14/9/2562 With ROE of Over 20% for a Decade While the Stock Price Falling - Bloomberg

Business

With ROE of Over 20% for a Decade While the

Stock Price Falling
10 กรกฎาคม 2562 21:38 GMT+8

With ROE of Over 20% for a Decade While the Stock Price Falling by Over 60%,
is China Medical System (0867. HK) Undervalued?

HONG KONG, July 10, 2019 - (ACN Newswire) - If there is an indicator to

measure whether the company is good or not from Buffett's perspective,
it's believed that most investors will choose ROE (Return on Equity).
According to some investors' statistics, the investment return of the
company with higher ROE is significantly higher than the market's average
return on investment (ROI).

"Based on the performance of all A-shares, during 1st Jan. of 2016 to 1st
Jan. of 2019, the return of the Shanghai Composite Index is -25.21%, and the
return of Growth Enterprise Index is -50.68%. However, the return of the
company with ROE over 10% is -16.35%, while the return of the company with ROE
over 15% is 10.15%. It seems that the differences will be more obvious if
lengthen the time range, "during 1st Jan. of 2008 to 30th April of 2019,
the Shanghai Composite Index decreased by 41.62%, while the share price of the
company with ROE over 10% for ten consecutive years rose 131.12%."

More importantly, the average ROE of China Medical System (CMS) has maintained
more than 20% for a decade, which is rare among companies in pharmaceutical
industry and the whole A+H shares.

If ROE is Buffett's first priority in company selection, PE may be the

indicator for him to determine the timing of investment since Buffett's
stock-picking philosophy can be summarized as "finding a business with a
wide and long-lasting moat + the reasonable price with margin of safety".
However, the valuation of CMS is now only 7.3 times PE-TTM.

What does the 7.3 times PE mean? It should be the valuation of the cyclical
stocks rather than the pharmaceutical stocks! Moreover, in terms of the
dividend yield ratio (DYR), the DYR of CMS is over 5% in 2019.

Looking at Buffett's investment history, we could find out that he often

buys shares of the leading consumer-goods companies with strong profitability
such as Coca-Cola at bargain prices when market undergoes systemic risks or
the company suffers crisis. As we all know, with the gradual release of policy
risks, the prices of many pharmaceutical stocks have halved or suffered even
greater decline in 2018-2019, and the stock price of CMS once dropped by 70%.
Therefore, is it the right time to invest in CMS?

I. Transition from CSO to R&D-oriented Pharmaceutical Company

1. CMS's Main Business
In early years, CMS was well-known as a CSO, and its main business model was
to introduce drugs from overseas small and medium-sized, innovative
pharmaceutical companies to Chinese market, and then engages in the
drugs' promotion and marketing. The business model has probably continued
to the year of 2010, and several drugs with relatively larger revenue
contribution were introduced during the early CSO stage. For instance,
Ursofalk was introduced from Dr. Falk Pharma GmbH, Germany in 2002; Deanxit
was introduced from Lundbeck, Danmark in 2002; Salofalk was introduced from
Dr. Falk Pharma, Germany in 2008; and Bioflor was introduced from Biocodex,
France in 2010.

However, since 2011, CMS has transferred its product introduction model from
CSO to rights control or China's asset-purchase. For instance, the two
products with relatively larger revenue contribution - Plendil and Xinhuosu,
among them, Plendil was acquired from AstraZeneca in 2016, and Xinhuosu was
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acquired from Tibet Rhodiola Pharmaceuticals ("Tibet Pharma") in
2008.

2. Transforming into R&D-oriented Company in the New Era

It has been mentioned above that CMS has made changes in its operation or
product introduction model during the past few years. While looking into the
characteristics of its products, most of them are with expired patents. From
the perspective of industry development trend, working on the R&D of
innovative products with patent protection will be the inevitable choice for
the companies.

Under the new round of drug approval reform, innovative drugs would be the
irresistible trend. Meanwhile, an increasing number of innovative R&D
companies have emerged in the capital market, and more and more McAb and
X-tinid drugs appeared in the new drugs market. And then there is an
interesting question-for new drugs R&D, pursuing hotspots or exploring a
different path?

According to the degree of innovation, innovative drugs / medical devices can

be divided into 4 categories: me-too, me-better, first-in-class and
global-new.

As mentioned before, driven by the policy factors, market demands, talents and
etc., the domestic innovative drugs industry enjoys booming development. While
limited by several factors including the current situation of fundamental
scientific research in China, admittedly most of domestic innovative
pharmaceutical companies mainly conduct innovation around me-too drugs
R&D, which is not significantly different from generic R&D in nature.
Because either from the efficacy or competition landscape, me-too innovative
drugs would face price war, or channel and expense competition that generics
suffered. Therefore, the return of me-too drugs R&D are destined to be low
despite of a higher success rate, especially against the background where
China is experiencing a skyrocketing clinical trial cost.

As for the development process of the new drugs, the more innovative parts
mainly lie in the discovery phase in pre-clinical stage and verification phase
in early-mid stage. For the companies that only focus on me-too R&D, their
innovation capability is nothing more than programmatic work of phase III
clinical trial, as the me-too new drugs do not require much early discovery
and verification. Therefore, it is obviously problematic to define the
innovation level of a company by high R&D expense generated from the phase
III clinical trials. Surely, this kind of new-drug development model is not
suitable for small and medium-sized pharmaceutical companies.

On another hand, return of innovative product R&D declines year by year.

According to the report published by Deloitte in 2018, world's top 12
pharmaceutical companies only received 1.9% of return on R&D investment,
which is the lowest in the past 9 years. Innovative products R&D cost is
going up as the average cost of developing a new product from scratch is 2.18
billion US dollars, while the peak sales of innovative products is going down.
The report shows that the average expected peak sales of newly launched drugs
only be 407 million US dollars. In conclusion, for Chinese pharmaceutical
companies, it's currently hard to be a real innovator to develop
innovative drugs.

3. CMS's R&D Model

For the pharmaceutical companies with a special business model, like CMS,
what's the direction of innovation and transformation? We can briefly
review the CMS's development path mentioned before to understand how it
transforms into an innovation-oriented enterprise.

CMS has no gene of generics and me-too drugs, as it has not been involved in
generics since the very beginning. Moreover, it proves that the innovation is
CMS's strategic positioning from the R&D process of Tyroserleutide
(CMS024), which has been conducted by the company and the R&D company
owned by its major shareholders since early years.

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However, limited by the objective reality, it's difficult for domestic
companies to carry out large-scale original R&D. Even for the leading
MNCs, most of their innovative drugs are licensed-in. Data indicates that the
revenue generating from licensed-in drugs has reached 72% of overall US drugs
market. Many blockbuster drugs were no longer self-manufactured by
pharmaceutical companies but purchased from other companies, such as
Adalimumab from Abbvie, several anti-tumor McAbs from Roche.

What CMS is doing now is more similar to what these MNCs had done in their
early years. Through participating in R&D process at different stages by
purchasing or investing in relevant products' rights under the
collaborative R&D model, the company has established and constantly
improved its own new-drug R&D system, improving its new drugs R&D
capability. However, as a domestic medium-sized pharmaceutical company, it is
necessary to avoid the hotspots competed by leading MNCs. It should be noted
that CMS has focused on specialty competition for many years, and the
historical records also proved its strategic success.

Of course, new-drug R&D has risks, especially for highly innovative drugs,
particularly global-new and first-in-class products. CMS's acquisition of
new projects in recent two years indicates that the company reduces its
R&D risk through diversifying its drug portfolio.

To be specific, besides global-new or first-in-class products, CMS has also

introduced some products with higher R&D success rate into its pipeline,
such as me-better product-- Intranasal Diazepam of 505b2 category. However, we
do not rule out the possibilities that CMS will introduce products in mid-late
clinical stages or even commercialized products in the future.

4. Selected R&D Projects

Let's analyze CMS's R&D positioning and strategy with the

example of NRL-1 (Intranasal Diazepam), which is developed relatively faster
under CMS's collaborative R&D model.

NRL-1, Intranasal Diazepam, was developed by Neurelis for the treatment of

Acute Repetitive Seizures. Neurelis has submitted the US FDA marketing
approval application in September, 2018. Its application for marketing
approval in China is also under preparation.

NRL-1 aims to solve the difficulty of injecting diazepam to epilepsy patients

and issue of drug action duration. As it is easy to use and effectively
shorten the duration of epileptic attack with high bioavailability, NRL-1 has
a significant clinical advantage. According to the research report from US
Neurology Annual Conference hosted by the University of Pennsylvania in May,
2019, diazepam nasal spray is safe and well-tolerated with higher
bioavailability for patients suffering cluster or acute repetitive seizure.
Among the total of 1,585 seizure attacks treated with nasal spray in this
study, a single dose of diazepam was effective to cease a epileptic attack for
1,457 times.

At present, among approximately 6 million patients with active epilepsy in

China, only 2 million have received formal treatment, 20% to 30% of whom are
still at the risk of repetitive seizures without effective control.

The example of NRL-1 can reflect that CMS's R&D strategy is

'Innovation' plus 'Specialty'. 'Innovation'
means that the product belongs to me-better category with obvious advantages
compared to the traditional diazepam injection. 'Specialty' means
that the company is able to avoid the competition against MNCs as the product
is not in global hotspot field; Moreover, the product's clinical needs
and therapeutic advantages guarantee its market potential and profitability.

II. Academic Promotion with Increasingly Prominent Advantages

After the volume-based purchase policy was issued, some investors might think
that the marketing capability is no longer significant, and even unnecessary,
while R&D capability is increasingly important. I think the view has two
sides. For the majority of the generics, large marketing expenses and
promotion teams might not be necessary. But for the innovative products, the

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promotion of products and the education for both doctors and patients will
always be necessary, which is also a crucial part of the value chain in
pharmaceutical industry, especially for the innovative drug industry.

1. The Necessity of Academic Promotion

For all industries including pharmaceutical industry, promotion, communication

and education are necessary when a new product is launched to the market. But
for the pharmaceutical companies, the ways of promotion and communication are
more special.

Besides, we need to distinguish academic promotion from commission-based

promotion. Drawing the line between them is undeniably difficult, but the
promotion model with large commission involved will be criticized undoubtedly,
especially for the common generics with highly developed market.

Over years, the profit margin of selling generic drugs in China has been
squeezed, which means the value of authentic academic promotion will be
highlighted and valued. Particularly in the era of the innovative drugs,
academic promotion itself is the indispensable weapon to conquer the market.

2. The Excellent Academic Promotion Ability

According to the 2018 Annual Report of CMS, the company employs around 2,800
promotional staff and its promotional network covers about 53,000 hospitals
and medical institutions across China.

Compared with the domestic first-line pharmaceutical companies, the promotion

team of CMS is highly efficient: the 2018 sales expense ratios of HengRui
Medicine and Betta Pharma (A-share companies) were 37% and 41% respectively,
and Sino Biopharm and CSPC (H-share companies) were 39% and 35% respectively;
while that of CMS during the same period was about 31%, and it would be merely
22% if excluding the effect of "two-invoice system".

Obviously, CMS's promotion team is not large-scale and the sales expense
ratio is not high as well, but the indicators such as output per capita of
sale staff have the leading position in the industry. We think the main reason
is that the projects selection and positioning strategies made by upstream
tend to fit for the downstream promotion model. Meanwhile, high-quality
promotion staff and strong multi-therapeutic departments coverage ability also
contribute to the high output. Certainly, the deeper reason may be that sales
commission is a necessary cost for many generics or me-too drug companies
under the homogeneous competition. The sales expense ratio of 20-30% should be
considered as normal among the top global pharmaceutical companies.

3. Evaluating CMS's Promotion Capability from the Performance of Xinhuosu

Xinhuosu (Recombinant Human Brain Natriuretic Peptide) is used in the

treatment of acute and chronic heart failure; it is the National Class One New
Drug as well as the only Recombinant Human Brain Natriuretic Peptide
("rhBnp") currently available in the China market. In 2005, Tibet
Pharma was the first company that received the approval to produce and sell
Xinhuosu.

In early years, the Tibet Pharma authorized Xinhuosu's exclusive sales

contract to Guangdong KangHong, YiBai Pharma and Hong Kong Core Healthcare
respectively, but all of them failed to perform well in product's
promotion. Xinhuosu's sales revenue was less than RMB 5 million in 2007
and never picked up until CMS took it over in 2008. By the end of 2018, its
annual sales revenue reached RMB 335 million, which was RMB 887 million if
excluding the effect of "two-invoice system".

It should be noted that the growing sales of Xinhuosu depends on CMS's

academic promotion supported by the various academic evidences of clinical
trials, rather than the promotional strategies of generics or me-too drugs
including increasing expenses or relying on channels.

The post-marketing IV clinical trial conducted by CMS for Xinhuosu has been
the largest rhBnp study in China so far. The large-scale clinical research was

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led by Society of Cardiovascular of China Medical Association with 8 clinical
centers and 2,160 recruited patients with acute and chronic heart failure. The
clinical data showed that the clinical application of rhBnp decreased the
incidence rate of adverse events, improved the dyspnea level of the patients,
decreased NT-proBNP, and increased left ventricular ejection fractions.

In addition to large-scale clinical trials, Xinhuosu has also been recommended

by several authoritative guidelines for the diagnosis and treatment of heart
failure after the academic promotion of CMS. Moreover, Xinhuosu has been
included in the National Reimbursement Drug List through national negotiation
in 2017, and its sales revenue has maintained a high growth rate.

Why CMS could achieve good sales performance of Xinhuosu? In addition to the
company's academic promotion capability, the characteristics of product
itself are also important. The most obvious characteristic is being
differential, which is also one of the substantive characteristics of
innovation. For instance, Xinhuosu is the only rhBnp available in China at
present without positive inotropic action or any increase on myocardial oxygen
consumption; and it has multiple action mechanisms. All of these can
differentiate the product from the other drugs in the same field.

The example of the Xinhuosu shows that CMS's excellent academic promotion
capability mainly comes from its products screening abilities, R&D and
even strategy orientation. In other words, the potential could be maximized
only when authentic innovative products integrate with the excellent academic
promotion capability.

III. Talking about CMS's Current Status and Volume-based Purchase Based
on Its Stock Price Performance
Reflecting on CMS's stock price performance since 2018, the stock price
has plummeted more than 60% from its historic highs during the same period
last year, and the volume-based purchase may be the core reason. As mentioned
in the beginning of the article, the company's major products are mainly
originators with expired patents. However, the core purpose of volume-based
purchase is to gradually replace the originators with the generics with low
price, zero promotion and zero channel expenses. Therefore, the market has
avoided branded-drugs-oriented companies like CMS.

It cannot be denied that the branded drugs would face greater policy pressure.
However, drug substitution is a process, and the replacement speed would be
different in terms of different types of drugs in different channels.

First of all, none of the company's products has been included in the
volume-based purchase list. Whether or not the company's products will be
included in the second or third batches of the volume-based purchase list
still depends on if any generic drug could pass the consistency evaluation.
Currently, the company has 20 products in its portfolio, among these, products
with relatively higher sales contribution are 4 exclusive products (Bioflor,
Stulln, Hirudoid, and Combizym), 2 exclusive dosage-form chemical drugs
(Ursofalk and Salofalk), and a biological agent, Xinhuosu, which is originally
immunized from the volume-based purchase. Therefore, among the large-weighted
products, only the generics of Deanxit has passed the consistency evaluation
and it might face the risk of price reduction from volume-based purchase,
while Plendil might encounter the risk of volume-based purchase in the medium
term.

Secondly, the originator products with large-weight on the company's

sales are mainly for chronic diseases, such as Plendil and Deanxit. These
drugs have stronger consumer attributes, mainly embodied in two aspects,
channel and brand. Firstly, for the channel, the OTC sales revenue of both
Plendil and Deanxit contribute over 30% of their sales, and the company also
strengthens its OTC channels construction. Against the background of
hierarchical diagnosis and prescription outflow, the non-hospital market is
likely to be the main market for chronic diseases. Secondly, for the brand,
anti-hypertensive and anti-depressant drugs are all long-term used medicines
with low unit price, so there must be the certain amount of patients with
strong loyalty. Even if such drugs would be included into the volume-based
purchase list, it is hard to predict that whether the performance of the
company would be the same as its share price suffered.

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Finally, the impact of volume-based purchase might not be as terrible as we

think. The current stock price has priced-in all of the negative aspects, even
though the company's products have not reduced their prices or lose the
market.

As mentioned above, CMS is no longer a CSO. It has been transformed from a

company that promoted patent-expired originators to an innovation-oriented
pharmaceutical company.

In terms of the basic indicators such as cash flow, valuation and dividend
yield ratio, investing in CMS now is more like buying a sound and valued-based
stock, while bundling a portfolio of innovative drugs options with a promising
return.

By Gelonghui

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