Deutsche Bank Markets Research Asia Industry Date China 2013 Outlook 10 December 2012 Health Care Industry Update Jack Hu, Ph.D Research Analyst Anticipate healthy revenue growth (+852) 2203 6208 [email protected] and modest margin pressure Healthy sector growth with modest margin pressure in 2013 Top picks We estimate 20-22% growth for the drug sector and 19% growth for the Sino Biopharmaceutical Buy medical device sector in 2013, driven primarily by healthy growth in medical (1177.HK),HKD3.72 reimbursement funding and completion of the infrastructure build-up cycle, China Shineway (2877.HK),HKD12.16 Buy respectively. We expect operating margin erosion to continue, due largely to Mindray Medical (MR.N),USD34.47 Buy rising sales and marketing expenses. We reiterate our top picks, namely Shineway (2877.HK), Sino Biopharm (1177.HK) and Mindray Medical (MR.N). Companies Featured Catalysts in 2013 We expect the following positive catalysts: 1) continuous demand growth, Sino Biopharmaceutical Buy (1177.HK),HKD3.72 demonstrated by growth acceleration of in-/out-patient visits to hospitals; 2) 2011A 2012E 2013E 2013 NRDL expansion, as more drugs should be reimbursed; and 3) new GMP P/E (x) 20.1 22.3 19.0 inspection for injectables by YE13, since sector consolidation is likely to ensue. EV/EBITDA (x) 8.9 9.7 8.2 We also anticipate the following uncertainties in 2013: 1) 2013 RDL tender, Price/book (x) 3.0 4.2 3.9 which could have a negative impact on drug pricing; and 2) hospital reform, which will affect prescription volumes, a larger risk compared with pricing. China Shineway (2877.HK),HKD12.16 Buy Outlook for reimbursement: healthy growth in reimbursement funding 2011A 2012E 2013E We expect healthy growth in reimbursement funding in all four major P/E (x) 13.9 11.4 9.8 insurance programs. We have also identified that two additional sources of EV/EBITDA (x) 8.8 6.3 5.3 funding are likely to add another leg of growth, including insurance premiums Price/book (x) 2.1 1.9 1.7 collected from migrant workers and commercial insurance. However, we Mindray Medical (MR.N),USD34.47 Buy remain cautious on pooled accounts for UBMI (Urban Basic Medical 2011A 2012E 2013E Insurance), which are more likely to have run into deficit in parts of China P/E (x) 16.8 19.3 17.0 already. We expect limited impact from global budgeting on medical EV/EBITDA (x) 11.5 12.7 10.9 reimbursement control, as UBMI represents only 18% of entire healthcare Price/book (x) 2.6 3.0 2.7 expenditure in China. WuXi PharmaTech (WX.N),USD15.34 Buy Outlook for policy: cost control and structural reform of public hospitals 2011A 2012E 2013E We anticipate more policy pressure on the drug sector and on high-end P/E (x) 12.0 11.3 10.3 medical consumables in 2H13 and beyond. However, we believe most risks are EV/EBITDA (x) 7.0 5.8 4.7 manageable. We highlight impactful policies, including 1) hospital reform, such Price/book (x) 1.5 1.8 1.5 as implementation of the zero mark-up policy, which may lead to structural changes in prescription volumes, 2) allowing hospitals to renegotiate drug Related recent research Date prices after centralized tenders, which could exert pressure on both price and Ris.reward favors long 21 May 2012 volumes, and 3) further NDRC price cuts on TCMs and other therapeutic China medical device market: 23 Nov 2012 classes. growth acceleration continues Proprietary buy-side survey indicates investor optimism for 2013 We have conducted a proprietary buy-side survey for our 2013 sector outlook. The majority of the participating investors expect 1) that China recovery may take a pause in 2H13, 2) that drug sector growth momentum will continue, but the sector is fairly valued, 3) modest policy pressure in 2013, and 4) risks of pricing pressure and global budgeting. We highlight that our views are not entirely in line with the survey results. Multiple-based valuation preferred; policy remains the primary risk We expect multiple expansion opportunities for turnaround stories, such as Shineway (2877.HK), and further upside for quality names, including Sino Biopharm (1177.HK) and Mindray (MR.N). We generally value the companies using a multiples-based approach, validated by DCF. Policy is a key industry risk. Company-specific risks relate generally to overexposure to centralized tenders. ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, 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. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 072/04/2012. 10 December 2012 Health Care 2013 Outlook Table Of Contents Healthy sector growth; margin pressure continues ....................... 5 Executive summary ........................................................................ 6 2013 Outlook for drug sector ....................................................... 11 2013 Outlook for device sector .................................................... 23 2013 Buyside outlook survey ....................................................... 33 Policy outlook: more challenges than opportunities .................... 57 Feedback from the hospital .......................................................... 67 Outlook for reimbursement .......................................................... 73 Stock performance and valuation ................................................ 83 3Q12 review.. ............................................................................... 90 Page 4 Deutsche Bank AG/Hong Kong 10 December 2012 Health Care 2013 Outlook Healthy sector growth; margin pressure continues Balancing demand growth and policy risks We estimate the drug sector to grow 20-22% in 2013, vs. 22% growth YTD September 2012 and 17% in 2011. We estimate the medical device sector to grow 19% in 2013, vs. 20% in 2012 and 20% in 2011. We believe the primary driver for drug sector growth is growth in reimbursement funding. As for the device sector, we attribute the main driver to accelerated demand growth upon completion of the infrastructure build-up cycle. We highlight that FAI (fixed asset investment) in healthcare has decelerated in 2012. We anticipate continuous pressure on gross margins for the healthcare sector in 2013, due to limited pricing power and policy headwinds. On operating margin, it is unlikely that operating efficiency improvement could offset gross margin (GM) erosion, due to increasing spending in sales and marketing. We also recommend investors focus on net profit growth in 2013, as drug manufacturers have started to increase ex-manufacturer prices as an accounting practice, to deal with potential policy headwinds; as such, GM is likely to be artificially inflated, while the operating profit margin (OPM) should decrease. We expect modest pricing pressure in 2013; however, we remain cautious on risks on volume growth, as we believe potential structural changes in prescription patterns, resulting from hospital reforms, is likely to morph into a larger risk going forward. We expect healthy growth in reimbursement funding, particularly in personal accounts, driven by salary inflation. We have also identified that two additional sources of funding are likely to add another leg of growth, including insurance premiums collected from migrant workers and commercial medical insurance. Valuation We primarily use a multiples-based valuation approach due to the relatively sustainable growth that we expect from the sector. For Shineway Pharma (2877.HK), our target price of HKD 15.5 is based on 12x 2013E EPS of HKD 1.30. For Mindray, we reiterate our Buy rating and target price of USD 38, based on 19x 2013E EPS of USD 2.02. For Sino Biopharm, our target price of HKD 4.10 is based on 21x FY13E EPS of HKD 0.196. Risks Industry risks relate mainly to government policies and regulatory changes in China, particularly healthcare reforms, which could negatively affect pricing. Additional risks include cost inflation, increasing competition and macroeconomic weakness. Deutsche Bank AG/Hong Kong Page 5 10 December 2012 Health Care 2013 Outlook Executive summary Outlook for sector growth and margins We estimate the drug sector to grow 20-22% in 2013, vs. 22% growth YTD September 2012 and 17% in 2011. We estimate the medical device sector to grow 19% in 2013, vs. 20% in 2012 and 20% in 2011. We believe the primary driver for drug sector growth is growth in reimbursement funding. As for the device sector, we consider the main driver to be accelerated demand growth upon completion of the infrastructure build-up cycle. We highlight that FAI (fixed asset investment) in healthcare has decelerated in 2012. We expect continuous pressure on gross margins for the healthcare sector in 2013, due to limited pricing power and policy headwinds. On operating margin, it is unlikely operating efficiency improvement could offset GM erosion, due to increasing spending in sales and marketing. We also recommend investors focus on net profit growth in 2013, as drug manufacturers have started to increase ex-manufacturer prices as an accounting practice to deal with potential policy headwinds; as such, GM is likely to be artificially inflated, while OPM should decrease. In the long term, we expect drugs with therapeutic benefits and solid health