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Healthcare Sector Review Wed, 08 Sep 2010 How to pick and what to pick? Equity Research Healthcare/ China . After significant adjustments in June and July, we believe many stocks with low valuations start to regain interests from investors. In 2H10, we expect price cut policies to affect non-exclusive drugs with multiple manufacturers. This note serves as a stock pick guide in 2H10. Key Summaries Essential drug list (“EDL”, 基 本 藥 物 目 錄 ) will only benefit pharmaceutical companies with exclusive products All county hospitals and rural clinics in PRC are obligated to use the 307 drugs on EDL, implying a tremendous growth in volume of those 307 drugs. However, volume growth does not mean margin expansion. For non-exclusive products, margins are under risk of potential price cut and capacity expansion in industry. Only companies with exclusive products can maintain margins and enjoy volume growth from EDL. Guangzhou Pharmaceutical (874.HK, BUY, TP: HK$9.86) In long run, segment leaders will prevail through consolidations Tighter pollution and safety regulations drive smaller drug companies out of business. Increasing inter-provincial drug procurements benefits large scales drug distributors. These all lead to consolidations Segment leaders will survive and become even stronger in consolidations. Lansen (503.HK, BUY, TP: HK$4.86), Trauson (325.HK, BUY, TP: HK$4.68), Weigao (1066.HK, NR), Lijun (2005.HK, NR) and Sino Pharm (1099.HK, NR) Intermediate and bulk drug companies are showing limited growth potential, they are either at fair value or overpriced They are making commodities, with inherited high volatility. Even worse, many intermediate and bulk drug segments are showing overcapacities, driving margins down. United Lab (3933.HK, SELL, TP: HK$9.56), China Pharm (1093.HK, NR) Invest in highly innovative firms with unique products; their products usually maintain higher margins High innovation drugs are qualified for patent protections, can enjoy “higher quality, higher price” policy of the government, and most importantly are hard to copy by competitors. Therefore, their higher margins are sustainable. Lees Pharm (950.HK, BUY, TP: HK$4.05) and Sino Biopharm (1177.HK, NR) Same quality but lower price, medical device is going to boom Quality of PRC manufactured medical devices is improved dramatically that we believe some are almost equivalent to the imported devices. We see no difference in quality between domestic and imported medical devices in several years while gap in price is expected to remain wide. Traunson (325.HK, BUY, TP: HK$4.68), MingYuan (233.HK, BUY, TP: HK$0.97) and Weigao (1066.HK, NR) John Yung Oriental Patron Securities Ltd +852 2842 5871 .hk 259 Oriental Patron Research 8 September 2010 Page 2 of 35 Table of Contents Policies, a concern but sector is optimistic in long run . 3 Before the policies become substantial, panic takes over . 3 Warningwe anticipate price cut in 2H10 . 3 Also expecting positive policies in 2H10 . 3 Healthcare sector will still draw money from investors . 4 The PRC Healthcare Sector Investment Summaries . 5 Companies with exclusive products on Essential Drug List (EDL) are benefited . 5 Consolidation is irreversible . 6 Intermediates (中間體) and bulk drugs (原料葯) are going to fade . 7 Innovative companies are going to perform . 10 Medical devices, high growth potential but with less regulatory risks . 11 The PRC Healthcare Sector, in its best era of growth . 14 Unmet robust demands . 14 Medical reform, you cant stop the train . 14 Mapping the HK-listed Healthcare Sector . 16 Companies Lansen Pharmaceutical (503 HK) . 19 Lees Pharmaceutical (950 HK) . 20 Trauson Holdings (325 HK) . 21 Guangzhou Pharmaceutical (874 HK) . 22 Mingyuan Medicare (233 HK) . 23 The United Laboratories (3933 HK) . 24 China Pharmaceutical (1093 HK) . 25 Lijun International (2005 HK) . 26 Ruinian International (2010 HK) . 28 Shandong Weigeo (1066 HK) . 29 Shineway Pharmaceutical (2877 HK) . 30 Sino Biopharmaceutical (1177 HK) . 31 Sinopharm (1099 HK) . 32 260 Oriental Patron Research 8 September 2010 Page 3 of 35 Policies, a concern but sector is optimistic in long run Since late June, news about drug price regulations struck the sector. Negative market sentiments also drove medical device and drug distribution stocks down, though they are not even mentioned in the policy draft. Before the policies become substantial, panic takes over Since the National Development and Reform Commission (NDRC, 發改委 ) showed its intention to further regulate margins and price setting mechanisms of the industries, the sector experienced significant corrections (refer to “A disaster to the industryNot yet” on 22, June, 2010). Till today, we observed the regulators had only been restating main themes of existing policies while no details of solid tightening policies are given. Warningwe anticipate price cut in 2H10 However, we believe NDRC are serious about the price regulation on finished drugs and we expect NDRC to release policies in 2H10 with following details: 1) For non-exclusive drugs with wide price range and multiple manufacturers, NDRC is expected to take reference from the manufacturer with the most efficient cost structure, i.e. use the existing lowest price as the new standard; higher price non-exclusive drugs will fail to compete. 2) Exclusive and innovative products are not likely to be affected. 3) Medical device makers and drug distributors are not likely to be affected. Therefore, you should A) buy companies with exclusive and innovative drugs. B) buy medical device and drug distribution sub-sector leaders. C) avoid companies with majority non-exclusive drugs. D) avoid intermediate and bulk drug manufacturers; their downstream customers make non-exclusive drugs. Also expecting positive policies in 2H10 Equally important, we expect positive policies in “the Twelfth Five-year Plan” (十二五計劃 ) , hopefully in late October We believe “the Twelfth Five-year Plan” will mention its supports to consolidations of the drug distribution sub-sector. The Ministry of Commerce has expressed about their future plan to develop 2-3 “national leaders” (with over RMB100bn revenue) and about 20 “regional leaders” (with over RMB10bn revenue) in the drug distribution sub-sector, eliminating other smaller inefficient players. We also believe “the Twelfth Five-year Plan” should also substantiate beneficial policies to 261 Oriental Patron Research 8 September 2010 Page 4 of 35 the Biotech sub-sector. In specific, we expect new tax benefits to qualified biotech companies and cash awards to future biotech drug inventions. From what we heard, the government is expected to spend RMB10bn to award each “outstanding innovation drug” RMB 5-10mn. Healthcare sector will still draw money from investors At this time, we are positive to the sectors long term prospect while we can hardly argue on the robust demands on drugs and medical care by the growing PRC patient population. Even we try to turn around and look at the sector from a depressive view, what is going to happen if the world economic enters recession again? The answer is no other sectors could be more attractive than this defensive sector in a yet growing country. We see in the following exhibit that, historically, healthcare sector has outpaced PRC GDP in growth. Exhibit 1: PRC GDP Growth vs Healthcare sector revenue growth 0 . 0 %1 0 . 0 %2 0 . 0 %3 0 . 0 %2004 2005 2006 2007 2008 2009 2010EG D P G r o w t h S e c t o r R e v e n u e G r o w t hSource: National Statistics Bureau, Wind China 262 Oriental Patron Research 8 September 2010 Page 5 of 35 The PRC Healthcare Sector Investment Summaries Companies with exclusive products on Essential Drug List (EDL) are benefited EDL means higher reimbursements to patients, but not higher margins to companies The PRC Essential Drug List (EDL, 基本藥物目錄 ) was published in May 2009 containing 307 inexpensive drugs that provide fundamental medical care to patients. Patients will be able to reimburse over 90% of EDL drug expense. The government promised to spend an extra of RMB850bn from 2009 to 2012 to push the medical reform, at least 1/5 of the spending is for procuring EDL drugs, we estimate. In 2H10, we believe volume growth of EDL drugs will be significant because Ministry of Health (衛生部 ) obligate all rural clinics and county hospitals to tender 100% EDL drugs before the year end. However, volume growth does not guarantee profit growth for companies. Most of the EDL drugs are non-exclusive; capacity expansion of existing EDL drug manufacturers and possible price cut policy of NDRC can drag margins down in long run. Only exclusive products can maintain their margin in long term Exclusive drugs are an exception; the sole manufacturer will be able to maintain high margin and to enjoy volume growth. In the PRC-listed universe, companies with exclusive products on EDL include: Exhibit 2: Companies with exclusive products on EDL Listed Company Ticker Products Yunnan BaiYao Group (雲南白藥 ) 000538 CN Yunan Baiyao (雲南白藥 ) China Resources Sanjiu (華潤三九 ) 000999 CN Sanjiu Weitai Keli, Zhengtian Wan (三九胃泰顆粒、 正天丸 ) Qianjin Parmacy (千金葯業 ) 600479 CN Fu Ke Qian Jin Jiao Nang(婦科千金膠囊 ) Wuhan Humanwell Healthcare (人福科技 ) 600079 CN Sufentanil Citrate Injection (芬太尼注射劑 ) Guangzhou Parmaceutical (廣州葯業 ) 600332 CN/ 874 HK Xiaoke Wan, Huatuo Zaizao Wan (消渴丸、華佗再造丸 ) Fosun Pharma (復星葯業 600196 CN Xianling Gubao Jiaonang (仙靈骨葆膠囊 ) Zhongxin Pharmaceuticals (中新藥業 ) 600329 CN Su Xia Jiu Xin Wan(速效救心丸 ) Tasly Group (天士力 ) 600535 CN Compound Danshen Dripping Pills (複方丹參滴丸 ) Jinlin Parmaceutical Co. Ltd (金陵藥業 ) 000919 CN Mailuoning Zhusheye (脈絡寧注射液 ) Merro Pharma (美羅藥業 ) 600297 CN Shang Ke Jie Gu Pian ( 傷科接骨片 ) Mayinglong Parm (馬應龍 ) 600993 CN Musk Hemorrhoids Oitment (馬應龍麝香痔瘡膏 ) Zhong Heng Group (中恒集團 ) 600252 CN Zhu She Yong Xue Shuan Tong (血栓 通凍乾粉 ) Source: Company, OP Research The only company benefited from EDL in Hong Kong. Within the Hong Kong listed universe, Guangzhou pharmaceutical (874.HK) is the only company with two exclusive EDL products. 1) Xiaokewan (消渴丸 ) accounted for 50% market shares of TCM (Traditional Chinese medicine) for diabetes in PRC and 10% market shares of all diabetes drugs in PRC. It contributed RMB500mn revenue (15% of total revenue) in 2009. We believe, its relatively low price (comparing to other western medicines and better accepted by rural population) and higher reimbursement rate will make its sales double in 3 years. 263 Oriental Patron Research 8 September 2010 Page 6 of 35 2) Huatuozaizaowan (華佗再造丸 ), listed as National Tier-1 Confidential Formula (國家一級保密處方 ), sales of RMB150mn or 4% of the companys 2009 revenue. Being one of the crucial TCM for treating growing stroke related diseases, its volume will grow further after its entry to EDL. The company is only traded at a FY11 PE of 16X, significantly lower than the peer average of 20X. We recommend BUY at TP HK$9.86 Exhibit 3: Xiaokewan and Huatuazaizaowan Source: Company Consolidation is irreversible Reasons behind consolidations Following are reasons for industrial consolidations: 1) To improve product safety, SFDA is enforcing stricter regulations, such as implementing the new European Good Manufacturing Practice (GMP) standard staring 2011; many existing plants has to be modified. Many of the smaller companies are unable to afford the extra Capex and will have to either close down or be bought out. 2) Besides, regulators are enforcing more stringent requirements on pollution preventions and require add-on constructions such as sewage treatments. Again, money problem for smaller firms. 3) Latest medical reform policies ask drug manufacturers to limit the number of distributors from door (of manufacturer) to door (of hospitals). 4) Inter provincial drug procurements have been happening more frequently, benefiting bigger distributors with interprovincial networks. 5) This month, the Ministry of Commerce has expressed about their future plan in the “the Twelfth Five-year plan” to develop 2-3 “national leaders” (with over RMB100bn revenue) and about 20 “regional leaders” (with over RMB10bn revenue) in the drug distribution sub-sector, eliminating other smaller inefficient players. While 1) and 2) push consolidations in drug and medical device segments, 3), 4) and 5) push for consolidations in drug distribution segment. After some years, smaller companies will not survive while subsector leaders will have acquired their market shares and become stronger. 264 Oriental Patron Research 8 September 2010 Page 7 of 35 Meeting the leaders In the long run, we believe consolidations will benefit the following companies with leading positions in their segments: Exhibit 4: Companies and their market share in the segments Company Ticker Leading position in Market Shares/Ranking Top 3 Market Shares Combined Sinopharm 1099 HK Logistic Distribution 12% / 1st 20% Lijun 2005 HK Plastic Intravenous Infusion Products (塑膠瓶大輸液 ) 15% / 3rd 57% Lansen 503 HK DMARDS ( ) 17% / 1st 35% Sino Biopharm 1177 HK Hepatitis Therapeutics 12%/ 3rd 80% Weigao 1066 HK Stents (心臟支架 ) 25%/ 1st 75% Trauson 325 HK Trauma Orthopedic Devices 8%/ 2nd 27% Source: Company, OP Research, Intermediates (中間體) and bulk drugs (原料葯) are going to fade It is a commodity business; it is hard to estimate the profit Intermediate drugs are mostly chemicals to be further processed into drugs; bulk drugs are raw drug powders before further containing or packaging. Intermediate drugs and bulk drugs from different suppliers are similar in quality; they are basically commodities. Company margins are hard to estimate and depend heavily on frustrating market price/company ASP. The following shows the relationship of company margins and historical price movements of intermediate drugs (6-APA, 7-ACA, etc.) and bulk drugs (Amoxillin, Cefotaxime, Vitamin C, etc.) Exhibit 5: Margins of the United Lab (3933.HK) intermediates depend on market price 02004006008001 , 0 0 01 , 2 0 0J a n - 07 J u l - 07 J a n - 08 J u l - 08 J a n - 09 J u l - 09 J a n - 106 - A P A ( R M B / K g ) 7 - A C A - ( R M B / K g )I n t e r m e d i a t e d r u g s a c h i e v e d 3 % o p e r a t i n g m a r g i n i n 1 H 0 9I n t e r m e d i a t e d r u g s a c h i e v e d 1 2 % o p e r a t i n gm a r g i n i n 1 H 0 8(RMB/Kg)Source: Company, OP Research, Wind China 265 Oriental Patron Research 8 September 2010 Page 8 of 35 Exhibit 6: Margins of the United Lab (3933.HK) bulk drugs depend on market price 02004006008001 , 0 0 01 , 2 0 01 , 4 0 0J a n - 07 J u l - 07 J a n - 08 J u l - 08 J a n - 09 J u l - 09 J a n - 10A m o x i l i n ( R M B / K g ) C e f o t a x i m e ( R M B / K g )B u l k d r u g s a c h i e v e d 6 %o p e r a t i n g m a r g i n i n 1 H 0 9B u l k d r u g s a c h i e v e d 1 6 %o p e r a t i n g m a r g i n i n 1 H 0 9(RMB/Kg)Source: Company, OP Research, Wind China Exhibit 7: Margins of the China Pharm (1093.HK) fall so does the market price 020406080100120140160V i t a m i n C ( R M B / K g )V i t a m i n C a c h i e v e d 54%o p e r a t i n g m a r g i n i n 1 H 0 9V i t a m i n C a c h i e v e d 4 3 % o p e r a t i n g m a r g i ni n 1 H 0 9(RMB/Kg)Source: Company, OP Research, Wind China Cursed by overcapacity, margins shrinking Overcapacity has been observed in intermediate and bulk drug segments for long time; we still constantly see new entrants to the segments. The follow shows how bad the overcapacities are in different products. Exhibit 8: Examples of overcapacities in intermediate and bulk drugs Product World demand/ Annual PRC capacity/ Annual The United Lab (3933.HK) Capacity/Annual China Pharm (1093.HK) Capacity/Annual 7-ACA 4,000ton 7,000 ton 700 ton 1,200 ton Penicillin 60,000 ton 100, 000 ton 10,000ton 15,000ton Vitamin C 100, 000 ton 180,000ton NA 32,000ton Source: Company, OP Research, Wind China Overcapacity can only drive segment margins down. In long run, we see players in the segments become marginally profitable. 266 Oriental Patron Research 8 September 2010 Page 9 of 35 2H10 price cut can hit them hard Both the United Lab (3933.HK) and China Pharm (1093.HK) have finished products, but all are non-exclusive drugs exposed to potential NDRC price cut in 2H10. For non-exclusive drugs with wide price range and multiple manufacturers, NDRC is expected to take reference from the manufacturer with the most efficient cost structure, i.e. use the existing lowest price as the new standard; higher price non-exclusive drugs will fail to compete. While we believe NDRC is likely to first cut price of non-exclusive EDL(基本藥物目錄 ) drugs, China Pharm has about 1/3 of their finished products listed on EDL list and the United Lab also has about 1/3 of their 34 finished products listed on EDL. Selling new finished products might not solve the problem Companies understand the problem with shrinking margins and they want to rely on introducing new finished products to boost future growth. However, we think this might not solve the problem because: usually their new products are second tier technology drugs facing fierce competitions they need to invest a lot of time and money to develop totally different channels For instance, the United Lab (3933.HK) launched in early FY10 their “second generation insulin” (二代 胰島素 ) product into the market, which is already saturated by foreign and domestic players. In the long run, we believe the technology advanced “third generation insulin” will take over “second generation insulin”. Exhibit 9: Insulin market shares in PRC No v o No r d is k z( 諾和諾德 )75%L i l l y ( 禮來 )11%S a n o f i - A v e n t is ( 賽諾菲 - 安萬特 )2%G a n & L e e ( 甘李 )2%D o n g B a o ( 東寶)1 0 % Source: Company, OP Research More importantly, the United Lab has been selling only antibiotics (抗生素 ). For insulin, they will need to build totally different channels in hospitals. This could means 2-3 years of efforts for their sales force and extra SG&A expenses (finished product segment margin dropped from 24.7% in 1H09 to 21.7% as SG&A up 33% to HK$633mn). We believe, their insulin product might not be able to break even in 2011 while its 2012 contribution is questionable. 267 Oriental Patron Research 8 September 2010 Page 10 of 35 Pricy stocks? The United Lab (3933.HK) is trading at FY10 PE of 19X(FY11 PE of 16), we think this is demanding for a company whose revenue still rely heavily on intermediate and bulk drugs (65% revenue in 2009) and risks heavy price cut to their finished products. We recommend SELL at TP $9.56. On the other hand, China Pharm (1093.HK) is less active on moving towards finished products, 70% of 2009 revenue is from intermediate and bulk drugs. While it is trading at FY11 PE of 11X, we believe the valuation is not attractive at this time. Innovative companies are going to perform Generic drugs, no more fat margins Making generic drugs can establish cash flow quickly, but the cash flow also drains quickly when everybody rushes to make the same drug. Tendency of the government is clear: they want companies to focus more on R&D and discovering new drugs. Currently, only new drugs are protected by an exclusive patent period. In future, NDRC (發改委 ) is expected to only allows patented new drugs and the “first followers” (首仿者 ) to set their price with reference to costs and global prices, resulting in higher margins. For the “second followers” and the “third followers”, they can only set their generic drug price 10% and 20% below that of the “first follower”, resulting in lower margins. The regulation substantially discourages companies from making generic drug Exhibit 10: Expected pricing policies of NDRC Drug Category NDRC price guideline Innovative patented new drugs Priced with reference to costs and global prices, highly flexible “First follower” generic drug Priced with reference to costs and global prices, usually significantly lower than price of new drugs “Second follower” generic drug Priced10% lower than that of “First follower” generic drug “Third follower” generic drug Priced 20% lower than that of “Second follower” generic drug “Forth follower” generic drug Price capped by price of “Third follower” generic drug Source: NDRC, OP Research Moreover, we expect the “the Twelfth Five-year Plan” to mention substantial incentives to drug innovations. From what we heard, the government is expected to spend RMB10bn to award each “outstanding innovation drug” RMB 5-10mn. In the future, we see generic drug makers to suffer from low margins and fierce competitions while innovative firms dominate. Innovations pay off, buy companies with new drugs In our view, companies focusing on new drug discoveries will be long term winners in the PRC pharmaceutical industry, because they enjoy: favourable policies, such as “higher quality, higher price” (優質優價 ) and other tax incentives. better patent protections, while they have 10-15 years selling the exclusive products. higher margins, when you compare to those of generic drugs. rich pipelines, to fuel long term growth of the company. 268 Oriental Patron Research 8 September 2010 Page 11 of 35 We believe there are only two companies in Hong Kong listed universe that is qualified as innovative firms, and they are: Sino Biopharm (1177.HK) and Lees Pharm (950.HK). Sino Biopharm (1177.HK) focuses on cardio-cerebral, hepatisis, oncology and analgesic medicines. Out of their 12 major products, 7 products contribute more than RMB100mn in 2009. We believe products with high growth potentials and pioneering innovations will come out from the company. After significant downward adjustments in previous weeks, its current valuation at FY11 PE of 22X is attractive, we believe. Lees Pharm (950.HK), focusing on heart disease, cancer and gynaecology drugs is expected to grow its profit by 50% in 2010 and 30% afterwards. Three of its products are looking forward to sell over the critical revenue level of HKD100mn in the future two years. Also downward adjusted recently, the current valuation at FY11 PE of 14X is cheap, in our view. We recommend BUY at TP $4.05. Medical devices, high growth potential but with less regulatory risks Closing up the gap with foreign players In recent years, the domestic medical device industry advanced dramatically. Many companies have successfully moved from fundamental devices (e.g. needles and syringes, with lower margin) to sophisticated devices (e.g. heard implant devices, higher margin). Some domestic companies established significant sales overseas, proving that foreign doctors confirmed quality of domestic products. Indeed, many domestic products have been selling OEM products to their international competitors for years. This shows that domestic products have reached same technology and quality level as their foreign counterparts, although they are selling at a significantly lower price. Even better, all of the recent policies didnt imply any tightening regulations to the device subsector; it is the best era for the medical device subsector. Backed by strong demands, domestic brands taking over Medical reform also benefits the medical device subsector. From the RMB850bn fiscal spending for the medical reform, at least 1/5 is estimated to be for building rural medical facilities which includes vast amount of medical device procurements, we estimate. Moreover, we believe these government procurements will mainly buy from domestic device makers rather than their foreign counterparts. Thus, market of domestic medical devices such as stents and orthopedic products are expected to grow significantly in the coming years PCI (percutaneous coronary intervention, 冠脈手術 ) are procedures to implant stents to patient bodies. While the PRC market of stents (支架 ) is about RMB25bn in 2009, we believe that only 4% of the patient demand is met. Therefore, we believe the market will grow at a CAGR of 30% in the coming years. Exhibit 10 shows the comparison on population and annual PCI procedure counts of three countries. We can see the huge growth potential of PCI procedures once it catches up with the developed countries. 269 Oriental Patron Research 8 September 2010 Page 12 of 35 Exhibit 11: National population and PCI procedures 02004006008001 , 0 0 01 , 2 0 01 , 4 0 002004006008001 , 0 0 01 , 2 0 01 , 4 0 0U S J a p a n P R C P o p u l a t i o n ( m n ) P C I ( 0 0 0 )Population(Mn)PCI procedures(000)Source: Company, OP Research Domestic domination is proven in history In Exhibit 11 we see currently 75% of market share is acquired by domestic players; back in 2006 over 90% market share was occupied by international players. Exhibit 12: Market share change in PRC stent market B e i j i n g L e p u25%W e i g a o #25%20093 I n t e r n a t i o a n l p l a y e r s *25%S h a n g h a i M i c r o p o r t25%2006D o m e s t i c p l a y e r s 1 0 %I n t e r n a t i o n a l p l a y e r s 9 0 %Source: Company, OP Research. * Three international players are Johnson & Johnson (JNJ), Medtronic (MDT), and Boston Scientific (BSX); #Stents of Weigao are sold under subsidiary Jiwei. Orthopedic products with a PRC market size of about RMB 6.0bn in 2009 and domestic market share is below 20%; we believe domestic companies are going to dominate the orthopedic market following the stent example. Looking forward, the market is expected to grow at a CAGR30%. Medical device companies in spotlight Weigao (1066.HK) is the all around medical device supplier with products ranging from medical consumables, orthopedic devices and heart surgery stents to blood purification products. While the company s consumable, stents and orthopedic products are expected to grow over 30% each year, its blood purification products should achieve 100% growth in the coming 2- 3 years, we estimate. 270 Oriental Patron Research 8 September 2010 Page 13 of 35 On the other hand, Trauson, focuses only on orthopedic devices. While its trauma products (11% market shares) and spine products (3% market shares) rank the 3rd and the 6th in PRC. The company profit is expected to grow at a CAGR of 30% in the coming three years. While Weigao (1066.HK) and Trauson (325.HK) are both quality device companies in the HK-listed universe. We believe Trauson (trading at FY11 PE of 18X) is more attractive in valuation than Weigao (trading at FY11 PE of 35X), and therefore should be preferred. We recommend buying Trauson at TP HK$4.68. 271 Oriental Patron Research 8 September 2010 Page 14 of 35 The PRC Healthcare Sector, in its best era of growth Unmet robust demands We can hardly argue about the PRCs fast growing GDP and the rising healthcare awareness of its population. To catch up with developed countries on healthcare expenditure, sector revenues are going to grow constantly. On the other hand, we believe the majority of patient populations are not being treated because of the current low coverage rate of medical care system. Medical reform is expected to be the solution. Exhibit 13: Healthcare Expenditure as % GDP 0246810121416(%)Source: Company, OP Research, Ministry of Health Exhibit 14: Treatment rate of some major diseases in PRC Disease Infected Population Treatment rate Diabetes 100mn 15% Coronary Heart disease 20mn 5% Cancer 11mn 10% Source: Company, OP Research, National Statistics Bureau Medical reform, you cant stop the train The ultimate goal of medical reform is to establish a basic, universal healthcare framework to provide Chinese citizens with safe, efficient, convenient and affordable healthcare. Step 1: from 2009-2011, to increase the accessibility while reducing the cost of healthcare and to build up network of basic healthcare facilities, expand the coverage of the public medical insurance system to cover 90% of the population and to reform the drug supply and public hospital system. Step2: 2011 to 2020, to establish a universal healthcare system. The entire population should be covered by public medical insurance; drug and medical services should be accessible and affordable to citizens in all public healthcare facilities. Starting from 2010, subsidy for each participant in Urban Resident Program increases from RMB40 to RMB 120, subsidy for each participant in New Urban Insurance Scheme 272 Oriental Patron Research 8 September 2010 Page 15 of 35 Program increases from RMB80 to RMB 120. To build 29,000 rural clinics in 2009, an additional 5,000 rural clinics, 2,000 county hospitals and 2,400 urban community clinics in under-developed areas. In our view, medical reform is irreversible, the robust demand it brought makes the PRC healthcare sector defensive yet fast growing in the coming years. 273 Oriental Patron Research 8 September 2010 Page 16 of 35 Mapping the HK-listed Healthcare Sector Since the IPO of Sinopharm (1099.HK) in 2009, the healthcare sector in Hong kong constantly gains more investor attentions. In exhibit 15 we selected HK-listed companies in the sector and tried to map them according to different sub-sectors (such as chemical drugs and medical devices, the vertical scale) and their positions in the industrial value chain (from intermediate drugs all the way to channels, the horizontal scale). While you see most of the companies are only manufactures of finished products, companies like the United Lab (3933.HK) and China Pharm (1093.HK) span also the upstream intermediates and bulk drugs, companies like Guangzhou Pharmaceutical (874.HK) also has business in distribution and retails. In exhibit 16, we try to summarize the characteristics of each of these sub-sectors in the HK-listed universe. Lastly, exhibit 17 shows the ongoing growth trend of the whole PRC healthcare industry, broken down in segments. 274 Oriental Patron Research 8 September 2010 Page 17 of 35 Exhibit 15: Mapping major HK-listed companies in the sector Source: Company, OP research. *TCM = Traditional Chinese Medicine, Bio = Biotech drugs, Chemical = Chemical Drugs, Devices = Medical Devices, Supplements = Health Supplements, 275 Oriental Patron Research 8 September 2010 Page 18 of 35 18 Exhibit 16: Characteristics of sub-sectors P r o p e r t i e s : M o s t o f d r u g m a k e r s i n P R C f a l l i n t o t h i s S u b s e c t o r E a s i e r t o c o p y m a n y g e n e r i c d r u g s L o w e r i n m a r g i n A n t i b i o t i c s a n d a s p i r i n f a l l i n t o t h i s c a t e g o r y A v e r a g e G r o s s M a r g i n * : 4 7 % T o t a l s a l e s i n 2 0 0 9 : R M B 5 2 1 b n* S e le c t e d s a m p le s In H K - L is t e d u n iv e r s eC h e m i c a l D r u g s P r o p e r t i e s : H i g h t e c h a n d r e p r e s e n t s t h e l a t e s t t r e n d M o r e d e m a n d i n g p r o c e d u r e s , s o h a r d e r t o c o p y U s u a l l y h i g h e r i n m a r g i n P r o d u c t s a r e u s u a l l y p r o t e i n s A v e r a g e G r o s s M a r g i n * : 7 0 % T o t a l s a l e s i n 2 0 0 9 : R M B P r o p e r t i e s : W i t h t h e l o n g e s t h i s t o r y i n P R C U s u a l l y c h e a p e r i n p r i c e a n d p o p u l a r i n r u r a l a r e a s S a m e p r o d u c t i n d i f f e r e n t b r a n d v a r i e s i n q u a l i t y a n d p r i c e H a r d t o s c i e n t i f i c a l l y q u a n t i f y t h e e f f e c t i v e n e s s A v e r a g e G r o s s M a r g i n * : 5 0 % T o t a l s a l e s i n 2 0 0 9 : R M B 2 6 8 b n P r o p e r t i e s : T e c h n o l o g y a n d q u a l i t y a d v a n c i n g f a s t D o m e s t i c c o m p a n i e s f o c u s o n m i d t o l o w e n d m a r k e t D o m e s t i c c o m p a n i e s a c q u i r i n g h i g h e r m a r k e t s h a r e s H i g h M a r g i n A v e r a g e G r o s s M a r g i n * : 6 2 % T o t a l s a l e s i n 2 0 0 9 : R M B 1 0 0 b n P r o p e r t i e s : H i g h M a r g i n L o w r e g u l a t o r y r i s k B e h a v i o r s i m i l a r t o c o m m e r c i a l s t o c k s H i g h S M & A c o s t A v e r a g e G r o s s M a r g i n * : 6 9 % T o t a l s a l e s i n 2 0 0 9 : R M B 5 8 b nB i o t e c hT C MD e v ic e sH e a l t h S u p p l e m e n t sSource: Company, OP Research Exhibit 17: Turnover of selected sub-sectors 01 0 0 , 0 0 02 0 0 , 0 0 03 0 0 , 0 0 04 0 0 , 0 0 05 0 0 , 0 0 06 0 0 , 0 0 07 0 0 , 0 0 08 0 0 , 0 0 09 0 0 , 0 0 01 , 0 0 0 , 0 0 02003 2004 2005 2006 2007 2008 2009 2010*(RMBmn)S u p p l e m e n tCA G R: 1 0 %D e v i c eC A G R : 3 2 %B i o t e c hC A G R : 2 4 %T C MC A G R : 2 0 %Ch e m i c a lC A G R : 1 8 %C A G R o f T o t a l T u r n o v e r : 20%Source: Company, OP Research 276 Oriental Patron Research 8 September 2010 Page 19 of 35 Lansen Pharmaceutical (朗生醫藥 ) Target Price: HK$4.86 (+40%) Price: HK$3.48 HKEx Code: 503 Leader in the niche of DMARDS Lansen is the leader in PRC DMARDS market, holding 25% market share. DMARDS ( 風濕病慢作用藥) , one kind of rheumatic drug (風濕病藥 ), accounts for 1/5 of the overall rheumatic drug market which was about RMB60bn in 2009. While the overall PRC rheumatic drug market is growing at a CAGR over 18%, PRC DMARDS sector grows at 29.2% CAGR. Leveraging on the established network While we estimate the PRC rheumatic disease population to be over 50mn, the disease ranks 4th in the PRC chronic diseases and is undertreated. Most of the older patients simply accept the chronic disease without seeking out professional medical care. This is going to change along with the increasing medical care coverage and rising life quality being pursued. Currently, all of Lansens rheumatic drugs are in the National Medical Insurance Reimbursement List; patients can seek 80% to 100% reimbursements using the companys products. Lansen serves over 1000 hospitals which include all the hospitals with rheumatology departments and the hospitals with high potential to open one. In particular, the company has maintained relationships with most of the rheumatology specialists in PRC hospitals. We think this established network is the core completive edge of the company comparing to its competitor. We believe the company can leverage on the network and capture the future high growth of rheumatic drugs in PRC. The risk: most of the key products are not self-developed 5 out of the 6 core rheumatic drugs being sold are licensed in; that is, Lansen is only being the sole distributor in PRC and the roles of sole distributor are subjected to contract renewals. However, most of the distribution relationships have been lasted for long time and original product makers developed reliance on the distribution interwork of Lansen. Therefore, we believe chance is slim for Lansen to lose their distributorships. Undervalued The stock is currently trading at FY11 PE of 16X, significantly lower than the peer average of 20X. Given the companys leading position in selling rheumatic drugs in PRC, we dont think the company deserve any discount. We used FY11 PE of 20X and the Bloomberg consensus FY11 profit of HK96mn; we recommend BUY at TP HK$4.86. BUY Key Data Close price (HK$) 3.48 12 Months High (HK$) 5.25 12 Month Low (HK$) 3.08 3M Avg Dail Vol. (mn) 2.68 Issue Share (mn) 415.00 Market Cap (HK$mn) 1,444.20 Free Float % 37.58 Net cash/share (HK$) Net debt/equity (%) 52.72 Fiscal Year 12/2009 Major shareholder (s) Cathay Intl (50.6%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart 0 . 0 1 . 0 2 . 0 3 . 0 4 . 0 5 . 0 6 . 0 M a y - 10 J u l - 10 S e p - 10Company Background The principal activities of the Group are engaged in the development, production and sale of specialty prescription western pharmaceuticals for the treatment of autoimmune rheumatic diseases in the PRC. The “5-pillar” Analysis 53445Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit A: Investment Summary Year to Dec (USD mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 24.2 37.1 47.9 20.8 28.4 Growth (%) - 53.7 29.1 n/a 36.3 Net Income (mn) 0.4 5.1 7.4 3.4 5 Growth (%) - 1,074.3 45.5 n/a 49.2 Gross margin (%) 68.1 70.1 67.7 68.1 65.4 Profit margin (%) 1.8 13.7 15.4 16.2 17.6 ROE (%) na 23.2 28.0 na na ROA (%) na 9.5 11.9 na na EPS na na na na na P/E (x) na na na na na P/B (x) na na na na na Dividend yield (%) na na na na na EV/EBITDA (X) na na na na na Source: Bloomberg, OP Research 277 Oriental Patron Research 8 September 2010 Page 20 of 35 Lees Pharmaceutical (李氏大藥廠 ) Target Price: HK$4.05 (+35%) Price: HK$3.01 HKEx Code: 950 Multiple pipelines fueling the growth While product pipeline decides future profitability of a pharmaceutical company, Lees Pharm ensures new product continuity by sourcing from 1) in-house R&D, 2) partnerships in international drug discovery projects and 3) being sole-distributors of foreign pharmaceuticals. The model is not so easily copies by others as 2) and 3) requires thorough understanding to the international pharmaceutical industry (CEO of the company worked in the US pharmaceutical companies for over 20 years) and good relationships with foreign companies (the company gets connections from its American and European strategic investors). Focusing on 4 rising urban disease sectors in PRC 1) Heart diseases, currently 250mn patients in China, 2) Cancers, there were about 11 mn cancer patients being diagnosed in PRC, 3) Gynopathy diseases (婦科病 ), there were 150mn gynopathy disease patients being diagnosed in 2008, 4)Dermatology diseases( 皮膚病 ) , there were about 60mn dermatology disease patients being diagnosed in 2008 Main products and their contributions High growth supported by existing and new products For existing products, Livaracine (heart disease drug) had just gained the “better quality, higher price (“優質優價 ”) approval and has increased the retail price by 40% since January 2010, Carnitene (heart disease drug) and Slounase (surgery drug) entered the national medical insurance reimbursement list since Jun 2010. The company has plans to promote its 2010 launched products, especially Zanidip , the drug to treat hypertension. In 2009, hypertension patient population is larger than 200mn, or about 20% of national population. However, only approximately 25% of these patients are treated. To further promote its new products, the company plans to expand its sales force from 150 to 300 people by the end of 2010. We estimate Zanidip to start contributing about RMB10mn revenue in 2010 and will grow at CAGR over 100% in the future three years. We believe the company will grow at over 35% CAGR for the future three years while FY10 profit is expected to grow over 50% yoy. We reiterate BUY with a target price at HK$4.05. BUY Key Data Close price (HK$) 3.01 12 Months High (HK$) 4.18 12 Month Low (HK$) 0.88 3M Avg Dail Vol. (mn) 0.32 Issue Share (mn) 450.58 Market Cap (HK$mn) 1,356.25 Free Float % 31.48 Net cash/share (HK$) (0.10) Net debt/equity (%) Net Cash Fiscal Year 12/2009 Major shareholder (s) Lees Family (40.0%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart - 50050100150200250300350Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10%9 5 0 HK M S C I C H I N ACompany Background The principal activities of the Group are engaged in manufacture and sale of self- developed pharmaceutical products, trading of license-in pharmaceutical products. The “5-pillar” Analysis 55545Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit B: Investment Summary Year ended Dec (HK$mn) FY09A FY10E FY11E FY12E 1H09 1H10 Revenue (mn) 173.8 259.1 356.7 491.1 76.6 105.3 Growth (%) 38.6 50 38 38 n/a 37.5 Net Income (mn) 46.4 68.1 88.3 117.7 20.1 26.3 Growth (%) 65.2 48 30 33 n/a 30.8 Gross margin (%) 72 72 72 72 72 72 Profit margin (%) 27 26 25 24 26. 25 ROE (%) 40 34 33 32 na na ROA (%) 29 27 26 26 na na EPS 0.10 0.15 0.20 0.26 na na P/E (x) 28 20 12 10 na na P/B (x) 9 5 4 3 na na Source: Bloomberg, OP Research 278 Oriental Patron Research 8 September 2010 Page 21 of 35 Trauson Holdings (創生控股 ) Target Price: HK$4.68 (+30%) Price: HK$3.59 HKEx Code: 325 Doing well in its niche The company, though with incomparable scale and product variety to Weigao, performs in the niche of PRC orthopedic device (including trauma, spine and joint products) subsector. Market share of Trauma: 8.4%, the largest domestic maker. Market share of Spine: 3%, 2nd largest domestic market. The following shows ranking and market share of players in Tapping into the joint orthopedic market While you might realize that the company sells no joint products now, they are entering the market by first distributing joint products of a Taiwanese orthopedic manufacturer. In the future, the company will release joint products in their R&D pipeline and leverage on their existing distribution channels. The potential is high as we believe PRC joint orthopedic market is going to grow at 35% CAGR in the coming years, among the highest of the other two segments (Trauma: expected CAGR25%, Spine:CAGR30%) Substitutes to foreign brands Same story as Weigaoss, the company makes OEM products for many foreign orthopedic device companies, including Medtronic (MDT.US). With almost the same quality and the existing price discount, company is going to further acquire existing market share of foreign players Undervalued While Trauson is in the same medical device sub-sector as Weigao (1066.HK) and enjoys a similar high growth rate, its smaller market cap and its shorter listed history should make it deserve a discount on valuation, we believe. We did our back-of-envelope calculation using FY11 PE of 24X (30% discount to Weigaos FY11 PE of 35X) and using the Bloomberg consensus FY11 profit of HK151mn; our TP is at HK$4.68, BUY. BUY Key Data Close price (HK$) 3.59 12 Months High (HK$) 3.96 12 Month Low (HK$) 3.21 3M Avg Dail Vol. (mn) NA Issue Share (mn) 774.33 Market Cap (HK$mn) 2,779.84 Free Float % 38.28 Net cash/share (HK$) - Net debt/equity (%) Net Cash Fiscal Year 12/2009 Major shareholder (s) Xu Yan Hua (67.2%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart 2 . 9 3 . 0 3 . 1 3 . 2 3 . 3 3 . 4 3 . 5 3 . 6 3 . 7 3 . 8 3 . 9 J u n - 10 J u l - 10 A u g - 10Company Background The principal activities of the Group are engaged in design, manufacturing and sale of a broad range of trauma and spine orthopaedic implants under the brands Trauson and Orthmed and related surgical instruments in China. The “5-pillar” Analysis 44454Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit D: Investment Summary Year to Dec (RMB mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 131.6 173.7 211.5 88.6 120.3 Growth (%) 32.0 21.8 n/a 35.8 Net Income (mn) 55.7 64.8 82.2 32.7 37.4 Growth (%) na 16.4 26.8 n/a 14.3 Gross margin (%) 59.0 66.1 70.6 69.6 72.5 Profit margin (%) 42.3 37.3 38.9 36.9 31.1 ROE (%) na 54.7 42.5 na na ROA (%) na 29.8 27.6 na na EPS 0.2 0.1 0.2 na na P/E (x) 22.44 29.92 23.93 na na P/B (x) na na na na na Dividend yield (%) na na na na na EV/EBITDA (X) na na na na na Source: Bloomberg, OP Research Exhibit C: Market share and ranking in PRC othorpedic market Trauma Market Rank Company Name Market Share (PRC)1 Synthes, Inc. US & Switz. 13.8% 2 Trauson PRC 8.4% 3 Kanghui Medical PRC 5.1% 4 Shangdong Weigao PRC 3.6% 5 Beijing Libeier PRC 2.7% 6 Tianjin Walkman Biomateriald PRC 2.3% Spine Market 1 Medtronics, Inc. US 13.3%2 Johnson & Johnson (Depuy) International 11.1% 3 Shangdong Weigao PRC 8.1% 4 Synthes, Inc International 7.4% 5 Styker Corporation International 5.7% 6 Trauson PRC 3.0% Source: Company, OP Research 279 Oriental Patron Research 8 September 2010 Page 22 of 35 Guangzhou Pharmaceutical (廣州藥業 ) Target Price: HK$9.86 (+22%) Price: HK$8.05 HKEx Code: 874 New force to historical repudiated brands The leading TCM company in China composed of 12 subsidiaries, 400 products ranging from prescription drugs to herbal teas with 40 out of that included in the “National protedted Chinese medicine list” (中藥保護品種 ) Intangible but valuable assets include famous brands like “Wang Lao Ji” (王老吉 ) and “Pan Gao Shou” (潘高壽 ), Jingxiutang (敬修堂 ), Chenliji (陳李濟 ) while the earliest was established in 1600s. Starting in 2004, the company brought in investors and formed JV on brand “Wanglaoji” to bring in new strategies to the state own management; revenue of “Wanglaoji” since then grew over 200% in three years. In the future, we believe the company will apply the same business model to its other brands with high potentials. Only HK-listed company with exclusive products on EDL While the company has more than 10 products listed on EDL (Essential Drug List,基本藥物目錄 ), two are exclusive. While all EDL products will grow in volume from tenders of all rural medical facilities in 2H10, two exclusive products listed below can also maintain a stable margin in long run. 1) Xiaokewan (消渴丸 ) accounted for 50% market shares of Traditional Chinese Medicine (TCM) for diabetes in PRC and 10% market shares of all diabetes drugs in PRC. It contributed RMB500mn revenue (15% of total revenue) in 2009. We believe, its relatively low price (comparing to other western medicines and better accepted by rural population) and higher reimbursement rate will make its sales double in 3 years. 2) Huatuozaizha (華佗再造丸 ), listed as National Tier-1 Confidential Formula (國家一級保密處方 ), sales of RMB150 mn or 4% of the companys 2009 revenue. Being one of the crucial TCM for treating stroke related diseases, its volume will grow further after its entry to EDL. Low valuation The stock is currently trading at FY11 PE of 16X, significantly lower than the peer average of 20X. The company owns many valuable brands and popular products; we expect future improvements to operation to be successful and the company deserves higher than its current valuation. Using FY11 PE of 20X and using the Bloomberg consensus FY11 profit of HK385mn ; we recommend BUY at TP HK$9.86. BUY Key Data Close price (HK$) 8.05 12 Months High (HK$) 9.44 12 Month Low (HK$) 3.53 3M Avg Dail Vol. (mn) 1.79 Issue Share (mn) 219.90 Market Cap (HK$mn) 10,707.83 Free Float % 100.00 Net cash/share (HK$) (0.78) Net debt/equity (%) Net Cash Fiscal Year 12/2009 Major shareholder (s) Guangzhou Pharm. (48.2%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart - 20020406080100120140Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10%8 7 4 HK M S C I C H I N ACompany Background The Group is principally engaged in the manufacture and sales of Chinese Patent Medicine (CPM); wholesale, retail, import and export of western and Chinese pharmaceutical products and medical apparatus; and research and development of natural medicine and biological medicine. The “5-pillar” Analysis 33445Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit E: Investment Summary Year to Dec (RMB mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 11,873.5 3,450.6 3,802.4 1,903.0 2,282.8 Growth (%) 15.9 -70.9 10.2 -8.0 20.0 Net Income (mn) 320.3 181.8 214.9 118.8 169.4 Growth (%) 46.9 -43.2 18.2 -20.5 42.6 Gross margin (%) 15.1 29.1 26.6 24.5 27 Profit margin (%) 2.7 5.3 5.7 6.3 7.4 ROE (%) 10.6 5.7 6.4 na na ROA (%) 5.3 3.4 4.9 na na EPS 0.4 0.2 0.3 na na P/E (x) 20.38 35.94 30.38 na na P/B (x) 2.06 2.01 1.89 na na Dividend yield (%) 1.54 0.50 0.62 na na EV/EBITDA (X) 21.3 38.2 45.0 na na Source: Bloomberg, OP Research 280 Oriental Patron Research 8 September 2010 Page 23 of 35 Mingyuan Medicare (銘源醫療 ) Target Price: HK$0.97 (+7%) Price: HK$0.91 HKEx Code: 233 Pioneer in preventative screening of diseases The company provides solutions to early detection and prevention of disease in PRC. Its products include: 1) C-12 cancer screening chip, which check patients for 10 cancers on one chip and 2)HPV cervical cancer screening kit is to check female patients for the 13 high-risk HPV viruses and 3)H1N1 testing kit and 4) Tuberculosis testing kit. Slower growth in 2010, catalyst ahead We think the 1H10 results revealed that growth in both products C-12 (96% of expected FY10 revenue) and HPV testing kits are below the previous guidance of the company and we believe the slow growth will continue in 2H10. We think, while the company should remain a slow growth of 5% in short term, any unanticipated catalysts (such as the possible C-12 entrance to National Medical Insurance Reimbursement List) can bring significant re-rating to the stock. Attractive price after adjustments However, we believe the stock is trading close to fair value and with limited downside risk after the previous adjustments. We believe the company has a spectrum of well equipped products. Riding on the tide of medical reform and the improve health awareness of PRC population; the company should grow with the whole medical sector. The stock is trading at a FY11 PE of 18X and we reiterate BUY at TP HK$0.97. BUY Key Data Close price (HK$) 0.91 12 Months High (HK$) 1.62 12 Month Low (HK$) 0.68 3M Avg Dail Vol. (mn) 10.36 Issue Share (mn) 3,732.02 Market Cap (HK$mn) 3,396.14 Free Float % 52.68 Net cash/share (HK$) (0.07) Net debt/equity (%) Net Cash Fiscal Year 12/2009 Major shareholder (s) Yao Yuan & Family (27.0%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart - 40- 20020406080100Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10%2 3 3 HK M S C I C H I N ACompany Background The principal activities of the Group are engaged in manufacture and trading of protein chips and equipments, provision of cervical cancer care and operation of Shanghai Woman and Child Healthcare Hospital of Hong-Kou District, Shanghai, the PRC, and Medical Centres Management. The “5-pillar” Analysis 54254Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit F: Investment Summary Year end Dec (HKD ) FY09A FY10E FY11E FY12E 1H09 1H10 Revenue (mn) 394.3 447.5 509.7 584.6 208 233.9 Growth (%) 20.9 13.5 13.9 14.7 35.0 12.5 Net Income (mn) 76.8 155.6 171.3 189.6 88.7 91.3 Growth (%) -48.8 102.6 10.1 10.7 8 3 Gross margin (%) 81.0 79.4 78.6 77.6 81.5 79.5 Profit margin (%) 19.5 34.8 33.6 32.4 42.7 39.0 ROE (%) 6 12.0 11 11 na na ROA (%) 5 8 8 8 na na P/E (x) 37 23 20 18 na na P/B (x) 1.1 1.8 1.6 1.5 na na Source: Bloomberg, OP Research 281 Oriental Patron Research 8 September 2010 Page 24 of 35 The United Laboratories (聯邦制藥 ) Target Price: HK$9.56 (-39%) Price: HK$15.70 HKEx Code: 3933 Finished drugs, hit hard if 2H10 price cut All of the companys finished drugs are non-exclusive and is exposed to potential NDRC price cut in 2H10. While we believe NDRC is likely to first cut price of non-exclusive EDL (基本藥物目錄 ) drugs, the United Lab also has about 1/3 of their 34 finished products listed on EDL. Relying on intermediate and bulk drugs, bothered by unstable margins and overcapacity The company relies on contributions from intermediates and bulk drugs. In FY09, 65% of revenue is from them. Like China Pharm (1093.HK), the company is affected by the unstable margin (led by market price volatility) and overcapacities. Outstanding vertical integration helps ease the harm of price volatility, but overcapacity concern remains On the bright side, the company has well managed vertical integration system. The company has its finished products Amoxicillin and Ampicillin (both are the downstream made out of intermediate and bulk drugs) awarded “better quality, better price”(優質優價 ) and can be sold at 40% retail premium than its competitive products. The company has higher flexibilities shifting revenues to downstream. However, the defensive mechanism does not change the growing overcapacities of intermediate and bulk drugs in PRC. Eventually, profit margin of the segments is in the trend going down. Overpriced, as a commodity company While the company plans to sell more finished products in the future, the first thing will be launching its “second generation” insulin product in 2H10. However, we are not too optimistic about the success of this new product because 1) it is the product with dated technology (most of the market players are moving towards the “third generation” insulin and 2) it will take the United Lab years to develop totally different channels in hospitals. Comparing to China Pharm (1093.HK), we think the company has better vertical integration and higher operational flexibilities but falls into the same business sub-sector: intermediate and bulk drugs. We think the company should at most trade at 20% premium over China Pharms FY10 PE of 8.7X, or 10.4X Using the FY10 PE of 10.4X and the Bloomberg consensus FY10 profit of HK960mn; we recommend SELL at TP HK$9.56. SELL Key Data Close price (HK$) 15.70 12 Months High (HK$) 15.76 12 Month Low (HK$) 2.80 3M Avg Dail Vol. (mn) 3.44 Issue Share (mn) 1,250.00 Market Cap (HK$mn) 19,625.00 Free Float % 26.42 Net cash/share (HK$) 1.87 Net debt/equity (%) 70.11 Fiscal Year 12/2009 Major shareholder (s) Choy Kam Lok & family (65.4%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart - 50050100150200250300350400450Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10%3 9 3 3 H K M S C I C H I N ACompany Background The Group is engaged in the manufacture and sale of antibiotics finished products, the bulk medicine and intermediate products. Moreover, the Group also produces and sells small amounts of cough syrup, anti-allergy medicine and capsule casings. The “5-pillar” Analysis 32322Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit G: Investment Summary Year to Dec (HKD mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 2,594.9 3,755.9 4,643.2 2,076.2 3,079.1 Growth (%) 24.7 44.7 23.6 5.3 48.3 Net Income (mn) 510.5 430.2 541.4 134.4 483.9 Growth (%) 193.6 -15.7 25.9 -55.2 260.0 Gross margin (%) 46.5 38.1 39.1 35.7 40.6 Profit margin (%) 19.7 11.5 11.7 6.5 15.7 ROE (%) 27.1 16.3 18.0 na na ROA (%) 12.1 7.9 7.9 na na EPS 0.5 0.4 0.5 na na P/E (x) 32.71 43.85 34.81 na na P/B (x) 7.68 6.69 5.90 na na Dividend yield (%) 1.08 0.96 1.21 na na EV/EBITDA (X) 8.3 4.9 6.4 na na Source: Bloomberg, OP Research 282 Oriental Patron Research 8 September 2010 Page 25 of 35 China Pharmaceutical (中國製藥 ) Price: HK$4.08 HKEx Code: 1093 Heavy contribution from intermediate and bulk drugs, unstable margins The company has 72% of 09 revenue contributed from intermediates and bulk drugs, segments with high price volatility. Price volatility of these products can change company operating margin from high double digits in first half to low single digit in second half in same year. Capacity leader in the industry which is cursed by overcapacity. The company is the largest 7-ACA manufacturer in PRC and the largest Vitamin manufacturer in the world. The leading position in capacity does not bring more bargaining power to the company; instead, it means high fixed cost and lower margins. The lower margins are unfortunately due to overcapacity of the companys main products. For instance, Vitamin C (35% of 09 revenue of the company) has a world demand of 100,000 ton/annual; production capacity in PRC is 180,000 ton/annual. Similar situation happens on other products of the company. Lack of growth catalysts in the near future The company claims that they will sell more finished drugs in the future so that they will rely less on intermediate and bulk drugs. However, at this stage, we do not see any future products form the company which is attractive and can contribute significantly to the company bottom line in short term. We do not believe commodity business nature of the company will be changed in short term and we think it is being traded at its fair value. Not Rated Key Data Close price (HK$) 4.08 12 Months High (HK$) 6.26 12 Month Low (HK$) 3.83 3M Avg Dail Vol. (mn) 4.13 Issue Share (mn) 1,534.96 Market Cap (HK$mn) 6,262.64 Free Float % 48.96 Net cash/share (HK$) 0.33 Net debt/equity (%) 9.57 Fiscal Year 12/2009 Major shareholder (s) Legend Holdings Ltd (51.0%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart - 25- 20- 15- 10- 5051015202530Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10%1 0 9 3 H K M S C I C H I N ACompany Background The principal activities of the Group are the manufacturing and sale of pharmaceutical products. The “5-pillar” Analysis 32223Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit H: Investment Summary Year to Dec (HKD mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 4,986.1 6,830.0 7,031.6 3,502.9 3,941 Growth (%) 40.9 37.0 3.0 6.3 12.5 Net Income (mn) 477.4 940.6 970.7 532.7 426.2 Growth (%) 2,947.7 97.0 3.2 20 -20.0 Gross margin (%) 30.8 33.4 32.2 33.5 31.2 Profit margin (%) 9.6 13.8 13.8 15.2 10.8 ROE (%) 15.9 24.0 20.1 na na ROA (%) 8.1 13.1 11.5 na na EPS 0.3 0.6 0.6 na na P/E (x) 13.14 6.67 6.45 na na P/B (x) 1.87 1.39 1.21 na na Dividend yield (%) 1.23 4.90 5.88 na na EV/EBITDA (X) 5.3 2.8 4.3 na na Source: Bloomberg, OP Research 283 Oriental Patron Research 8 September 2010 Page 26 of 35 Lijun International (利君國際 ) Price: HK$2.71 HKEx Code: 2005 IVI is where the high growth lies in Intravaneous Infusion (“IVI”, 靜脈輸液 , 打 點 滴 ) products. IVI products manufactured in its Shijiazhuang plant (石家莊四葯 ) contributed for 40% of revenues and 60% of profit in 2009. In 2010, the Shijiazhung plant is the middle to expand its IVI capacity from 500mn bottles/bags to 600mn bottles/bags. The company expects to expand capacity in IVI products by 100mn bottles/bags every year until the capacity reaches 1bn bottles/bags. We believe the IVI arm of Lijun to grow in a CAGR of 25% in future three years. Consolidation of IVI market is irreversible IVI products can be classified into plastic and glass IVI products, while the market trend is eliminating dated class products and moving towards plastic products. Lijun has 70% of its capacity in plastic IVI products ranked #3 in the PRC IVI market (6% market share in overall IVI market and 15% in plastic IVI products). In the ongoing irriversible consolidations in PRC IVI market, Lijun is expected to be benefited as one of the market leaders. Comparing to other 2 leaders, Kelun (002422.SZ) and Shuanghe (600062.SH), we believe Lijun has better economy of scale and quality control by concentrating all IVI productions in one site. Therefore, we believe Lijuns gap between its bigger Not Rated Key Data Close price (HK$) 2.71 12 Months High (HK$) 3.30 12 Month Low (HK$) 0.80 3M Avg Dail Vol. (mn) 21.45 Issue Share (mn) 2,354.91 Market Cap (HK$mn) 6,381.79 Free Float % 27.51 Net cash/share (HK$) 0.14 Net debt/equity (%) 20.23 Fiscal Year 12/2009 Major shareholder (s) Prime United Ind (27.3%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart - 50050100150200250Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10%2 0 0 5 H K M S C I C H I N ACompany Background The Group is principally engaged in the research, development, manufacture and sale of a wide range of pharmaceutical products, including antibiotics, intravenous infusion solution, non-antibiotics finished medicines, bulk pharmaceuticals and OTC and healthcare products. The “5-pillar” Analysis 33344Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s sExhibit J: Investment Summary Year to Dec (RMB mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 1,110.9 1,420.1 1,533.2 866.3 988.8 Growth (%) 29.1 27.8 8.0 2.4 14.1 Net Income (mn) 116.5 91.1 190.4 112.2 140.3 Growth (%) 37.8 -21.8 109.0 -3.6 25.1 Gross margin (%) 50.8 45.7 49.4 48.8 51.6 Profit margin (%) 10.5 6.4 12.4 12.95 14.19 ROE (%) 14.1 8.0 14.4 na na ROA (%) 8.0 4.5 8.6 na na EPS 0.1 0.0 0.1 na na P/E (x) 40.28 60.72 29.01 na na P/B (x) 4.89 4.56 4.02 na na Dividend yield (%) 0.58 0.53 1.30 na na EV/EBITDA (X) 15.3 7.4 7.3 na na Source: Bloomberg, OP Research Exhibit I: China IVI product break-down (current and projected) P l a s t i c t i c I V I P r o d u c t35%G l a s s I V I P r o d u c t 65%C u r r e n tP l a s t i c t i c I V I P r o d u c t70%G l a s s I V I P r o d u c t 30%2014Source: Company, OP research 284 Oriental Patron Research 8 September 2010 Page 27 of 35 competetor is going to narrowed if not reversed. Gradually growing old business: Antibiotics and chemical drugs. Major products include Lijunsha (利君沙 , an antibiotic) which provides stable cash flow and Paiqi (派奇 , an antibiotic). We believe the sector should remain high single digit or low teen growth before another significant new product is released. In FY09, both antibiotics and chemical drugs contributed 56% of revenues. 285 Oriental Patron Research 8 September 2010 Page 28 of 35 Ruinian International (瑞年國際 ) Price: HK$6.00 HKEx Code: 2010 High growth consumer stock? The company mainly sells amino acid supplements (71%of revenue) and health drinks (22% of revenue). While supplements are not drugs, they also need to be approved by SFDA, but with less stringent procedures and is less time consuming. Interim result is Not apple to apple, growth in 2011 questionable While 1H10 revenue and profit grew yoy 132% and 325% respectively, they only grew hoh 4% and 6%, due to the 2H skewed revenue and profit distribution in FY09 (1H09 revenue = RMB 263mn, 1H09 profit = RMB41mn; 2H09 revenue = RMB 587mn, 2H09 profit = RMB168mn). If 2H10 and FY11 repeat a single digit hoh growth similar to that of 1H10, company will be unable to achieve the Bloomberg consensus CAGR of 38% (FY10-FY12), we believe. In the shadow of divestments Investors are scattered while multiple funds holding about 34% of outstanding shares with the lowest entry costs ranging from HK$1.36/share to HK$2.70/share. While the stock is currently trading at HK$5.97/share, we think the selling pressure is high. Not Rated Key Data Close price (HK$) 6.00 12 Months High (HK$) 6.64 12 Month Low (HK$) 2.75 3M Avg Dail Vol. (mn) 12.71 Issue Share (mn) 1,046.59 Market Cap (HK$mn) 6,279.52 Free Float % 47.80 Net cash/share (HK$) Net debt/equity (%) 1.36 Fiscal Year 12/2009 Major shareholder (s) Wang Fucai (38.2%) Source: Company data, Bloomberg, OP Research Closing price are as of 7/9/2010 All figures are subject to rounding Price Chart 0 . 0 1 . 0 2 . 0 3 . 0 4 . 0 5 . 0 6 . 0 7 . 0 Company Background The principal activities of the Group are engaged in the manufacturing and sales of amino acid-based nutritional supplement, general health products, health drinks and pharmaceutical products. The “5-pillar” Analysis 43304Pr of it ab ilit yT e c h n o lo g y / I nn ov at io nGrow t h Po t en t ia lPolic y Ben ef itVal uat ion At t rac t iv ene s s* analysis on policy effect of this company is not appropriate Exhibit L: Investment Summary Year to Dec (RMB mn) FY07A FY08A FY09A 1H09 1H10 Revenue (mn) 405.5 632.4 850.6 263.9 612.8 Growth (%) 106.1 55.9 34.5 n/a 132.2 Net Income (mn) 135.2 120.0 209.7 41.8 177.6 Growth (%) 451.5 -11.3 74.8 n/a 325.1 Gross margin (%) 78.6 67.4 69.2 60.05 73.43 Profit margin (%) 33.3 19.0 24.7 15.83 28.98 ROE (%) 55.7 25.9 29.8 na na ROA (%) 16.9 14.1 19.6 na na EPS 0.3 0.2 0.3 na na P/E (x) 22.64 37.50 21.43 na na P/B (x) na na na na na Dividend yield (%) na na na na na EV/EBITDA (X) na na na na na Source: Bloomberg, OP Research Exhibit K: Selected investors and their status Name of selected investors Holding share count/ % of outstanding Investment cost of shares Status Tetrad(Government of Singapore Investments) 68.5mn shares/6.55% HK$2.4 All shares sold at price HK$5.71 on 24/8/2010 Templeton 50.3mn/4.80% HK$2.32 Selling pressure exists Raffles 54.7mn/5.23% HK$1.36 Selling pressure exists Turrence (CK life Science) 93.2mn/8.91% HK$1.36 Selling pressure exists CCBI 14.4mn/1.44% HK$2.70 Selling pressure exists HSBC Holdings 45.0mn/4.30% N/A NA Harvest Fund 48.5mn/4.63% N/A NA JP Morgan Chase &Co 45.8mn/4.37% N/A NA Source: company prospectus, Bloomberg 286 Oriental Patron Research 8 September 2010 Page 29 of 35 Shandong Weigao (山東威高 ) Price: HK$21.40 HKEx Code: 1066 True domestic leader in medical device The company produces and sells 1) Consumables (overall: 15% market share; infusion sets (40%market share), syringes(20% market share) and blood bags(50% market shares), 2) Blood purification filters (6% market share), 3) Orthopedic products (4% market share)and 4)Stents(25% market share). While none of domestic medical device companies can compare to Weigao on product variety, we believe the company should further reinforce its leadership roles. The big trend of domestic brands taking over Indeed, many domestic producers have been selling OEM products to their international competitors for years showing that many domestic products have reached similar technology and quality level in some products comparing to their foreign counterparts, although they are selling at a significantly lower price. In the long run, we believe domestic devices are going to further acquire market shares of foreign brands. This trend is shown in the stent segment: currently, 75% of market share is acquired by domestic players; back in 2006 over 90% market share was occupied by international players. A sustainable high growth The company will benefit from volume growth in absolute term driven by the demand of medical reform. While most of the companys revenues are from high end hospitals, medical reform triggers demands in rural areas. We estimate, within the RMB850bn extra fiscal spending for medical reform, about 1/5 will be used to acquire medical devices and for building rural area medical facilities. We think the company should continue to be the leader in the sub-sector. Considering its sustainable high growth potential in the future, we established our long view to the company. Not Rated Key Data Close price (HK$) 21.40 12 Months High (HK$) 23.20 12 Month Low (HK$) 10.90 3M Avg Dail Vol. (mn) 1.30 Issue Share (mn) 856.24 Market Cap (HK$mn) 32,194.21 Free Float % 81.15 Net cash/share (HK$) (0.14) Net debt/equity (%) Net Cash Fiscal Year 12/2009 Major shareholder (s) Weigao Holding (49.5%) Source: Company data, Bloomberg, OP Research Closing price are as o

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