New strategy on CEGI will drive its future development, Buy 脑苷肌肽新战略将推动其未来增长, 买入

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1 GTJA Research 国泰君安研究 Company Report: Sihuan Pharmaceuticals (00460 HK) Johnson Sun 孙凤强 公司报告 : 四环医药 (00460 HK) johnson.sun@gtjas.com.hk New strategy on CEGI will drive its future development, Buy 脑苷肌肽新战略将推动其未来增长, 买入 Taking largest CCV market shares in China. Sihuan Pharm is a developer, manufacturer and distributor of medicines in China. CCV drugs accounted to 80.8% and 88.3% of its total sales in 2010 and 1H2011, respectively. It is the largest CCV medicine franchise in China, taking about 9% market shares of the CCV medicine market in 1H2011. M&A has greatly improved the fundamentals of the Company and is driving its growth. In 1H2011, sales of newly acquired products reached RMB425 mn, accounting 42.8% of the Company s total sales. From the M&A of Durpomise Pharm, Sihuan acquired CEGI (Cattle Encephalon Glycoside and Ignotin Injections), and from the M&A of Vinise Pharm, Sihuan has strategically become the exclusive manufacture of CEGI in China. The new strategy will strengthen Sihuan s competence in neuroprotectant field as well as the whole CCV medicine market. The uncertainty policy environment has greatly affected the valuation of healthcare stocks, including Sihuan, but we have already fully considered the price cut possibilities and margin pressures of the Company. Furthermore, the Company s new strategy on CEGI will drive the future development of the Company. Rating: Buy Initial 评级 : 买入 ( 首次研究 ) 6-18m TP 目标价 : HK$3.60 Share price 股价 : Stock performance 股价表现 HK$2.990 EPS is estimated to grow by 14.5%, 20.3% and 24.0% yoy to RMB14.9 Cents, 18.0 Cents and 22.3 Cents in Our TP of HK$3.60 represents 19.8x 2011 PE and 16.4x 2012 PE. Valuation is attractive, Buy. 占有中国心脑血管用药最大的市场份额 四环医药是一家在中国进行药品研发 生产和销售的公司 在 2010 年和 2011 上半年, 心脑虚构用药分别占其总收入的 80.8% 和 88.3% 在 2011 年上半年, 四环医药在中国心脑血管用药市场的份额约为 9%, 按市场份额是中国最大的心脑血管药品企业 并购极大改善了公司的基本面, 并成为公司增长的推动力 在 1H2011, 通过并购的新产品收入达 RMB425 百万, 或其总收入的 42.8% 通过收购多菲制药, 四环获得了新产品脑苷肌肽 ; 通过收购万生联合制药, 四环战略性地成为了脑苷肌肽在中国的独家生产商 新战略将增强四环在神经保护剂领域及整个心脑血管市场的竞争力 政策环境的不确定性极大影响力医药股东估值, 包括四环 但是我们认为, 我们已经充分考虑了公司药品降价的影响及毛利的压力 更重要的是, 公司的脑苷肌肽新战略将推动公司将来的发展 Change in Share Price 股价变动 1 M 1 个月 3 M 3 个月 Since IPO 上市至今 Abs. % 绝对变动 % 18.1 (10.4) (34.6) Rel. % to HS index 相对恒指变动 % (15.8) Avg. share price(hk$) 平均股价 ( 港元 ) Source: Bloomberg, Guotai Junan International 预测每股盈利在 年将分别增长 14.5%,20.3% 及 24.0% 至人民币 14.9 分 18.0 分及 22.3 分 目标价 3.60 港元, 相当于 19.8x2011 PE 和 16.4x2012PE 估值吸引, 买入 Year End Turnover Net Profit EPS EPS PER BPS PBR DPS Yield ROE 年结 收入 股东净利 每股净利 每股净利变动 市盈率 每股净资产 市净率 每股股息 股息率 净资产收益率 12/31 (RMB m) (RMB m) (RMB Cents) ( %) (x) (RMB) (x) (RMB) (%) (%) 2009A A 1, F 2, F 2, F 3,202 1, Shares in issue (m) 总股数 (m) 5,175 Major shareholder 大股东 Plenty Gold 62.9% Market cap. (HK$ m) 市值 (HK$ m) 15,473 Free float (%) 自由流通比率 (%) month average vol. 3 个月平均成交股数 ( 000) 18,289 FY11 Net gearing (%) FY11 净负债 / 股东资金 (%) Net Cash 52 Weeks high/low (HK$) 52 周高 / 低 / Source.. the Company, Guotai Junan International. See the last page for disclaimer Page 1 of 20

2 Sector Background The pharmaceutical market in China is growing fast in recent years. According to IMS, China s pharmaceutical market is expected to become the world s 3 rd largest by 2011, up from its 5 th ranking in 2009 and the hospital pharmaceutical purchases value grew from RMB121 billion in 2006 to RMB313 billion in 2010, representing a CAGR of 26.8%. The value is expected to reach RMB691 billion by 2014, according to IMS, representing a CAGR of 21.9% from 2010 to Driving forces of the pharmaceutical market in the PRC include: Increasing disposable income and health awareness Increasing urbanization Aging population and the prevalence of chronic health problems Government initiatives relating to the healthcare industry Increasing government spending related to healthcare reform Figure-1: Hospital pharmaceutical purchases (RMB bn) and growth in China Source: IMS, Guotai Junan International Market of western cardio-cerebral vascular (CCV) drugs is expanding fast in China. Because of aging population, lifestyle changes associated with urbanization and economic growth, incidence rate of cardio-cerebral vascular (CCV) diseases is increasing in China. According to the China Ministry of Health, incidence rates of Cardiovascular diseases, Cerebrovascular diseases and Hypertension increased from 1.4%, 0.7% and 2.6% in 2003 to 1.8%, 1.0% and 5.5% in 2008, respectively. The increasing incidence rate of CCV diseases in China have directly impact and will continue impacting the demand for drugs and medical services for these diseases. According to IMS, the total hospital purchases value of CCV drugs in China has increased at a CAGR of 29.1% (2.3pts faster than the CAGR of total hospital pharmaceutical purchases value) from RMB13.4 bn in 2006 to RMB37.4 bn in The market of CCV drugs has been growing faster by 2.3pts than that of the total hospital purchases, and as a result, the proportion of CCV drugs in the total hospital purchases increased from 11.1% in 2006 to 12.0% in 2010 in China. We think the western CCV drug market in China will remain its high growth rate in the next few years as a result of many factors, including the expansion of the medical insurance coverage, the inclusion in the National Medical Catalogue of new drugs, the increase of household income and the rising incidence rate of stroke and cardiac diseases such as acute myocardial infarction. See the last page for disclaimer Page 2 of 20

3 Figure-2: Hospital purchases value and growth of CCV medicines (RMB mn) Source: IMS, Guotai Junan International There are five main sub-segments of the western CCV drugs: 1) drugs for cerebral and peripheral vascular therapies, 2) anti-hypertensives, 3) CNS agents for CCV disorders, 4) cardiac therapies, and 5) lipid regulators. In 1H11, the five sub-segments accounted for about 37%, 25%, 18%, 13% and 7% of the total western CCV drug market, respectively. Two of Sihuan s major products, Kelinao and Anjieli (Cinepazide Maleate), belong to the largest sub-segment, drugs for cerebral and peripheral vascular therapies, while Aodimei (Cattle Encephalon Glycoside and Ignotin Injection, CEGI), Aogan (Ganglioside GM1 Injection), Qu ao (Cerebroprotein Hydrolysate for Injection) and Qingtong (Edaravone Injection) belong to the sub-segment of CNS agent for CCV disorders. Figure-3: Market shares of the sub-segments of western CCV drugs in China in 1H11 Source: IMS, Guotai Junan International Figure-4: Hospital purchases of drugs for cerebral and peripheral vascular therapies (RMB mn) and growth in China Source: IMS, Guotai Junan International See the last page for disclaimer Page 3 of 20

4 Figure-5: Hospital purchases of CNS agents for CCV disorders (RMB mn) and growth in China Source: IMS, Guotai Junan International Sihuan Pharm has had the largest market share in the western CCV drug market each year since 2007, and had a market share of 7.5% in Its market share increased significantly to 9.0% in 1H11, as a result of the M&A of Dupromise Pharm. We expect Sihuan to be able to maintain its current market status. Furthermore, with the integration trend of the pharmaceutical industry boosted by the new GMP standard effective on Feb 2011, we think the large players such as Sihuan will take even more market shares from the smaller ones. Figure-6: Market shares of CCV medicine market by the top 5 companies in China Source: IMS, Guotai Junan International Tightened control of antibiotic uses will damage the antibiotic segment greatly. The overuse of antibiotics in China is much more severe than the western countries, and thus causes lots of problems, such as drug tolerance and wastes of healthcare resources and expenses. Although the government has already taken some measures to control antibiotic uses, including listing all antibiotics as prescription drugs which require doctors prescriptions when purchasing, antibiotic overuse is not effectively controlled. The government is formulating a new strict framework to further control antibiotic uses, and the antibiotic segment will be damaged greatly. Besides, there are two more noticeable risks in the pharmaceutical industry in China. Firstly, in order to improve the healthcare qualities with limited government expenses, drug prices would be cut. Especially, certain drugs with high margins are exposed in high risks. Secondly, hospital promotions will be restricted and the sales volume of drugs which depend largely on hospital promotions might be affected. See the last page for disclaimer Page 4 of 20

5 Company analysis Sihuan Pharm, founded in 2001 and headquartered in Hainan Province, China, is a leading pharmaceutical developer, manufacturer and distributor in China, and it is the largest cardio-cerebral vascular drug enterprise in China by market share, taking about 9.0% of China s CCV market in 1H11. Sihuan Pharm currently has a product portfolio of about 100 products encompassing the top five medical therapeutic areas in China: anti-infective, metabolism, cardiovascular system, oncology and nervous system. Major products such as Kelinao, Anjieli, Chuanqing, Qu'Ao and Aogan are widely used in the treatment of various CCV diseases. Sihuan has a differentiated sales and marketing model, supported by an extensive nationwide distribution network covering about 12,000 hospitals through 2,500 distributors in 31 provincial regions in China. Products Sihuan depends on CCV drugs, especially Aodimei, Kelinao and Anjieli. Sihuan Pharm has a portfolio of 15 CCV drugs, which are used for treatment of a range of CCV diseases. Sales of CCV drugs accounted for 79.1%, 80.8% and 88.3% of its total revenue in 2009, 2010 and 1H2011 respectively. The company s traditional best-selling CCV drugs, Kelinao and Anjieli which are the only two SFDA-approved drugs containing the active ingredient of Cinepazide Maleate in China, collectively ranked first among all drugs sold in hospitals in China from Sales of the two drugs accounted for 57.3%, 55.0% and 29.9% of Sihuan s total sales in 2009, 2010 and 1H2011. After the M&A of Dupromise Pharm in Jan 2011, Aodimei, a new product added to Sihuan Pharm s portfolio from the M&A became a new flagship product and a key contributor to Sihuan s sales, accounting to 34.7% of its total sales in 1H2011. Another three major products, Chuanqing, Aogan and Qu ao contributed 3.9%, 5.9% and 4.4% to Sihuan s total sales in 1H2011. Figure-7 and Figure-8 set forth the Sihuan s sales breakdown by products in 2010 and 1H2011. Figure-7: Sihuan s sales breakdown in 2010 Figure-8: Sihuan s sales breakdown in 1H2011 Kelinao and Anjieli (Cinepazide Maleate Injection) Kelinao and Anjieli are the two products with the active ingredient Cinepazide Maleat in injection form, packaged in 80mg and 320mg dosages, respectively. Cinepazide Maleate is commonly used in stroke therapy in China. It 1) increases blood flow to the brain and acts as a neuro protectant, 2) improves the blood supply to the ischemic tissues, and 3) can effectively protect nerve cells and myocardial cells. Cinepazide Maleate is one of the leading molecules in the sub-segment of cerebral and peripheral vascular therapies market, accounting for 14.4%, 12.9% and 10.7% in terms of market share in 2009, 2010 and 1H2011, respectively. It was firstly synthesized by Delalande Isnardi Laboratori (France) in 1969, and launched as an oral CCV drug named Vasodistal in France in Although it had been introduced to other countries such as the US and Japan, it is not widely used internationally now, because cinepazide has very little evidence in terms of randomized clinical trial data, which is especially important in western countries. Cinepazide Maleate was launched in China by Sihuan Pharm in 2002, sold with the brand names of Kelinao and Anjieli. Currently. Kelinao and Anjieli are the only SFDA approved drugs containing the active ingredient of Cinepazide Maleate in See the last page for disclaimer Page 5 of 20

6 China. The Company s Cinepazide Maleate product experienced fast yoy growth of 60.8%, 32.6% and 40.3% in , but the growth suddenly slowed down to 8.5% in 1H2011. Figure-9: Sales and Growth of Cinepazide Maleate of Sihuan (RMB mn) The exclusivity of Sihuan s Cinepazide Maleate product might be challenged. As a first-to-market generic drug in China, Sihuan s Cinepazide Maleate is granted a 6-year administrative protection by the SFDA, during which the SFDA would not approve the application for clinical trials of such product by other applicants. Effectively, no other manufacturer is allowed to manufacture or import the same product before the protection period expired on Sihuan believes that its 20-year patent protection of the production method and the stringent quality standards make it technologically difficult for its competitors to indentify an alternative approach to synthesis product of comparable quality, providing it significant advantages over potential new entrants. However, we have found at least 2 companies are transferring their techniques for synthesize of cinepazide as well as the production batches, including Jinan Ruilin Medical Technology Co., Ltd and Beijing HiHealth Pharma. Sci.& Tech. Co., Ltd. If other companies successfully launch the same cinepazide products, Sihuan s sales volume and price would be challenged. There is a large gap between the factory prices and the hospital retailing prices for Kelinao and Anjieli. Sihuan s sales of Cinepazide Maleate was only 27.1%, 27.3%, 31.9% and 35.2% of the hospital purchases value of the drug in 2008, and 1H2011, respectively, indicating that Sihuan s distributors mark-up greatly in the prices of Cinepazide Maleate. According to our rough estimates, about 68% of the hospital purchase price of the drug is distributors mark-up, which might be used in various ways of hospital marketing to drive the sales growth. We think that the sales of the two major products might be affected if the government takes initiatives in public hospital reform and break the value chain of the prescription drugs. Figure-10: Comparison of Sales of Sihuan and Hospital purchase Value of Cinepazide Maleate (RMB mn) Figure-11: Rough Decomposition of the Hospital Purchase price of Cinepazide Maleate Source: The Company, IMS, Guotai Junan International. Source: Guotai Junan International. See the last page for disclaimer Page 6 of 20

7 The Company has become less dependent on the Cinepazide Maleate products, after the successful M&A of Dupromise Pharm in Jan The sales contribution of Cinepazide Maleate products to the Company s total sales dropped significantly from 55.0% in 2010 to 29.9% in 1H2011, as a result of the great sales contribution by Aodimei, the flagship product of Dupromise Pharm. We think the enhanced product portfolio is positive to the Company s future stable development and growth. Aodimei (Cattle Encephalon Glycoside and Ignotin Injection, CEGI) Aodimei, a intravenous neuroprotectant, is Cattle Encephalon Glycoside and Ignotin Injection (CEGI), a product made from cerebroprotein hydrolysate and used for treatment of vascular or traumatic central nervous system damage and Parkinson s disease. CEGI is similar with Ganglioside GM1 in active ingredient and mechanism, but is not the purified type, widely used in China. According a research, the mean cost of CEGI per treatment is about RMB186, about 44% higher than that of Cinepazide Maleate, but 60% cheaper than that of Ganglioside GM1 (Table-1). According to another research of intracerebral haemorrhage (ICH), one sub-category of stroke, of the 72% of total patients who are treated with neuroprotectant, 9.9% are treated with CEGI, while only 5.0% and 2.6% are treated with Cinepazide Maleate and Ganglioside GM1, repectively (Table-2 and Table-3). Table-1: Mean cost of selected investigations, treatments, and wards of acute stroke in China (total sample: 5,255) 45 Level 3 hospital investigated 14 Level 2 hospital investigated Treatments intravenous (by ampoule) tpa (tissue plasminogen activator) Urokinase Defibrase Mannitol 11 5 Neuroprotectants Edaravone Ganglioside GM Cattle encephalon glycoside & ignotin Cinepazide Maleate Citicholine 8 5 Traditional Chinese medicine Treatments oral (by tablet) Beta blocker 2 1 Calcium channel blocker 7 2 Angiotensin-converting enzyme inhibitor 3 1 Clopidogrel Angiotensin II receptor blocker 6 5 Traditional Chinese medicine 7 11 Remarks: *Cv: Coefficient of variation, equal to the standard deviation divided by the mean; Source: Wei et al. PLoS ONE 5(9) Table-2: Different treatment for ICH patients in hospitals (total sample: 1,572) Treatment No. of Patients (%*) Antihypertensive therapy 1007 (64%) Intravenous traditional Chinese medicine 657 (42%) Intravenous neuroprotectan 1130 (72%) Intravenous haemodiluting agents (eg mannitol) 1511 (96%) Intravenous corticosteroids 158 (10%) In neurology ward with stroke unit 380 (24%) Neurosurgical intervention Open craniotomy haematoma evacuation 59 (4%) Shunt insertion 2 (0.1%) Microsurgery haematoma evacuation 59 (4%) Other 17 (1%) Remarks: *As a proportion of all the total 1,572 patients in the research. Source: Wei et al. BMC Neurology 2011, 11:16 See the last page for disclaimer Page 7 of 20

8 Table-3: Different neuroprotectant used to treat ICH patients in hospitals (total sample: 1,130) Neuroprotectant n (%*) Edaravone 95 (8.4%) Ganglioside GM1 29 (2.6%) Cattle encephalon glycoside and ignotin 112 (9.9%) Cinepazide 56 (5.0%) Citicholine 334 (29.6%) Other 198 (17.5%) Unspecified 321 (28.4%) Remarks: *As a proportion of all patients on any neuroprotectant therapy (n = 1,130); Source: Wei et al. BMC Neurology 2011, 11:16 Figure-12: Average cost of per treatment in Level3 Hospitals (RMB) Figure-13: Proportion of all patients on any neuroprotectant therapy Source: Wei et al. BMC Neurology 2011, 11:16 Source: Wei et al. BMC Neurology 2011, 11:16 Currently, only Sihuan (from the M&A of Dupromise Pharm) and Vinise Pharma (a 50% subsidiary of Sihuan) have the SFDA batches of CEGI. We expect the exclusivity would last long as the loose regulatory condition of SFDA s approval is no long in place. Sales of Aodimei reached RMB 344 mn in 1H11 and became the best-selling product of Sihuan, accounting to 34.7% of the Company s total sales. We think the major purpose Sihuan s M&A of Vinise Pharma was to get the SFDA batch of CEGI, and to control the market of CEGI. We believe that there is a great potential market for CEGI. As a substitute of Ganglioside GM1 which experienced a CAGR of 79% in in sales in China, CEGI will experience fast growth in sales, because of its advantageous of low treatment cost compared to Ganglioside GM1. Furthermore, CEGI is a higher-end substitute of Cinepazide Maleate, and Sihuan may upgrade the current market of Cinepazide Maleate to CEGI as well as develop the lower-end market dominated by Citicholoine. In 1H11, the sales of Aodimei, the only CEGI product in China, reached RMB344 mn with Sihuan s marketing efforts in only 17 provinces of China. The market size of CEGI will greatly expand after Sihuan developing the rest market. Aogan Aogan is Ganglioside GM1 in injection form, used for treatment of vascular or traumatic central nervous system damage and Parkinson s disease. It is listed in the Provincial Medicine Catalogue in more than 15 provinces in China. Ganglioside GM1 was the best selling molecule in CCV drug market in 2009, with an estimated market size of RMB1,869 mn which had grown at a CAGR of 93.5% in The Ganglioside GM1 raw material had been the bottleneck of the production of Aogan, and the problem would have been solved after Sihuan acquired 80% equity interest in Changchun Xiangtong, which was announced in Jan Together with Changchun Xiangtong, Sihuan took a market share of 16% in the Ganglioside GM1 market, next to Shandong Qilu Pharm (54% market share) and Harbin Medical University Pharma (20% market share) in 1H2011. With the market monopoly in Cinepazide Maleate and CEGI, the two relatively lower end neuroprotectants, we think Sihuan will be able to seize more market share of Ganglioside GM1 via its existing distribution See the last page for disclaimer Page 8 of 20

9 channel. Figure-14: Market shares of Ganglioside GM1 in 1H2011 in China Source: IMS, Guotai Junan International Chuanqing Chuanqing is ligustrazine hydrochloride lyophilised powder for injection, used in the treatment of ischemic CCV diseases related to insufficient blood supply to the brain. The size of China s ligustrazine market was estimated at RMB493.2 mn in 2009, grown at a CAGR of 28.1% since Sihuan launched Chuanqing in 2003, and it was the best selling ligustrazine for injection drug in China in terms of market share, accounting for approximately 59% in 1H2011, while its largest competitor, Hefei Pingguang Pharma had a much smller market share of 27% of all ligustrazine hydrochloride products in 1H2011. Figure-15: Market shares of Ligustrazine in 1H2011 in China Source: IMS, Guotai Junan International Qu ao Qu ao is cerebroprotein hydrolysate lyophilised powder for injection, used primarily in the treatment of traumatic brain injury and cerebral vascular disease sequelae associated with memory impairment and the protection of brain tissue. It is clinically proven to be able to regulate and improve nerve cell metabolism, promote synapse generation, induce nerve cell differentiation and protect nerve cells against damage from ischemia and neurotoxins. Qu ao (product of Sihuan) has the second largest market share of cerebroprotein hydrolysate drug in China, accounting for 23% of China s market of cerebroprotein hydrolysate products, next to the 35% market share of Yunnan Mengsheng Pharma in 1H2011. See the last page for disclaimer Page 9 of 20

10 Figure-16: Market shares of Cerebroprotein Hydrolysate in 1H2011 in China Source: IMS, Guotai Junan International Qingtong. Qingtong is edaravone injection used primarily in the treatment of ischemia-reperfusion injury in patients with cerebral infarction. It is clinically proven to act as a potent antioxidant and strong scavenger of free radicals and to protect against oxidative stress and neuronal apoptosis. Simcere dominates more than 90% market share of edaravone in China, and the competition from other manufacturers is also very fierce. Anti-infective drugs. Sihuan market and sell about 11 anti-infective drugs, including cefpiramide sodium for injection, cefmenoxime hydrochloride for injection, sulbenicillin sodium for injection. Sihuan s sales of Anti-infective drugs increased by 55.0% yoy in 2010, contributing 12% of its total sales. Despite the fast growth in 2010, we think the sales of this segment would be affected by the tightened control of anti-infective drugs by the government in Sales model and distribution network Traditionally, Sihuan has a unique sales model. Instead of maintaining an in-house marketing and promotion team at high costs, or outsourcing the marketing and promotion activities entirely and losing the control of the distribution network, Sihuan has a in-house team of around 300 sales and product managers who manage the third-party sales representatives employed by its distributors. The in-house team formulate the marketing and promotion strategies, sets sales targets and product mix, trains, coordinates, and monitors the performance of distributors and sales representatives, making sure the efficiency, productivity and stability of the network. The distributors and third-party sales representatives have a deep knowledge and understanding of the local markets and have established sales channels with local hospitals and physicians and can therefore effectively promote the products. This unique model makes it more convenient to encourage doctors to prescribe Sihuan s products, while the risks have been passed to Sihuan s distributors and sales representatives. Figure-17: the unique sales and promotion model of Sihuan See the last page for disclaimer Page 10 of 20

11 The post-m&a integration of the distribution channels. After the M&A of Dupromise Pharm, Sihuan has maintained the sales model of Dupromise, which has in-house team of sales representatives who are responsible for hospital promotions. The sales model of Dupromise is widely used by most large pharmaceutical Companies. With this sales model, the distribution expenses by the representatives are included in the P&L of the pharmaceutical manufacturers and thus the net profit margins are generally lower than Sihuan s traditional sales model. As a result, prices of products from these manufactures are less likely to be cut by the government. We think Sihuan might gradually shift its traditional sales model to the sales model of Dupromise, by incorporating its distributors and sales representatives. Sihuan is constantly developing its sales team and distribution network. Before its listing in late Oct 2010, Sihuan s sales and distribution network covered 10,000 hospitals (around 890 or 70% all Class III hospitals, 3,600 or 55% of all Class II hospitals and 5,400 Class I and other hospitals and medical institutions) in China through over 2,000 distributors. In 2010 after listing, Sihuan newly hired over 30 additional marketing staff and expanding its distribution network to over 2,500 distributors. On one hand, its distribution network is extensive and stable for the existing products and the fast growth of new products; on the other hand, compared to the developed eastern or coastal provinces, Sihuan still has a lot potential to develop the middle and western market to support its sales growth. R&D Sihuan Pharm has two R&D teams composed of 333 personnel, including 11 Ph.D holders and 134 master s degree holders. The Shandong team of 289 personnel led by 6 key research scientists focuses on the discovery and development of new chemical entities as novel therapeutic agents, while the Hainan and Beijing team of 44 personnel focuses on the development of first-to-market generic drugs, in relation to which it has developed intellectual property rights in formulation, production process, improved chemical attributes or drug delivery system. According to the disclosure of its annual report, Sihuan spends a lot portion of its revenue (9.1% in 2010) in R&D, and has got several patents and a pipeline of over 30 product candidates, 4 of which are possible to be launched in Sihuan s R&D expenses were much smaller than the R&D spending, mainly because a big portion of the R&D spending was for capitalized programs such as purchase of equipment and purchase of R&D projects (Figure-18) and its relatively short history in R&D. We think Sihuan s R&D scale or R&D expenses to revenue ratio is still much smaller compared to the large international peers (Figure-19), and its knowledge accumulation in R&D is not rich enough due to its short history. Figure-18: R&D spending (RMB thousand) and R&D spending to revenue ratio (%) of Sihuan Figure-19: R&D expenses to revenue ratio (%) of Sihuan and other companies Source: the Companies, Guotai Junan International See the last page for disclaimer Page 11 of 20

12 M&A Activities Sihuan has announced 5 major M&A activities after its IPO in Oct 2010 with total net considerations of RMB2.7 bn, including 1) acquisition of Dupromise Pharm, 2) acquisition of distribution rights from Benxi Leilong, 3) acquisition of Changchun Xiangtong Pharma, 4) the acquisition of Vinise Pharma and Hainan Litzman Pharma, and 5) dispose of the 50% equity interests of Vinise Pharma to Shandong Buchang. Table-4 sets forth the details of these M&A activities. Table-4: 5 Major M&A activities Date Company Acquired / Disposed % Acquired (Disposed) Total Consideration Products Dupromise Pharma 100% RMB2,400 mn Aodimei (Cattle Encephalon Glycoside and Ignotin Injection), Yuanzhijiu (Troxerutin and Cerebroprotein Hydroilysate Injection) Benxi Leilong Pharma - RMB36.2 mn Alprostadil injection (30-year exclusive distribution rights) Changchun Xiangtong Pharma 80% RMB140.6 mn Ganglioside GM1 API facilities and 40 drug batches Vinise Pharma and Hainan Litzman Pharma 100% RMB775 mn Vinise Pharma (50%) (RMB637.5 mn) Breviscapin Sodium Chloride Injection, Breviscapine Glucose Injection, Salivae Miltiorrhizae and Liguspyragine Hydrochloride Injection, Salivae Miltiorrhizae, Liguspyragine Hydrochloride and Glucose Injection Breviscapin Sodium Chloride Injection, Salivae Miltiorrhizae, Liguspyragine Hydrochloride and Glucose Injection M&A activities have driven the sales growth of the Company. Sales of newly acquired products launched in 1H2011 amounted RMB425 mn, or 42.8% of the total revenue in the period. The organic sales growth (i.e., excluding the newly acquired products) of the Company was only 20.6% yoy, while the total sales growth was 109.2% yoy in 1H2011. M&A activities have been the major growth drivers of the Company. M&A activities have greatly optimized the product portfolio of the Company. Through M&A, the Company acquired several major products, including Aodimei and Yuanzhijiu from Dupromise Pharma, the exclusive distribution rights of Yimaining from Benxi Leilong, Ganglioside GM1 API from Changchun Xiangtong, and Breviscapine and Salivae Miltiorrhizae and Liguspyragine products from Vinise Pharma. Sales of Aodimei surpassed Cinepazide Maleate (Kelinao and Anjieli) and reached RMB 344 mn in 1H2011, accounting to 34.7% of the Company s total sales and greatly reducing its dependence on the Cinepazide Maleate products, the sales contribution of which reduced significantly from 57.6% in 1H2010 to 29.9% in 1H2011. Sihuan will monopoly the market of CEGI via the M&A of Vinise Pharma. Without enough experience in traditional Chinese CCV medicines, Sihuan should have very limited interest in traditional Chinese CCV medicine business. We think that Sihuan acquired Vinise Pharma mainly for its SFDA batch for CEGI. So, after the successful M&A of Vinise Pharma, Sihuan disposed 50% equity interests to Shandong Buchang, and greatly reduced its risks in traditional Chinese CCV medicine business. Currently, according to SFDA, Sihuan and Vinise Pharma are the two only manufacturers who have CEGI batches. We expect the exclusivity would last long as the loose regulatory condition of SFDA s approval is no long in place. Strong cash position and successful M&A tracks bring bright future for the M&A prospect of the Company. On 30 June 2011, the Company had cash of about RMB5 bn, and it is expected to generate strong cash flow from operations in the next future years. The strong cash position strongly supports its future M&A activities. Furthermore, the successful experiences in the M&A as well as in the post-m&a synergies give the Company a good image as an acquirer and may be helpful for the Company s future M&A negotiations. According to our conservative estimates, Sihuan s capital expenditure for M&A may amount to RMB 3,104 mn, 700 mn and 700 mn in Strong M&A will continue being the growth driver of Sihuan. See the last page for disclaimer Page 12 of 20

13 Financial Analysis Aodimei (CEGI) will be the sales driver of the Company. In 1H2011, sales of Aodimei reached RMB344 mn, accounting for 34.7% of the Company s total sales in the period. As a higher-end substitute of Cinepazide Maleate and lower-end substitute of Ganglioside GM1, we think Aodimei has a very large market. In 1H11, Aodimei is only promoted in 17 provinces, and we expect the sales of Aodimei to grow greatly as the Company will expand the market of Aodimei to all other provinces. Furthermore, we think the Company may focus to promote Aodimei via its current distribution channel of Cinepazide Maleate, and purposely change the doctors prescription customs from Cinepazide Maleate to Aodimei. Based on the above positive factors and our conservative assumptions, we expect the sales of Aodimei to reach RMB735.6 mn in 2011, and grow by 31.3% to RMB964.4 mn in 2012 and by 25.7% to RMB1,212.2 mn in 2013, accounting to 34.1%, 36.0% and 37.9% of the Company s total sales, respectively. Sales growth of Cinepazide Maleate is slowing down. Sihuan s Cinepazide products, Kelinao and Anjieli are already mature products, and are facing fierce competitions from other substitutes as well as the potential new Cinepazide products to be launched by its competitors, thus, we think the sales growth of Cinepaide Maleate is slowing down. The products also have some risks of price cuts by the government. Moreover, the Company s focus on Aodimei promotions may slightly affect the sales volume of Cinepazide Maleate. Thus, although sales of the two Cinepazide products collectively experienced fast growth of 32.6% in 2009 and 40.4% in 2010, the sales growth has started to slow down to 8.5% yoy in 1H2011. We expect the sales of Cinepazide Maleate to grow by 5.4% yoy to RMB601.0 mn in 2011, 0.4% yoy to RMB603.7 mn in 2012 and retreat by 3.6% yoy to RMB581.9 mn in Accordingly, proportion of Cinepazide Maleate is estimated to reduce from 55.1% in 2010 to 27.9%, 22.6% and 18.2% in Ganglioside GM1 will become the third best selling product of Sihuan. Sihuan has greatly increased its market share of Ganglioside GM1 from 7.4% in 1H2010 to 16% in 1H2011, after the successful M&A of Changchun Xiangtong. Moreover, the acquisition also broke the bottleneck problem of Ganglioside GM1 API for the Company. As a higher-end substitute of Cinepazide Maleate and CEGI, we think sales of Ganglioside GM1 wil grow fast upon the distribution channel synergy among the three products. We expect its sales to grow by 117.8%, 66.0% and 37.6% to RMB144.1 mn, RMB239.2 mn and RMB mn in , accounting to 6.7%, 8.9% and 10.3% of the Company s total sales, respectively. Figure-20: Sihuan s sales breakdown by products (RMB mn) Total drug sales to grow by 108.0%, 24.1% and 19.6% yoy to RMB2,155 mn, RMB2,675 mn and RMB3,200 mn in (excluding the sales of Vinise Pharma which is a JV of Sihuan and Shandong Buchang), according to our estimates. The fast growth in 2011 will be mainly driven by the successful M&A activities, and the continuous fast growth in will be driven by the fast growth of Aodimei and Ganglioside GM1, while partially offset by the slowing down growth or retreat of Cinepazide Maleate and the anti-infective drugs. Collectively, the total sales of CCV drugs is estimated to grow by 126.1%, 24.6% and 20.1%, accounting to 87.8%, 88.2% and 88.5% of the Company s total sales in See the last page for disclaimer Page 13 of 20

14 Table-5: Sales(RMB mn) and growth estimates of Sihuan s major products in A 2010A 2011F 2012F 2013F 1H2010 1H2011 Kelinao Growth 27.8% 37.9% 1.2% -3.0% -7.9% - 3.6% Anjieli Growth 58.3% 51.3% 22.4% 11.9% 8.7% % Chuanqing Growth 27.2% 31.5% 35.0% 21.0% 0.0% % Ganglioside GM Growth % 189.7% 117.8% 66.0% 37.6% % Qu'ao Growth 60.8% 58.8% 44.4% 41.1% 37.4% % Qingtong Growth % 8.8% 11.4% 12.9% % Aodimei , Growth % 25.7% - - Yuanzhijiu Growth % 19.8% - - Yimaining Growth % 23.3% - - Other CCV Growth -7.3% 24.2% 128.7% 88.0% 74.4% % Total CCV , , , Growth 39.7% 49.4% 126.1% 24.6% 20.1% % Anti-infective drugs Growth 20.1% 55.6% 37.5% 12.8% 3.3% % Other products Growth 38.7% 30.6% 28.7% 26.7% 25.4% % Total drug sales , , , , Growth 39.0% 46.3% 108.0% 24.1% 19.6% 109.2% Gross margin is expected to increase in 2011, but decrease in The newly acquired business relatively has higher gross margins, because of the in-house teams of sales representatives. As a result, the gross margin of the Company increased significantly by 5pts to 78.2% in 1H2011. According to our estimates, the gross margin of Sihuan s original products was about 72.0%, while that of the newly acquired products was about 87.6% in 1H11. As we expect the gross margins of both the original products and the newly acquired products to reduce in the future because of drug price cut by the government as well as in drug biddings. We expect the gross margin of the original products to reduce to 69.1%, 67.4% and 66.0% in , and that of the newly acquired products to be 87.7%, 86.5% and 84.6% in Total gross margin of the Company is expected to reduce from 78.2% in 1H2011 to 76.5%, 75.4% and 74.1% in Distribution expenses ratio (distribution expenses to total sales) will increase significantly. Because of the different distribution models of the newly acquired business, the distribution expenses ratio of the Company increased significantly from 5.6% in 1H2010 to 29.7% in 1H2011. We have decomposed the total distribution expenses ratio to the Company s original products and newly acquired products, and we think the distribution expenses of the newly acquired products is about 65.5% in 1H2011. We expect the total distribution expenses ratio of the Company to be about 29.5%, 29.9% and 30.3% in See the last page for disclaimer Page 14 of 20

15 Figure-21: Gross margin of Sihuan Figure-22: Distribution expenses ratio of Sihuan Gains from the Vinise Pharma JV. The Vinise Pharma JV with Shandong Buchang is estimated to contribute RMB20 mn, 70 mn and 160 mn to Sihuan s total net income, accounting to 2.6%, 7.5% and 13.9% of the Company s total net income in With the strong marketing networks of Sihuan in CCV drugs and expertise of Shandong Buchang in traditional Chinese CCV medicines, we expect the Vinise Pharma JV to develop stably and fast, being another profit driver of Sihuan. Net profit is estimated to grow by 48.1% yoy, 20.2% yoy and 24.0% yoy to RMB773 mn, RMB929 mn and RMB1,152 mn in Because of the dilution effect of the IPO, we expect the EPS to grow mildly by 14.5% yoy to RMB14.9 Cents in 2011, and faster by 20.3% yoy to RMB18.0 Cents and 24.0% yoy to RMB22.3 Cents in Peers Comparison and Valuation Comparison of Sihuan with Sino Biopharm (01177 HK), Jiangsu Hengrui ( CH) and other several A-share pharmaceutical companies and several of the world s largest pharmaceutical companies listed in NYSE. We think these companies are good references to evaluate the opportunities, strength, as well as the problems of Sihuan, and to value the Company. Compare Sihuan with Sino Biopharm (01177 HK). Size and business scope: Both Sihuan and Sino Biopharm are two largest companies engaging in specialized medicines. They develop, manufacture, and sell specialized medicines to doctors through kinds of clinical promotions and academic activities, and build up their brands as specialty medicine enterprise. In the end of 2010, Sihuan s total assets of RMB 6,902 mn is in the similar size with the HKD 5,620 mn of Sino Biopharm. In 2010, net profit of Sihuan was RMB522 mn, similar with the HKD567 mn of Sino Biopharm. Product mix: Sino Biopharm s products can be grouped under the two major therapeutic catergories of CCV and hepatitis, accounting to about 37% and 43% of Sino Biopharm s total sales in It also actively develops medicines for treating tumors, analgesia, respiratory system diseases, diabetes and digestive system diseases (Figure-23). Compared with Sino Biopharm, Sihuan focuses more on CCV products, which collectively accounted about 80.8% and 88.3% of the Sihuan s total sales in 2010 and 1H2011, respectively. Sales model: Sino Biopharm maintains an in-house marketing and promotion team at high costs (the most popular sales model for large pharmaceutical companies) and thus the total employees amounted 8590 in In contract, Sihuan traditionally has a unique sales model in that it has an in-house team of around 300 sales and product managers who manage the third-party sales representatives employed by its distributors, and thus, Sihuan had only 1030 employees in In Jan 2011, Sihuan acquired Durpomise Pharma and maintained its sales model, which is similar with Sino Biopharm. See the last page for disclaimer Page 15 of 20

16 Margins: Gross margin of Sino Biopharm was 80.9% in 2010, while Sihuan s gross margin was 71.8% in But Sihuan s net margin was 50.3%, much higher than 13.9% of Sino Biopharm in the same period. We think the differences are caused by the different sales models. However, as Sihuan s newly acquired Dupromise Pharma has a similar sales model as Sino Biopharm, Sihuan s gross margin increased and net margin decreased significantly after the acquisition. R&D: Both Sihuan and Sino Biopharm declare themselves to be high-tech companies and highly value the innovations. Sino Biopharm s R&D expenses to revenue was 4.5% in 2009 and 5.6% in 2010, while Sihuan s R&D expenses to revenue was 3.3% in 2009 and 2.9% in 2010 (the R&D expenses contain the amortization of the historical R&D spending). Although Sihuan s R&D spending reached 7.1%, 6.8% 9.1% in , respectively, we think the capital expenditure in R&D, especially the purchases of R&D equipments would not generate instant advantage for Sihuan, because R&D need historical accumulations. Instead, we think Sihuan is more likely to include new products to its product portfolio from M&A activities. Figure-23: Sino Biopharm s sales breakdown by products Growth prospects: Net profit of Sihuan is estimated to grow by 48.1% in 2011 and 20.2% in 2012 (or 58% in 2011 and 35% in 2012, according to Bloomberg consensus), driven by its M&A projects after its IPO in HKEx. In contract, recurring net profit of Sino Biopharm is estimated to organically grow by 6% in 2011 and 27% in 2012, according to Bloomberg consensus. Sihuan surpasses Sino Biopharm in the growth prospects. Compare Sihuan with Jiangsu Hengrui ( CH) Jiangsu Hengrui is one of the largest companies in China in developing, manufacturing and distributing generic oncology medicines, analgesic medicines and antibiotics. Product mix: Oncology medicines, surgical operation medicines, antibiotics and other products accounted for 58%, 14%, 11% and 17% of the total sales of Hengrui. Most of these products are generic drugs developed by the oversea top pharmaceutical manufacturers, have been the proven to be very effective, and are very widely used internationally. Docetaxel and Oxaliplatin, its top two products, contributed to 25% and 17% of its total sales in Compared with Hengrui, Sihuan s top 2 flagship products, CEGI and Cinepazide Maleate are two drugs uniquely used in China, contributing to 34.7% and 29.9% of Sihuan s total sales. Currently, Sihuan is the exclusive manufacturer for these two products. See the last page for disclaimer Page 16 of 20

17 Figure-24: Jiangsu Hengrui s sales breakdown by product segment Market status: Hengrui has strong market dominance in oncology medicine market and surgical operation medicine market, with an about 17% and 11% market share, respectively in Similar with Hengrui, Sihuan is the largest CCV franchise with a market share of 9% in CCV medicine market in 1H11. R&D: Hengrui s R&D could be dated back to 1997, when it started cooperation with some research institutes. In 2009 and 2010, the R&D expenses to total sales of Hengrui was about 8% and 9%, respectively. Hengrui has three R&D centers: Lianyungang R&D centre for chemosynthesis, Shanghai R&D centre for novel drugs and the US R&D centre for novel drugs. Leveraged by its strong R&D, Hengrui is launching new products continuously, and has lots of potential products to be launched. Compared to Hengrui, which is generally considered to be the most competitive pharmaceutical company in R&D in China, Sihuan has a shorter history and less accumulation. Internationalization: Besides the R&D center in the US, Hengrui also seeks to apply the US FDA s approvals for several of its products. Although the export might not generate great sales for Hengrui, we think its international presence would improve its image among doctors and patients. Compared with Hengrui, Sihuan has a much less international presence. But we do not think the weak internationalization of Sihuan may affect its domestic sales in China. Conclusion Rated Buy with TP of HK$3.60. According to Consensus, Sino Biopharm is now traded at around 19.6x 2011PE and 15.3x 2012 PE, while Hengrui is traded at 32.9x 2011 PE and 26.3x2012 PE. Compared to the valuation of Sino Biopharm and valuation premium of Hengrui over the China-A-Share peers, as well as the valuation of other pharmaceutical peers in HKEx, we set our target price for the Company at HK$3.60, reflecting 19.8x 2011 PE, 16.4x 2012 PE and 13.2x 2013 PE. Trading at 13.6x 2012 PE, the Company has a potential 19.6% upside for the shares, and we give it a Buy rating. The uncertainty policy environment has greatly affected the valuation of healthcare stocks, including Sihuan, but we think we have already fully considered the price cut possibilities and margin pressures of Sihuan. Furthermore, the share price of Sihuan was greatly affected by 1) the slowing down growth of the Cinepazide Maleate products, 2) the uncertainties of its new approach to Chinese CCV medicines by acquiring Vinise Pharma and the disposal of 50% equity interests of Vinise Pharma. However, we think 1) Sihuan s product mix has greatly improved after the M&A of Durpomise Pharm and it is much less dependent on the Cinepazide Maleate product. Furthermore, the slowing down growth of Cinepazide Maleate might because Sihuan is strategically focusing more on CEGI, the substitute of Cinepazide Maleate, 2) we think the main purpose of the M&A of Vinise Pharma was to acquire its CEGI batch and thus become the exclusive manufacture of CEGI. Sihuan greatly reduced its risks in Chinese CCV medicine business by disposing the 50% equity interests of Vinise Pharma to Shandong Buchang. See the last page for disclaimer Page 17 of 20

18 Major risks The uncertain policy environment may last long, and we think Sihuan s products may be subject to price cuts. The top 2 best selling products of Sihuan, Cinepazide Maleate and CEGI, collectively accounted to about 65% of the Company s total sales in 1H2011. The government will launch stricter policies to restrict over-uses of anti-infection drugs, and the policy may affect the sales of some of Sihuan s products. Healthcare Reform in China may restrict hospital promotions and thus affect the sales of Sihuan. Table-6: Peers Comparison Company Stock Code Currency Share Price Mkt Cap PE PB ROE (%) (million) 11F 12F 13F 11F 12F 13F 11F 12F HK listed companies Sihuan Pharmaceutical Hldgs HK HK$ , Sino Biopharmaceutical HK HK$ , China Shineway Pharmaceutica HK HK$ , The United Laboratories Inte HK HK$ , Guangzhou Pharmaceutical-H HK HK$ , China Medical System Holding HK HK$ , Sinopharm Group Co-H HK HK$ , Shanghai Pharmaceuticals-H HK HK$ , China Medical System Holding HK HK$ , Shandong Weigao Gp Medical-H HK HK$ , Simple Average Weighted Average China listed companies Guangxi Wuzhou Zhongheng G-A CH RMB , n.a. n.a. n.a. n.a. n.a. Guangzhou Pharmaceuticals-A CH RMB , Harbin Pharmaceutical Grp-A CH RMB , Jiangsu Hengrui Medicine C-A CH RMB , Simple Average Weighted Average Pfizer Inc PFE US US$ , Sanofi-Adr SNY US US$ , n.a. n.a. n.a n.a. Glaxosmithkline Plc-Spon Adr GSK US US$ , n.a n.a Merck & Co. Inc. MRK US US$ , Roche Holdings Ltd-Spons Adr RHHBY US US$ , n.a. n.a. n.a. n.a n.a. Novartis Ag-Adr NVS US US$ , n.a. n.a. n.a n.a. Eli Lilly & Co LLY US US$ , Simple Average Weighted Average Source: Bloomberg, Guotai Junan International See the last page for disclaimer Page 18 of 20

19 Financial Statements and Ratios P&L (RMB mn) FY09A FY10A FY11F FY12F FY13F Cash Flow (RMB mn) FY09A FY10A FY11F FY12F FY13F Net revenue 709 1,037 2,157 2,677 3,202 Profit before tax ,168 1,424 Cost of sales (192) (292) (507) (660) (829) Depreciation and Amortisation Gross profit ,650 2,018 2,373 Interest income (6) (24) (70) (24) (23) Other adjustment 41 (116) Other income (16) Change in working capital (4) (15) (449) 206 (450) S&D expenses (49) (57) (637) (802) (969) Tax paid (53) (136) (199) (226) (260) Administrative expenses (79) (129) (177) (205) (232) Cash flow from operations , Operating profit ,077 1,244 Finance income, net Purchase of PPE (57) (108) (120) (152) (207) Gains from JV M&A 0 (236) (3,104) (700) (700) Profit before income tax ,168 1,424 Interest income Income tax expense (67) (128) (199) (226) (260) Others 67 (39) Profit after tax ,164 Cash flow from investment 16 (364) (3,134) (813) (844) Minority interests (13) (15) (12) (12) (12) Free cash flow (2,798) 379 (69) Net profit ,152 EPS (RMB cents ) Equity raised / (repaid) 0 5, Debt raised / (repaid) DPS(RMB Cents) Dividends paid (120) (174) (676) (219) (263) Yield (%) Others Cash flow from financing (120) 5,222 (676) (219) (263) Balance Sheet (RMB mn) FY09A FY10A FY11F FY12F FY13F Cash and equivalents 613 5,851 2,377 2,537 2,205 Cash at yr beginning ,851 2,377 2,537 Accounts receivable Net Change in Cash 282 5,239 (3,474) 160 (332) Inventories Cash at yr end 613 5,851 2,377 2,537 2,205 Others Current assets 797 6,165 3,175 3,149 3,294 Growth (%) FY09A FY10A FY11F FY12F FY13F Revenue Long-term investments Gross Profit PPE Operating profit Intangible assets ,359 3,972 4,569 Net Profit Other non-current assets EPS Total non-current assets ,061 4,834 5,619 Margins (%) FY09A FY10A FY11F FY12F FY13F Total assets 1,173 6,902 7,236 7,983 8,913 Gross margin (%) Operating margin (%) Trade and other payables Net margin (%) Short-term loans Other current liabilities Ratios FY09A FY10A FY11F FY12F FY13F Total Current liabilities Inventory turnover (x) Receivable turnover (x) Non-current liabilities Payable turnover (x) Total liabilities Net debt / equity (%) (67.5) (87.9) (82.2) (74.2) (71.3) ROA (%) Shareholders' equity 908 6,657 6,839 7,545 8,418 ROE (%) Non-Controlling interests Valuation FY09A FY10A FY11F FY12F FY13F Total liabilities and equity 1,173 6,902 7,236 7,983 8,913 P/B (x) BVPS (RMB) P/E (x) See the last page for disclaimer Page 19 of 20