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Sector Update

June 4, 2013
Jessica LI, Ph.D
SFC CE Ref: AWV098

Health Care
SFC CE Ref: AUB778


Implementation of Guangdong Drug Tender Model Likely

Favor Leading Distributors; Pharma Stocks at Risk

Whats new?
On May 17, Guangdong released draft drug tender guidelines which if implemented would lead to greater pricing pressure and would likely influence tender trends across the nation. Domestic pharmaceutical companies are objecting fiercely. Immediately after the release, shares of offshore-listed Chinese pharmaceutical distributors and manufacturers underwent 3% and 4% corrections, respectively. While the correction continues for leading distributors, pharmaceutical manufacturers quickly rebounded, assuming the Guangdong model will likely not be implemented in its current form.

We believe implementation of the Guangdong tender model with minor modification is very likely. We think the divergent share performance of pharmaceutical manufacturers and distributors creates trading opportunities: potential upside for distributors and downside for manufacturers. Could be as soon as July. According to Nanfang Daily, the officer in charge of Guangdong centralized drug procurement indicated that the guidelines would be finalized in June. The new online drug tender/procurement system is expected to be implemented in July for essential drugs and in October for drugs on the national reimbursed drug list (NDRL). We and some industry contacts anticipate only minor modifications to the guidelines. Guangdong model indicative of stricter future policies; more pricing pressure. We believe the Guangdong tender model shows strong government desire to effectively reduce generic drug prices in China and is indicative of future policy direction. We also expect more provinces to followZhejiang, Hunan, Jiangxi, Shanghai and Beijingand with stricter pricing rules in 2013/14, with pricing pressure to intensify and drug industry growth to slow to the mid-teens in China. Manufacturers sales and earnings could face downward pressure in 2013/14. Rich valuation renders pharmaceutical stocks vulnerable; leading pharma distributor is fairly valued. Forward multiples of off-shore listed Chinese pharmaceutical stocks are high at ~18x vs. the sectors mid-teens growth potential. They are therefore vulnerable to downward adjustments. However, pharmaceutical manufacturers with more exclusive drugs and/or substantial new product introductions should be better off. Conversely, we believe leading distributor Sinopharms correction has ended at a forward P/E of ~15x, which reflects the anticipated slowdown in industry growth in an increasingly cost containing environment. We continue to believe that Sinopharm is best positioned to benefit from the industry consolidation and most capable of outpacing the industry growth.

Valuation and recommendation

We maintain BUY ratings for Fosun Pharma (02916.HK, 12-month TP HK$16.50), Mindray (MR.US, 12-month TP US$41.00), Shandong Weigao (01066.HK, 12-month TP HK$9.00), and Sinopharm (01099.HK, 12-month TP HK$31.00); ACCUMULATE for Shanghai Pharma (02607.HK, 12-month TP HK$17.50), and Concord Medical (CCM.US, 12-month TP US$5.20). We keep Guangzhou Pharma (00874.HK, 12-month TP HK$17.00) at HOLD.

Slower economic growth in China; less favorable government policy on healthcare spending; stiffer competition; product development failures; price cuts; slower pace of M&A.

Please read carefully the important disclosures at the end of this report

CICC Research: June 4, 2013

Guangdong model pressures the Chinese pharmaceutical sector

From January to mid-May, offshore listed Chinese pharmaceutical manufacturers and distributors outperformed the Heng Seng Index (-4%), rising 48% and 3%, respectively; the outperformance was mainly due to strong FY12 financial results with tamed pricing pressure. In the week following Guangdong released the draft drug tender guidelines on May 17th, offshore listed pharmaceutical distributors underwent a 3% correction. After the event, offshore listed pharmaceutical manufacturers also corrected by 4% but later rebounded to almost the same level; A-share healthcare stocks only declined by 2% but later rebounded to level which was 4% higher than the previous mark. Both offshore listed pharmaceutical manufacturers and A-share healthcare stocks rebounded assuming a low probability for the Guangdong model to be implemented at its current form. From January to mid-May, offshore listed pharmaceutical manufacturers experienced significant multiple expansion from ~13x to ~18x. The release of Guangdong draft drug tender guideline lowered multiples of the segment to ~17x but quickly rebounded to the current level of 18x again, due to some market participants belief on the non-implementation of the Guangdong model. On the other hand, offshore listed pharmaceutical distributors expanded multiples from ~16x in January 2013 to the peak ~18x in March 2013, then adjusted slowly to ~16x in mid-May. The event further dragged multiples of offshore listed pharmaceutical distributors to the current ~15x. Figure 1: Chinese healthcare sector reacted strongly to Guangdong model (YTD)
Pharma Manufacturers Pharma Distributors HSI A-share HC

160 150 140 130 120 110 100 90 80

Issuance of Guangdong Draft Drug Tender Guidelines

Source: Bloomberg; CICC Research

Please read carefully the important disclosures at the end of this report 2

CICC Research: June 4, 2013 Figure 2: Chinese healthcare sector reacted strongly to Guangdong model (May 2013)
Pharma Manufacturers Pharma Distributors HSI A-share HC

112 110 108 106 104 102 100 98 96 94

Issuance of Guangdong Draft Drug Tender Guidelines

Source: Bloomberg; CICC Research

Figure 3: Forward P/E trends of Chinese pharmaceutical manufacturing subsector

Pharma Manufacturers 20 19 18 17 16 15 14 13 12
15x 18x Issuance of Guangdong Draft Drug Tender Guidelines

Source: Bloomberg; CICC Research

Please read carefully the important disclosures at the end of this report 3

CICC Research: June 4, 2013 Figure 4: Forward P/E trends of Chinese pharmaceutical distribution subsector
20 19 18 17 16 15 14
15x 18x Issuance of Guangdong Draft Drug Tender Guidance

Pharmal Distributors (excluding Guangzhou Pharma)

Source: Bloomberg; CICC Research

Guangdong model confirmed stricter price control and growth deceleration ahead
We continue to believe that the draft Guangdong tender model is showing the overall policy direction and indicative of the government's stronger desire to effectively reduce generic drug prices in China. The Guangdong tender model also implements a more market-driven tendering system for the long run. The draft tender guidelines published on May 17 have sparked strong opposition from domestic pharmaceutical manufacturers. Major pushbacks center on the overemphasis on pricing over quality and the frequent monthly tendering cycle. We think the odds of implementation of the Guangdong model are high; implementation will consequently have a material impact on Chinas pharmaceutical industry, leading to increased pricing/margin pressure and growth deceleration. Anticipate implementation in 3Q with high participation rate Though the Guangdong tender model met with many voices of objection (like many of the implemented provincial tenders), we expect it to be finalized in June, while the online drug tender/procurement system is to be implemented in July 2013 to immediately start essential drug tendering. Tendering on RDL drugs is expected to start by October. As China's largest regional pharmaceutical market, Guangdong is important to pharmaceutical manufacturers and they cannot afford foregoing sales in the region. Therefore, we expect healthy industry participation as Guangdong is too large for pharmaceutical manufacturers to miss. We do not anticipate a low participation rate like Anhuis 2010 EDL tender (which later led to a drug supply shortage). Market mechanism with more transparency and stricter monitoring In our view, the proposed new online drug tender/procurement system 1) creates a platform for market-oriented price competition by linking demand with prices, which could potentially eliminate under-the-table price fixing; and 2) should help propel industry consolidation by eliminating smaller, less efficient players with less differentiated generic drugs. The online drug tender/procurement system of the Guangdong model allows medical institutions to submit their demands periodically and starts procurement rounds in every month; therefore, there could be a new procurement winner and a new procurement price for each product in each round. Though it means higher price pressure, we believe the system allows drug prices to be adjusted in keeping with real market demand. The system also emphasizes higher transparency during procurements as 1) pharmaceutical manufacturers can see the real demand for each round before they bid, 2) there will be only one winner in each round to avoid grey area lobbying and to reward the winner with exclusive market share and economies of scale, and 3) medical institutions can only specify demand and product specification requirements but not the supplier. The system also involves stricter monitoring by 1) enforcing the two-invoice system (1st invoice generated at the factory, second at the medical institution) to limit number of drug distributors to one, in order to squeeze mark-ups in distribution
Please read carefully the important disclosures at the end of this report 4

CICC Research: June 4, 2013 channels and to lower drug prices for end users, 2) enforcing penalize measurements on medical institutions which fail to pay in 60 days, as an aim to ease working capital for pharmaceutical manufacturers, and 3) apply comprehensive monitoring on tendering rules, drug qualifications, price bidding and procurement transactions.

Expect future tenders to follow stricter pricing rules; possible lengthier tender rollout timelines
After Guangdong, we expect provinces such as Zhejiang, Hunan, Jiangxi, Shanghai and Beijing will publish similar tendering guidelines soon (either in draft or final version). Overall, we expect these tendering rules to be stricter with the strong tendency to take the Guangdong Model as their reference: 1) stringent price cap policy with referral to all provinces; 2) RDL drug quality layers will no longer differentiate first-to-market from other generics and 3) EDL drug price cut could be severe in the next few years while volume growth might not be sufficient to make up losses immediately. While we expect 10~15 provinces to publish their tendering guidelines in the next 12~18 months, the roll-out of provincial tenders could progress slower than expected. Besides provinces, the final tender result for all military districts in China is expected to be published timely.

Pharmaceutical manufacturer valuations high; leading distributors fairly valued

Pharmaceutical manufacturers multiples are currently at ~18x. We believe this is high and could be vulnerable to future adjustments triggered by new price containment policies being introduced. While the stricter policies are expected to impact all pharmaceutical manufacturers, those with more exclusive drugs will be better off. Pharmaceutical distributors (excluding Guangzhou Pharma) are currently trading at a multiple level of ~15.x. We believe the current valuation of the segment is fair, reflecting the anticipated slowdown in industry growth in an increasingly cost containing environment. Figure 5: Sales contribution from exclusive products

% of total pharma sales in FY12

70% 60% 50% 40% 30% 20% 10% 0% Sihuan CMS CSPC Sino Biopharm Guangzhou Pharma Fosun Pharma Shanghai Pharma

Source: company data; CICC Research

Please read carefully the important disclosures at the end of this report 5

CICC Research: June 4, 2013 Figure 6: Forward P/E trends of selected off-shore listed Chinese pharmaceutical distributors and manufacturers
21 20 19 18 17 16 15
16x 20x Issuance of Guangdong Draft Drug Tender Guidelines

Shanghai Pharma
15x Issuance of Guangdong Draft Drug Tender Guidelines





16 14 12 10 8 6 4
8x Issuance of Guangdong Draft Drug Tender Guidelines 14x

Sino Bioppharm
25 24 23 22 21 20 19 18 17 16 15
20x 22x Issuance of Guangdong Draft Drug Tender Guidelines

22 21 20 19 18 17 16 15


China Medical System

21x Issuance of Guangdong Draft Drug Tender Guidelines 20x

United Lab

21 20 19 18 17
18x Issuance of Guangdong Draft Drug Tender Guidelines

16 15 14 13 12

18 17 16 15 14 13 12 11

Issuance of Guangdong Draft Drug Tender Guidelines 16x

Source: Bloomberg; CICC Research

Please read carefully the important disclosures at the end of this report 6

CICC Research: June 4, 2013

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