高盛 2010年中国医疗行业研究报告

December 17, 2010 China: Healthcare Equity ResearchHealthy prospects initiating at Buy for Zhongheng (CL) and SanjiuTraditional Chinese medicine boosted by policy support Traditional Chinese medicine (TCM) is regarded as an important part of Chinese life, but growth momentum has been lackluster for some time. That is now changing. The Chinese government accelerated development when it stepped up support for the industry in 2009, and we now expect TCM growth to be in line with the overall pharmaceuticals sector. We also see new products and capacity expansion driving longer-term strategy and increasing the likelihood of sustainable growth. Focus on brands and chronic disease treatments with EDL potential We think TCM companies will focus on getting their medicines on the essential drug list (EDL) as a means of boosting sales competitiveness, as substances on this list are trusted as effective treatments for chronic conditions. Chinese consumers are faithful to branded TCMs with centuriesof history, and this brand power could help extend product lines on alreadyextensively-developed sales networks. We therefore see two investment themes: 1) TCMs for chronic ailments with exposure to the EDL Zhongheng, Tasly and Kunming； (2) firms with branded TCMs Sanjiu, Yunnan Baiyao and Dong-E E-jiao. Initiating with Buy Zhongheng (CL) & Sanjiu； Neutral on Kunming With a forecast 2010-13E net profit CAGR of 50%, Zhongheng is our top pick as (1) its Xueshutong product is an exclusive item on the EDL, and we see rapid volume growth and capacity expansion； (2) we think the partnership with Buchang will bolster growth and push up valuations. We also like Sanjiu, which is a long-established branded TCM firm. We see it growing through product line expansion. We are Neutral on Kunming as we think the stock is fully valued despite a rapid increase in profitability and rapid growth/capex expansion for core product Xuesaitong. Risks include government price control moves on EDL and RDL drugs. We prefer EV/GCI vs. CROCI/WACC as our valuation method With this report, Fengqi Qian will assume co-coverage of A-shares in the China healthcare sector with Wei Du. We retain our 12-month target prices and upgrade Baiyao from Neutral to Buy as we see it reaping returns on investment in its toothpaste business. We select EV/GCI vs. CROCI/WACC as our valuation method and cross-check it with P/B vs. ROE and PEG. ZHONGHENG (600252.SS, BUY, CL): VALUATIONS, PROFITABILITY Source: Company data, Gao Hua Securities Research estimates. TCM FIRMS UNDER OUR COVERAGE *The stock is on our regional conviction list. For important disclosures, go to /research/hedge.html. Source: Gao Hua Securities Research estimates. 1-YEAR PRICE PERFORMANCE OF NEWLY COVERED COMPANIES Source: Datastream, Gao Hua Securities Research estimates. Fengqi Qian +86(21)2401-8929 Beijing Gao Hua Securities Company LimitedThe Goldman Sachs Group, Inc. 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. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to /research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S. Wei Du, Ph.D +86(21)2401-8928 Beijing Gao Hua Securities Company LimitedThe Goldman Sachs Group, Inc. Global Investment Research2009 2010E 2011E 2012EEPS (Rmb) 0.5 0.8 1.5 2.1EPS YoY (%) 123.7 57.0 103.4 35.0Gross margin (%) 50.2 57.8 68.6 69.0Net margin (%) 17.6 22.8 30.7 31.5CROCI (%) 18.5 31.7 47.6 53.2ROE (%) 24.8 44.7 51.9 48.3PE (X) 82.6 52.6 25.9 19.2PB (X) 18.3 17.0 11.1 7.9Company Ticker RatingPrice (12-15)12-m TPPotential upside / downsideZhongheng 600252.SS Buy* 39.8 52.8 33%Sanjiu 000999.SZ Buy 25.0 31.6 26%Baiyao 000538.SZ Buy 62.0 74.3 20%Kunming 600422.SS Neutral 15.4 16.6 8%E-jiao 000423.SZ Neutral 53.1 49.8 -6%Tasly 600535.SS Neutral 40.6 38.1 -6%0%50%100%150%200%250%300% Zhongheng Sanjiu KunmingDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 2 Table of contents Investment views: Buy Zhongheng (CL) and Sanjiu 3Earnings drivers: Government support, new products, capacity expansion 6Investment theme 1: Branded TCM firms 10Investment theme 2: TCMs for chronic diseases with exposure to the EDL 13Valuation: EV/GCI vs. CROCI/WACC as our primary methodology 17At a glance: Comparative analysis of Zhongheng, Sanjiu and Kunming 21Zhongheng (600252.SS, Buy, CL): Poised for a second take-off 23Sanjiu (000999.SZ, Buy): Expertise strengthened by dedication 30Kunming Pharma (600422.SS, Neutral): EPS accretion unfolding 33Yunnan Baiyao (000538.SZ, Buy): Driven by brand/sales, up to Buy 36EXPECTED NEWS FLOW/EVENTS DATE EVENT COMMENT Mar-Apr, 2011 Mar-Apr, 2011 Mar-Apr, 2011 1Q 2011 Zhongheng 2010 annual report Sanjiu 2010 annual report Kunming 2010 annual report Announcement of National Drug Price Administration Measures 4Q results expected to significantly improve compared with 1-3Q Watch closely for promotion of dermatology-related medicine Focus on the impact of TCM raw materials on 4Q gross margin. Original schedule is Oct 2010, postponed several times Source: Company data, Gao Hua Securities Research Estimates. Prices in the body of this report are as of the market close of December 15, 2010. The authors would like to thank Li Yu for his valuable contribution to this report. December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 3 Investment views: Buy Zhongheng (CL) and Sanjiu We initiate coverage on three TCM firms, with Buy ratings for Zhongheng (600252.SS, on our Conviction List) and Sanjiu (000999.SZ) and Neutral on Kunming (600422.SS). For other A share TCM stocks under our coverage, we upgrade to Buy from Neutral on Baiyao (000538.SZ) and remain Neutral on Tasly (600535.SS) and E-jiao (000423.SZ). Key drivers Since 2009, growth in the traditional Chinese medicine (TCM) sector has gradually caught up with that of the overall pharm industry, at an average rate of c. 25%. We believe this rate can be sustained, and we think the key drivers of TCM profit growth over the next few years include: Chinese government support: The government has been increasing its support for TCM particularly since 2009, and this is accelerating growth within the whole sector. Extensions to new product lines: New products can provide support for future growth as part of longer-term strategic plans. Capacity expansion is an important means of reinvesting capital, and it improves product quality and production efficiency. It is essential for sustainable growth. Government policy support boosts growth in the sector as a whole, but product line extensions and capacity expansion are crucial for longer-term growth in individual firms. Investment themes There are obvious advantages and disadvantages to traditional Chinese medicine. It is popularly viewed as effective for chronic diseases because it is targeted at long-term health preservation and curing the causes of disease rather than treating the symptoms. It also tends to be priced higher than Western medicines. Consumers trust branded TCM products with long histories, and they therefore show loyalty to these brands. At the same time, consumers and doctors are becoming more and more inquisitive about pharmacological and medical ingredients, and these traditional medicines are not the type of products that would win the support of skeptics who want a clear explanation of how therapies work. So far, TCM has served as only an auxiliary type of medication. Given the characteristics of TCM and sector fundamentals, we recommend TCM firms with following investment themes. Branded TCM firms: Companies with branded TCMs are well positioned to expand their product lines because of existing customer preference for their products and well-developed sales networks. TCM firms with medications included on the essential drugs list (EDL) for chronic diseases (esp. exclusive items, medicines for which the generic drug name is unique in China): The incidence of chronic diseases is rising rapidly as the population increases, and TCM appears to be an effective treatment for chronic diseases. We also expect to see sharp growth in the usage of EDL TCMs at basic medical institutions as EDL coverage expands (i.e. it is introduced in more hospitals). Meanwhile, we expect “exclusive medicines”, to have both a competitive and price advantage. December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 4 Our top pick is Zhongheng (600252.SS), Buy, Conviction List We estimate 2010-13E CAGR on revenue at 35.4% and net profit at 50.5%. We think such strong growth over the coming years would be a considerable accomplishment after the high growth achieved in 2009-10. The sustained rapid growth is mainly a result of consistent rapid sales growth and capacity expansion in the core product, Xueshuantong. This medicine is an exclusive item in the EDL, listed for the treatment of chronic cerebrovascular problems. This status gives it considerable competitive advantage, leaving room for an ex-factory price hike. We forecast a 2010-13E sales volume CAGR of 38.6% for Xueshuantong with a 4.2% CAGR for the ex-factory price. We expect the gross margin to improve to 87.4% from 86.1% over the same period. We also think Zhonghengs growth potential is will be reinforced by its sales partnership with Buchang Pharma. We also expect a new Guilinggao product series to be another growth area. We believe sales revenue will exceed RMB1 bn in 2013, and 2010-13E CAGR will reach 74%. The Guilinggao series should contribute to profit starting from 2011. Our EV/GCI vs. CROCI/WACC methodology shows that Zhongheng is undervalued now. Our 12-month target price is RMB52.8, implying a 33% upside potential. Buy Sanjiu (000999.SZ) We believe 2010-13E CAGR on revenue and net profit are 19.2% and 23.8%, respectively. Sanjius growth reveals a strong competitive edge bolstered by a high sales base and its exposure to a slow-growing OTC market. Sanjius growth comes from product line extension on the back of brand power. We forecast a 2010-13E CAGR of c.10% in OTC market, however, we think Sanjius OTC products will grow by 21%. Our EV/GCI vs. CROCI/WACC methodology indicates Sanjiu is undervalued. Our 12-month target price is RMB31.6, implying 26% upside potential. Neutral on Kunming (600422.SS) We believe Kunmings profit growth should accelerate in 2010-13E, with 19.0% and 39.9% CAGR on revenue and net profit respectively. We expect gross margin to increase from 33.6% to 37.8% in 2013, and the administrative expense and finance cost ratio to fall 0.5% and 0.3% respectively. We also foresee the build-up of almost a 100% loan loss reserve ratio. We expect continue substantial growth in the Xuesaitong series, a treatment for chronic cerebrovascular disease. With a new capacity ramp-up in 2011, we expect Xuesaitongs revenue CAGR to reach 42% in 2010-13E. Our EV/GCI vs. CROCI/WACC methodology suggest that Kunming is trading at fair value. Our 12-month target price of RMB16.6 implies an 8% upside potential. December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 5 Exhibit 1: Our top pick is Zhongheng Buy, Conviction List Summary financials for A share pharmaceuticals under our coverage *The stock is on our regional Conviction List. For important disclosures, please go to /research/hedge.html Source: Gao Hua Securities Research estimates. Exhibit 2: Our Sanjiu EPS estimates are higher than consensus Our EPS estimates for the three new TCMs in our coverage vs. consensus (Rmb) Source: Wind, Gao Hua Securities Research estimates. EPS CAGR ImpliedP/E (X) PEG (X) PB (X) ROEGross marginEBIT marginNet marginCROCI10E 11E 12E 10-13E 10E 11E 12E 11E 11-13E 11E 11E 11E 11E 11E 11EBuyZhongheng 600252.SS Buy* 22 39.8 52.8 33% 0.8 1.5 2.1 66% 53 26 19 34 0.9 11.1 52% 69% 39% 31% 48%Sanjiu 000999.SZ Buy 24 25.0 31.6 26% 0.9 1.2 1.5 25% 27 21 17 27 0.9 5.0 25% 63% 25% 20% 33%Huahai 600521.SS Buy 5 17.4 21.9 26% 0.3 0.6 0.9 60% 50 30 19 37 0.6 5.2 19% 41% 14% 19% 21%Baiyao 000538.SZ Buy 43 62.0 74.3 20% 1.4 1.9 2.4 28% 43 33 26 40 1.3 7.9 26% 34% 12% 10% 59%Kehua 002022.SZ Buy 10 19.6 22.9 17% 0.5 0.7 0.8 25% 37 29 24 34 1.4 7.2 28% 55% 39% 35% 68%NeutralKunming 600422.SS Neutral 5 15.4 16.6 8% 0.3 0.5 0.7 45% 48 32 23 35 0.9 5.7 19% 35% 9% 7% 20%Hisun 600267.SS Neutral 19 41.5 41.4 0% 0.7 0.8 1.2 33% 63 50 36 50 1.1 4.6 9% 29% 5% 7% 12%Hepalink 002399.SZ Neutral 60 149.0 146.3 -2% 3.4 4.6 3.3 -1% 44 32 45 32 13.7 5.8 20% 44% 38% 33% 99%E-jiao 000423.SZ Neutral 31 53.1 49.8 -6% 1.0 1.2 1.3 17% 54 44 39 42 5.1 11.7 28% 56% 27% 27% 118%Tasly 600535.SS Neutral 20 40.6 38.1 -6% 0.8 1.0 1.2 20% 50 40 35 37 4.4 8.3 22% 32% 11% 9% 24%Hengrui 600276.SS Neutral 42 56.9 49.5 -13% 1.2 1.4 1.8 23% 49 39 32 34 2.1 9.3 27% 82% 27% 22% 44%SellBeijing SL 002038.SZ Sell 14 55.6 44.7 -20% 1.2 1.5 1.6 15% 45 38 34 31 2.6 8.8 26% 79% 64% 63% 50%NHU 002001.SZ Sell 18 27.7 20.2 -27% 1.4 1.4 1.6 7% 20 20 18 14 2.3 5.0 27% 52% 41% 30% 33%Average 23 14% 1.0 1.3 1.5 33% 46 33 27 37 2.5 7.1 25% 46% 22% 20% 52%Median 20 17% 0.7 1.0 1.3 28% 46 32 24 35 1.2 6.5 26% 42% 19% 20% 53%Price2010/12/1312-m TargetPricePotentialUpside/DownsideEPSCompany Ticker RatingM.cap (RMBbn)P/E (X) Gaohua forecast Consensus Difference(%) Gaohua forecast Consensus Difference(%) Gaohua forecast Consensus Difference(%)Zhongheng 600252.SS 0.76 0.79 -4.3% 1.54 1.54 0.1% 2.08 2.03 2.5%Sanjiu 000999.SZ 0.93 0.87 6.7% 1.18 1.08 8.9% 1.46 1.36 7.7%Kunming 600422.SS 0.32 0.30 7.4% 0.48 0.46 3.9% 0.67 0.68 -1.2%EPS 2012ECompany TickerEPS 2010E EPS 2011EDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 6 Earnings drivers: Government support, new products, capacity expansion TCM industry growth picked up significantly in 2009 and has largely maintained 25% yoy, in line with industrial growth. We believe this relative pace of growth can be sustained, bolstered by the three factors we expect to drive it in the next few years: 1) supportive government policy； 2) new product launches； 3) capacity expansion. We expect supportive policy to boost overall industry growth, while new products and capacity expansion would be the key drivers in the medium and long term at the company level. 1. Chinese government support We see government support playing an important role in the development of the TCM sector, and we think this support could result in rapid sector-wide expansion over the next three-to-five years. Despite the fact that TCM is an integral part of the Chinese lifestyle, the industry was shrinking until recently. It appears that the influence of Western culture in China prompted a preference for Western medicine. Growth in the TCM industry as a whole was obstructed by various issues such as a general lack of innovation, and poor explanation of the ingredients and their efficacy. In 2009, the Chinese government began introducing policies to support TCM: These included: 1) an increase in the ratio of prepared TCMs included in the Reimbursement Drug List (RDL) vs. Western medications； 2) the introduction of a smaller cut (compared to Western medications) in the retail price ceiling for the RDL TCMs, helping to defend prices； 3) the introduction of herbal TCMs in the RDL for the first time to boost consumption； 4) the State Council proposal of various measures to support/promote the TCM development, including the construction of a TCM service system, the promotion of advancement and innovation in TCM science, talent cultivation, sustainable TCM resource growth, improvements in industry systems, and TCM globalization. We see in Exhibit 3 that growth in prepared TCMs (i.e. processed medications) has been slightly ahead of TCMs as a whole since 2009, while growth in herbal TCMs (i.e. raw materials) has been much more rapid. Revenues from herbal TCMs contribute only one fifth of TCM revenues, with the bulk coming from prepared products. We expect government support to drive further growth in the TCM industry. December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 7 Exhibit 3: TCM growth has been outperforming pharmaceuticals since 2009 Revenue growth trends for pharma manufacturers and the TCM industry Source: NBS, Gao Hua Securities Research. Xueshuantong frozen powder injection agent, used to treat cerebro-vascular disease, is one of Zhonghengs core products and an exclusive item in the EDL. Its retail price ceiling has been revised upward, and we expect Xueshuantongs volume growth to be driven considerably by the primary medicine market. Xueshuantong accounted for 74% of company pharma revenue in 2009, and significant growth in this product can have a substantial impact on company earnings. Xueshuantong is an exclusive, patented product, it has a clear competitive advantage over rival products in terms of purity, stability, ease of preservation and efficacy duration. Sixty-eight of Sanjius products are included in the EDL. The government lowered price ceilings on EDL items, but the impact on the market prices of Sanjius products was limited because, on average, market prices were already lower than the price ceilings. Sanjius Zhuanggu Guanjie Pills have been newly included in the EDL, and Free decoction TCMs, an integration of traditional and modern decoctions, was also included in some regional Reimbursement Drug Lists (RDL). Kunmings Xuesaitong belongs to the same category as Zhonghengs Xueshuantong. It is not an exclusive product on the EDL, but the price has risen, and inclusion in EDL will facilitate growth in the primary market. Exhibit 4: Zhongheng has the highest proportion of revenues coming from products benefiting from government support A comparison of government support benefits for our three new coverage companies Source: National Essential Drug List (for primary medical institutions, 2009), Gao Hua Securities Research. 0 10 20 30 40 50 60 70 80 2003-022003-052003-082003-112004-022004-052004-082004-112005-022005-052005-082005-112006-022006-052006-082006-112007-022007-052007-082007-112008-022008-052008-082008-112009-022009-052009-082009-112010-022010-052010-08Pharmaceutical manufactures Herbal TCM Prepared TCM(%)Company EDL productsGuided price changeNew RDL productsCommentsZhongheng Xueshuantong 7% -Govt. support products account for 74% of 2009 pharma industrial salesSanjiusanjiu weitai, Zhengtian Wan, etc.-10%/-3%zhuanggu guanjie pillsFree decoction TCM included in some regional RDLsKunming Xuesaitong improved -Govt. support products account for 25% of 2009 TCM business salesDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 8 2. Product line extension We think new product launches could be a key driver of future earnings growth in the TCM industry as part of medium- and long-term strategies, mainly through: 1) R&D on new products； 2) expansion of product lines through the acquisition of homogeneous products； 3) acquisition of products along value chains. In addition to R&D, most TCM companies focus on new product acquisition because of their weak R&D/investment capabilities and the relatively low level of development on their products. Zhongheng gained its Guilinggao business when it acquired Wuzhou Doublecoins this year. The company also developed a new product called Guilingbao, an upgraded version of Guilinggao, to be the core of its future development in health drinks. The company has been proactively promoting Guilingbao, which was launched only in Guangdong, Guangxi, Shanghai and Beijing, and sold out its entire stock. As a brand, Guilinggao as a whole enjoys high consumer recognition, and we think product series could develop into a future core product for Zhongheng alongside Xueshuantong with capacity expansion, gradual extension of distribution channels, and further enhancement of Guilinggao brand-name. Sanjius new products mainly come from expansion in existing categories. The company has started new launches from influenza drugs, which has produced positive effects over the past few years. This was demonstrated by the Sanjiu influenza medicine series, which ranked top in the influenza medicine category in China and realized revenues of over RMB1.2 bn, about 38% of company-wide revenue from the pharmaceutical business. By leveraging this success experience and the brand-name of Sanjiu, the company is entering dermatologic medicine with Compound Dexamethasone Acetate as their core product. It has launched 5 new dermatology products with the hope of duplicating the success of its influenza medicine. The company recently focused on TCM prescription drugs for chronic diseases such as antineoplastic drugs. We expect the revenue for its main product, the Huachan Su series, to achieve 50%+ growth in 2010. Sanjius category planning strategy is well-developed, and we think new product growth could be a key driver of profit growth over the next 3-5 years. Kunmings artemether finished dosage form, a malaria treatment, is not a new product in real sense and its only sold in private market with a small annual revenue of about RMB70 million/year, but the GMP international system certification may boost its growth. The global market for artemether finished dosage form is around US$250 million/year, led by Novartis, a global player. However, Kunming could enjoy a cost advantage as a result of its self-sufficiency in finished dosage form materials, and this could accelerating its growth rate in 2013, when we expect it to be given GMP international system certification. Exhibit 5: Comparison of the three companies in new product lines Source: Company data, Gaohua Securities Research Company New product line Source of product Reasons for new productsZhongheng Guilinggao, GuilingbaoProduct acquistion to expand the product lineGuilingao is the subsidiarys product pre-restructuring, Guilinbao is a derivative product from GuilingaoSanjiuTCM injectables for dermatology, gynecology, antineoplastic usage etc.Acquistion of similar products to expand the product lineExpansion for dematology and gynecology durgs/strengthen the franchise for antineoplastic TCM Rx drugsKunmingInternational GMP certificate for Artemeter finished dosage formR&D for new productsTo gain approval for making dosage form to supplyArtemeter API to international marketDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 9 3. Capacity expansion Capacity expansion is an important means of company reinvestment, product quality improvement, and enhancement of economies of scale. It is a necessary strategy for long term growth, and also key to improving investor returns. The TCM industry as a whole is accelerating, but many companies are facing capacity constraints. Capacity expansion is therefore necessary to ensure their products can keep up with market needs. At the same time, the introduction of new capacity that meets new production standards also allows the company to meet rising product quality standards, and boosts operating profits. According to company guidance, Zhongheng plans to increase production capacity for Xueshuantong frozen powder injection by 300 million units/year, which would ensure production can keep up with demand for the next 3 years. Meanwhile, there has been a lag in development of the extraction process for the raw material, Sanqi, but capacity is expected to expand in next 1-2 years. We project that Zhongheng will be able to produce Xueshuantong independently next year, and we estimate 100% in-house production would improve gross margin as 40% of Xueshuantongs production costs come from outsourcing expenses. Sanjiu began using its new production base in 2008. It also started expanding its operations at Guanlan Sanjiu Industrial Park with the purpose of concentrating production, R&D, marketing and function departments in one area to improve operating efficiency. Meanwhile, it is continuing with construction of a base in Huaibei Jinchan, another base in Yaan, Anhui, and soft capsule and soft cream production base in Nanchang, Jiangxi. It is also building a chemical medicine base in northeast China on the new GMP standard, and we think all these bases will be the foundation for Sanjius long term development. Kunming will also have 30 mn piece/year additional capacity in Xuesaitong frozen powder injections reaching 100% utilization next year, which would secure its capacity needs for the next 3 years. Moreover, the company is applying for a GMP international system certification for artemether finished dosage form, which is expected to get approval in 2013. This would give rise to further capacity of 100 million/year. Exhibit 6: Additional capacity comparison for the three initiation companies Source: Company data, Gaohua Securities Research TCM industry risks Persistent accidents involving low-quality/unstable TCM injections could impact overall development of TCM injections. Volatile TCM material prices could impact the cost of prepared TCMs. The ex-factory prices of TCMs could decline as the government tightens price controls on EDL and RDL drugs. CompanyMajor capacity expansion projectsExpected finishing datePrevious capacityAdditional capacityProds from new capacity as a % of 09 pharma industrial salesZhonghengXueshuantong frozen powder injection agent, Phase II2011 30 mn unit/year 300 mn unit/year 74%HuarunSanjiuManufacturing base in Guanlan2008Kunming PharmaXueshuantong frozen powder injection agent2011 8 mn unit/year 30 mn unit/year 16%Surface area of 110,000 square meters to accommodate the general relocation of HQs production line, another 70,000 square meters for Phase IIDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 10 Investment theme 1: Branded TCM firms Chinese consumers are highly loyal to branded TCM with long histories. This helps branded TCM firms win stable market shares. Brand name sales channels have been established and consistently improved through years of effort, and they help these firms to outperform the sector. These companies have a legacy of traditional applications for their products and target specific disease. By leveraging their brands and sales channels, they can better expand product lines, enabling them to maintain growth going forward. We focus on branded TCM firms such as Sanjiu, Yunnan Baiyao and Dong-E E-jiao. Brand effect helps grow market share The majority of branded TCM firms in China primarily focus on OTC sales. According to a survey by China Nonprescription Medicines Association, about 75% of consumers currently favor brand names among drugstore OTC products. Branded TCM firms with decades, even hundreds years, of history have built up a strong brand image among consumers which in turn win them high loyalty. This helps branded TCM firms to either maintain their market shares at a stable level or increase them. Exhibit 7: Sanjiu, E-Jiao and Baiyao are among top 20 OTC firms 2009 OTC manufacturer ranking in China (ranked by sales) Source: Medicine Economic News, Gao Hua Securities Research. Most of the OTC pharmaceuticals with annual sales over RMB500 mn in China are TCM and they share one important marketing similaritybrand. There are seldom new TCM brand launches due to the sectors long history and lack of new products. Although this is negative for sector development, it also serves as an entry barrier. Rank Company Rank Company1 Xiuzheng Pharmaceutical Group (Jilin) 11 Guilin Sanjin Pharmaceutical Co., Ltd.2 Xian-Janssen Pharmaceutical Ltd. 12 Mayinglong Pharmaceutical Co Ltd. 3 Harbin Pharmaceutical Group Co., Ltd. 13 Yunnan Baiyao Group Co. Ltd.4 China Beijing Tongrentang (Group) Co., Ltd. 14 Wyeth Pharmaceutical Co., Ltd.5 Sanjiu Medical & Pharmaceutical Co., Ltd. 15 Yangtze River Pharmaceutical Group6 Shandong Dong-E-Jiao Co, Ltd. 16 Zhejiang Conba Pharmaceutical Co., Ltd.7 Jiangsu Jiangzhong Group Co., Ltd. 17 Shanghai J&J Pharmaceuticals, Co. Ltd.8 Sino-American Tianjin Smithkline & French Labs, Ltd. 18 Kunming Dihon Pharmaceutical Co Ltd.9 Bayer HealthCare AG 19 Qingdao Growful Pharmaceutical Co. Ltd.10 Jiangxi Zhangshu Renhe Group 20 Hangzhou Minsheng Pharmceutical Group Co., Ltd.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 11 Exhibit 8: Major features of OTC pharmaceuticals with annual sales of over RMB500 mn in China Source: Gao Hua Securities Research. Strong sales channels ensure sustainable development The OTC market is highly reliant on the strength of its sales channels. Sales channel establishment takes time, and this is a challenge for new entrants and small businesses. Companies can promote growth of main products and expand coverage in terminal markets for new products by: (1) cultivating and adjusting internal sales channels； (2) maintaining long-term relations with distributors； (3) training sales staff to improve sales channels. Through years of efforts, Chinas branded TCM firms have established integrated sales channels with high terminal market penetration. This is the basic method through which TCM firms are able to achieve sustainable growth. Exhibit 9: Sales channels of branded TCM firms are generally strong Comparison of sales channels for branded TCM companies in our coverage Source: Company data, Gao Hua Securities Research The OTC market grew at a relatively low CAGR of 10% from 2006 to 2009 due to (1) a slow increase in incidence rates； (2) shortage of new products on the OTC market； (3) slow development of new brands (the business focuses on long-established TCM brands)； (4) limited growth in overall marketing capability； (5) rapid development of primary rural and community medical institutions as a result of medical reform, which further reduced the use of OTC pharmaceuticals. However, during the same period, pharmaceutical manufacturing revenues at the branded TCM firms grew much more rapidly than in the OTC sector as a whole. Type of DiseaseTherapeuticalCategoryRepresentative ProductsMarketing StrategyHighlightsInfluenza Gan Kang, 999 Gan Mao Ling, New ContacCough Jingdu Niancian Milian Chuanbei Pipa Gao, Ke Sou TingThroat Golden throat, Watermelon Frost Lozenges DermatologyDyclonine (Miconazole nitrate), 999 Compound Dexamethasone Acetate Cream Hypertension Anti-hypertensive No. 0, Norvasc (Amlodipine)Cardio-vascularCompound Danshen Dripping Pills, Tong Xin Luo, Buchang Naoxintong Capsule, DiAo Xinxuekang Capsule, Suxiao Jiuxin Pill Gastro-intestinalLosec (Prilosec), Motilium (Domperidone) , Jiangzhong Health Gastric Digestion Tablets, Vitamin U/Belladonna and Aluminium Capsules (Si Da Shu)Diabetes Glucobay, Diamicron (Gliclazide), Xiaoke Wan PillGynecology Gynecology Qianjin SeriesTonic and NutritionalTonics and NutritionalsCompound E-Jiao Jiang/Cream, Qing Chun Bao Anti-Aging TabletsBrand+Advertisment+National distribution networkChronicBrand+National distribution network+Promotion and control at terminal marketGeneralBrand+Advertisment+National distribution network+Promotion and control at terminal marketCompany Sales channel Sales force Coverage of terminal marketSanjiuOTC, prescription drug, generic drug800 for OTC, 500 for Rx drugsOTC coverage 50,000 retail outlets, in-house Rx drug dept. covering 300 hospitals, agents cover Class II and 900 Class III hospitalsBaiyaoMedicine business,transdermal products, health products350 general distributors, 1500 distribution agents3,700 sales terminals, 10,000+ pharmacies, major supermarkets and chain storesE-JiaoRetail pharmacies, medical instituions, specialty pharmacies1200+ sales reps 20,000+ sales terminals, 17 specialty pharmaciesDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 12 Exhibit 10: Baiyaos TCM pharma revenues have been growing at their most rapid rate over the past four years TCM pharma revenue growth at the three brand TCM firms, yoy (%) Source: CNMA, company annual reports, Gao Hua Securities Research. Product line expansion drives growth In addition to the brand effect, branded TCM firms also benefit from their unique legacy prescriptions (medicines containing ancestra and other special components). Along with support from strong networks, they find product line expansion easier. Examples of successful product line expansion at Yunnan Baiyao include toothpaste and Chuangketie wound plasters. Under intensified market competition, the companys Chuangketie and toothpaste products have become the first and fifth-largest brand names in China in terms of domestic market share thanks to the strong therapeutic effect of Baiyao (a medicine for hemostasis ) and unique product positioning. Sanjiu represents another mode of success in product line expansion. Although the company has no legacy prescriptions or drugs targeting specific disease, it exercises category management by leveraging its brand strength. Sanjiu has expanded its influenza-curing series with a focus on Ganmaoling, and it has continued to develop and improve the business. Ganmaoling is currently the No. 1 influenza-treating drug in domestic market. Exhibit 11: All three of the branded TCM firms has targeted product line expansion Source: Company data, Gao Hua Securities Research. The TCM sector has seen few innovative OTC pharmaceutical brands in recent years. Therefore, product line expansion has become a key factor to further drive growth. Branded TCM firms are clearly well positioned in product line expansion, which also boosts long-term growth. 0%10%20%30%40%50%60%70%206207208209OTC market Baiyao E-jiao SanjiuCompanyProduct line expansion% of 2009 industrial pharma salesSales increase as a % of 09 pharma industrial sales increaseExpected new product lineSanjiuInfluenza-treating series4% 10%Dermatology, Gynecological, antitumor infection, etc.BaiyaoToothpaste, Chuangketie, First aid kit, etc.24% 28%Cosmetic, shower gel, etc.E-jiaoHealth food, medical supplement7% 8% Health foodDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 13 Investment theme 2: TCMs for chronic diseases with exposure to the EDL The aging population and resulting rise in per capita drug consumption is creating a much stronger outlook for chronic disease medication. TCM is well-positioned for treating chronic diseases (80% of products target this area). The primary market EDL was largely adopted as part of the governments ongoing effort to promote TCM products. TCM products given exclusive status on this list should especially benefit from rapid growth as the status will expedite consumption in local healthcare institutions. We recommend Zhongheng (Xushuantong is an EDL exclusive product for cerebrovascular disease), Tasly (compound danshen dripping pills are an EDL exclusive product for cardio-vascular diseases) and Kunming (Xuesaitong is an EDL product for cerebrovascular diseases). Promising outlook for chronic disease medicine The Chinese Ministry of Health reports that more than 60% of medical spending in China goes to chronic diseases such as tumors, CCVD and respiratory illness. This is well above the global average of 46%. With population aging and growth in per capita drug consumption, we expect promising market growth for chronic disease medications. According to National Healthcare Service Survey, the population with chronic diseases in 2008 increased by 30% from the level of 2003, a CAGR of 5.4%. The incidence rate for chronic diseases among the aged (population aged 60 and above) reached 43.8% in 2008. The over-60 population account for 47% of total population with chronic diseases, consuming 60% of all chronic disease medicines. Exhibit 12: The chronic disease incidence rate is on the rise in China Comparison of chronic disease mortality rates in the 3rdand 4thNational Healthcare Service Surveys Source: the 3rd and 4th National Healthcare Service Surveys, Gao Hua Securities Research. Total Urban rural Total Urban rural Total Urban ruralTotal incidence rate 15.4% 21.4% 13.4% 20.0% 28.3% 17.1% 4.6% 6.9% 3.7%The aged incidence rate 38.2% 49.2% 31.8% 43.8% 53.2% 38.9% 5.6% 4.0% 7.1%Computative total prevalence number (mn)2003 2008 Increment200 260 30%December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 14 Exhibit 13: 47% of the 60+ population have chronic diseases Percent of population with chronic diseases by age group Exhibit 14: Chinas population rapidly aging % of population aged 60 and above in China Source: China Healthcare Statistics Yearbook 2010, Gao Hua Securities Research Source: MOH, UN world population forecast, Gao Hua Securities Research Chinas population is aging at a rapid rate. According to the UN population forecast, 17.2% of Chinas population will be over 60 years old by 2020； rising to 30%, or more than 400 million by 2050. The UN projects that Chinas over-60 population will grow at a CAGR of 3.3% from 2010 to 2020. According to the China Healthcare Statistics Yearbook 2010, the illness incidence rate of Chinas over-60 population grew at a CAGR of 2.8% between 2003 and 2008, while the ratio of patients to consultant doctors grew at a CAGR of 1.7%. Meanwhile, the statistics yearbook calls for Chinas over-60 population to grow at a CAGR of 3.3% between 2010 and 2020. Based on simple calculation, this would mean that the market for medications aimed at aged people with chronic disease would grow at a CAGR of 8% over this period based solely on growth in the over-60 population, the incidence rate, and the doctor consultation rate. We think it will grow even faster with further increase in drug consumption, the incidence rate, and the doctor consultation rate. Exhibit 15: Government and individual medical spending grow year by year Growth rate of medical spending by government, urban and rural residents Source: the 3rd and 4th National Healthcare Service Surveys, Gao Hua Securities Research Aged 0-141%Aged 15-242% Aged 25-344%Aged 35-4413%Aged 45-5421%Aged 55-6425%Aged 65 and above34%0%5%10%15%20%25%30%35%1982 1990 2002 2009 2020 2040 20500%10%20%30%40%50%1995 2000 2005 2006 2007 2008 2009Government healthcare expenditure YoYHealthcare expenditure for urban households per capita YoYHealthcare expenditure for rural households per capita YoYDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 15 As the governments medical spending increases and per capital healthcare spending of both urban and rural residents grow, per capita medicine consumption in China has been gradually expanding. This should give a strong boost to growth in the market for chronic disease medicines. TCM is favorably positioned for treating chronic diseases There is a popular saying in China that states “western medicine for acute diseases； traditional medicine for chronic diseases”. Chinas consumers have long believed in TCMs advantage in treating chronic diseases. They believe TCM performs better than western medicine in removing the root of the disease and aiding recuperation. Therefore, it is believed that TCM is more applicable to chronic disease patients who have to take medication over extended periods of recuperation. Moreover, TCM is generally less expensive than western medicine for the same category, thus a better choice for consumers concerned with affordability. According to MENET TCM consumption statistics for hospitals in nine Chinese cities, around 80% of TCM usage on the hospital market goes to chronic disease treatments. The main applications for TCM include CCVD, tumor, and respiratory diseases which account for 65% of the total TCM consumption on this market. Exhibit 16: Chronic diseases account for 80% of TCM consumption in TCM hospitals TCM consumption in the nine sample hospitals by therapeutic category Source: MENET, Gao Hua Securities Research. EDL products help boost sales volume in local markets The old version of the governments EDL was ineffective and failed to perform its practical function. However, the products newly added on 2009 EDL for local medical institutions are expected to benefit from a boost in growth through local consumption. By end of 2010, EDL will be implemented in 60% of local healthcare institutions. We expect 100% coverage next year. After EDL is fully implemented, we foresee significant turning point in EDL product growth. According to estimates from the China Pharmaceutical Enterprises Association (CPEMA), full implementation of the EDL will directly generate RMB160bn to RMB170bn in medicine consumption. Medicine consumption at local healthcare institutions only accounted for 18% of total consumption in 2009, but the 36% 37% 37% 36%15%15% 16%16%13% 11%11% 13%8% 8% 9% 8%8%7%7%6%4%4%4% 4%3% 4% 3% 3%0%20%40%60%80%100%2006 2007 2008 2009PediatricsQi and blood supplyOther medicinesDermatologyOtolaryngologyNeural systemUrinary systemGynecological medicineDigestive systemMusculo-skeletal systemRespiratory systemAnti-tumorCardiovascular and cerebrovascular diseaseDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 16 association expects this percentage to rise significantly after EDL is fully implemented and coverage is significantly improved. The enlarged version of EDL may also help boost the ratio of EDL products consumed in hospitals above county level. We believe TCMs with exclusive designations in the EDL will benefit most because: (1) the EDL limits downward pressure on prices； (2) it decreases competition between similar products. Price decline normally becomes the biggest concern after a product is included into the EDL because there is a bigger risk of the government cutting the price. Among products that suffered from price decline after inclusion in the 2009 EDL, the biggest decline in the retail price was only around 7%, well below that of the western medicines (average of 15%). Price declines on TCMs with exclusive designations on the EDL are generally below 5%, and prices even rise on some products. TCM products are given exclusive EDL designations when they show outstanding therapeutic efficacy through long-term clinical verification. These products usually have little competition on the market, which allows them to filter directly through to the end market on the back of their EDL designation, further raising the visibility of these TCM firms and increasing their brand popularity. Exhibit 17: Minimal price declines for exclusive EDL products TCM products for chronic diseases with exclusive designation on the EDL Source: 2009 Essential Drugs List (for primary medical institutions), company data, Gao Hua Securities Research. Medicine Treatment Company2009 Revenue (Rmbm)% of pharmaceutical manufacturesPrice change in EDLSanjiu Weitai Gastropathy Sanjiu 228 7% -3% /-9%Zhengtian Wan Headache Sanjiu 112 4% -10%Suxiao Jiuxin Wan Cardiovascular Zhongxin 465 31% 0%Compound danshen dripping pillsCardiovascular Tasly 1,200 74% -5%Mailuoning Infection cerebrovascular Jinling 793 68% 0%Xueshuantong Cerebrovascular Zhongheng 380 74% 7%Xiaoke Wan Diabetes GZ Pharm 456 23% 0%December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 17 Valuation: EV/GCI vs. CROCI/WACC as our primary methodology We adopt EV/GCI vs. CROCI/WACC as our primary valuation methodology while also cross-checking with P/B vs. ROE and PEG. EV/GCI vs. CROCI/WACC is based on cash returns, which are the fundamental to the survival and development of an enterprise, objectively reflecting operating status. At the same time, we do not believe earnings growth fully represents a companys strength as accounting methods can distort figures (for details see our report titled Introducing Directors Cut Returns matter more than growth, August 7, 2009). Pharmaceutical companies tend to be relatively flexible with accounting practices, and we think cash generation capabilities are a more reliable measure than profits. As cash return is key to the medium-/long- term performance of an enterprise, we adopt EV/GCI vs. CROCI/WACC as the valuation framework for this sector. EV/GCI vs. CROCI/WACC: compares (EV/GCI) vs. excess returns (CROCI/WACC). Enterprise value (EV): Market cap + Net debt + Minorities + Unfunded pension obligations + Capital leases Gross cash invested (GCI): Gross tangible and intangible assets + Investment in associates + working capital Cash return on cash invested (CROCI): (CFO Change in working capital (1-tax rate)*Net interest expense) / Average gross cash invested Weighted average cost of capital (WACC): (debt/asset)*cost of debt*(1-tax rate) + (1-(debt/asset)*cost of equity CROCI is a catalyst, and investors would award higher valuations to listed companies with higher cash returns. Exhibit 18: Zhongheng has the highest 2010-13E CROCI CAGR under our coverage 2008-13E CROCI changes for A-share pharmaceuticals under coverage Source: Gao Hua Securities Research estimates. Company Ticker 2008 2009 2010E 2011E 2012E 2013E2010-2013 CROCI changeZhongheng 600252.SS 10% 19% 32% 48% 53% 56% 24%Sanjiu 000999.SZ 15% 27% 29% 33% 37% 40% 11%Kunming 600422.SS 14% 15% 16% 20% 24% 27% 11%Huahai 600521.SS -2% 24% 17% 21% 26% 30% 13%Hepalink 002399.SZ 72% 145% 118% 99% 54% 63% -54%Hisun 600267.SS 16% 15% 12% 12% 13% 15% 3%Kehua 002022.SZ 54% 63% 68% 68% 65% 67% -1%Baiyao 000538.SZ 49% 47% 61% 59% 59% 59% -2%Tasly 600535.SS 21% 21% 21% 24% 25% 24% 3%Hengrui 600276.SS 39% 32% 40% 44% 46% 47% 7%Beijing SL 002038.SZ 62% 47% 48% 50% 50% 51% 3%E-jiao 000423.SZ 46% 67% 117% 118% 117% 110% -7%NHU 002001.SZ 102% 47% 38% 33% 31% 30% -7%Average 41% 46% 49% 48% 46% 47% -2%Median 43% 40% 39% 39% 41% 44% 3%December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 18 We use EV/GCI vs. CROCI/WACC for our target price We divide the A-share pharmaceutical companies in our coverage into 4 quartiles using CROCI, putting the top 25% CROCI companies into the first quartile and so on. Based on our calculations for EV/GCI vs. CROCI/WACC in the coverage group, we have derived a regression line formula as well as the position of each company relative to the regression line. We set the 2011E premium or discount for the A share companies under our coverage by considering the historical premium or discount of companies in each quartile as well as the historical premium/discount for the company itself. In this way we arrive at a 2011E EV/GCI target and then calculate the target price. Exhibit 19: Zhongheng and Sanjiu appear relatively undervalued Exhibit 20: Zhongheng appears even more undervalued based on 2012E Source: Gao Hua Securities Research estimates Source: Gao Hua Securities Research estimates Exhibit 21: We see Zhongheng rising to the 2ndquartile in 2011 CROCI quartile rankings for our pharmaceutical coverage Source: Gao Hua Securities Research estimates Based on our calculation of premiums/discounts for our A-share coverage in each quartile over the past two years, we found that the 1stand 2ndquartile companies were assigned with 31% and 20% premiums, respectively, while the 3rdand 4thquartile companies were given 12% and 25% discount. Therefore, we believe the 1stand 2ndquartile pharmaceutical companies will enjoy premiums in terms of EV/GCI vs. CROCI/WACC in 2011 relative to the overall coverage group, while the 3rdand 4thquartile ones should trade at a discount. y=2.3xR=0.805101520253035404502468101214EV/GCI(X)CROCI/WACC(X)FY11EV/GCIvs.CROCI/WACCSanjiuZhonghengKunmingEjiaoTaslyBaiyaoHisunHuahaiHepalinkkehuaHengruiBeijingSLy=2.3xR=0.805101520253035402468101214EV/GCI(X)CROCI/WACC(X)FY12EV/GCIvs.CROCI/WACCKehuaHengruiTaslyBaiyaoEjiaoHisunHepalinkHuahaiZhonghengSanjiuKunmingBeijingSLCompany Ticker 2008 2009 2010E 2011E 2012E 2013EZhongheng 600252.SS 4 3 3 2 2 2Sanjiu 000999.SZ 3 3 3 3 3 3Kunming 600422.SS 3 4 4 4 4 3Huahai 600521.SS 4 3 3 3 3 3Hepalink 002399.SZ 1 1 1 1 2 1Hisun 600267.SS 3 4 4 4 4 4Kehua 002022.SZ 1 1 1 1 1 1Baiyao 000538.SZ 2 2 2 2 1 2Tasly 600535.SS 3 3 3 3 3 4Hengrui 600276.SS 2 2 2 3 3 3Beijing SL 002038.SZ 1 2 2 2 2 2E-jiao 000423.SZ 2 1 1 1 1 1NHU 002001.SZ 4 4 4 4 4 4December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 19 Exhibit 22: Our calculations for CROCI premium/discount in each quartiles of our A-share pharmaceutical coverage Source: Gao Hua Securities Research For the three new initiation companies, our major considerations in setting the premium/discount are: We apply a 10% premium for Zhongheng. The stock traded at a 20% discount on average over the past two years. As its operational performance greatly improves, we think Zhongheng will see a rapid increase in CROCI, bringing it up to the 2ndquartile in 2011. We expect Zhongheng to trade at a reasonable premium as concerns about the outlook for sales gradually disappear. We apply a 21% discount for Sanjiu. Although Sanjius CROCI has been improving, it is a third quartile company. We believe a 21% discount to the historical average is reasonable. We apply a 10% discount for Kunming. The company traded at a 10% discount to the historical average over the past two years. Although Kunmings CROCI has been improving, it is still a fourth quartile company. We believe the discount to the historical average is reasonable. Exhibit 23: We use EV/GCI vs. CROCI/WACC valuation for our healthcare coverage Source: Gao Hua Securities Research estimates Cross-checking with P/B vs. ROE and PEG methodology We have compared our results with the distribution of P/B vs. ROE and PEG for our A-share coverage to cross check EV/GCI vs. CROCI/WACC valuation. P/B vs. ROE: Although P/B is not low, Zhonghengs extremely high level of ROE results in low valuations； Sanjiu is positioned at the low end of the valuation range； Kunming is reasonably valued. Quartiles 1st quartile 2nd quartile 3rd quartile 4th quartileAverage premium/discount31% 20% -12% -25%Metrics Unit Zhongheng Sanjiu Kunming Valuation RationaleVal Ratio x 2.3x 2.3x 2.3x On-shore pharm sector EV/GCI vs. CROCI/WACCHistorical EV/GCI premium/(discount) % -11% -21% -10% All have historical discountCurrrent EV/GCI premium/(discount) % -11% -33% -10% Zhonghengs discount is disappearing2011 forecast Premium/(discount) % 10% -21% -10%10% premium for Zhongheng as it moves into 2nd Quartile CROCICROCI/WACC x 5.4x 3.8x 2.3xImplied EV/GCI x 13.8x 6.9x 4.7x2011 Gross capital invested Rmb mn 2,108 4,228 1,093Implied EV Rmb mn 29,013 29,254 5,173Net debt and minority interest Rmb mn (69) (1,705) (32) Sanjiu has rich cash flow after debt restructuring in 2008Implied market cap Rmb mn 29,082 30,959 5,205Weighted average shares outstanding No. in mn 546 979 314Target price Rmb 52.8 31.6 16.6Current price Rmb 39.8 25.0 15.4 At the close of 15 December, 2010Potential upside/Downside % 33% 26% 8% Zhongheng has 33% potential upsideEPS (2011E, GH estimate) Rmb 1.54 1.18 0.48EPS (2011E, Consensus) Rmb 1.54 1.08 0.46Difference % 0% 9% 4% We are more confident in Sanjius product line expansion2011-13 EPS CAGR % 36% 22% 35%Current P/E(2011E) x 26x 21x 32x Zhonghengs 2011E 26x P/E is undervaluedImplied P/E(2011E) x 34x 27x 35xDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 20 P/E vs. EPS CAGR (2011-13E): compared with other A-share coverage, Zhongheng is substantially undervalued, implying significant upside potential； Sanjiu and Kunming are also undervalued. Overall, the results of our EV/GCI vs. CROCI/WACC valuations are in line with traditional valuation methods. Exhibit 24: Zhongheng and Sanjiu are relatively undervalued P/B vs. ROE valuation for our A-share pharmaceutical coverage Exhibit 25: Zhongheng, Sanjiu and Kunming are relatively undervalued PEG valuations for our A-share pharmaceutical coverage Source: Gao Hua Securities Research estimates Source: Gao Hua Securities Research estimates HisunHepalinkTaslyHengruiBeijingSLEjiaoNHUHuahai亿元357911130% 20% 40% 60% 80%Zhongheng2011EROE2011EP/B(X)SanjiuKunmingBaiyao2011EP/B(X)KehuaHepalinkHisunBaiyaoTaslyHengruiBeijingSLEjiaoNHU101520253035404550550% 10% 20% 30% 40% 50% 60%SanjiuZhonghengKunming2011EP/E(X)201113EEPSCAGRHuahaiKehuaDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 21 At a glance: Comparative analysis of Zhongheng, Sanjiu and Kunming We have also compared the overall performance of our three initiation companies using factors such as fundamentals, financial data, and valuation. Zhongheng is our top pick as: 1) We think its core product, Xueshuantong, will benefit from its exclusive designation in the EDL by the Chinese government. We expect to see significant volume growth at primary medical institutions and believe capacity expansion will ensure sustainable growth in the next 3-5 years； 2) We think growth can be sustained, and higher margins mean higher returns； 3) Current valuations are low among peers, and liquidity is high. We also expect a strong overall performance from Sanjiu thanks to: 1) strong brand and sales potential； 2) solid returns； 3) low current valuation. We foresee relatively modest overall performance for Kunming, with lower profit margins and returns. We believe Kunming is at a turning point in terms of management and marketing reforms. However, we need to wait for evidence of a turnaround in profitability. Exhibit 26: We expect Zhongheng to perform best overall Comparison of fundamentals, financial data, valuations, and liquidity for our three initiation companies Source: Gao Hua Securities Research estimates. Criteria ZH Sanjiu KM TCM Average Key Highlights and Caveats Brand recognition (+) Reflects consumer acceptance Sales channels (+) Reflects companys market penetration Benefit from EDL (+) Reflects the extent to which company can leverage EDL system Core product pricing (+) Reflects pricing power in face of policy headwinds R&D (+) Determines product quality and efficacy Product acquisition (+) Affects the companys ability to expand product linesCapacity Capacity expansion (+) Reflects ability to retain long-term growth prospects Revenue growth Earnings growth Gross margin EBIT margin Net margin Return on net asset ROIC CROCI P/E P/B vs. ROE EV/GCI vs. CROCI/WACC 3M average trading value 3M average turnover rate Overal Overall evaluationZhongheng possesses the best valuation/financials profile. Sanjiu is more stable across the board. Kunmings earnings have improved and there is plenty of room for further growth.Defining metricsCompany FundamentalsBrandPolicy impactNew productKunming Pharma (600422.SS) still sees room for growth after 2 years of reshaping of its managerial and sales lines.MarginsXueshuantong, Zhongheng (600252.SS)s core product, has a gross margin of more than 80%； its agency sales model keeps sales expenses lower than rival companies.GrowthZhonghengs strong earnings give it a high return profile, while Huarun Sanjiu (000999.SS) provides a more stable long-term return.Valuation and LiquidityValuationMultiplesZhongheng and Sanjiu have fairly low valuations among TCM stocks； Kunmings valuation is not demanding given its strong earnings growth.FinancialsReturnZhongheng has high volatility, high liquidity, and is consistently among the Top 5 in pharma stocks in terms of trading turnover rate. Sanjiu and Kunming are relatively stable.LiquidityDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 22 Exhibit 27: We expect Zhonghengs CROCI to increase significantly Projected CROCI changes in the three newly initiated TCM firms Exhibit 28: Zhongheng is expected to show the highest ROE, while we see strongest upside in Kunming Projected ROE changes for the three newly initiated TCM firms *We expect Zhonghengs rapid CROCI growth to mainly stem from a significant rise in net profit. We do not foresee big increases in cash investment/capex. *We foresee Zhonghengs rapid ROE improvement coming from a significant rise in net profit, however, ROE is expected to decline from 2012 due to a considerable increase in undistributed earnings and slowing net profit growth. Source: Company annual report, Gao Hua Securities Research estimates. Source: Company annual report, Gao Hua Securities Research estimates. Exhibit 29: We see a rapid rise in Zhonghengs gross profit Projected gross profit changes for our three newly initiated TCM firms Exhibit 30: We project significant growth in net margins at Zhongheng, Sanjiu and Kunming Projected net margin changes at our three newly initiated TCM firms Sanjius commercial business will be divested in 2010, which should boost overall gross margin. Zhonghengs strong gross margin comes from high-margin Xueshuantongs rising market share. Sanjius commercial business will be divested in 2010, which should boost overall net margin. Zhonghengs strong net margin comes from high-margin Xueshuantongs rising market share. Source: Company annual report, Gao Hua Securities Research estimates. Source: Company annual report, Gao Hua Securities Research estimates. 0%10%20%30%40%50%60%2008 2009 2010E 2011E 2012E 2013EZhonghengSanjiuKunming0%10%20%30%40%50%60%70%80%2008 2009 2010E 2011E 2012E 2013EZhonghengKunmingSanjiu20%30%40%50%60%70%2008 2009 2010E 2011E 2012E 2013EZhonghengKunmingSanjiu0%5%10%15%20%25%30%35%2008 2009 2010E 2011E 2012E 2013EZhonghengSanjiuKunmingDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 23 Zhongheng (600252.SS, Buy, CL): Poised for a second take-off Source of opportunity We initiate on Zhongheng with a Buy rating and include it on our Conviction List. Our 12-month TP is Rmb52.8. We expect Zhonghengs revenues to grow at a CAGR of 35.4% over 2010-2013E with net profit at 50.5%, the strong performance stemming mainly from core product Xueshuantong. We expect Zhonghengs CROCI to grow rapidly from 19% in 2009 to 48% in 2011, boosting valuation. The drivers behind a higher CROCI are: Cooperation with Buchang will gradually penetrate into Xueshuantongs untapped market. Zhongheng currently covers only 5,000 hospitals, with 15,000 hospitals and primary market, which accounts for 18% of the overall pharma market left untapped. As an exclusive item in the EDL and a class A product in RDL, Xueshuantong will penetrate into these untapped markets on the back of strong sales capabilities, in our view. Gross margins are expanding. The ex-factory price is rising steadily despite bad market conditions over the past two years. Under its exclusive EDL designation, the guided retail price ceiling has risen and there is little downward price pressure. We also see a fall in production costs as in-house production rises along with a rise in capacity to 300 mn units next year. Catalysts We see cooperation with Buchang Pharma boosting valuation. Despite strong growth, some question Zhonghengs sales models, especially the surrogate marketing model. The Buchang agreement should ensure sales expansion over the next five years, boosting the earnings outlook. We expect the market to begin recognizing Zhonghengs high growth, boosting valuation. Significantly better 4Q results will promote investor confidence. Xueshuantong inventory in distribution channel decreased to zero amid concerns of retail price ceilings downward revision. It significantly dampened sales volume in the first three quarters as distribution inventory turnover was normally one quarter. Along with the clarity on price controls, going back to previous inventory level would ensure Zhongheng meets its results forecast made at the beginning of the year. Valuation Our 12-month target price of Rmb52.8 is based on our primary valuation method of EV/GCI vs. CROCI/WACC, implying 34X 2011E P/E and 33% upside potential. Our 2011-12 net income estimates are largely consistent with consensus. Risks to investment case Potential price control could post downside risk to Xueshuantongs ex-factory prices. INVESTMENT LIST MEMBERSHIPAsia Pacific Buy listAsia Pacific Conviction Buy listCoverage View: NeutralGrowthReturns *MultipleVolatility VolatilityMultipleReturns *GrowthInvestment ProfileLow HighPercentile 20th 40th 60th 80th 100th* Returns = Return on Capital For a complete description of the investment profile measures please refer to the disclosure section of this document.Guangxi Wuzhou Zhongheng Group (600252.SS)Asia Pacific Pharmaceuticals Peer Group AverageKey data CurrentPrice (Rmb) 39.7812 month price target (Rmb) 52.80Market cap (Rmb mn / US$ mn) 21,714.9 / 3,262.9Foreign ownership (%) -12/09 12/10E 12/11E 12/12EEPS (Rmb) 0.480.761.542.08EPS growth (%) 123.7 57.0 103.4 35.0EPS (diluted) (Rmb) 0.48 0.76 1.54 2.08EPS (basic pre-ex) (Rmb) 0.48 0.76 1.54 2.08P/E (X) 82.6 52.6 25.9 19.2P/B (X) 18.3 17.0 11.1 7.9EV/EBITDA (X) 13.6 38.5 19.5 14.4Dividend yield (%) 0.0 0.4 0.8 1.6ROE (%) 24.8 44.7 51.9 48.32,4002,6002,8003,0003,2003,4003,60010152025303540Dec-09 Mar-10 Jun-10 Sep-10Price performance chartGuangxi Wuzhou Zhongheng Group (L) Shanghai SE A Share Index (R)Share price performance (%) 3 month 6 month 12 monthAbsolute 60.9 111.4 193.3Rel. to Shanghai SE A Share Index 46.6 86.8 230.3Source: Company data, Goldman Sachs Research estimates, FactSet. Price as of 12/15/2010 close.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 24 Xueshuantong is crucial for Zhongheng development in the next three years As the largest category in TCM, CCVD medicine grows more than 20% in recent years, we expect a sector revenue CAGR of c.20% during 2009-13E. Exhibit 31: We forecast a CAGR of 20% in TCM sales of CCVD medicine during 2009-13E TCM sales of CCVD medicine Source: Medicine Economic News, Gao Hua Securities Research estimates. Xueshuantong is the fourth largest category in CCVD TCM, and an exclusive item of Zhongheng as well. It experienced sales revenue growth of 35.6% CAGR during 2007-09. However, compared with other competitive products, its growth rate is modest. Constrained by capacity, Xueshuantong is in short supply. The capacity of 0.3bn per year which is expected to be available next year will guarantee rapid growth of Zhongheng in the next three to five years. Exhibit 32: Xueshuantong ranked No. 4 in terms of market share among CCVD TCMs in 2009 Top 10 CCVD TCMs in Chinas nine cities Exhibit 33: Xueshuantong is ranked third place in comparison with rival products with similar indications Sales volume and market share of main rival products Source: MENET, Gao Hua Securities Research. Source: MENET, Gao Hua Securities Research. 0%5%10%15%20%25%30%10203040506070802007 2008 2009 2010E 2011E 2012E 2013ETCM sales of CCVD medicine (Rmbbn,LHS) YoY (RHS)2007 2008 20091 Shuxuetong Injection Youbo Pharmaceutical 2.2% 2.1% 5.0% 85.1%2 Danhong Injection Shandong Buchang Group 3.0% 4.8% 4.7% 52.0%3 Xingnaojing Injection Shanhe Group 2.2% 3.3% 3.9% 66.8%4 Xueshuantong Wuzhou Zhongheng 2.9% 3.3% 3.6% 35.6%5Ginkgo Biloba Leaves InjectionShineway 1.3% 2.0% 2.7% 78.3%6 Tongxinluo capsule Yiling Pharmaceutical 3.4% 3.2% 2.6% 6.3%7Ginkgo Biloba Leaves InjectionZBD Pharmaceutical 2.2% 2.5% 2.5% 29.5%8Compound danshen dripping pillsTasly 3.0% 2.7% 2.2% 2.6%9Ginkgo Biloba Leaves pillsYangtze River Pharmaceutical2.1% 2.1% 2.1% 23.5%10Danshentong IIA Huangsuanna InjectionShanghai No.1 Bio & Pharm1.9% 1.8% 2.0% 22.4%Market shareRank Drug name Company2007-09 CAGR 2007 2008 20091Shuxuetong Injection74.7% 15.5% 197.3% 12.7% Not listed2Xingnaojing Injection130.5% 68.0% 44.6% 12.5% Not listed3 Xueshuantong 62.5% 27.3% 30.5% 10.2% Listed4Ligustrazine Injection93.9% 55.7% 20.6% 5.7% Not listed5Xuesaitong Injection1.9% 8.8% 15.8% 5.5% Listed6 Kudiezi Injection 325.1% 49.0% 52.0% 5.2% Not listed7 Xuesaitong pills 5.4% -4.4% 71.1% 5.1% Not listed8Xueshuantong capsule42.0% 239.0% 718.6% 5.0% Not listed9Naoxintong capsule187.0% 27.5% 25.0% 4.6% Not listed10Dengzhanhuasu pills0.0% 0.0% 5794.0% 4.3% Not listedmarket share 2009EDLYoY growthRank Drug nameDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 25 Zhongheng signed a five-year sales agreement with Buchang. We believe it further ensures the high growth of Zhongheng, mainly because: Buchang has proven that it has a strong sales team capable of penetrating into Xueshuantongs untapped market: Buchang has built a very strong sales team in CCVD area over more than ten years. It has a sales force of 15,000 and covers 15,000 hospitals. Zhongheng currently covers only 5,000 hospitals, so we see considerable growth potential for Xueshuantong. Buchangs sales network covers prefecture-level cities and key counties nationwide. Given projected capacity expansion, Xueshuantong should expand smoothly into the primary market given its exclusive designation on the EDL. The strong outlook for Xueshuantong should ensure Buchangs ability to meet the goals set in its sales agreement: Zhongheng and Buchang have signed a five-year agreement. We expect pharma revenues (sales tax included) to rise to RMB2.3bn and 3.0bn in 2011 and 2012 respectively, with further growth in the subsequent three years. There is large gap between the Xueshuantong ex-factory price of RMB9/unit and tender price of about RMB30/unit, and we see substantial profit potential for Buchang as Xueshuantongs sales volume is currently around only 200 mn units per year. Given the promising outlook for this product, we see Buchang promoting it extensively to ensure the effective execution of the agreement. Cooperation should boost Zhonghengs profitability: The company will leave the management of its original distributors to Buchang, which will save sales and management fees and increase its share of revenues from Xueshuantong, with its high gross margins. We see this leading to a significant rise in overall profitability. Guilinggao series expected to be another growth area Zhongheng acquired Wuzhou Double Coins this year and took its Guilinggao business. Zhongheng processed and extracted a new product, Guilingbao, from its previously-established Guilinggao business. Zhongheng stays away from clashing head-on with the market leader Wanglaoji by using a different focus in its advertising campaign. Guilinggaos history can be traced back over a thousand years. The Double Coins brand has a history of more than 300 years and has high brand recognition among Chinese consumers, giving it an advantage over Wanglaoji in terms of kick-starting its promotion. The market for Chinese tea drinks grew at a CAGR of 32% over the past six years, and Wanglaoji grew at 68%. The whole market was in a rapid expansion stage at the time. We think Guilingbao should be able to significantly increase market share given that Chinese consumers are well aware of Guilinggaos effectiveness in helping users deal with heat/humidity and feel rejuvenated. December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 26 Exhibit 34: National tea market grew at a CAGR of 32% Chinese tea market size and growth rate Exhibit 35: Wanglaoji showed rapid growth Wanglaoji revenue and growth rate Source: CEIC, Gao Hua Securities Research estimates Source: GZ Pharm annual report、Gao Hua Securities Research Guilingbao distributes products through agents. It sold only in Guangdong, Guangxi, Shanghai and Beijing this year due to capacity constraints, but the very positive customer acceptance - the product sold out has boosted Zhonghengs confidence that it should make the business bigger and stronger. Zhongheng is expanding production lines to accommodate RMB 1bn sales per year, which should further boost growth potential in the next two years. We expect the Guilinggao series gross margin to be 40% and the net margin to be 13% after sales get back on track. Our estimate is based on EBIT margin of more than 10%. Further expansion of Zhonghengs capacity and improvement of its sales system should offer considerable growth potential. We believe Guilinggao series will become the biggest driver of Zhongheng profit after Xueshuantong. Exhibit 36: Chinas tea drink market has an EBIT margin of over 10% Chinas tea drink market gross margin and EBIT margin Source: CEIC, Gao Hua Securities Research. Sensitivity and scenario analysis We conducted a sensitivity analysis of Xueshuantong sales volume and ex-factory price vs. overall EPS and CROCI. We used the median values as our projected Xueshuantong sales volume and ex-factory price under the Buchang agreement. 0102030405060702005 2006 2007 2008 2009 2010E0%10%20%30%40%50%Revenue(Rmbbn,LHS) YoY(RHS)CAGR 32%0%20%40%60%80%100%120%140%02004006008001,0001,2001,4002005 2006 2007 2008 2009Wanglaoji of GZ Pharm (Rmbm, LHS) YoY (RHS)CAGR 68%0%5%10%15%20%25%30%35%2005 2006 2007 2008 2009 2010 Jan.-Aug.Gross Margin EBIT MarginDecember 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 27 Exhibit 37: Sensitivity analysis of 2011-12E EPS and CROCI to sales volume and ex-factory price Source: Gao Hua Securities Research estimates. We undertook a simple assumption analysis of the rate of Buchang sales in 2011. Our worst case scenario assumed the company would only achieve 80% of its sales volume target and the best case as 120%. We assume ex-factory prices will remain unchanged from our forecast of RMB8.8/unit. The company results and valuation under the three scenarios are shown in Exhibit 38. Exhibit 38: Buchang 2011E base-case valuation is RMB52.8 Buchang results and valuation under three scenarios Source: Gao Hua Securities Research estimates Exhibit 39: Revenue cost estimates Source: Company data, Gao Hua Securities Research estimates. 166 187 207 228 249 199 224 249 274 2998.2 1.11 1.25 1.39 1.53 1.67 8.6 1.53 1.71 1.89 2.07 2.258.5 1.16 1.31 1.45 1.60 1.75 8.9 1.60 1.78 1.97 2.16 2.358.8 1.22 1.36 1.54 1.67 1.82 9.2 1.66 1.85 2.08 2.24 2.449.1 1.26 1.42 1.58 1.74 1.90 9.5 1.72 1.92 2.13 2.33 2.539.4 1.32 1.48 1.65 1.81 1.98 9.8 1.78 1.99 2.20 2.42 2.63166 187 207 228 249 199 224 249 274 2998.2 36% 40% 44% 48% 51% 8.6 41% 45% 49% 53% 58%8.5 38% 42% 46% 50% 53% 8.9 43% 47% 51% 56% 60%8.8 39% 44% 48% 52% 56% 9.2 44% 49% 53% 58% 62%9.1 41% 45% 49% 54% 58% 9.5 46% 50% 55% 60% 64%9.4 42% 47% 51% 56% 60% 9.8 47% 52% 57% 62% 66%2011 CROCI (%)Volume (mn units)2012 CROCI (%) Volume (mn units)Ex-factory price (Rmb/unit)Ex-factory price (Rmb/unit)2011 EPS (Rmb)Volume (mn units)2012 EPS (Rmb)Volume (mn units)Ex-factory price (Rmb/unit)Ex-factory price (Rmb/unit)ScenarioVolume (mn units)EPS (Rmb)CROCI (%)Valuation (Rmb)Upside (%)Implied 11E P/E (X)Bear case 166 1.22 40% 39.0 -2% 32Base case 207 1.54 48% 52.8 33% 35Bull case 249 1.82 61% 66.3 67% 362009 2010E 2011E 2012E 2013E 2009 2010E 2011E 2012E 2013ERevenue breakdown (Rmbm) Revenue YoYXueshuantong 385 922 1,825 2,290 2,784 Xueshuantong 88.9% 139.8% 97.9% 25.5% 21.6%Other pharmaceuticals 130 124 161 257 411 Other pharmaceuticals -13.9% -5.0% 30.0% 60.0% 60.0%Guilinggao series - 200 435 822 1,061 Guilinggao series - - 117.5% 89.0% 29.1%Property 182 550 300 210 221 Property -26.0% 202.5% -45.5% -30.0% 5.0%Others 16 17 18 19 19 Others -42.6% 5.0% 5.0% 5.0% 5.0%Total 712 1,813 2,738 3,597 4,496 Total 13.4% 154.5% 51.1% 31.4% 25.0%Revenue proporation Gross marginXueshuantong 54.0% 50.9% 66.7% 63.7% 61.9% Xueshuantong 75.0% 84.3% 86.1% 87.0% 87.4%Other pharmaceuticals 18.2% 6.8% 5.9% 7.1% 9.1% Other pharmaceuticals 32.9% 35.0% 35.0% 35.0% 35.0%Guilinggao series - 11.0% 15.9% 22.9% 23.6% Guilinggao series - 27.0% 35.0% 40.0% 40.0%Property 25.5% 30.3% 11.0% 5.8% 4.9% Property 7.4% 30.0% 30.0% 30.0% 30.0%Others 2.2% 0.9% 0.6% 0.5% 0.4% Others 79.3% 40.0% 40.0% 40.0% 40.0%Total 100.0% 100.0% 100.0% 100.0% 100.0% Total 50.2% 57.8% 68.6% 69.0% 68.4%December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 28 Exhibit 40: Xueshuantong contributes 51% of revenue Zhongheng 2010E revenue breakdown Exhibit 41: Xueshuantong contributes 74% of gross profit Zhongheng 2010E gross profit margin breakdown Source: Gao Hua Securities Research estimates. Source: Gao Hua Securities Research estimates. Xueshuantong51%Other pharmaceuticals7%Guilinggao series11%Property30%Others1%Xueshuantong74%Other pharmaceuticals4%Guilinggao series5%Property16%Others1%December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 29 Guangxi Wuzhou Zhongheng Group: Summary financialsProfit model (Rmb mn) 12/09 12/10E 12/11E 12/12E Balance sheet (Rmb mn) 12/09 12/10E 12/11E 12/12ETotal revenue 712.4 1,812.7 2,738.4 3,597.2 Cash & equivalents 128.1 703.3 831.1 1,051.7Cost of goods sold (355.0) (765.8) (861.1) (1,116.3) Accounts receivable 84.9 216.1 326.5 428.8SG&A (199.5) (484.5) (780.4) (1,025.2) Inventory 274.4 592.0 665.6 862.9R&D - - - - Other current assets 395.4 395.4 395.4 395.4Other operating profit/(expense) 1.7 (14.5) (21.9) (28.8) Total current assets 882.8 1,906.7 2,218.5 2,738.8EBITDA 177.9 569.7 1,106.3 1,470.1 Net PP&E 476.7 691.1 980.0 1,225.7Depreciation & amortization (18.3) (21.8) (31.4) (43.2) Net intangibles 75.5 74.4 73.2 72.1EBIT 159.6 547.9 1,074.9 1,426.9 Total investments 64.0 64.0 64.0 64.0Interest income 0.7 1.0 5.6 6.6 Other long-term assets 5.5 5.5 5.5 5.5Interest expense (29.7) (39.3) (41.8) (29.3) Total assets 1,504.6 2,741.6 3,341.2 4,106.1Income/(loss) from uncons. subs. 0.0 0.0 0.0 0.0Others 26.8 5.0 5.0 5.0 Accounts payable 117.1 252.5 283.9 368.1Pretax profits 157.4 514.6 1,043.8 1,409.3 Short-term debt 240.0 340.0 140.0 140.0Income tax (29.3) (95.2) (193.1) (260.7) Other current liabilities 174.6 257.1 342.5 514.7Minorities (2.5) (6.8) (11.3) (15.0) Total current liabilities 531.7 849.6 766.4 1,022.7Long-term debt 395.0 595.0 595.0 295.0Net income pre-preferred dividends 125.6 412.6 839.4 1,133.5 Other long-term liabilities 1.0 1.0 1.0 1.0Preferred dividends 0.0 0.0 0.0 0.0 Total long-term liabilities 396.0 596.0 596.0 296.0Net income (pre-exceptionals) 125.6 412.6 839.4 1,133.5 Total liabilities 927.6 1,445.6 1,362.4 1,318.7Post-tax exceptionals 0.0 0.0 0.0 0.0Net income 125.6 412.6 839.4 1,133.5 Preferred shares 0.0 0.0 0.0 0.0Total common equity 567.7 1,280.0 1,951.5 2,744.9EPS (basic, pre-except) (Rmb) 0.48 0.76 1.54 2.08 Minority interest 9.2 16.1 27.4 42.4EPS (basic, post-except) (Rmb) 0.48 0.76 1.54 2.08EPS (diluted, post-except) (Rmb) 0.48 0.76 1.54 2.08 Total liabilities & equity 1,504.6 2,741.6 3,341.2 4,106.1DPS (Rmb) 0.00 0.15 0.31 0.62Dividend payout ratio (%) 0.0 20.0 20.0 30.0 BVPS (Rmb) 2.18 2.34 3.57 5.03Free cash flow yield (%) (12.7) (0.2) 2.2 3.1Growth & margins (%) 12/09 12/10E 12/11E 12/12E Ratios 12/09 12/10E 12/11E 12/12ESales growth 13.4 154.5 51.1 31.4 ROE (%) 24.8 44.7 51.9 48.3EBITDA growth 70.8 220.2 94.2 32.9 ROA (%) 9.8 19.4 27.6 30.4EBIT growth 75.1 243.3 96.2 32.7 ROACE (%) 17.4 34.5 51.6 57.6Net income growth 168.5 228.5 103.4 35.0 Inventory days 286.4 206.5 266.5 249.9EPS growth 123.7 57.0 103.4 35.0 Receivables days 41.7 30.3 36.2 38.3Gross margin 50.2 57.8 68.6 69.0 Payable days 106.1 88.1 113.7 106.6EBITDA margin 25.0 31.4 40.4 40.9 Net debt/equity (%) 87.9 17.9 (4.9) (22.1)EBIT margin 22.4 30.2 39.3 39.7 Interest cover - EBIT (X) 5.5 14.3 29.8 63.1Valuation 12/09 12/10E 12/11E 12/12ECash flow statement (Rmb mn) 12/09 12/10E 12/11E 12/12ENet income pre-preferred dividends 125.6 412.6 839.4 1,133.5 P/E (analyst) (X) 82.6 52.6 25.9 19.2D&A add-back 18.3 21.8 31.4 43.2 P/B (X) 18.3 17.0 11.1 7.9Minorities interests add-back 2.5 6.8 11.3 15.0 EV/EBITDA (X) 13.6 38.5 19.5 14.4Net (inc)/dec working capital (196.5) (313.3) (152.6) (215.5) Dividend yield (%) 0.0 0.4 0.8 1.6Other operating cash flow 21.9 0.0 0.0 0.0Cash flow from operations (28.1) 128.0 729.4 976.3Capital expenditures (192.1) (145.0) (219.1) (287.8)Acquisitions 0.0 (90.0) (100.0) 0.0Divestitures 8.7 0.0 0.0 0.0Others (12.5) 0.0 0.0 0.0Cash flow from investments (195.9) (235.0) (319.1) (287.8)Dividends paid (common & pref) (3.3) 0.0 (82.5) (167.9)Inc/(dec) in debt 294.1 300.0 (200.0) (300.0)Common stock issuance (repurchase) 0.0 382.2 0.0 0.0Other financing cash flows (32.6) 0.0 0.0 0.0Cash flow from financing 258.3 682.2 (282.5) (467.9)Total cash flow 34.2 575.1 127.8 220.6 Note: Last actual year may include reported and estimated data.Source: Company data, Goldman Sachs Research estimates.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 30 Sanjiu (000999.SZ, Buy): Expertise strengthened by dedication Source of opportunity We initiate on Sanjiu with a Buy rating and 12-month target price of Rmb31.6. We expect sales to grow at a CAGR of 19.2% in 2010E-2013E and net profit at 23.8%. After restructuring its debt in 2007, Sanjiu set pharmaceuticals as its core business and divested its other businesses with the backing of China Resources Group, and is poised to become the central TCM segment of the Group. We think Sanjiu will see stable revenue growth in the long run owing to its strong brand name and clear development strategy: Secular growth driven by brand-name: Sanjiu has a strong brand name through its four key products of Gan Mao Ling, 999 Pi Yan Ping Cream, Zheng Tian Wan and Sanjiu Weitai ranking among top 4 in their respective areas (Exhibit 42). Category planning could also help more Sanjiu products to add brand name strength in their respective fields. Dual engines of TCM OTC and prescriptions: With TCM OTC as the core of development, Sanjiu has observed the slowing down of OTC market and developed long-term category planning, which has helped boost the growth of its OTC series. With prescriptions for chronic disease as the core of the China pharm market, Sanjiu will gradually expand TCM OTC for chronic diseases through its existing products and M&A, and drive total revenue and profit growth. Catalysts M&A - the key driver of growth: We expect Sanjiu to expand its category mostly through M&A. The acquisition of gynecological products is already in the pipeline. The company also focuses on other prescriptions for chronic ailments such as anti-neoplastic, respiratory and CCVD drugs. Asset injection providing promising outlook: After the restructuring of Beijing Pharmaceutical Group and China Resources Group, Sanjiu (the TCM segment of China Resources Group) will inject assets into some subsidiaries (e.g. Benxi TCM No.3 Factory, Hefei Shenlu TCM Factory and Beijing Shuanghe Gaoke) formerly under Beijing Pharmaceutical Group. Valuation Our 12-month target price of Rmb31.6 is based on our primary valuation method of EV/GCI vs. CROCI/WACC, implying 27X 2011E P/E and 26% upside potential. Our net income estimates for 2011E-2012E are 9% and 8% higher than Wind consensus estimates mainly because we are more positive on the marketing of its dermatology product series. Key risks Sanjiu has acquired various products through M&A, which could imply difficulties with management, sales and production integration. INVESTMENT LIST MEMBERSHIPAsia Pacific Buy listCoverage View: NeutralGrowthReturns *MultipleVolatility VolatilityMultipleReturns *GrowthInvestment ProfileLow HighPercentile 20th 40th 60th 80th 100th* Returns = Return on Capital For a complete description of the investment profile measures please refer to the disclosure section of this document.China Resources Sanjiu Pharmaceutical (000999.SZ)Asia Pacific Pharmaceuticals Peer Group AverageKey data CurrentPrice (Rmb) 25.0212 month price target (Rmb) 31.60Market cap (Rmb mn / US$ mn) 24,492.1 / 3,680.2Foreign ownership (%) -12/09 12/10E 12/11E 12/12EEPS (Rmb) 0.720.931.181.46EPS growth (%) 41.9 28.6 26.6 23.9EPS (diluted) (Rmb) 0.72 0.93 1.18 1.46EPS (basic pre-ex) (Rmb) 0.72 0.93 1.18 1.46P/E (X) 34.5 26.8 21.2 17.1P/B (X) 6.6 5.8 5.0 4.2EV/EBITDA (X) 15.6 18.5 14.5 11.5Dividend yield (%) 1.2 1.5 1.9 2.3ROE (%) 20.6 23.0 25.2 26.79001,0001,1001,2001,3001,4001,50018202224262830Dec-09 Mar-10 Jun-10 Sep-10Price performance chartChina Resources Sanjiu Pharmaceutical (L) Shenzhen A Index (R)Share price performance (%) 3 month 6 month 12 monthAbsolute (7.3) (8.7) 19.1Rel. to Shenzhen A Index (18.5) (27.4) 7.9Source: Company data, Goldman Sachs Research estimates, FactSet. Price as of 12/15/2010 close.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 31 Core growth drivers 1) Category expansion to drive OTC growth: The organic growth of OTC market is much slower than that of the prescription market and the CAGR for 2006-2009 was only 10%. We foresee that the market will grow at c. 10% in 2009-13, while Sanjiu will see OTC CAGR of 21.2%. Sanjius long-term category planning mainly involves acquiring developed product lines and leveraging its brand name in sales and marketing. Sanjius confidence in this planning was boosted by its success with influenza drugs, and the company has launched five new dermatology products, with 999 Pi Yan Ping cream at the core. The company could potentially also launch another new OTC series of gynecological products through acquisition (under negotiation). Exhibit 42: Sanjius key products are top-ranking Sanjiu product rankings in TCM OTC market in 2009 Source: China Nonprescription Medicines Association, Gao Hua Securities Research. 2) TCM prescriptions for chronic disease should boost total revenue growth We foresee prescription revenue growth of 30% CAGR in 2009-2013E. Sanjiu focuses on TCM prescriptions for chronic disease such as anti-neoplastic, respiratory and CCVD drugs. It has set up a prescription sales force with 500+ staff, in order to increase marketing to practitioners and establish large categories with revenue of Rmb1 bn. Sanjiu gained presence in CCVD and cancer TCM injections with its core products - Shenfu injection and Huachan oral solution they are exclusive EDL designations and will likely be Sanjius primary development focus. 3) Sales/profit boost from free decoctions increasing year by year We expect 28.7% sales CAGR for free decoction (competitor of TCM decoction) in 2009-2013E. Free decoction combines modern medication and traditional treatment. Although the price is 2 to 3 times higher than that of TCM decoction, it is portable and more convenient with an increasingly larger consumer base. Sanjiu is building a best-in-class production base in China to strengthen its value chain position, increase R&D, and upgrade quality/technology. We foresee a rise in its 25% market share in China. Exhibit 43: TCM decoction recorded 26% revenue CAGR over the past 8 years Historical revenue growth for TCM decoction Source: National Bureau of Statistics, Gao Hua Securities Research. Medicine Category Brand ranking 2009 Revenue (Rmbm)999 Ganmaoling Influenza 1 950Piyanping External application drugs 2 389Zhengtian Wan Headache and insomnia 3 112Sanjiu Weitai Digestive system 4 2280 10 20 30 40 50 60 70 80 2003-022003-052003-082003-112004-022004-052004-082004-112005-022005-052005-082005-112006-022006-052006-082006-112007-022007-052007-082007-112008-022008-052008-082008-112009-022009-052009-082009-112010-022010-052010-08(%)December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 32 Exhibit 44: Revenue/cost estimates Revenue from commercials is excluded in calculation of 2009-10. Source: Company data, Gao Hua Securities Research estimates. Exhibit 45: OTC products account for 59% of total revenue 2010E revenue breakdown for Sanjiu Exhibit 46: OTC products account for 65% of total gross profit 2010E gross profit breakdown for Sanjiu Source: Gao Hua Securities Research estimates. Source: Gao Hua Securities Research estimates. 2009 2010E 2011E 2012E 2013E 2009 2010E 2011E 2012E 2013ETCM OTC 2,257 2,772 3,406 4,120 4,876 TCM OTC 30.7% 22.9% 22.9% 20.9% 18.4%TCM prescription 419 565 735 956 1,195 TCM prescription 37.3% 35.0% 30.0% 30.0% 25.0%Antibiotics & raw medicine 261 287 316 347 375 Antibiotics & raw medicine 13.1% 10.0% 10.0% 10.0% 8.0%Free decoction TCM 213 278 361 469 586 Free decoction TCM 42.8% 30.0% 30.0% 30.0% 25.0%Others 676 765 832 908 947 Others 21.5% 13.1% 8.7% 9.1% 4.3%Total 4,853 4,717 5,650 6,800 7,979 Total 11.5% -2.8% 19.8% 20.3% 17.4%TCM OTC 46.5% 58.8% 60.3% 60.6% 61.1% TCM OTC 69.3% 68.0% 68.0% 68.0% 68.0%TCM prescription 8.6% 12.0% 13.0% 14.1% 15.0% TCM prescription 79.9% 81.5% 81.5% 81.5% 81.5%Antibiotics & raw medicine 5.4% 6.1% 5.6% 5.1% 4.7%Antibiotics & raw medicine 48.0% 52.0% 52.0% 52.0% 52.0%Free decoction TCM 4.4% 5.9% 6.4% 6.9% 7.3%Free decoction TCM 60.7% 60.0% 60.0% 60.0% 60.0%Others 13.9% 16.2% 14.7% 13.4% 11.9% Others 30.6% 28.6% 28.5% 28.5% 28.6%Total 100.0% 100.0% 100.0% 100.0% 100.0% Total 50.6% 61.2% 62.5% 63.3% 64.0%Revenue proporation Gross marginRevenue breakdown (Rmbm) Revenue YoYTCM OTC59%TCM prescription12%Antibiotics & raw medicine6%Free decoction TCM6%Wholesale and retail1%Package printing8%Medical service4%others4%TCM OTC65%TCM prescription16%Antibiotics & raw medicine5%Free decoction TCM6%Wholesale and retail0%Package printing3%Medical service2%others3%December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 33 Kunming Pharma (600422.SS, Neutral): EPS accretion unfolding Investment view We initiate on Kunming Pharma with Neutral and a 12-month target price of RMB16.6. One positive point for this company over the past three years has been substantial improvement in profitability through management restructuring. We forecast 19.0% CAGR in revenues over 2010-13 and 39.9% for net income. Core drivers of growth 1) Profitability improvements should boost net income growth: Kunmings growth was previously driven by revenues, but it now mainly comes from profitability improvements. It has made substantial efforts in restructuring management and sales force and has resolved legacy problems, benefiting from improved gross margin, a decline in SG&A/finance expenses, and the clean-up of uncollected A/Rs and inventory. We expect Kunming net income to grow rapidly over 2010-13, but revenue growth could be relatively slow. 2) Xuesaitong should drive growth in the TCM segment: Xuesaitong frozen powder injection agent has grown rapidly over past two years, driven by increased share in the mass market share. We expect revenue CAGR of 42% over 2010-13. The company recently increased capacity to 30 mn units/year and it could reach 100% utilization in 1Q2011. This capacity will allow for 100% in-house production and could improve gross margin. We expect a revenue CAGR of 28% for Xuesaitong injections over 2010-13E and 40% for capsules. We foresee combined revenue CAGR of 30%, accounting for c. 50% of TCM revenue growth. 3) Marketing reform at the TCM factory could help enhance profit in the TCM segment: Subsidiary Kunming Chinese Medicine Factory contributed nearly 35% of Kumning Pharmas TCM revenue in 2010E, but weak marketing resulted in a net profit contribution of only 6%. This subsidiary is one of the top 50 TCM manufacturers in China, and it has 114 types of products (incl. 14 TCMs that are price and component protected by the government), which should provide good support for future growth. Kunming Pharms marketing reforms target short term net margins of 8%-10%, which should boost profit growth. Risks to the investment case Tighter government control on drug prices could reduce prices on core products (e.g. Xuesaitong) and dampen ex-factory prices. Upside risks include better-than-expected profitability improvement. Valuation Our 12-month target price of RMB16.6 is based on our primary valuation methodology of EV/GCI vs. CROCI/WACC, implying 35X 2011E P/E and 8% upside potential. Our net income estimates for 2011-12 are largely consistent with Wind estimates. INVESTMENT LIST MEMBERSHIPNeutralCoverage View: NeutralGrowthReturns *MultipleVolatility VolatilityMultipleReturns *GrowthInvestment ProfileLow HighPercentile 20th 40th 60th 80th 100th* Returns = Return on Capital For a complete description of the investment profile measures please refer to the disclosure section of this document.Kunming Pharmaceutical (600422.SS)Asia Pacific Pharmaceuticals Peer Group AverageKey data CurrentPrice (Rmb) 15.3812 month price target (Rmb) 16.60Market cap (Rmb mn / US$ mn) 4,832.0 / 726.1Foreign ownership (%) -12/09 12/10E 12/11E 12/12EEPS (Rmb) 0.19 0.32 0.48 0.67EPS growth (%) 81.6 73.0 49.7 40.2EPS (diluted) (Rmb) 0.19 0.32 0.48 0.67EPS (basic pre-ex) (Rmb) 0.19 0.32 0.48 0.67P/E (X) 82.8 47.9 32.0 22.8P/B (X) 7.3 6.6 5.7 4.9EV/EBITDA (X) 19.3 27.4 20.0 14.8Dividend yield (%) 0.3 0.6 0.9 1.3ROE (%) 9.2 14.4 19.1 23.12,4002,6002,8003,0003,2003,4003,6003,8004,00091011121314151617Dec-09 Mar-10 Jun-10 Sep-10Price performance chartKunming Pharmaceutical (L) Shanghai SE A Share Index (R)Share price performance (%) 3 month 6 month 12 monthAbsolute 9.9 19.0 41.1Rel. to Shanghai SE A Share Index 0.2 5.2 58.9Source: Company data, Goldman Sachs Research estimates, FactSet. Price as of 12/15/2010 close.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 34 Exhibit 47: Revenue/cost estimates Source: Company data, Gao Hua Securities Research estimates. Exhibit 48: Natural herbal medicine accounts 41% of revenue 2010E revenue breakdown of Kunming Pharma Exhibit 49: Natural herbal medicines account for 67% of gross profit 2010E gross profit breakdown of Kunming Pharma Source: Gao Hua Securities Research estimates. Source: Gao Hua Securities Research estimates. Exhibit 50: Kunming Pharmas profitability expected to improve over time We expect gross margin to rise, and the expense ratio to fall Exhibit 51: 100% provision on pensions A/Rs provision by year Source: company annual reports, Gao Hua Securities Research estimates. Source: Company annual report, Gao Hua Securities Research estimates. 2009 2010E 2011E 2012E 2013E 2009 2010E 2011E 2012E 2013ETCM 579 725 909 1,125 1,400 TCM 3.4% 25.2% 25.4% 23.8% 24.4%Chemical products 350 436 539 633 727 Chemical products 24.6% 24.6% 23.5% 17.5% 14.8%Commercials 510 591 680 748 822 Commercials 2.7% 16.0% 15.0% 10.0% 10.0%Total 1,435 1,752 2,127 2,506 2,950 Total 9.5% 22.1% 21.4% 17.8% 17.7%TCM 40.3% 41.4% 42.7% 44.9% 47.5% TCM 58.1% 53.0% 54.0% 54.5% 54.5%Chemical products 24.4% 24.9% 25.3% 25.3% 24.6% Chemical products 43.1% 44.0% 45.0% 46.0% 46.0%Commercials 35.5% 33.7% 31.9% 29.8% 27.9% Commercials 2.7% 2.1% 2.1% 2.1% 2.1%Total 100.0% 100.0% 100.0% 100.0% 100.0% Total 35.3% 33.6% 35.1% 36.7% 37.8%Revenue proportion Gross marginRevenue breakdown (Rmbm) Revenue YoYTCM41%Chemical products25%Commercials34%TCM65%Chemical products33%Commercials2%0%10%20%30%40%50%60%2005 2006 2007 2008 2009 2010E 2011E 2012E 2013EGross margin of manufactures Adminstration expense ratioInterest expense ratio0510152025303540452005 2006 2007 2008 2009 2010E 2011E 2012E 2013E(Rmbm)December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 35 Kunming Pharmaceutical: Summary financialsProfit model (Rmb mn) 12/09 12/10E 12/11E 12/12E Balance sheet (Rmb mn) 12/09 12/10E 12/11E 12/12ETotal revenue 1,434.9 1,752.4 2,127.4 2,506.2 Cash & equivalents 194.7 211.9 264.2 378.4Cost of goods sold (929.1) (1,163.7) (1,379.9) (1,585.9) Accounts receivable 319.2 389.8 473.2 557.5SG&A (399.1) (446.8) (542.5) (639.1) Inventory 272.1 340.7 404.0 464.4R&D - - - - Other current assets 24.2 24.2 24.2 24.2Other operating profit/(expense) (21.4) (5.3) (6.4) (7.5) Total current assets 810.1 966.6 1,165.7 1,424.4EBITDA 121.4 173.8 235.7 311.1 Net PP&E 287.5 305.6 303.3 306.4Depreciation & amortization (36.2) (37.3) (37.0) (37.4) Net intangibles 109.5 106.6 103.8 100.9EBIT 85.2 136.5 198.7 273.7 Total investments 3.0 3.0 3.0 3.0Interest income 1.1 1.6 1.7 2.1 Other long-term assets 34.1 34.1 34.1 34.1Interest expense (11.7) (10.2) (9.9) (9.9) Total assets 1,244.1 1,416.0 1,609.9 1,868.9Income/(loss) from uncons. subs. 0.0 0.0 0.0 0.0Others 5.0 5.0 5.0 5.0 Accounts payable 300.6 376.5 446.4 513.1Pretax profits 79.6 132.9 195.5 271.0 Short-term debt 112.0 112.0 112.0 112.0Income tax (12.7) (21.3) (31.3) (43.4) Other current liabilities 59.0 73.6 88.6 106.8Minorities (8.6) (10.8) (13.3) (15.9) Total current liabilities 471.6 562.1 647.0 731.9Long-term debt 34.0 34.0 24.0 34.0Net income pre-preferred dividends 58.3 100.9 151.0 211.7 Other long-term liabilities 0.2 0.2 0.2 0.2Preferred dividends 0.0 0.0 0.0 0.0 Total long-term liabilities 34.2 34.2 24.2 34.2Net income (pre-exceptionals) 58.3 100.9 151.0 211.7 Total liabilities 505.8 596.2 671.2 766.1Post-tax exceptionals 0.0 0.0 0.0 0.0Net income 58.3 100.9 151.0 211.7 Preferred shares 0.0 0.0 0.0 0.0Total common equity 665.8 736.4 842.1 990.3EPS (basic, pre-except) (Rmb) 0.19 0.32 0.48 0.67 Minority interest 72.6 83.3 96.6 112.5EPS (basic, post-except) (Rmb) 0.19 0.32 0.48 0.67EPS (diluted, post-except) (Rmb) 0.19 0.32 0.48 0.67 Total liabilities & equity 1,244.1 1,416.0 1,609.9 1,868.9DPS (Rmb) 0.05 0.10 0.14 0.20Dividend payout ratio (%) 26.9 30.0 30.0 30.0 BVPS (Rmb) 2.12 2.34 2.68 3.15Free cash flow yield (%) 4.2 0.5 1.8 3.0Growth & margins (%) 12/09 12/10E 12/11E 12/12E Ratios 12/09 12/10E 12/11E 12/12ESales growth 9.5 22.1 21.4 17.8 ROE (%) 9.2 14.4 19.1 23.1EBITDA growth 32.6 43.1 35.6 32.0 ROA (%) 4.9 7.6 10.0 12.2EBIT growth 48.1 60.1 45.5 37.8 ROACE (%) 10.6 16.5 21.9 27.9Net income growth 81.6 73.0 49.7 40.2 Inventory days 98.4 96.1 98.5 99.9EPS growth 81.6 73.0 49.7 40.2 Receivables days 81.9 73.8 74.0 75.1Gross margin 35.2 33.6 35.1 36.7 Payable days 106.9 106.2 108.8 110.4EBITDA margin 8.5 9.9 11.1 12.4 Net debt/equity (%) (6.6) (8.0) (13.7) (21.1)EBIT margin 5.9 7.8 9.3 10.9 Interest cover - EBIT (X) 8.0 15.8 24.3 35.3Valuation 12/09 12/10E 12/11E 12/12ECash flow statement (Rmb mn) 12/09 12/10E 12/11E 12/12ENet income pre-preferred dividends 58.3 100.9 151.0 211.7 P/E (analyst) (X) 82.8 47.9 32.0 22.8D&A add-back 36.2 37.3 37.0 37.4 P/B (X) 7.3 6.6 5.7 4.9Minorities interests add-back 8.6 10.8 13.3 15.9 EV/EBITDA (X) 19.3 27.4 20.0 14.8Net (inc)/dec working capital (0.9) (63.4) (76.8) (77.9) Dividend yield (%) 0.3 0.6 0.9 1.3Other operating cash flow 26.4 0.0 0.0 0.0Cash flow from operations 128.6 85.5 124.5 187.1Capital expenditures (18.8) (52.6) (31.9) (37.6)Acquisitions 0.0 0.0 0.0 0.0Divestitures 0.9 0.0 0.0 0.0Others 0.0 0.0 0.0 0.0Cash flow from investments (17.9) (52.6) (31.9) (37.6)Dividends paid (common & pref) 0.0 (15.7) (30.3) (45.3)Inc/(dec) in debt (62.0) 0.0 (10.0) 10.0Common stock issuance (repurchase) 0.0 0.0 0.0 0.0Other financing cash flows (10.8) 0.0 0.0 0.0Cash flow from financing (72.8) (15.7) (40.3) (35.3)Total cash flow 37.8 17.2 52.3 114.2 Note: Last actual year may include reported and estimated data.Source: Company data, Goldman Sachs Research estimates.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 36 Yunnan Baiyao (000538.SZ, Buy): Driven by brand/sales, up to Buy Source of opportunity We upgrade YBY from Neutral to Buy. We expect it to maintain earnings net profit growth at CAGR 26.7% in 2010-13 following 36.7% CAGR in 2003-10, mainly driven by: 1) Consumer chemical product expansion, driven by strong brand-name and strong sales capabilities: The success of Baiyao toothpaste and first-aid packs has demonstrated strong brand and sales capability. YBY achieved top 3 rankings in the highly competitive consumer chemicals market in a short period of time and plans to launch beauty products and shampoos that we think have strong potential. 2) Ready to reap returns in the tooth-paste segment: YBYs market share gains are a result of the strength of its styptic tooth-paste, successful new product launches, and strong sales capability. We expect tooth-paste to become the strong profit driver, with revenues growing around 64% in 2010 (a return on investment phase) and further high growth of around 50% in 2011. 3) Drug segment benefiting from mass market: The government may extend EDL coverage to all Chinese basic hospitals in 2011. Exclusive EDL products (e.g. Baiyao powder, Baiyao Ding, and Baiyao spray) could grow rapidly. Catalysts We see sustained strong growth in Baiyao tooth-paste resulting in higher-than-expected earnings and boosting the share price. The company should be able to substantially expand capacity after it relocates (we forecast that the manufacturing business will reach an output of RMB10 bn, with logistics s reaching RMB10 bn). This should also add to YBYs development efficiency. Valuation Our 12-month target price of RMB74.3 is based on our primary valuation methodology of EV/GCI vs. CROCI/WACC, implying 40X 2011E P/E and 20% upside potential. We upgrade Yunnan Baiyao to Buy. In our report titled 2011 outlook: Rivalry in third terminal market； initiate CMS with Buy (CL), lift Wuxi to Buy* dated Nov. 26, 2010, we revised 2010-12E EPS up by 4%-6%, as sales performance is better than we previously thought, and gross margin is higher than expected thanks to the mix shift to high-profit products. Key risks Costs change driven by volatility of TCM (e.g. Sanqi) input prices. Increase of A/Rs and inventory driven by expansion of commercials business will affect operational cash flows. INVESTMENT LIST MEMBERSHIPAsia Pacific Buy listCoverage View: NeutralGrowthReturns *MultipleVolatility VolatilityMultipleReturns *GrowthInvestment ProfileLow HighPercentile 20th 40th 60th 80th 100th* Returns = Return on Capital For a complete description of the investment profile measures please refer to the disclosure section of this document.Yunnan Baiyao Grp Co. (000538.SZ)Asia Pacific Pharmaceuticals Peer Group AverageKey data CurrentPrice (Rmb) 62.0012 month price target (Rmb) 74.30Market cap (Rmb mn / US$ mn) 43,044.5 / 6,467.9Foreign ownership (%) -12/09 12/10E 12/11E 12/12EEPS (Rmb) 0.87 1.45 1.86 2.36EPS growth (%) 17.6 66.3 28.5 27.1EPS (diluted) (Rmb) 0.87 1.45 1.86 2.36EPS (basic pre-ex) (Rmb) 0.87 1.45 1.86 2.36P/E (X) 71.3 42.9 33.4 26.3P/B (X) 12.0 9.8 7.9 6.3EV/EBITDA (X) 30.0 33.2 25.3 19.5Dividend yield (%) 0.2 0.4 0.5 0.7ROE (%) 18.0 25.1 26.1 26.79001,0001,1001,2001,3001,4001,5001,6004045505560657075Dec-09 Mar-10 Jun-10 Sep-10Price performance chartYunnan Baiyao Grp Co. (L) Shenzhen A Index (R)Share price performance (%) 3 month 6 month 12 monthAbsolute (2.7) 19.2 44.6Rel. to Shenzhen A Index (14.4) (5.2) 31.0Source: Company data, Goldman Sachs Research estimates, FactSet. Price as of 12/15/2010 close.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 37 Yunnan Baiyao Grp Co.: Summary financialsProfit model (Rmb mn) 12/09 12/10E 12/11E 12/12E Balance sheet (Rmb mn) 12/09 12/10E 12/11E 12/12ETotal revenue 7,171.8 9,967.5 12,559.5 15,704.9 Cash & equivalents 2,283.6 2,642.9 3,263.4 4,091.1Cost of goods sold (4,994.9) (6,637.2) (8,328.0) (10,380.3) Accounts receivable 764.9 1,063.1 1,339.6 1,675.0SG&A (1,513.3) (2,103.3) (2,650.2) (3,313.9) Inventory 1,649.0 2,191.2 2,749.5 3,427.0R&D - - - - Other current assets 311.5 311.5 311.5 311.5Other operating profit/(expense) (6.0) (8.3) (10.5) (13.1) Total current assets 5,009.1 6,208.8 7,664.0 9,504.6EBITDA 657.6 1,218.6 1,570.8 1,997.6 Net PP&E 501.0 629.3 730.3 828.1Depreciation & amortization (35.3) (77.5) (80.9) (84.2) Net intangibles 377.5 321.2 264.9 208.6EBIT 622.3 1,141.1 1,489.9 1,913.4 Total investments 36.1 36.1 36.1 36.1Interest income 48.9 47.8 55.4 68.4 Other long-term assets 81.8 81.8 81.8 81.8Interest expense (18.7) (14.0) (14.0) (14.0) Total assets 6,005.3 7,277.1 8,777.0 10,659.1Income/(loss) from uncons. subs. (1.1) 0.0 0.0 0.0Others 54.2 89.5 92.9 96.2 Accounts payable 1,114.2 1,480.6 1,857.7 2,315.5Pretax profits 705.6 1,264.5 1,624.2 2,064.0 Short-term debt 10.0 10.0 10.0 10.0Income tax (96.5) (252.9) (324.8) (412.8) Other current liabilities 1,066.0 1,136.3 1,186.6 1,248.1Minorities (5.5) (7.8) (9.9) (12.4) Total current liabilities 2,190.2 2,626.9 3,054.3 3,573.6Long-term debt 6.7 6.7 6.7 6.7Net income pre-preferred dividends 603.7 1,003.8 1,289.5 1,638.8 Other long-term liabilities 178.6 178.6 178.6 178.6Preferred dividends 0.0 0.0 0.0 0.0 Total long-term liabilities 185.3 185.3 185.3 185.3Net income (pre-exceptionals) 603.7 1,003.8 1,289.5 1,638.8 Total liabilities 2,375.5 2,812.2 3,239.6 3,758.9Post-tax exceptionals 0.0 0.0 0.0 0.0Net income 603.7 1,003.8 1,289.5 1,638.8 Preferred shares 0.0 0.0 0.0 0.0Total common equity 3,581.1 4,408.2 5,470.9 6,821.3EPS (basic, pre-except) (Rmb) 0.87 1.45 1.86 2.36 Minority interest 48.8 56.6 66.5 78.9EPS (basic, post-except) (Rmb) 0.87 1.45 1.86 2.36EPS (diluted, post-except) (Rmb) 0.87 1.45 1.86 2.36 Total liabilities & equity 6,005.3 7,277.1 8,777.0 10,659.1DPS (Rmb) 0.15 0.25 0.33 0.42Dividend payout ratio (%) 17.6 17.6 17.6 17.6 BVPS (Rmb) 5.16 6.35 7.88 9.83Free cash flow yield (%) (0.1) 1.1 1.9 2.5Growth & margins (%) 12/09 12/10E 12/11E 12/12E Ratios 12/09 12/10E 12/11E 12/12ESales growth 25.3 39.0 26.0 25.0 ROE (%) 18.0 25.1 26.1 26.7EBITDA growth 25.3 85.3 28.9 27.2 ROA (%) 11.0 15.1 16.1 16.9EBIT growth 27.5 83.4 30.6 28.4 ROACE (%) 52.0 61.5 61.3 62.8Net income growth 29.7 66.3 28.5 27.1 Inventory days 107.8 105.6 108.3 108.6EPS growth 17.6 66.3 28.5 27.1 Receivables days 29.1 33.5 34.9 35.0Gross margin 30.4 33.4 33.7 33.9 Payable days 72.6 71.3 73.2 73.4EBITDA margin 9.2 12.2 12.5 12.7 Net debt/equity (%) (62.5) (58.8) (58.6) (59.0)EBIT margin 8.7 11.4 11.9 12.2 Interest cover - EBIT (X) NM NM NM NMValuation 12/09 12/10E 12/11E 12/12ECash flow statement (Rmb mn) 12/09 12/10E 12/11E 12/12ENet income pre-preferred dividends 603.7 1,003.8 1,289.5 1,638.8 P/E (analyst) (X) 72.6 43.7 34.0 26.8D&A add-back 35.3 77.5 80.9 84.2 P/B (X) 12.2 9.9 8.0 6.4Minorities interests add-back 5.5 7.8 9.9 12.4 EV/EBITDA (X) 30.0 33.8 25.8 19.9Net (inc)/dec working capital (175.0) (474.0) (457.5) (555.2) Dividend yield (%) 0.2 0.4 0.5 0.7Other operating cash flow (8.9) 0.0 0.0 0.0Cash flow from operations 460.5 615.1 922.7 1,180.1Capital expenditures (502.3) (149.5) (125.6) (125.6)Acquisitions 0.0 0.0 0.0 0.0Divestitures 0.5 0.0 0.0 0.0Others 167.2 0.0 0.0 0.0Cash flow from investments (334.6) (149.5) (125.6) (125.6)Dividends paid (common & pref) (160.2) (106.2) (176.6) (226.9)Inc/(dec) in debt (11.4) 0.0 0.0 0.0Common stock issuance (repurchase) 0.0 0.0 0.0 0.0Other financing cash flows (6.2) 0.0 0.0 0.0Cash flow from financing (177.8) (106.2) (176.6) (226.9)Total cash flow (51.9) 359.3 620.5 827.6 Note: Last actual year may include reported and estimated data.Source: Company data, Goldman Sachs Research estimates.December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 38 Reg AC We, Fengqi Qian and Wei Du, Ph.D, hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. Investment Profile The Goldman Sachs Investment Profile provides investment context for a security by comparing key attributes of that security to its peer group and market. The four key attributes depicted are: growth, returns, multiple and volatility. Growth, returns and multiple are indexed based on composites of several methodologies to determine the stocks percentile ranking within the regions coverage universe. The precise calculation of each metric may vary depending on the fiscal year, industry and region but the standard approach is as follows: Growth is a composite of next years estimate over current years estimate, e.g. EPS, EBITDA, Revenue. Return is a year one prospective aggregate of various return on capital measures, e.g. CROCI, ROACE, and ROE. 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Analyst compensation: Analysts are paid in part based on the profitability of Goldman Sachs, which includes investment banking revenues. Analyst December 17, 2010 China: Healthcare Goldman Sachs Global Investment Research 39 as officer or director: Goldman Sachs policy prohibits its analysts, persons reporting to analysts or members of their households from serving as an officer, director, advisory board member or employee of any company in the analysts area of coverage. Non-U.S. Analysts: Non-U.S. analysts may not be associated persons of Goldman Sachs & Co. and therefore may not be subject to NASD Rule 2711/NYSE Rules 472 restrictions on communications with subject company, public appearances and trading securities held by the analysts. Distribution of ratings: See the distribution of ratings disclosure above. Price chart: See the price chart, with changes of ratings and price targets in prior periods, above, or, if electronic format or if with respect to multiple companies which are the subject of this report, on the Goldman Sachs website at /research/hedge.html. Additional disclosures required under the laws and regulations of jurisdictions other than the United States The following disc