2018 Healthcare Sector Outlook Nov 17, 2017 Equity Research | Healthcare Favorable structural changes to drive earnings growth in 2018 Natalie Chiu SFC CE No. AVH029 [email protected]+852 3760 2030 GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Sector view Positive The healthcare industry has seen sustained market growth, despite increased policy headwinds. Differentiation among players in each subsector is becoming increasingly significant. Prefer big pharma, TCM and CRO players over healthcare service providers. Key themes Healthcare sector lagging other cyclical sectors The sector has been seen as a laggard play vs cyclical stocks in 2017, gaining about 30% in 4Q17. The valuation gap with the MSCI China index is narrowing. We believe there is a good chance the sector will outperform in early 2018. China pharmaceutical end-market should see high single-digit growth in FY17 Amid industry transformation and a demand upgrade, the healthcare sector is likely to post steady growth for the 2016-20 period. More positives than negatives in the short term Positive impacts on earnings have been seen on the P&L of pharma companies that have differentiated products, and the Shanghai- and Shenzhen-Hong Kong stock connects now allow investors to buy related healthcare stocks and subsectors that had previously been out of reach. Valuation analysis The MSCI China healthcare index is trading at a forward P/E of 20.1x, above its five-year average of 18.1x. Although sector valuations look rich, we note that the valuation gap over the MSCI China index is narrowing and is now almost at the historical low of 30-45% seen at end- 2012. Investment strategy Pharmas (including chemical drugs and biologics) We see upside for companies with high NDRL exposure, although there is uncertainty surrounding the impact of volume gains and pricing trade-offs in the near term. Traditional Chinese medicines (TCM) Stocks are trading at a 20% discount to their pharma peers; government policy should spur a demand upgrade. Contract research organizations (CRO) Companies in the segment have a competitive advantage in terms of economies of scale and scope, and will benefit from government policy to accelerate drug approvals. Top picks CSPC Pharma (1093 HK, Accumulate) Continued solid growth in 3Q17; new generics launches to underpin growth. Wuxi Biologics (2268 HK, Buy) Beneficiary of pharma technology upgrades; backlog mix shifted towards post-IND services. CTCM (570 HK, Buy) Margin expansion through new acquisitions; 3Q17 sales momentum on track. CR Pharma (3320 HK, Buy) New distribution agreement could be accretive for its P/E valuation. Risks Upside risks: Faster-than-expected drug/R&D approvals; more favorable government policies Downside risks: Larger-than-expected price cuts; unfavorable government policies.
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2018 Healthcare Sector Outlook
Nov 17, 2017 Equity Research | Healthcare
Favorable structural changes to drive earnings growth in 2018
Natalie Chiu SFC CE No. AVH029 [email protected] +852 3760 2030 GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong
Sector view Positive
The healthcare industry has seen sustained market growth, despite increased policy headwinds.
Differentiation among players in each subsector is becoming increasingly significant.
Prefer big pharma, TCM and CRO players over healthcare service providers.
Key themes
Healthcare sector lagging other cyclical sectors The sector has been seen as a laggard
play vs cyclical stocks in 2017, gaining about 30% in 4Q17. The valuation gap with the MSCI China index is narrowing. We believe there is a good chance the sector will outperform in early 2018.
China pharmaceutical end-market should see high single-digit growth in FY17 Amid
industry transformation and a demand upgrade, the healthcare sector is likely to post steady growth for the 2016-20 period.
More positives than negatives in the short term Positive impacts on earnings have been
seen on the P&L of pharma companies that have differentiated products, and the Shanghai- and Shenzhen-Hong Kong stock connects now allow investors to buy related healthcare stocks and subsectors that had previously been out of reach.
Valuation analysis
The MSCI China healthcare index is trading at a forward P/E of 20.1x, above its five-year average of 18.1x. Although sector valuations look rich, we note that the valuation gap over the MSCI China index is narrowing and is now almost at the historical low of 30-45% seen at end-2012.
Investment strategy
Pharmas (including chemical drugs and biologics) We see upside for companies with
high NDRL exposure, although there is uncertainty surrounding the impact of volume gains and pricing trade-offs in the near term.
Traditional Chinese medicines (TCM) Stocks are trading at a 20% discount to their
pharma peers; government policy should spur a demand upgrade.
Contract research organizations (CRO) Companies in the segment have a competitive
advantage in terms of economies of scale and scope, and will benefit from government policy to accelerate drug approvals.
Top picks
CSPC Pharma (1093 HK, Accumulate) Continued solid growth in 3Q17; new generics
launches to underpin growth. Wuxi Biologics (2268 HK, Buy) Beneficiary of pharma technology upgrades; backlog mix
shifted towards post-IND services. CTCM (570 HK, Buy) Margin expansion through new acquisitions; 3Q17 sales momentum on
track. CR Pharma (3320 HK, Buy) New distribution agreement could be accretive for its P/E
valuation.
Risks
Upside risks: Faster-than-expected drug/R&D approvals; more favorable government
policies Downside risks: Larger-than-expected price cuts; unfavorable government policies.
Distributors As reforms continue, distributors should also benefit, but with a mixed outlook.
Industry consolidation remains the key theme, with the government committed to rolling out the
two-invoice policy nationwide in 2018 to further squeeze profit out of the drug distribution process.
The industry will also continue to see more M&A to boost revenue growth for leading distributors.
While industry consolidation will favor larger players with wide distribution networks, their margins
will come under pressure due to more indirect sales to hospitals.
Figure 14: Policies streamlining the distribution process
Sources: Wind, GF Securities (Hong Kong)
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Two invoice system• Issuances of only two invoices between hospital and drug manufacturers and between drug manufacturers to distributors• Central procurement of drugs by all public hospitals and establish a trace mechanism to identify drug’s ex-factory price, thereby
increasing the transparency of the drug distribution chain
Business tax to Value-added tax• Drug distributors Business Tax of 5% is now converted to VAT of 11%, increasing the tax burden of drug distributors, thereby
preventing mechanisms such as: the dominance of low invoicing cost drug distributors and transfer of invoicing
Prescription drugs outflow • Allowing the outflow of prescription drugs from hospitals to retailers
Nov 17, 2017
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2018 Sector Outlook
Figure 15: Policies encouraging drug R&D
Sources: Wind, GF Securities (Hong Kong)
Figure 16: China healthcare reform progress
Sources: GF Securities (Hong Kong)
Limited room for upward earnings revisions and/or surprises in the near term The
healthcare sector’s forward P/E is currently at a high level as 1) corporate earnings YTD are
growing 5-10% faster than market expectation, and 2) consensus is expecting one-year forward
earnings growth of about 20% YoY in 2018. While a 20% YoY growth target may not seem too
aggressive for quality leaders, any negative news such as earlier than expected price cuts may
increase risks to maintain such a high valuation. The last time consensus had forward earnings
expectations of 20% YoY and a similar P/E profile was in early 2014 after strong earnings
surprises. We believe further re-rating will be mainly driven by forward P/E expansion based on
the currently improving market sentiment.
Healthcare sector to become more structurally defensive The China healthcare sector has
been underweight by investors as more fund allocations were placed in cyclical names.
Considering that China is going through an economic rebalancing phase, with a shift from
investment to consumption, we expect an expanding premium vs MSCI China index, supported by
improving earnings in 4Q17 and 1H18 earnings. We recommend investors stay selective and
consider stocks that either have less exposure to uncertainties or would benefit most from reforms.
Policy Type Description
Prioritized review and approval system
Projects with major innovation can obtain prioritized approval via the green channel
Product registration Marketing Authorization Holder Pilot Program
Medical insurance support Medical insurance independent negotiation system; Development in commercial insurance, etc.
Increased clinical trial monitoring Clinical data self-examination and verification etc.
Period Key Policies Healthcare Reforms
2007 to 2010
1. Comments on county level hospitals pilot reform 2. Comments on strengthening and improving the essential drugs system3. Comments on developing critical illness insurance for urban and rural
residents
Accessibility:• Universal health insurance, promoting the unification of 3 government
insurances• Establish a basic medical system and a system for all general practitioners• Promote the use of NDRL
2011 to 2013
1. Proposal on deepening healthcare reform during twelve 5-year plan2. Accelerating public hospital reforms3. Promoting private participation in healthcare4. Pilot program of critical illness insurance5. Accelerating reform progress of county level hospitals
Payable:• Pricing, bidding and medical insurance jointly control medical costs• Speed up public hospital and county-level hospital’s deep reform• Abolishing the system of providing compensation to doctors via high drug
costs
2014 to 2015
1. Facilitating pharmaceutical price reform2. Strengthening and improving tiered health care system3. Deepening healthcare reform at grassroots medical institutions4. Opinions on carrying out the two invoice system for drug procurement5. Conducting self-examination by drug clinical trial institutions
Quality and efficiency:• Strengthen the industry standard, eliminate distribution channel profits• Payer reform, develop business insurance• Encourage the society to develop hospitals, in particular, medical centers
within the primary market• Improve quality standards to promote industry consolidation
2016 to 2017
1. Evaluation of the quality and efficacy of generic drugs2. Pilot program plan for the system of the drug marketing authorization
authorisation holders3. Deepening reform on the system for review and examination and
approval of drugs and medical devices
Drug quality and innovation:• Establish priority review system based on clinical value of drugs• Accelerate import drugs approval• Resolve registration backlog of chemical drugs
Nov 17, 2017
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2018 Sector Outlook
Figure 16: Top 10 outperformers (% chg YTD as of Nov 10) Figure 17: Top 10 Underperformers (% chg YTD as of Nov 10)
ROE (%)P/E (x) Revenue growth (%) Net profit growth (%)
Nov 17, 2017
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2018 Sector Outlook
CSPC Pharmaceutical (1093 HK)
Accumulate (maintained)
Target price: HK$16.10
Continued solid growth in 3Q17
Figure 19: Stock performance (as of Nov 16) Figure 20: Key data
Sources: Bloomberg
Figure 21: Stock valuation
Sources: Company data, GF Securities (Hong Kong)
Better-than-expected 3Q17 operation CSPC Pharma posted HK$4.0bn in net profit and
HK$730m in net profit during 3Q17, representing growth of 29% and 37% respectively. The accelerating growth vs 1H17’s 17% and 27% was a result of rapid growth in finished drugs and the turnaround of its API businesses.
Near-term pipeline products - albumin-bound paclitaxel and clopidogrel to receive approval by end-2017 Abraxane reached US$973m in worldwide sales in 2016, vs about Rmb270m in
China. As a 2nd-line treatment for several types of cancers in China, Celgene is currently the only player, accounting for about 15% of the Rmb1bn paclitaxel market. According to CDE, CSPC Ouyi Pharma, Jiangsui Hengrui (600276 CH) and seven other companies have filed for applications. The former two were granted priority review in March and June 2017 respectively. Management targets Rmb200m in sales for paclitaxel and sales of Rmb500m-1bn for metformin in 2018, based on the current market size of Rmb1bn and Rmb3.1bn respectively, which would imply 20% and 25% market shares after launch.
Net change of cash flow 932 1,602 2,176 1,989 2,588 Net cash/(debt) (HK$ m) 843 2,099 4,411 6,400 8,988
Forex changes (103) 0 0 0 0
Cash and cash equivalents an beginning 1,468 2,299 3,235 5,411 7,400 ROE (%) 20% 24% 27% 27% 29%
Cash and cash equivalents an end 2,299 3,901 5,411 7,400 9,988 ROA (%) 13% 16% 19% 20% 21%
Income Statement Balance Sheet
Cash Flow Statement
Financial Ratios
Nov 17, 2017
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2018 Sector Outlook
WuXi Biologics (2269 HK)
Buy (maintained)
Target price: HK$50.1
Primary beneficiary of pharma technology upgrade
Figure 25: Stock performance (as of Nov 1) Figure 26: Key data
Sources: Bloomberg
Figure 27: Stock valuation
Sources: Company data, GF Securities (Hong Kong)
“Follow-the-molecule” strategy through end-to-end services platform WuXi Biologics was
China’s largest biologics outsourcing services provider in 2016 with a market share of 48%. It has been working on customer projects from an early stage of the biologics development process and develops an in-depth understanding of the relevant biologics drug candidates. With a solid track record in growing its customer base, WuXi Biologics should see improving quality and efficiency for its services for such projects once it progresses to later stages. Strong backlog to support future earnings growth WuXi Biologics posted a backlog of
US$452m as of 1H17 with new business of US$172m (+163% HoH) and US$69m (+18% MoM). Of the US$383.2m backlog in May 2017, the company will convert US$172.4m, US$136.5m and US$74.6m into service fees in 2017, 2018 and afterwards, representing a backlog conversion rate of about 45%. We expect revenue growth momentum to remain strong in 2H17, as its backlog mix shifts to late phase projects and anticipated milestone fees of US$816m from Arcus Biosciences.
Figure 28: Revenue breakdown by pre-IND services and post-IND services (2016)
Figure 29: Revenue breakdown by development phases (2016)
Sources: company data, GF Securities (Hong Kong)
Valuation Our PEG-derived target price is HK$50.10 which is based on 80.5% EPS CAGR and
1.0x PEG. The DCF valuation gave us HK$47.80/share for the intrinsic value of the company, with a WACC of 8% and terminal growth rate of 2%.
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2269 HK Equity Hang Seng Index
Nov 8 close (HK$) 44.80
Shares in issue (m) 1163
Major shareholder Founding Individuals (80.59%)
Market cap (HK$ bn) 52.10
3M avg. vol. (m) 1,255.28
52W high/low (HK$) 25/49.25
Turnover
(Rmb m)
Adj net profit
(Rmb m)
Adj EPS
(Rmb)
EPS YoY
(%)
P/E BPS
(Rmb)
P/B ROE
(%)
2015 557 65 0.07 39% 584.9 0.2 260.0 44%
2016 989 219 0.23 238% 173.3 0.3 140.4 81%
2017E 1,563 375 0.32 42% 122.1 3.5 11.4 9%
2018E 2,305 614 0.53 64% 74.6 3.9 10.1 13%
2019E 4,272 1,116 0.96 82% 41.1 4.8 8.2 20%
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31%
Pre-IND services Post-IND services
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65.60%
11.40%
0.30%21.30%
Drug Discovery Preclinical Development Early Phase (Phase I & II)
Late Phase (Phase III) Commercial Manufacturing
Nov 17, 2017
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2018 Sector Outlook
Figure 30: Financial statements
Sources: Company data, GF Securities (Hong Kong)
Year-end Dec 31 (Rmb m) FY15 FY16 FY17E FY18E FY19E Year-end Dec 31 (Rmb m) FY15 FY16 FY17E FY18E FY19E
Proceeds from issue of ordinary shares 0 0 3,573 0 0 ROA (%) 10% 16% 19% 12% 21%
Dividend paid (18) 0 0 0 0
Others 400 (562) (697) (227) (249)
Financing cash flow 377 343 2,171 (227) (249)
Net change of cash flow 148 4 1,939 (622) 483
Forex changes 4 17 (18) 0 0
Cash and cash equivalents an beginning 6 158 169 2,108 1,486
Cash and cash equivalents at end of year 158 169 2,108 1,486 1,969
Financial Ratios
Income Statement Balance Sheet
Cash Flow Statement
Nov 17, 2017
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2018 Sector Outlook
China TCM (570 HK)
Buy (maintained)
Target price: HK$5.40
Margin expansion through new acquisitions
Figure 31: Stock performance (as of Nov 14) Figure 32: Key data
Sources: Bloomberg
Figure 33: Stock valuation
Sources: Company data, GF Securities (Hong Kong)
3Q17 operations on track Sales momentum of Tianjiang and Yifang continued (20% and over 20%
respectively) in 3Q17 after solid growth in 1H17 (+24% YoY). Sales in Guangdong reached Rmb600m and maintained market position with a significant increase in the number of medicine dispensing machines. Management is still expecting the segment to grow at least 20% in 2017. Chance to improve net margins from integration China TCM will have nationwide geographic
coverage of TCM decoction pieces in key regions in China following the Huamiao, Jianyou and HLJ Sinopharm acquisitions. This will give it healthy exposure to the entire value chain of the CCMG business. China TCM already has an extensive channel network in eastern and southern China while Huamiao and Jianyou have a larger market exposure in Beijing and Sichuan. In addition, the integration will also expand production capacity for its modernized decoction and toxic decoction pieces. The production plant in Sichuan is the largest production base for toxic decoction pieces in China with an annual production capacity of 4,000 tonnes. Consolidation of the four companies is expected in early 2018.
Net cash/(debt) (Rmb m) (312) (484) (331) (580) 358
Net change of cash flow 1,691 92 1,932 (249) 888 Gearing ratio (%) 22% 34% 46% 43% 39%
Forex changes (28) 0 0 0 0
Cash and cash equivalents at beginning 439 2,102 2,373 4,305 4,056 ROE (%) 9% 9% 10% 11% 11%
Cash and cash equivalents at end 2,102 2,194 4,305 4,056 4,944 ROA (%) 5% 5% 6% 5% 6%
Financial Ratios
Income Statement Balance Sheet
Cash Flow Statement
Nov 17, 2017
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2018 Sector Outlook
China Resources Pharma (3320 HK)
Buy (maintained)
Target price: HK$11.10
New distribution agreement could be accretive for its P/E valuation
Figure 37: Stock performance (as of Nov 14) Figure 38: Key data
Sources: Bloomberg
Figure 39: Stock valuation
Sources: Company data, GF Securities (Hong Kong)
New distribution agreement with Beigene On Nov 10, CR Pharma signed a distribution
agreement with Beigene to distribute three blockbuster products in China (Abraxane, Revlimid and Vidaza). Abraxane and Revlimid have a market size of about Rmb270m and Rmb19m respectively, whereas Vidaza will launch soon in China. While the company did not disclose much information about the payment terms and conditions, we believe it could be accretive to its earnings given these products have high margins and high growth. Pharmaceutical distribution saw stable momentum in 8M17 The company’s distribution
business posted stable revenue growth in July and Aug 2017. They see ongoing distribution GPM pressure from the rollout of the two-invoice system but believe the effect will be offset by higher direct-to-hospital sales.
Figure 40: Overall revenue mix (HK$ m, 1H17) Figure 41: CR Pharma's distribution channel mix
Sources: Company data, GF Securities (Hong Kong)
Valuation We expect the company to maintain above-peer profitability in FY17-18 on an
expansion of its distribution network, stable growth in its manufacturing business, and a more proactive M&A strategy. Our SOTP-derived TP of HK$11.10 implies 17.3x FY18 P/E on 21% growth.
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3320 HK Hang Seng Index
Nov 13 close (HK$) 9.45
Shares in issue (m) 6284.506
Major shareholder CR Corp (53.04%)
Market cap (HK$ bn) 59.39
3M avg. vol. (m) 4.79
52W high/low (HK$) 8.28/10.28
Turnover
(HK$ m)
Net profit
(HK$ m)
EPS
(HK$)
EPS YoY
(%)
P/E BPS
(HK$)
P/B ROE
(%)
2015 146,568 2,850 0.62 NA 16.1 4.6 2.1 14%
2016 156,705 2,821 0.57 -8% 17.5 6.1 1.6 13%
2017E 173,075 3,338 0.53 -7% 18.8 6.3 1.6 9%
2018E 193,122 4,034 0.64 21% 15.5 6.8 1.5 10%
2019E 214,362 4,644 0.74 15% 13.5 7.5 1.3 10%
Distribution, 69,070 , 83%
Manufacturing, 11,480 , 14%
Retail , 2,117 , 3%
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Hospitals and other medical institutions Other distributors Retail pharmacies and others
Nov 17, 2017
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2018 Sector Outlook
Figure 42: Financial statements
Sources: Company data, GF Securities (Hong Kong)
Year-end Dec 31 (HK$ m) FY15 FY16 FY17E FY18E FY19E Year-end Dec 31 (HK$ m) FY15 FY16 FY17E FY18E FY19E
Financing cash flow (1,554) (625) 8,830 (8,244) (2,444) Net debt/(cash) (HK$ m) 24,840 11,751 18,899 14,604 8,944
Net debt/equity (%) 62% 22% 31% 21% 11%
Net change of cash flow 515 1,541 811 (1,466) 4,750
Forex changes (1,036) (784) 0 0 0
Cash and cash equivalents at beginning 13,735 13,214 13,972 14,783 13,317 ROE (%) 14% 13% 9% 10% 10%
Cash and cash equivalents at end 13,214 13,972 14,783 13,317 18,067 ROA (%) 5% 4% 5% 5% 5%
Income Statement Balance Sheet
Cash Flow Statement
Financial Ratios
Nov 17, 2017
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2018 Sector Outlook
Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months
Company ratings
Buy Stock expected to outperform benchmark by more than 15%
Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15%
Hold Expected stock relative performance ranges between -5% and 5%
Underperform Stock expected to underperform benchmark by more than 5%
Sector ratings
Positive Sector expected to outperform benchmark by more than 10%
Neutral Expected sector relative performance ranges between -10% and 10%
Cautious Sector expected to underperform benchmark by more than 10%
Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report.
Disclosure of Interests (1) The proprietary trading division of GF Securities (Hong Kong) Brokerage Limited (“GF Securities (Hong Kong)”) and/or its affiliated or associated companies do not hold any shares of the securities mentioned in this research report. (2) GF Securities (Hong Kong) and/or its affiliated or associated companies do not have any investment banking relationship with the companies mentioned in this research report in the past 12 months. (3) Neither the analyst(s) preparing this report nor his/her associate(s) serves as an officer of the company mentioned in this report and has any financial interests or hold any shares of the securities mentioned in this report.