EQUITY RESEARCH INITIATION OF COVERAGE November 15, 2012 CHINA/HEALTHCARE Stock Rating: Sinopharm Group Co Ltd PERFORM 12-18 mo. Price Target NA Dominant Leader in a Growing/Consolidating 1099.HK - HKSE HK$24.90 Industry; Initiating with Perform 3-5 Yr. EPS Gr. Rate 21% SUMMARY 52-Wk Range HK$27.45-HK$16.76 We are initiating coverage of Sinopharm (1099.HK) with a Perform rating. China's Shares Outstanding 2,403.0M pharma distribution is growing rapidly and consolidating gradually from a competitive Float 828.0M to an oligopolistic industry. Sinopharm, China's largest pharmaceutical distributor, Market Capitalization HK$59,825.4M represents the best investment vehicle to gain exposure, in our view. In recent years, Avg. Daily Trading Volume 2,452,955 it has gained market share, and we believe it will continue to do so with strong Dividend/Div Yield HK$0.19/0.76% government backing, ample capital and economies of scale. Although most pharma wholesalers experience margin erosion, Sinopharm's margins have been relatively Book Value HK$6.73 stable. We believe it can grow revenue/net income at 21.5%/21.4% CAGRs during Fiscal Year Ends Dec 2011-17. However, its fair valuation keeps us on the sideline initially. We would look 2012E ROE 9.0 % to become more constructive as valuation becomes more attractive. LT Debt HK$5,229.0M Preferred NM KEY POINTS Common Equity HK$21,528M ■ Absolute Dominance. China's No. 1 pharma distributor, Sinopharm has more Convertible Available No than 10% market share in an industry that's growing at a double-digit rate and, interestingly, consolidating at the same time, backed by government support. We Revenue(CNY/ 1H 2H Year Mult. view Sinopharm as the future top oligopoly player in the space. mil) 2011A 48.0B 54.2B 102.2B ■ Expect Above-industry Growth. Management targets growing revenue 2012E 66.6BA 64.6B 131.2B 300-500bps above the industry's. We estimate Sinopharm's revenue will rise at 2013E 81.4B 79.9B 161.3B a 21.5% CAGR during 2011-17, on: 1) increasing direct sales, 2) expanding its 2014E -- -- 195.1B distribution network, 3) developing retail pharmacies, and 4) using M&A. 2015E -- -- 234.2B ■ EPS So Far, Margins Remain Stable. Chinese pharma distributors' margins, higher 1H 2H Year Mult. Diluted than global peers', are declining as regulations tighten. Industry margins could 2011A 0.34 0.32 0.66 become similar to global peers' at some point. So far, Sinopharm's gross margin 2012E 0.40A 0.39 0.79 has been stable, on more direct sales and better product mix. 2013E 0.54 0.46 1.00 ■ Valuation. Sinopharm trades at 25x/20x our 2012-13E EPS of 2014E -- -- 1.24 HKD0.97(RMB0.79) and HKD1.24(RMB1.00), respectively. DCF analysis gives 2015E -- -- 1.48 Revenue and diluted EPS figures are in CNY. P/E us a fair value in the mid-20s HKD, which keeps us on the sideline; however, multiples based on HK$ are: 2011A-30x; 2012E-25x; we would become more constructive if Sinopharm can consistently deliver stable 2013E-20x; 2014E-16x. margins, given industry challenges. This research report is intended for use only by institutions to which the subject security or securities may be sold pursuant to an exemption from state securities registration in the state in which the institution is located. Stock Price Performance Company Description Sinopharm Group is China’s largest pharmaceutical distributor. Its network covers 178 prefecture-level cities in 30 provinces in China. It also has 1,801 retail drugstores. Oppenheimer & Co. Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment Ingrid Yin, Ph.D. Melody Li decision. See "Important Disclosures and Certifications" section at the end of this report for important disclosures, including potential conflicts of interest. See 212-667-7194 212-667-7409 [email protected] [email protected] "Price Target Calculation" and "Key Risks to Price Target" sections at the end of this report, where applicable. Oppenheimer & Co Inc. 85 Broad Street, New York, NY 10004 Tel: 800-221-5588 Fax: 212-667-8229 Sinopharm Group Co Ltd Table of Contents Investment Thesis ........................................................................................ 2 Company Overview ..................................................................................... 3 China Pharmaceutical Distribution Industry Overview ................................. 6 A Fragmented Market Undergoing Consolidation .................................... 6 Simplify Structure by Eliminating Bottom Layer ...................................... 7 Double-Digit Growth Rate to Stay ........................................................... 8 Distributors Must Focus to Survive ........................................................ 11 History as a Mirror: Margin Trend of Global Pharma Distributors ......... 16 Regulations Pressure China’s Pharmaceutical Distributors ..................... 18 Value-added Services Is Still at Early-Stage in China .............................. 20 Industry Consolidation ........................................................................... 21 Competitive Landscape .......................................................................... 23 M&A Environment ................................................................................ 28 Sinopharm: Competitive Advantages ......................................................... 32 1.Extensive Distribution Network .......................................................... 32 2.Leading Logistics Capabilities .............................................................. 33 3.Providing Value-added Services ........................................................... 34 4.Diversified Product Offerings ............................................................. 36 Growth Strategies ...................................................................................... 37 1.Increase Direct Sales to Hospitals ........................................................ 37 2.Expand Distribution Network ............................................................. 38 3.Grow Retail Pharmacy Business .......................................................... 38 4.Grow Through M&A .......................................................................... 39 Valuation.................................................................................................... 41 Investment Risks ........................................................................................ 44 Financial Analysis ....................................................................................... 45 Management .............................................................................................. 55 Financial Statements ................................................................................... 56 2 Sinopharm Group Co Ltd Investment Thesis We Are Initiating Coverage of Sinopharm Group (1099.HK) with a Perform Rating. Sinopharm is China‟s largest pharmaceutical distributor with 10.8% market share (see Exhibit 3). Its competitive advantages help it continue to gain share in this consolidating industry, which we foresee as transforming into an oligopolistic one. Although overall, China‟s pharma distribution industry is facing declining margins, so far Sinopharm has been able to maintain or even improve margins by adjusting sales channel mix and improving operation efficiencies. However, we view the current valuation as fair and begin coverage on the sideline, waiting until valuation becomes more attractive. Absolutely Dominant Player. With the largest pharmaceutical distribution network in China, Sinopharm likely will continue to gain market share, benefiting from industry consolidation. We expect Sinopharm‟s market share to grow from 10.8% in 2011 to 14.4% in 2017 (see Exhibit 53), through organic growth and M&A activities. Long-term, we believe Sinopharm will be the top oligopoly player with significant market share. So Far, Margins Remain Stable. Chinese pharma distributors enjoy better margins than global counterparts‟. However, recently, Chinese distributors‟ gross margins have started experiencing pressure, from drug price cuts and mark-up reductions. In the long term, we believe industry gross margin will continue a gradual decline to a global average level. So far, Sinopharm has been able to maintain a stable gross margin at 8.0-8.4% (see Exhibit 72), driven by increasing direct sales to hospitals and adjusting its product portfolio. We Expect Sinopharm to Grow Revenue/Net Income at a 21.5%/21.4% 2011-2017 CAGR. Sinopharm can grow revenue by: 1) increasing direct sales to hospitals; 2) expanding its distribution network; 3) further developing its retail pharmacy business; and 4) engaging in M&A activities. With improving operating efficiency, we think it can achieve net income growth of 21.4% during 2011-2017. Valuation. Sinopharm is trading at 25x and 20x our 2012 and 2013 EPS estimates of HKD0.97 (RMB0.79) and HKD1.24 (RMB1.00), respectively, 67% above global peers and in-line with domestic peers‟ 21x PE multiple for 2013 (using consensus estimates for peers). Applying a DCF analysis, we derived a fair value range in the mid-20s in HKD terms. Believing the valuation quite rich, we will begin coverage on the sideline and would become more constructive if Sinopharm consistently delivers stable margins.