Health Care Sector: Antibiotic Industry Continues Deteriorating

What happened: Recently, some antibiotic bulk drug manufacturers have raised factory prices of antibiotic bulk drugs and intermediates incl uding 7-ACA, Penicillin Industry Salt and 6-APA . Some people may consider it as a good sign of turning point of the industry.

Comments and Views: Prices of major antibiotic bulk drugs have started dropping since 2011 and mostly have been the lowest in history now . Because of increasing cost, especially the increasing environment protection cost, some of these manufacturers are in deficit, while some have closed part or all of their production lines. We think there are two major reasons: 1) low entry barrier in technologies caused production expansion and overcapa cities, 2) government started to tightly control the clinical uses of antibiotics, re sulting in the shrinking of downstream antibiotic finished drug market, which is expected to cut by 40% in the future if antibiotics are reasonably used in the future. Consequently, we think the antibiotic industry will continue deteriorating despite of the short-term price rises of antibiotic bulk drugs.

Investment suggestion: China Pharma (01093 HK) and Lijun Int’l (02005 HK) are two companies with major products of antibiotic bulk drugs and antibiotic finished drugs, respectively. In the negative background of the antibiotic industry, we expect the profits of the two companies to continue retreating. We could not see turning point or investment opportunities now and will maintain “Reduce” and “Neutral” rating for them, respectively.

Shanghai Pharmaceuticals (02607 HK): Pharmaceutical Distribution Business to Lead its Growth, “Buy”

Shanghai Pharmaceuticals Holding Co., Ltd (SPH) is the largest vertical integrated pharmaceutical company in China, ranking No.3 in pharmaceutical manufacturing and No.2 in pharmaceutical distribution. Production, distribution and retail segments accounted 61.4%, 35.9% and 1.4% of SPH’s total operating profit in 2010, respectively.

Production: Most products in its rich product portfolio are “General Medicines” and face fierce competitions. Future M&A other than its relatively poor R&D would be the growth driver, but its M&A of the Antibiotic Business in 2011 may be a drag for both revenue and profit growth. Segment operating profit is expected to grow mildly by 3.2%, 10.1% and 14.3% yoy in 2011-13.

Distribution: SPH is traditionally the largest pharmaceutical distributor in Eastern China, taking 11.0% market shares in 2009. It has extended geographical coverage in Fuji an, Guangdong and Beijing via M&As. It distributes over 18,600 different products of more than 2,600 manufacturers to over 7,600 hosp itals, 2,300 sub-di stributors and 2,200 retailers. Segment revenue is expected to grow fast as a result of market ex pansion and operating margin is expected to improve with improving efficiencies. Segment operating pr ofit is estimated to grow by 65.9%, 43.1% and 29.0% yoy in 2011-13.

Adjusted EPS is expected to grow by 26.5%, 13.1% and 18.5% yoy to RMB0.860, 0.973 and 1.153 in 2011-13. Sum-of-The-Parts-Valuation method based on peers comparisons suggests fare value of HK$19.86, which is 11% discount to the DCF Valuation. Initiation with “Buy” rating.

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