China China Healthcarepg.jrj.com.cn/acc/Res/CN_RES/INDUS/2012/8/6/e1d2e2...Deutsche Bank Markets Research Asia China Health Care Health Care Industry China Healthcare Date 6 August

Deutsche Bank Markets Research

Asia China Health Care Health Care

Industry

China Healthcare

Date 6 August 2012

Industry Update

China Healthcare Prepbook: Essential Drug List EDL Prepbook as a reference

________________________________________________________________________________________________________________

Deutsche Bank AG/Hong Kong

All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. 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.

Jack Hu, Ph.D

Research Analyst (+852) 2203 6208 [email protected]

Top picks

The United Laboratories (3933.HK),HKD3.63

Buy

Companies Featured

The United Laboratories (3933.HK),HKD3.63

Buy

2011A 2012E 2013EP/E (x) 121.2 25.4 16.9EV/EBITDA (x) 19.6 8.9 7.3Price/book (x) 1.1 0.9 0.9

Shanghai Pharmaceuticals (2607.HK),HKD11.38

Hold

2010A 2011E 2012EP/E (x) – 13.2 13.6EV/EBITDA (x) – 5.8 4.9Price/book (x) 0.0 1.0 1.0

China Shineway (2877.HK),HKD11.16 Hold 2010A 2011E 2012EP/E (x) 19.2 10.0 9.6EV/EBITDA (x) 13.4 5.7 5.1Price/book (x) 5.0 2.1 1.8

With EDL expansion looming, we brief investors with this reference piece on EDL basics. We include an overview of the EDL, the history and evolution of the EDL, policies related to the EDL and its implementation during healthcare reform, as well as the impact on company P&L. We highlight potential risks associated with EDL expansion in the near term due to pricing risks, as well as opportunities with EDL inclusion for the long term for volume gains. We stay on the sidelines with companies with substantial EDL exposure, including Shineway (2877.HK) and Shanghai Pharma (2607.HK).

EDL 101: EDL as a prelude to healthcare reform The Chinese government adopted the WHO (World Health Organization) concept of essential drugs to provide a range of drugs that satisfy basic medical needs for the general public. Since the first version was published in 1996, the EDL has been revised five times, with 307 drugs in the 2009 version. The government sets price caps on EDL drugs and mandates centralized procurement to ensure fair pricing and accessibility, as reimbursement of EDL drugs remains highest among all drugs. We think EDL implementation represents a prelude to healthcare reform, instead of an isolated event.

Implementation of EDL; impact on drug sector The primary objectives of EDL implementation include price deduction and reimbursement expansion. On centralized procurement, the Anhui model, marked by a double-envelope selection method and single supplier mandate, has become a boilerplate and gained nation-wide adoption. Meanwhile, reimbursement for EDL drugs targets near the 100% level. As the Anhui model led to competitive underbidding, the average price erosion for the EDL drug tender was approximately 42% in 2011, which created enormous pricing pressure on the drug industry; even the total amount of EDL drug sales represented only 10% of the entire drug sales. Industry antagonism to the Anhui model was based on the fear that it could spread to RDL (reimbursement drug list) drug tenders, as RDL drug sales represent over 65% of the drug market. During the 2012 RDL drug tender season, a modified version of the Anhui model was adopted.

Outlook for EDL We anticipate that 1) EDL expansion will exert pricing pressure for the new additions in the 2013/2014 EDL tender season; 2) volume benefits will emerge in the long term for EDL drugs; 3) the current procurement system is likely to facilitate consolidation of EDL manufacturers. We have conviction that implementation of the EDL is more likely to bring tangible benefits for the general public at the expense of manufacturers.

We prefer multiples-based valuation; risks relate mainly to policy/regulations We use a multiples-based valuation approach in light of the sustainable growth that we expect from the sector. Industry risks relate mainly to government policies and regulatory changes in China, particularly healthcare reforms, which could negatively affect pricing. Additional risks generally relate to rising raw material costs and over-exposure to the EDL.

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Page2 Deutsche Bank AG/Hong Kong

Table Of Contents

Summary ........................................................................................ 3 The big picture: EDL as a prelude to further reform .......................................................... 3 Impact on value chain: near term negative, long term positive ........................................ 3

Essential Drug List 101 ................................................................... 4 Definition of National Essential Drug List (EDL) ................................................................ 4 History of EDL..................................................................................................................... 4 Current version of EDL ....................................................................................................... 5 Provincial EDLs expanded based on national EDL ............................................................ 6 EDL pricing ......................................................................................................................... 7 Policies related to EDL procurement process .................................................................... 8 EDL drug procurement process ......................................................................................... 9 Anhui model tender process ............................................................................................ 10 Selective achievements .................................................................................................... 11 Potential EDL expansion ................................................................................................... 18

Companies’ exposure to EDL ....................................................... 20 The United laboratories (3933.HK) ................................................................................... 20 Shanghai Pharmaceuticals (2607.HK) .............................................................................. 21 China Shineway (2877.HK) ............................................................................................... 22

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Deutsche Bank AG/Hong Kong Page3

Summary

The big picture: EDL as a prelude to further reform

As we contextualize EDL implementation into the framework for healthcare reform, we believe the EDL is the prelude to further reform. By orchestrating a simplified version of multi-agency collaboration, the government successfully achieved multiple near-term objectives, including

• reducing drug prices by more than 40%, which will save significant costs for the reimbursement system; meanwhile, the experience from centralized procurement on EDL drugs is likely to be expanded to RDL drug tender;

• implementing zero mark-up policies, vs. 15% mark-up for all other drugs, which represents the first step to expanding the zero mark-up policy;

• further consolidation of distributors for EDL drugs.

Importantly, further consolidation of EDL drug manufacturers is highly likely, as smaller manufacturers would be unable to sustain the low margin structure. At the same time, manufacturers expressed antagonism toward this policy, stating that drug quality could be jeopardized with deeply discounted prices.

It is clear to us that the incoming leadership has a defined agenda on healthcare reform, a multi-year initiative that would have a significant impact on the healthcare value chain. We strongly recommend that investors view the EDL as an integral part of the reform, not as an isolated event.

Impact on value chain: near-term negative, long-term positive

In the near term, the implementation of the EDL had a negative impact on drug manufacturers and distributors as a whole, due to significant price reduction and relatively anemic volume growth. As the entire EDL drug class suffers more than 40% price deduction, any modest volume gains are unlikely to make up for the significant price erosion. As such, it would be hard to fathom winners among the EDL manufacturers.

However, as EDL drugs are reimbursed at a much higher rate than any other drug classes, and most times at 100%, we have conviction that it is just a matter of time for accelerated volume growth for this class of drugs. Therefore, we anticipate outperformance of EDL manufacturers in the mid/long term.

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Essential Drug List 101

Definition of National Essential Drug List (EDL)

EDL system is the key to China’s healthcare reform National drug policy reform is one of the most important components of China’s healthcare reform. The primary objective of the national drug policy reform is to establish a drug supply system based on a national EDL system and to ensure drug supply and safety for the public. The main contents of the EDL system, set up by the community and state departments, are reasonable selection of drugs; complete policies on EDL drugs’ production, supply, use, pricing and reimbursement; and ensuring the public’s basic drug demand is met.

Essential drugs should be affordable and easily accessible to the public The concept of “Essential Drugs” was named by the World Health Organization in the 1970s. It refers to drugs that can satisfy basic medical care demand with appropriate dosage/formulation, stable supply, and suitability for grass roots healthcare institution use. The drugs should also be equally accessible to everyone with regards to safety, necessity, effectiveness and low prices.

EDL system may lead to consolidation of drug manufacturing and distribution sector The government stated that the establishment of the EDL system will assist in consolidating drug manufacturing and distribution, regulating medical service, enhancing reasonable drug usage and price, and ensuring the public has access to basic medical service. The EDL system can also meet the public’s basic healthcare needs.

History of EDL

China published its first EDL in 1996 The Chinese government started the EDL project in 1992. After four years of research, the first version of the EDL was published in 1996, with 699 chemical and biological drugs and 1,699 TCM drugs, totaling 2,398 drugs. Since then, the State Food and Drug Administration (SFDA) has made adjustments based on the 1996 version, but the total number of drugs on the EDL has always hovered around 2,000. The number of TCM drugs, as a percentage of total drugs on the EDL, was 71% in the 1996 version and then decreased to around 62%. In the current EDL, TCM drugs account for only 33%. Chemical and biological drugs increased from 29% in 1996 to 37% in 2004 and jumped to 67% in 2009.

EDL as part of medical reform plan, ensures accessibility and cuts medical costs In August 2009, the Ministry of Health (MOH) published the EDL with 307 essential drugs, as part of the medical reform plan to 1) create an essential medicine system; 2) ensure the public's access to essential drugs and 3) cut their medical costs. According to the MOH, the EDL will be adjusted every three years based on healthcare demand. We believe a much shorter EDL should make the implementation of the EDL system much easier. This also indicates the government’s determination to reform the national drug policy.

The creation of the EDL

system is to ensure the

public’s most basic drug

demand is met, and it could

potentially lead to the

consolidation of drug

manufacturers and

distributors

First EDL was published in

1996 and consisted of over

2,000 drugs. Current EDL

consists of 307 drugs and its

short length should make

implementation of EDL

system much easier

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China’s Health Minister Chen Zhu indicated that the system would help safeguard people's basic rights in using drugs, and promote the integration of drug manufacturers and distributors. By 2020, all state-owned health institutions in both urban and rural areas should give priority to using essential drugs.

Figure 1: Historical EDLs 1996 1998 2000 2002 2004 2009

chemical and biological drugs

699 740 770 759 733 205

% of total 29% 32% 38% 38% 37% 67%

TCM drugs 1699 1570 1249 1242 1260 102

% of total 71% 68% 62% 62% 63% 33%

Total 2398 2310 2019 2001 1993 307

Source: NDRC, SFDA

Source: NDRC, SFDA

Figure 2: Chemical and biological drugs Figure 3: TCM drugs

0

200

400

600

800

1000

1200

1400

1600

1800

1996 1998 2000 2002 2004 2009

0

100

200

300

400

500

600

700

800

900

1996 1998 2000 2002 2004 2009

Source: Deutsche Bank Source: Deutsche Bank

Current version of EDL

EDL is broken down into chemical/biological drugs and TCM drugs The current version of the EDL was validated on 21 September 2009, a month after its publication. This EDL has three components: chemical and biological drugs, TCM drugs and TCM tablets. There are 307 drugs in this version of the EDL, with 205 chemical and biological drugs and 102 TCM drugs. For TCM tablets, no specific names were included. Chemical and biological drugs are divided into 24 therapeutic classes, such as antimicrobial agents, antiparasitic and anesthetic. TCM drugs are categorized into six traditional Chinese therapeutic classes, including internal medicine, gynecology medicine and ophthalmic medicine. The EDL mainly consists of low-priced or generic drugs.

Current EDL shrank by 85% from the 2004 EDL Compared with the 2004 EDL, the current EDL has shrunk by 1,686 drugs, or 85%, with the majority of the reduction in the TCM drug list. The ratio of chemical and biological drugs to TCM drugs also changed from 1:2 in 2004 to 2:1 in 2009. In publishing the 2009 EDL, the government emphasized that the selection of EDL drugs shifted from clinical needs to preventative needs. Furthermore, despite the drastic reduction in the

EDL drugs are also included

in NDRL and generally have

higher reimbursement ratios.

We believe that a new EDL

will be published in 2012

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number of drugs included in the current EDL, the design of the EDL is aimed at covering at least 80% of basic clinical needs.

EDL drugs are also included in NDRL Class A list Drugs on the EDL are also included in the Class A list of the National Drug Reimbursement List (NDRL) and, under the Basic Medical Insurance scheme (BMI), do not require upfront copayment; instead, the drug cost will be included in the final reimbursable healthcare expense and is reimbursed according to the BMI scheme of that particular jurisdiction.

Current EDL is not complete and awaits newest version We also noted that the current version of the EDL is only the first part of the complete list and is intended for primary healthcare facilities, including all disease prevention centers, grass roots healthcare institutions and community health centers. Part II of the EDL has not been released yet and is supposed to include drugs that should not be used by primary healthcare facilities. Based on the MOH’s mandate that the EDL be adjusted every three years, we believe that the new EDL will likely be published in 2012. We show the first 10 drugs listed in the EDL in Figure 4.

Figure 4: First 10 drugs in EDL No. English Name Dosage Form

1. Anti-microbial drugs

Penicillin

1 Benzylpenicillin injection

2 Oxacillin injection

3 Ampicillin injection

4 Piperacillin injection

5 Amoxicillin regular oral dosage form

6 Amoxicillin and Clavulanate Potassium regular oral dosage form

Cephalosporin

7 Cefazolin injection

8 Cefalexin regular oral dosage form, granule

9 Cefuroxime regular oral dosage form, granule

10 Ceftriaxone injection

Source: MOH

Provincial EDLs expanded based on national EDL

According to related policies, local governments can make adjustments to the national EDL when creating provincial EDLs. On average, provinces added 174 drugs to the EDL, with 90 chemical and biological drugs and 84 TCM drugs. We list the number of drugs on provincial EDLs.

In creating provincial EDLs,

provinces added 174 more

drugs to the national EDL on

average

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Figure 5: Provincial EDLs

Region Total Chemical Chemical % of total TCM TCM % of total

Shanghai 689 442 64% 247 36%

Jiangsu 608 397 65% 211 35%

Zhejiang 457 302 66% 155 34%

Anhui 574 390 68% 184 32%

Fujian 307 205 67% 102 33%

Jiangxi 307 205 67% 102 33%

Shandong 521 350 67% 171 33%

Beijing 497 N/A N/A N/A N/A

Tianjin 536 324 60% 212 40%

Hebei 500 304 61% 196 39%

Shanxi 514 337 66% 177 34%

Inner Mongolia 307 205 67% 102 33%

Liaoning 517 340 66% 177 34%

Jilin 664 364 55% 300 45%

Heilongjiang 426 269 63% 157 37%

Guangdong 540 314 58% 226 42%

Guangxi 503 N/A N/A N/A N/A

Hainan 307 205 67% 102 33%

Shaanxi 498 317 64% 181 36%

Gansu 513 305 59% 208 41%

Qinghai 407 235 58% 172 42%

Ningxia 369 230 62% 139 38%

Xinjiang 530 307 58% 223 42%

Chongqing 512 335 65% 177 35%

Sichuan 338 230 68% 108 32%

Guizhou 407 237 58% 170 42%

Yunnan 403 267 66% 136 34%

Tibet 762 205 27% 557 73%

Henan 610 339 56% 271 44%

Hubei 484 357 74% 127 26%

Hunan 505 317 63% 188 37%

China 307 205 67% 102 33% Source: Deutsche Bank

EDL pricing

NDRC sets price caps on EDL drugs EDL drugs are subject to price caps (set by the National Development and Reform Commission, or NDRC) to ensure fair pricing and accessibility of key medicines for the public. Additionally, essential drugs used by state facilities are bought by compulsory tenders at the local level.

According to current healthcare reform policies, EDL drug pricing should follow the measures listed below:

EDL drugs are subject to

price ceiling set by NDRC;

additionally, grassroots

hospitals should adopt zero

mark-up rule for EDL drugs

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EDL drugs are priced by the government at the same suggested retail prices; operators can independently decide the actual purchase and selling prices under government regulations

Provincial governments decide the procurement prices (distribution cost included) according to the actual tender results. The procurement prices should accord with the suggested retail prices

Grass roots healthcare institutions should adopt a zero mark-up rule for the distribution of EDL drugs, and other non-profit healthcare institutions should also gradually adopt the zero mark-up rule

Policies related to EDL procurement process

Article No. 56, a landmark guideline for EDL procurement On November 19, 2011, the state department released the no.56 article, Guidelines on Establishing and Standardizing the Essential Drugs Procurement Mechanism for Government-funded Medical and Health Institutions at Basic Healthcare Institutions.

In order to standardize the purchase of essential drugs at government-funded grass-root hospitals and clinics and to ensure the implementation of the essential drug system, the Chinese central government published its guidance on the essential drugs procurement mechanism in December 2012. According to the guidance, the medicines on the essential drug list (EDL) should be procured at the provincial level, to achieve rationalization of the procurement cost, to reduce the supply price level and to promote the production and supply of essential drugs.

The major guidelines for establishing and regulating the essential drug procurement mechanism include the following:

A provincial-level procurement platform of essential drugs would be established by the provincial health administration to seek procurement from manufacturers through tenders. The procurement agency appointed by the provincial health administrative is responsible for the operation, management and maintenance of the platform. The grassroots health institutions enter into delegated a procurement contract / agreement with the dedicated procurement agency.

The procurement agency will consolidate the demand of essential drugs from the grassroots health institute. The provinces that cannot determine the procurement quantity can go through a single supplier, requiring it to make a commitment for the procurement of an essential drug, with the dedicated supplier taking the entire market share for that particular drug.

The procurement price shall not be higher than the market selling price.

The procurement price plus delivery cost mark-up from the centralized procurement will be the selling price by the grassroots healthcare institutions.

Adopting different procurements methods for different types of drugs:

Exclusive drugs could be purchased directly from manufacturers or distributors through negotiation or a dedicated manufacturing arrangement;

Necessities but less commonly prescribed drugs could be purchased through a tendering or negotiations system;

Commonly used and low-priced drugs could be purchased through tendering;

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Psychotropic drugs, treatment of infectious and parasitic diseases, vaccine for immunization, birth control and herbal medicines would continue at country-level purchasing system;

The others are through public tendering process, if the bidding price is higher than the actual market price. It would be declared nullified bidding if the procurement agency fails to negotiate with the supplier.

If the essential drugs cannot be procured through any of the above mentioned procedures, the procurement agency can search for alternatives with consents from provincial healthcare authorities.

Less commonly prescribed medicines could be ordered from drug wholesalers or distributors

Double-envelope, a quality and pricing evaluation tendering system, is encouraged for enhanced quality assurance of essential drugs.

The procurement agency will enter a contract with the drug supplier on behalf of grassroots health institutions with strict payment terms for the purchase of essential drugs. The payment term should be no longer than 30 days from acceptance to delivery of drugs (the specific number of days to be agreed upon in the contract).

Drug suppliers could be penalized if found guilty of fraud, manipulation of drug prices, or bribery.

The State Food and Drug Administration (SFDA) is urged to improve the national drug digital monitoring network and tighten monitoring of all essential drug products to ensure the transparency of the procurement system.

EDL drug procurement process

Provinces purchase drugs listed on the EDL through centralized procurement. Provincial MOHs appoint officials from public hospitals and the government to form a committee to head the centralized procurement platform. Provinces generally hold separate procurement processes for EDL and RDL drugs annually. Figure 6 illustrates the general procurement process. In the occasion where tendering fails to receive a successful bid for a drug type (often because drug companies drop out in the middle of the tendering process or the tendering committee disqualifies drug companies), the committee will hold additional tendering for that drug type.

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Figure 6: Drug procurement process

Purchasing office

announces initiation of

tender and list of drugs

Registration by pharmaceutical

companies

Announcement of selected

pharmaceutical companies and

drugs

Announcement of selected distributors

Announcement of final tender

result

Announcement of price ceiling

Companies submit initial

bid

Companies undergo online

price bargaining

Source: Deutsche Bank

Anhui model tender process

Anhui model of EDL drug tender process won national government’s support In August 2010, Anhui province announced its EDL drug tender implementation method for centralized procurement. The method was very aggressive and introduced many new measures. Since the Anhui tender model was designed based on “Instructions on EDL procurement mechanism for government healthcare institutions”, the tender method could be a potential model for China’s drug tender in the future. Additionally, the Vice Governor of Anhui, who spearheaded the Anhui EDL implementation, has been promoted to the vice minister of the NDRC. Currently, he is also the chief of the Office of the State Council’s Leaders Group for Deepening Pharmaceutical and Health System Reform. This may further facilitate the national adoption of the Anhui model tender process for EDL drug procurement.

Anhui model is noteworthy for its “double-envelope” method and single supplier mandate The following are the main measures in the Anhui model:

The “double-envelope” tender method – technical tender first, then the commercial tender. Technical tender focuses on drug quality and reliability, referring to GMP, manufacturer scale, industry rankings, reputation, etc., while commercial tender takes the lowest-priced drug as the tender winner. The final tender price cannot be higher than the suggested retail price or the average of the final tender prices in 11 other provinces.

Link tender price with quantity – the procurement plan should identify the quantity and then determine the tender price. The manufacturer could also win the distribution contract

Single supplier – every EDL drug tender would only have one manufacturer as the final winner. If it wins the tender, then this manufacturer will win 100% market share in all grassroots healthcare institutions in the province

To participate in the tender, a drug could have three types of formulations, and two different dosages for each formulation – there were a total of 278 drugs with 852 specifications in the Anhui tender

Anhui model’s “double-

envelope” method and single

supplier mandate form the

basis for centralized

procurement

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Provincial level government is responsible for EDL drug procurement and to be delegated authority from grassroots hospitals to sign contracts with drug manufacturers. The contract should identify all aspects of the drug procurement

Manufacturers are responsible for distribution. Distribution tenders will not be held. The manufacturers should ensure drug supply according to the contract

Distribution transferable – drug manufacturers can entrust distributors to deliver drugs, but manufacturers are responsible for distribution

The local government treasury is in charge of clearing, and payment days should be no more than 30

We summarize the Anhui model tender process in Figure 7.

Figure 7: Anhui model tendering process

Drugs enter technical

tender (criteria include quality,

scale, sales, ranking,

reputation, past records)

Select top few drugs to enter

commercial tender based on ratings in

technical tender (e.g. 2 out of 4, 4 out

of 10, etc.)

Selected drug companies

submit bidding price

In principal, the lowest priced drug

wins commercial tender (final

tender)

If bidding price exceeds price ceiling, drugcompanies

may potentially enter price negotiation


Selective achievements and improvement opportunities

42% average price reduction on national average The most significant achievement for the EDL tender is price reduction, at a 42% national average according to media reports. Volume increase, which was widely expected before EDL implementation, did not seem to materialize. Instead, anecdotal evidence suggested that certain drugs experienced volume reduction due to discount pricing.

According to the deputy head of the Health Bureau of Anhui province, in 2011, 1,747 grassroots medical institutes in the province purchased drugs listed in the EDL through the provincial centralized procurement platform with total purchase value of RMB1.7bn and total distribution value of RMB1.61bn at a distribution rate of 96.7%.

Single supplier mandate creates significant downward pressure on drug tender prices The Anhui model, where the tender is awarded to the manufacturer with the most competitive pricing, is quite different from other tender processes, whereby multiple manufacturers can share the tender order for the same drug (of the same dosage and format) at the same or slightly different prices. The Anhui model thus implies that one manufacturer could take the entire market share, creating significant downward pressure on EDL drug prices. According to the Health Department of Anhui, the

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tendered drug prices were substantially lower than prices in other provinces in China, with as much as a 47.22% drop in prices.

All except three provinces/cities completed EDL tender in 2011 All provinces completed the 2011 EDL tender, except Beijing, Tianjing and Tibet, in 2011. For 2012, we estimate the majority will implement the Anhui model for EDL tenders. Figure 8 tracks the Anhui model implementations of the provinces.

Figure 8: EDL tender tracker

Province Province2011 tender

processGuideline

release dateDouble

EnvelopeSingle supplier

Anhui Model

2012 tender process

山东 Shandong Completed Jan-11 Y Y Y Completed天津 Tianjin TBD TBD Y Y Y Completed广东 Guangdong Completed Jun-11 Y Y Y Completed浙江 Zhejiang Completed Jun-11 Y Y Y Completed江苏 Jiangsu Completed Mar-11 Y Y Y In process内蒙古 Inner Mongolia Completed Feb-11 Y Y Y In process辽宁 Liaoning Completed Mar-11 Y Y Y In process吉林 Jilin Completed Aug-11 Y Y Y In process海南 Hainan Completed May-11 Y Y Y In process宁夏 Ningxia Completed Jan-11 Y Y Y In process新疆 Xinjiang Completed Aug-11 Y Y Y In process四川 Sichuan Completed Jan-11 Y Y Y In process贵州 Guizhou Completed May-11 Y Y Y In process江西 Jiangxi Completed Mar-11 Y By regions Y In process广西 Guangxi Completed May-11 Y Y Y In process重庆 Chongqing TBD TBD NA NA TBD In process青海 Qinghai Completed May-11 Y Y Y In process山西 Shanxi Completed Apr-11 Y Y Y In process湖南 Hunan Completed Jun-11 Y Y Y In process河北 Hebei Completed Jul-11 Y Y Y Not started上海 Shanghai Completed Dec-10 N N N Not started安徽 Anhui Completed Aug-10 Y Y Y Not started福建 Fujian Completed Jan-11 N N N Not started北京 Beijing TBD TBD NA NA TBD Not started黑龙江 Heilongjiang Completed Mar-11 Y Y Y Not started陕西 Shaanxi Completed Aug-11 N N N Not started甘肃 Gansu Completed Jun-11 Y Y Y Not started云南 Yunnan Completed Jan-11 Y N (two suppliers) Y Not started西藏 Tibet TBD TBD NA NA TBD Not started河南 Henan Completed May-11 Y Y Y Not started湖北 Hubei Completed Mar-11 Y Y Y Not started

Source: Provincial Ministry of Health: Deutsche Bank

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Figure 9: Price reduction after tendering process

Generic Name(form) Company Speci fication

Ave TP under Anhui

model Min TP Latest TP

Oldest TP (Guangdong

TP)% Latest VS.

Ave% Latest VS.

oldest

Shenmai(10ml) Shineway Injection 4.52 1.89 1.89 5.57 -58% -66%

Qingkai l ing(10ml) Shineway Injection 1.32 0.94 0.94 1.87 -29% -50%

Penici l l in Sodium injection(0.48g) Ruiyang Pharma Menstruum crysta l 0.22 0.17 0.21 0.28 -5% -25%

Ceftriaxone Sodium(0.5g) North China Pharma Menstruum crysta l 0.81 0.72 0.73 0.90 -10% -19%

Huo Xiang Zheng Qi Shui (10ml) Yunnan Tenyao Tincture 2.30 0.51 0.51 1.00 -78% -49%

Ampici l l in sodium injection(1g) Sichuan Pharma Frozen powder injection 0.57 0.45 0.61 0.70 7% -13%

Cefuroxime Axeti l (0.125*12) Shenzhen Li jian Capsules 9.85 6.74 10.26 13.51 4% -24%

Azi thromycin(0.25*6) Da l ian Mei luo Tablets 2.26 1.98 2.19 2.30 -3% -5%

Shedan Chuanbei (10ml*6) Wuhan Tai fu Syrup 2.06 1.73 1.73 2.25 -16% -23%

Fol ic acid(5mg*100) Changzhou Pharma Tablets 1.02 0.83 1.30 1.13 27% 15%

Compound berberine tablets(30mg*100) Ta i ji Group Tablets 2.68 1.98 6.40 1.90 139% 237%Source: Deutsche Bank; MOH

Figure 10: Qing Kai Ling Figure 11: Ampicillin sodium injection

2.38 2.43

1.96

2.86

2.02 2.02

2.27 2.302.19

2.35 2.43 2.43 2.432.31

2.40

2.10

0.94 1.00 1.00 1.07 1.03 1.03 1.03 1.00 1.041.15 1.10

1.49

1.751.66

1.79 1.791.98

1.87

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Shan

ghai

Shan

ghai

Shan

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unan

Hun

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Heb

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anjin

Hun

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angx

iJi

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ner …

Jilin

Gua

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Gan

suH

ubei

Yunn

anH

eilo

ngjia

ngSi

chua

nSh

ando

ngN

ingx

iaA

nhui

RMB

under Anhui model

Non Anhui model

0.82

1.10 1.15

1.27

0.90

1.28

0.95

1.12 1.10

0.61

0.48 0.45 0.49 0.50 0.50 0.50 0.54 0.54 0.55

0.68 0.70

0.82

-

0.20

0.40

0.60

0.80

1.00

1.20

1.40 RMB

under Anhui model

Non Anhui model

Source: Deutsche Bank; MOH Source: Deutsche Bank; MOH

Figure 12: Ceftriaxone Sodium Figure 13: Shedan Chuanbei

1.45

2.15 2.29

1.60 1.75

2.29 2.14

3.02

2.29 2.29

3.20

0.73 0.72 0.73 0.80 0.81 0.81 0.84 0.90 0.87 0.90

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50 RMB

under Anhui model

Non Anhui model

5.50 5.00 5.00 5.00 5.00 5.00

5.50

1.73

3.58

1.90 1.69 1.92 2.00 1.89 1.88 1.91 1.95 1.88 1.95 2.20 2.10 2.00 2.20 2.25

-

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

under Anhui model

Non Anhui model


6 August 2012

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China Healthcare


Figure 14: Penicillin Sodium injection Figure 15: Azithromycin

0.32

0.40 0.44 0.44 0.44 0.44 0.44

0.21 0.22

0.17 0.18 0.19 0.19 0.20 0.24 0.24

0.27 0.26 0.28

-

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50 RMB

under Anhui model

Non Anhui model

2.25

4.60

3.91

2.87

4.08

4.50 4.50

3.91 3.91

2.19 2.11 2.23 2.00

2.22 2.22 2.19 2.24 1.98

2.25

3.48

2.25 2.20 2.14 2.20 2.20 2.30

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00 Non Anhui model

under Anhui model


Exception: CDDP had significant volume increase under Anhui model Under the Anhui model, most EDL producers have been suffering from price and volume erosion, which has seriously affected their revenues and margins. However, there are still some exceptions, such as Tasly Pharm’s (600535.SS) product Compound Danshen Dripping Pills (CDDP). The CDDP are included in the EDL and account for approximately 70% of Tasly Pharm’s revenue. Compared with the 47% average price erosion under the Anhui model, the tender price of Compound Danshen Dripping Pills (27mg*180) only dropped 3% to RMB25.2 in Guangdong in June 2012, from RMB25.91 in Liaoning in Feb 2010. At the same time, the revenue of Tasly Pharm has increased 114% YoY from 1Q10 to 1Q12, which translated into the drastic volume increase. See Figure 16 and Figure 17 for the pricing and revenue trends of Compound Danshen Dripping Pills (27mg*180) and Tasly Pharm.

Figure 16: Price track of CDDP Pills (27mg*180) Figure 17: Revenue trend of Tasly Pharm

22232425262728293031

RMB

0%

10%

20%

30%

40%

50%

60%

0

500

1000

1500

2000

2500

3000

1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12

Revenue (RMB M) YOYRMB M

Source: Deutsche Bank; MOH; company data Source: Deutsche Bank; company data

Anhui model may also drive

out smaller players, leading to

drug industry consolidation

and therefore benefiting the

major players

6 August 2012

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China Healthcare


Anhui model may lead to consolidation It is widely believed the Anhui model may drive out smaller market players and therefore help the government to achieve its objective of drug manufacturing and distribution consolidation. On the other hand, certain drug companies view Anhui model adoption as an opportunity to expand their market share.

In 2011, only 4,422 out of 9,676 drugs passed the technical hurdles and entered commercial tendering; primarily small manufacturers with lower assurance of product quality couldn’t make the cut. In addition, 88 out of 392 winning drug manufacturers are ranked amongst the top 100 manufacturers, according to the Ministry of Industry and Information Technology (MII); 188 out of 392 winning drug manufacturers are ranked in the top 400. Meanwhile, 46.8% of 297 drugs listed in the provincial supplement drug list come from the top 100 manufacturers and 65.6% from the top 400 manufacturers.

Figure 18: Tendering processes

Over 9,676 drugs from1,202 drug manufacturers

nationwide enter tender

7,676 drugs with effective

quotations are selected to enter technical tender

4,422 drugs qualified for

technical tender enter commercial tender based on

ratings in technical tender

Over48% of winning drug

manufacturers are ranked amongst

top 400 manufacturers.

22% of winning drug

manufacturers are ranked amongst

top 100 manufacturers

Source: Deutsche Bank; NOH

Figure 19: Competitive landscape of top 400 Figure 20: Competitive landscape of top 100

Others52%

Top 400 manufacturers

48%

Others78%

Top 100 manufacturers

22%

Source: Deutsche Bank; MI Source: Deutsche Bank; MOO

Anhui model may also drive

out smaller players, lead to

drug industry consolidation

and therefore benefit the

major players

6 August 2012

Health Care

China Healthcare


Implementation status in Anhui: so far so good In 2011, Anhui province purchased RMB1.25bn essential drugs, which accounted for over 75.1% of total purchasing value; the purchase value of provincial supplement drugs was RMB390m, which accounted for 23.3% of total procurement value over the same period. With strict control over the procurement of drugs, we expect the utilization rate of essential drugs to improve.

Implementation status in the rest of China: lack of clarity, but results mixed It remains challenging to estimate the actual status of EDL implementation, due to lack of data. However, anecdotal data suggests that results could be mixed. For example, only 40% of the basic healthcare institutions purchased EDL drugs through the province-based platform, while the rest (60%) conducted drug purchases through their own channels, as if province-based centralized procurement did not exist.

Anhui model faces fierce industry opposition: drug quality played as card Drug margin erosion due to the Anhui model implementation caused the pharmaceutical industry to oppose adoption of the model. In their statements, the bidding price may be substantially lower than the production cost as a result of competitive underbidding. Industry experts also suggest the Anhui model may lead to deterioration of drug quality as manufacturers try to lower the cost of production to counter price erosion; quality producers of medicine may also be driven out of the market as underbidding continues. Moreover, we sensed the industry was concerned the Anhui model may be applied to RDL drug tendering as well; whereas EDL drugs account for 8-10% of drug sales in China, RDL drugs account for 65-70%. If RDL tendering were to follow the Anhui model, the impact could be much larger. Our Beijing contact indicated that decision makers intend to keep tender processes for EDL/RDL drugs separate, so RDL tendering is unlikely to adopt the Anhui model.

In addition to potential drug quality deterioration, some industry experts also criticized the single supplier mandate in the Anhui model because, for the same drug type, it deprives the public of the freedom to choose from different drug companies. They suggested that Anhui model implementation lowers the quality of drugs used in primary healthcare facilities and therefore induces patients to choose higher tier hospitals over primary healthcare facilities; this would eventually hurt public interest. We illustrate the effect of the Anhui model on the prices of a few selected drugs in Figure 21-Figure 24. We note that among all the provinces that adopted the Anhui model, Anhui’s actual tender price was not the lowest and tender prices continued to decline with time. This shows that underbidding continued to lower drug tender prices.

6 August 2012

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Figure 21: Penicillin Sodium (0.48g) Figure 22: Folic acid

0.32

0.40 0.44 0.44 0.44 0.44 0.44

0.21 0.22

0.17 0.18 0.19 0.19 0.20 0.24 0.24

0.27 0.26 0.28

-

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50 RM B

under Anhui model

Non Anhui model

0.90

1.45

1.79

2.17

1.57

2.10

1.30 1.17

0.98 0.98 1.01 0.83

1.06 1.00 0.99 0.96 1.00 1.03

0.83

1.13

-

0.50

1.00

1.50

2.00

2.50

RM B

under Anhui model

Non Anhui model

Source: Provincial Ministry of Health Source: Provincial Ministry of Health

Figure 23: Cefuroxime Axetil (0.125g 12 pills/pack) Figure 24: Qing Kai Ling (10ml)

8.67

18.60

16.57 15.80

16.60

10.26

8.45

6.74 7.70

13.87

9.52

7.50 7.76

11.80

10.11 9.90 9.89 9.64 10.32 10.60

13.51

-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

RM BNon Anhui model

under Anhui model

2.382.43

1.96

2.86

2.022.02

2.272.302.19

2.352.432.432.43

2.312.40

2.10

0.941.001.001.071.031.031.031.001.041.151.10

1.49

1.751.66

1.791.79

1.981.87

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50Sh

ang

hai

Shan

gh

ai

Shan

gh

aiIn

ner

…

Hu

nan

Hu

nan

Hu

nan

Heb

eiH

ebei

Heb

eiH

ebei

Ch

on

gq

ing

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on

gq

ing

Ch

on

gq

ing

Ch

on

gq

ing

Gu

izh

ou

Gu

ang

do

ng

Tian

jin

Hu

nan

Jian

gxi

Jian

gsu

Jian

gsu

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gsu

Inn

er …

Jilin

Gu

ang

xi

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suH

ub

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un

nan

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lon

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Sich

uan

Shan

do

ng

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gxi

aA

nh

ui

RM B

under Anhui model

Non Anhui model

Source: Provincial Ministry of Health Source: Provincial Ministry of Health

Anhui model may reach a compromise in 2012-13 There is still much speculation about the possibly of further national adoption of the Anhui model. While 24 provinces have adopted the Anhui model, key regions such as Beijing and Shanghai showed few signs of doing so. It is difficult to conclude whether the Anhui model will continue its expansion without modifications. We believe compromise between the regulator and drug industry will likely be achieved in 2012-13. Additionally, we expect to see reshuffling in the NDRC sometime next year, and this may also affect the possibility of the national adoption of the Anhui model.

Shanghai model is hard to duplicate In December 2010, Shanghai announced its implementation method for EDL drug centralized procurement. Unlike the Anhui model, the Shanghai model does not use the double-envelope method; whereas the Anhui model selects tender winners based on price as long as those drugs pass the technical tender, the Shanghai model considers quality and price together and gives 70% weighting to quality and 30% to price when selecting the tender winner. For the same drug, the Shanghai model divides drugs into “standard quality” and “premium quality”, and drug companies could win tendering in both. This benefits drug companies with higher quality and cost. The pharmaceutical industry far prefers the Shanghai model to the Anhui model; however, the industry also

Shanghai model weighs

quality over price and is much

preferred by the drug

industry, but it is too

expensive to replicate in other

regions

6 August 2012

Health Care

China Healthcare


believes that not all regions can afford the Shanghai model, and it is unlikely to be adopted at the national level.

Hebei implemented uniform pricing for selected drugs In September 2011, Hebei province announced uniform-pricing procurement for sodium chloride, glucose, and glucose sodium chloride injections; the prices set for these drugs were similar to or slightly above the tender prices of other provinces that adopted Anhui model. Hebei province also announced a list of drug companies that are eligible to supply these drugs, and these companies are those that won the last centralized tendering in Hebei. Hospitals have the freedom to purchase these drugs from eligible drug companies at prices equal to the announced uniform prices. This procurement process avoided competitive underbidding and gave hospitals the freedom to choose drug companies.

Government may start experimenting with national uniform pricing According to its “Five priorities of healthcare reform: major tasks in 2011”, the national government will implement national uniform pricing for drugs with stable supply and pricing following repeated centralized tendering. Public reports also suggested that the national government may experiment with uniform pricing for 41 drugs that have stable supply and pricing and then slowly expand the drug selection. For these drugs, tendering will switch from “double-envelope” to “single-envelope” because drugs will be selected based on quality if their bidding price equals the uniform price. This may finally put a stop to the vicious cycle characterized by competitive underbidding driving down the national average tender price and thus forcing more price drops in the following rounds of tendering; and this may also benefit drug companies with better quality. Yet, it will be difficult to set the perfect price that is not too high to undermine the EDL system or too low to hurt the drug industry.

Potential EDL expansion

Updates on EDL expansion It is widely expected that the new EDL will be released in August 2012, with either 500 or 700 drugs on it. A version of the new EDL has already surfaced online; we examined the list and believe it is likely to be a provincial EDL. We continue to believe that new additions to the EDL will face pricing pressure in the near term, while long-term volume benefits will emerge.

Background on EDL Expansion EDL adjustment is stated in the “Five priorities of healthcare reform: major tasks in 2011”. We believe that the future EDL adjustment will most likely focus on adding drugs. Industry experts also expect that the new EDL list will consist of about 766 drugs, with the majority of the additions from the RDL Class A list and a select few from the RDL Class B list. Expansion of the EDL may be a solution to the lack of drug and dosage form within the EDL. As previously discussed, the 2009 EDL contained 307 drugs and aimed to cover at least 80% of drug demand; however, after two years of EDL system implementation, the lack of drug types and dosage forms remains a concern. The main reasons for the lack of drugs and dosage forms of EDL are:

�Different prescription habits in China – Generally, grassroots healthcare institutions have around 300 drugs available, and this varies by regions. In some cases, only 50% are included in the EDL list

Grassroots healthcare institutions are providing more healthcare services to patients, and the demand for non-EDL drugs is expanding

National government may

start experimenting with

uniform pricing for selected

drugs with stable pricing and

supply; Hebei also

implemented uniform pricing

for sodium chloride injection

and other drugs

6 August 2012

Health Care

China Healthcare


Community healthcare centers in urban areas take over many patients from higher tier hospitals. These patients require the same high-end non-EDL drugs they get in higher tier hospitals

As discussed previously, the current EDL is only the first part of the complete list; the second part hasn’t been published and should consist of drugs intended only for higher tier hospitals. Therefore, we believe that new EDL drugs will most likely be drugs that are riskier and pricier than the existing ones. Industry experts also commented that anti-tumor and cardiovascular drugs as well as drugs associated with other chronic disease treatments will likely be the top picks of the expanded list, as the current EDL includes few of these drug types.

6 August 2012

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China Healthcare


Company exposure to EDL

The United Laboratories (3933.HK)

TUL has limited direct exposure to EDL due to its product mix TUL’s total sales are broken down into raw medicine, intermediate products and finished products, with finished products accounting for approximately one-third of its total revenue in 1H11. Therefore, this naturally reduces TUL’s direct exposure to EDL since the EDL does not include any raw or bulk medicines. Additionally, not all of TUL’s finished products are listed on the EDL, further reducing the EDL’s impact on TUL’s margin. We show TUL’s revenue breakdown as of FY11 in Figure 25. Because TUL does not provide revenue by drug type but only by antibiotics class, we can only estimate the maximum revenue contribution from each of its EDL drugs. Figure 26 shows the revenue contribution from each antibiotics class; Figure 27 shows the estimated revenue contribution from each EDL drug.

Figure 25: TUL revenue breakdown by business segment as of FY11

Intermediate products26%

Bulk medicine44%

Finished products30%

Source: Deutsche Bank; Company data

Figure 26: TUL revenue contribution from each antibiotics class as of FY11 Finished products % of 1H11 revenue

Semi-synthetic penicillin antibiotics 9%

B- lactamase inhibitor antibiotics 7%

Cephalosporin antibiotics 5%


TUL has limited direct

exposure to EDL because

about only 1/3 of its revenue

comes from its finished

products segment

6 August 2012

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China Healthcare


Shanghai Pharmaceuticals (2607.HK)

EDL drugs account for about 25% of SPH’s manufacturing revenue Shanghai Pharmaceuticals is divided into pharmaceutical distribution, pharmaceutical manufacturing, retail pharmacy, and other businesses, with pharmaceutical manufacturing accounting for 15% of total sales in 2011; however, in terms of operating profits, pharmaceutical manufacturing accounted for 46% in 2011, disproportionately larger than its contribution to revenue. Therefore, pharmaceutical manufacturing is the key to SPH’s profit growth. Within the pharmaceutical manufacturing segment, SPH manufactures over 900 drugs, with 214 of them listed on the EDL, and these EDL drugs account for about 20% of SPH’s manufacturing revenue. We show SPH’s revenue breakdown and operating profit breakdown by business segment as of 2011 in Figure 27 and Figure 28, respectively. We also show SPH’s EDL drugs with annual revenue over RMB100m in 2009 in Figure 29.

Figure 27: SPH revenue breakdown by business segment in 2011

Pharmaceutical distribution

80%

Pharmaceutical manufacturing

15%

Retail pharmacy

4%

Other business operations

1%

Source: Deutsche Bank; company data

Figure 28: SPH operating profits breakdown by business segment in 2011

Pharmaceutical distribution

52%

Pharmaceutical manufacturing

47% Retail pharmacy1%

Other business operations

0%

Source: Deutsche Bank; company data

EDL drugs account for 25% of

SPH’s manufacturing revenue

6 August 2012

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China Healthcare


Figure 29: SPH EDL drugs with sales over RMB100m in 2009 Product Treatment

Ceftriaxone Sodium for Injection

Generic prescription drug used for bacterial infections

Captopril Tablet Generic prescription drug used for hypertension and congestive heart failure

Shenmai Injection Prescription modern TCM used for the treatment of circulatory shock, coronary heart diseases, viral myocarditis, chronic pulmonary heart diseases and neutropenia

Rupixiao Prescription modern TCM used for mammary gland diseases


China Shineway (2877.HK)

EDL drugs account for almost half of Shineway’s revenue Qing Kai Ling injection and Shen Mai injection, two of Shineway’s top sellers, are both listed on the EDL and accounted for 32% and 12% of Shineway’s revenue in 1H10, respectively. Together, they accounted for 44% of Shineway’s revenue in 1H10, or 10% more than their weighting in 2009. In other words, Shineway has a relatively large exposure to EDL. We show our estimated revenue breakdown for Shineway by EDL and RDL drugs as of 1H10 in Figure 30.

Figure 30: Shineway’s revenue breakdown as of 1H10

EDL44%

RDL29%

Others27%


QingKai Ling and Shen Mai

injections account for about

half of Shineway’s revenues

and therefore expose

Shineway to DEL pricing

pressure and policy

uncertainties

6 August 2012

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China Healthcare


Appendix 1

Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. Jack Hu Equity rating key Equity rating dispersion and banking relationships

Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ) , we recommend that investors buy the stock. Sell: Based on a current 12-month view of total share-holder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Notes:

1. Newly issued research recommendations andtarget prices always supersede previously published research. 2. Ratings definitions prior to 27 January, 2007 were:

Buy: Expected total return (including dividends) of 10% or more over a 12-month period Hold: Expected total return (including dividends) between -10% and 10% over a 12-month period Sell: Expected total return (including dividends) of -10% or worse over a 12-month period

58 %

37 %

5 %11 % 14 % 8 %0

50100150200250300350400450500

Buy Hold Sell

Asia-Pacific Universe

Companies Covered Cos. w/ Banking Relationship

6 August 2012

Health Care

China Healthcare


Regulatory Disclosures

1. Important Additional Conflict Disclosures

Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

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3. Country-Specific Disclosures

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