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China Healthcare Shattered landscape; hope and opportunity  Sell-off creating buying opportunities: The MSCI China

China Healthcare

Shattered landscape; hope and opportunity

Sell-off creating buying opportunities: The MSCI China healthcare index (down 13.5% in the past three months and 28% YTD) is trading at the lowest multiples since mid-2009, with many counters offering enticing valuations when set against the growth prospects, in our view. We believe the sentiment has been too negative given that the secular growth of healthcare industry looks intact and it is in the government’s interest to strengthen, not weaken, the domestic players. We are confident that many healthcare companies can withstand short-term negative macro headwinds and emerge with growth outlooks intact. We believe the recent sell-off has created some attractive buying opportunities.

Fundamentals for long-term growth look strong - underpinned by ageing population, rising disposable income, increasing government healthcare expenditure, and expanding insurance coverage: Annual drug sales are expected to grow nearly 20% annually for the next 5-10 years and China will become the third-largest drug market in 2011 and No.2 by 2020, according to IMS China. The use of medical devices will continue to expand given low penetration levels. Increased government spending will benefit all healthcare subsectors as we foresee total healthcare spending as a proportion of GDP rising from 5% today to about 10% by 2020, growing at a CAGR of 18%, roughly twice that of nominal GDP growth for next 10 years.

We prefer devices over drugs because of price cut overhang: We see continued short-term pricing pressure on pharmaceuticals as we expect the recent Fujian type of drug-tendering to possibly be repeated in other provinces. With rising raw material costs and labor inflation, and price-cuts taking full effect in 2H11 for many drugs, consensus profit projection for many drug companies could be at risk. Hence, in the short term, we prefer medical device players to drug names for lower regulatory risks.

Stock picks: Buy Sino Biopharma for 54% upside potential, Sinopharm for 46% upside, and Mindray for 29% upside. Those are leaders of their respective subsectors that possess sustainable competitive advantages to keep them strong for years to come. We recommend selling China Shineway due to its continued downside earnings risk from EDL drug cuts. We are Overweight on Weigao, Sihuan, and Concord Medical Services, and Neutral on United Labs and MicroPort.

China healthcare coverage universe

Asia Pacific Equity Research

15 October 2011

Healthcare Sean Wu AC

(852) 2800-8538

sean.wu@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

One-year China & APxJ Healthcare 20% 10% 0% -10% -20% -30% -40% -50% Oct-10 Nov-10
One-year China & APxJ Healthcare
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
Oct-10
Nov-10
Dec-10
Jan-11
Feb-11
Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11

MSCI China H

APxJ Healthcare

MCSI China Healthcare

Source: Bloomberg

Three-month China & APxJ Healthcare 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% -35.0% 1-Jul
Three-month China & APxJ Healthcare
5.0%
0.0%
-5.0%
-10.0%
-15.0%
-20.0%
-25.0%
-30.0%
-35.0%
1-Jul
1-Aug
1-Sep
MSCI China H
APxJ Healthcare
MSCI China Healthcare

Source: Bloomberg

 

MCAP

Vol

1W

Chg

3M

11E

12E

11E EV/

11E

P/B

11E Yld

ND/E

Company Name

Code

Price (PT)

US$m

US$m

Chg

P/E (x)

P/E (x)

EBITDA

ROE (%)

(x)

(%)

(%)

CHINA SHINEWAY (UW) CONCORD MEDICAL (OW) MICROPORT (N) MINDRAY (OW) SHANDONG WEIGAO (OW) SIHUAN (OW) SINO-BIOPHARM (OW) SINOPHARM (OW) UNITED LAB (N)

2877 HK

11.5 (12)

1,223

5.6

24.2

(16.1)

9.8

9.0

5.0

22.8

3.6

1.8

(76.1)

CCM US

3.19 (4.6)

151

0.1

3.2

(21.3)

6.3

4.7

2.6

8.5

0.9

0.0

(23.8)

853 HK

4.7 (5.5)

868

1.2

9.3

(5.1)

20.0

15.9

11.1

12.9

3.0

0.0

(44.3)

MR US

24.8 (32)

2,857

12.6

2.6

(7.3)

17.1

14.5

10.7

16.4

2.6

1.2

(47.6)

1066 HK

9.2 (11.5)

5,311

5.4

15.8

(16.1)

30.1

22.5

23.2

23.8

7.6

1.0

(44.8)

460 HK

3.14 (4.9)

1,847

4.2

18.5

(1.9)

15.5

12.1

9.1

12.2

2.9

0.0

(54.0)

1177 HK

2.28 (3.5)

1,444

2.4

4.6

(14.9)

20.1

17.0

7.4

15.1

3.6

2.8

(42.0)

1099 HK

20.6 (30)

6,362

15.2

4.8

(11.0)

21.1

14.6

10.4

14.7

4.5

0.8

(22.8)

3933 HK

6.46 (7.5)

1,078

3.5

16.2

(25.0)

6.7

4.6

5.1

22.7

3.2

2.6

34.1

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

See page 144 for analyst certification and important disclosures, including non-US analyst disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

www.morganmarkets.com

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

Table of Contents

15 October 2011 sean.wu@jpmorgan.com Table of Contents Investment summary 3 Poor performance creates

Investment summary

3

Poor performance creates opportunity

3

Why

the underperformance

4

Why would the sector recover

5

Stock investment views

7

Valuation Analysis and Price Targets

14

Healthcare – a major pillar industry

15

Fundamentals driving industry growth to remain intact

15

Chemical-Drugs/APIs

27

Pharmaceutical demand by therapeutic area

32

Selected chemical drug companies in China

33

Medical Equipment/Devices

36

Key success factors in Medical Devices

37

Selected medical equipment/devices companies in China

38

Traditional Chinese Medicines

40

Selected Pharmaceutical and TCM companies

42

Medical Distribution/Retailing

44

Selected companies with extensive drug-distribution businesses

48

Chinese Vaccine Market

50

Selected companies in the vaccine space

51

Companies

China Shineway Pharmaceutical Group Limited

54

Concord Medical Services Holdings Limited

63

MicroPort Scientific Corp

74

Mindray Medical

85

Shandong Weigao Group Medical Polymer Co.

93

Sihuan Pharmaceutical Holdings

104

Sino Biopharmaceutical

115

Sinopharm

127

The United Laboratories

136

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

Investment summary

15 October 2011 sean.wu@jpmorgan.com Investment summary Poor performance creates opportunity There has never been a

Poor performance creates opportunity

There has never been a more tumultuous period for healthcare stocks than the third quarter of 2011. Clearly, the overall market has not done well, but is not the healthcare industry a defensive sector, resistant to the business cycle? We believe this might still hold true, but Chinese healthcare stocks have done badly owing to some specific issues pertinent to this industry. During 3Q11, the MSCI China healthcare index fell by 23%, while the China’s A-share drug index and MSCI APxJ healthcare index fell by about 10% and 15%, respectively. Given the relatively better performance by the A-share drug companies, the H-share China healthcare names have apparently suffered disproportionally more. Among our coverage space, The United Labs performed the worst, with a 3-month decline of about 50%, while Mindray managed to perform relatively well but still dropped by 16%. While the current macro-environment does appear to be difficult for the healthcare industry and some level of stock pull-back is understandable and healthy in light of excessive valuation for some companies, we believe that the recent carnage suffered by healthcare stocks have nonetheless created very attractive buying opportunities for many of our companies. We believe the sentiments have been too negative. China’s healthcare industry remains a secular growth story and, over the long term, healthcare stocks are bound to outperform the general market, in our opinion. Our top picks are Sino Biopharmaceutical, Sinopharm, and Mindray.

Figure 1: Healthcare stocks took a beating in 3Q11 % 10.0% 0.0% -10.0% -20.0% -30.0%
Figure 1: Healthcare stocks took a beating in 3Q11
%
10.0%
0.0%
-10.0%
-20.0%
-30.0%
-40.0%
-50.0%
-60.0%
7/5/2011
7/12/2011
7/19/2011
7/26/2011
8/2/2011
8/9/2011
8/16/2011
8/23/2011
8/30/2011
9/6/2011
9/13/2011
9/20/2011
9/27/2011
2877
HK
CCM US
853 HK
MR US
1066
HK
460 HK
1177 HK
1099 HK
3933
HK
A-share Drug Index
MSCI APxJ Healthcare
MSCI China Healthcare

Source: Bloomberg

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Table 1: Summary of performance of companies against sector

Table 1: Summary of performance of companies against sector and regional healthcare companies

Company Name

Code

Price

MCAP

Vol

1M

3M

YTD Chg

11e PE

12e

EPS CAGR

PEG

PEG

EV

EV/Sales

(TP)

US$MM

US$mn

Chg

Chg

(%)

(x)

PE (x)

(10_12e)

'11E

'12E

(US$mn)

('11E)

Covered Companies CHINA SHINEWAY (UW)* CONCORD MEDICAL (OW)* MICROPORT (N)* MINDRAY (OW)* SHANDONG WEIGAO (OW)* SIHUAN (OW)* SINO-BIOPHARM (OW)* SINOPHARM (OW)* UNITED LAB (N)* Coverage Universe Average Distribution Average Chemical Drugs Average TCM Average Medical Devices Average Biologicals Average HK/China Average Taiwan Average Korea Average India Average AU/NZ Average Singapore Average ASEAN Average

2877 HK

10.3 (12)

1,098.7

5.2

4.1

(25.0)

(52.7)

9.2

9.8

-6.6%

(1.4)

(1.5)

1,090.4

3.1

CCM US

3.1 (6.4)

18.6

0.0

(5.3)

(24.7)

(56.8)

6.7

5.3

19.6%

0.3

0.3

20.9

2.3

853 HK

4.6 (5.5)

844.2

1.3

28.1

(6.7)

(38.2)

18.2

15.2

11.6%

1.6

1.3

974.1

2.5

MR US

24 (32)

2,811.9

11.3

(2.8)

(9.2)

(6.4)

16.7

14.5

12.9%

1.3

1.1

1,970.0

2.4

1066 HK

9.2 (12)

5,291.3

5.5

4.3

(16.4)

(16.2)

35.0

26.3

24.3%

1.4

1.1

5,175.0

10.1

460 HK

2.9 (4.9)

1,908.3

4.4

(3.3)

(14.0)

(47.5)

14.8

11.9

23.2%

0.6

0.5

2,458.1

6.2

1177 HK

2.2 (3.5)

1,396.8

2.3

4.3

(15.7)

(22.0)

29.1

25.2

4.4%

6.7

5.8

1,546.4

2.2

1099 HK

20.8 (30)

6,405.5

16.2

11.3

(15.7)

(22.9)

26.8

22.0

21.8%

1.2

1.0

7,336.6

0.5

3933 HK

6.2 (7.5)

1,035.1

3.2

1.1

(28.3)

(60.5)

14.9

9.8

-10.2%

(1.5)

(1.0)

2,256.5

2.6

 

2,312.3

5.5

4.7

(17.3)

(35.9)

19.0

15.6

11.2%

1.1

1.0

2,536.4

3.5

1,762.9

8.5

(7.9)

(17.0)

(27.3)

29.0

23.3

20.6%

2.1

1.7

1,249.5

1.0

841.4

4.0

(10.2)

(14.8)

(20.7)

27.6

20.0

41.3%

1.1

0.8

1,180.4

5.9

1,257.4

5.6

(9.4)

(14.3)

(21.0)

25.4

20.3

26.2%

1.5

1.2

1,378.9

9.1

573.8

2.6

(12.7)

(16.5)

(6.5)

26.6

19.8

37.3%

0.9

0.7

2,207.1

47.4

860.3

3.9

(11.0)

(21.4)

(36.0)

24.5

26.6

23.5%

0.6

0.5

1,281.5

10.0

1,059.2

4.9

(10.2)

(16.8)

(22.3)

26.6

22.0

29.8%

1.2

1.0

1,459.5

14.7

235.0

0.8

(8.6)

(18.0)

(17.5)

25.8

15.1

22.1%

0.9

0.7

284.6

21.9

478.4

7.3

2.2

5.5

20.1

89.3

16.0

36.3%

(0.8)

(1.3)

403.8

9.8

1,326.8

2.1

(3.2)

(9.9)

(11.1)

16.6

14.2

28.9%

0.5

0.4

1,514.7

10.1

1,878.2

8.9

1.2

(11.0)

(0.3)

26.3

15.1

7.8%

1.1

1.2

2,319.4

53.2

631.8

0.7

(0.6)

(7.5)

(2.9)

20.6

16.7

30.9%

1.4

1.2

495.8

2.9

594.4

0.6

0.1

0.1

12.3

14.8

13.3

8.1%

2.1

1.9

622.0

4.5

Source: Bloomberg; J.P. Morgan Estimates; Prices are as of the close of 11 October 2011.

Why the underperformance

Macrowinds currently blowing the wrong way The National Development and Reform Commission (NDRC) has announced three rounds of price cuts recently, first for the essential drugs, then for antibiotics and circulatory system drugs earlier this year, which resulted in ~20% cut at retail reference levels. The tendering of drugs on the essential drug list (EDL) at the provincial levels has resulted in 40%-plus price cuts for some drugs and many major brands have been completely shut out from the EDL catalogue of certain provinces. The Anhui model of EDL tendering, conducted mostly on price, is especially controversial. It has resulted in very severe price cuts, compared to a more balanced approach taken by the Shanghai government, which has considered both quality and price for tendering. Unfortunately, the Anhui model appears to be winning, as more and more provinces adopt its approach. Expectations for further price cuts of drugs have severely hampered the drug companies’ stock performance. Even for medical devices, there are expectations that dramatic price cuts may be forthcoming, following the rounds of tendering organized by the local governments. Nonetheless, we remain steadfast that the regulatory risks for the medical-device/equipment sector are much lower than those for the drug companies.

Table 2: Recent NDRL Cuts of Retail Ceiling Prices

Date

No. of Drugs

Price Cut

Drug Categories Involved

Dec-10

17

12%

17 categories of EDL drugs 162 anti-infective and circulatory system drugs Hormonal and endocrine system drugs

Feb-11

162

21%

Aug-11

82

14%

Source: NDRC

Short-term pain may persist, especially for drug names Whatever damage the Anhui model has done to the prices of EDL drugs, we think the Fujian model of non-EDL drug tendering could likely do worse for the overall

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com drug prices. First, the Fujian model intends to dramatically

drug prices. First, the Fujian model intends to dramatically cut down the categories of drugs that companies can bid in. For each category, there may be only 2-3 winners, which significantly lowers the number of winning companies. Finally, the price difference among drugs in the same category cannot be more than 30% and the winning bid price for lower-quality class cannot be any higher than the higher class, which would likely make certain drugs enjoying independent pricing power sure losers if the producers of these drugs want to maintain premium prices in other provinces. While companies can complain about the quality/price trade-off for the Anhui model, there are no legitimate complaints, according to our assessment, about the Fujian model, especially about limiting drug categories. We see a high likelihood that the Fujian model may be duplicated in other provinces in the future rounds of drug tendering. This would likely spell bad news for many companies. According to estimates by some industry experts, more than 50% of tender winners that occupied top-100 ranks in terms of sales in the Guangdong province for 2010 might be completely shut out of Fujian.

Why would the sector recover

Valuation has become more attractive With MSCI China Healthcare Index down by 23% over the last three months till October 1, we believe the overall healthcare sector valuation has become more attractive. The index is currently trading at about 21x forward P/E, unseen since 2009. Comparatively, this also allows the healthcare sector to be in a more favorable position compared with other Chinese sectors given the healthcare sector’s strong growth ahead.

Figure 2: Forward P/E of MSCI China Healthcare Index 50 45 40 35 30 25
Figure 2: Forward P/E of MSCI China Healthcare Index
50
45
40
35
30
25
20
15
10
5
0
Forward P/E

Source: Bloomberg

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Fundamentals of the healthcare industry stay strong We

Fundamentals of the healthcare industry stay strong We believe the healthcare industry will continue to grow at a robust pace for the next 5-10 years because of favorable demographics and government support for expanding insurance coverage. With expanding insurance coverage and rising disposable income, an aging population is bound to demand more and more quality medical services. We expect healthcare spending in China to grow 15-20% each year over the next ten years and healthcare expenditure as a portion of GDP should reach approximately 10% by 2020 from the current level of ~5%. Furthermore, the government is encouraging consolidation within each healthcare subsector, meaning that the leading players should be able to achieve top-line growth of over 25% a year.

Remain positive in the longer term Even with tough macro headwinds, the healthcare industry output for 1H11 grew Y/Y by 27.9% to Rmb714.6bn, with the output of chemical drug APIs, finished dosages, Chinese patent medicines, and biologic products growing Y/Y by 25.4%, 23.4%, 32%, and 25.4%, respectively. The drug-manufacturing industry’s industrial value-added output increased by 16.8% Y/Y in 1H11. Hence, despite a challenging environment, the overall industry has managed to maintain a very healthy growth. We firmly believe that the Chinese government will need a healthy healthcare industry with players generating decent profits in order to fulfill its goal to provide quality medical services to the population at affordable prices. If companies continue to make losses by selling drugs, they will either stop selling drugs or exit businesses altogether, making some drugs unavailable to patients. In order to make the essential drugs available to its people, the government might be forced to raise prices in order to attract domestic manufacturers or import drugs at even higher prices. Hence, there is a balance between price cuts and drug supply. In addition, if the government wants to achieve its goal of upgrading the healthcare industry to be more competitive globally, it would need the leading companies to generate profits to fund R&D for innovative product development. We think the current downturn could have the potential to rid the industry of weak players so that strong players with consolidated market positions might eventually emerge.

Building R&D capabilities key to sustainable margins In the longer term, we believe only companies that have strong R&D capabilities and a pipeline of products would thrive. New-product launches are key to sustainable healthy margins in the future, which are under constant attack these days with rounds of government price cuts, labor and raw-material inflation. Some companies might acquire new products through acquisitions to build product portfolios in lieu of in- house R&D. In our coverage space, we believe Sihuan, Sino Biopharma have strong R&D capabilities that deserve special investor attention. The other companies with strong R&D capabilities are Jiangsu Hengrui (600276 CH, Not covered), and Simcere (SCR US, Not Covered).

Channel consolidation to benefit leading distributors Local governments are cutting drug prices in order to make drugs more affordable. Those price cuts are carried out in light of the perception that there is a huge gap between ex-factory prices and retail prices for some drugs with too much value lost to distributors, or drug sales organizations, which do not provide much value added. Price cuts may force channel reshuffling, forcing business model changes as we see more and more manufacturers internalizing sales and marketing by adopting direct sales model while using distributors as pure logistics organizers. National level distributors, such as Sinopharm and Shanghai Pharmaceuticals, are not drug sales

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com organizations and are less susceptible to cleaning up the

organizations and are less susceptible to cleaning up the channels. Since the Chinese government plans to support the emergence of 1-3 distributors with sales of above Rmb100bn and 20-plus local distributors with sales of above Rmb10bn by 2015 as a part of 12th five-year plan, we believe the consolidation of drug distribution industry would pick up and view consolidators with successful track-record of integration as ultimate winners.

Stock investment views

Currently, we have nine Chinese healthcare companies under coverage. None escaped the sharp downturn in 3Q11. Particularly hard hit was The United Labs, whose shares were down 50% in 3Q11, followed by Shineway, whose shares fell by 42%. We think there are good reasons, while not totally justifiable, for the two companies to fall a lot because of the disproportionally high exposure of The United Labs to antibiotics and Shineway to EDL sales. We believe the retreat of The United Labs shares has created a good buying opportunity, while Shineway no longer looks over-valued at current levels. On the other hand, Mindray shares and Sinopharm shares have not suffered as much for good reasons. They are industry leaders, shouldering the tough macro environment well and thus deserve premium pricing, in our view. We have summarized individual stock views below.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

Table 3: Stock performance and drivers

sean.wu@jpmorgan.com Table 3: Stock performance and drivers Company Ticker % off 52-wk high What’s in the

Company

Ticker

% off 52-wk high

What’s in the price

Potential recovery drivers

     

Very large EDL exposure;

 

CHINA

SHINEWAY

Qing Kai Ling Sales affected greatly;

EDL exposure may be over-estimated;

2877

HK

-61.9%

the company lost EDL tendering in multiple provinces;

GM to go down further

non-injections perform really well and may pick up the slack

   

CONCORD

CCM US

-57.0%

Continued doubt with business model;

Diversifying into hospitals;

MEDICAL

overall bad performance by China ADRs

Financial performance may get better recognition

       

Stent price cut may be less than expected;

Stent price cut overhang;

Nano should not take away too much market share yet

Firehawk success would fundamentally change MicroPort

MICROPORT

SCIENTIFIC

853

HK

-45.8%

Lepu’s Nano may take away a large trunk of market share

MINDRAY

MEDICAL

MR US

-21.2%

overall business slowdown, particularly China business;

China business rebounding and may show continuing strength in 3Q, 4Q earnings;

Unimpressive new product launch

New products may show progress

     

Stent price cut pressure;

Weigao may find a reputable partner for dialysis center business;

SHANDONG

1066

HK

-27.3%

Doubt with dialysis business take-off;

WEIGAO

 

Doubt with super-strong growth sustainable?

Good deal terms with JW Medical divesture

Valuation very high

Unabated growth momentum

     

Sales slowdown of Kelinao/Anjieli;

 

SIHUAN

460

HK

-49.0%

CCV price cut;

Too many acquisitions too quickly

Oudimei appears to be taking over from Kelinao as key driver;

Dupromise acquisition works fine so far;

CCV price cut better than expected

       

Sales have shown continued strength;

SINO

BIOPHARMACEU

TICAL

1177

HK

-32.5%

Continued SG&A deleveraging;

sales may slow down;

Management focus or lack of it

Expenses being controlled better;

Good acquisitions may complement growth;

Strong performance by new products

       

Relative resistant to EDL drug price cut;

Price cut may affect gross margin;

Business tied to overall sales but not any particular drugs;

SINOPHARM

1099

HK

-38.8%

Integration may be more difficult than expected;

Competition for acquisitions may be getting fierce

 

Organic growth under-estimated

Sales continue being strong with solid organic growth complemented with acquisitions;

Positions best with widest network and experience for acquisitions

       

May be able to handle price cut better with individual pricing for some antibiotics in place;

UNITED

LABORATORIES

3933

HK

-63.4%

Antibiotics price cut + restriction of use;

Doubt with Insulin uptake;

Price cut of antibiotics on bulk medicine businesses

Use of its main antibiotics products unrestricted

 

so sales impact may be less than market expectations;

Improved enzyme-method for Amoxicillin bulk medicine production may improve profitability

Source: J.P. Morgan; All prices are as of close of October 14 for HK-listed stocks and Oct.13 close for US-listed stocks

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Price Performance 4.0 3.5 HK$ 3.0 2.5 2.0 Sep-10

Price Performance

4.0 3.5 HK$ 3.0 2.5 2.0 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 1177.HK share price (HK$
4.0
3.5
HK$
3.0
2.5
2.0
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
1177.HK share price (HK$
HSCEI (rebased)
YTD
1M
3M
12M
Absolute (%)
-27.3
-12.5
-14.3
-34.2
Relative (%)
3.9
2.7
15.7
-5.1
Source: Bloomberg.

OW, PT – HK$3.5, 27.6x 2012E EPS

Key drivers: sales of new products;

Tide listing

Price Performance

35 HK$ 25 15 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 1099.HK share price (HK$ HSCEI (rebased)
35
HK$
25
15
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
1099.HK share price (HK$
HSCEI (rebased)
YTD
1M
3M
12M
Absolute (%)
-27.7
4.7
-22.7
-37.9
Relative (%)
3.5
19.9
7.3
-8.8
Source: Bloomberg.

OW, PT – HK$30, 32.0x 2012e EPS Key drivers: SG&A leveraging; M&A

Sino Biopharmaceutical – 1177 HK: We believe Sino Biopharma is among the best

all-around Chinese pharmaceutical companies, as it features a balanced portfolio

with 14 or more blockbuster drugs by next year. It operates an unrivaled hepatitis

franchise with 20% market share, and its CCV franchise is among the strongest with

75% of market share of alprostidil, a top-5 drug in China. SBP boasts an enviable

track record of M&A and integration successes and is poised to make additional

acquisitions, which, combined with its industry-leading R&D pipeline, should

sustain SBP’s strong top-line growth well into the future. While many investors dislike SBP’s holding-company structure and its involvement in apparently non-core business, SBP is a rare HKeX Main Board listed firm that reports quarterly results and pays a quarterly dividend, which we believe provides visibility and reduces investment risk. We reiterate OW rating and believe it should be a core holding for investors seeking investment opportunities in the booming healthcare industry.

Sino Biopharma shares have dropped by 14% in past three months, but have managed to outperform Hang Seng China Enterprise Index by 16%. The stock is currently trading at 17.4x 2012E EPS. We believe that the stock’s decline may have been due to the investors’ concerns about continued SG&A deleveraging and apprehension about management’s lack of focus. We believe Sino Biopharma shares will perform when the market recovers, as the company has shown continued strength with its products sales, apparently shouldering price cuts better than most competitors. We are pleased with the company's expense controlling efforts as shown in 1H11 results. The key drivers for the company going forward are: 1) Good acquisitions to complement growth; and 2) Strong performance by new products.

Sinopharm – 1099 HK: Sinopharm is the largest medical product distributor that

operates the widest network covering 159 prefecture-level cities in 30 provinces,

positioning the company in the best place for further consolidation of the distribution

industry. Although sales growth will eventually slow down, as acquisitions result in

business canalization, we believe this is a ‘consolidation first, leveraging second’

story. Leveraging would eventually materialize after Sinopharm builds up sufficient

scale and network reach. We believe the recent pull back in the stock has established

a very attractive buying opportunity. Sinopharm is among our three top picks in the

healthcare space.

Sinopharm shares have dropped by 23% over the past three months but have managed to outperform the Hang Seng China Enterprise Index by 7%. The stock is currently trading at 21x 2012E EPS. We believe the stock’s decline may have been due to the investors’ concern about the impact of EDL and NDRL drug price cuts on the company's sales and margins. In addition, investors might have become more pessimistic about the company's ability to extract SG&A leverage with the new acquisitions. Finally, investors may start discounting Sinopharm's scarcity value post-IPO of Shanghai Pharmaceutical. We believe Sinopharm shares will perform well when the market recovers and re-rating of healthcare stocks starts. First, 1H11 results highlighted Sinopharm’s ability to continue performing even under today's tough macro-environment, with its 48% Y/Y growth in total revenue apparently reassuring investors and driving the stock to outperform the HSCEI index by 20% in the last month. The company has been able to deal with price cuts by shifting product mix and sales mix towards more direct sales to hospitals. We believe investors will eventually appreciate that the company is well-positioned to leverage its nationwide distribution network for additional businesses and acquisitions. The key drivers for the company going forward are: 1) M&A success; 2) receding price

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com pressures; and 3) financial results showing SG&A

pressures; and 3) financial results showing SG&A leveraging and finance cost in control.

Price Performance 34 30 $ 26 22 18 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 MR share
Price Performance
34
30
$
26
22
18
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
MR share price ($)
HSCEI (rebased)
YTD
1M
3M
12M
Absolute (%)
-6.7
-2.0
-8.0
-20.8
Relative (%)
16.1
-0.3
12.3
5.5
Source: Bloomberg.

OW, PT – US$32, 19x 2012e EPS Key drivers: Continued China sales strength; M&A; and new product launch

Price Performance 25 HK$ 15 5 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 2877.HK share price (HK$
Price Performance
25
HK$
15
5
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
2877.HK share price (HK$
HSI (rebased)
YTD
1M
3M
12M
Absolute (%)
-56.8
-6.8
-35.7
-61.1
Relative (%)
-33.7
4.1
-13.6
-37.4
Source: Bloomberg.

UW, PT – HK$12, 11.6x 2012e EPS Key drivers: EDL price pressure; NDRC policy of unified pricing

Mindray Medical: Mindray is a leading global medical equipment company with

deep roots in China and deriving more than half of its revenue abroad. The key

products include patient monitors and life-support systems, in-vitro diagnostic

products and medical imaging. While we are forecasting only a modest EPS CAGR

of 14% for next 3 years (2011- 2013), we still believe the stock price (15.5x 2012E

EPS) is undervalued. We think Mindray, as a predominant market leader in China,

deserves a premium valuation. The company’s diversified product mix and balanced

sales contribution from China and ex-China greatly reduce investment risks. Its strong R&D capabilities and wide sales network should sustain the company’s growth for many years to come, in our view.

Mindray shares, while down 21 % from 52-week high, have performed relatively well over the past three months and managed to post a gain of 12.3% relative to Hang Seng Mainland Enterprise Index. Mindray shares have underperformed the overall China healthcare sector in past couple years as investors appear to view Mindray more and more like a global medical equipment company with its days of year-after-year strong sales growth behind it. Instead of being a China company with strong sales growth momentum, Mindray's China sales actually dragged down the company's growth in the past couple of years. However, we do see value in Mindray as a global player hailing from China. The company still maintains a cost advantage against most MNCs and its R&D capabilities, brand recognition and quality perception are second to none among domestic medical equipment makers. We see continued strengthening of China business and the launch of new products as key drivers for share performance.

China Shineway 2877 HK: Shineway is the largest TCM injection and soft-capsule

modernized Chinese medicine manufacturer, in terms of both sales volume and

production capacity. The company has more than 15 years of experience in the

production of TCM injection – a relative new development in the TCM field. TCM

injections have been controversial and many people do not believe in the safety of

TCM injections. However, the Chinese government has been very supportive of the

development of TCM injections as a way to lower drug costs, while fostering

modernization of TCMs, a national pride. The company's two leading TCM injections, Shineway-branded Qing Kai Ling and Shenmai injections are among the best-known TCM injections and have occupied the No.1 and No.2 market positions in their respective categories. Shineway enjoys much higher gross margins than its peers, who are engaged in producing common generics.

Shineway shares have traded down by 61% in the past 12 months and dropped by more than one third in the past three months. We think the dramatic retreat of Shineway shares was mainly due to the company’s disproportionally high exposure to EDL price cuts. In 2010, the two injection products included in the EDL, Shenmai injection and Qing Kai Ling injection, roughly accounted for 50% of the company’s total sales. The initial enthusiasm about having two drugs on the EDL has been replaced with a nightmare of relentless price cuts. Furthermore, Shineway has lost EDL tendering in several major provinces, where they may only supply drugs through non-tender channels. We do not see EDL pain to cease anytime soon, and hence investors should look elsewhere within the healthcare space for better values

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com without overhangs of price cuts of key products and

without overhangs of price cuts of key products and continued weak financial performance for some time.

Price Performance 9 7 $ 5 3 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 CCM share price
Price Performance
9
7
$
5
3
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
CCM share price ($)
S&P500 (rebased)
YTD
1M
3M
12M
Absolute (%)
-58.8
-16.8
-28.1
-56.0
Relative (%)
-45.2
-10.4
-10.2
-52.7

Source: Bloomberg.

OW, PT – US$6.4, 14x 2012e EPS Key drivers: Closing of Chang’an Hospital acquisition; Strong quarterly results; and M&A deal for centers

Price Performance 9 7 HK$ 5 3 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 0853.HK share price
Price Performance
9
7
HK$
5
3
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
0853.HK share price (HK$
HSCEI (rebased)
YTD
1M
3M
12M
Absolute (%)
-48.8
-0.5
-22.2
-53.3
Relative (%)
-17.0
14.7
7.8%
-24.2

Source: Bloomberg.

N, PT – HK$5.5, 19x 2012e EPS Key drivers: Firehawk clinical progress; stent price cut; ramp up of ortho business

Concord Medical Services – CCM US: Concord is the largest operator of third-

party radiotherapy and diagnostic imaging centers in China with approximately 20%

market share. Concord has developed beneficial relationships with partner hospitals.

As of June 30, 2011, Concord operated 125 centers across 46 major cities in China.

The company’s network centers employ hundred of surgeons and medical staff, who

can learn from each other by attending semi-annual conference, and surgeons can

compare notes with treatment options for difficult cases, for which Concord is

maintaining a database. Concord's network of centers also offer training for staff to be placed in new centers, facilitating the ramp-up of new centers. The company has been moving aggressively into the private hospital services space. In January 2011, Concord announced that it was acquiring 52% interest of the entire Chang’an

Hospital, which has 1,100 beds. Although the deal has faced delays, it should close by the year-end of 2011. Separately, Concord has entered into a 70:30 JV agreement with the Oncology Hospital of Zhongshan Medical University to establish a 400-bed specialty hospital in Guangzhou for cancer diagnosis and treatment. The JV hospital is expected to open to treat patients in 2013. Concord is developing an independent Proton Beam therapy center with a partner that is slated for opening in 2012-2013. As the government opens up hospital services for private investment, we believe Concord is moving into a very lucrative space, whereby it can serve well-off patients and enjoy more leeway with flexible pricing for high-end services

Concord shares have declined 58.8% since the beginning of this year and 28% in the past three months. We believe the continued weakness of CCM shares mainly reflects: 1) accounting scandals associated with US-listed Chinese companies in general; and 2) continued doubts by the US investors on the sustainability of Concord’s lease-and-management business model. We view the first reason as unfair and the second largely misplaced. After all, Concord’s financials are audited by E&Y professionals, directly supervised by the regional practice head. Most of Concord’s centers are quite profitable and its longstanding relationship (6 centers) with the reputable Navy General Hospital in Beijing validates the demand for third-party radiotherapy and diagnostic centers. Although we do not see many major catalysts in the near term that will drive tremendous upside, we believe trading at 7.2x 2011E EPADS and 5.8x 2012E EPS, Concord shares are certainly undervalued in light of the company’s growth potential. Low liquidity notwithstanding, we think this company offers a good opportunity for investors participate in the tremendous growth potential of China private hospital space.

MicroPort Scientific – 853 HK: Unlike other healthcare markets, the stent market is

dominated by three domestic players, MicroPort, Lepu, and JW Medical, a joint venture of Shandong Weigao and Biosensor of Singapore. MicroPort pioneered the

market in China and has been industry leader for several years. Even after strong

growth in the past few years, the PCI penetration rate is still low, leaving further

room for continued growth ahead. We expect MicroPort to maintain its current

leadership position (29% share in 2009) for a few more years, while staking its future on the success of its Firehawk stents in clinical trials, which may enable it to launch a high-end stent competing with MNC stents for the global markets. Meanwhile, MicroPort is diversifying into orthopedic market, diabetic infusion pumps, and cardiac ablation catheters. The success of other business segments may relieve MicroPort’s over-reliance on a single stent product (Firebird II) as of now.

11

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Over the past twelve months, MicroPort declined by 53%,

Over the past twelve months, MicroPort declined by 53%, underperforming the HSCEI index by 24%. The stock was down by 22% over the past three months along with the market and other healthcare names. We believe some level of pullback in MicroPort shares is understandable given its sky-high valuation attached to the company based on investor enthusiasm about a potential Shandong Weigao because both are strong players in the stent space. However, the severity of the pullback has surprised us. We think there are some key concerns about MicroPort, including: 1) the looming price cuts of stents; 2) the competition of Lepu’s Nano™ stent against Firebird II; and 3) MNC competition pressure. However, we recommend investors stay on the sideline, and wait for more clarity on the level of stent price cuts. We also see risks with the company’s efforts to diversify away from its core competence area. On the other hand, we see tremendous upside in MicroPort shares if the clinical trials of Firehawk are successful.

Price Performance 6.5 5.5 HK$ 4.5 3.5 2.5 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 0460.HK share
Price Performance
6.5
5.5
HK$
4.5
3.5
2.5
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
0460.HK share price (HK$
HSCEI (rebased)
YTD
1M
3M
12M
Absolute (%)
-53.7
0.8
-27.3
-42.8
Relative (%)
-22.5
16.0
2.7
-13.7

Source: Bloomberg.

OW, PT – HK$4.9, 21x 2012E EPS Key drivers: Rebounding of Kelinao/Anjieli business; Continued strength of Oudimei.

Sihuan Pharmaceutical – 460 HK: Sihuan is a leading provider of cardio-cerebral

drugs used in major hospitals for the emergency treatment of strokes and other

cardio-cerebral diseases. Sihuan has ranked No.1 for CCV sales since 2007, featuring

Kelinao as the best-selling drug among all products procured by hospitals. The

acquisition of Dupromise boosted Sihuan's market share to 9% for 1H11, as

compared with 7.8% for 1H10. Sihuan’s portfolio features products for three out of

five most-frequently prescribed CCV molecules in China. With low market share for

edaravone and GM1, Sihuan is poised to grab more significant market shares for

those products. Although we are concerned about a growth slowdown in

Kelinao/Anjieli, given the poor 1H11 results, we are encouraged by the initial sales

performance of Oudimei. The strong performance was substantiated by the hospital

purchases data compiled by IMS. We expect Sihuan to maintain its strong growth momentum as we see potential for sales recovery of Kelinao and Anjieli. Our Dec12 price target is HK$4.9.

Sihuan shares debuted on the Hong Kong stock exchange last October at HK$4.60. Since reaching the post-IPO high of HK$6.19, the price has been cut by an half, and the shares are currently trading at less than 12.7x our 2012E EPS. This is probably uncalled for, in our view, in light of its historically strong financial performance, its leadership position in cardio-cerebral medicine and the ability to develop related new products to boost growth better than most peers and its growth potential. We think the weakness in Sihuan shares are probably caused by three factors: 1) slowdown of Kelinao/Anjieli sales; 2) potential price cuts for CCV drugs; and 3) concerns about the absorption of all these new acquisitions post-IPO. We believe Sihuan’s shares are likely to rebound as: 1) Oudimei appears to have the potential to take over Kelinao as the key driver for continued growth; 2) Kelinao and Anjieli’s sales are likely to rebound after the removal of reimbursement restrictions; and 3) the new acquisitions appear to be complementary to the company's business and will drive future growth.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Price Performance 13 11 HK$ 9 7 Sep-10 Dec-10 Mar-11
Price Performance 13 11 HK$ 9 7 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 1066.HK share price
Price Performance
13
11
HK$
9
7
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
1066.HK share price (HK$
MSCI-Cnx (rebased)
YTD
1M
3M
12M
Absolute (%)
-23.7
-7.5
-25.6
-21.2
Relative (%)
2.2
6.0
-2.9
3.9
Source: Bloomberg.

OW, PT – HK$11.5, 33x 2012e EPS Key drivers: rollout of pilot dialysis centers; favorable terms for JW Medical divesture; unabated growth momentum

Shandong Weigao – 1066 HK: Over the years, Weigao has built up a vast sales and

distribution network that is critical for the success as a medical consumable

company. While Becton-Dickinson, Weigao’s main MNC competitor for high-end

consumables, relies on distributors for product sales, Weigao uses its own sales

force, and hence it gains more control of end-user hospital market. Weigao’s

products usually enjoy a price premium versus its domestic peers and they are

positively perceived by large hospitals that evaluate medical products on both price

and quality. Compared to the medical equipment makers, whose products generally have a replacement cycle lasting several years that may be prolonged under tough economic conditions, Weigao’s products are mostly disposable consumables that patients rely on daily and are largely non-discretionary, which we view as a distinct advantage with Weigao’s business model. Weigao’s stock has been trading at a very hefty forward PE of 30-40x for quite long. However, one can hardly find any large Chinese healthcare companies growing their sales 30-40% year after year for so long. Hence, we believe as long as Weigao can keep such robust pace of growth, its shares will continue to trade at a premium.

Weigao’s stock has traded down 24% year-to-date and down 25.6% in the past three months. While the CFO announced the resignation during the company’s 1H11 earnings call, we do not think it was anything related to the financials or the stock performance. We think the weakness may have been caused by the following four factors: 1) pressure from stent price-cuts; 2) doubts about the take-off of the dialysis business; 3) doubts about the sustaining power of the company’s hyper-strong growth enjoyed for the past few years; and 4) high valuation. Even after the pullback, Weigao’s shares are still trading at 25x 2012E EPS, which might not look cheap. However, if investors believe that Weigao can continue to grow as strongly as it has done in previous years, we think the recent pullback of Weigao shares actually offers an opportunity for the investors to add to their existing positions or to establish new positions. Some key catalysts that could drive Weigao’s share performance include:

1) successful rollout of pilot dialysis centers; 2) favorable terms for JW Medical divestures; and 3) strong quarterly earnings results.

Price Performance 20 16 HK$ 12 8 4 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 3933.HK share
Price Performance
20
16
HK$
12
8
4
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
3933.HK share price (HK$
HSI (rebased)
YTD
1M
3M
12M
Absolute (%)
-64.3
-20.1
-45.9
-64.8
Relative (%)
-39.9
-9.0
-24.9
-42.7
Source: Bloomberg.

N, PT – HK$7.5, 11.9x 2012E EPS Key drivers: 6-APA price: recovery of bulk medicine business; sales ramp up of insulin products

The United Laboratories – 3933 HK: We continue to like The United Laboratories

(TUL) for its strong antibiotics franchise that features well-established brand names.

The company’s low-cost 6-APA facility in Mongolia has a distinct competitive edge.

Its enzyme process for amoxicillin production is likely to expand segment margins

for the bulk medicines. Nevertheless, we believe TUL shares will continue being

under pressure as the market digests the full impact of antibiotics price cuts and

restriction of use on the company’s short term financial performance. Hence, we rate

TUL at Neutral.

TUL shares have fallen by 64% year-to-date and 46% in 3Q11, making them by far the worst performer among our coverage space. There is no question that TUL is facing some difficulties specific to the company and the company has reported 1H11 results, with segmental profits declining across all the three business segments. We believe the recent decline in TUL shares has been due to the concerns about the restrictions on antibiotics use on top of the price cuts in antibiotics. Management may have worked too hard on curbing investor enthusiasm on the market potential and sales ramp-up of insulin products. In addition to 6-APA average selling price trend, key drivers for TUL include: 1) the sales performance of antibiotics in face of price cuts and restriction of use; 2) sales ramp up of insulin products; and 3) the impact of enzyme process on the profitability of bulk medicines businesses.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Table 4: Summary of Changes to Our EPS Estimates, Ratings,

Table 4: Summary of Changes to Our EPS Estimates, Ratings, and 12-month Price Targets for Companies Under coverage

   

Rating

 

Price Target

 

2011E EPS

 

2012E EPS

Company Name

Code

New

Prior

New

Prior

Change

New

Prior

Change

New

Prior

Change

CHINA SHINEWAY

2877

HK

UW

UW

HK$12.0

HK$22.0

-45.5%

0.922

0.967

-4.6%

0.863

1.046

-17.5%

CONCORD MEDICAL (OW)*

CCM US

OW

OW

US$6.4

US$7.0

-8.6%

0.51

0.46

-10.8%

0.68

0.56

-17.8%

MICROPORT SCIENTIFIC

853

HK

N

OW

HK$5.5

HK$7.2

-23.6%

0.206

0.193

6.8%

0.245

0.242

1.3%

MINDRAY MEDICAL

MR US

OW

OW

US$32.0

US$40.0

-20.0%

1.63

1.62

0.7%

1.86

1.88

-1.2%

SHANDONG WEIGAO

1066

HK

OW

OW

HK$12.0

HK$15.0

-20.0%

0.215

0.251

-14.4%

0.287

0.336

-14.7%

SIHUAN

460

HK

OW

OW

HK$4.9

HK$7.4

-33.8%

0.158

0.167

-5.1%

0.198

0.214

-7.6%

SINO BIOPHARMACEUTICAL

1177

HK

OW

OW

HK$3.5

HK$3.6

-2.8%

0.110

0.114

-2.9%

0.127

0.134

-5.0%

SINOPHARM

1099

HK

OW

OW

HK$30.0

HK$35.0

-14.3%

0.635

0.803

-20.9%

0.774

1.157

-33.1%

UNITED LABORATORIES

3933

HK

N

OW

HK$7.5

HK$22.0

-65.9%

0.416

0.961

-56.7%

0.630

1.411

-55.4%

Source: Bloomberg, J.P. Morgan estimates.

Valuation Analysis and Price Targets

DCF - our primary valuation methodology We have derived our Dec-12 price targets for our covered companies mostly based on discounted cash flow (DCF) analysis of our base-case financial projections for the individual company. For all our DCF analyses, we generally assume a market risk premium of 6.0% and a risk-free rate of 4.2% (common yield on 10-year government notes in China). The beta values are based on Bloomberg adjusted beta figures calibrated by our own assessments of the reliability of cash flow forecasts. We derive cost of equity according to the capital asset pricing model (CAPM). The weighted cost of capital (WACC) is calculated based on the debt to capital ratio, cost of equity and interest rate of debt. We estimate free cash flow until 2015 and assume a terminal growth rate of 3-6%, based on the annual growth rate expected in 2015 and the nature of the healthcare subsector.

P/E Valuation – mainly used as a sanity check Although we believe each company has its own intrinsic value as determined by properly structured DCF analysis, the stock of a company must also be evaluated in the context of its peers. We routinely compare P/E as if the price target is achieved to see how the company would be traded compared to peers to assess the likelihood of achievement of the PT.

Risks to our price target We routinely perform sensitivity analysis of our price target based on different assumptions of terminal growth rate and WACC, two of the most subjective factors affecting valuations, in our opinion. Although we are trying to determine the price target with about one-year horizon, we see long-term prospects to have different impact on short-term performances and hence, we also test our price target versus multiple negative or positive surprises that may affect the price targets.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Healthcare – a major pillar industry Fundamentals driving

Healthcare – a major pillar industry

Fundamentals driving industry growth to remain intact

Despite the recent negative macro headwinds, we believe the secular growth story of the China healthcare industry remains in place. In China, healthcare expenditure is just less than 5% of the GDP compared with over 10% for many developed nations. In recent years, there have been debates in both China and the US about healthcare spending and reforms. In the US, the reforms intend to curb excessive healthcare spending that accounts for ~16% of the GDP, while in China, the new Healthcare Reform aims to increase healthcare spending as a proportion of GDP and allocate resources more optimally. The Chinese are demanding the government to increase healthcare spending and pay for a higher percentage of their healthcare costs. We expect the government to continue to invest heavily in building up healthcare infrastructure and subsidize the expansion of healthcare insurance coverage to eventually get all Chinese citizens covered by some form of health insurance by 2020. In addition, with the rising disposable income, the Chinese are becoming more health-conscious and willing to spend out-of-pocket money even to treat minor illnesses. Finally, the population is fast aging and consequently cancer, chronic illnesses, Alzheimer’s, and other aging-related illnesses are become more prevalent.

Figure 3: Chinese have consistently under-spent on healthcare, while the economy has been growing at an unprecedented pace

20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 - % GDP (1980) %
20.0
18.0
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
-
% GDP (1980)
% GDP (1990)
% GDP (2000)
% GDP (2009)

Source: OECD, Chinese government websites.

Although the healthcare stocks have undergone a painful de-rating this year due to all kinds of negative headlines, we think that all the underlying fundamentals that drove the healthcare industry growth of ~18% for the past six years remain intact. We believe that the sheer size of the population and the propensity of Chinese to take care of their elders could offer ample opportunities for the healthcare industry to continue its huge growth in the next 10-15 years. Hence, while we are cautious in the short term, especially on drug companies, we remain extremely positive on the long term prospects of the industry.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Healthcare names under-represented in the public market

Healthcare names under-represented in the public market Healthcare in aggregate is one of the largest sectors in the U.S. economy and its aggregate market capitalization is approximately 10% of the entire stock market capitalization. In contrast, China does not have any healthcare stock with a market cap of over US$10bn and the total market capitalization of all public-traded healthcare companies is about 4.2% of all the listed companies, as per Bloomberg estimates. Post-healthcare reform, we believe that many strong companies will emerge that will be attractive to investors. Companies with strong R&D capabilities and sales network should be long-term winners, in our view. We expect healthcare companies as an aggregate will eventually account for more and more of the Chinese market capitalization, and take their rightful place in the market, given their importance to the economy as a whole, i.e. healthcare spending will eventually account for ~10% of the GDP by 2020.

Table 5: Chinese under-capitalized healthcare companies compared with global peers

# of Public Companies

HC Market Cap ($bn)

Average Market

Cap ($mn)

Total Market

Cap ($bn)

HC % of Total

China

238

4,790.0

840.3

200.0

4.2%

US

1,001

14,770.0

1,468.5

1,470.0

10.0%

India

189

1,210.0

305.2

57.7

4.8%

Japan

148

3,670.0

1,526.3

225.9

6.2%

UK

97

2,510.0

1,824.9

177.0

7.1%

Source: Bloomberg; Priced on Sep.23, 2011

Low spending per-capita drives superior growth As Table 6 shows, the spending per-capita on healthcare in China is less than 2% of that in the US in 2006, according to the World Health Organization. The growth rate is nearly double that of most countries, but we note that even at this growth rate, the spending per-capita would still be well below 5% of that in the US by 2015.

Table 6: Low per-capita healthcare spending even after growing the fastest among select peers

Total in 2006 (US$bn)

Per Capita ($)

2001

Per Capita ($)

2006

01-06 CAGR (%)

China

121.5

50.0

92.0

13.0

Spain

105.2

1,596.0

2,387.0

8.4

Japan

355.0

2,609.0

2,626.0

0.1

Italy

175.0

2,358.0

3,002.0

4.9

UK

215.0

2,478.0

3,552.0

7.5

Canada

123.9

2,853.0

3,799.0

5.9

Germany

318.0

3,537.0

3,870.0

1.8

France

262.0

3,227.0

4,278.0

5.8

US

2,010.0

4,915.0

6,714.0

6.4

Source: WHO.

More prosperity to accelerate healthcare spending – rising income leading to heightened health awareness Along with GDP growth, disposable income of Chinese has also been rising very fast in recent years. Consumers have raised their awareness of public health, increasing focus on disease prevention, general wellness, and the early diagnosis of medical conditions. According to the China Statistical Yearbook, from 2000 to 2007, average spending on healthcare and medical services increased from approximately 6.4% to 7.0% of household expenditure for urban households and from approximately 6.8% to 7.6% for rural households. This in part reflects growing health awareness in the

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com PRC. The substantial growth in disposable income of urban

PRC. The substantial growth in disposable income of urban residents combined with the increase of awareness of public health and focus on disease prevention and general wellness would lead to greater demand for pharmaceuticals and healthcare- related products.

Figure 4: Rising disposal income propelling out-of-pocket spending on healthcare

30000 40% 30% 20000 20% 10000 10% 0 0% -10% -10000 -20% -20000 -30% -30000
30000
40%
30%
20000
20%
10000
10%
0
0%
-10%
-10000
-20%
-20000
-30%
-30000
-40%
GDP per Capita (Rmb)
Per Capita
Real GDP
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008

Source: Statistics Bureau; J.P. Morgan estimates.

We believe the rising prosperity of China should accelerate the spending on healthcare, especially in rural areas. Since 2000, the annual growth in total healthcare expenditure in China is approximately 15%, which is higher than the rate of GDP growth but well below some of the growth rates in other sectors, such as investment in infrastructure and power. We believe the government has refocused on providing better healthcare services to the people and the next stage of growth would be driven by spending on rural healthcare. Currently, the healthcare spending per-capita in rural areas is only 23% of that for urban residences (MOH).

Figure 5: Healthcare spending rising but staying relative stable and low as a percentage of
Figure 5: Healthcare spending rising but staying relative stable and low as a percentage of GDP
1,980.0
Healthcare Spending
% of GDP
Y/Y Growth
1,900.0
1,700.0
1,611.9
1,453.5
1,500.0
1,300.0
1,157.4
1,100.0
984.3
866.0
900.0
759.0
658.4
700.0
579.0
458.7 502.6
500.0
319.7 367.9 404.8
300.0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

Source: CEIC, MOH, and other Government Websites

35%

30%

25%

20%

15%

10%

5%

0%

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Figure 6: Rural versus city spending (Rmb ‘bn) suggests

Figure 6: Rural versus city spending (Rmb ‘bn) suggests considerable room to grow as Rural Co-op insurance takes off

1200 1000 800 600 400 200 0 1990 1995 2000 2001 2002 2003 2004 2005
1200
1000
800
600
400
200
0
1990
1995
2000
2001
2002
2003
2004
2005
2006
2007
City
Rural

Source: Ministry of Health

Population continues to age, regardless of government policies The latest data from the China National Committee on Aging shows that the number of people over 60 years reached 167mn or 12.5% of the total population in 2009, with rapid Y/Y growth of 4.5%, the highest during the past four years. According to a UN projection, by 2050, over 400 million or nearly 33% of Chinese population will be over 60 years of age. Population aging is clearly the direct result of government’s one-child policy, but it is also the result of people living longer life. Unfortunately, people who live longer tend to also see more illness. For example, cancer and Alzheimer’s diseases are not the diseases of the young. More and more elderly are also developing chronic diseases, such as hypertension and diabetes because of lifestyle changes. With more people getting older and living longer, the demand for healthcare services will increase tremendously along the way. Since the Chinese have the propensity to take care of the elderly people and many people feel morally compelled to spend as much as they can to keep their parents alive, this part of inelastic demand is expected to last well in the future. Currently, the elderly already consume more than half of all drugs sold in China. That share should clearly increase with the population ageing.

Figure 7: Life expectancy at birth for Chinese to double to 80

Figure 8: China's ageing population puts extra demand on healthcare

90.0

80.0

70.0

60.0

50.0

40.0

30.0

Life Expectancy at Birth Life Expectancy at Birth 1950-1955 1955-1960 1960-1965 1965-1970 1970-1975 1975-1980
Life Expectancy at Birth
Life Expectancy at Birth
1950-1955
1955-1960
1960-1965
1965-1970
1970-1975
1975-1980
1980-1985
1985-1990
1990-1995
1995-2000
2000-2005
2005-2010
2010-2015
2015-2020
2020-2025
2025-2030
2030-2035
2035-2040
2040-2045
2045-2050

Source: UN, 2009.

Source: United Nations.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Chronic diseases becoming epidemic in China – substantial

Chronic diseases becoming epidemic in China – substantial untapped market With the population aging and lifestyle changing to diets containing more fat and calories, chronic diseases have reached epidemic proportions. From 1993 to 2005, patients with ischemic stroke increased by 251.3%, cancer by 111.5%, hypertension 387.2%, diabetes 482.9%, and heart diseases 82.4%. Clearly, the burden for treating chronic diseases has clearly outpaced the growth of GDP. In the old days, the Chinese might have chosen to live with chronic diseases and pushed off treatment as late as possible. Nowadays, as they become more health-conscious, many people are electing to get treatment. As there is normally no cure for chronic diseases and all that the doctors can do is slow down the disease progression, the treatment for chronic diseases is routinely long term and very costly. Manufacturers of medicines for chronic diseases stand to benefit greatly from these demographic changes. This is the reason why we like United Labs and Sino Biopharmaceutical particularly well. United Labs has the potential to be a prominent domestic supplier with its comprehensive portfolio of insulin products, which were launched recently to the market. Sino Biopharmaceutical is by far the most-dominant player in the lucrative hepatitis space. China has one-third of the world’s patients with chronic hepatitis B. patients, with hepatitis B patients routinely taking anti-viral products for more than one year daily to keep viral breakthrough under control.

Increased government portion of total healthcare expenditure a major force behind industry growth In the 1980s, the proportion of healthcare costs paid by the government or government-related entities (including insurance) was in excess of 80%. The government under-invested in the healthcare area in the early reform years, with individuals losing jobs from state-owned enterprises that provided full healthcare benefits and moving to private sectors that provided much-less generous healthcare coverage. By 2000, the individual contribution to healthcare spending reached a high of nearly 60%. In the following decades, the government looked to alleviate the burden of individuals and the payment from government sources and social spending increased to about 60% in 2008, with individuals still paying 40% of the cost of healthcare. The trend to greater government subsidies and insurance reimbursements should raise the affordability and the demand for healthcare in China. The main reasons are expanded health insurance coverage through three new public insurance schemes: 1) Urban Workers’ Medical Insurance Scheme launched in 1999; 2) the New Rural Cooperative Health Insurance Scheme launched in 2003; and 3) the Urban Residents Basic Medical Insurance launched in 2007. The Rural Cooperative Scheme offers insurance coverage for rural population for the first time and it is reimbursing patients up to 40% of out-patient services costs, including drugs. The Urban Resident Program ensures children, elderly, and college students to receive some form of insurance, with patients more generally reimbursed by the governments than the rural program. By year 2020, the government aims to have universal coverage of all its population. We believe that, with more government subsidies to the rural and urban resident schemes, many more people will elect to purchase insurances and opt to receive treatment for diseases people use to tolerate or even die of. This fundamental driver behind industry growth is clearly unperturbed by the recent negative macro headwinds.

Sean Wu (852) 2800-8538 Asia Pacific Equity Research 15 October 2011 sean.wu@jpmorgan.com Figure 9: Personal
Sean Wu
(852) 2800-8538
Asia Pacific Equity Research
15 October 2011
sean.wu@jpmorgan.com
Figure 9: Personal contribution to healthcare spending declining - still quite a lion's share
100%
80%
588
510
407
452
485
271
301
334
368
60%
507
40%
389
223
259
321
117 121
154
179
20%
258
359
71 80
91
112
129
155
178
0%
2000
2001
2002
2003
2004
2005
2006
2007
2008
Government
Social
Personal

Source: Source: CEIC and J.P. Morgan estimates.

Figure 10: % of public spending on healthcare by Chinese government still below World average
Figure 10: % of public spending on healthcare by Chinese government still below World average
%
100.00
80.00
60.00
40.00
20.00
0.00
2001
2002
2003
2004
2005
2006
2007
2008
2009
World
China
India
Japan
United Kingdom
United States

Source: The World Bank.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Table 7: Three different insurance schemes dramatically to

Table 7: Three different insurance schemes dramatically to expand insurance coverage greatly

   

Basic Medical Insurance System

New Rural Cooperative Health Care System

Urban Residents' Basic Medical Insurance

Launch Date

 

1999

2003

2007

Qualified

       

Individuals

 

Urban workers

Rural residents

Urban non-workers (Students, elderly, etc)

Participation

 

Mandatory

Voluntary

 

Voluntary

   

2010: 237 mm (~100%)

2009: 833 mm (94%)

 

2010: 195 mn

900

800

800

700

600

500

400

Covered

300

Population

200

100

0

2005

2006

2007

2008

2009

2010

New Rural Cooperative Health Care SystemUrban Residents' Basic Medical Insurance

Urban Residents' Basic Medical Insurance

Urban Residents' Basic Medical Insurance

Basic Medical Insurance SystemCare System Urban Residents' Basic Medical Insurance Source: MOH, NDRC, and MOHRSS; Left axis shows people

Source: MOH, NDRC, and MOHRSS; Left axis shows people insured in millions

Coverage Plan

Basic medications, hospitalization, in-patient expenses

 

Hospitalization and in-patient expenses Maximum reimbursement rate: 75% Max: Rmb60,000 (depending on region)

 

Hospitalization and major illness

Premium payer

Employer: 6% of employee's salary & up to 4% of supplementary insurance Employee: 2% of salary

Central government: Rmb60/person/year Local government: Rmb60/person/year Individual: Rmb30/person/year (varies among different regions)

Individual contribution varies among children, elderly, handicapped, etc Government: Rmb120/person/year (varies among regions)

breakdown

Government

       

spending

2006: Rmb130 billion

2008: Cumulatively up to Rmb85mn

 

2007: Rmb7 billion

Key Ministries

Ministry of Human Resources & Social Security Ministry of finance Ministry of health SFDA

Department of Rural Health Management of Ministry of Health Ministry of Finance

Ministry of Human Resources & Social Security Ministry of Finance Ministry of Health, NDRC

Involved

Source: Chinese government websites.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com Healthcare Reform brings opportunities and challenges The

Healthcare Reform brings opportunities and challenges The government released the New Healthcare Reform plan and associated three-year execution plan in April 2009. It also appropriated Rmb850bn for the implementation of the plan for 2009-11, although it remains unclear whether the entire fund would be incremental to baseline spending or a mix of both. According to IMS estimates, the government spent about 98% of its budgeted Rmb850bn in the initial two years and would invest Rmb284bn more to implement the Reform. The Reform efforts intend to achieve five key goals to be accomplished by 2011:

1)

To further expand medical insurance coverage and to increase the

2)

medical insurance participation rate To set up a national essential drug system

3)

To establish an extensive public health system

4)

To provide equal public health services in both rural and urban

5)

areas To pilot the reform of state-owned hospitals

The No.1 goal is undoubtedly positive for the industry. The government subsidy for rural co-op insurance scheme has increased per head from Rmb40 to Rmb120 in 2011. Even with the government spending only a quarter of the Rmb850bn for expanding insurance coverage, Rmb200bn extra insurance will be largely spent on drug purchases, benefiting the drug distribution and manufacturing industries. The No. 3 goal clearly favors vaccine developers and medical equipment companies developing diagnostic machines. The No.4 goal involves building up local community health centers and rural medical facilities that are supposed to divert traffic away from large urban hospitals, which is clearly beneficial to the low-end medical equipment and consumable makers because those hospitals will need to be equipped with basic medical equipment and operate with daily consumable for patients. On the other hand, the build-up of local healthcare facilities appears to be detrimental to drugstore operators. As far as the No.5 goal is concerned, the reform of state-owned hospitals will take much longer time than three years and its impact should be minimal in the near term. The hospital reform may open the door to the establishment of more private hospitals and privatization of some hospitals, which could benefit medical service players, such as Concord Medical and Chindex (CHDX US, Not Rated).

Industry players initially had high expectations with the implementation of the EDL as they saw opportunities with vastly expanding sales volume to rural areas, the so- called third terminal. However, the EDL has turned out to be the most controversial part of the New Healthcare Reform and nightmarish for companies such as Shineway which depend heavily on sales of EDL drugs.

Anhui model – can we do away with the EDL? By way of reference, the EDL includes 307 most commonly used drugs deemed essential by the government, two-thirds chemical drugs and one-third TCMs. The Anhui-based tender model was developed and used in Anhui Province last year as a means of controlling the prices of essential drugs. On top of the 307 drugs listed on the national EDL, Anhui government added 277 drugs to the list and subjected them to provincial-level EDL tendering. All the hospitals and clinics below county-level stock only those EDL drugs. The bidders were asked to submit two envelopes – one showing adequate GMP certification and one showing the bid price. Under the Anhui system, those producers offering the lowest prices in a bidding contest were awarded contracts to manufacture the stipulated medicines, given that most of the bidders could fulfill the requirements of the other envelop in which a manufacturer submitted manufacture certificate. Otherwise, they would not be in the business. The Anhui model was highly controversial because of the large price cuts that resulted from the

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com tendering, with an average of 40% price cut. In addition,

tendering, with an average of 40% price cut. In addition, some reputable providers of EDL drugs, such as Shineway for Qing Kai Ling TCM injection, were completely shut out of Anhui EDL tendering, making their products unavailable to patients through the regular channels.

Some experts estimated that the prices offered by some small drug manufacturers were so low that they would not even cover the production costs. Hence, some experts have been openly concerned that many manufacturers may be compelled to supply low-quality products in order to be profitable. The widely reported (e.g. Xinhua News) manufacturing issues identified with low-price manufacturer, Shuzhong Pharmaceutical, which is based in Sichuan Province and has won many EDL bids in Anhui, appeared to confirm this concern. However, conversations with Anhui officials from the tender office indicate that they remain steadfast with their approach. Local government officials seeking to build political capital have copied the Anhui model to achieve the highest magnitude of price cuts. Even the wealthy Guangdong province’s EDL tendering was mostly modeled after the Anhui model.

Given the news flow surrounding the Anhui Model of EDL tendering and its potential adverse effects on drug quality (too low) and supply (shortage), many are now looking at the central government for remedy. It has been widely circulated (e.g. Yangcheng Evening News) that the NDRC may establish a unified pricing mechanism this year for the EDL drugs and the initial focus will be on 50 or so drugs provided each by a single manufacturer or drugs that have been in the market with established efficacies and stable prices over many years. It is stipulated that the bidders will compete mainly on qualities now that the prices are fixed. The questions remain on how one evaluates qualities, as unlike prices, they are quite subjective.

NDRL drug price cuts – yet more to come The implementation of the 2009 version of the NDRL is supposed to make drugs more affordable for patients, hence expanding the drug sales volume, as the list contains 14% more number of drugs than in the 2004 version with many popular drugs moving from Class-B to Class-A, which is reimbursable from 80-90%, with some completely reimbursable. However, it is almost inevitable that drugs will see price cuts if they are included in the NDRL as the government, the ultimate payer, seeks to control medical costs. In fact, the government has already cut prices twice this year, first for antibiotics and circulatory system drugs in February. It cut the prices of drugs for the hormonal/endocrine drugs in August 2011. For both batches, the price cuts were about 20%. Additional price cuts may be forthcoming for oncology drugs, CCV drugs, and other drugs. However, the timeline appears to be stretching further out. The cut in retail ceiling prices may not hit manufacturers directly if the prevailing tendering prices are well under the ceiling prices. Non-EDL drug tendering, which sets the hospital purchase prices, on the other hand, will almost certainly affect ex-manufacturing prices directly.

Fujian model – NDRL tendering causing fear among manufacturers The Fujian government is conducting tendering for non-EDL drugs included in the government’s provincial drug reimbursement list. As per the plan released by the Fujian government, the tendering will dramatically reduce the number of formulations that drug manufacturers can bid to 20. As a reference, for drug tenders conducted in 2010 in Henan, Hebei, Zhejiang, and Guangdong, there were 127, 75, 64, and 47 drug classes for manufacturers to bid on, respectively. In the Fujian model, a formulation category may not be further subdivided into categories, while this was allowed in other provinces. There may be only 2-3 winners for any quality class, which, combined with fewer categories to bid in, significantly lowers the number of winning companies. For example, cefaclor (头孢克洛) products are divided into four classes, according to the qualities of manufacturers to tender their bids: 1) Highest-

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

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(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com quality capsules – 1 bid and 1 winner; 2) Capsules,

quality capsules – 1 bid and 1 winner; 2) Capsules, 1 bid and 1 winner; 3) Capsules, tablets, tablets covered with thin film, and dispersible pills, all treated as group (oral) for bidding - 11 bidders, 3 potential winners; and 4) Same four formulations as 3), still one group, 4 bidders and 2 winners. There are potentially only seven winners, compared to 20 in Guangdong.

Table 8: Fujian Non-EDL Tender Cutting down Winning Bids Dramatically

 

Last

Formulation

Dosage

Quality

Potential

Total

tender

Categories

Forms

Classes

Winning Bids

Winning Bids

Henan

2010

127

2

4

2.5

2,540

Hebei

2010

75

2

4

2.5

1,500

Zhejiang

2010

64

2

4

2.5

1,280

Guangdong

2009

47

2

4

2.5

940

Fijian

2011

20

1

5

2.5

250

2009 NDRL

 

19

Source: Fujian Government; JP Morgan Estimates; * Numbers fro Dosage Forms, Quality Classes, and Potential Winning Bids are illustrations according to normal practice. For Fujian, no separation of dosage forms into different bidding categories.

Furthermore, the price difference among drugs in the same quality class cannot be more than 30%, and the winning bid price for lower-quality class cannot be any higher than the higher class, which makes certain drugs enjoying independent pricing power sure losers if the manufacturers of those drugs want to maintain premium prices in other provinces. While companies can complain about the quality/price trade-off for the Anhui model, we see no legitimate complaints about the Fujian model, especially for the aspects of limiting drug categories to 20. For the 2009 version of NDRL, only 19 formulations were listed. According to the estimates by some industry experts, more than 50% of tender winners that occupied top-100 ranks in term of sales in Guangdong province for 2010 may be completely shut out of the Fujian model. Previously, the Fujian government has also issued two-invoice rules for the sales of drugs in Fujian. The plan further stipulates that the markup between ex-manufacturing prices and hospital purchase prices can be only in the range of 5- 8%, effectively shutting down the indirect sales model that tenders to offer much higher channel markup than allowable range. We see high likelihood that Fujian model may be duplicated in other provinces in the future rounds of drug tendering. If the model is adopted widely, fewer companies will have a slice of the pie, which could potentially force out some weak players as there appears to be no recourse.

However, there might be some positives going forward. Sino Biopharma’s Runzhong is likely to win the Fujian tender, with Jiangsu CTTQ accepting a ~15% price cut, squeezing out Bristol Myers-Squibb, which owned an 80% market share in 2010, according to Sino Biopharmaceutical. Given the weak domestic competition, Sino Biopharma is likely to more than make up the price cuts with market-share gain in Fujian. Similar situations might exist for other drugs. Hence, MNCs may fare very poorly in the Fujian model of tendering.

Supply/Demand conundrum must be solved – companies will adapt Clearly, the drug industry is facing tremendous pressure from rounds of price cuts, with more to come. However, we would like to remind investors that the industry has faced similar pressure before and it is still standing strong. In fact, prior to recent rounds of NDRL price cuts, the government had conducted about 26 rounds of price adjustments, with only once involving upward price adjustments since 1994. Microeconomics dedicates that there is always a balance between demand and supply, which is determined by price. The government cannot continue cutting prices without affecting drug supply. When manufacturers realize that no profits can be made from producing certain products, they will stop producing them. In fact, one

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

(852) 2800-8538 15 October 2011 sean.wu@jpmorgan.com study found that, for 1,500 essential drugs defined by the

study found that, for 1,500 essential drugs defined by the SFDA previously, prior to the release of the new EDL, a third of them were not available in the Beijing market. Of the products not available in Beijing, about 30% were no longer even being produced. Herein lies the conundrum – pricing essential medicines too low may cause medicine shortages and force patients to choose more expensive alternatives, which would negate the purpose of setting low prices for essential medicines. In order to make the essential drugs available to its people, the government might be then forced to raise prices in order to attract domestic manufacturers or import drugs at even higher prices. It is a possibility that the NDRC may install uniform price nationwide for certain EDL drugs, as mentioned earlier, to prevent the running to bottom competitions that have provinces compete against each other to see who can cut EDL drug prices by the largest amount, which may cause quality problems or supply shortage. Other alternatives may also emerge, including a wider adoption of Shanghai Model, which values a balance between prices and qualities for EDL tendering, a distinct minority as of now.

In addition, if the government wants to achieve its goal to upgrade the healthcare industry to be more competitive globally, it will need China’s leading companies to generate decent profits in order to fund R&D for innovative product development. We think the current downturn could have the potential to rid the industry of weak players so that strong players with consolidated market positions might eventually emerge.

Finally, over the long term, companies can adapt to new pricing schemes with cost- structure changes. Manufacturers can improve cost efficiency by adopting new manufacturing processes or improving labor productivity. The government may also be able to keep costs down for manufacturers by implementing rigorous monitors of raw material costs, which sometimes may be subject to price gouging and offering subsidies for producing certain products.

Recent Guangdong drug price adjustments contained some good news, though it is not necessarily a trend The price bureau of Guangdong recently announced price adjustments for products included in the provincial drug reimbursement list that would be implemented on October 1. Although the adjustments included lowering retail ceiling prices for ampillicin and other drugs in Guangdong, so that they would be in line with the NDRC price cuts, the adjustments actually had some surprising price increases as well. For example, the retail ceiling prices for alprostadil and Cattle Encephalon Glycoside and Ignotin Injection (苷肌) will be raised by 15% and 35%, respectively. Given that Guangdong is among the largest drug market in China, we believe this should be good news for Sihuan, which sells both drugs, and Sino Biopharma, which holds the largest market share for alprostadil in China. Furthermore, this could be an indication that some rationality might be coming back in the government’s decision process regarding drug pricing.

Sean Wu

Asia Pacific Equity Research

(852) 2800-8538

15 October 2011

sean.wu@jpmorgan.com

Table 9: Asian Healthcare Comparison

sean.wu@jpmorgan.com Table 9: Asian Healthcare Comparison Company Name Code P r i c e MCAP Vol

Company Name

Code

Price

MCAP

Vol

1M

3M

YTD Chg

11e PE

12e

EPS CAGR

PEG

PEG

EV

EV/Sales

(TP)

US$MM

US$mn

Chg

Chg

(%)

(x)

PE (x)

(10_12e)

'11E

'12E

(US$mn)

('11E)

Covered Companies CHINA SHINEWAY (UW)* CONCORD MEDICAL (OW)* MICROPORT (N)* MINDRAY (OW)* SHANDONG WEIGAO (OW)* SIHUAN (OW)* SINO-BIOPHARM (OW)* SINOPHARM (OW)* UNITED LAB (N)* Average

2877 HK

10.3 (12)

1,098.7

5.2

4.1

(25.0)

(52.7)

9.2

9.8

-6.6%

(1.4)

(1.5)

1,090.4

3.1

CCM US

3.1 (6.4)

18.6

0.0

(5.3)

(24.7)

(56.8)

6.7

5.3

19.6%

0.3

0.3

20.9

2.3

853 HK

4.6 (5.5)

844.2

1.3

28.1

(6.7)

(38.2)

18.2

15.2

11.6%

1.6

1.3

974.1

2.5

MR US

24 (32)

2,811.9

11.3

(2.8)

(9.2)

(6.4)

16.7

14.5

12.9%

1.3

1.1

1,970.0

2.4

1066 HK

9.2 (12)

5,291.3

5.5

4.3

(16.4)

(16.2)

35.0

26.3

24.3%

1.4

1.1

5,175.0

10.1

460 HK

2.9 (4.9)

1,908.3

4.4

(3.3)

(14.0)

(47.5)

14.8

11.9

23.2%