Expected Return to Profits in 2H

The United Laboratories (TUL) mainly engages in the production and sales of pharmaceutical preparations, raw materials, pharmaceutical intermediates and capsules. In 1H 2016, the company's revenue dropped by 8.6% to HK$3.5 billion, recording a loss of HK$15.1 million, due to the decrease in sales volume and price of the main products. First, the price of the company's main intermediate 6APA and part of the APIs fell. Second, in 1H 2016, TUL's raw material plant in Zhuhai City expanded and upgraded a by-product recovery system starting from March, leading to the decline in amoxicillin production, from 700 ton/month to 200 ton/month. Eventually, the company's sales of 6APA and semi-synthetic penicillin were down by 8.7% and 18.1% Y-o-Y, respectively.

Nevertheless, relevant projects in Q3 have been completed, and some of the previous orders have not been fulfilled. With the gradual release of production capacity, the main product sales will be back on track. At the same time, after more than five years of falling, the recent prices of 6APA, amoxicillin and cephalosporin antibiotics have indicated a slower downtrend, and some varieties even showed signs of recovery. Thus, we expect that the company's intermediates and APIs will gradually return to profits.

Rapid Future Growth in Insulin Business

TUL established the production base of insulin APIs and preparations in Zhuhai in 2010, the largest in China so far, and a total of eight new production plants as of June 2016. Currently, the production scale of the insulin API is up to 3 ton/year, including one ton of second generation insulin, one ton of insulin glargine and one ton of insulin aspart, and 300 million preparations can be produced each year. The diabetes segment is expected to be the company's future focus of development and layout. Moreover, the proportion of Chinese patients with diabetes using insulin to control blood glucose is much lower than 30%, the proportion of developed countries. In addition, the foreign-funded companies have dominated the China's market of the second and third generations of insulin. With the consideration of China's medical insurance control, broad prospects lie before import substitutes of insulin.

In addition, TUL is also expected to become the first domestic enterprise providing both second and third generations of insulin. The company has passed One-in-Three Review (production on-site inspection report, production site sampling inspection report and technical review report for comprehensive views), and is expected to be China's second enterprise producing insulin glargine, contributing to the revenue in 2017. Meanwhile, the aspart insulin has completed clinical trials and is submitting for the production approval. The company's growth rate of insulin sales and revenue was up to 57.8% and 84.3%, respectively, in 2015, and we expect that the rapid growth will continue, being the company's main growth driver.

Cost of Capital May Reduce by Issuing Convertible Bonds

The company recently proposed to issue a USD130 million of convertible bonds with an initial conversion price of HK$5.35. The bonds represent 10.38% of the enlarged share capital if fully conversed to the new shares. This move is to provide lower financing costs for the company because the company's short-term debts were due, which have higher financing costs.

In short, with the stabilization of the antibiotic business and the rapid growth of the insulin business, we expect the company's performance to be significantly improved. We give an estimation of 1.15x BVPS in 2017 and the target price of HK$5.14, with the "Accumulate" rating initially. (Closing price as at 7 Dec 2016)

Risks

Fluctuations in the API prices;

Risks of approval policies.

Financials

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