Concentrated Chinese Medicine Granule (CCMG) Market Access Liberalization Remains to Be Seen

After the acquisition of Tianjiang Pharmaceutical in 2015, China Traditional Chinese Medicine (CTCM) has taken the leading position in the domestic CCMG sector. Overall, with outstanding security, effectiveness, convenience and the sustained 15% drug-price addition policy, CCMG may take a part of the Chinese traditional medicine market. Also, currently all TCM hospitals are eligible to sell CCMG, while in the past only those of secondary or above levels did. The CCMG market will maintain high growth, and the company, as a leader, will benefit from its expansion.

Previously only five enterprises produced CCMG, but the market-access policies are likely to be loosened, causing market concerns about disorderly competition. We believe, against the backdrop of the supply-side structural reform, CCMG national standards will be set relatively high in order to ensure TCM quality and protect the brand. Furthermore, within the three years (2017-2019) during formulating the industry standard guidelines, all companies in the industry will be encouraged to conduct research and develop industry standards for more than 500 CCMG products, which only five enterprises are able to sell at present. New manufacturers can only sell CCMG products after meeting the industry standards during the transition period, and are required to undergo a six-month production stability test prior to commercial production. Therefore, we expect new entrants to have very limited impact on the current market pattern.

CTCM has enhanced its core competitiveness through R&D, with the research of high-performance liquid chromatography (HPLC) of more than 150 varieties completed, and will continue to improve corporate internal quality standards. In the meantime, the company will support CCMG's high profitability through the centralized procurement of 105 medicinal materials. In addition, the CCMG marketing network has nearly covered all provinces in China, among which 18 provinces have recorded a sales volume of over RMB100 million. With the further marketing reform in such aspects as academic promotion and incentive system, the marketing advantage of CCMG will be consolidated. It is notable that the company plans to invest RMB2 billion in the next three years to expand production capacity, of which extraction capacity will rise from 28,500 tons to 60,000 tons and granulation capacity from 8,000 tons to 16,000 tons, and this will further enhance the company's scale edge and consolidate its leading position.

Destocking of Chinese Traditional Medicine Basically Ends

In H1, the revenue and net profit from the company's original Chinese traditional medicine business fell by 19.5% and 32.9% to RMB1.14 billion and RMB160 million, respectively, due to the introduction of "two invoices" policy and medical insurance cost control and reduction of inventories in channels, as well as the drop in tender price of the company's products by 3 to 4% on average, and the second bargain in some provinces. In H2, the deepening of destocking led to the decline in drug products over 20% YoY and the scale shrinkage triggered the sharp fall in profits.

However, currently destocking pressure has been basically released, with distributors` channel inventory falling from 4 months turnover at the end of 2015 to around 2 months, and the inflection point has appeared. We expect, in 2017, the company's Chinese traditional medicines will develop steadily, or even resume single-digit growth.

Valuation Reaches Margin of Safety

The company has resumed dividend and will maintain a payout ratio of more than 30%, which is expected to enhance the market recognition. We adopt the Sum of the Parts Valuation (SOTP), and give the company's CCMG business and Chinese traditional medicine business 20X P/E ratio and 10X P/E ratio, respectively. The target price is HK$5.08, with the "Buy" rating. (Closing price as at 23 Jan 2017)

Risks

Further price drop in products;

Competition intensifies more than expected.

Financials

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