Share of Wong Lo Kat Continued to Expand

In 1H16, the company's Great Health business focusing on Wong Lo Kat saw sound development, and its revenue increased by 7.6% to RMB4.7 billion. Specifically, the Q2 revenue witnessed a QoQ increase of nearly 20%. Overall, Wong Lo Kat has recovered the sole right to use the trademark, advertisement, red can packaging and formula assets, contributing to increasingly obvious competitive edge and continued expand in market share. Jiaduobao has changed red cans into gold cans, and hence may lose some of the festive market share. In the meantime, it significantly reduced marketing expenses and changed the management this year. By contrast, Wong Lo Kat will increase terminal investment by virtue of considerable funds, so it is expected to continue enhancing competitive advantage.

Additionally, we are optimistic about the improvements in profitability of Wong Lo Kat. Previously, the expense pressure on the two competitors was immense. Net profit margin of Wong Lo Kat plunged from about 20% to less than 5%, far lower the industry. Nevertheless, presently Jiaduobao emphasizes cost control and reduces advertising investment, so the expense pressure on the two parties was alleviated, and the profitability of Wong Lo Kat is projected to improve. In 2015, net profit margin of Wong Lo Kat rose by 0.23 percentage points to 5.03%.

Grand Southern TCM Business is Expected to Recover

In spite of an increase of over 60% in the revenues of An Gong Niu Huang pill and Jin Ge, the revenue of the company's Grand Southern TCM segment dropped by 7.9% to RMB3.5 billion in 1H16, which was mainly because of the influence of de-stocking by distributors and relocation of such enterprises as Qi Xing Pharmaceutical Factory. However, the improvement in product structure resulted in an increase of 3 percentage points in gross profit margin of Grand Southern TCM to 45.4%. Furthermore, with the relocation and reconstruction of pharmaceutical factories and completion of de-stocking, better performance in the second half of 2016 is expected.

It is worth mentioning that Pfizer's patent protection on Viagra expired. Increase in the company's Jin Ge lived up to expectations. Jin Ge is RMB34.5/pill, 73% cheaper than Viagra, which is RMB128/pill. Besides, the company continues to build drug sales network after private placement. Therefore, we expect that the market share of Jin Ge will significantly increase, and the sales may exceed the original target of RM B300-400 million in 2016.

The Government Participated in Private Placement with Heavy Investment

The company completed the private placement, with the non-public offering price of RMB23.56/share and the total size of RMB7.9 billion. The Guangzhou Municipal Government invested RMB7.3 billion, showing its firm support to the company. The company, as the only pharmaceutical listed platform of Guangdong SASAC, is likely to gather pharmaceutical resources. Additionally, the shareholding by YF Capital would also introduce the resources of Alibaba, so the company may speed up the efforts to promote regional medicine integration in the future.

In conclusion, the company's Grand Southern TCM segment is projected to recover. The profitability of the Great Health segment will be improved, and the Great Commerce segment will witness constant and rapid growth due to policy changes. We grant it 20x EPS in 2016 and the target price of HK$24.48, with the "Buy" rating initially. (Closing price as at 13 Oct 2016)

Risks

Competition of consumer goods market is more intense;

Integration of Grand Southern TCM segment fails to meet expectations.

Financials

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