Vol change - ASP change Others - Vol change - ASP change Total YoY Weighted average vol change Granules YoY - Vol change - ASP change
2009 1,633 28.1% 930 56.9% 28.6% 391 23.9% 16.7% 277 17.0% 43.0% 33 2.0% 35.0% 236 10% 5% 25% 10% 45% 70 7% 930 28.6%
2010 2,038 24.8% 1,275 62.6% 37.1% 386 18.9% -1.3% 328 16.1% 18.1% 50 2.4% 52.8% 266 10% 3% 55% 5% 15% 5% 77 10% 1,275 37.1%
2011E 2,217 8.7% 1,263 57.0% -0.9% 467 21.0% 20.9% 405 18.3% 23.5% 82 3.7% 65.0% 328 30% -5% 10% -20% 12% -6% 73 -5% 1,263 -0.9%
2012E 2,332 5.2% 1,177 50.5% -6.8% 553 23.7% 18.5% 500 21.4% 23.5% 103 4.4% 25.0% 315 20% -20% 15% -25% 11% -6% 73 1,177 -6.8%
2013E 2,703 15.9% 1,325 49.0% 12.5% 661 24.5% 19.6% 594 22.0% 18.8% 123 4.6% 20.0% 362 15% 15% 8% 73 1,325 12.5%
2014E 3,108 15.0% 1,468 47.2% 10.9% 786 25.3% 18.9% 712 22.9% 20.0% 142 4.6% 15.0% 414 14% 10% 7% 84 15% 1,468 10.9%
2015E 3,417 9.9% 1,538 45.0% 4.8% 889 26.0% 13.1% 826 24.2% 16.0% 163 4.8% 15.0% 410 10% -10% 8% 7% 88 5% 1,538 4.8%
210 50% 25% 35% 46 30% 391 16.7% 277 43.0% 30% 10%
205 -3% 10% -10% 44 -5% 386 -1.3% 328 18.1% 20%
231 13% 30% 30% -6% 61 50% -6% 467 20.9% 405 23.5% 30% -5%
249 15% -6% 29% 24% -6% 87 50% -6% 553 18.5% 500 23.5% 30% -5%
271 14% -5% 27% 22% 119 38% 661 19.6% 594 18.8% 25% -5%
307 14% 26% 19% 143 20% 786 18.9% 712 20.0% 20%
345 12% 20% 5% 157 10% 889 13.1% 826 16.0% 16%
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SWOT analysis
Strengths
Market leadership in the TCM injection space. Well established reputation for product quality. Unbroken track record of product safety. State-of-the-art TCM injection manufacturing facility featuring very large capacity. Strong management with years of industry experience.
Weaknesses
Disproportionally high exposure to the EDL list. Most of its products with multiple competitors.
Opportunities
EDL inclusion of two major products should eventually result in a significant increase in the sales volume. With increasing evidence of efficacy, TCM injection sales could continue to ramp up. Significant growth potential ahead with non-injection products and new products. Financially strong to make M&As if tough market environment forces smaller competitors to sell out.
Threats
Low-price competition from competitors. Substitutes of major drugs with chemical drugs that could have better established clinical efficacy and safety profiles. Raw material supply shortage.
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China Shineway Pharmaceutical Group Limited: Summary of Financials

Income Statement Rmb in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet Rmb in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets FY09 1,633 28.1% 1,178 28.8% 758 24.0% 712 23.8% 43.6% 46 884 85.6% -117 13.2% 767.2 92.6% 827 0.93 92.6% FY09 2,319 81 136 148 2,685 FY10 2,038 24.8% 1,435 21.8% 1,031 36.1% 944 32.5% 46.3% 46 992 12.2% -170 17.2% 821.7 7.1% 827 0.99 7.1% FY10 2,349 271 192 130 2,941 FY11E 2,217 8.7% 1,443 0.6% 1,007 -2.3% 869 NM 39.2% 67 932 -6.0% -169 18.2% 762.8 -7.2% 827 0.92 (7.2%) FY11E 2,326 294 209 116 2,945 166 1,258 4,452 0 182 506 688 0 0 688 3,764 4.55 Cash flow statement FY12E FY13E Rmb in millions, year end Dec 2,332 2,703 EBIT 5.2% 15.9% Depr. & amortization 1,452 1,676 Change in working capital 0.6% 15.4% Taxes 994 1,120 Cash flow from operations -1.3% 12.7% 799 903 Capex NM 13.0% Net Interest 34.3% 33.4% Other 66 70 Free cash flow 861 968 -7.6% 12.4% -148 -166 Equity raised/(repaid) 17.2% 17.2% Debt raised/(repaid) 713.8 802.2 Other -6.4% 12.4% Dividends paid 827 827 Beginning cash 0.86 0.97 Ending cash (6.4%) 12.4% DPS Ratio Analysis FY12E FY13E Rmb in millions, year end Dec 2,439 2,693 Gross margin 310 359 EBITDA margin 220 254 Operating margin 153 435 Net margin 3,121 3,741 Sales per share growth 169 172 Sales growth 1,603 1,586 Net profit growth 4,968 5,567 EPS growth Interest coverage (x) 0 0 192 222 Net debt to equity 513 520 Working Capital to Sales 705 742 Sales/assets 0 0 Assets/equity 0 0 ROE 705 742 ROCE 4,263 4,825 5.16 5.83 FY09 712 45 313 -78 1,039 -128 46 46 911 FY10 944 87 -181 -117 779 -459 46 46 320 FY11E 869 138 -16 -170 889 -620 67 67 269 FY12E 799 195 -80 -169 812 -540 66 66 272 FY13E 903 217 -427 -148 615 -200 70 70 415
0 -182 1,586 2,319 0.37 FY09 72.1% 46.4% 43.6% 47.0% 28.1% 28.1% 92.6% 92.6% -85.2% 4.9% 0.57 1.21 31.6% 29.3%
76 -318 2,319 2,349 0.40 FY10 70.4% 50.6% 46.3% 40.3% 24.8% 24.8% 7.1% 7.1% -72.7% 14.5% 0.56 1.20 27.6% 31.7%
-76 -280 2,349 2,326 0.28 FY11E 65.1% 45.5% 39.2% 34.4% 8.7% 8.7% -7.2% (7.2%) -61.8% 14.5% 0.53 1.18 21.8% 24.9%
0 -221 2,326 2,439 0.26 FY12E 62.3% 42.6% 34.3% 30.6% 5.2% 5.2% -6.4% (6.4%) -57.2% 14.5% 0.50 1.17 17.8% 19.9%
0 -227 2,439 2,693 0.29 FY13E 62.0% 41.4% 33.4% 29.7% 15.9% 15.9% 12.4% 12.4% -55.8% 14.5% 0.51 1.15 17.7% 19.9%
LT investments 70 162 Net fixed assets 457 777 Total Assets 3,270 3,972 Liabilities Short-term loans 0 0 Payables 138 168 Others 409 499 Total current liabilities 548 667 Long-term debt 0 0 Other liabilities 0 76 Total Liabilities 548 743 Shareholders' equity 2,722 3,230 BVPS 3.29 3.91 Source: Company reports and J.P. Morgan estimates.
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15 October 2011
Concord Medical Services Holdings Limited

Moving aggressively into private-hospital services
Misunderstood business model offers upside: We believe the persisting weakness of Concord shares mainly reflects: 1) accounting scandals associated with Chinese ADRs and 2) continued investor doubts on the sustainability of Concords lease and management business model. We view the first reason as unfair and the second largely misplaced. Most of Concords 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 is moving aggressively into the lucrative private-hospitals sector. Hence, we believe Concords 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 Changan 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 slowerthan-expected pace of acquisition of new-hospital contracts.
Concord Medical Services Holdings Limited (Reuters: CCM, Bloomberg: CCM US) $ in th, year-end Dec FY09A FY10A FY11E FY12E FY13E Revenue ($ th) 42,842 59,018 72,044 121,053 153,115 Net Profit ($ th) 6,800.0 19,607.0 21,571.2 26,719.4 32,062.2 EPS ($) 0.27 0.40 0.45 0.56 0.67 DPS ($) 0.00 0.00 0.00 0.00 0.00 Revenue growth (%) 70.2% 37.8% 22.1% 68.0% 26.5% EPS growth (%) (107.1%) 48.2% 13.6% 23.3% 19.5% ROCE 9.2% 7.7% 7.9% 8.5% 10.3% ROE 2.7% 6.0% 6.2% 7.1% 8.0% P/E (x) 12.1 8.2 7.2 5.8 4.9 P/BV (x) 0.7 0.6 0.6 0.5 0.5 EV/EBITDA (x) 0.4 1.7 1.9 1.7 1.4 Dividend Yield 0.0% 0.0% 0.0% 0.0% 0.0%
Overweight
CCM, CCM US Price: $3.28
Price Target: $6.40

Previous: $7.00

AC

Price Performance
9 7 $ 5 3
CCM share price ($) S&P500 (rebased)
Abs Rel
YTD -58.8% -45.2%
1m -16.8% -10.4%
3m -28.1% -10.2%
12m -56.0% -52.7%
Company Data Shares O/S (mn) Market cap ($ mn) Market cap ($ mn) Price ($) Date Of Price Free float (%) 3-mth trading volume (mn) 3-mth trading value ($ mn) 3-mth trading value ($ mn) S&P500 Exchange Rate Fiscal Year End
47 156 156 3.28 13 Oct 11 32.8% 27,105,500,000 82,671,775,000 82,672 1,207 1.00 Dec
Company Description

Number of centers added in 2010 Impact of 5 new centers Patient fees Impact of each 1 percentage points change Profit share percentage Impact of each 1 percentage points change GM Impact of each 100bps increase
EBIT impact (%) 3.1% 1.9% 2.4% 1.5%
EPS impact (%) 4.3% 2.7% 3.4% 2.1%
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.
Price target and valuation analysis Revenue mix (2010A)
Our 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%.
Cancer center revenues Management Services Hospital Others

Source: Company report
4.20% 6.00% 1.50 13.2% 2.00%
EPS: J.P. Morgan vs consensus (US$)

FY11E FY12E FY13E
J. P. Morgan 0.45 0.56 0.67
Consensus na na na
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.
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Investment summary
Positive share price drivers
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 of radiotherapy 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 & Sullivans 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 Changan 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
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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-thanfriendly 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 companys 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 Concords 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 Concords 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,
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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 companys 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.
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SWOT analysis
Strengths Weaknesses
The largest operator of third-party radiotherapy and The nature of the business is competitive and there are a diagnostic imaging centers in China with well-established number of operators that compete for new hospital reputation. projects. 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. 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
Threats
Strong demand for radiotherapy cancer treatment in China The renewals of cancer clinic contracts could be uncertain should increase the number of patients for Concord and the profit share of Concord may be impacted if there centers. is competition during contract renewals. Government budget constraints could encourage more hospitals to seek private partners for their cancer clinics. New technologies make the equipment at Concord obsolete and require expensive upgrades.
Concord may be invited by its hospital partners to operate The company is dependent on a limited number of key centers for other illnesses that require modern equipment doctors that can move to other hospitals and jeopardize the sales and profitability of Concord. Concord could acquire smaller private operators and lift The ownership structure could come under regulatory their efficiency and profitability. scrutiny as the typical partners of Concord are non-profit Private hospitals open a new area for the company to hospitals. diversify its business
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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.
Table 20: DCF analysis
Net operating revenues EBITDA % Growth Y/Y % Margin EBIT % Growth Y/Y % Margin Tax Expense Tax Rate % NOPAT Reported Net income Depreciation and amortization Changes in working capital Cash flow from operations Less: Capital expenditures Unlevered Free Cash Flow CapEx as % of Rev Discount Period WACC PV of Unlevered Free Cash Flow
2009 42.8 35.5 82.8% 24.5 57.2% 5.3 22.6% 19.2 18.3 10.9 (6.7) 23.4 (34.6) (11.2) 80.7% na na na
2010 59.0 45.3 76.7% 27.2 46.1% 6.6 25.1% 20.6 19.6 18.0 (7.4) 31.2 (68.3) (37.1) 115.8% 0.0 11.5% (37.1)
2011E 72.0 52.0 72.2% 32.2 44.6% 8.5 27.7% 23.6 21.6 19.8 (1.3) 42.2 (95.5) (53.4) 132.6% 0.0 11.5% (53.4)
2012E 121.1 71.1 58.7% 39.7 32.8% 8.5 23.1% 31.2 26.7 31.4 (18.9) 43.7 (81.6) (37.9) 67.4% 1.0 11.5% (34.0)
2013E 153.1 92.2 60.2% 51.3 33.5% 10.9 23.1% 40.4 32.1 40.9 (10.2) 71.1 (90.5) (19.4) 59.1% 2.0 11.5% (15.6)
2014E 170.8 105.5 61.7% 58.6 34.3% 12.5 23.1% 46.0 37.6 46.9 (5.2) 87.7 (70.2) 17.5 41.1% 3.0 11.5% 12.7
2015E 190.2 119.9 63.0% 69.4 36.5% 15.1 23.1% 54.3 46.0 50.5 (5.7) 99.1 (63.7) 35.4 33.5% 4.0 11.5% 22.9
2016E 211.2 133.9 63.4% 80.6 38.2% 17.8 23.1% 62.8 55.6 52.8 (5.9) 109.6 (68.8) 40.8 32.6% 5.0 11.5% 23.7
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Table 21: WACC assumptions

WACC KD KE=Rf+(Rm-Rf) Rf Rm Tax rate Leverage Total debt Total equity
Table 22: Terminal Value - Perpetuity Growth

11.5% 6.0% 13.2% 4.2% 1.50 10.2% 25.1% Sum of Unlevered FCF Long Term FCF Growth Rate Terminal Value in Perpetuity PV of Terminal Value Total PV of FCFs Less: Debt Plus: Cash Equity Value Shares 89.6 363.0 Equity Value/Share % TV/Total PV
9.7 2.0% 431.0 250.3 260.1 (89.6) 133.5 303.9 47.5 $6.40 96.3%
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 companys strong EPS growth potential 26.0% Y/Y in 2012E and 22.7% in 2013E.
Table 23: ConcordDCF sensitivity analysis

US$/ADS 6.5% 7.5% 8.5% 9.5% 10.5% 11.5% 12.5% 13.5% 14.5% 15.5% 0.0% $11.00 $9.30 $8.00 $7.00 $6.10 $5.50 $4.90 $4.40 $4.00 $3.70 1.0% $12.70 $10.50 $8.90 $7.60 $6.70 $5.90 $5.20 $4.70 $4.30 $3.90 LT FCF growth rate 2.0% 3.0% $15.30 $19.30 $12.20 $14.60 $10.00 $11.60 $8.50 $9.60 $7.30 $8.10 $6.40 $7.00 $5.60 $6.10 $5.00 $5.40 $4.50 $4.80 $4.10 $4.40 4.0% $26.50 $18.40 $14.00 $11.10 $9.20 $7.80 $6.70 $5.90 $5.20 $4.60 5.0% $43.20 $25.30 $17.60 $13.40 $10.70 $8.80 $7.50 $6.40 $5.60 $5.00
WACC
Table 24: Comparison of CCM shares vs. Hospital Services Peers Clearly undervalued
Company Name CONCORD MEDICAL (OW)* Hospital Services Peers AIER EYE HSPTL-A (NR) APOLLO HOSPITALS (NR) BANGKOK DUSIT MD (NR) BUMRUNGRAD HOSPI (NR) CHINA CORD BLOOD (NR) RAFFLES MEDICAL (NR) CHINA RENJI MED (NR) Hospital Services Average Code CCM US 300015 CH APHS IN BGH TB BH TB CO US RFMD SP 648 HK Price MCAP Vol 1M 3M Chg YTD 10 PE 11e 12e EPS CAGR PEG PEG EV EV/Sales (TP) US$MM US$mn Chg Chg (%) (x) PE (x) PE (x) (10_12e) '11E '12E (US$mn) ('11E) 3.1 (6.4) 18.6 0.0 (5.3) (24.7) (56.8) 7.6 6.7 5.3 19.6% 0.3 0.3 20.9 2.3 22.3 1,496.9 489.2 1,302.9 65.0 3,236.3 40.0 938.6 2.9 216.6 2.2 893.9 0.1 104.4 1,170.0 4.8 0.8 5.0 1.4 0.1 0.6 1.8 (7.0) (7.2) 2.6 (6.1) 5.9 (1.7) 6.5 (1.1) 21.5 8.8 (11.7) (7.3) 2.4 (18.9) 8.3 39.8 29.3 (26.9) (8.2) 3.3 79.4 33.0 25.1 19.7 12.3 23.8 na 32.2 49.0 28.9 24.1 20.4 12.3 22.5 na 26.2 33.4 24.0 21.0 19.1 10.1 19.8 na 21.2 54.2% 0.9 0.6 17.2% 1.7 1.4 9.4% 2.6 2.2 1.6% 12.5 11.7 9.9% 1.2 1.0 9.6% 2.4 2.1 na na na 17.0% 3.5 3.2 1,741.7 1,347.4 3,126.9 957.1 156.0 961.2 113.6 1,200.6 8.5 10.3 10.7 4.6 8.5
Source: Bloomberg; J.P. Morgan Estimates; All prices are of market close as of 11 October 2011
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Financial analysis
We expect a sales CAGR of 37% between 2010 and 2013E
Sales growth driven by new centers
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 companys 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
100% 80% 60% 40% 20% 0%
2009A
2010A
2011E
2012E
2013E
2014E
2008PF
Cancer center revenues Hospital

Source: Company reports and J.P. Morgan estimates.
Management Services Others
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 companys 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.
2015E
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Figure 22: Concord Medical Services: Sales growth and EBITDA margin
100.0% 80.0% 60.0% 40.0% 20.0% 0.0% 2009A 2010A
EBITDA margin s
2011E
2012E
Sales Growth
2013E
Net profit CAGR of 21% from 2010 to 2013E
We estimate Concords 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.
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Concord Medical Services Holdings Limited: Summary of Financials

Income Statement $ in thousands, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet $ in thousands, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets Cash flow statement FY09 FY10 FY11E FY12E FY13E $ in thousands, year end Dec 42,842 59,018 72,044 121,053 153,115 EBIT 70.2% 37.8% 22.1% 68.0% 26.5% Depr. & amortization 30,014 40,427 47,761 60,556 77,625 Change in working capital 62.4% 34.7% 18.1% 26.8% 28.2% Taxes 35,384 45,266 51,997 71,061 92,217 Cash flow from operations 67.7% 27.9% 14.9% 36.7% 29.8% 24,521 27,222 32,154 39,687 51,280 Capex 64.4% 11.0% 18.1% 23.4% 29.2% Net Interest 57.2% 46.1% 44.6% 32.8% 33.5% Other -871 64 -1,313 -3,040 -4,332 Free cash flow 23,619 26,484 30,841 36,646 46,948 59.2% 12.1% 16.5% 18.8% 28.1% -5,332 -6,647 -8,529 -8,470 -10,850 Equity raised/(repaid) 22.6% 25.1% 27.7% 23.1% 23.1% Debt raised/(repaid) 6,800.0 19,607.0 21,571.2 26,719.4 32,062.2 Other -109.4% 188.3% 10.0% 23.9% 20.0% Dividends paid 25 49 47 48 48 Beginning cash 0.27 0.40 0.45 0.56 0.67 Ending cash (107.1%) 48.2% 13.6% 23.3% 19.5% DPS Ratio Analysis FY09 FY10 FY11E FY12E FY13E $ in thousands, year end Dec 151,956 94,214 133,481 117,016 109,686 Gross margin 16,310 24,748 31,077 51,677 63,127 EBITDA margin 1 2 3 4 5 Operating margin 12,756 11,173 15,593 25,555 31,129 Net margin 181,068 130,135 180,151 194,247 203,943 Sales per share growth LT investments 1 2 3 4 5 Sales growth Net fixed assets 85,684 136,079 206,178 253,547 307,765 Net profit growth Total Assets 358,028 392,212 496,050 540,911 581,356 EPS growth Liabilities Interest coverage (x) Short-term loans 6,907 21,163 22,412 23,267 23,267 Payables 1,430 1,519 2,269 3,773 4,609 Net debt to equity Others 13,312 17,487 26,156 38,932 46,360 Working Capital to Sales Total current liabilities 21,649 40,169 50,838 65,973 74,237 Sales/assets Long-term debt 15,054 6,631 67,236 69,802 69,802 Assets/equity Other liabilities 5,652 6,907 14,994 17,006 19,010 ROE Total Liabilities 42,502 53,707 133,067 152,782 163,049 ROCE Shareholders' equity 315,526 338,505 362,982 388,130 418,306 BVPS 4.88 5.22 5.78 6.18 6.66 Source: Company reports and J.P. Morgan estimates. FY09 FY10 24,521 27,222 10,863 18,044 -14,504 -28,848 -5685 -5065 15,035 9,644 FY11E FY12E 32,154 39,687 19,843 31,374 -1,189 -17,081 -6778 -7542 40,609 39,518 FY13E 51,280 40,938 -9,436 -10067 60,902
-34,559 -68,349 -95,538 -81,579 -90,491 -871 64 -1,313 -3,040 -4,332 -76 -2,201 -190 30 25 -19,524 -58,705 -54,929 -42,061 -29,589
132,000 0 0 0 0 5,462 5,749 61,855 3,422 0 -1,000 5,284 21,545 23,110 23,239 0 0 0 0 0 52,058 152,535 94,214 133,481 117,016 152,535 94,214 133,481 117,016 109,686 0.00 0.00 0.00 0.00 0.00 FY09 70.1% 82.6% 57.2% 15.9% FY10 68.5% 76.7% 46.1% 33.2% FY11E 66.3% 72.2% 44.6% 29.9% 26.1% 22.1% 10.0% 13.6% 39.60 -12.1% 40.0% 0.16 1.37 6.2% 7.9% FY12E 50.0% 58.7% 32.8% 22.1% 67.3% 68.0% 23.9% 23.3% 23.37 -6.2% 39.6% 0.23 1.39 7.1% 8.5% FY13E 50.7% 60.2% 33.5% 20.9% 26.0% 26.5% 20.0% 19.5% 21.29 -4.0% 38.2% 0.27 1.39 8.0% 10.3%
29.5% (29.2%) 70.2% 37.8% -109.4% 188.3% (107.1%) 48.2% 40.62 -41.2% 34.7% 0.15 1.13 2.7% 9.2% -19.6% 39.4% 0.16 1.16 6.0% 7.7%
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15 October 2011
Neutral
MicroPort Scientific Corp

Looming Stent Price Cut Keeps Us on the Sideline
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 up Nano stent sales, which we expect will take a while. We think MicroPorts 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 products 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.
MicroPort Scientific Corp (Reuters: 0853.HK, Bloomberg: 853 HK) Rmb in mn, year-end Dec FY09A FY10A FY11E Revenue (Rmb mn) 561 728 858 Net Profit (Rmb mn) 186.4 240.1 297.4 EPS (Rmb) 0.16 0.20 0.21 DPS (Rmb) 0.15 0.00 0.00 Revenue growth (%) 15.6% 29.8% 17.9% EPS growth (%) 3.3% 20.6% 4.4% ROCE 64.7% 24.2% 16.3% ROE 46.9% 20.4% 13.7% P/E (x) 23.6 19.6 18.7 P/BV (x) 11.3 2.8 2.3 EV/EBITDA (x) 19.6 15.1 11.4 Dividend Yield 3.9% 0.0% 0.0%
Previous: Overweight 0853.HK, 853 HK Price: HK$4.69

Previous: HK$7.20

AC

Price Performance
9 HK$ 7 5 3
Abs Rel
YTD -48.8% -17. %
1m -0.5% 14.7%
3m -22.2% 7.8%
12m -53.3% -24.2%
FY12E 1,057 355.1 0.25 0.00 23.2% 19.4% 16.6% 13.9% 15.7 2.0 9.0 0.0%
FY13E 1,244 383.9 0.27 0.00 17.6% 8.1% 15.8% 13.1% 14.5 1.8 7.6 0.0%
Company Data Shares O/S (mn) Market cap (Rmb mn) Market cap ($ mn) Price (HK$) Date Of Price Free float (%) 3mth Avg daily volume 3M - Avg daily Value (HK$ mn) 3M - Avg daily Value (USD) ($ mn) HSCEI Exchange Rate Fiscal Year End
1,441 5,547 869 4.69 14 Oct 11 47.1% 1,853,837.00 7.36 0.95 9,585 7.78 Dec
Company Description
P&L sensitivity metrics (11E)

Utilization rates Impact of 1% increase Stents (ASP) Impact of 1% increase Non-stents business Impact of 1% increase GM Impact of each 100bps increase
EBIT impact (%) 0.9% 1.9% 0.6% 2.2%
EPS impact (%) 1.1% 2.4% 0.8% 2.2%
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.
Price target and valuation analysis Revenue mix (2011E)
Our 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).
Drug eluting stents 98%
0% 2%
DCF assumptions
4.20% 6.00% 1.20 11.4% 5.00%
Source: J.P. Morgan estimates
EPS: J.P. Morgan vs consensus

J. P. Morgan FY11E FY12E FY13E 0.206 0.245 0.265 Consensus 0.226 0.248 n.a
Source: Bloomberg and 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.
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Investment summary
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
300.0 250.0 200.0 150.0 100.0 50.0 2006 2007 PCI cases ('000)
Source: MOH Online Registry.
35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 2008 Y/Y 2009
Figure 24: Total revenue of China's coronary stent market (based on retail prices charged by hospitals)
Rmb (billions)
20 15 10 5 0 2007
Source: Frost & Sullivan.
16.92 13.79 11.32 4.57 5.71 7.17 8.97
3.76
2008
2009
2010E
2011E
2012E
2013E
2014E
76
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 companys 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 off
Rmb '000
300 250 200 150 100 50 2007 2008 2009 2010 2011E 2012E 2013E 2014E % Y/Y 2015E R&D ('mn)
50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% % of total sales
Comprehensive distribution network: In line with market practice, MicroPort sells all 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.
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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 pricecutting pressure.
Figure 26: MicroPort: 2008 orthopedic implantation rate China vs. US
China 50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Trauma
Source: Frost Sullivan
US
Spine
Joints

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/ListofRecal ls/default.htm, numerous instances of medical device recalls are listed. In the past ten
78
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 largescale 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 companys nearterm 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 stents have 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-byprovince 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
Company MicroPort Scientific Corporation Beijing Lepu Medical Device, Inc. Shandong JW Medical Systems Limited Johnson and Johnson (through its Cordis subsidiary) Medtronic, Inc. Dalian Yinyi Biomaterials Development Co., Ltd. Boston Scientific Corporation Others
Source: Frost & Sullivan.
Percentage (%) in the coronary stent market in China 28.9 23.5 22 11.6 7.7 3.2 2.9 0.3
Foray into other product fields may not necessarily be successful: We understand MicroPorts 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 medicaldevice 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 MicroPorts commercial success of Firehawk.
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SWOT analysis
Strengths
Market leadership in the stent space Industry pioneer with well-established reputation 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
Threats
MNCs may become more aggressive in competing for the market share in China
Exit of JNJ from stent business offering opening to well- New technology and products may make MicroPorts positioned domestic players products obsolete 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 XIENCE may be much more successful than expected after next rounds of tendering Lepus 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.
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DCF valuation at HK$5.5
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.
Table 25: MicroPortBase-case DCF analysis
2007 421 158 158 (37) 13 263 398
2008 485 238 214 (64) 17 31 198 0% 11.4% 5,817 1,099 0 0 6,916 1,443 5.5
2009 561 267 209 (54) 24 (81) 98
2010 728 287 214 (125) 37 (611) (485)
2011E 858 355 289 (148) 56 (31) 165
2012E 1,057 426 358 (182) 73 (38) 211
2013E 1,244 462 385 (214) 93 (40) 225 5.0% 4.2% 6.0% 1.2 34.8% 14
2014E 1,453 530 441 (250) 116 (42) 265
2015E 1,649 587 488 (284) 140 (34) 311
Table 26: MicroPort Sensitivity analysis based on WACC and perpetual terminal growth rate
11.3 9.9% 10.4% 10.9% 11.4% 11.9% 12.4% 12.9% 3.5% 5.8 5.4 5 4.7 4.5 4.3 4.1 4% 6.1 5.7 5.3 5 4.7 4.4 4.2 4.5% 6.5 6 5.6 5.2 4.9 4.6 4.4 Terminal growth rate 5.0% 5.5% 6.0% 7.1 7.7 8.5 6.4 7 7.6 5.9 6.4 6.8 5.5 5.9 6.3 5.1 5.4 5.8 4.8 5.1 5.4 4.6 4.8 5 6.5% 9.5 8.4 7.5 6.7 6.2 5.7 5.3
WACC
81
Financial analysis
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 companys voluntary price cut of 5% implemented earlier this year.
Figure 28: MicroPortRevenue mix
100% 3.7 5.9 5.0 5.9 6.0 35.0 8.9 9.0 52.5 17.8 20.0 70.9 35.6 25.0 90% 557.1 721.8 841.2 1,004.3 71.3 30.0 1,153.3 1,321.2 92.1
Figure 29: MicroPort Cost breakdown

Manufacturing costs 26%
95%
R&D 29%
85%
1,455.2
80% 2009 2010 2011E EP Devices 2012E 2013E 2014E 2015E
Admin 16% Selling 29%

Source: Company data; J.P. Morgan estimates.
Vascular devices
Diabetes Devices
Orthopedic Devices
MicroPorts 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 companys 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 companys 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
100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2007 GM 2008 R&D 2009 2010 SG&A 2011E 2012E 2013E 2014E Net Margin 2015E
Operating Margin
82
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, MicroPorts 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.
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MicroPort Scientific Corp: Summary of Financials

Income Statement Rmb in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet Rmb in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets Cash flow statement FY10 FY11E FY12E FY13E Rmb in millions, year end Dec 728 858 1,057 1,244 EBIT 29.8% 17.9% 23.2% 17.6% Depr. & amortization 630 721 872 986 Change in working capital 30.4% 14.5% 21.0% 13.0% Taxes 324 411 499 555 Cash flow from operations 11.3% 26.8% 21.5% 11.2% 287 355 426 462 Capex 7.4% 23.8% 20.0% 8.4% Net Interest 39.4% 41.4% 40.3% 37.1% Other -1 -1 -1 -0 Free cash flow 295 354 425 461 14.0% 19.9% 20.1% 8.5% -55 -57 -70 -78 Equity raised/(repaid) 18.7% 16.0% 16.5% 16.8% Debt raised/(repaid) 240.1 297.4 355.1 383.9 Other 28.8% 23.8% 19.4% 8.1% Dividends paid 1,220 1,447 1,447 1,447 Beginning cash 0.20 0.21 0.25 0.27 Ending cash 20.6% 4.4% 19.4% 8.1% DPS Ratio Analysis FY09 FY10 FY11E FY12E FY13E Rmb in millions, year end Dec 90 928 1,104 1,326 1,556 Gross margin 144 210 248 305 359 EBITDA margin 57 84 100 123 144 Operating margin 194 644 826 813 805 Net margin 484 1,867 2,277 2,566 2,865 Sales per share growth LT investments 23 64 64 64 64 Sales growth Net fixed assets 157 223 364 472 593 Net profit growth Total Assets 712 2,174 2,724 3,122 3,541 EPS growth Liabilities Interest coverage (x) Short-term loans 0 4 4 4 4 Payables 5 96 113 139 164 Net debt to equity Others 26 166 170 187 197 Working Capital to Sales Total current liabilities 261 163 287 330 365 Sales/assets Long-term debt 4 4 1 1 1 Assets/equity Other liabilities 59 59 59 59 59 ROE Total Liabilities 324 203 346 389 424 ROCE Shareholders' equity 388 1,971 2,378 2,733 3,117 BVPS 0.34 1.37 1.65 1.89 2.16 Source: Company reports and J.P. Morgan estimates. FY09 561 15.6% 483 21.4% 291 14.2% 267 12.1% 47.6% -8 259 13.5% -66 25.4% 186.4 4.2% 1,142 0.16 3.3% FY09 267 24 -81 1 211 -34 -8 169 FY10 287 37 -611 -66 -353 -166 -1 -520 FY11E 355 56 -31 -55 324 -148 -1 176 FY12E 426 73 -38 -57 404 -182 -1 222 FY13E 462 93 -40 -70 445 -214 -0 230
4 -22 0 -127 66 90 0.15 FY09 86.1% 51.9% 47.6% 33.2% 14.5% 15.6% 4.2% 3.3% 36.96 -22.1% 34.8% 0.84 1.84 46.9% 64.7%
1,444 0 -86 90 928 0.00 FY10 86.5% 44.5% 39.4% 33.0% 21.5% 29.8% 28.8% 20.6% 289.37 -46.7% 27.3% 0.50 1.10 20.4% 24.2%
0 0 928 1,104 0.00 FY11E 84.0% 47.9% 41.4% 34.7% (0.6%) 17.9% 23.8% 4.4% 463.16
0 0 1,104 1,326 0.00 FY12E 82.5% 47.2% 40.3% 33.6% 23.2% 23.2% 19.4% 19.4% 938.99
0 0 1,326 1,556 0.00 FY13E 79.3% 44.6% 37.1% 30.9% 17.6% 17.6% 8.1% 8.1% 2,786.96 -49.8% 27.3% 0.37 1.14 13.1% 15.8%
-46.2% -48.3% 27.3% 27.3% 0.35 0.36 1.15 1.14 13.7% 13.9% 16.3% 16.6%
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15 October 2011
Mindray Medical
China business may be turning a corner
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 MRs diversified product mix and balanced sales contribution from China and ex-China significantly reduce investment risks. MRs 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 MRs 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 isnt low vs. its peers, we believe the premium is reasonable, given MRs market leadership in medical devices and proven track record in new product development. A key risk to our PT is the sustainability of the domestic market recovery.
Mindray Medical (Reuters: MR, Bloomberg: MR US) $ in mn, year-end Dec FY09A FY10A Revenue ($ mn) 634 704 Net Profit ($ mn) 138.6 155.7 EPS ($) 1.28 1.37 DPS ($) 0.26 0.30 Revenue growth (%) 15.8% 11.1% EPS growth (%) 25.2% 6.8% ROCE 19.2% 17.5% ROE 24.3% 19.4% P/E (x) 19.2 18.0 P/BV (x) 4.1 2.7 EV/EBITDA (x) 15.7 12.2 Dividend Yield 1.0% 1.2%
Overweight
MR, MR US Price: $24.62
Price Target: $32.00

Previous: $40.00

AC

Price Performance
34 30 $ 26 22 18
MR share price ($) HSCEI (rebased)
Abs Rel
YTD -6.7% 16.1%
1m -2.0% -0.3%
3m -8.0% 12.3%
12m -20.8% 5.5%
FY11E 832 172.1 1.52 0.33 18.1% 11.1% 16.9% 16.5% 16.2 2.3 10.4 1.4%
FY12E 991 198.4 1.76 0.38 19.1% 15.3% 16.9% 16.4% 14.0 2.0 8.7 1.6%
FY13E 1,163 229.3 2.03 0.44 17.4% 15.6% 16.9% 16.3% 12.1 1.7 7.1 1.8%
Company Data Shares O/S (mn) Market cap ($ mn) Market cap ($ mn) Price ($) Date Of Price Free float (%) 3-mth trading volume (mn) 3-mth trading value ($ mn) 3-mth trading value ($ mn) HSCEI Exchange Rate Fiscal Year End
85 2,105 2,105 24.62 13 Oct 11 81.3% 1 16 16 9,803 1.00 Dec
Company description

FY11E Growth in export sales Impact of each 5 percentage increase Change in Selling costs Impact of each 5 percentage increase Change in manufacturing costs Impact of each 5 percentage increase GM: 1% Increase Impact of each 1% increase
EBIT impact (%) 5.9% 4.3% 10.2% 4.7%
EPS impact (%) 5.1% 3.8% 8.9% 4.2%
Mindray is Chinas 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.

Others 6% Monitors 43% Ultrasound 26% Diagnostic 25%
Our Dec-12 price target of $32 is based on DCF methodology. The nature of the industry leads us to apply a terminal growth rate of 5% (the middle of the 3% to 6% growth rate used for health care stocks).
Risk free rate: Market risk premium: Beta: Cost of equity Terminal g:
4.20% 6.00% 1.00 10.20% 5.00%
EPS: J.P. Morgan vs. consensus ($)

(NonGAAP) FY11E FY12E FY13E J. P. Morgan 1.63 1.86 2.12 Consensus 1.53 1.76 2.09
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.
86
Investment summary
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 lowend products is comparable with that of multinationals. Mindrays devices are typically priced at ~30% discount to similar models from multinationals, making those products very competitive in emerging markets, which underlines the companys strong growth there. In China, MRs market share has surpassed that of global brands for several major products, although the companys 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 governments 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 Mindrays 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
87
acquisitions, we expect MR to maintain growing the China business at 20%+ for the next several years.
Figure 31: MindrayChina sales appear to be picking up momentum
US$ in millions
100 90 80 70 60 50 40 30 20 10 0 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Y/Y 4Q10 1Q11 2Q11 China sales
50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -10.00%

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 companys cost is mostly denominated in Rmb, Rmb appreciation, left largely unhedged by Mindray, could negatively impact its operating margins. Competition is becoming fiercer We 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 that region. 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.
88

DCF valuation
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.
Table 27: MindrayBase case DCF analysis
2007 306 83 41 (50) 9 (2) (2)
2008 548 118 164 (71) 22 (35) 79 0% 12.2% 3,237 532 0 0 3,770 118 32.0
2009 634 141 122 (56) 27 4 96
2010E 704 156 129 (63) 32 65 163
2011E 832 177 159 (70) 37 (20) 105
2012E 991 205 176 (75) 41 (30) 112
2013E 1,163 238 203 (71) 45 (29) 147 5.0% 4.2% 6.0% 1.00 6.6% 11.5
2014E 1,334 274 230 (65) 48 (25) 188
2015E 1,509 311 258 (59) 50 (23) 226
Table 28: MindraySensitivity analysis based on WACC and perpetual terminal growth rate
11.3 10.7% 11.2% 11.7% 12.2% 12.7% 13.2% 13.7% 3.5% 33.2 31.3 29.6 28.1 26.8 25.7 24.6 4% 34.9 32.7 30.9 29.2 27.8 26.5 25.4 Terminal growth rate 4.5% 5.0% 5.5% 36.9 39.3 42.1 34.4 36.4 38.8 32.3 34 36 30.5 31.9 33.6 28.9 30.1 31.6 27.5 28.6 29.8 26.2 27.2 28.2 6.0% 45.5 41.5 38 35.5 33.2 31.2 29.4 6.5% 49.7 44.9 41 37.8 35.1 32.8 30.8
We also analyze the DCF price sensitivity to WACC, and the terminal multiple. At our price target of US$32, Mindray would be trading at 18x our 2012 EPS estimate, which we believe is reasonable given its China market leadership, strong global presence, and its historical track record of launching products to fuel further growth.
WACC
89
Financial analysis
We expect EPS CAGR of 13.8% over the next three years
As Mindray derives majority of its sales from overseas, its business should actually be much less affected by the current negative macro headwind in China that has caused us to lower our estimates for many of our covered companies substantially. We revise our model only slightly to incorporate the reported 2Q11 results and bring our full-year estimates roughly in line with management guidance.
Table 29: MindrayRevisions to our model
US$ in millions Year to Dec (US$ MM) FY11E Turnover Gross profit EBIT Non-GAAP Net profit Non-GAAP EPADS Gross margin 832 471 177 191 1.63 56.6% New FY12E 991 552 205 218 1.86 55.7% FY11E 851 471 180 190 1.62 55.4% Old FY12E 1,021 558 213 221 1.88 54.7% FY11E -2.2% -0.2% -1.7% 0.7% 0.7% 1.2% Change FY12E -3.0% -1.1% -4.0% -1.2% -1.2% 1.1%
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.
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SWOT analysis
Leading brand recognition and quality perception enable Technologically, Mindray is still not as strong as MNC the company to enjoy premium pricing vs. local competitors, so it cannot compete effectively for a lions competitors. share of business from large tier-1 hospitals. 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 lowend domestic manufacturers. 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.
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.
Cross-selling still feasible in the US for Mindrays patient Labor and raw material cost inflation could severely monitor products. impact the companys profitability and its ability to Austerity measures in European countries could hit generate cash to fund R&D. spending on healthcare and increase the demand for Political turmoil may spill over and affect Mindrays medical equipment offering favorable quality/price tradebusinesses in some countries. off.
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Mindray Medical: Summary of Financials

Income Statement $ in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet $ in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets FY09 634 15.8% 354 19.2% 184 18.3% 141 19.7% 22.2% 1 167 33.2% -29 17.2% 138.6 27.5% 106 1.28 25.2% FY09 215 113 102 81 512 FY10 704 11.1% 401 13.4% 204 11.0% 156 10.8% 22.1% 9 173 3.6% -18 10.2% 155.7 12.3% 106 1.37 6.8% FY10 434 143 79 39 695 FY11E 832 18.1% 471 17.3% 230 12.6% 177 13.4% 21.2% 13 200 15.5% -28 14.0% 172.1 10.5% 106 1.52 11.1% FY11E 532 161 94 41 828 139 295 1,322 0 52 137 189 0 11 201 1,121 10.58 FY12E 991 19.1% 552 17.4% 262 14.2% 205 16.0% 20.7% 16 234 16.6% -35 15.0% 198.4 15.3% 106 1.76 15.3% FY12E 648 182 111 38 979 142 338 1,513 0 62 140 203 0 13 216 1,296 12.23 FY13E 1,163 17.4% 643 16.5% 300 14.3% 238 16.4% 20.5% 19 273 17.0% -44 16.0% 229.3 15.6% 106 2.03 15.6% FY13E 803 203 131 58 1,195 Cash flow statement $ in millions, year end Dec EBIT Depr. & amortization Change in working capital Taxes Cash flow from operations Capex Net Interest Other Free cash flow FY09 141 43 4 0 172 -56 1 0 116 FY10 156 48 65 0 261 -63 9 0 199 FY11E 177 53 -20 0 206 -70 13 -0 136 FY12E 205 57 -30 0 232 -75 16 -0 156 FY13E 238 61 -29 0 273 -71 19 -0 203
Equity raised/(repaid) Debt raised/(repaid) Other Dividends paid Beginning cash Ending cash DPS Ratio Analysis $ in millions, year end Dec Gross margin EBITDA margin Operating margin Net margin
13 12 -22 216 215 0.26 FY09 55.8% 29.0% 22.2% 21.9% 13.7% 15.8% 27.5% 25.2% -7.1% 28.4% 0.72 1.25 24.3% 19.2%
4 -31 215 434 0.30 FY10 57.0% 29.0% 22.1% 22.1% 5.6% 11.1% 12.3% 6.8% -44.9% 25.3% 0.67 1.25 19.4% 17.5%
2 -36 434 532 0.33 FY11E 56.6% 27.6% 21.2% 20.7% 18.7% 18.1% 10.5% 11.1% -47.5% 24.3% 0.67 1.25 16.5% 16.9%
2 -40 532 648 0.38 FY12E 55.8% 26.5% 20.7% 20.0% 19.1% 19.1% 15.3% 15.3% -50.0% 23.3% 0.70 1.17 16.4% 16.9%
2 -47 648 803 0.44 FY13E 55.3% 25.8% 20.5% 19.7% 17.4% 17.4% 15.6% 15.6% -52.7% 22.4% 0.71 1.15 16.3% 16.9%
LT investments 183 136 Net fixed assets 208 254 Total Assets 966 1,151 Liabilities Short-term loans 103 0 Payables 36 44 Others 116 130 Total current liabilities 255 175 Long-term debt 66 0 Other liabilities 5 9 Total Liabilities 326 184 Shareholders' equity 641 967 BVPS 6.04 9.12 Source: Company reports and J.P. Morgan estimates.
Sales per share growth 144 Sales growth 372 Net profit growth 1,760 EPS growth Interest coverage (x) 0 73 Net debt to equity 145 Working Capital to Sales 218 Sales/assets 0 Assets/equity 16 ROE 234 ROCE 1,526 14.39
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15 October 2011
Shandong Weigao Group Medical Polymer Co. Ltd.

Growth in dialysis the key catalyst for a breakout
Overweight
1066.HK, 1066 HK Price: HK$8.83

Previous: HK$15.00
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, Weigaos products are mostly disposable consumables which are largely nondiscretionary, offering Weigao a distinct advantage. Weigaos 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 Weigaos share price as an attractive buying opportunity. Strong brands and unrivaled sales reach underpin long-term growth: Weigaos vast sales and distribution network is critical for success as a medical consumable player. While Becton-Dickinson, Weigaos 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. Weigaos products usually enjoy a price premium versus domestic peers, and they are positively 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 Weigaos business model could become extremely lucrative by operating those centers as government-subsidized nonprofit 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.
Shandong Weigao Group Medical Polymer Co. Ltd. (Reuters: 1066.HK, Bloomberg: 1066 HK) Rmb in mn, year-end Dec FY09A FY10A FY11E FY12E FY13E Revenue (Rmb mn) 1,878 2,463 3,253 4,364 5,579 Net Profit (Rmb mn) 633.4 799.1 954.8 1,296.7 1,554.1 EPS (Rmb) 0.15 0.19 0.22 0.29 0.35 DPS (Rmb) 0.18 0.08 0.09 0.12 0.14 Revenue growth (%) 24.0% 31.1% 32.1% 34.2% 27.8% EPS growth (%) 20.0% 26.2% 17.1% 33.2% 19.9% ROCE 19.9% 20.5% 18.0% 19.0% 21.4% ROE 23.4% 24.3% 20.6% 21.5% 22.6% P/E (x) 49.0 38.9 33.2 24.9 20.8 P/BV (x) 10.6 8.6 5.7 5.0 4.4 EV/EBITDA (x) 54.6 44.1 34.6 25.7 20.1 Dividend Yield 2.5% 1.0% 1.2% 1.6% 1.9%

AC

Price Performance
13 11 HK$ 9 7
1066.HK share price (HK$) MSCI-Cnx (rebased)
Abs Rel
YTD -23.7% 2.2%
1m -7.5% 6.0%
3m -25.6% -2.9%
12m -21.2% 3.9%
Company Data Shares O/S (mn) Market cap (Rmb mn) Market cap ($ mn) Price (HK$) Date Of Price Free float (%) 3-mth trading volume (mn) 3-mth trading value (HK$ mn) 3-mth trading value ($ mn) MSCI-Cnx Exchange Rate Fiscal Year End
1,884 13,599 2,138 8.83 14 Oct 11 82.9% 5 45 6 5,419 7.78 Dec
Company description

FY11E No blood purification growth in 2011 - assumes 2011 sales = 2010 sales No new product introduction for 2011 - only organic growth from existing products Selling expenses Impact of each 5 percentage points increase GM: 1% Increase Impact of each 1% increase
EBIT impact (%) -7.1% -8.7% -10.8% 3.8%
EPS impact (%) -5.8% -9.0% -10.2% 3.1%
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.

Infusion 30%
Our 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).
others 24% Ortho 8%
Syringes 15% Blood Bags 6% Needles 17%
Risk free rate: Market risk premium: Beta: Wacc Terminal g:
4.20% 6.00% 0.71 8.43% 5.50%
EPS: J.P. Morgan vs consensus

J. P. Morgan FY10A FY11E FY12E 0.186 0.215 0.287 Consensus 0.186 0.229 0.301
Source: Bloomberg, 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 include regulatory 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.
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Investment summary
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 Weigaos shares. In addition, Weigaos 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 WeigaoAn impressive record of consistent strong top-line growth
Rmb in millions
9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 2005 2006 2007 2008 2009 20102011E 2012E 2013E 2014E 2015E Sales Gross margin Sales growth
60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%
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, Weigaos 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. Weigaos 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 toptier 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
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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 consumables was 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 Nikkisos 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 Nikkisos 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 100,000 patients 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 yearend 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 companys overall profitability.

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 Weigaos
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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 companys 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 Biosensors business would show up on Weigaos 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
Current FCF 0 Difference
2011E 137.5 161.3 23.8
2012E 136.6 162.4 25.8
2013E 139.4 172.3 32.9
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DCF valuation
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 Weigaos strong growth momentum, we believe 6% terminal growth rate is justifiable. We also analyze the DCF price sensitivity to WACC, and the terminal multiple.
Table 31:WeigaoBase-case DCF analysis
2007 1,095 291 281 (226) 47 (114) (12)
2008 1,514 491 408 (202) 58 (67) 196 0% 8.4% 41,988 2,002 (82) 0 43,908 4,439 11.5
2009 1,878 568 529 (318) 72 (108) 175
2010E 2,463 700 726 (296) 94 69 593
2011E 3,253 855 873 (328) 113 (237) 421
2012E 4,364 1,169 1,198 (402) 131 (307) 619
2013E 5,579 1,497 1,481 (320) 147 (302) 1,006 6.0% 4.2% 5.5% 0.71 6.2% 25x
2014E 6,909 1,865 1,789 (490) 166 (310) 1,154
2015E 8,423 2,261 2,144 (740) 198 (332) 1,269
Table 32: WeigaoSensitivity analysis based on WACC and perpetual terminal growth rate
11.3 6.9% 7.4% 7.9% 8.4% 8.9% 9.4% 9.9% 3.0% 9.2 8.2 7.4 6.8 6.3 5.8 5.4 3.5% 10.3 9.1 8.1 7.4 6.7 6.2 5.8 4.0% 11.9 10.2 9.0 8.0 7.3 6.7 6.1 Terminal growth rate 4.5% 5.0% 5.5% 14.0 17.3 23.0 11.7 13.9 17.2 10.1 11.6 13.7 8.9 10.0 11.5 8.0 8.8 9.9 7.2 7.9 8.7 6.6 7.1 7.8 6.0% 34.6 22.7 17.0 13.6 11.4 9.8 8.6
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WACC
Financial analysis
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, Weigaos 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: WeigaoSales and GM forecasts
Rmb in millions
Figure 34: WeigaoComposition of sales for 2010

Selling 20% Operating profit 24% Others 0% Manufacturing 41%
9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 2005 2006 2007 2008 2009 20102011E 2012E 2013E 2014E 2015E Sales Gross margin Sales growth
60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%

R&D 5% Depreciation 4%
Source: Company reports, J.P. Morgan.
GA 6%
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 EPS estimate for 2011 and 2012 by 14.4% and 14.7%, respectively.
Table 33: Revisions to our model
Rmb in millions New FY11E Turnover Gross profit EBIT Net profit EPS (CNY) Gross margins 3,253 1,743 855 955 0.215 53.6% FY12E 4,364 2,331 1,169 1,297 0.287 53.4% FY11E 3,306 1,799 932 1,116 0.251 54.4% Old FY12E 4,616 2,474 1,308 1,521 0.336 53.6% FY11E -1.6% -3.1% -8.2% -14.4% -14.4% -0.8% Change FY12E -5.4% -5.8% -10.6% -14.7% -14.7% -0.2%
Source: Company data, J.P. Morgan estimates. Note: Earnings revision made due to assumption of coverage.
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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: WeigaoMargin forecasts
60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2008 2009 Gross Profit Margin
2010
2011E SG&A
2012E
2013E
2014E Net Margin
2015E
EBIT Margin
FCF sensitivity to AR Days

2011E Current FCF 0 Difference 137.5 161.3 23.8 2012E 136.6 162.4 25.8 2013E 139.4 172.3 32.9
Weigao has been experiencing some difficulty in cash collection problems because of strong bargaining power of hospitals and Weigaos 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.
Source: J.P. Morgan Estimates
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SWOT analysis
Strengths
The superior business model fulfilling the daily needs of patients and physicians at hospitals. An unparalleled sales network and established brands. A diversified product portfolio reduces risks to any particular segment. Management's ability to identify and execute growth is a key advantage. Low cost associated with favorable government policy and local support.
Weaknesses
Lack of market research to lower-tier hospitals. Difficulty in managing JVs. Low bargain power with hospitals in regard to cash collection. The over-reliance on Chinas domestic markets could increase the impact of a hard-landing of the China economy.
Opportunities
Low penetration into low-tier hospitals to provide extra room for growth. Dialysis consumable offers substantial opportunity to gain market share from MNCs. Invitro fertilization and wound management could offer some upsides.
Threats
MNCs may target high-tier hospitals more aggressively. Local players may take market share away from Weigao with aggressive pricing schemes. The government may grant more licenses to operate independent dialysis centers. The government may target medical consumable for next round of price controls.
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Table 34: Shandong WeigaoRevenue forecast

Rmb in millions Year to Dec (Rmb in millions) Total turnover Y/Y Growth PRC Exports % exports Segment Infusion Syringes Blood Bags Medical needles Other consumables Total consumables Orthopedic Blood purification PVC Granules Others (Medical Instruments & others) Total segmented sales Infusion Y/Y Growth Syringes Y/Y Growth Blood Bags Y/Y Growth Medical needles Y/Y Growth Orthopedic (49% owned) Y/Y Growth Blood purification Y/Y Growth PVC Granules Y/Y Growth
2008 1,514 38% 1,383 131 9% 374 265 119 267 161 1,186 172 25 70 61 1,514 374 41% 265 23% 119 14% 267 80% 171.8 55% 25 63% 70 -5%
2009 1,878 24% 1,678 200 11% 525 319 140 329 214 1,527 125 69 63 94 1,878 525 36% 319 21% 140 18% 329 22% 125.3 -27% 69 175% 63 -12%
2010 2,463 31% 2,142 310 13% 724 408 169 398 272 1,971 175 143 60 103 2,452 724 40% 408 28% 169 16% 398 23% 175.2 40% 143 107% 60 -11%
2011E 3,253 32% 2,776 477 15% 975 482 196 558 343 2,554 251 251 63 134 3,253 975 35% 482 18% 196 16% 558 40% 250.8 43% 251 76% 63 5%
2012E 4,364 34% 3,638 727 17% 1,269 568 223 715 430 3,205 327 593 65 174 4,364 1,269 30% 568 18% 223 14% 715 28% 327.4 31% 564 125% 65 3%
2013E 5,579 28% 4,539 1,041 19% 1,576 649 251 879 537 3,891 401 993 67 226 5,579 1,576 24% 649 14% 251 12% 879 23% 401.5 23% 903 60% 67 2%
2014E 6,909 24% 5,483 1,427 21% 1,906 722 278 1,042 605 4,553 480 1,572 68 238 6,909 1,906 21% 722 11% 278 11% 1,042 19% 479.7 19% 1,367 51% 68 2%
2015E 8,423 22% 6,515 1,908 23% 2,174 788 306 1,199 680 5,147 572 2,387 69 249 8,423 2,174 14% 788 9% 306 10% 1,199 15% 571.5 19% 1,989 46% 69 1%
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Shandong Weigao Group Medical Polymer Co. Ltd.: Summary of Financials

Income Statement Rmb in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet Rmb in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets FY09 1,878 24.0% 1,001 32.0% 642 16.5% 568 15.7% 30.2% 8 705 34.2% -72 10.2% 633.4 30.8% 4,474 0.15 20.0% FY09 723 852 319 100 1,995 FY10 FY11E 2,463 3,253 31.1% 32.1% 1,360 1,743 35.9% 28.2% 797 970 24.1% 21.8% 700 855 23.4% 22.2% 28.4% 26.3% -4 7 888 1,077 26.0% 21.3% -86 -98 9.6% 9.1% 799.1 954.8 26.2% 19.5% 4,474 4,474 0.19 0.22 26.2% 17.1% FY10 FY11E 628 2,117 1,056 1,394 380 502 134 267 2,198 4,281 1,063 1,628 6,993 26 1,108 72 1,206 88 27 1,321 5,640 1.26 FY12E 4,364 34.2% 2,331 33.7% 1,302 34.2% 1,169 36.7% 26.8% 28 1,488 38.2% -141 9.5% 1,296.7 35.8% 4,474 0.29 33.2% FY12E 2,271 1,871 674 376 5,192 1,128 1,900 8,240 26 1,486 103 1,616 88 36 1,740 6,419 1.43 FY13E 5,579 27.8% 2,967 27.3% 1,646 26.4% 1,497 28.0% 26.8% 31 1,839 23.6% -193 10.5% 1,554.1 19.9% 4,474 0.35 19.9% FY13E 2,682 2,392 861 530 6,465 Cash flow statement Rmb in millions, year end Dec EBIT Depr. & amortization Change in working capital Taxes Cash flow from operations Capex Net Interest Other Free cash flow FY09 568 75 -108 -49 479 -318 8 3 161 FY10 700 96 69 -72 782 -296 -4 97 486 FY11E 855 115 -237 -86 645 -328 7 100 317 FY12E 1,169 133 -307 -98 893 -402 28 135 491 FY13E 1,497 149 -302 -141 1,199 -320 31 126 879
Equity raised/(repaid) Debt raised/(repaid) Other Dividends paid Beginning cash Ending cash DPS Ratio Analysis Rmb in millions, year end Dec Gross margin EBITDA margin Operating margin Net margin
9 -171 830 723 0.18 FY09 53.3% 34.2% 30.2% 33.7% 13.7% 24.0% 30.8% 20.0% -19.5% 21.3% 0.51 1.36 23.4% 19.9%
-9 -542 723 628 0.08 FY10 55.2% 32.4% 28.4% 32.5% 31.2% 31.1% 26.2% 26.2% 191.63 -14.2% 24.3% 0.57 1.28 24.3% 20.5%
1,441 7 -352 628 2,117 0.09 FY11E 53.6% 29.8% 26.3% 29.3% 29.5% 32.1% 19.5% 17.1% -35.5% 24.3% 0.56 1.24 20.6% 18.0%
9 -450 2,117 2,271 0.12 FY12E 53.4% 29.8% 26.8% 29.7% 31.6% 34.2% 35.8% 33.2% -33.6% 24.3% 0.57 1.28 21.5% 19.0%
10 -570 2,271 2,682 0.14 FY13E 53.2% 29.5% 26.8% 27.9% 27.8% 27.8% 19.9% 19.9% -34.9% 24.3% 0.62 1.33 22.6% 21.4%
LT investments 766 1,019 Net fixed assets 1,167 1,411 Total Assets 3,989 4,649 Liabilities Short-term loans 37 26 Payables 772 839 Others 94 42 Total current liabilities 903 907 Long-term debt 114 88 Other liabilities 30 20 Total Liabilities 1,046 1,015 Shareholders' equity 2,940 3,626 BVPS 0.68 0.84 Source: Company reports and J.P. Morgan estimates.
Sales per share growth 1,196 Sales growth 2,074 Net profit growth 9,756 EPS growth Interest coverage (x) 26 1,900 Net debt to equity 171 Working Capital to Sales 2,097 Sales/assets 88 Assets/equity 46 ROE 2,232 ROCE 7,352 1.64
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15 October 2011
Sihuan Pharmaceutical Holdings

Remain OW due to the Strong Performance of Acquired Products
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 its strong 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. Sihuans 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. Sihuans 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 Sihuans 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.
Sihuan Pharmaceutical Holdings (Reuters: 0460.HK, Bloomberg: 460 HK) Rmb in mn, year-end Dec FY09A FY10A FY11E FY12E Revenue (Rmb mn) 709 1,037 2,516 4,039 Net Profit (Rmb mn) 326.3 522.0 820.7 1,023.8 EPS (Rmb) 0.09 0.13 0.16 0.20 DPS (Rmb) 0.03 0.04 0.00 0.00 Revenue growth (%) 39.0% 46.3% 142.7% 60.5% EPS growth (%) 72.6% 49.8% 21.6% 24.7% ROCE 46.4% 16.2% 13.5% 14.8% ROE 40.6% 13.8% 11.6% 12.8% P/E (x) 28.8 19.3 15.8 12.7 P/BV (x) 13.0 2.0 1.7 1.5 EV/EBITDA (x) 35.1 13.3 9.2 7.9 Dividend Yield 1.3% 1.8% 0.0% 0.0%
Overweight
0460.HK, 460 HK Price: HK$3.07

Previous: HK$7.40

AC

Price Performance
6.5 5.5 HK$ 4.5 3.5 2.5
Abs Rel
YTD -53.7% -22.5%
1m 0.8% 16.0%
3m -27.3% 2 7%
12m -42.8% -13.7%
FY13E 4,983 1,166.7 0.23 0.00 23.4% 14.0% 15.3% 12.8% 11.1 1.3 6.0 0.0%
Company Data Shares O/S (mn) Market cap (Rmb mn) Market cap ($ mn) Price (HK$) Date Of Price Free float (%) 3mth Avg daily volume 3M - Avg daily Value (HK$ mn) 3M - Avg daily Value (USD) ($ mn) HSCEI Exchange Rate Fiscal Year End
5,175 12,989 2,042 3.07 14 Oct 11 25.9% 13.69 42.21 5.45 9,803 7.78 Dec
Company description
P&L sensitivity metrics (FY10E)

Kelinao ASP Impact of 5% increase Kelinao (volume) Impact of 5% increase Other cardio-cerebral (ASPs) Impact of 5% increase GM Impact of each 100bps increase
EBIT impact (%) 4.0% 3.2% 1.8% 1.7%
EPS impact (%) 3.6% 2.9% 2.0% 1.6%
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.
Revenue mix (2011E)
Our 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).
Antiinfective drugs 5%
Cardiocerebral vascular 89%
DCF assumptions
Others 6%
Risk free rate: Market risk premium: Beta: Cost of equity Terminal g:
4.20% 6.00% 1.0 10.20% 6.00%
Source: Company, J.P. Morgan estimates.

Rmb FY11E FY12E FY13E J. P. Morgan 0.158 0.198 0.225 Consensus 0.157 0.210 n.a
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.
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Investment summary
A leading cardio-cerebral vascular drug company in China. Recent acquisitions have boosted Sihuans 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: SihuanRevenue mix
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 09 10 2011E 2012E 2013E 2014E 2015E
Anti-infective drugs Others
Figure 37: SihuanSales growth and gross margins

160% 140% 120% 100% 80% 60% 40% 20% 0% 2008 2009 2010 2011E
Sales growth
2012E
Cardio-cerebral vascular
Gross margin
Source: Company data; J.P. Morgan estimates.
Source: Company data. J.P. Morgan estimates.
Increasing demand for cardio-cerebral vascular drugs: According to the MOHs Fourth National Survey on the PRCs 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 () (Cerebroside-Kinin Injection) as one of three
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major products. Cerbroside-Kinin, branded as Kailuoxin (), 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 Sihuans strength in distributing CCV products, we are significantly upbeat about Oudimeis 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 companys 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 Sihuan can 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 289 employees 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 companys current product offerings such as drugs for circulatory system disorders but also new areas such as respiratory and epilepsyrelated 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
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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 companys net profit was about Rmb20mn in 2010. We believe strong 1H11 validates management's decision to purchase Dupromise.

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 that adverse 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 companys 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.
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SWOT analysis
Strengths
The market leadership for cardio-cerebral drugs used in major hospitals for the emergency treatment of strokes and other cardio-cerebral illnesses.
Weaknesses
The anti-infective drugs market to become more competitive. For example, several of Sihuans antiinfective drugs, namely Kanglixin, Xiboao, Aolang and Anjiejian, experienced a decrease in their wholesale The largest market share in the CCV drug market each prices of 3.9%-14.2% in the past three years, mainly year since 2007 and had a market share of 7.4% in 2009, attributable to intense competition. highlighting the companys strong distribution network. The over-reliance on the sales of Kelinao and Anjieli, its Patent protection into 2020s for two key products cinepazide maleate products. In 2009, the revenue derived Oudimei and Kelinao. from the sale of Kelinao and Anjieli represented 57.3% of total revenue. Oudimei is expected to alleviate this An extensive nationwide distribution network covering problem. close to 10,000 hospitals through over 2,000 distributors in all 31 provinces in China. The indirect sales model does not allow much to control the end-user market as the direct sales model. Management team is made up of seasoned veterans, many of whom have over 20 years experience in the pharmaceutical areathe medical background of the two co-founders confers credibility when dealing with physicians and surgeons.
Opportunities
Threats
Vast market opportunitiesSihuan has 44 products Competition with international players which have greater covering the top five medical therapeutic areas in China: resources. Sihuan competes in a highly competitive anti-infective, metabolism, cardiovascular system, market, which is significantly affected by the introduction oncology and nervous system. The aggregate market size of new products and price reductions by industry of products in these five therapeutic areas amounted to participants. Rmb166.4 billion in 2009, accounting for approximately Sihuans products are subject to price controls and it does 81.8% of the overall pharmaceutical market in China. not have full discretion over the pricing of its products. These top five areas are projected to continue to grow rapidly and reach Rmb466.8 billion by 2014, representing Delays in obtaining regulatory approvals. The company a CAGR of 22.9% from 2009. depends on the approval of new products in order to sustain its growth, which is higher than the QuAo, the CNS drug for cardio-cerebral vascular pharmaceutical industry. The SFDA approval process diseases, ranked second in the cerebroprotein hydrolysate now takes longer to complete than before. 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 departmentsneurology and neurosurgery. According to management, cinepazide can find use in about 10 departments because of the versatility of the drug class.
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DCF valuation
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.
Table 35: SihuanBase-case DCF analysis
2007 286 187 187 (31) 1 (270) (113)
2008 510 276 268 (29) 3 (23) 218 0% 10.3% 17,065 4,880 14 0 21,959 5,175 4.9
2009 709 373 303 (60) 19 (13) 249
2010E 1,037 613 505 (108) 26 (145) 278
2011E 2,516 954 770 (1,628) 78 (223) (1,003)
2012E 4,039 1,182 947 (1,441) 108 (393) (779)
2013E 4,983 1,387 1,090 (70) 131 (299) 852 6.0% 4.2% 6.0% 1.0 6.2% 16.3x
2014E 5,772 1,563 1,209 (81) 162 (282) 1,007
2015E 6,460 1,707 1,297 (91) 185 (252) 1,139
Table 36: SihuanSensitivity analysis based on WACC and perpetual terminal growth rate
11.3 8.8% 9.3% 9.8% 10.3% 10.8% 11.3% 11.8% 4.5% 5.1 4.7 4.3 4.0 3.7 3.5 3.3 5% 5.6 5.0 4.6 4.2 3.9 3.7 3.5 5.5% 6.2 5.5 5.0 4.5 4.2 3.9 3.6 Terminal growth rate 6.0% 6.5% 7.0% 7.1 8.3 10.3 6.1 7.0 8.2 5.4 6.0 6.9 4.9 5.4 6.0 4.5 4.8 5.3 4.1 4.4 4.8 3.8 4.1 4.4 7.5% 13.7 10.1 8.1 6.8 5.9 5.2 4.7
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WACC
Financial analysis
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 be recorded as a part of the distribution cost by Sihuan. Hence, 2H11 and 2012 sales will 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 Sihuans bottom line performance, in our view.
Table 37: SihuanConfusing revenue rebooking to have no economic impact
Hospital purchase price Sihuan ex-factory price Cost of Sales GM G&A Distribution Cost Operating profit Operating margin
Old 400 100 30 70% 10 10 50 50.0%
New 400 372 30 92% 10 282 50 13.4%
Comments
272 reimbursed to distributors
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.
Table 38: SihuanRevisions to our models
Year to Dec (RmbMM) Turnover Gross profit EBIT Net profit EPS (HK$) Gross margin New FY11E 2,516 2,009 954 821 0.158 79.8% FY12E 4,039 3,203 1,182 1,024 0.198 79.3% Old FY11E 1,804 1,294 1,025 864 0.167 71.8% Change FY12E 2,313 1,668 1,323 1,108 0.214 72.1% FY11E 39.5% 55.2% -6.9% -5.1% -5.1% 8.1% FY12E 74.6% 92.0% -10.7% -7.6% -7.6% 7.2%
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.
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Figure 38: SihuanRevenue and gross margins forecasts

Rmb in millions
7,000 6,000 5,000 4,000 3,000 2,000 1,000 2007 2008 2009
Sales
160% 140% 120% 100% 80% 60% 40% 20% 0% 2010 2011E
Gross margin
2012E
2013E
2014E
Sales growth
2015E
Sihuans 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: SihuanForecasts of expense ratios and profit margins
90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E
Gross Margin
Distribution cost
Administrative cost
EBIT margin
Net margin
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, Sihuans 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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Table 39: SihuanKey products and revenue forecasts

in millions 2009 Cardio-cerebral vascular Kelinao () Cinepazide Maleate (80mg) % of sales y-y growth Anjieli () Cinepazide Maleate (320mg) % of segment sales y-y growth Oudimei Injection () Cerebroside-Kinin % of sales y-y growth Chuanqing () Ligustrazine Hydrochloride) y-y growth QuAo () Cerebroprotein hydrolysate y-y growth Aogan () Ganglioside (GM1) y-y growth Qingtong () Edaravone y-y growth Yimaining () Alprostadil y-y growth Yuanzhijiu () Troxerutin and Cerebroprotein Hydrolysate y-y growth Others y-y growth Total CCV sales Anti-infective drugs Anjiejian () Cefmenoxime hemihydrochloride y-y growth Poja () Sulbenicillin sodium y-y growth Others y-y growth Total anti-infective sales Others Naloxone hydrochloride () y-y growth Nalmefene () y-y growth BiAo () Ambroxol hydrochloride y-y growth Fufangsanwei B Injection (II) ( B(II), Compound Trivitamin B for Injection (II)) y-y growth New Products (Levetiracetam, Levophencynonate, etc) y-y growth Others y-y growth Total COGS % of sales GP
2010 456.1 54.5% 37.9% 113.9 13.6% 51.3%
2011E 752.6 33.8% 65.0% 216.4 9.7% 90.0% 750.0 33.7%
2012E 1,505.1 40.9% 100.0% 540.9 14.7% 150.0% 825.0 22.4% 10.0% 77.2 -5.0% 106.3 50.0% 254.8 75.0% 58.2 25.0% 146.9 150.0%
2013E 1,730.9 38.2% 15.0% 649.1 14.3% 20.0% 1,031.3 22.8% 25.0% 74.5 -3.5% 143.5 35.0% 343.9 35.0% 68.3 17.5% 257.0 75.0% 153.4 42.0% 74.8 33.6% 4,526.7 58.1 19.2% 100.0 30.0% 65.1 20.0% 223.2 16.1 50.0 150.0% 59.1 10.3% 60.0 20.0% 25.0 72.6 20.0% 232.9 1,059 21.3% 3,923
2014E 1,925.6 36.9% 11.3% 746.5 14.3% 15.0% 1,185.9 22.7% 15.0% 72.9 -2.1% 173.7 21.0% 429.9 25.0% 76.7 12.3% 321.3 25.0% 191.7 25.0% 92.4 23.5% 5,216.6 67.0 15.4% 120.0 20.0% 78.1 20.0% 265.2 16.1 87.5 75.0% 65.2 10.3% 72.0 20.0% 50.0 87.2 20.0% 290.5 1,242 21.5% 4,531
2015E 2,120.6 36.7% 10.1% 824.8 14.3% 10.5% 1,292.7 22.4% 9.0% 71.6 -1.9% 195.5 12.6% 494.4 15.0% 83.3 8.6% 369.5 15.0% 220.5 15.0% 107.6 16.5% 5,780.4 75.3 12.3% 132.0 10.0% 93.7 20.0% 301.0 16.1 131.3 50.0% 71.9 10.3% 86.4 20.0% 100.0 104.6 20.0% 379.0 1,402 21.7% 5,059
330.9 59.0% 27.8% 75.3 13.4% 58.3%
63.1 27.2% 37.2 60.8% 22.8 1186.6% 22.8 1186.6%
82.9 31.4% 59.1 58.9% 66.2 189.7% 35.8 56.7%
81.3 -2.0% 70.9 20.0% 145.6 120.0% 46.5 30.0% 58.8
67.5 31.4 52.9% 560.6 16.1 281.1% 23.6 -24.7% 837.6 30.2 87.5% 20.0 39.4 -6.2% 55.5 16.1 -6.5% 36.2 60.0% 86.4 16.1 37.8 60.0% 2,227.2 39.3 30.0% 51.3 156.5% 45.2 25.0% 135.8 16.1 33.6 105.8% 38.6 30.0% 46.7 21.0% 40.0
108.0 60.0% 56.0 48.0% 3,678.3 48.8 24.0% 77.0 50.0% 54.2 20.0% 179.9 16.1 20.0 53.6 14.7% 50.0 25.0%
35.0 27.1% 84.8 192 27.1% 517
42.0 20.0% 110.8 292 28.2% 741
50.4 20.0% 153.3 507 20.2% 1,895
60.5 20.0% 180.2 835 20.7% 3,203
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Sihuan Pharmaceutical Holdings: Summary of Financials

Income Statement Rmb in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet Rmb in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets FY09 709 39.0% 517 37.3% 392 40.0% 373 35.1% 52.6% 0 381 32.7% -67 17.7% 326.3 37.7% 3,750 0.09 72.6% FY09 613 141 43 0 797 FY10 FY11E FY12E 1,037 2,516 4,039 46.3% 142.7% 60.5% 745 2,009 3,203 44.0% 169.8% 59.4% 639 1,032 1,289 63.2% 61.5% 24.9% 613 954 1,182 64.4% 55.6% 23.9% 59.1% 37.9% 29.3% 0 0 0 635 1,011 1,274 66.6% 59.3% 26.0% -128 -207 -265 20.2% 20.5% 20.8% 522.0 820.7 1,023.8 60.0% 57.2% 24.8% 4,005 5,179 5,179 0.13 0.16 0.20 49.8% 21.6% 24.7% FY10 5,851 260 53 0 6,165 FY11E 4,880 631 129 0 5,633 413 453 8,030 0 337 0 557 0 10 567 7,478 1.44 FY12E 4,228 1,012 208 0 5,321 413 841 9,306 0 541 0 824 0 10 834 8,501 1.64 FY13E 4,983 23.4% 3,904 21.9% 1,518 17.8% 1,387 17.4% 27.8% 0 1,501 17.8% -316 21.1% 1,166.7 14.0% 5,179 0.23 14.0% FY13E 5,218 1,249 256 0 6,558 Cash flow statement Rmb in millions, year end Dec EBIT Depr. & amortization Change in working capital Taxes Cash flow from operations Capex Net Interest Other Free cash flow FY09 373 19 -13 1 380 16 0 397 FY10 613 26 -145 -136 358 -364 0 -5 FY11E 954 78 -223 -128 681 -1,628 0 -947 FY12E 1,182 108 -393 -207 689 -1,441 0 -751 FY13E 1,387 131 -299 -265 955 -70 0 885
Equity raised/(repaid) Debt raised/(repaid) Other Dividends paid Beginning cash Ending cash DPS Ratio Analysis Rmb in millions, year end Dec Gross margin EBITDA margin Operating margin Net margin
0 0 0 -120 331 613 0.03 FY09 72.9% 55.2% 52.6% 46.0% 74.2% 39.0% 37.7% 72.6% -
5,396 0 -174 613 5,851 0.04 FY10 71.8% 61.7% 59.1% 50.3% 37.0% 46.3% 60.0% 49.8% -
0 -90 5,851 4,880 0.00 FY11E 79.8% 41.0% 37.9% 32.6% 87.7% 142.7% 57.2% 21.6% -65.3% 16.8% 0.34 1.07 11.6% 13.5%
0 0 4,880 4,228 0.00 FY12E 79.3% 31.9% 29.3% 25.4% 60.5% 60.5% 24.8% 24.7% -
0 0 4,228 5,218 0.00 FY13E 78.4% 30.5% 27.8% 23.4% 23.4% 23.4% 14.0% 14.0% -
LT investments 77 313 Net fixed assets 162 271 Total Assets 1,173 6,902 Liabilities Short-term loans 0 0 Payables 120 139 Others 0 0 Total current liabilities 219 233 Long-term debt 0 0 Other liabilities 30 10 Total Liabilities 249 243 Shareholders' equity 908 6,657 BVPS 0.19 1.29 Source: Company reports and J.P. Morgan estimates.
Sales per share growth 413 Sales growth 974 Net profit growth 10,677 EPS growth Interest coverage (x) 0 668 Net debt to equity 343 Working Capital to Sales 1,011 Sales/assets 0 Assets/equity 10 ROE 1,020 ROCE 9,668 1.87
-67.5% -87.9% 9.0% 16.8% 0.70 0.26 1.29 1.04 40.6% 13.8% 46.4% 16.2%
-49.7% -54.0% 16.8% 16.8% 0.47 0.50 1.09 1.10 12.8% 12.8% 14.8% 15.3%
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15 October 2011
Sino Biopharmaceutical
Industry leading product portfolio and pipeline + solid track record of successful M&As = Top pick
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 industryleading 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 SBPs 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 newlylaunched 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 Ganmeis 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.
Overweight
1177.HK, 1177 HK Price: HK$2.21

Previous: HK$3.60

AC

Price Performance
4.0 3.5 HK$ 3.0 2.5 2.0
Abs Rel
YTD -27.3% 3.9%
1m -12.5% 2.7%
3m -14.3% 15.7%
12m -34.2% -5.1%
Sino Biopharmaceutical (Reuters: 1177.HK, Bloomberg: 1177 HK) HK$ in mn, year-end Dec FY09A FY10A FY11E Revenue (HK$ mn) 3,244 4,086 5,429 Net Profit (HK$ mn) 397.0 566.9 546.5 EPS (HK$) 0.09 0.12 0.11 DPS (HK$) 0.05 0.08 0.08 Revenue growth (%) 42.2% 26.0% 32.9% EPS growth (%) 33.3% 33.2% -5.6% ROCE 33.3% 34.9% 28.8% ROE 16.9% 18.5% 14.6% P/E (x) 25.2 18.9 20.0 P/BV (x) 4.0 3.0 2.9 EV/EBITDA (x) 9.4 6.4 6.5 Dividend Yield 2.2% 3.6% 3.4%
FY12E 6,741 630.6 0.13 0.09 24.2% 15.3% 31.6% 16.1% 17.4 2.7 5.8 4.0%
FY13E 7,991 814.8 0.16 0.11 18.5% 29.3% 38.9% 19.7% 13.4 2.6 4.6 5.1%
Company Data Shares O/S (mn) Market cap (HK$ mn) Market cap ($ mn) Price (HK$) Date Of Price Free float (%) 3mth Avg daily volume 3M - Avg daily Value (HK$ mn) 3M - Avg daily Value (USD) ($ mn) HSCEI Exchange Rate Fiscal Year End
4,941 10,921 1,404 2.21 14 Oct 11 45.1% 5.98 13.83 1.73 9,803 7.78 Dec
Company description
P&L sensitivity metrics (FY11E)

Hepatitis sales (base case 19%) Impact of 5% increase Cardio-Cerebral sales (base case 27%) Impact of 5% increase Selling expenses (base case 41%) Impact of 1% points inc GM Impact of each 1.0% increase
EBIT impact (%) 2.2% 1.5% 1.8% 4.4%
EPS impact (%) 1.1% 0.8% 0.9% 7.0%
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 from medical practitioners and patients.
Price target and valuation analysis Revenue mix (2010)
Our 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).
Others 26% Hepatitis 44%
DCF valuation
Oncology 7% Analgesic Cardio2% cerebral 30%
Risk free rate: Market risk premium: Beta: WACC Terminal g:

4.2% 6.0% 1.20 11.4% 5.0%
Source: Company data.

HK$ FY11E FY12E FY13E J. P. Morgan 0.110 0.127 0.164 Consensus 0.115 0.147 n.a
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.
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Investment summary
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 China130 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.
Figure 40: Market share of adefovir in 2009
1.00% 30% 37.00%
JCTT GSK
32.00%
Tianjing Pharmaceutical Research Institute Others
Source: IMS China.
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. SBPs 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 its key 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$400 million for full year 2011, a significant feat for a Chinese company, in our view. SBP is poised to launch Kaifen patch and pronase powder for endoscopy enhancement, both having strong potential to become blockbuster drugs. SBP has demonstrated a solid record of successful M&As. The capability of identifying candidates and integrating the acquired businesses should, we believe, position the company for future growth in a consolidating industry. The company acquired Shanghai Tong Yong Pharmaceutical to gain a foothold in the booming dermatology market and it is closing a transaction to acquire an orthopedic specialty hospital in Shaoyang, Hunan, according to management.
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Table 40: Products newly included in 2009 NDRL (HK$ mn)

Product Adefovir Entercavir Tianqingganmei Beraprost Fenghaineng Fructose Injections Kaifen 47.0 127.3 50.9 177.5 8.2 39.4 1H10 Sales 325.5 38.4 191.4 1H11 Sales 350.1 193.2 375.1 Y/Y (%) 7.6 403.3 96.0
Clearly benefiting from the implementation of 2009 NDRL: 2Q11 sales of Tianqingganmei and Mingzheng grew by 96% and 7.6%, respectively. Given Ganmeis 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 BMSs entecavir, the sales volume increase of Renzhong should more than make up for the price cut. We believe SBPs 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 companys 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 managements full-year guidance of ~30%. Quarterly reporting and dividend provide visibility and reduced risk: Many investors dislike SBPs 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.

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-thanexpected price cuts could result in the stocks 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, SBPs 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 managements focus or lack of it. Such activities could occur again and they could be perceived negatively.
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DCF valuation at HK$3.5
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.
Table 41: SBBase-case DCF analysis
2007 1,164 274 245 (74) 30 55 255
2008 2,281 609 549 (215) 43 (178) 198 0% 11.4% 15,399 2,183 (423) 0 17,159 4,956 3.5
2009 3,244 801 663 (340) 58 (31) 349
2010E 4,086 1,095 763 (427) 88 (686) (262)
2011E 5,429 1,123 721 (567) 140 (640) (345)
2012E 6,741 1,295 819 (635) 182 (634) (267)
2013E 7,991 1,691 1,070 (694) 227 (610) (8) 5.0% 4.2% 6.0% 1.20 8.0% 15.7
2014E 9,312 2,097 1,317 (752) 272 (699) 138
2015E 10,897 2,549 1,600 (816) 319 (827) 276
Table 42: SBSensitivity analysis based on WACC and perpetual terminal growth rate
WACC
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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 until 2007 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.
Figure 41: Sino BiopharmaceuticalForward P/E
90 80 70 60 50 40 30 20 10 2/5/2008 4/5/2008 6/5/2008 8/5/2008 2/5/2009 4/5/2009 6/5/2009 8/5/2009 2/5/2010 4/5/2010 6/5/2010 8/5/2010 2/5/2011 4/5/2011 6/5/2011 10/5/2007 12/5/2007 10/5/2008 12/5/2008 10/5/2009 12/5/2009 10/5/2010 12/5/2010 8/5/2011 0
Forward PE
Forward PE
Source: Bloomberg.
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Financial analysis
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 managements 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 managements efforts to rein in operating expense. While SBPs 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 companys 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: SBSales growth and gross margins
8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2007 2008 2009 2010 2011E 2012E 120% 100% 80% 60% 40% 20% 0%
Figure 43: SBCost breakdown (FY11E)

Others 26% Hepatitis 44% Oncology 7% Analgesic Cardio2% cerebral 30%
Sales (HK$ 'mn)
Gross margin
Sales growth
SBs 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
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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 of HK$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 SBPs 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$686mn in 2011, due to a large sum of investment in tradable securities, which was classified as part of operating cash flow under HK financial reporting. Hence, the forecasts may well be too high and err on the conservative side, which negatively impact the valuation. Historically, SBs profitable business has generated sufficient cash to fund its capital expenditure and dividends for 2007 through 2009. SBP had a net cash position at the end of 2010 with a placement in June 2010 replenishing its cash position even more and giving it ample financing for organic or acquisitive growth. Table 43: Sino BiopharmaceuticalChanges to our models
HK$MM, except for EPS Turnover Gross profit EBIT Net profit EPS (HK$) Gross margins New FY11E 5,429 4,245 1,123 547 0.110 78.2% FY12E 6,741 5,165 1,295 631 0.127 76.6% Old FY11E 5,507 4,334 1,157 563 0.114 78.7% FY12E 6,816 5,257 1,363 664 0.134 77.1% Change FY11E -1.4% -2.1% -2.9% -2.9% -2.9% -0.5% FY12E -1.1% -1.7% -5.0% -5.0% -5.0% -0.5%
Source: Company reports, J.P. Morgan estimates. Earnings revisions made due to assumption of coverage.
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Table 44: Sino BiopharmaceuticalKey products and their performance in 1H11

Drug name Chinese Name PVC Fructose Injections Estriol capsule 51 141 8% 49% Jiangsu Chia Tai Fenhai Qindao Chia Tai Haier Beijing Tide NJCTT NJCTT Beijing Tide NJCTT JCTT Biapenem 102 231% JCTT Zolebronate Acid Flurbiprofen Axetil 178 198 87 39% 83% 70% JCTT Beijing Tide Adefovir Dipivoxil Magnesium Isoglycyrrhizinate Diammonium Glycyzzhizinate Diammonium Glycyzzhizinate Entecavir Marineand Glucose Injection Alprostadil Hydroxyethylstarch 130 Irbesartan Hydrochlorothiazide Puerarin and Glucose Injection Glycerol and Fructose Injection 130 658 88 96 26 26 1,183 350 375 93 113 193 35 27% 16% 30% -16% -5% 45% 8% 96% -7% 15% 403% -20% JCTT JCTT JCTT JCTT JCTT JCTT Beijing Tide NJCTT NJCTT NJCTT NJCTT Generic name Chinese Name 1H11 HK$MM Y/Y Mfr. subsidiary
Cardio-cerebral
Kaishi Tianqingning Yilunping Spring PVC-free soft bags for IV injections and the Spring injections Tianqingganan
Hepatitis
Mingzheng Tianqingganmei Ganlixin Tianqingganping Runzhong Tianqingfuxin
Analgesic
Kaifen
Oncology
Tianqingyitai
Anti-infectious
Tiance Others Fenghaineng Fructose New ossified estriol capsules
Future blockbusters
Kaifen patch Getai Saiweijian Oral Kaishi Tuotuo Flurbiprofen topical patch Diosmin Tablets Raltitrexed injection Beroprost Rosuvastatin Tenofovir
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Table 45: Sino BiopharmaceuticalRevenue model

Currency (HK$ '000) Dividend Income Total Product Sales % YOY Change Cardio-cerebral medicines Total sales of Kaishi injections (by Beijing Tide) Share of Turnover from Beijing Tide Beraprost (Oral Kaishi) Tianqingning injections (hydroxyethyl starch) Tianqingganan injections (glycerin and fructose) Spring PVC-free soft bags & spring injections (Purun) Yilungping (Irbesartan/Hydrochlorothiazide) Tablets Others % YOY Change Hepatitis medicines Mingzheng (adefovir dipivoxil) Runzhong tablets (entecavir) Tainqingganmei injections (magnesium isoglycyrrhizinate) Tainqingganping enteric capsules Ganlixin injections and capsules (diammonium glycyrrhizinate) Tainqingfuxin injections (marine) Others % YOY Change Oncology medicines (Tianqing Yitai, Renyi and others) % YOY Change Analgesic medicines Kaifen Kaifen Patch % YOY Change Anti-infectious Tiance (Biapenem) Injections Other % YOY Change Others Getai (Diosmin) Tablets Fenghaineng Fructose Injections New Ossified Estriol Capsules Taibai Shaoyang Hospital Shanghai Tong Yong Others % YOY Change
Source: Company data, J.P. Morgan estimates. 124
2009A 8,674 3,234,975 611,410 757,694 265,193 103,197 49,530 54,550 92,979 45,961 57% 1,565,700 634,050 333,860 183,680 239,570 110,830 63,710 37% 181,910 51% 66,909 191,168
2010A 11,182 4,086,144 26% 841,745 1,094,600 367,786 155,010 51,210 55,720 146,920 65,099 38% 1,805,760 647,910 144,800 454,340 202,640 209,180 89,370 57,520 15% 283,190 56% 96,823 288,164 45%
2011E 13,978 5,428,620 33% 1,006,293 1,313,520 441,343 35,000 178,262 48,650 47,362 187,323 68,354 20% 2,320,333 664,304 400,788 690,605 228,153 190,992 78,213 67,279 28% 438,945 55% 130,711 389,021 35% 240,000 220,000 20,000
2012E 15,375 6,741,157 24% 1,130,727 1,510,548 453,164 70,000 196,088 43,785 42,626 234,154 90,911 12% 2,802,656 631,089 641,260 932,317 250,968 175,713 70,392 100,918 21% 602,571 37% 157,718 505,728 20,000 21% 300,000 275,000 25,000 25%
2013E 16,913 7,990,771 19% 1,270,191 1,661,603 498,481 122,500 215,696 39,406 38,363 269,277 86,468 12% 3,250,883 599,534 897,764 1,118,780 263,516 166,927 78,213 126,148 16% 766,969 27% 204,648 632,160 50,000 30% 361,250 330,000 31,250 20% 2,136,830 166,175 113,052 494,908 63,590 230,000 218,700 850,404 22%
2014E 18,604 9,312,222 17% 1,413,694 1,786,223 535,867 183,750 230,795 37,436 34,527 296,204 95,115 11% 3,604,642 569,558 1,077,317 1,286,597 276,692 158,581 78,213 157,685 11% 946,161 23% 257,578 758,592 100,000 26% 418,563 379,500 39,063 16% 2,671,584 199,411 109,661 593,890 76,308 345,000 284,310 1,063,005 25%
2015E 20,464 10,897,129 17% 1,533,499 1,875,534 562,660 229,688 242,335 35,564 32,801 325,825 104,626 8% 3,962,244 541,080 1,238,914 1,479,587 276,692 150,652 78,213 197,106 10% 1,124,602 19% 295,335 834,451 150,000 15% 466,278 417,450 48,828 11% 3,515,171 229,322 107,468 712,668 91,570 690,000 355,388 1,328,756 32%
809,046 116,537 142,011 32,945
1,058,626 123,961 217,542 36,800
1,292,338 115,400 123,961 304,559 44,160 25,000 135,000
1,747,484 138,480 117,763 395,926 52,992 200,000 162,000 680,323 35%
517,553
680,323 31%
544,258 22%
SWOT analysis
Strengths
Market leadership for hepatitis (20% market share) and CCV drugs (75% share of alprostadil).
Weaknesses
Holding company structure means less visibility of individual lines of business.
Strong R&D capabilities and rich product pipeline feature Incentives may not be aligned for the parent company and drugs with blockbuster potential. management of subsidiaries. Solid track record of M&A and integration success; well Overly dependent on the hepatitis business. positioned to make additional acquisitions. Less susceptible to price cuts with proprietary and firstto-market generic products.
Opportunities
Diversifying into oncology, respiratory diseases, and other areas. Implementation of 2009 NDRL to expand sales volume for the company with five major drugs included for the first time. Significant market seen for Kaifen patch; 800 million similar patches are sold annually in Japan.
Threats
Price cut for drugs on the NDRL list. MNCs may become more aggressive with defending market share of viral products. Domestic competitors may undercut SBP's positions on entecavir and adefovir with extremely low prices. Pipeline failure may not allow SBP to keep launching new products while old products become obsolete.
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Sino Biopharmaceutical: Summary of Financials

Income Statement HK$ in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet HK$ in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets FY09 3,244 42.2% 2,604 44.0% 859 31.7% 801 31.5% 24.7% -3 799 33.2% -135 16.9% 397.0 33.4% 4,526 0.09 33.3% FY09 1,739 479 211 57 2,551 FY10 4,086 26.0% 3,301 26.8% 1,183 37.7% 1,095 36.7% 26.8% -6 1,088 36.0% -228 21.0% 566.9 42.8% 4,854 0.12 33.2% FY10 2,338 626 369 0 4,030 FY11E 5,429 32.9% 4,245 28.6% 1,262 6.7% 1,123 2.5% 20.7% -17 1,123 3.2% -247 22.0% 546.5 -3.6% 4,956 0.11 (5.6%) FY11E 1,789 832 490 0 4,323 231 1,670 6,224 32 212 937 1,181 143 97 1,421 3,820 0.77 FY12E 6,741 24.2% 5,165 21.7% 1,478 17.0% 1,295 15.4% 19.2% -19 1,295 15.4% -285 22.0% 630.6 15.4% 4,956 0.13 15.3% FY12E 1,349 1,033 609 0 4,570 230 2,123 6,923 36 263 987 1,285 160 97 1,542 4,019 0.81 FY13E 7,991 18.5% 6,237 20.8% 1,917 29.8% 1,691 30.5% 21.2% -21 1,691 30.5% -380 22.5% 814.8 29.2% 4,956 0.16 29.3% FY13E 1,182 1,224 722 0 5,032 Cash flow statement HK$ in millions, year end Dec EBIT Depr. & amortization Change in working capital Taxes Cash flow from operations Capex Net Interest Other Free cash flow FY09 801 58 -51 -118 689 -340 -3 337 FY10 1,095 88 -539 -135 508 -426 -6 152 FY11E 1,123 140 -474 -228 560 -567 -17 -23 FY12E 1,295 182 -443 -247 788 -635 -19 134 FY13E 1,691 227 -361 -285 1,272 -694 -21 558
Equity raised/(repaid) Debt raised/(repaid) Other Dividends paid Beginning cash Ending cash DPS Ratio Analysis HK$ in millions, year end Dec Gross margin EBITDA margin Operating margin Net margin
-85 -19 -308 1,875 1,739 0.05 FY09 80.3% 26.5% 24.7% 12.2% 42.1% 42.2% 33.4% 33.3% 309.85 -70.2% 17.5% 0.92 1.52 16.9% 33.3%
1,137 -101 -389 1,739 2,338 0.08 FY10 80.8% 29.0% 26.8% 13.9% 17.5% 26.0% 42.8% 33.2% 203.84 -59.9% 20.5% 0.87 1.54 18.5% 34.9%
20 -381 2,338 1,789 0.08 FY11E 78.2% 23.3% 20.7% 10.1% 30.1% 32.9% -3.6% (5.6%) 75.38 -42.2% 20.5% 0.92 1.63 14.6% 28.8%
20 -403 1,789 1,349 0.09 FY12E 76.6% 21.9% 19.2% 9.4% 24.2% 24.2% 15.4% 15.3% 78.70 -28.7% 20.5% 1.03 1.72 16.1% 31.6%
20 -495 1,349 1,182 0.11 FY13E 78.1% 24.0% 21.2% 10.2% 18.5% 18.5% 29.2% 29.3% 92.18 -22.6% 20.5% 1.08 1.84 19.7% 38.9%
LT investments 231 231 Net fixed assets 895 1,243 Total Assets 3,766 5,621 Liabilities Short-term loans 1 28 Payables 123 160 Others 560 908 Total current liabilities 687 1,096 Long-term debt 0 127 Other liabilities 51 97 Total Liabilities 738 1,319 Shareholders' equity 2,474 3,648 BVPS 0.55 0.74 Source: Company reports and J.P. Morgan estimates.
Sales per share growth 230 Sales growth 2,591 Net profit growth 7,853 EPS growth Interest coverage (x) 39 312 Net debt to equity 1,094 Working Capital to Sales 1,445 Sales/assets 176 Assets/equity 97 ROE 1,718 ROCE 4,275 0.86
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15 October 2011
Sinopharm
The dominant player stays ahead of the industry consolidation curve
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 networka 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.
Overweight
1099.HK, 1099 HK Price: HK$19.74

Previous: HK$35.00
China Healthcare Technology & Distribution Sean Wu

AC

Price Performance
35 HK$ 25 15
Abs Rel
YTD -27.7% 3.5%
1m 4.7% 19.9%
3m -22.7% .3%
12m -37.9% -8.8%
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 DCFbased Dec-12 PT of HK$30 implies CY12E P/E of 32x, well within the historical P/E trading range, and supported by accelerating earnings growth in prospect. Key risks include: (1) unexpected industry-wide slowdown; (2) acquisitions becoming prohibitively expensive; and (3) finance cost stays high for longer than expected.
Sinopharm (Reuters: 1099.HK, Bloomberg: 1099 HK) Rmb in mn, year-end Dec FY09A FY10A Revenue (Rmb mn) 52,668 69,234 Net Profit (Rmb mn) 967.2 1,208.8 EPS (Rmb) 0.54 0.52 DPS (Rmb) 0.35 0.13 Revenue growth (%) 37.9% 31.5% EPS growth (%) 51.3% -4.3% ROCE 18.8% 16.8% ROE 13.7% 10.3% P/E (x) 29.6 31.0 P/BV (x) 3.3 3.1 EV/EBITDA (x) 14.3 12.1 Dividend Yield 2.2% 0.8%
FY11E 96,416 1,471.6 0.63 0.16 39.3% 21.7% 17.3% 10.7% 25.4 2.5 8.2 1.0%
FY12E 120,302 1,859.2 0.77 0.19 24.8% 22.0% 17.3% 11.4% 20.8 2.3 6.5 1.2%
FY13E 149,057 2,454.5 1.02 0.26 23.9% 32.0% 19.3% 13.6% 15.8 2.0 5.1 1.6%
Company Data Shares O/S (mn) Market Cap (Rmb mn) Market Cap ($ mn) Price (HK$) Date Of Price Free float (%) 3-mth trading volume (mn) 3-mth trading value (HK$ mn) 3-mth trading value (US$) ($ mn) HSCEI Exchange Rate Fiscal Year End
828 35,600.99 5372.31 19.74 14 Oct 11 26.1% 13 103 13 9,803 7.78 Dec
Company description

FY11E Chinese herbs Impact of each 5 percentage increase Selling cost Impact of each 5 percentage points increase Demand for products under EDL Impact of each 5 percentage points increase GM: 1% Increase Impact of each 1% increase
EBIT impact (%) 3.9% 3.9% 2.7% 2.8%
EPS impact (%) 7.6% 9.1% 6.3% 8.2%
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 thirdparty distributors. Sinopharm also has small operations of drug retailing and manufacturing businesses.
Revenue mix (2011E)
Our 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).
Others 3%
Retail+others 3% Sales to local Distributors & Others 45%
Hospital sales 49%
Risk free rate: Market risk premium: Beta: WACC Terminal g:
4.20% 6.00% 1.00 11.7% 5.00%
EPS: J.P. Morgan vs consensus (Rmb)

Rmb FY11E FY12E FY13E J. P. Morgan 0.635 0.774 1.022 Consensus 0.665 0.836 n.a
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.
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Investment summary
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 Chinas current low spending per capita on pharmaceutical products and the governments 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: SinopharmHospital sales of drugs in China
400.0 35.0% 350.0 30.0%
Figure 45: SinopharmRising market concentration in China

40%
300.0
30%
25.0%
250.0 20.0% 200.0 15.0% 150.0 10.0%
20% 10% 0% 2004 2005 2006 2007 2008 2009E 2010E 2011E 2012E 2013E 2014E 2015E
100.0
50.0
5.0%
1998
1999
2000
2001
2002
2003
2004
2005 Sales
2006
2007
2008e
2009e
2010e
2011e
2012e
2013e
0.0%
3 largest suppliers market share

Sinopharm market share
Y/Y Growth
Source: IMS China.
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 companys 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.
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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 further strengthens Sinopharms 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 Sinopharms business For investors who expect revenue growth to slow because of drug price cuts, Sinopharms 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.

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 companys 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
130
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 Sinopharms operating profit for 1H11 was 15% above our estimate, net profit available to common shareholders was 7% below, largely due to the higher interest expense. Sinopharms finance cost for 1H11 increased by 227.6% from Rmb105 million 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 Chinas tightening lending policy, we are concerned that finance cost may continue bleeding the companys 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 userslarge 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.
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DCF valuation and Dec-12 PT of HK$30
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: SinopharmBase-case DCF analysis indicates an equity value per share of HK$36
Rmb million Cash flow estimates Sales EBIT NOPAT Capex, net Depreciation Change in working capital Free operating CF (FoCF) DCF Parameters Liabilities as a % of EV WACC Enterprise NPV (10E-16E) + Net cash (debt), current - Minorities (Market value) +/- Other items = Equity value / Number of shares = Equity value per share (HK$)
2007 31,110 789 1,183 (582) 135 (1,029) (293)
2008 38,187 1,172 1,579 166 174 (647) 1,272 20% 11.7% 71,393 4,623 (16,897) 0 59,119 2,400 30.0
2009E 52,668 1,892 2,141 (1,169) 190 (3,240) (2,079)
2010E 69,234 2,409 2,730 (2,644) 204 (3,551) (3,261)
2011E 96,416 3,407 3,867 (2,533) 366 (4,407) (2,707)
2012E 120,302 4,402 5,044 (1,115) 384 (2,848) 1,466
2013E 149,057 5,630 6,457 (1,206) 409 (3,286) 2,373 5.0% 4.2% 6.0% 1.00 6.2% 26.7x
2014E 180,181 7,195 8,258 (898) 440 (3,092) 4,708
2015E 215,157 9,037 10,369 (894) 476 (3,402) 6,549
Table 47: SinopharmSensitivity analysis based on WACC and perpetual terminal growth rate
38.0 10.2% 10.7% 11.2% 11.7% 12.2% 12.7% 13.2% 3.5% 33.8 30.8 28.3 26.0 24.0 22.3 20.7 4.0% 35.6 32.4 29.6 27.1 24.9 23.0 21.3 4.5% 37.9 34.2 31.0 28.3 25.9 23.9 22.0 Terminal growth rate 5.0% 6.0% 6.5% 40.7 48.9 54.9 36.4 43.0 47.6 32.9 38.2 41.8 29.8 34.1 37.0 27.2 30.8 33.2 24.9 28.0 29.9 22.9 25.5 27.2 7.0% 62.7 53.4 46.3 40.5 36.0 32.2 29.1
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WACC
Financial analysis
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: SinopharmSales growth and gross margins

140.0 120.0 100.0 80.0 60.0 40.0 20.0 2006 2007 2008 2009 2010 2011E 2012E
Sale s growth
Figure 47: SinopharmCost breakdown (2011E)

45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
Selling costs 2.8% Admin costs 1.9% Cot of drugs 91.8% Operating profit 3.5%
Sale s (Rmb 'mn)
Gross margin
Sinopharms 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 companys 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 Sinopharms EPS will increase at a CAGR of 25% between 2010 and 2013. Historically, Sinopharms 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 become acquisition targets of large firms.
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SWOT analysis
The company is the largest distributor of pharmaceutical Very low net margins of around 2% do not offer much products in China and looks well positioned to gain room for errors. market share from smaller distributors through above The market is fragmented and subject to competition from industry organic growth and acquisitions. numerous distributors all selling different drugs to same The company has historically been able to maintain hospitals that Sinopharm services. above-industry average gross margins. The business is working-capital intensive and a fast The company is able to leverage its resources to offer growing company tends to tie up bulk of its cash flows in valued-added logistic services unavailable from rising inventories and receivables balances. resources-strapped small distributors. The company is dependent on a number of key suppliers, The countrys largest portfolio to meet demand from all of which may opt to use smaller distributors if they customers and widest network coverage to satisfy the offer better terms. needs of manufacturers to grow business nationwide. Nearly 50% of the sales rely on non-exclusive third-party The management team is made up of seasoned veterans, distribution channels for smaller clinics and more rural many of whom have over 20 years experience in the regions. 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.
Opportunities
Threats
Strong demand for pharmaceutical products and low per There are a number of other strong distributors and many capita spending on healthcare should lead to a long period of them are working with international drug distribution of annual growth in the vicinity of 20%. companies and this may pose a threat to the long term growth prospects of the company. As the largest distributor with a 12% market share, it is in The implementation risk of moving from developed tier a good position to grab a significantly higher market share, in our view. In developed markets, the top three one cities to smaller cities is quite significant, in our view. players typically command a 60%-80% market share. The government has historically controlled the price of Higher volume should allow Sinopharm to use existing drugs and discouraged hospitals from making excessive facilities better and may lift GM and OPM. sales and profits from this area. These controls have a great impact on the relationship between hospitals and The company has a strong presence in the distribution of distributors. pharmaceuticals but has not generated significant business from medical devices and medical consumables The aggressive rolling up of distribution assets by China space which offer upside, building on the relationship Resources may mean higher acquisition prices for with its hospital customers. Sinopharm. Numerous M&A opportunities in the distribution industry The successful IPO of Shanghai Pharmaceutical on the with many small distributors that maybe available at Hong Kong Stock Exchange allows it to gain financial reasonable valuations. resources to compete with Sinopharm while cutting into the investor base of Sinopharm.
134
Sinopharm: Summary of Financials

Income Statement Rmb in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet Rmb in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets Cash flow statement FY09 FY10 FY11E FY12E FY13E Rmb in millions, year end Dec 52,668 69,234 96,416 120,302 149,057 EBIT 37.9% 31.5% 39.3% 24.8% 23.9% Depr. & amortization 4,407 5,836 7,857 9,754 12,010 Change in working capital 45.2% 32.4% 34.6% 24.1% 23.1% Taxes 2,082 2,613 3,773 4,787 6,039 Cash flow from operations 54.6% 25.5% 44.4% 26.9% 26.2% 1,892 2,409 3,407 4,402 5,630 Capex 61.4% 27.3% 41.4% 29.2% 27.9% Net Interest 3.6% 3.5% 3.5% 3.7% 3.8% Other -231 -172 -626 -847 -931 Free cash flow 1,909 2,398 3,032 3,831 4,999 76.8% 25.6% 26.4% 26.4% 30.5% - Equity raised/(repaid) - Debt raised/(repaid) 967.2 1,208.8 1,471.6 1,859.2 2,454.5 Other 64.6% 25.0% 21.8% 26.3% 32.0% Dividends paid 2,400 2,238 2,403 2,403 2,403 Beginning cash 0.54 0.52 0.63 0.77 1.02 Ending cash 51.3% (4.3%) 21.7% 22.0% 32.0% DPS Ratio Analysis FY09 FY10 FY11E FY12E FY13E Rmb in millions, year end Dec 7,568 7,475 13,258 14,200 17,624 Gross margin 11,980 17,752 24,840 30,955 38,307 EBITDA margin 5,301 7,530 10,537 13,131 16,250 Operating margin 4,258 2,106 3,537 4,667 5,939 Net margin 29,107 34,863 52,173 62,953 78,120 Sales per share growth LT investments 1,588 3,820 5,845 6,377 6,916 Sales growth Net fixed assets 1,952 3,331 3,473 3,672 3,930 Net profit growth Total Assets 32,647 42,104 61,491 73,002 88,966 EPS growth Liabilities Interest coverage (x) Short-term loans 1,668 3,344 6,476 7,226 9,476 Payables 13,703 19,831 27,617 34,459 42,696 Net debt to equity Others 2,047 2,579 3,874 5,019 6,495 Working Capital to Sales Total current liabilities 17,418 25,754 37,968 46,704 58,668 Sales/assets Long-term debt 50 91 2,159 2,409 3,159 Assets/equity Other liabilities 1,106 1,450 1,450 1,450 1,450 ROE Total Liabilities 18,624 27,386 41,577 50,563 63,277 ROCE Shareholders' equity 11,867 11,711 15,690 17,084 18,925 BVPS 4.94 5.23 6.53 7.11 7.88 Source: Company reports and J.P. Morgan estimates. FY09 1,892 190 -3,240 -259 -1,649 -355 -231 -205 -2,004 FY10 FY11E 2,409 3,407 204 366 -697 -1,565 -465 -568 1,179 1,013 -411 -172 -266 768 -508 -626 -346 506 FY12E 4,402 384 -1,287 -743 1,910 -583 -847 -437 1,326 FY13E 5,630 409 -1,438 -943 2,727 -667 -931 -558 2,060
8,786 459 -366 1,712 7,568 0.35 FY09 8.4% 4.0% 3.6% 1.8% 26.8% 37.9% 64.6% 51.3% 9.02
2,103 -465 7,568 7,475 0.13
2,875 5,109 -335 7,475 13,258 0.16
1,000 -416 13,258 14,200 0.19 FY12E 8.1% 4.0% 3.7% 1.6% 20.5% 24.8% 26.3% 22.0% 5.65
3,000 -539 14,200 17,624 0.26 FY13E 8.1% 4.1% 3.8% 1.7% 23.9% 23.9% 32.0% 32.0% 6.49
FY10 FY11E 8.4% 8.2% 3.8% 3.9% 3.5% 3.5% 1.8% 1.5% 0.7% 31.5% 25.0% (4.3%) 15.20 39.2% 39.3% 21.8% 21.7% 6.02
-49.3% -34.5% -29.5% -26.7% -26.4% 6.8% 7.9% 8.1% 8.0% 8.0% 2.16 1.85 1.86 1.79 1.84 2.75 3.60 3.92 4.27 4.70 13.7% 10.3% 10.7% 11.4% 13.6% 18.8% 16.8% 17.3% 17.3% 19.3%
135

15 October 2011
Neutral
The United Laboratories

Insulin: The key to long term growth
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 be under-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 companys short term financial performance. Not expecting sharp share rebound after recent significant pullback: We believe recently TULs 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. Insulina 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$7.5 implies CY12E P/E of 11.9x. Key risks to our PT include regulatory steps on the pricing of healthcare supplies and any slower-than-expected sales ramp-up of newly launched insulin products.
The United Laboratories (Reuters: 3933.HK, Bloomberg: 3933 HK) HK$ in mn, year-end Dec FY09A FY10A FY11E Revenue (HK$ mn) 4,643 6,503 6,660 Net Profit (HK$ mn) 541.4 974.1 541.2 EPS (HK$) 0.45 0.78 0.42 DPS (HK$) 0.19 0.30 0.16 Revenue growth (%) 23.6% 40.1% 2.4% EPS growth (%) 25.9% 73.3% -46.8% ROCE 14.2% 18.1% 9.7% ROE 16.0% 21.5% 10.3% P/E (x) 13.8 7.9 14.9 P/BV (x) 1.9 1.6 1.5 EV/EBITDA (x) 8.2 5.6 8.0 Dividend Yield 3.1% 4.8% 2.6%
Previous: Overweight 3933.HK, 3933 HK Price: HK$6.21

Previous: HK$22.00
China Pharmaceuticals Sean Wu

AC

Price Performance
20 16 HK$ 12 8 4
Abs Rel
YTD -64.3% -39.9%
1m -20.1% -9.0%
3m -45.9% -24.9%
12m -64.8% -42.7%
FY12E 7,512 818.8 0.63 0.24 12.8% 51.3% 13.2% 14.4% 9.9 1.4 6.1 3.9%
FY13E 8,497 1,035.7 0.80 0.31 13.1% 26.5% 15.5% 16.5% 7.8 1.2 4.7 4.9%
Company Data Shares O/S (mn) Market cap (HK$ mn) Market cap ($ mn) Price (HK$) Date Of Price Free float (%) 3-mth trading volume (mn) 3-mth trading value (HK$ mn) 3-mth trading value ($ mn) HSI Exchange Rate Fiscal Year End
1,302 8,082 1,039 6.21 14 Oct 11 34.2% 5 33 4 18,758 7.78 Dec
Company description

FY11E Antibiotics Impact of 5% increase (w. no change in costs) Selling cost Impact of 5% increase (w. 50% pass through ) Demand for products under EDL Impact of 5% points inc (w. 50% pass through ) GM Impact of each 100bps increase
EBIT impact (%) 11.6% 1.8% 0.8% 5.1%
EPS impact (%) 12.0% 1.8% 0.8% 5.5%
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 companys revenue was generated from the operations in China, with the rest from overseas.
Revenue mix (2011E)
Intermedi ate products 30%
Our 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).
Finished products 30%
DCF assumptions
Bulk medicines 40%

4.20% 6.00% 0.90 10.20% 4.00%

HK$ FY10 FY11E FY12E J.P. Morgan 0.782 0.416 0.630 Consensus 0.782 0.466 0.534
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.
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Investment summary
Unrivaled strength with a vertically integrated antibiotics business: TULs fullyintegrated 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 companys 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 Chinas 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 TULs 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 governments recognition confers legitimacy to TULs claim of superior quality for its products and enables it to bid for higher tendering prices as well. Amoxin, TULs brand for amoxicillin, is among the best recognized medicine brands in China. Although the companys ceiling prices were cut late last year alongside many other drugs with individual pricing power, it is encouraging that the government allows TULs 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 TULs 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 TULs antibiotics
Rmb Drug Formulation Granule Amoxicillin Capsules Capsules Dosage form Package size 125mg 250mg 500mg 250mg 500mg 12 packs 24 tablets 24 tablets 24 tablets 24 tablets Individual Regular pricing ceiling price 8.4 13.7 23.3 14.0 23.8 4.8 7.4 12.6 5.7 Premium 75% 85% 85% 146%
Ampicillin
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.
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Figure 48: 2009 Market share of Insulin in China

3.70% 13.80% 13.80% 63% Tonghua Dongbao Others Novo Nordisk Sanofi-Aventis Eli Lilly 5.70%
Source: IMS China.
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.

A price cut could have more severe-than-expected impact on sales: We expect TULs 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 TULs market entry with pricing and promotions that make TULs insulin products less attractive for hospitals. TULs 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, TULs 6-APA franchise could suffer. Overreliance on commodity business: Two-third of TULs 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 TULs 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.
139

DCF valuation
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.
Table 49: TULBase-case DCF analysis
2007 2,595 638 500 (837) 187 (385) (535)
2008 3,756 650 594 (1,156) 253 42 (267) 0% 11.6% 12,161 (2,405) 0 0 9,756 1,301 7.5
2009 4,643 782 632 (850) 339 (188) (68)
2010 6,503 1,255 1,048 (839) 334 (1,336) (793)
2011E 6,660 751 635 (1,000) 428 (106) (43)
2012E 7,512 1,104 922 (1,006) 476 (255) 136
2013E 8,497 1,382 1,140 (227) 488 (295) 1,107 4.0% 4.2% 6.0% 0.90 7.4% 11.8
2014E 9,550 1,531 1,248 (1,376) 514 (342) 45
2015E 10,426 1,562 1,274 (388) 545 (196) 1,234
Table 50: TULOur sensitivity analysis based on WACC and perpetual terminal growth rate
140
WACC
Financial analysis
We expect EPS to decline then recoverbumpy 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.
Table 51: TULRevisions to our models
HK$MM Year to Dec (HK$MM) Turnover Gross profit EBIT Net profit EPS (HKD) Gross margin New FY11E 6,660 2,378 751 541 0.416 35.7% FY12E 7,512 2,821 1,104 819 0.630 37.6% FY11E 8,244 3,258 1,599 1,249 0.961 39.5% Old FY12E 10,743 4,717 2,334 1,834 1.411 43.9% FY11E -19.2% -27.0% -53.0% -56.7% -56.7% -3.8% Change FY12E -30.1% -40.2% -52.7% -55.4% -55.4% -6.4%
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.
141
SWOT analysis
Strengths
The scaleTUL is one of the largest producers of antibiotics products in China and the largest producer of 6-APA in the world.
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 A vertically integrated production and operation model to its competitors such as China Pharmaceutical. full control over the production of intermediate, API, and TUL may not compete well in rural areas compared to finished dosage form of amoxicillin. larger cities. Management team is made up of seasoned veterans with Low entry barriers and intense competition for antibiotics. many possessing over 20 years experience in the pharmaceutical area and staying with the company for a There are hundreds of antibiotics producers in China. long time. Lack of pricing power for the commodity business. 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.
Opportunities
Threats
The newly launched insulin products have the potential of EDL tendering may shut TULs more expensive becoming a new growth catalyst for TUL. There are more antibiotics off certain markets. than 100 million diabetic patients in China which pose Prices of 6-APA and 7-ACA have been volatile in the significant demand for recombinant human insulin every past and these could cause earnings uncertainty. year. The restriction on antibiotics use may affect the overall High demand for lysine eye drops and compound use of all kinds of antibiotics, even those in unrestricted chondroitin sulfate eye drops is high. categories. Expanding the healthcare insurance coverage creates Domestic competitors could undercut TULs insulin additional demand for essential drugs such as amoxicillin. business with better products or very low prices. The adoption of the enzyme process for amoxicillin bulk medicine should make the company more competitive with flexible pricing.
142
The United Laboratories: Summary of Financials

Income Statement HK$ in millions, year end Dec Revenues % change Y/Y Gross Profit % change Y/Y EBITDA % change Y/Y EBIT % change Y/Y EBIT Margin Net Interest Earnings before tax % change Y/Y Tax as % of EBT Net income (reported) % change Y/Y Shares outstanding EPS (reported) % change Y/Y Balance sheet HK$ in millions, year end Dec Cash and cash equivalents Accounts receivable Inventories Others Current assets FY09 4,643 23.6% 1,814 26.9% 1,120 24.1% 782 20.3% 16.8% -88 693 30.2% -152 21.9% 541.4 25.9% 1,200 0.45 25.9% FY09 192 885 1,669 0 2,746 FY10 6,503 40.1% 2,568 41.6% 1,589 41.8% 1,255 60.5% 19.3% -101 1,163 67.8% -189 16.3% 974.1 79.9% 1,246 0.78 73.3% FY10 464 1,248 2,567 386 4,666 FY11E 6,660 2.4% 2,378 -7.4% 1,179 -25.8% 751 NM 11.3% -103 648 -44.3% -107 16.5% 541.2 -44.4% 1,300 0.42 (46.8%) FY11E 145 1,278 2,629 552 4,605 299 5,223 10,127 2,040 2,016 22 4,078 510 96 4,684 5,443 4.19 FY12E 7,512 12.8% 2,821 18.6% 1,580 34.0% 1,104 46.9% 14.7% -111 992 53.1% -173 17.5% 818.8 51.3% 1,300 0.63 51.3% FY12E 175 1,442 2,966 532 5,115 308 5,753 11,177 2,200 2,274 109 4,583 550 96 5,229 5,948 4.58 FY13E 8,497 13.1% 3,283 16.4% 1,870 18.4% 1,382 25.2% 16.3% -111 1,270 28.0% -235 18.5% 1,035.7 26.5% 1,300 0.80 26.5% FY13E 674 1,631 3,355 729 6,388 Cash flow statement HK$ in millions, year end Dec EBIT Depr. & amortization Change in working capital Taxes Cash flow from operations Capex Net Interest Other Free cash flow FY09 FY10 782 1,255 339 334 -188 -1,336 -102 -152 830 101 -853 -1,006 -88 -101 -110 -1,006 FY11E 751 428 -106 -189 884 -1,009 -103 -228 FY12E 1,104 476 -255 -107 1,218 -1,015 -111 91 FY13E 1,382 488 -295 -173 1,402 -236 -111 1,054
Equity raised/(repaid) Debt raised/(repaid) Other Dividends paid Beginning cash Ending cash DPS Ratio Analysis HK$ in millions, year end Dec Gross margin EBITDA margin Operating margin Net margin
0 426 -106 -180 165 192 0.19 FY09 39.1% 24.1% 16.8% 11.7% 23.6% 23.6% 25.9% 25.9% 12.66 56.5% 13.6% 0.64 2.13 16.0% 14.2%
1,633 -54 -301 192 464 0.30 FY10 39.5% 24.4% 19.3% 15.0% 34.9% 40.1% 79.9% 73.3% 15.80 36.9% 28.4% 0.72 1.88 21.5% 18.1%
200 -291 464 145 0.16 FY11E 35.7% 17.7% 11.3% 8.1% (1.8%) 2.4% -44.4% (46.8%) 11.44 44.2% 28.4% 0.67 1.86 10.3% 9.7%
200 -261 145 175 0.24 FY12E 37.6% 21.0% 14.7% 10.9% 12.8% 12.8% 51.3% 51.3% 14.17 43.3% 28.4% 0.71 1.88 14.4% 13.2%
-200 -356 175 674 0.31 FY13E 38.6% 22.0% 16.3% 12.2% 13.1% 13.1% 26.5% 26.5% 16.77 28.5% 28.4% 0.73 1.85 16.5% 15.5%
LT investments 123 291 Net fixed assets 4,116 4,651 Total Assets 8,455 9,608 Liabilities Short-term loans 2,431 2,350 Payables 1,924 1,968 Others 69 84 Total current liabilities 4,424 4,402 Long-term debt 0 0 Other liabilities 69 96 Total Liabilities 4,493 4,498 Shareholders' equity 3,962 5,110 BVPS 3.30 3.93 Source: Company reports and J.P. Morgan estimates.
Sales per share growth 318 Sales growth 5,492 Net profit growth 12,198 EPS growth Interest coverage (x) 2,040 2,572 Net debt to equity 394 Working Capital to Sales 5,006 Sales/assets 510 Assets/equity 96 ROE 5,612 ROCE 6,586 5.07
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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)
Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.
Important Disclosures
Client: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients: China Shineway Pharmaceutical Group Limited, Concord Medical Services Holdings Limited, Mindray Medical, Shandong Weigao Group Medical Polymer Co. Ltd., Sino Biopharmaceutical, Sinopharm. Client/Investment Banking: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as investment banking clients: Sino Biopharmaceutical. Client/Non-Investment Banking, Securities-Related: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients, and the services provided were non-investment-banking, securities-related: Concord Medical Services Holdings Limited, Mindray Medical, Sinopharm. Investment Banking (past 12 months): J.P. Morgan received in the past 12 months compensation for investment banking Sino Biopharmaceutical. Investment Banking (next 3 months): J.P. Morgan expects to receive, or intend to seek, compensation for investment banking services in the next three months from Sino Biopharmaceutical, Sinopharm. Non-Investment Banking Compensation: J.P. Morgan has received compensation in the past 12 months for products or services other than investment banking from Concord Medical Services Holdings Limited, Mindray Medical, Sinopharm. Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on J.P. Morgans website https://mm.jpmorgan.com/disclosures.jsp or by calling this U.S. toll-free number (1-800-477-0406). Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] In our Asia (ex-Australia) and UK small- and mid-cap equity research, each stocks expected total return is compared to the expected total return of a benchmark country market index, not to those analysts coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analysts coverage universe can be found on J.P. Morgans research website, www.morganmarkets.com.
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J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2011

J.P. Morgan Global Equity Research Coverage IB clients* JPMS Equity Research Coverage IB clients* Overweight (buy) 47% 51% 45% 70% Neutral (hold) 42% 44% 47% 60% Underweight (sell) 11% 33% 7% 52%
*Percentage of investment banking clients in each rating category. For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.
Equity Valuation and Risks: For valuation methodology and risks associated with covered companies or price targets for covered companies, please see the most recent company-specific research report at http://www.morganmarkets.com , contact the primary analyst or your J.P. Morgan representative, or email research.disclosure.inquiries@jpmorgan.com . Equity Analysts' Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking. Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under NASD/NYSE rules, may not be associated persons of JPMS, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.
Other Disclosures
J.P. Morgan ("JPM") is the global brand name for J.P. Morgan Securities LLC ("JPMS") and its affiliates worldwide. J.P. Morgan Cazenove is a marketing name for the U.K. investment banking businesses and EMEA cash equities and equity research businesses of JPMorgan Chase & Co. and its subsidiaries. Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation's Characteristics and Risks of Standardized Options, please contact your J.P. Morgan Representative or visit the OCC's website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf Legal Entities Disclosures U.S.: JPMS is a member of NYSE, FINRA, SIPC and the NFA. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. U.K.: J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorized and regulated by the Financial Services Authority. Registered in England & Wales No. 2711006. Registered Office 125 London Wall, London EC2Y 5AJ. South Africa: J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. Hong Kong: J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. Korea: J.P. Morgan Securities (Far East) Ltd, Seoul Branch, is regulated by the Korea Financial Supervisory Service. Australia: J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) is regulated by ASIC and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066) is a Market Participant with the ASX and regulated by ASIC. Taiwan: J.P.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Bureau. India: J.P. Morgan India Private Limited, having its registered office at J.P. Morgan Tower, Off. C.S.T. Road, Kalina, Santacruz East, Mumbai - 400098, is a member of the National Stock Exchange of India Limited (SEBI Registration Number - INB 230675231/INF 230675231/INE 230675231) and Bombay Stock Exchange Limited (SEBI Registration Number - INB 010675237/INF 010675237) and is regulated by Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission. Indonesia: PT J.P. Morgan Securities Indonesia is a member of the Indonesia Stock Exchange and is regulated by the BAPEPAM LK. Philippines: J.P. 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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. 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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.
Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P
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Asia Pacific Equity Research

(852) 2800-8538 sean.wu@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited

One-year China & APxJ Healthcare

MSCI China H APxJ Healthcare MCSI China Healthcare

Three-month China & APxJ Healthcare

MSCI China H APxJ Healthcare MSCI China Healthcare

Source: Bloomberg, J.P. Morgan estimates. Prices as of close 13 October 2011.

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

Healthcare a major pillar industry......................................15

Medical Equipment/Devices ..................................................36

Traditional Chinese Medicines ..............................................40

Medical Distribution/Retailing ...............................................44

Chinese Vaccine Market ........................................................50

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

-60.0% 7/5/2011 7/12/2011 7/19/2011 7/26/2011 2877 HK 1066 HK 3933 HK

8/9/2011 8/16/2011 8/23/2011 8/30/2011 853 HK 1177 HK MSCI APxJ Healthcare

9/6/2011 9/13/2011 9/20/2011 9/27/2011 MR US 1099 HK MSCI China Healthcare

CCM US 460 HK A-share Drug Index

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

Why the underperformance

No. of Drugs 17 162 82

Price Cut 12% 21% 14%

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

Why would the sector recover

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

Stock investment views

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

Table 3: Stock performance and drivers

SINO BIOPHARMACEU TICAL

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

1177.HK share price (HK$) HSCEI (rebased)

YTD Absolute (%) Relative (%) Source: Bloomberg. -27.3 3.9

12M -34.2 -5.1

1099.HK share price (HK$) HSCEI (rebased)

YTD Absolute (%) Relative (%) Source: Bloomberg. -27.7 3.5

12M -37.9 -8.8

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

MR share price ($) HSCEI (rebased)

YTD Absolute (%) Relative (%) -6.7 16.1

12M -20.8 5.5

2877.HK share price (HK$) HSI (rebased)

YTD Absolute (%) Relative (%) -56.8 -33.7

12M -61.1 -37.4

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

CCM share price ($) S&P500 (rebased)

YTD Absolute (%) Relative (%) -58.8 -45.2

12M -56.0 -52.7

0853.HK share price (HK$) HSCEI (rebased)

Sean Wu (852) 2800-8538 sean.wu@jpmorgan.com

Asia Pacific Equity Research 15 October 2011

0460.HK share price (HK$) HSCEI (rebased)

YTD Absolute (%) Relative (%) -53.7 -22.5